Assume an economy in which there are three securities: Stock A with r_A = 10% and $\sigma$_A = 10%; Stock B with r_B = 15% and $\sigma$_B = 20%; and a riskless asset with r_RF = 7%.Stocks A and B are uncorrelated (r_AB = 0).Which of the following statements is most CORRECT? A) The expected return on the investor's portfolio will probably have an expected return that is somewhat below 10% and a standard deviation (SD) of approximately 10%. B) The expected return on the investor's portfolio will probably have an expected return that is somewhat below 15% and a standard deviation (SD) that is between 10% and 20%. C) The investor's risk/return indifference curve will be tangent to the CML at a point where the expected return is in the range of 7% to 10%. D) Since the two stocks have a zero correlation coefficient, the investor can form a riskless portfolio whose expected return is in the range of 10% to 15%. E) The expected return on the investor's portfolio will probably have an expected return that is somewhat above 15% and a standard deviation (SD) of approximately 20%.

Question

Quizplus · Accepted Answer

The expected return on the portfolio will be a weighted average of the expected returns on the individual securities, so it will be somewhat below 15%. The portfolio's standard deviation will be a weighted average of the individual securities' standard deviations, so it will be between 10% and 20%. The investor's risk/return indifference curve will be tangent to the capital market line (CML) at the point where the expected return on the portfolio equals the expected return on the tangent portfolio. This tangent portfolio will have a higher expected return than the riskless asset, but less standard deviation than the individual stocks, so the expected return will be in the range of 10% to 15%. It is not possible to form a riskless portfolio with only two risky securities, regardless of their correlation coefficient. Therefore, options A and D are incorrect. Option E is also incorrect as it suggests a higher expected return than the highest individual security.

Assume an Economy in Which There Are Three Securities: Stock σ\sigmaσ

Assume an Economy in Which There Are Three Securities: Stock $\sigma$