Portfolio Management - Portfolio Management Section 1
- Option : A
- Explanation : Higher correlations will result in a lower diversification benefit and higher volatility.
- Option : C
- Explanation : 10% = w¡* 16 % + (1 – w¡)* 6%; w¡ = 40%, (1 – w¡) = 60%. Thus, 40 percent should be invested in the small-cap fund and 60 percent should be invested in the bond fund.
8. Information about a portfolio that consist of two assets is provided below:
| Asset | Portfolio Weight | Standard deviation |
| ABC | 30% | 10% |
| JKL | 70% | 8% |
If the correlation coefficient between the two assets is 0.8, the standard deviation of the portfolio is closest to:
- Option : A
- Explanation : Portfolio standard deviation = √((0.3)² (0.1)² + (0.7)² (0.08)² + 2 (0.8)(0.3)(0.7)(0.1)(0.08)) = 0.082 = 8.2%.
- Option : B
- Explanation : Diversification benefit is greatest when a portfolio consists of securities that do not move together and thus the investor should invest in securities with the lowest correlation i.e. – 0.86.
10. A correlation matrix of the returns for securities A, B, and C is reported below:
| Security | A | B | C |
| A. | 1 | ||
| B. | -1 | 1 | |
| C. | 0.5 | -0.5 | 1 |
Assuming that the expected return and the standard deviation of each security are the same, a portfolio consisting of an equal allocation of which two securities will be most effective for portfolio diversification?
Securities:
Securities:
- Option : A
- Explanation : The negative correlation of –1.0 between investment instruments A and B is lowest and therefore is most effective for portfolio diversification.
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