Question

You consider investing in an emerging market. Its stock market volatility (standard deviation of returns measured in U.S. dollars) is 25%. The volatility of the World index of developed markets is 15%. The correlation between the emerging market and the World index is 0.2.

a. What would be the volatility of a portfolio invested 95% in the World index and 5% in this emerging market?

b. Compare the result found in the previous question with the volatility of the World index and give an intuitive explanation.

Answer 1

A. Volatility of the portfolio can be simply calculated by the Standard deviation of the portfolio.

The calculations are shown in the excel screenshot.

B. The volatility/risk with the world index is simply 15%, but as we add the stocks from the emerging market into the portfolio it decreases the risk/volatility of the portfolio, with a probable higher return as the emrging makret have a higher Standard deviation, which would probably fetch a higher return increasing the overall portfolio return. This means that it is atleast better than investing 100% in the world portfolio and there is a diversification benefit. Obviously, we'd also compare the expected returns before making the decision. But given the following information, we can say that, this portfolio is well diversified than investing in world index and might fetch a better return than that.