Question

Assume that you have a portfolio (P) with $1,000 invested in Stock A and $3,000 in Stock B. You also have the following information on both stocks:   

Stock A Stock B ________________________________________________________

Expected Return (A) 0.15 (B) 0.24

Standard Deviation (A) 0.16 (B) 0.20

The covariance between A and B is - .0256

1)Draw a graph and demonstrate the effect that diversification would have on the portfolio return curve if you were to combine stocks A and B in different proportions in portfolio P

2)Draw a graph showing the effect of diversification on just the standard deviation curve that would be possible if you were to combine stocks A and B in different proportions in portfolio P. (Note: I know you can’t draw it exactly, but roughly draw what you think the curve may look like).

3) Now combine both risk and return into one graph connecting stocks A and B, with risk on one axis and return on the other axis (be sure to label the axis).

4) Now draw a curve of the efficient frontier, along with a risk-free asset, and briefly (one or two sentences) describe what the graph is meant to portray. Be sure to identify the market portfolio on the graph and label both of the axis correctly.

Answer 1