Question

Discuss how the correlation between the returns on two individual stocks can affect the risk of a portfolio that contains the two stocks. Discuss how this explains what happens when we diversify effectively.  

Answer 1

If "-1<r<1 -- we can reduce the risk, but not to zero.

The minimum risk will be at minimum variance portfolio.

If "r=-1", the risk can be reduced to "Zero"

If "r=+1", we can't reduce the risk, portfolio risk will be the weighted avg risk of securities in that portfolio.

Min Variance portfolio, where "-1<r<1"

Investment in A (Wt) = [ (SD of B)² - (r * SD of A * SD of B) ] / [ (SD of B)² + (SD of A)² - (2* r * SD of A * SD of B) ]

if "r=-1"

Weight in A = SD of B / [SD of A + SD of B]