There are two risky assets and one risk-free asset available for investment. The two risky assets have the following features: Asset X has an expected return of 25% and a variance of returns of 625%2 (0.04). Asset Y has an expected return on 20% and a standard deviation of returns of 20%. The covariance between the returns on X and Y is 500%2 (0.0500). Short selling risky assets is NOT allowed. The risk-free asset offers a return of 8%.
a) Plot the expected returns and standard deviations of returns of the three assets in a graph. Draw the set of feasible portfolios of only the RISKY assets onto the same graph. Please note: no need to very accurate in your drawing of the assets or the feasible set.
b) What is the optimal combination of risky assets that a risk-averse investor should hold? (Remember that there is also a risk-free asset available – no calculations, just describe).
c) What level of standard deviation risk does an investor have to hold in order to achieve an expected return of 18% on their portfolio?