Topic 5.

Diversification and Delimiting the Efficient

Frontier
Questions and Answers

Question 5.1. Consider the following expected returns and risk for two securities.

Expected Return
10%
4%

1
2

Standard Deviation
5%
2%

For the two securities shown, plot all combinations of the two securities in rP P space
assuming that (i) 12 1 , (ii) 12 0 and (iii) 12 1 . For each correlation coefficient, what
is the combination that yields the minimum P and what is that P ? Assume no short selling.

Question 5.2. 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 sovereign
bond fund that yields a risk-less rate of return of 8%. The probability distributions of the two
funds are

Stock Fund (S)

Bond Fund (B)

Expected Return
20%
12%

Standard Deviation
30%
15%

The correlation between the two funds is 0.10.

i.

ii.
iii.
iv.

What are the investment proportions in the minimum variance portfolio of the two
risky funds and what is the expected value and standard deviation of its rate of
return?
Solve numerically for the proportions of each asset and the expected return and
standard deviation of the optimal portfolio.
What is the reward-to-volatility ratio of the best feasible CAL?
You require that your portfolio yield an expected return of 14% and that it be on the
best feasible CAL.
a. What is the standard deviation of the portfolio?
b. What is the proportion invested in the sovereign bond fund and each of the two
risky funds?
1

v.

If you were to use only the two risky funds and still require an expected return of
14% what would be the investment proportions of the portfolio?

Question 5.4. Which one of the following portfolios cannot lie on the efficient frontier as
described by Markowitz?

Portfolio
W
X
Y
Z

Expected Return (%)

15
12
5
9

Standard Deviation (%)

36
15
7
21

Question 5.5. Stocks A, B and C have the same expected return and standard deviation. The
following shows the correlation between the returns on the stocks.

Stock A
Stock B
Stock C

Stock A
1.0
0.9
0.1

Stock B

Stock C

1.0
-0.4

1.0

Given these correlations, the portfolio constructed from these stocks having the lowest risk is
a portfolio
i.
ii.
iii.
iv.

Equally invested in stocks A and B.

Equally invested in stocks A and C.
Equally invested in stocks B and C.
Invested only in stock C.

Question 5.6. Abigail Grace has a $900,000 fully diversified portfolio. She subsequently
inherits ABC Company common stock worth $100,000. Her financial advisor provided her
with the following forecast information.

Expected Monthly Returns

Original Portfolio
ABC Company

0.67%
1.25%

Standard Monthly Deviation

of Monthly Returns
2.37%
2.95%

The correlation coefficient of ABC with the original portfolio is 0.40.

i.

ii.

iii.

Assuming Grace keeps the ABC stock calculate the

a. Expected return of her new portfolio which includes ABC stock.
b. Covariance of ABC with the original portfolio.
c. Standard deviation of the new portfolio which includes the ABC stock.
If Grace sells the ABC stock she will invest the proceeds at the risk-free rate of
0.42% per month. Assuming that Grace sells the ABC stock and buys Government
securities calculate the
a. Expected return of her new portfolio which includes Government securities.
b. Covariance of Government securities with the original portfolio.
c. Standard deviation of the new portfolio which includes the Government
securities.
Determine whether the systematic risk of her new portfolio which includes
government securities is higher or lower than that of her original portfolio.