Question 3 (21 marks) Pauline, a portfolio manager, is making recommendations to her clients, Luke. Pauline is considering whether to add Stock A or Binto Luke's well-diversified portfolio. She has made the following estimates: Table 1Expected Returns and Standard Deviations of different assets Expected Returns Standard Deviations Stock A 16% Stock B Market index Luke's portfolio 10% Risk-free rate 3% Table 2. Correlation coefficient Market index Stock A 0.66 Stock B 0.42 Market index Stock A Stock B 0.48 Stock B Stock A (a) Describe briefly how diversification effect reduces portfolio risk. (4 marks) (b) Compute expected returns of Stock A and Stock B respectively by using CAPM. (4 marks) (c) Identify and explain whether Stock A or Stock B should be added in Luke's portfolio for minimizing risk. (3 marks) (d) Actual returns of Stock A, Stock B and market index are shown as below: Actual Returns Stock A 7.8% Stock B 7.5% Market index 10.5% Compute the systematic portion and unsystematic portion of unexpected returns of Stock A and Stock Brespectively. (4 marks) (e) Statement 1: If the assumptions in CAPM are held, reward-to-risk ratios of all securities are the same. Therefore, all people should adopt passive management Statement 2: All investors should invest in market portfolio only, as it is the best portfolio in the financial market. Do you agree with these two statements? Explain. (6 marks)