Question

Assume

A portfolio consists of two assets, Investment A and Investment B.

Market Value of Investment A at beginning of period: $600

Market Value of Investment B at beginning of period: $300

Investment A has an expected return of 8%

Investment B has an expected return of 3%

Investment A has a standard deviation (volatility) of returns 15%

Investment B has a standard deviation (volatility) of returns of 6%

The correlation of returns for Investment A and Investment B is 20%

Deliverable

Word or Excel spreadsheet items.

A. Calculate the portfolio standard deviation (volatility) of returns. Show your work.

B. If the correlation of returns was negative 20%, i.e., -20%, what is the portfolio standard deviation (volatility) of returns? Show your work.

C. Did risk increase or decrease when the correlation declined from 20% to -20%? Why? Briefly explain your answer using non-mathematical terminology.

Answer 1

a.  

	Expected return	Investment	Investment Proportion	Standard Deviation	Correlation Coefficient (A to B)
A	8%	$600	66.67%	15%
B	3%	$300	33.33%	6%	20%
Total		$900	100.00%
Expected return of portfolio	6.33%
Standard deviation of portfolio	10.58%

Standard deviation of portfolio 10.58%

b.

	Expected return	Investment	Investment Proportion	Standard Deviation	Correlation Coefficient (A to B)
A	8%	$600	66.67%	15%
B	3%	$300	33.33%	6%	-20%
Total		$900	100.00%
Expected return of portfolio	6.33%
Standard deviation of portfolio	9.80%

Standard deviation of portfolio 9.80%

c. When the correlation declined from 20% to -20%; the portfolio risk has been decreased from 10.58% to 9.80% because they have negative correlation from each other (if one will increase then other will decrease in same proportion) which will help them to reduce the risk at greater extent.

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