Question
(a) Invest In Us plc is a Scottish investment company that wishes to diversify its portfolio by investing in UK equities and the shares traded
(a) Invest In Us plc is a Scottish investment company that wishes to diversify its portfolio by investing in UK equities and the shares traded in up to two international stock markets. As the senior portfolio manager, you believe that the emerging markets of Chile and India offer excellent investment opportunities. You have forecast that the expected returns of each investment in three different states of the world are as follows:
State | Probability | Expected Return Chile | Expected Return India |
1 | 0.2 | 60% | 40% |
2 | 0.6 | 20% | 25% |
3 | 0.2 | 5% | 30% |
Required:
Calculate the expected return and standard deviation of return for each separate investment.
Calculate the covariance between the returns for this pair of investments.
(iii) If the expected return of the UK is 15% with a standard deviation of 8%, and if the correlation between the returns of the UK and Chile is 0.5 while the correlation between the returns of the UK and India is -0.5, determine which of the following three options represents the optimal investment strategy:
Invest equally in the UK and Chile
Invest equally in the UK and India
Spread the portfolio between all three markets such that half of the portfolio is invested in the UK while the rest is split equally between Chile and India.
(b) Explain why emerging stock markets, although very risk individually, can lead to lower overall portfolio risk
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