Question 2: (a) (i) Explain the benefits of portfolio diversification for investing and discuss how diversification benefits are affected by the correlation between the securities in a portfolio. (8 marks) (ii) Suppose that you are holding a portfolio consisting of stocks of companies based and operating in countries A and B. Discuss whether the diversification benefits will be mitigated or reinforced if each one of the following changes occur, relating your discussion to the potential change in the correlation between the securities in your portfolio: a. There is a dangerous virus outbreak affecting the whole region where the two countries are located. b. After the adoption of a regional trade agreement, the two countries lower the trade tariffs on imported goods. c. The number of cross-border mergers & acquisitions between the firms from the two countries has recently increased. d. Exchange rate volatility between the currencies of the two countries is expected to increase substantially over the next 5 years.

(b)

Summarizing the numerous event studies conducted in US stock markets, Eckbo et al. (Eckbo, B. & Masulis, Ronald & Norli, Oyvind. 2007. Security Offerings. Handbook of Corporate Finance: Empirical Corporate Finance) report that announcements of equity issues result in significant negative stock price reaction, which is -2.22% on average, while announcements of straight bond issues have no effect on the stock price. Discuss the reaction of investors to equity and bond issues relating your discussion to the pecking order theory of capital structure.