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(40 points) Suppose that investors base their decisions on mean-variance analysis. Suppose that we have the following two assets: Stock A has a expected return

  1. (40 points) Suppose that investors base their decisions on mean-variance analysis. Suppose that we have the following two assets:

    Stock A has a expected return E[rA] = 0.20, and standard deviation of = 0.30. Stock B has a expected return E[rB] = 0.25, and standard deviation of = 0.40.

    The correlation between A and B is = 0.5.

  2. (a) Let E[rp] be the expected return of a portfolio that invests wA in stock A and wB = 1 wA in stock B. Let p be the standard deviation of that portfolio. Find the equations that relate both E[rp] and p to w.

  3. (b) Choose different portfolios and find their mean and variance (you can start with a weight of wA = 1 and vary it in 0.10 increments up to wA = 2 say). Plot the mean-standard deviation combinations that you get from these portfolios. What is the relationship between E[rp] and p?

  4. (c) Describe as precisely as you can the set of portfolios that are mean variance efficient.

  5. (d) How does this set of efficient portfolios change if the correlation between the two stocks is -0.5? Be specific.

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