21 Lecture - Two stock portfolio theory, risk and expected return

  1. Home
  2. Courses
  3. Financial Management
  4. 21 Lecture

21 Lecture

MGT201

Midterm & Final Term Short Notes

Two stock portfolio theory, risk and expected return

The two-stock portfolio theory is a concept that refers to investing in two different stocks as a means of reducing investment risk. The theory suggests that by investing in two stocks that are not highly correlated, investors can reduce their o


Important Mcq's
Midterm & Finalterm Prepration
Past papers included

Download PDF

  1. What is the main concept of the two-stock portfolio theory? A) Investing in two different stocks as a means of reducing investment risk. B) Investing in two highly correlated stocks to increase portfolio risk. C) Investing in a single stock to maximize portfolio risk. Answer: A

  2. How can investors reduce portfolio risk through the two-stock portfolio theory? A) By investing in two highly correlated stocks. B) By investing in a single stock. C) By investing in two stocks that are not highly correlated. Answer: C

  3. What is the expected return of a two-stock portfolio? A) It is the sum of the expected returns of each stock in the portfolio. B) It is the average of the expected returns of each stock in the portfolio. C) It is the weighted average of the expected returns of each stock in the portfolio. Answer: C

  4. How does the correlation between two stocks in a portfolio affect the overall risk of the portfolio? A) Higher correlation leads to higher portfolio risk. B) Lower correlation leads to higher portfolio risk. C) Correlation has no impact on portfolio risk. Answer: B

  5. What is diversification in the context of a two-stock portfolio? A) Spreading investments across multiple asset classes. B) Spreading investments across multiple stocks. C) Investing in a single stock. Answer: B

  6. Which of the following is a potential benefit of the two-stock portfolio theory? A) Increased portfolio risk. B) Decreased portfolio risk. C) Increased portfolio returns. Answer: B

  7. How is portfolio risk calculated in the context of a two-stock portfolio? A) It is the sum of the risks of each stock in the portfolio. B) It is the average of the risks of each stock in the portfolio. C) It is a function of the correlation between the two stocks. Answer: C

  8. What is the expected return of a stock? A) It is the return an investor can expect to receive on the stock. B) It is the price at which the stock is expected to be sold. C) It is the price at which the stock was purchased. Answer: A

  9. Which of the following factors is NOT considered when calculating the expected return of a two-stock portfolio? A) The expected return of each individual stock in the portfolio. B) The correlation between the two stocks in the portfolio. C) The total amount invested in the portfolio. Answer: C

  10. Which of the following is an example of diversification in a two-stock portfolio? A) Investing in two highly correlated stocks. B) Investing in a single stock. C) Investing in two stocks that are not highly correlated. Answer: C



Subjective Short Notes
Midterm & Finalterm Prepration
Past papers included

Download PDF

  1. What is a portfolio in the context of stock investments? Answer: A portfolio is a collection of stocks or other securities held by an investor.

  2. What is diversification, and why is it important in stock portfolio theory? Answer: Diversification means spreading your investments across different types of stocks or securities to reduce risk. It is important in portfolio theory because it helps to minimize the impact of any single stock's performance on the overall portfolio.

  3. What is the difference between systematic and unsystematic risk? Answer: Systematic risk refers to risks that are inherent in the entire market or economy, while unsystematic risk is specific to a particular company or industry.

  4. How is expected return calculated in the context of portfolio theory? Answer: Expected return is calculated by taking the weighted average of the expected returns of each stock in the portfolio, where the weights are the proportions of the portfolio invested in each stock.

  5. What is the correlation coefficient, and how is it used in portfolio theory? Answer: The correlation coefficient measures the degree to which two stocks move together. In portfolio theory, it is used to determine the degree of diversification achieved by adding a stock to an existing portfolio.

  6. What is the efficient frontier in portfolio theory? Answer: The efficient frontier is the set of portfolios that achieve the highest possible return for a given level of risk, or the lowest possible risk for a given level of return.

  7. What is the Capital Asset Pricing Model (CAPM), and how is it used in portfolio theory? Answer: The CAPM is a model that describes the relationship between risk and expected return. It is used in portfolio theory to calculate the expected return of a stock or portfolio given its level of risk.

  8. What is the difference between a market portfolio and a risk-free asset? Answer: A market portfolio is a portfolio that contains all stocks in the market, while a risk-free asset is an investment with no risk of loss.

  9. What is the Sharpe ratio, and how is it used in portfolio theory? Answer: The Sharpe ratio measures the excess return earned by a portfolio per unit of risk. It is used in portfolio theory to compare the performance of different portfolios.

  10. What is the importance of regularly rebalancing a stock portfolio? Answer: Regularly rebalancing a stock portfolio helps to maintain the desired level of risk and return, as well as ensure that the portfolio remains diversified. It also helps to avoid the risk of overconcentration in any one stock or sector.

Two-Stock Portfolio Theory is a fundamental concept in finance, which helps investors determine the risk and expected return of a portfolio. In this theory, the risk of a portfolio is not just the sum of the risks of the individual stocks but is also influenced by the correlation between the stocks. Correlation measures the extent to which the returns of two stocks move together. The expected return of a portfolio is the weighted average of the expected returns of the individual stocks in the portfolio. The weights are determined by the proportion of the portfolio invested in each stock. The risk of a portfolio is measured by the standard deviation of its returns. The theory states that when two stocks with a positive correlation are combined in a portfolio, the portfolio risk will be lower than the weighted average of the risks of the individual stocks. However, when two stocks with a negative correlation are combined in a portfolio, the portfolio risk will be even lower. The combination of two stocks with a negative correlation can result in a portfolio that has lower risk than either of the individual stocks. The expected return of a two-stock portfolio can be calculated using the formula: Expected Return = (Weight of Stock 1 × Expected Return of Stock 1) + (Weight of Stock 2 × Expected Return of Stock 2) The risk of a two-stock portfolio can be measured by the co-variance of the returns of the two stocks. The co-variance is a measure of the degree to which the returns of two stocks move together. The co-variance of two stocks can be calculated using the formula: Co-variance = (Correlation Coefficient × Standard Deviation of Stock 1 × Standard Deviation of Stock 2) By combining stocks with different expected returns and risks in a portfolio, investors can achieve a desired level of risk and return. The optimal portfolio is the portfolio that offers the highest expected return for a given level of risk or the lowest risk for a given level of expected return. The theory of portfolio selection provides a framework for building diversified portfolios that optimize the risk and return trade-off.

Course Lectures