Question 2

An investor has two investment opportunities in the shares of Company X and Company Y. The risk and return characteristics of the two securities are shown below:

X

Y

Expected Return

12%

22%

Risk (Standard deviation)

6%

9%

The investor plans to invest 70% of available funds in X and 30% in Y.The correlation coefficient between the returns of the two securities is -0.5.

Required:

a)(i) Calculate the expected return from the proposed portfolio of securities X and Y.

(ii) Calculate the risk of the portfolio and comment upon your result in the context of the risk reduction effect of diversification.

(iii) In the context of portfolio theory, explain how the envelope curve is established and what is meant by the efficiency frontier.

b)Explain what beta means within the context of the Capital Asset Pricing Model (CAPM).

c)Calculate the return that a well-diversified investor would expect from security A given the following information and identify whether the security is defensive or aggressive:

_A = 15%, _M= 10% and _A,M = +0.4

Risk free rate = 2%, Return on the market = 8%