Question 3 (20 marks) Pauline, a portfolio manager, is making recommendations to her clients, Luke. Pauline is considering whether to add Stock A or B into Luke's well-diversified portfolio. She has made the following estimates: Table 1: Expected Returns and Standard Deviations of different assets Expected Returns Standard Deviations Stock A 16% 25% Stock B 20% 28% Market index 12% 10% Luke's portfolio 11% 11% Risk-free asset 3% Table 2: Correlation coefficient Market index Stock A 0.70 Stock B 0.40 Luke's portfolio 0.92 Market index 1 Stock A 1 Luke's portfolio 0.65 0.42 1 Stock B 0.56 1 (a) Identify and explain briefly which stock (Stock A and/or Stock B) is/are overpriced under CAPM. Show your calculations, (6 marks) (b) Identify and explain whether Stock A or Stock B should be added in Luke's portfolio for minimizing market risk exposure. (3 marks) (e) Calculate the expected return and standard deviation of the portfolio consisting of 20% Stock B, 60% Luke's portfolio and 20% risk-free asset. (3 marks) (d) Explain how to evaluate risk-adjusted returns of Stock A and Stock B by comparing their corresponding expected risk premiums and standard deviations respectively without involving calculations. (4 marks) (e) "Zero correlation represents no diversification effect." Do you agree? Explain. (4 marks) Question 3 (20 marks) Pauline, a portfolio manager, is making recommendations to her clients, Luke. Pauline is considering whether to add Stock A or B into Luke's well-diversified portfolio. She has made the following estimates: Table 1: Expected Returns and Standard Deviations of different assets Expected Returns Standard Deviations Stock A 16% 25% Stock B 20% 28% Market index 12% 10% Luke's portfolio 11% 11% Risk-free asset 3% Table 2: Correlation coefficient Market index Stock A 0.70 Stock B 0.40 Luke's portfolio 0.92 Market index 1 Stock A 1 Luke's portfolio 0.65 0.42 1 Stock B 0.56 1 (a) Identify and explain briefly which stock (Stock A and/or Stock B) is/are overpriced under CAPM. Show your calculations, (6 marks) (b) Identify and explain whether Stock A or Stock B should be added in Luke's portfolio for minimizing market risk exposure. (3 marks) (e) Calculate the expected return and standard deviation of the portfolio consisting of 20% Stock B, 60% Luke's portfolio and 20% risk-free asset. (3 marks) (d) Explain how to evaluate risk-adjusted returns of Stock A and Stock B by comparing their corresponding expected risk premiums and standard deviations respectively without involving calculations. (4 marks) (e) "Zero correlation represents no diversification effect." Do you agree? Explain. (4 marks)
