a.
Adequate information:
| State | Probability of Outcome | Return on Security 1 | Return on Security 2 | Return on Security 3 |
| 1 | 0.15 | 0.20 | 0.20 | 0.05 |
| 2 | 0.35 | 0.15 | 0.10 | 0.10 |
| 3 | 0.35 | 0.10 | 0.15 | 0.15 |
| 4 | 0.15 | 0.05 | 0.05 | 0.20 |
To compute: The expected return and standard deviation of Security 1, Security 2, and Security 3.
Introduction: Expected return simply refers to the return that is anticipated on the investment.
b.
Adequate information:
| State | Probability of Outcome | Return on Security 1 | Return on Security 2 | Return on Security 3 |
| 1 | 0.15 | 0.20 | 0.20 | 0.05 |
| 2 | 0.35 | 0.15 | 0.10 | 0.10 |
| 3 | 0.35 | 0.10 | 0.15 | 0.15 |
| 4 | 0.15 | 0.05 | 0.05 | 0.20 |
To compute: The covariance and correlations between the securities.
Introduction: The relationship between two securities is referred to as covariance.
c.
Adequate information:
| State | Probability of Outcome | Return on Security 1 | Return on Security 2 | Return on Security 3 |
| 1 | 0.15 | 0.20 | 0.20 | 0.05 |
| 2 | 0.35 | 0.15 | 0.10 | 0.10 |
| 3 | 0.35 | 0.10 | 0.15 | 0.15 |
| 4 | 0.15 | 0.05 | 0.05 | 0.20 |
Weight of security 1 (W1) = 50% or 0.50
Weight of security 2 (W2) = 50% or 0.50
Expected return of Security 1 [E(R1)] = 0.1250 or 12.50%
Expected return of Security 2 [E(R2)] = 0.1250 or 12.50%
Standard deviation of Security 1 (σ1) = 0.0461 or 4.61%
Standard deviation of Security 2 (σ2) = 0.0461 or 4.61%
Correlation between Security 1 and Security 2 (?1,2) = 0.59
To compute: The expected return and standard deviation of a portfolio if half of the funds are invested in Security 1 and a half in Security 2.
Introduction: Expected return on the portfolio refers to the return that is anticipated on the portfolio as a whole.
d.
Adequate information:
| State | Probability of Outcome | Return on Security 1 | Return on Security 2 | Return on Security 3 |
| 1 | 0.15 | 0.20 | 0.20 | 0.05 |
| 2 | 0.35 | 0.15 | 0.10 | 0.10 |
| 3 | 0.35 | 0.10 | 0.15 | 0.15 |
| 4 | 0.15 | 0.05 | 0.05 | 0.20 |
Weight of security 1 (W1) = 50% or 0.50
Weight of security 3 (W3) = 50% or 0.50
Expected return of Security 1 [E(R1)] = 0.1250 or 12.50%
Expected return of Security 2 [E(R3)] = 0.1250 or 12.50%
Standard deviation of Security 1 (σ1) = 0.0461 or 4.61%
Standard deviation of Security 2 (σ3) = 0.0461 or 4.61%
Correlation between Security 1 and Security 3 (?1,3) = -1
To compute: The expected return and standard deviation of a portfolio if half of the funds are invested in Security 1 and half in Security 3.
Introduction: Expected return on the portfolio refers to the return that is anticipated on the portfolio as a whole.
e.
Adequate information:
| State | Probability of Outcome | Return on Security 1 | Return on Security 2 | Return on Security 3 |
| 1 | 0.15 | 0.20 | 0.20 | 0.05 |
| 2 | 0.35 | 0.15 | 0.10 | 0.10 |
| 3 | 0.35 | 0.10 | 0.15 | 0.15 |
| 4 | 0.15 | 0.05 | 0.05 | 0.20 |
Weight of security 2 (W2) = 50% or 0.50
Weight of security 3 (W3) = 50% or 0.50
Expected return of Security 2 [E(R2)] = 0.1250 or 12.50%
Expected return of Security 3 [E(R3)] = 0.1250 or 12.50%
Standard deviation of Security 2 (σ2) = 0.0461 or 4.61%
Standard deviation of Security 3 (σ3) = 0.0461 or 4.61%
Correlation between Security 2 and Security 3 (?2,3) = -0.59
To compute: The expected return and standard deviation of a portfolio if half of the funds are invested in Security 2 and a half in Security 3.
Introduction: Expected return on the portfolio refers to the return that is anticipated on the portfolio as a whole.
f.
Adequate information:
| State | Probability of Outcome | Return on Security 1 | Return on Security 2 | Return on Security 3 |
| 1 | 0.15 | 0.20 | 0.20 | 0.05 |
| 2 | 0.35 | 0.15 | 0.10 | 0.10 |
| 3 | 0.35 | 0.10 | 0.15 | 0.15 |
| 4 | 0.15 | 0.05 | 0.05 | 0.20 |
To compute: About diversification by considering Parts (a), (c), (d), (e).
Introduction: Correlation defines how two or more securities in the portfolio are related to each other.
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Chapter 11 Solutions
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EBK CONTEMPORARY FINANCIAL MANAGEMENTFinanceISBN:9781337514835Author:MOYERPublisher:CENGAGE LEARNING - CONSIGNMENT