Problem 1. Assume ABC are all positively correlated. A fourth stock is being considered for addition to the portfolio, either stock D or stock E. Both D and E have expected returns of 12%. If stock D is positively correlated with ABC and E is negatively correlated with ABC, which stock should be added to the portfolio? Why?
Problem 2. Assume that the dividend payout ratio on the S&P 100 will be 40 percent when the rate on long-term government bonds falls to 9 percent. Investors being more risk averse demand an equity risk premium of eight percent. If the growth rate of dividends is expected to be 10 percent, what will be the price of the market index if the earnings expectation is $30?
Problem 3. . Calculate the risk (standard deviation) of the following two-security portfolio if the correlation coefficient between the two securities is equal to 0.5.
Variance Weight (in the portfolio)
Security A 10 0.3
Security B 20 0.7
b. Given the following probability distribution, calculate the expected return of security XYZ.
Security XYZ's
Potential return Probability
20% 0.3
30% 0.2
-40% 0.1
50% 0.1
10% 0.3