You are shown the following Markowitz frontier and Capital Market Line, from a UK perspective, when combining UK stocks with German stocks. UK stocks have an expected return of 4% and a standard deviation of returns of 15%. German stocks have an expected return of 10% and a standard deviation of returns of 22%. The correlation between UK and German equity returns is -0.5. The UK risk-free rate is 2.5%.

a) You wish to construct the optimal portfolio with a standard deviation of returns of 5%. What is the expected return to this portfolio? Approximately what proportion of your assets should you place in UK equities, German equities and the risk-free asset to achieve the optimal portfolio with this level of risk?

b) How does your answer to part (a) change if you are prepared to have a standard deviation of returns of 20%? You are not permitted to short-sell equity and are unable to borrow.
 

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Expected return 16% 14%- 12% - 10% 8% m 50 4% - 2% 0% 0% 5% 10% .. 15% Standard Deviation ***** 20% 25% 30% Expected return 16% 14%- 12% - 10% 8% m 50 4% - 2% 0% 0% 5% 10% .. 15% Standard Deviation ***** 20% 25% 30%

Answer rating: 100% (QA)

To solve this problem we can use the principles of Modern Portfolio Theory MPT developed by Harry Markowitz MPT suggests that investors can construct ... View the full answer