Financial Economics Question on Efficient Diversity and risky assets.
a. Minimum risk portfolios if correlation is: -1: 62.5% AT&T, 37.5% Microsoft 0: 73.5% AT&T, 26.5% Microsoft .5: 92.1% AT&T, 7.9% Microsoft 1: 250% AT&T, short sell 150% Microsoft
As the correlation grows from -1 to +1, so does the allocation to AT&T. When two stocks have a negative correlation, combining them in a portfolio can significantly lower standard deviation. It is advantageous for investors to weight more heavily the stock with the higher anticipated return since this produces a high portfolio expected return while decreasing the portfolio's standard deviation. As a result, the maximum allocation to Microsoft is found with a correlation of -1, and the allocation to Microsoft diminishes as the correlation increases to +1. The returns of the two stocks will move in lockstep with a correlation of +1.
What is the minimum risk (variance) portfolio of AT&T and Microsoft if the correlation between the two stocks is 0? .5? 1? -1? What do you notice about the change in the allocations between AT&T and Microsoft as their correlation moves from -1 to 0? to .5