## Suppose That The Returns On The Stock Fund Presented In Spreadsheet 6.1 Were

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What is the expected return on this three-asset portfolio?

Bodie-Kane-Marcus: I II. Portfolio Theory I 6. Efficient Diversification I I © The McGraw-Hill

Essentials of Investments, Companies, 2003

Fifth Edition

### 6 Efficient Diversification

2. An investor is considering adding another investment to a portfolio. To achieve the maximum diversification benefits, the investor should add, if possible, an investment that has which of the following correlation coefficients with the other investments in the portfolio?

3. Consistent with capital market theory, systematic risk:

i. Refers to the variability in all risky assets caused by macroeconomic and other aggregate market-related variables.

ii. Is measured by the coefficient of variation of returns on the market portfolio.

iii. Refers to nondiversifiable risk.

a. i only b. ii only c. i and iii only d. ii and iii only

4. Suppose that the returns on the stock fund presented in Spreadsheet 6.1 were -14%, 13%, and +30% in the three scenarios.

a. Would you expect the mean return and variance of the stock fund to be more than, less than, or equal to the values computed in Spreadsheet 6.2? Why?

b. Calculate the new values of mean return and variance for the stock fund using a format similar to Spreadsheet 6.2. Confirm your intuition from part (a).

c. Calculate the new value of the covariance between the stock and bond funds using a format similar to Spreadsheet 6.4. Explain intuitively why covariance has increased.

5. Use the rate of return data for the stock and bond funds presented in Spreadsheet 6.1, but now assume that the probability of each scenario is: Recession: 0.4; Normal: 0.2; Boom: 0.4.

a. Would you expect the mean return and variance of the stock fund to be more than, less than, or equal to the values computed in Spreadsheet 6.2? Why?

b. Calculate the new values of mean return and variance for the stock fund using a format similar to Spreadsheet 6.2. Confirm your intuition from part (a).

c. Calculate the new value of the covariance between the stock and bond funds using a format similar to Spreadsheet 6.4. Explain intuitively why the absolute value of the covariance has increased.

### The following data apply to problems 6-10.

A pension fund manager is considering three mutual funds. The first is a stock fund, the second is a long-term government and corporate bond fund, and the third is a T-bill money market fund that yields a sure rate of 5.5%. The probability distributions of the risky funds are: