Question 4

The following are the returns on shares of four of the largest banks in the UK:

Royal bank of Scotland (RBS) - 6%

Lloyds TSB - 8%

Natwest - 3%

HSBC - 4%

Also provided is the standard deviation of all four shares:

Royal bank of Scotland (RBS) - 1.2

Lloyds TSB - 1.8

Natwest - 0.6

HSBC - 0.8

Given that the returns of UK Gilts is currently 2% and the FTSE100 is consistently returning 3.2% per annum calculate:

a)The returns of an equally weighted portfolio of all four shares.

b)The variance of an equally weight portfolio of shares in RBS and HSBC. (Note: that the correlation between RBS and HSBC is 0.5)

c)Highlight and discuss a known financial theory which illustrates a simple risk-return relationship