Question
Abby has a $800,000 fully diversified portfolio. She subsequently inherits ABC Company common stock worth $200,000. Her financial adviser provided her with the following forecast
Abby has a $800,000 fully diversified portfolio. She subsequently inherits ABC Company common stock worth $200,000. Her financial adviser provided her with the following forecast information:
Expected monthly return | Standard deviation of monthly return | |
Original Portfolio | 1% | 1.50% |
ABC Company | 1.25% | 2% |
The correlation coefficient of ABC stock returns with the original portfolio returns is 0.40.
i) The inheritance changes Abbys overall portfolio and she is deciding whether to keep the ABC stock. Assuming Abby keeps the ABC stock, calculate the:
a. Expected return of her new portfolio which includes the ABC stock.
b. Covariance of ABC stock returns with the original portfolio returns.
c. Standard deviation of her new portfolio, which includes the ABC stock.
ii) If Abby sells the ABC stock, she will invest the proceeds in risk-free government securities yielding 0.5% monthly. Assuming Abby sells the ABC stock and replaces it with the government securities, calculate the
a. Expected return of her new portfolio, which includes the government securities.
b. Covariance of the government security returns with the original portfolio returns.
c. Standard deviation of her new portfolio, which includes the government securities.
iii) Determine whether the systematic risk of her new portfolio, which includes the government securities, will be higher or lower than that of her original portfolio.
iv) On the basis of conversations with her husband, Abby is considering selling the $200,000 of ABC stock and acquiring $200,000 of XYZ Company common stock instead. XYZ stock has the same expected return and standard deviation as ABC stock. Her husband comments, It doesnt matter whether you keep all of the ABC stock or replace it with $100,000 of XYZ stock. State whether her husbands comment is correct or incorrect. Justify your response.
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