Question

Review the example from the lecture about Umbrella Inc and Sunscreen Inc. Both companies have 10% return & 45% volatility and are perfectly negatively correlated.

The risk of each stock (Sunscreen or Umbrella) by ITSELF is the its standard deviation, which is this example is 45%.

What is the measure of each stock’s contribution to risk when held together in a portfolio? (Hint: the risk of a portfolio comprising equal proportions of Sunscreen & Umbrella is zero. Yet the risk of each stock by itself is 45%). (10 pts)

Answer 1

The measure of the risk which would generally be calculated by the the level of the correlation existing between those portfolios and measure of the beta as well.

in this case, it is seen that both the stocks are negatively correlated so it can be said that both these stocks are not having a high correlation which will be diversifying the portfolio because negative correlation is also offering no better diversification opportunity.

when they are held together in the portfolio, the return of one stock would be completely opposite to the return of the another stock because they would be having different movements which will be completely opposite of each other so there would be lessor chances of making a high return because return of one stock be completely eliminated by the loss of another stock.