Question 2 (30 marks) a) Consider two risky stocks X and Y. Stock Y has an expected return of 16% and a standard deviation of 13%. Stock X has an expected return of 20% and a standard deviation of 25%. The correlation between the returns of X and Y is +0.3. i) What is the expected return and standard deviation of a portfolio with 40% in Y and 60% in (8 marks) ii) Is there any diversification benefit resulting from forming the portfolio? Support your conclusion with calculations. (4 marks) X? b) Consider two assets: The market portfolio (M) and Stock A. - The expected rate of return and standard deviation of the market portfolio is 8% and 15%, respectively. - The risk-free rate is 2%. - The standard deviation of the market portfolio's return is 15%. - Stock A has a beta of 1 and a standard deviation of 30%. Currently all your client's funds are invested in stock A. Assume that the CAPM holds (=> expected return = required return). The following questions are independent of each other. (a) Draw the capital market line and show the position of stock A. (5 marks) (b) Draw the security market line and show the position of stock A. (5 marks) [Hints for (a) and (b): Full mark would only be given to completely and correctly labelled diagram.] (C) Show how your client can "do better" if she wants to keep her risk exposure (standard deviation of the return on her investment) the same at 30%. Specifically, i) What expected return can she earn? ii) What would be the composition of her portfolio? (8 marks)