Class 5

1. Answer the following questions:

a. Briefly explain the difference between beta as a measure of risk and variance as a
measure of risk.
b. What is the correlation coefficient between two stocks that gives the maximum
reduction in risk for a two-stock portfolio (assuming that the portfolio contains
long positions in both stocks)?
c. Historical nominal annual returns for stock A are –8%, +10% and +22%. The
nominal returns for the market portfolio in the same years are +6%, +18% and
24%. Calculate the beta for stock A.
d. The correlation coefficient between stock B and the market portfolio is 0.8. The
standard deviation of the stock B is 35% and that of the market is 20%. Calculate
the beta of the stock.

2. You can form a portfolio of two assets, A and B, whose returns have the following
characteristics:

Stock Expected Return % Standard Deviation % Correlation

A 10 20 0.5
B 15 40

If you demand an expected return of 12%, what are the portfolio weights? What is the
portfolio’s standard deviation?

3. Here are some historical data on the risk characteristics of Dell and Home Depot:

Dell Home Depot

Yearly standard deviation of return (%) 29.32 29.27

Assume that the standard deviation of the market return is 15 percent.

a. The correlation coefficient between Dell and Home Depot’s return is 0.59. What
is the standard deviation of a portfolio invested half in Dell and half in Home
Depot?
b. What is the standard deviation of a portfolio invested one-third in Dell, one-third
in Home Depot and one-third in Treasury bills? [NOTE: assume that Treasury
bills are completely risk-less.]
c. What is the standard deviation of a portfolio that is split evenly between Dell and
Home Depot and is financed at 50 percent margin, i.e., the investor puts up only
50 percent of the total amount and borrows the balance from his broker?