 # Study Session 12 Qbank

Hi, Could someone try and explain this answer to me: Q) In a two asset portfolio, REDUCING the correlation between then two assets moves the efficient frontier in which direction? A) The frontier extends to the left, or northwest quadrant representing a reduction in risk while maintaining or enhancing portfolio returns B) The efficient frontier is stable unless return expectations change. If they do, the efficient frontier will extend to the upper right with little or no change in risk C) The frontier tends to move down and to the left, representing increased risk from negative correlation D) The frontier is stable unless the assets expected volatility changes. This depends on each assets Standard Deviation Thanks!

ok, from what i can remember, if you reducing the correlation between the two assets, then you are reducing the std dev of the portfolio, ie. your risk is going down. so if your risk is graphed on the horizontal axis your risk is going down, however the porfolio return is same. so I’d pick A. C is clearly the wrong choice, because if EF moves left your risk is decreased not increased. B is wrong, because a move to upper right would indicate, higher returns for higher risk. D… hmm… I dont know, but I wouldn’t pick this, cuz the thing is that port. std deviation is dependent on the correlation between two assets, not with the individual std deviations.

A. Diversification reduces risk. A two asset portfolio with low correlation will contain less risk then a two asset portfolio that gives the same return but whose assets are closely correlated. Thus the two asset portfolio is preferred. It will definitely help if you revisit the picture in the schweser notes.

brianr Wrote: ------------------------------------------------------- > A. Diversification reduces risk. A two asset > portfolio with low correlation will contain less > risk then a two asset portfolio that gives the > same return but whose assets are closely > correlated. Thus the two asset portfolio is > preferred. > > It will definitely help if you revisit the picture > in the schweser notes. A is correct. To see how lower correlation reduces risk, remember that the portfolio variance is (squared weight of A)*(Variance of A) + (squared weight of B)*(Variance of B) + (2 * Correlation between A & B)(Variance of A)(Variance of B) if the correlation is lower, the final term is smaller, and hence, portfolio variance is lower.

i am tempted to pick A , but i will say D could be the answer, as lowering risk does not mean returns will increase.corelation is used only to predict direction of assets, i.e, movement not the returns

level1_dec Wrote: ------------------------------------------------------- > i am tempted to pick A , but i will say D could be > the answer, as lowering risk does not mean returns > will increase.corelation is used only to predict > direction of assets, i.e, movement not the returns It’s true that correlation doesn’t change returns. But the efficient frontier is the set of preferred combinations of risk AND return. In other words, for a given level of return, what the lowest risk you can achieve? Or alternately, for a given level of risk, what’s the highest return? Lower correlation means that you get lower risk (portfolio variance) for a given combination of assets. So, you get lower risk for a given level of return (or alternately, higher return for a given level of risk). Therefore, the frontier (which is graphed in risk/return space) for the lower-correlation case is above and to the left of the frontier for the higher-correlation case.

A) The frontier extends to the left, or northwest quadrant representing a reduction in risk while maintaining or enhancing portfolio returns It’s A.

Thanks everyone