Course Assignment

Discussions

ACCT 6010 Corporate Finance

Lecturer Dr. Carl Robinson
Student Angelica Lopez
ID Number 400002613
 1. Discuss the diversification benefits offered by different stocks.

Diversification involves the inclusion of a large number of investments in a portfolio to

reduce risk. Moreover, the key to reducing risk through diversification is to combine

investments whose returns do not move together and thus are not perfectly correlated. The

disappearance of volatility is due to such diversification. By diversifying the portfolio, it is

possible to eliminate some risk without sacrificing expected return. Surely then,

diversification is beneficial. It leads to a “free” risk reduction which is favorable to risk-

averse investors.

The concept of correlation is a critical aspect in understanding portfolio diversification as it

measures the degree to which the returns on two investments are correlated using the

correlation coefficient. The correlation coefficient is a measure of the relationship of the

return earned by one investment to that earned of another. A correlation of 1 shows a perfect

linear relationship between assets; thus yielding no potential benefits of diversification. On

the other hand, with correlation of 0.5, diversification can be achieved. The lower the

correlation, the greater the diversification benefit offered by the stock. In fact, a correlation

of 0 indicates that there is no linear relationship between the assets and more diversification

can be attained. A correlation of -1 demonstrates a perfect inverse linear relationship and a

high achievement of diversification benefits.

An analysis of the thirty (30) US stocks shows that diversification benefits are offered by the

different stocks. For example, the table below illustrates stocks that enjoyed the highest

diversification benefits with a range from -0.04 to .10 . The correlation of these diversified

stocks shows means that as the price of one stock falls, the price of the other stick increases,

thus reducing the risk to the investor.

Stock 1 Stock 2 Correlation

Chevron Corp Eastman Kodak -0.04

AT&T Int Business Mach Corp -0.02

AT&T Texaco 0

Eastman KODAK Co Wool worth Corp 0

Boeing Co. Eastman Kodak Co 0.02

Bethlehem Steel USX Corp 0.02

Corporation

Eastman KODAK Co Boeing Co 0.02

Eastman KODAK Co Goodyear Tire & Rubr Co 0.02

Eastman KODAK Co Bethlehem Steel Corp 0.04

Eastman KODAK Co Union Carbide 0.04

Eastman KODAK Co Texaco Inc 0.05

Phillip Morris Texaco Inc .05

Chevron Corp AT &T 0.06

Goodyear tire& Rubr Co Int Business Mach Corp 0.06

Eastman KODAK Co Exxon Corp 0.07

Eastman KODAK Co General Motors Corp 0.07

Navistart Int Corp 3M 0.07

Phillip Morris General Motors Corp 0.07

XXON CORP Union Carbide 0.08

Goodyear tire &Rubr Co Philip Morris Cos Inc 0.08

Merck & Co Inc USX Corp 0.08

Phillip Morris Chevron Corp .08

 Phillip Morris Goodyear Tire & Rubr Co .08

Chevron Corp Bethlehem Steel Corp 0.09

Int Business Mach Corp Wool Worth Corp 0.09

3m American Expresso Co .10

Apart from these stocks, a variety of other stocks enjoyed correlations between .15 to .40.

Surely then, the combination of US domestic stocks would lead to diversification

benefits.

6. Using the results from Questions 2 and 5, Discuss the benefits of Domestic VS

International diversification

The US Domestic Portfolio yields a minimum variance of 19.59 while the Global Stocks

yields a minimum variance of 418.16. Notably, this is the minimum variance for a given

level of risk. The more significant the change in price, the higher its variance, and more

volatile. On the other hand, the Sharpe ratio for the Domestic US Portfolio is 0.82 while

the Global Portfolio is 0.02. The Sharpe ratio indicates how well an equity investment

performs in comparison to the rate of return on a risk-free investment. Evidently, the

global stocks/ global portfolio has a higher variance than the US domestic stocks. It is

likely that the global/international stocks are less likely to be correlated; the lower the

correlation, the greater the diversification benefit offered by the stock. Higher variance

means more diversification and greater benefits. Surely then, International Diversification

yields more benefits than Domestic diversification