Question

(i)

The expected returns on two distinct risky assets A and B are correlated and a portfolio consisting of A and B has zero variance of expected return. What can be said about the correlation between the expected returns of risky assets A and B?

(ii)

An investor constructs an efficient portfolio that invests 150% of his investment in the tangent portfolio of risky asset and is short in the risky free asset for the rest. What can be said about the standard deviation of the efficient portfolio?

Answer 1

I) when the standard deviation of two assets is zero, it means that both the assets will have similar rate of return and it will mean that the asset will be perfectly correlated to each other because it is a positive correlation when the the return of one stock is completely replicated by another stock. It will mean that both the assets are perfectly positively correlated and they will have a correlation of +1.

Ii) standard deviation of this portfolio would be relatively low because it is mostly focusing into investment at the tangency point, which is also known as Efficient market portfolio so at these points the deviation from the mean would be lowest.