Question

Answer the following questions:

1. Explain the primary goal of portfolio diversification as it relates to asset allocation and correlation.

2. You are advising several individual investors who are interested in investing in portfolios comprised of both stocks and bonds. In preparation for meeting with these various investors, you plot the investment opportunity set for stocks and bonds. Given this information, why might you advise some of the investors to invest in a portfolio other than the minimum variance portfolio?

3. Foreign securities are generally considered to be more risky than domesticsecurities. Given assumption, explain how adding foreign securities into a domestic portfolio can affect the Markowitz efficient portfolios.

4. Explain the relationship between the security market line and market efficiency.

5. Identify and describe each of the three components of a security's expected return according to the capital asset pricing model.

6. Alfonso Rodriquez has served as the president of Imports United for the past six years. During his tenure, the company has grown significantly and provided above-average returns to its shareholders. Thus, Mr. Rodriquez is highly admired. Yesterday, he announced that he will be retiring at the end of this quarter. You expected the stock price of Imports United to decline on this news because of the admiration investors have for this gentleman. Contrary to your expectations, the price of the stock remained unchanged. There was no other relevant market news related to this firm and the overall market also remained relatively unchanged for the day. What explanation can be given for the market not reacting as you expected to Mr. Rodriquez's announcement?

7. Explain the similarities and differences between the Sharpe and Treynor ratios. Also, explain the most appropriate application for each.

8. Explain a key advantage and a key disadvantage of Jensen's alpha.

9. A conservative investor has a well-diversified portfolio but is still concerned about two things. First, he is concerned about the downside risk and secondly, he is concerned whether he is earning a sufficient rate of return to compensate for the total risk he is assuming. How could you quantify these concerns for this investor?

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1. Explain the primary goal of portfolio diversification as it relates to asset allocation and correlation.

The primary goal of portfolio diversification is to lower the total risk of a portfolio without sacrificing expected return. The lower the correlation among the returns of securities within a portfolio, the better this goal is met. Individual securities tend to be more correlated with other securities within its asset class and less correlated with individual securities in other asset classes. For example, stocks tend to be highly positively correlated with other stocks, bonds tend to be highly positively correlated with other bonds (and inversely with interest rates), yet stock and bond returns are less positively correlated with each other. Therefore, a portfolio will be more broadly diversified across several asset classes than if it is comprised of securities within one or fewer asset classes....

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