Question

# You are constructing an investment portfolio. You can invest in American Airlines, Southwest Airlines, and

T-bills. The expected return on American is 7% with a standard deviation of 12%. The expected return on Southwest is 13% with standard deviation of 24%. The correlation coefficient between American and Southwest is .2. The T-bill rate is 2%.

(a) Initially you mistakenly assume that you can only invest in one of the airlines and T-bills. Which airline should you invest in? (Hint: Think about slopes of lines in risk-return space)

(b) Now your realize you can invest in both of the airlines and you want to construct a portfolio by investing solely in the two airlines and yielding an expected return of 10%.

(i) What are the portfolio weights on the two airlines?

(ii) What is the standard deviation of this portfolio?

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