Question

Calculate the followings and verify the diversification effect with the data in the table assuming that with the initial endowment of $10,000, you invest $6,000 in Stock A and $4,000 in Stock B. Also four states of the economy are assumed to be equally likely.

Return on Stock A		Return on Stock B
−20%		5%
10%		20%
30%		−12%
50%		9%

Question 1.    Covariance between securities

Question 2.    Correlation coefficient between securities

Question 3.    Variance of a portfolio

Question 4.    Standard deviation of a portfolio

Question 5. Compare the weighted average of standard deviations of individual securities with

the portfolio standard deviation. Did you see diversification effect?

Answer 1