You are interested in creating a portfolio of two stocks – Coca Cola and Texas Utilities. Over the last decade, an investment in Coca Cola stock would have earned an average annual return of 25%, with a standard deviation in returns of 36%. An investment in Texas Utilities stock would have earned an average annual return of 12%, with a standard deviation of 22%. The correlation in returns across the two stocks is 0.28.
a. Assuming that the average and standard deviation, estimated using past returns, will continue to hold in the future, estimate the average returns and standard deviation of a portfolio composed 60% of Coca Cola and 40% of Texas Utilities stock.
b. Estimate the minimum variance portfolio.
c. Now assume that Coca Cola’s international diversification will reduce the correlation to 0.20, while increasing Coca Cola’s standard deviation in returns to 45%. Assuming all of the other numbers remain unchanged, answer (a) and (b).