The Bank of Tiny town has two $20 000 loans with the following characteristics: Loan A has an

QUESTION

The Bank of Tiny town has two $20,000 loans with the following characteristics: Loan A has an expected return of 10 percent and a standard deviation of returns of 10 percent. The expected return and standard deviation of returns for loan B are 12 percent and 20 percent, respectively.
a. If the correlation between loans A and B is .15, what are the expected return and the standard deviation of this portfolio?
b. What is the standard deviation of the portfolio if the correlation is -.15?
c. What role does the covariance, or correlation, play in the risk reduction attributes of modern portfolio theory?
a) Expected return = 10%*.5 + 12%*.5 = 11% SD of portfolio = Sq root (.10^2*.5^2 + .12^2*.5^2 + .15*.10*.12*.5*.5) = 8.09% b)SD of portfolio = Sq root (.10^2*.5^2 + .12^2*.5^2 -.15*.10*.12*.5*.5) = 7

ANSWER:

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