Suppose a client wants to combine one of two stocks, D and E with C. Stocks...
Suppose a client wants to combine one of two stocks, D and E with C. Stocks D and E both have the same expected return, 15%, but D's risk is 20% while E's risk equals 30%. However, CORR(C,D) equals +1.00 and CORR(C,E) is -.80. Which stock, D or E, should be combined in a portfolio with C? Explain.
Homework Answers
Stock E should be added to the portfolio with the C, because it will reduce the overall risk of the portfolio due to negative correlation between C and E. It will reduce the risk.
For example, the risk of the portfolio (C and E) = (Wc*Rc)^2 + (We*Re)^2 - .8*2Wc*We*SD of C * SD of E)^.5
Here, -.8*2Wc*We*SD of C * SD of E in above equation, will reduce the risk.
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