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Suppose the expected returns and standard deviations of stocks A and B are E(RA) = 0.17,
E(RB) = 0.27, StdDevA = 0.12, and StdDevB = 0.21, respectively.

a. Calculate the expected return and standard deviation of a portfolio that is composed of
35 percent A and 65 percent B when the correlation between the returns on A and B is 0.6.

b. Calculate the standard deviation of a portfolio that is composed of 35 percent A and
65 percent B when the correlation coefficient between the returns on A and B is -0.6.

c. How does the correlation between the returns on A and B affect the standard deviation
of the portfolio?

Suppose the expected return on the market portfolio is 14.7 percent
and the risk-free rate is 4.9 percent.
Morrow Inc.stock has a beta of 1.3 Assume the capital-asset-pricing model holds.

a. What is the expected return on Morrow's stock?

b. If the risk-free rate decreases to 3.7 percent, what is the expected return on Morrow's
stock?

A portfolio that combines the risk-free asset and the market portfolio has an expected return
of 22 percent and a standard deviation of 5 percent. The risk-free rate is 4.9 percent, and
the expected return on the market portfolio is 19 percent. Assume the capital-asset-pricing
model holds.
What expected rate of return would a security earn if it had a 0.6 correlation
with the market portfolio and a standard deviation of 3 percent?

Suppose you have invested \$50,000 in the following four stocks:

Security Amount Invested Beta
Stock A \$10,000 0.7
Stock B 15,000 1.2
Stock C 12,000 1.4
Stock D 13,000 1.9

The risk-free rate is 5 percent and the expected return on the
market portfolio is 18 percent.
Based on the capital-asset-pricing model, what is the expected return on the above
portfolio?

You enter into a forward contract to buy a 10 -year, zero-coupon bond that will be issued in
one year.The face value of the bond is \$1,000 , and the 1 -year and 11 -year spot interest rates
are 4 percent per annum and 9 percent per annum, respectively. Both of these interest rates
are expressed as effective annual yields (EAYs).

a. What is the forward price of your contract?

b. Suppose both the spot rates unexpectedly shift downward by 1 percent.
What is the price of a forward contract otherwise identical to yours?

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#### Solution Preview

Please see the attached file.

I Suppose the expected returns and standard deviations of stocks A and B are E(RA) = 0.17,
E(RB) = 0.27, StdDevA = 0.12, and StdDevB = 0.21, respectively.

a. Calculate the expected return and standard deviation of a portfolio that is composed of
35 percent A and 65 percent B when the correlation between the returns on A and B is 0.6.

The expected returns can be calculated by using the portfolio weights.
Expected Return on portfolio is = Weight of Stock 1 X expected return of stock 1 +
weight of stock 2 x expected return on stock 2 and so on.
For a 2 stock portfolio with weights as Wa=35% and Wb=65% and E(RA)=0.17 and
E(Rb)=0.27, the expected return is=0.35X0.17+0.65X0.27
Expected Return= 23.5%
SD=Square root(Wa^2*SD(a)^2+Wb^2*SD(b)^2+2*Wa*Wb*SD(a)*Sd(b)*correlation
coefficient

Given that
Wa 0.35
SD(a) 0.12
Wb 0.65
SD(b) 0.21
Correlation Coefficient 0.6
Standard Deviation = 16.52%

b. Calculate the standard deviation of a portfolio that is composed of 35 percent A and
65 percent B when the correlation coefficient between the returns on A and B is -0.6.

SD=Square root(Wa^2*SD(a)^2+Wb^2*SD(b)^2+2*Wa*Wb*SD(a)*Sd(b)*correlation
coefficient

Given that
Wa 0.35
SD(a) 0.12
Wb 0.65
SD(b) 0.21
Correlation Coefficient -0.6
Standard Deviation = 11.63%

c. How does the correlation between the returns on A and B affect the standard deviation
of the portfolio?

The standard deviation is lower if the correlation is negative. This is the principle of
diversification. If the correlation is negative, then the returns move in opposite
directions and the portfolio standard deviationw ill be lower

II Suppose the expected return on the market portfolio is ...

#### Solution Summary

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