FM212 - Principles of Finance
Michaelmas Term: Asset Pricing
Problem Set 5 - Risk, Return and the Cost of Capital
1. Answer the following questions:
(a) What is the correlation coefficient between two stocks that gives the maximum reduction
in risk (variance) for a two-stock portfolio (assuming that the portfolio contains long
positions in both stocks)?
(b) 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.
(c) The correlation coefficient between stock B and the market portfolio is 0.8. The standard
deviation of stock B is 35% and that of the market is 20%. Calculate the beta of the
stock.
2. You are considering how to invest part of your retirement savings. You have decided to put
£200,000 into three stocks: 50% of the money in stock A (currently £25 per share), 25% of
the money in stock B (currently £80 per share) and the remainder in stock C (currently £2
per share). If stock A goes up to £30 per share, stock B drops to £60 per share and stock C
rises to £3 per share:
(a) What is the new value of the portfolio?
(b) What return did the portfolio earn?
(c) If you dont buy or sell any shares after the price change, what are your new portfolio
weights?
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3. You can form a portfolio of two assets, A and B, whose returns have the following charac-
teristics:
Stock Expected Return Standard Deviation Correlation Between A and B
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?