Portfolio Management MCQ - Portfolio Management Section 1

6 If the correlation between Stock A and Stock B in a two-asset portfolio increases during a market decline, with a constant weightage of the assets and expected standard deviations of each, the portfolio’s volatility will:

Higher correlations will result in a lower diversification benefit and higher volatility.

7 Arman is considering investing in a small-cap stock fund and a general bond fund. The correlation between the two fund returns is 0.12. Expected annual return equaled 16% and 6% respectively with standard deviation of 30% for small-cap stock and 11.5% for general bond fund. If Arman requires a portfolio return of 10 percent, the proportions in each fund respectively should be closest to:

10% = w¡* 16 % + (1 – w¡)* 6%; w¡ = 40%, (1 – w¡) = 60%.
Thus, 40 percent should be invested in the small-cap fund and 60 percent should be invested in the bond fund.

8 Information about a portfolio that consist of two assets is provided below:

Asset	Portfolio Weight	Standard deviation
ABC	30%	10%
JKL	70%	8%

If the correlation coefficient between the two assets is 0.8, the standard deviation of the portfolio is closest to:

Portfolio standard deviation = √((0.3)² (0.1)² + (0.7)² (0.08)² + 2 (0.8)(0.3)(0.7)(0.1)(0.08)) = 0.082 = 8.2%.

9 Assume that two securities that are present in equal proportions in an investor’s portfolio have the same expected returns and volatility. For which of the following correlations between the two securities would the investor most likely be able to achieve the greatest diversification benefit?

Diversification benefit is greatest when a portfolio consists of securities that do not move together and thus the investor should invest in securities with the lowest correlation i.e. – 0.86.

10 A correlation matrix of the returns for securities A, B, and C is reported below:

Security	A	B	C
A.	1
B.	-1	1
C.	0.5	-0.5	1

Assuming that the expected return and the standard deviation of each security are the same, a portfolio consisting of an equal allocation of which two securities will be most effective for portfolio diversification?
Securities:

The negative correlation of –1.0 between investment instruments A and B is lowest and therefore is most effective for portfolio diversification.