QUESTION THREE

A. Describe the relationship between correlation and diversification. [5 MARKS]

B. You are a portfolio manager with K1 000 000 of funds under your management. The forecast for the market in the coming year is as follows.

Market Scenario	Probability	Stock Market Return	Bond Market Return
Bull Market	0.25	25%	8%
Neutral Market	0.50	10%	5%
Bear Market	0.25	-5%	3%

The risky portfolio is comprised of stocks and bonds in a ratio of 60% stocks and 40% bonds. The correlation between stocks and bonds is 0.2.

I. Calculate the expected return of stocks. [2 MARKS]

II. Calculate the standard deviation of stocks. [3 MARKS]

III. If the expected return and variance of bonds are 5.25% and 3.1875% respectively, calculate the following:

• Expected return of the risky portfolio [2 MARKS]

• Standard deviation of the risky portfolio [7 MARKS]

IV. If the risky portfolio has a target of 9.5% expected return, calculate the amount (out of the K1000 000) you would allocate to each of the two portions of stocks and bonds [6 MARKS]