Question

a) i. Determine the expected return and risk of a portfolio made up of 70 per cent of security X and 30 per cent of security Y if the correlation coefficient for the returns on X and Y is +0.2 Security Expected Return Standard Deviation of Return

X 12 per cent 15 per cent

Y 18 per cent 22 per cent

ii. Explain briefly why the risk of the portfolio specified above is below the weighted average of the risk of securities of X and Y.

b) Explain how increasing the number of securities in a portfolio is likely to reduce the risk of the portfolio but it is unlikely to eliminate all of the risk.

Answer 1

There are two types of risk viz. Systematic Risk and Unsystematic Risk. Systematic risk can be reduced and mitigated by creating a portfolio of securities having low correlation. In the above question, since the correlation was very insignificant and hence the portfolio risk is even lower than individual risks of both securities.

Portfolio risk is not merely weighted average of the security risks but the reference is made as to the relation between the two securities.