QUESTION 2 (25 MARKS)

Suppose there are an infinite number of assets with an expected return of 12% p.a. and a standard deviation of 40%. Further, assume investors form equally-weighted portfolios.

(a) If the correlation between any two assets is zero, calculate the expected return and standard deviation of a randomly selected two-stock portfolio and three-stock portfolio. (8 marks)

(b) If the correlation between any two assets is 0.45, elaborate the highest possible expected return and lowest possible standard deviation in this case. (5 marks)

(c) Explain the implications of your results to the concept of diversification based on the key differences between the two approaches in estimating the mean variance optimal portfolio: the Sharpe diagonal and the Markowitz approach. (12 marks)