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