An investor considers two risky common stocks X and Y. The correlation between X and Y is
Question:
An investor considers two risky common stocks X and Y. The correlation between X and Y is 0.886. A 3-month risk-free Treasury Bill offers an interest rate of 2.25% per annum. The market portfolio’s expected return is 15% and its standard deviation is 6.8%.
The table below summarizes the subjective distributions of returns for stocks X and Y:
State of Economy | Probability | R(X) | R(Y) |
Stagnation | 30% | 5% | 0% |
Stable Growth | 40% | 20% | 5% |
Booming | 30% | 22.5% | 11% |
The investor forms a portfolio P which consists of X with 30% weight and Y with 70% weight.
a) Calculate the expected returns and standard deviations for X, Y and P.
(24 marks)
b) Suppose that all risky assets in the market are correctly priced (no mispricing), calculate the beta coefficients of X, Y and P. What are the proportions of X and Y in the portfolio P such that beta of P is equal to beta of the market portfolio?
(24 marks)
c) Write down the CML equation and prove that portfolio P (30% X and 70% Y) lies under the CML (your answer should be supported by graphs or numbers)
(26 marks)
d) If the investor decides to maximize the benefits of diversification by choosing a portfolio on the CML, describe the portfolios on the CML that dominate portfolio P (your answer should be supported by graphs or numbers)
Expert Answer:
a To calculate the expected return for stock X we can use the following formula Expected return for X 30 5 40 20 30 225 185 Similarly we can calculate the expected return for stock Y as Expected retur... View the full answer
