1. Describe the efficient market hypothesis in the context of pricing securities. Identify and explain the three different forms of market efficiency discussed in class.

2. Most amateur investors think that picking specific investments is the key to investment success, while most professionals will say that asset allocation is the key. Write a paragraph explaining what asset allocation means and why the professionals are correct.

3. You have the following information about two stocks:

• Assume you invest 60% of your funds in Beyonce and 40% in Jay Z, and the correlation of returns between the two is 0.65. Calculate the expected return and the standard deviation of this portfolio.
• Calculate what happens to the expected return and the standard deviation of the portfolio if the correlation of returns between the stocks is a) 1.0, b) 0.0, and c) -1.0.
• 4. Suppose a portfolio consists of the following stocks:
• Determine the expected return for the portfolio.
• Suppose the investor wants the portfolio to earn 12.1%. Determine how much Eric stock must
• be sold and reinvested in Ivanka stock in order to make this happen.

Beyonce, Inc.

Jay Z, Ltd.

Expected return

17.8%

10.6%

Standard deviation

18%

7%

Stock

Amount

Expected Return

Don

$160,000

9%

Eric

$100,000

5%

Ivanka

$140,000

16%

1

5. Explain the difference between unsystematic and systematic risk, and give some examples of each type. Why can educated investors comfortably ignore unsystematic risks when constructing a portfolio? You are considering adding one of the following three investments to your portfolio, which each have the following correlations to your existing investments. Which one would reduce your risk the most if you added it? Which one would reduce your risk the least?

FIN 3315-Problem Set #2 (Ch 4-5)-Winter 2019

Investment

Correlation

Simon, Inc.

-0.55

Paula, Inc.

0.78

Randy, Inc.

0.21