You are considering investing in the following stocks:
|
|
Expected Return
|
Standard Deviation
|
|
Stock A
|
10%
|
9%
|
|
Stock B
|
8%
|
6%
|
The correlation coefficient for the two stocks is -0.3. The risk-free rate is 1%.
1. Compute the expected return and standard deviation for a portfolio formed by combining the two stocks with the following weights:
a. Invest 10% in Stock A and 90% in Stock B
b. Invest 20% in Stock A and 80% in Stock B
c. Invest 50% in Stock A and 50% in Stock B
d. Invest 80% in Stock A and 20% in Stock B
e. Invest 90% in Stock A and 10% in Stock B
2. Using the Sharpe Ratio approach (here you can compute the shape ratio as [expected return less risk-free rate] over standard deviation. Which portfolio should you invest in?
3. Re-compute the expected return and standard deviation for the portfolios if the stocks are perfectly correlated (correlation coefficient is 1). What can you say about what the Sharpe Ratios of the portfolios that confirms the fact that diversification gives no benefit if stocks are perfectly correlated?