Question

(20 points) Suppose that the return of stock A is normally distributed with mean 4% and standard deviation 5%, the return of stock B is normally distributed with mean 8% and standard deviation 10%, and the covariance between the returns of stock A and stock B is -30(%)2. Now you have an endowment of 1 dollar, and you decide to invset w dollar in stock A and 1 - w dollar in stock B. Let rp be the overall return of your portfolio, then Answer the following questions using w-0.5. (a) Compute the expectation and variance of your portfolio. (i.e., E[rp] and Var(rp)) (b) Find the 5th percentile of rp. (This quantity is often called the 5% Value at Risk.) (c) If Cov(TA,TB)-30(%)2 rather than-30(%)2, find ErP] and Var(rp) agian (d) Would Cov(rA,TB) have an impact on E[rpl? (e) In order to more efficiently reduce the risk (i.e., variance) of the investment portfolio through diversification, should one look for financial assets that are positively correlated or negatively correlated?

Answer 1

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