Stocks offer an expected return of 18%, with a standard deviation 22%. Gold offers an expected...

Stocks offer an expected return of 18%, with a standard deviation 22%. Gold offers an expected return of 10% with a standard deviation of 30%.

a) In the light of the apparent inferiority of gold with respect to both mean and return volatility, would anyone hold gold?

b) Re-answer (a) with the additional assumption that the correlation coefficient between gold and stocks equals 1. Explain why one would or would not hold gold in one’s portfolio. Could this set of assumptions about expected returns, volatility and correlation sustain in an equilibrium for the security market?

Solutions

Expert Solution

a) Expected return of gold is 10% which is lower than stock return of 18%. As well as SD of gold is 30% which is more risky than Stock risk of 22%.

One should not ignore the fact that higher risk brings higher return. If there is positive movement in gold price due to higher SD upward movement of gold could be by 30% above mean, which would give us a return of 40%.

b) One adds another asset in a portfolio when the overall risk of the portfolio is reduced (lower portfolio SD) and giving us maximum return. Assets in the portfolio should consist of assets which have lower positive correlation (If possible close to zero) between them which in turn helps in overall risk of the portfolio.

However, we observe that correlation between stock and gold is 1. Which means they are highly correlated. Such mix of assets will not reduce the overall risk of the portfolio, hence it is not a portfolio that will sustain on the security market line.

jeff jeffy answered 1 year ago

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