You estimated the single index (market) model for stocks P and Q with the following results: Return on Stock P: Rp = 0.04 +0.6RM + ep Return on Stock Q: RQ = 0.04 + 1.4RM + еQ Where RM is return on the single index and ep and eq are error terms which are not correlated with anything and have zero means. In addition, the following statistics are known for RM and the error terms: Mean Risk-free rate 3% Single index return, RM 8% Error term for Stock P return, ep 0% Error term for Stock Q return, eq 0% Standard Deviation 15% 20% 10% Based on the information above, calculate the smallest possible portfolio return standard deviation one can get by forming a two-asset portfolio of Stock P and Q. Hint: Recall the formula for the weight of the minimum variance portfolio. (6 marks) b. Suppose you intend to hold a combined portfolio by allocating 50% in the risk-free asset and the remaining in the minimum variance portfolio (i.e., the risky portfolio you constructed in part a). What is the expected return of your combined portfolio? (4 marks)

Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
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You estimated the single index (market) model for stocks P and Q with the following results:
Return on Stock P: Rp = 0.04 +0.6RM + ep
Return on Stock Q: RQ = 0.04 + 1.4RM + еQ
Where RM is return on the single index and ep and eq are error terms which are not correlated
with anything and have zero means.
In addition, the following statistics are known for RM and the error terms:
Mean
Risk-free rate
3%
Single index return, RM
8%
Error term for Stock P return, ep
0%
Error term for Stock Q return, eq
0%
Standard Deviation
15%
20%
10%
Based on the information above, calculate the smallest possible portfolio return
standard deviation one can get by forming a two-asset portfolio of Stock P and Q.
Hint: Recall the formula for the weight of the minimum variance portfolio.
(6 marks)
b. Suppose you intend to hold a combined portfolio by allocating 50% in the risk-free
asset and the remaining in the minimum variance portfolio (i.e., the risky portfolio you
constructed in part a). What is the expected return of your combined portfolio?
(4 marks)
Transcribed Image Text:You estimated the single index (market) model for stocks P and Q with the following results: Return on Stock P: Rp = 0.04 +0.6RM + ep Return on Stock Q: RQ = 0.04 + 1.4RM + еQ Where RM is return on the single index and ep and eq are error terms which are not correlated with anything and have zero means. In addition, the following statistics are known for RM and the error terms: Mean Risk-free rate 3% Single index return, RM 8% Error term for Stock P return, ep 0% Error term for Stock Q return, eq 0% Standard Deviation 15% 20% 10% Based on the information above, calculate the smallest possible portfolio return standard deviation one can get by forming a two-asset portfolio of Stock P and Q. Hint: Recall the formula for the weight of the minimum variance portfolio. (6 marks) b. Suppose you intend to hold a combined portfolio by allocating 50% in the risk-free asset and the remaining in the minimum variance portfolio (i.e., the risky portfolio you constructed in part a). What is the expected return of your combined portfolio? (4 marks)
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