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AB
o
A
o
B
, for
AB
=0.6,
o
p
2
= (.30)
2
(.18)
2
+(.70)
2
(.21)
2
+2(.30)(.70)(0.6)(.18)(.21)
= 0.034051
or, o
p
= 18.45%
For
AB
=-0.4,
o
p
2
= (.30)
2
(.18)
2
+(.70)
2
(.21)
2
+2(.30)(.70)(-0.4)(.18)(.21)
= 0.018175
or, o
p
= 13.48%
3.b. Assume now that
AB
=-1.0 and find the portfolio (p) of stocks A and B that has no risk (i.e. such that
o
p
=0). Can you do the same when
AB
=1.0? If not, why? If so, find that portfolio. Explain.
SOLUTI ON:
From
o
p
2
=e
A
2
o
A
2
+e
B
2
o
B
2
+ 2e
A
e
B
AB
o
A
o
B
, we want to find e
A
such that o
p
2
=0, when
AB
=-1.0.
Since e
B
=1-e
A
, we need to solve
e
A
2
o
A
2
+(1e
A
)
2
o
B
2
2e
A
(1e
A
)o
A
o
B
=0,
or equivalently,
e
A
o
A
(1e
A
)o
B
( )
2
= 0.
This has the solution
5385 . 0
21 . 0 18 . 0
21 . 0
=
+
=
+
=
B A
B
A
o o
o
e .
The remaining weight is e
B
=1-e
A
=0.4615.
For the case when
AB
=1.0, we need to solve
e
A
2
o
A
2
+(1e
A
)
2
o
B
2
+2e
A
(1e
A
)o
A
o
B
=0,
or equivalently,
e
A
o
A
+ (1e
A
)o
B
( )
2
= 0.
This has the solution
7
18 . 0 21 . 0
21 . 0
=
=
A B
B
A
o o
o
e ,
and e
B
=1-e
A
=-6 (which is a short position).
An alternative method is to use the Solver or Goal Seek tools in Excel. This has the disadvantage
that the computer may stop looking for a solution when it is close enough, but may still be
significantly off.
3.c. Finally, assume that
AB
=0. Find the standard deviations of portfolios with the following expected
returns: 8%, 9%, 10%, 11%, 12%, 13%, 14% and 15%. Plot the pairs of expected return and standard
deviation on a graph (with the standard deviations on the horizontal axis, and the expected returns on the
vertical axis).
SOLUTI ON:
To figure out the portfolio weights needed to generate each expected return, you can solve E[r
P
] = e
A
E[r
A
] +e
B
E[r
B
] for e
A
, using e
B
=1-e
A
,
% 2
] [ % 12
% 12 % 10
% 12 ] [
] [ ] [
] [ ] [
P P
B A
B P
A
r E r E
r E r E
r E r E
=
= e
for each desired level of E[r
P
]. Once you determine e
A
, and since
AB
=0, we can then get the standard
deviation for each portfolio, using
2 2 2 2 2 2 2 2
21 . 0 ) 1 ( 18 . 0
A A B B A A p
e e o e o e o + = + =
Mean-Standard Deviation Frontier
8%
9%
10%
11%
12%
13%
14%
15%
6%
7%
8%
9%
10%
11%
12%
13%
14%
15%
16%
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7
Standard Deviation
E
x
p
e
c
t
e
d
R
e
t
u
r
n
4. Every time a certain asset A experiences a 1 percent increase in its rate of return, the return on asset B
experiences exactly a 0.5 percent decrease (with no error). What is the correlation coefficient between the
returns of these two assets? Explain.
SOLUTI ON:
There is a negative perfect correlation (correl =-1) between assets A and B. When A goes up, asset B
goes down by a certain amount (with no error). Therefore the correlation between the two asset returns
is exactly -1. I f we had run a regression of return of asset B on return of asset A we would have found
that the beta (slope) would be -0.5 and the fit of the line was perfect.
On slide 38 of Lecture Notes 2 (Quantitative Review), the very last expression on the properties of the
correlation measure, can be re-written as follows:
Corr(a+b*r1, r2)=[Cov(a+b*r1, r2)]/[SD(a+b*r1)*SD(r2)]=[b*Cov(r1, r2)]/[|b|*SD(r1)*SD(r2)]=
[Cov(r1, r2)]/[SD(r1)*SD(r2)] =Corr(r1,r2) if b>0 or =- Corr(r1,r2) if b<0 or =0 if b=0
Therefore: Corr(a+b*r1, r2) =Corr(r1,r2) if b>0 or =- Corr(r1,r2) if b<0 or =0 if b=0