Lecture 3 (Chapter7)

Question 1

Diversification tries to remove what?

Answer 1

Firm-specific risk

Question 2

Portfolio return of two risky assets

Answer 2

r\p = w\d r\d + w\e r\e

Question 3

Variance of Rp

Answer 3

o^2\p = w^2\d o^2\d + w^2\e o^2\e + 2w\d w\e Cov(r\d, r\e)

Question 4

Covariance of returns on bonds and equity

Answer 4

Cov(r\d, r\e) = p\de o\d o\e

Question 5

What happens when p\de o\do\e = -1?

Answer 5

• Debt and equity are perfectly inversely related
• There is no diversification
• A perfect hedge is available