Stocks offer an expected rate of return of 18%, with a standard deviation of 22%. Gold offers an expected return of 10% with a standard deviation of 30%.
a) In light of the apparent inferiority of gold with respect to both mean return and volatility, would anyone hold gold? If so, demonstrate graphically why one would do so.
b) Given the data above, reanswer a) with the additional assumption that the correlation coefficient between gold and stocks equals 1. Draw a graph illustrating why one would or would not hold gold in one’s portfolio. Could this set of assumptions for expected returns, standard deviations, and correlation represent an equilibrium for the security market?