Problem 1

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

a. Calculate the expected return and standard deviationof a portfolio that is composed of 35% A and 65% B when the correlationbetween 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?

Problem 2

Suppose the expected return on the market portfolio is 14.7% and the risk-free rate is 4.9%. 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?

This solution is comprised of a detailed explanation to calculate the expected return and standard deviation of a portfolio that is composed of 35% A and 65% B when the correlation between the returns on A and B is 0.6.