QUESTION THREE Expected returns on common stocks can vary quite a bit. One important determinant is the industry in which a company operates. For example, according to recent estimates from Morningstar, the median expected retum for department stores, which includes companies such as Sears and Kohl's, is 11.78 percent, whereas air transportation companies such as Delta and Southwest have a median expected retum of 12.75 percent. Computer software companies such as Microsoft and Oracle have a median expected return that is even higher, 14.87 percent. These estimates raise some obvious questions. First, why do these industries' expected retums differ so much, and how are these specific numbers calculated? Also, does the higher return offered by software stocks mean that investors should prefer these to, say, department store stocks? 13757 Required: 147 A. Show the effect on portfolio risk of perfect positive (Correlation of positive 1) and perfect negative correlation (Correlation of negative 1) between the retums on the investments in a portfolio consisting of Investments A and B below. (Assume that Investment A makes up 40 percent of the value of the portfolio and Investment B 60 percent). 601 3 Investment A State Return Probability Worst outcome 5% 0.2 Most likely outcome 15% 0.6 Investment B Return Probability 7% 0.2 14% 21% 0.2 Best outcome 25% 0.2 (20 Marks) B. Explain, using your calculations in (a) to illustrate your answer, how a fund manager can take account of correlation in constructing a portfolio to increase the value of the portfolio