Why in part (ii) is the variance of return for portfolio (b) from part (i) 0 + 0.85^2 * 0.02^2? The guaranteed return of 5% obviously has no variance but why is the allocation of 0.85 being squared in relation to the variance of i_t? Many thanks in advance.
Hi The return on a portfolio with two risky assets is given by: RP = xA*RA + (1-xA)*RB If the returns RA and RB are independent then the variance of the portfolio return is given by: Var(RP) = xA^2*Var(RA) + (1-xA)^2*Var(RB). This is because Var(a * X) = a^2*Var(X) where a is a scalar and X is a random variable. Hope that helps.
