In her new career in a portfolio management firm, a portfolio manager is learning the way to select securities for including in a portfolio. She has gathered recent data about the market and observed that the govt bond rate is 5.2 per cent and the risk premium for the market is 9.3 per cent. She has identified one security, TSR, with a beta value of 2.8 and an expected return of 19.2 per cent. She becomes confused after finding another security, ZXN, with a beta value of -1.2 and an expected return of 3.2 per cent. For further analysis, she calculated standard deviations for TSR and ZXN as 29.0 per cent and 10.5 per cent respectively. In addition, a correlation coefficient of 0.26 is calculated between returns of these two securities. The portfolio manager is asking for details about the following requirements:

Requirement-a. Draw the Security Market Line (SML) with clear labels and plot these two securities on the graph.

Requirement-b. Are these securities properly priced? If not, explain what we might expect to happen to the prices of these securities in the market.

Requirement-c. Briefly explain with necessary calculation and using your own words to the query of the manager: "Why isn't the total risk of a portfolio simply equal to the weighted average of the risks of the securities in the portfolio?". You can make a portfolio by investing 71 per cent in TSR and the remaining (to make it 100 per cent) in ZXN.

Answer rating: 100% (QA)

Security type ZNX Government Bond Beta ... View the full answer