FIN 3104 Chapter Notes - Chapter 8: Capital Asset Pricing Model, Market Risk, Weighted Arithmetic Mean

The financial markets of country X are not very developed: there are only two companies, A and B, which are traded. The expected rate of return on A is 8% and 14% on B; the standard deviations of their rates of return are 5% for A and 10% for B and the correlation coefficient between their returns is 0.1.

a. Calculate the expected return and standard deviation of the following portfolios:

portfolio Percentage in A Percentage in B

P1 0 100

P2 40 60

P3 60 40

P4 80 20

P5 100 0

b. Represent in a graph (with the standard deviation of the portfolio on the horizontal axis and the expected returns on the vertical axis) the points corresponding to the combinations of expected return-standard deviation for each of the above portfolios. Draw approximately theset of all feasible expected returns-standard deviations that can be obtained by investing in the two stocks A and B.
c. Which of the above portfolios are ecient?

What is the portfolio of assets?

What is well-diversified portfolio?

What happens to the risk of single investments when it is held as part of a portfolio of assets?

Explain the differences between stand-alone risk, diversifiable risk ,and portfolio risk.

Why should all investors hold well-diversified portfolios rather than individual assets?

Is standard deviation the appropriate risk measure for an individual asset?

Is standard deviation the appropriate risk measure for investor’s portfolio of assets? Explain your answer.

A project in a non-profit business is held as part of what two portfolios?

1. The diversification effect of a portfolio of two stocks: . A. increases as the correlation between the stocks declines. B. increases as the correlation between the stocks rises. C. decreases as the correlation between the stocks rises. D. Both A and C. E. None of the above. 2. Irene Adler is considering investing in the common stock of Holmes and Watson. The following data are available for the two securities. . ................... Expected Return ..... Standard Deviation Holmes .............. 0.12 ......................... 0.08 Watson ............. 0.19 .......................... 0.25 . If she invests 60% of her funds Holmes and 40% in Watson, and if the correlation of returns between these two securities is 0.45, what is the portfolio’s expected return and standard deviation? . A. 14.8% and 12.89% B. 13.6% and 11.03% C. 14.6% and 13.94% D. 14.4% and 11.03% E. 13.21% and 10.08% 3. What does a security bring to the risk of a well diversified portfolio? . A. It brings its standard deviation of possible returns. B. It brings its covariance with the other securities in the portfolio. C. It brings its total risk. D. It brings its unsystematic risk. 4. Diversification can effectively reduce risk. Once a portfolio is diversified, the type of risk remaining is: . A. individual security risk. B. riskless security risk. C. unsystematic risk D. systematic risk 5. Efficient portfolios are those, which offer: . A. Highest expected return for a given level of risk B. Highest risk for a given level of expected return C. The maximum risk and expected return D. All of the above