Equity markets 16 - Chapter 7 Capital Allocation Between...

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Chapter 7 Capital Allocation Between the Risky Asset and the Risk-Free Asset 41.Describe how an investor may combine a risk-free asset and one risky asset in order to obtain the optimal portfolio for that investor. Answer: The investor may combine a risk-free asset (U. S. T-bills or a money market mutual fund and a risky asset, such as an indexed mutual fund in the proper portions to obtain the desired risk-return relationship for that investor. The investor must realize that the risk-return 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 risk-free 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.

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