Question 3 (30 marks) Joanne, a portfolio manager, is making recommendations to her clients, Mark. Joanne is considering whether to add Stock A or B into Mark's well-diversified portfolio. She has made the following estimates: Table 1: Expected Returns and Standard Deviations of different securities Expected Returns Standard Deviations Stock A ??? 16% Stock B 18% Market index 9% 12% Mark's portfolio 10% 13% Risk-free rate 3% ??? Table 2: Correlation coefficient Market index Stock A 0.66 Stock B 0.42 Market index 1 Stock B 0.48 1 Stock A 1 (a) Describe briefly how diversification effect reduces portfolio risk. (6 marks) (b) Compute expected returns of Stock A and Stock B respectively by using CAPM. (8 marks) (c) Identify and explain whether Stock A or Stock B should be added in Mark's portfolio for minimizing risk. (6 marks) (d) Statement 1: If the assumptions in CAPM are held, reward-to-risk ratios of all securities are the same. Therefore, all people should adopt passive management in investment. Statement 2: All investors should invest in market portfolio only, as it is the best portfolio in the financial market. Do you agree to these two statements? Explain. (10 marks) 3