Question

6) After analyzing historical data you determine that in the past the returns on two different assets had a correlation of 0.2. You decide to buy both assets, investing 50% of your savings in each. However, over the following year that you are holding the assets the correlation between them is much higher than it has been in the past, with correlation equal to 0.8. Explain how the performance of your account would differ from what you were expecting when you bought the assets and believed their correlation would be 0.2.

Answer 1

If the correlation increases from 0.2 to 0.8 the expected return of the portfolio would remain same as correlation has no affect on the expected return of portfolio.Expected Return = weight of A * return of A + weight of B * return of B

However risk or standard deviation would increase because as correlation increases standard deviation of the portfolio increases .Standard Deviation = ((Weight of A * Standard Deviation of A)² + (weight of B* standard Deviation of B)² + 2* Weight of A * Standard Deviation of A * weight of B * standard Deviation of B * correlation)^0.5
Initially when correlation was 0.2 standard deviation was low . However when correlation increases to 0.8 standard deviation increases making the portfolio more risky.

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