8006 Exam Dumps : Exam I: Finance Theory Financial Instruments Financial Markets - 2015 Edition

When assets are uncorrelated, variances are additive. But volatility (which is standard deviation) is not. In the given situation, the total variance of the portfolio will be equal to the the square root of the sum of the variances of the assets in the portfolio weighted by the square of their weights. Its volatility will be the square root of this variance. Thus Choice 'c' is the correct answer.

(This is because V(cA + dB) = c^2 V(A) + d^2 V(B) - refer tutorial on combining variances.)

Choice 'a' is incorrect as it describes the calculation of variance, not volatility. Also, the presence of a large number of uncorrelated assets does not create a portfolio with volatility equal to zero or that of the market. The other choices are therefore incorrect.

The stock has a beta of 1.2, therefore intuitively it can be expected to earn more than the broad market index. It will earn the risk free rate, ie 3%, and 1.2 times the equity risk premium of 5% (8% - 3%). The expected returns from the stock therefore are 3% + (8% - 3%)*1.2 = 9%

Systematic risk refers to market risk that cannot be diversified away. Specific risk relates to the unique risk from the securities selected in the portfolio, and these can be diversified away by adding other securities to the portfolio. Diversifiable risk is risk that can be diversified away, ie the same as specific risk. Portfolio risk is the total risk of the portfolio that includes both specific and systematic risk.