Use the table for the question(s) below . Consider the following expected returns, volatilities, and correlations:...

Use the table for the question(s) below . Consider the following expected returns, volatilities, and correlations: Stock Expected Return Standard Deviation Correlation with Duke Energy Correlation with Microsoft Correlation with Wal Mart − Duke Energy 14% 6% 1.0 1.0 − 0.0 Microsoft 44% 24% 1.0 − 1.0 0.7 Wal Mart − 23% 14% 0.0 0.7 1.0 Which of the following combinations of two stocks would give you the biggest reduction in risk? A. Microsoft and Duke Energy B. Duke Energy and Wal Mart − C. Wal Mart and Microsoft − D. No combination will reduce risk.

Solutions

Expert Solution

B. Duke Energy and Walmart

Reduction in risk of Portfolio depends upon the correlation between stocks. Correlation values lies between -1.00 to + 1.00. If correlation is 1.00 i.e positively perfectly correlated then there would be no reduction in risk of portfolio it will be same as weighted average of risk. As correlation reduces the reduction in portfolio risk also reduces.

In above case, Duke and Walmart has lowest correlation i.e 0 (uncorrelated) Thus, this combination would give biggest reduction in risk.

Please refer to below spreadsheet for calculation and answer. Cell reference also provided.

Cell reference -

Hope this will help, please do comment if you need any further explanation. Your feedback would be appreciated.

jeff jeffy answered 7 months ago

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