You are interested in creating a portfolio of two stocks Zoomla Inc and Ooppl Inc. Over the last three years, an investment in Zoomla shares would have earned an average annualized return of 27%, with an annualized standard deviation (of returns) of 51%. An investment in Ooppl shares would have earned an average annual return of 21%, with an annualized standard deviation of 32%. The three-year correlation in returns across the two stocks is 0.71.

1. Based on the average annual returns and the standard deviations, estimated using the past returns for both stocks, compute the average return and standard deviation of a portfolio composed 25% of Zoomla and 75% of Ooppl shares respectively. Compute risk-return (Sharpe) ratio. Does the portfolio of two stocks exhibit a better risk-return profile than either of the two stocks do individually? Explain (10 marks)
2. Now assume that Zoomlas near-future business acquisitions will increase the correlation to 0.85, while potentially reducing Zoomlas standard deviation in returns to 41%. By keeping the remaining assumptions unchanged, recompute the required values given in a). What would happen to the portfolios risk-return profile, would it improve or get worse? (5 marks)

Marking scheme:

Part a)

3 marks for correctly computing the portfolio return

3 marks for correctly computing the portfolio standard deviation

4 marks for correctly answering the key question

Part b)

1 mark for correctly computing the portfolio return

1 mark for correctly computing the portfolio standard deviation

3 marks for correctly answering the key question