Suppose that the standard deviation of returns from a typical share is about .40 (or 40%) a year. The correlation between the returns of each pair of shares is about .3.

a. Calculate the variance and standard deviation of the returns on a portfolio that has equal investments in 2 shares, 3 shares, and so on, up to 10 shares.

b. Use your estimates to draw a graph like Figure 7.11 . How large is the underlying market risk that cannot be diversified away?

c. Now repeat the problem, assuming that the correlation between each pair of stocks is zero.

AppendixLO1