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a) The UK stock market has an annual expected return of 5% and a standard...

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a) The UK stock market has an annual expected return of 5% and a standard deviation of returns of 24%. The Japanese stock market has an annual expected return of 8% and standard deviation of returns of 30% in sterling terms. The correlation between the returns of the UK and the Japanese sterling returns is 0.25. Show whether Portfolio A, which is constructed by investing 30% in the UK and 70% in Japan, is a better portfolio for a UK investor to hold than the UK stock market alone. (25% weighting) b) The UK risk-free rate for both borrowing and lending is 1.5%. Show whether a Portfolio B constructed from a combination of Portfolio A and the risk-free asset can be a better portfolio for a UK investor to hold than the Japanese stock market alone. (25% weighting) c) Diversification eliminates idiosyncratic (unique or firm-specific) risk but does not eliminate systematic risk. Evaluate this statement. What happens to the benefits of diversification as portfolios get larger? Why do you think there are changes to the benefits of diversification as portfolios get larger? (50% weighting)

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