This individual assignment is (1) to replicate Figure 11.5 on p.385 in your text under three different correlation coefficient assumptions and (2) to replicate Figure 11.6 on page 385, which is nothing but putting all there figures you got in (1) into one figure. To help you do this, I strongly recommend you to read section 11.4 of your text.

This is an INDIVIDUAL assignment designed to provide a better understanding of the concepts of diversification, risk and return trade-off, and the efficient frontier. It will also help you upgrade your Excel skills. You are required to use Excel in order to draw the efficient frontier for a set of given securities (stocks and bonds) and identify the minimum variance portfolio.

Project Description

Assume that you are forming a two risky asset portfolio made up of two mutual funds, (a bond fund and a stock fund). To replicate figure 11.5, you will use the following expected return and standard deviation numbers below. Note that you have three different correlation coefficient numbers. You will find efficient frontiers and minimum variance portfolios under each assumption for correlation coefficient between the bond and stock funds.

Expected return for bonds is 0.07 and standard deviation for stocks is 0.16. Expected Return for stocks is 0.18 and the standard deviation for stocks is 0.27. Assumption-01 Corr(B,S) is 0.90, Assumption- 02 Corr(B,S) is 0.05, and Assumption - 03 Corr(B,S) is -0.85.

Take the following steps:

1. Consider, first, two-asset portfolios formed by varying the weights for the two funds provided above under the assumption-01, correlation coefficient between these two risky assets is 0.90. That is, start with a portfolio that has 0% in the stock fund and 100% in the bond fund and calculate E(r_P) and Standard deviation . Repeat the exercise by increment of 4% for the weight of the stock fund (i.e. recalculate E(r_P) and Standard deviation for a portfolio that has 4% in stocks, then 8%, then 12% etc). Note that as long as you know the weight of the stock fund in the portfolio of two assets, the weight of the bond fund is also known (the two weights should add to 1). When you are done with this step, you should have 26 pairs of data points for (E(r_P), standard deviation of portfolio ), which should be organized in a table similar to Table 11.11 in your textbook.

2. Graph these data points the resulting figure should be your investment opportunity set (your graph should be similar to Figure 11.5 in your textbook, except that it should be closer to a straight line). What is your efficient frontier?

3. Repeat steps 1 through 3 under assumption-02 and assumption-03 for correlation coefficients between these two funds. How and why does the shape of your investment opportunity set change? What is the new minimum variance portfolio in each one of these cases? Explain!

4. Last, combine these three graph into one and you must get a very close to Figure 11.6.

THAT'S IT!