Problem. 05: The Bank of Tinytown has two $20 000 loans that have the following characteristics: Loan A has an expected return of 10 per cent and a standard deviation of returns of 10 per cent. The expected return and standard deviation of returns for loan B are 12 per cent and 20 per cent, respectively. a. If the covariance between A and B is 0.015 (1.5 per cent), what are the expected return and standard deviation of this portfolio? b. What is the standard deviation of the portfolio if the covariance is -0.015 (-1.5 per cent)? c. What role does the covariance, or correlation, play in the risk reduction attributes of modern portfolio theory? Solution