Optional exercise: Portfolio risk

Open the Excel file PortfolioRisk.xls. There are two assets, stocks and bonds, and
you choose standard deviations and the correlation coefficient between them.
In the table “Portfolio standard deviation,” the formula that calculates the standard
deviation for a portfolio of stocks and bonds as a function of the weights is:
q q
σP = σP2 = wS2 σS2 + wB 2 2
σB + 2wS wB σS σB ρS,B ,

where wS and wB are the weights in stocks and bonds; also recall that wB = 1 − wS .
You see the portfolio standard deviation as a function of the weight in stocks in the
graph to the right.

Questions

1. Study the curve. The red and blue squares should be located where the weight in
the stock portfolio is zero and one, respectively. Is there a minimum-risk portfolio
along the curve? If so, approximately where is it?

2. Change the correlation to 0.50, and then in steps of 0.10 to the maximum of
1.00. Discuss how the curve changes, and why. Specifically, does diversification
between stocks and bonds always lead to risk reduction?

3. Change the correlation in steps of 0.10 from –0.50 to –1.00 (lower bound). What
is the lowest risk we can achieve, and why?

8
Answers

1. The red square is the stock portfolio (wS = 1) and the blue square is the bond
portfolio (wS = 1 − wB = 0). Since the curve has a minimum point around
wS = 0.20, a minimum-risk portfolio does indeed exist.

2. The stock and bond portfolios (the squares) are not affected, but the curve be-
tween them approaches a straight line when the correlation increases. When the
correlation equals one, it is exactly a straight line. This means that the diversifi-
cation benefits decreases when the correlation between assets increases. Perfect
positive correlation implies no diversification benefits at all; risk is then a linear
function of the weights.

3. When the correlation is negative, the curve bends down more. The minimum-
risk level is therefore lower the lower the correlation is. When the assets are
perfectly negatively correlated, we can create a portfolio that has no risk at
all (i.e., a standard deviation of zero). This is because the two assets always
move in opposite directions, and we can therefore select weights in such a way
that the two assets’ movements exactly cancel out in the portfolio. Note that it is
highly unrealistic to think that the bond and stock should be perfectly negatively
correlated.