Answer ALL the questions in this paper. Question 1 (40 marks) You have recently been appointed chief investment officer of a major charitable foundation. Its large endowment fund is currently invested in a broadly diversified portfolio of stocks (60 percent) and bonds (40 percent). The foundation's board of trustees is a group of prominent individuals whose knowledge of modern investment theory and practice is superficial. You decide a discussion of basic investment principles would be helpful. (a) Explain the concepts of specific risk, systematic risk, variance, covariance, standard deviation, and beta as they relate to investment management. (20 marks) You believe that the addition of other asset classes to the endowment portfolio would improve the portfolio by reducing risk and enhancing return. You are aware that depressed conditions in U.S. real estate markets are providing opportunities for property acquisition at levels of expected return that are unusually high by historical standards. You believe that an investment in U.S. real estate would be both appropriate and timely, and have decided to recommend a 20 percent position be established with funds taken equally from stocks and bonds. Preliminary discussions revealed that several trustees believe real estate is too risky to include in the portfolio. The board chairman, however, has scheduled a special meeting for further discussion of the matter and has asked you to provide background information that will clarify the risk issue. To assist you, the following expectation data have been developed: Asset Class Return Coefficient of Correlation U.S. U.S. Bonds Real Estate U.S. T-Bills U.S. Stocks U.S. Bonds U.S. Real Estate U.S. Treasury Bills 12.0% 8.0 12.0 4.0 Standard Deviation 21.0% 10.5 9.0 0.0 U.S. Stocks 1.00 0.14 -0.04 -0.05 1.00 -0.03 -0.03 1.00 0.25 1.00 (b) Explain the effect on both portfolio risk and return that would result from the addition of U.S. real estate. Include in your answer two reasons for any change you expect in portfolio risk. (Note: It is not necessary to compute the exact expected return and risk.) (10 marks) (c) Your understanding of capital market theory causes you to doubt the validity of the expected return and risk for U.S. real estate. Justify your scepticism. (10 marks)