rate of return is   E(rHumanex) .5E(rBest) .5rBills (.5 10.5) (.5 5) 7.75% The standard deviation of the portfolio may be derived from rule 4. Rule 4 When a risky asset is combined with a risk-free asset, the portfolio standard devi- ation equals the risky assets standard deviation multiplied by the portfolio proportion in- vested in the risky asset. The Humanex portfolio is 50% invested in Best stock and 50% invested in risk-free bills. Therefore,   Humanex .5 Best .5 18.9 9.45%   By reducing its exposure to the risk of Best by half, Humanex reduces its portfolio stan- dard deviation by half. The cost of this risk reduction, however, is a reduction in expected return. The expected rate of return on Best stock is 10.5%. The expected return on the one- half T-bill portfolio is 7.75%. Thus, while the risk premium for Best stock over the 5% rate on risk-free bills is 5.5%, it is only 2.75% for the half T-bill portfolio. By reducing the share of Best stock in the portfolio by one-half, Humanex reduces its portfolio risk premium by one-half, from 5.5% to 2.75%. In an effort to improve the contribution of the endowment to the operating budget, Humanexs trustees hire Sally, a recent MBA, as a consultant. Researching the sugar and candy industry, Sally discovers, not surprisingly, that during years of sugar shortage, SugarKane, a big Hawaiian sugar company, reaps unusual profits and its stock price soars. A scenario analysis of SugarKanes stock looks like this:   Normal Year for Sugar Abnormal Year   Bullish Bearish Stock Market Stock Market Sugar Crisis   Probability .5 .3 .2 Rate of return 1% 5% 35%   The expected rate of return on SugarKanes stock is 6%, and its standard deviation is 14.73%. Thus SugarKane is almost as volatile as Best, yet its expected return is only a notch better than the T-bill rate. This cursory analysis makes SugarKane appear to be an un- attractive investment. For Humanex, however, the stock holds great promise. SugarKane offers excellent hedging potential for holders of Best stock because its return is highest precisely when Bests return is lowest-during a sugar crisis. Consider Hu- manexs portfolio when it splits its investment evenly between Best and SugarKane. The rate of return for each scenario is the simple average of the rates on Best and SugarKane because the portfolio is split evenly between the two stocks (see rule 3).