a. Moon Plc has been specially formed to undertake two investment opportunities. The risk and return characteristics of the two projects are shown below:
X Y
Expected Return 10% 20%
Risk (standard deviation) 4% 7%
Moon plans to invest 60% of its available funds in Project X and 40% in Project Y. The directors believe that the correlation coefficient between the returns of the projects is +0.18.
Required:
i. Calculate the expected return from the proposed portfolio of Projects X and Y
ii. Calculate the risk of the portfolio and comment upon your result in the context of the risk reduction effect of diversification.
iii. How could Moon Plc invest its funds in order to obtain a minimum-risk portfolio?
b. Explain the principle of diversification. Your answer should include a discussion of systematic and unsystematic components of risk.
c. What return would a well-diversified investor expect from a Company, given the following information:
σA = 20%, σM=10% and rhoA,M =+0.6
Rf = 6%, RM =13%
