Stocks A, B & C have the same expected return and standard deviation. The correl
ID: 2794893 • Letter: S
Question
Stocks A, B & C have the same expected return and standard deviation. The correlations between the returns of these stocks are shown in the table below.
Stock A
Stock B
Stock C
Stock A
+1.0
Stock B
+0.87
+1.0
Stock C
+0.16
-0.42
+1.0
Given these correlations, the portfolio constructed from these stocks having the lowest risk is a portfolio:
Equally invested in stocks A & B
Equally invested in stocks A & C
Equally invested in stocks B & C
Totally invested in stock C
Stock A
Stock B
Stock C
Stock A
+1.0
Stock B
+0.87
+1.0
Stock C
+0.16
-0.42
+1.0
Explanation / Answer
Standard deviation is a measure of risk for assets.
Higher the correlation between two assets or stocks, higher is the standard deviation.
As we can see that the correlation between Stock B and C is -0.42, a portfolio comprising of these 2 stock will yield least Standard deviation hence risk.
A single asset as in case of last option will have more SD or risk because it will not have any diversification benefit
Hence 3rd option or Equally invested in stocks B & C is the correct answer