1. Suppose there are only two risky securities available A and B. A portfolio can be constructed with only these two securities. (Hint: read Bradfield Ch 8 Introduction to the Economics of Finacial Markets)

a) Assuming that A and B must be held in zero or positive amounts (no short- selling) describe intuitively the effect of the correlation between their returns on the shape of the efficient frontier. In particular:

i. Describe what happens if the correlation is zero, perfectly correlated, perfectly inversely correlated.

ii. Under what circumstances is it possible to construct a riskless portfolio?

b) Now allow for the possibility of short selling (portfolio shares can be negative). Describe how a pair of securities that are perfectly correlated can be used to construct a riskless portfolio.