The financial markets of country X are not very developed: there are only two co

Question

The financial markets of country X are not very developed: there are only two companies, A and B, which are traded. The expected rate of return on A is 8% and 14% on B; the standard deviations of their rates of return are 5% for A and 10% for B and the correlation coefficient between their returns is 0.1.

a. Calculate the expected return and standard deviation of the following portfolios:

portfolio Percentage in A Percentage in B

P1 0 100

P2 40 60

P3 60 40

P4 80 20

P5 100 0

b. Represent in a graph (with the standard deviation of the portfolio on the horizontal axis and the expected returns on the vertical axis) the points corresponding to the combinations of expected return-standard deviation for each of the above portfolios. Draw approximately theset of all feasible expected returns-standard deviations that can be obtained by investing in the two stocks A and B.
c. Which of the above portfolios are ecient?

Explanation / Answer

Calculation of expected return Expected return 8% 14% Portfolio Percentage in A Percentage in B Expected return (%) P1 0 100 14 P2 40 60 11.6 P3 60 40 10.4 P4 80 20 9.2 P5 100 0 8 Calculation of standard deviation Standard deviation 5% 10% Correlation coefficient 0.1 Portfolio Percentage in A Percentage in B Standard deviation of portfolio P1 0 100 0.10000 P2 40 60 0.06325 P3 60 40 0.05000 P4 80 20 0.04472 P5 100 0 0.05000 Evaluation of portfolio P1 0.00714 P2 0.00545 P3 0.00481 P4 0.00486 P5 0.00625 Portfolio 3 has got minimum coefficient of variation,hence portfolio is most efficient

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