Y8

Abigail Grace has a $900,000 fully diversified portfolio. She subsequently inherits ABC Company common stock worth $100,000. Her financial adviser provided her with the following forecast information: The correlation coefficient of ABC stock returns with the original portfolio returns is .40 .

a. The inheritance changes Grace's overall portfolio and she is deciding whether to keep the ABC stock. Assuming Grace keeps the ABC stock, calculate the:

i. Expected return of her new portfolio which includes the ABC stock.

ii. Covariance of ABC stock returns with the original portfolio returns.

iii. Standard deviation of her new portfolio, which includes the ABC stock.

b. If Grace sells the ABC stock, she will invest the proceeds in risk-free government securities yielding .42%monthly. Assuming Grace sells the ABC stock and replaces it with the government securities, calculate the

i. Expected return of her new portfolio, which includes the government securities.

ii. Covariance of the government security returns with the original portfolio returns.

iii. Standard deviation of her new portfolio, which includes the government securities.

c. Determine whether the systematic risk of her new portfolio, which includes the government securities, will be higher or lower than that of her original portfolio.

d. On the basis of conversations with her husband, Grace is considering selling the $100,000of ABC stock and acquiring $100,000 of XYZCompany common stock instead. XYZ stock has the same expected return and standard deviation as ABC stock. Her husband comments, "It doesn't matter whether you keep all of the ABC stock or replace it with $100,000 of XYZ stock." State whether her husband's comment is correct or incorrect. Justify your response.

e. In a recent discussion with her financial adviser, Grace commented, "If I just don't lose money in my portfolio, I will be satisfied." She went on to say, "I am more afraid of losing money than I am concerned about achieving high returns."

i. Describe one weakness of using standard deviation of returns as a risk measure for Grace.

ii. Identify an alternate risk measure that is more appropriate under the circumstances