Assume an economy in which there are three securities: Stock A with return (rA)

Question

Assume an economy in which there are three securities: Stock A with return (rA) = 10% and standard deviation-A = 10%; Stock B with return (rB) = 15% and standard deviation-B = 20%; and a riskless asset with rRF = 7%. Stocks A and B are uncorrelated (rAB = 0). Which of the following statements is correct? Please explain how you determined answer.

a) The expected return on the investor's portfolio will probably have an expected return that is somewhat above 15% and a standard deviation (SD) of approximately 20%.

b) The expected return on the investor's portfolio will probably have an expected return that is somewhatbelow 15% and a standard deviation (SD) of approximately 10%.

c) The expected return on the investor's portfolio will probably have an expected return that is somewhatbelow 15% and a standard deviation (SD) that is between 10% and20%.

d) The investor's risk/return indifference curve will be tangent to the CML ata point where the expected return is in the range of 7% to 10%.

e) Since the two stocks have a zero correlation coefficient, the investor can form a riskless portfolio where expected return is in the range of 10% to 15%.

Explanation / Answer

e) Since the two stocks have a zero correlation coefficient, the investor can form a riskless portfolio where expected return is in the range of 10% to 15%.

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