Question

1. Holding asset expected return constant, our efficient frontier gets better when the covariance (correlations) between our assets’ returns does what?

2. What do you think is the biggest hurdle when implementing the Markowitz portfolio selection model? Briefly discuss how you address the problem.

3. Describe one way that the risk borne by investors in a securitization can be lessened.

Answer 1

1.) For a two asset portfolio variance is given by:

Portfolio Variance = w2A*σ2(RA) + w2B*σ2(RB) + 2*(wA)*(wB)*Cov(RA, RB)

As we can see, the Portfolio variance will decrease when covariance (or correlation) between the assets decreases.

2.) One of the biggest hurdles of Markowitz portfolio theory is, it assumes correlation between assets in a portfolio to be constant. However, in the real world, the correlation keeps on changing.

3.) By securitization, the risk borne by the investor is distributed among a pool of borrowers. So, even if some borrowers default, the investor will still be entitled the cash flows.