Question

In: Finance

Mrs Daisy is considering two securities, A abd B, and the relevant information is given below:...

  1. Mrs Daisy is considering two securities, A abd B, and the relevant information is given below:

State of Economy

Probability

Retrun on Security A (%)

Return on Security B (%)

Bear

0.6

3.00%

6.50%

Bull

0.4

15.00%

  1. Calculate the expected returns and standard deviations of security A and security B.

2. Explain how diversification can reduce the unsystematic risk of a given portfolio?

(Answer in 1000 words)

Solutions

Expert Solution

2. Unsystematic risk is known as diversifiable risk or specific risk which means that this risk is associated with a specific company or industry. And diversification of a portfolio means investing or putting your money into different asset classes or securities which may include domestic stocks, bonds, short-term investments, international stocks, sector funds, commodity based funds, real estate funds etc. We invest in diversified portfolio to limit the risk asscociated with one type of asset. By investing into different asset classes we mitigate the risk and volatility associated with the single security or industry. Let us understand this by taking an example of airline industry and railway industry. Suppose the employee of the airline industry goes on strike for an indefinite period, it will cause the damage to airline industry and the prices will go down and at the same if you have diversified your portfolio with railway industry which will be at the best price that time due to strike in the airline industry, then you will be able to mitigate your risk from the railway stock.

a)

jeff jeffy answered 1 year ago
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