Kate Smith owns an equity portfolio worth 80,000. She recently received a bonus of 20,000 in shares in the company which employs her. Kate's financial adviser has provided her with the following estimates:

Risk and Return Characteristics

Expected Annual Returns

Standard Deviation of Annual Returns

Original portfolio

9%

20%

Company share

14%

30%

The correlation coefficient of the company share returns with her original portfolio returns is 0.70.

a) How will the addition of the company shares change Kate's original portfolio in terms of reward and risk? 

b) Kate wishes to sell the company shares and uses the funds to acquire another investment which has the same expected return and standard deviation as the company share but a different correlation with the original portfolio. Illustrate with a diagram how different correlation values would give rise to various possible combinations of expected return and risk for a two-risky assets portfolio in general.

Explain to Kate why there is always a benefit from diversification if the correlation is less than one.