Consider a 12 months two-security potential investment from the following three. The correlation coefficients between pairs of the stocks are as follows: Corr(A,B) = 0.85, Corr(A,C) = 0.60, Corr(A,D) = 0.45. Each stock has an expected return of 8% and a standard deviation of 20%.

Your entire portfolio is now composed of stock A and you can add some of only one stock to your portfolio.

Required:

1. Identify the stock to be added to Stock A and determine the optimum portfolio mix. [8 Marks]

2. If the overall rate of return on the LUSE is 9%, the risk-free rate is 4%, and the beta of 1.2, is it justifiable to invest in the new portfolio? [5 Marks]

3. Discuss the assumption of keeping the correlations between stock returns constant in modern portfolio theory. [7 Marks]