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Chapter 7
Capital Allocation Between the Risky Asset and the RiskFree
Asset
41.Describe how an investor may combine a riskfree asset and one risky asset in order to obtain
the optimal portfolio for that investor.
Answer: The investor may combine a riskfree asset (U. S. Tbills or a money market
mutual fund and a risky asset, such as an indexed mutual fund in the proper portions to
obtain the desired riskreturn relationship for that investor.
The investor must realize that
the riskreturn relationship is a linear one, and that in order to earn a higher return, the
investor must be willing to assume more risk.
The investor must first determine the
amount of risk that he or she can tolerate (in terms of the standard deviation of the total
portfolio, which is the product of the proportion of total assets invested in the risky asset
and the standard deviation of the risky asset).
One minus this weight is the proportion of
total assets to be invested in the riskfree asset.
The portfolio return is the weighted
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This note was uploaded on 01/31/2010 for the course ECON 3660DE taught by Professor Patrickmartinandvitalialexeev during the Spring '10 term at University of Guelph.
 Spring '10
 PatrickMartinandVitaliAlexeev
 Economics

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