National Tsing Hua University

Financial Management
Instructor: Tak-Yuen Wong
Assignment 3

Problem 1. Are the following statements True or False? Justify your answer.
(a) Diversification can reduce risk only when asset returns are negatively correlated.
(b) Stock A has a 10% expected return and 18% volatility, and stock B has a 13% expected
return and 12% volatility. Then, no investor will buy stock A.

Problem 2. You are considering how to invest part of your retirement savings. You have
decided to put $300,000 into three stocks: 60% of the money in GoldFinger (currently
$23/share), 30% of the money in Moosehead (currently $71/share), and the remainder in
Venture Associates (currently $4/share). If GoldFinger stock goes up to $40/share, Moose-
head stock drops to $53/share, and Venture Associates stock rises to $14 per share,
(a.) What is the new value of the portfolio?
(b) What return did the portfolio earn?
(c) If you don’t buy or sell any shares after the price change, what are your new portfolio
weights?

Problem 3. You own three stocks: 600 shares of Apple Computer, 10,000 shares of Cisco
Systems, and 5000 shares of Colgate-Palmolive. The current share prices and expected
returns of Apple, Cisco, and Colgate-Palmolive are, respectively, $547, $18, $95 and 12%,
10%, 8%.
(a) What are the portfolio weights of the three stocks in your portfolio?
(b) What is the expected return of your portfolio?
(c) Suppose the price of Apple stock goes up by $20, Cisco rises by $7, and Colgate-Palmolive
falls by $14. What are the new portfolio weights?
(d) Assuming the stocks’ expected returns remain the same, what is the expected return of
the portfolio at the new prices?

Problem 4. You are given the return data for stock A and B in the following table:
Year 2010 2011 2012 2013 2014 2015
Stock A −10% 20% 5% −5% 2% 9%
Stock B 21% 7% 30% −3% −8% 25%
(a) Estimate (i) the average return and volatility for each stock, (ii) the covariance between
the stocks, and (iii) the correlation between these two stocks. (Hint: note that these are
1
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historical returns. Sample estimators for average and volatility are required. Using the lecture
note’s notations, sample covariance between two assets i = 1, 2 is given by
1 ∑
T
σ̂12 = (r1t − r̄1 )(r2t − r̄2 ).
T − 1 t=1

Consider a portfolio that maintains a 50% weight on stock A and 50% weight on stock B.
(b) What is the return each year of this portfolio?
(c) Based on your results from part (b), compute the average return and volatility of the
portfolio.
(d) Show that the average return of the portfolio is equal to the average of the average
returns of the two stocks.
(e) Now, calculate the volatility of the portfolio directly using the definition of sample stan-
dard deviation, and then verify your result using “a2 + b2 + 2ab” (the blue equation on page
16 of lecture note FM.05pdf).
(f) Explain why the portfolio has a lower volatility than the average volatility of the two
stocks.

Problem 5. Consider an equally weighted portfolio of stocks in which each stock has a
volatility of 40%, and the correlation between each pair of stocks is 27%.
(a) What is the volatility of the portfolio as the number of stocks becomes arbitrarily large?
(b) What is the average correlation of each stock with this large portfolio?

Problem 6. Suppose Ford Motor stock has an expected return of 15% and a volatility of
38%, and Molson-Coors Brewing has an expected return of 12% and a volatility of 28%. If
the two stocks are uncorrelated,
(a) What is the expected return and volatility of a portfolio consisting of 70% Ford Motor
stock and 30% of Molson-Coors Brewing stock?
(b) Given your answer to part (a), is investing all of your money in Molson-Coors stock an
efficient portfolio of these two stocks?
(c) Is investing all of your money in Ford Motor an efficient portfolio of these two stocks?

Problem 7. Suppose Johnson & Johnson and Walgreens Boots Alliance have expected
returns and volatilities shown below, with a correlation of 21%.
Expected return Volatility
Johnson & Johnson 6.9% 17.9%
Walgreens Boots Alliance 9.6% 21.6%
(a) Calculate the expected return and the volatility of a portfolio that is equally invested in
Johnson & Johnson’s and Walgreens’ stock.
(b) If the correlation between Johnson & Johnson’s and Walgreens’ stock were to increase,
would the expected return of the equally invested portfolio rise or fall? What about the
volatility of the portfolio?
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(c) Calculate the expected return and the volatility of a portfolio that consists of a long
position of $8,500 in Johnson & Johnson and a short position of $1,500 in Walgreens’ stock.
(d) Plot the expected return as a function of the portfolio volatility. Using your graph,
identify the range of Johnson & Johnson’s portfolio weights that yield efficient combinations
of the two stocks, rounded to the nearest percentage point. (You may consider short-selling
but it suffices to consider portfolio weight below 120%.)
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