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Correlation and dependence (/learn/correlation-and-
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Use the following risk and return value to

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Question:
Use the following risk and return value to calculate the risk and return behavior for various
combinations of assets A and B under different degrees of correlation:

Asset Expected return, k Risk (standard deviation), σ

A 8% 5%

B 13% 10%

(a) If the returns of assets A and B are perfectly positively correlated, describe the range of (1)
expected return and (2) risk associated with all possible portfolio combinations.

(b) If the returns of assets A and B are perfectly negatively correlated, describe the range of (1)
expected return and (2) risk associated with all possible portfolio combinations.

Negative Correlation:
A negative correlation exists when the returns of two assets move in opposite directions. A
perfectly negative correlation implies that they move in perfectly offsetting directions (i.e.
+5.0% and -5.0%).

 Answer and Explanation:

Part (a)

Given perfectly positive correlation, a portfolio of the two assets will reflect an expected return
and a standard deviation that are each reflective of the weighted average of the underlying
assets' metrics.

Part (b)

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9/24/23, 8:10 PM Use the following risk and return value to calculate the risk and return behavior for various combinations of assets A and B under d…

Given perfectly negative correlation, a portfolio of the two assets will reflect an expected return
that is reflective of the weighted average of the underlying assets' expected returns. The
expected standard deviation (SD) will be reflective of the product of the formula below.

SD = ((wA
2 2
∗ sdA ) + (wB
2 2
∗ sdB ) + (2 ∗ wA ∗ wB ∗ sdA ∗ sdB ∗ rAB))
(1/2)

Where:

wA = the portfolio weight of stock A

wB = the portfolio weight of stock B

sdA= the standard deviation of stock A

sdB = the standard deviation of stock B

rAB = the correlation of A and B

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