QM 6 – Portfolio Expected Return and ris — Flashcards

Question

What happens to diversification benefits when correlation approaches $+ 1$ ?

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Answer

They shrink; portfolio risk falls less from combining assets.

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Question

Why does lower correlation between two assets improve diversification?

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Answer

It reduces the covariance term, lowering portfolio variance.

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Question

How is covariance from joint probabilities calculated across states of the world?

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Answer

$\sum P (s) [R_{i} - E (R_{i})] [R_{j} - E (R_{j})]$ .

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Question

How do you compute two-asset portfolio variance?

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Answer

$r a c σ_{p}^{2} = w_{1}^{2} σ_{1}^{2} + w_{2}^{2} σ_{2}^{2} + 2 w_{1} w_{2} ρ_{12} σ_{1} σ_{2}$ .

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