i.

Expected rate of return of individual stocks =

n

åk
^
k = i Pi
i=1

ABC expected rate of return:

= 0.3(-0.65) + 0.4(0.25) + 0.3(0.95)
= -0.195 + 0.1 + 0.285
= 0.19 or 19%

XYZ expected rate of return:

= 0.3(0.06) + 0.4(0.30) + 0.3(0.40)
= 0.018 + 0.12 + 0.12
= 0.26 or 26%

Standard deviation:

σ = √(ki – kp)2Pi

ABC standard deviation:

(-0.65-0.19)2 × 0.3 + (0.25-0.19)2 × 0.4 + (0.95-0.19)2 × 0.3

= 0.21 + 0.0014 + 0.17
σ2 = 0.38

σ = √0.38
σ = 0.62

XYZ standard deviation:

 (0.06-0.26)2 × 0.3 + (0.30-0.26)2 × 0.4 + (0.40-0.26)2 × 0.3
= 0.012 + 0.0006 + 0.006
σ2 = 0.019
σ = √0.019
σ = 0.14

XYZ stock is preferable because it has a lower risk as shown by a significantly smaller standard
deviation.

ii. The expected return of the portfolio is,

(0.5 × -0.65) + (0.5 × 0.06) × 0.3= -0.09

(0.5 × 0.25) + (0.5 × 0.30) × 0.4= 0.11
(0.5 × 0.95) + (0.5 × 0.40) × 0.3= 0.20
0.22

Portfolio standard deviation:

(-0.09-0.22)2 × 0.3 + (0.11-0.22)2 × 0.4 + (0.20-0.22)2 × 0.3

= 0.03 + 0.005 + 0.00012
σ2 = 0.035
σ = √0.035
σ = 0.19

Combining the two stocks has significantly reduced the risk of the stock that has the highest
stand-alone risk (ABC).