Question 1

1. Explain why it is important to have diversification in a portfolio.
2. The following table represents a portfolio of two (2) assets:

State of NatureProbability of State of NatureReturn of Stock A under Different State of NatureReturn of Stock B under Different State of Nature

Boom

Normal

Recession

0.3

0.5

0.2

20%

10%

5%

25%

20%

10%

1. What is the expected return on Stock A and Stock B?
2. What is the standard deviation of returns of Stock A and Stock B?
3. Which Stock is more volatile?

c. Suppose you use J$100 000 to construct a portfolio comprising of Stock A and stock B,

such that you invest J$30 000 and J $70 000 in Stock A and Stock B respectively. Also

you have done some research and estimated the Beta (B) of the Stocks to be: Stock

A=0.75 and Stock B=0.50.

Use the expected returns calculated for each stock in (b), above to calculate the following:

1. The expected return on the portfolio.
2. Calculate the expected beta of the portfolio.
3. Explain briefly how you would approach diversifying this portfolio.