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An investor is faced with two risky asset portfolios (each of which is highly diversified within its asset class) – an equity fund and a bond fund.
The investor is aware that asset returns are not always normally distributed, but is nonetheless prepared to use the normal distribution as a tool for the estimation of approximate portfolio risks and expected returns.
The equity fund has a forecast expected return of +11% pa over the time horizon of 12 months, and the investor is more than 99.7% sure that the range of outcomes will lie between a worst case scenario of about -34%pa and a best case scenario of approximately+56%pa.
The bond fund has a forecast expected return over the time horizon of +4% pa, and an interval between worst and best case scenarios of -8%pa to +16%pa.
The covariance between the equity fund and the bond fund is believed to be approximately +6.
There is a perfectly competitive banking system, where interest rate margins for customers such as this investor have been driven down to zero. The current interest rate on 12 month deposits is 1%pa.
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