Question 2 (20 Marks). You have combined two stocks, ABC and DEF, into an equall

Question

Question 2 (20 Marks). You have combined two stocks, ABC and DEF, into an equally weighted portfolio ABC is a resource stock and has a variance twice that of DEF. You have formed another portfolio (Growth) that has an expected return of 17% and a variance of 50%. The expected return on the market is 15% and the risk free rate is 7% Covariance (ABC,Market)-22% and Covariance (DEF-Market) 15.5% and the vanance of the Market is 15%. Required: a) What is the varianoe of ABC and DEF? (5 marks) b) What is the correlation of ABC with DEF? (5 marks) e) Is your Stable portfollio efficient? Explain. (5 marks) d) What are four characteristics of an efficient portfolio? (5 marks)

Explanation / Answer

Stable Portfolio Weights Growth Portfolio ABC(Wa) 0.5 Expected Return 17% DEF (Wd) 0.5 Variance 50% Portfolio Covariance 35% Covariance(ABC,DEF) 25% VarABC 2x Standard Dev = Sqrt(Var) varDEF x Assume Risk Free Rate 7% Market Variance 15% Covariance (ABC,Market) 22% Covariance (DEF,Market) 15.50% Portfolio Variance^2 = (Wa*std dev (abc))^2 + (Wd*Std dev(def))^2+ 2*Wa*Wd*cov(ABC,DEF)                                            0.35 (0.5*sqrt(2x))^2+(0.5*sqrt(x))^2+2*0.5*0.5*0.25 Solving this we get x = 0.3 Hence Var ABC 60% Var DEF 30% Correlation (ABC,DEF) = Covariance (ABC,DEF)/ (Std Dev (ABC)*Std Dev(DEF))           0.59 B5/(SQRT(B19)*SQRT(B20)) Characteristics of an efficient portfolio An efficient portfolio is one that is well-diversified and adequately compensates you for risk. When it comes to putting together an efficient investment portfolio, reducing volatility is the name of the game.

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