Question 1: Suppose there is a negative correlation (-0.8) between the two risky assets (LARGE stocks and SMALL stocks).

1A:Will the variance of the minimum-variance portfolio increase, stay the same, or decrease when we switch from a correlation of 0.4 to a negative correlation of -0.8? (5 points)

1B:Calculate the portfolio composition (weights) of the minimum-variance portfolio in this case. (10 points)

1C:Calculate the expected return of the minimum-variance portfolio in this case. (5 points)

1D:Calculate the standard deviation of the minimum-variance portfolio in this case. (5 points)

Question 2: Suppose there is a negative correlation (-0.8) between the two risky assets (LARGE stocks and SMALL stocks).

2A:Will a portfolio of only LARGE stocks continue to be a dominated asset? (5 points)

2B:Calculate the portfolio composition (weights) of the most efficient portfolio that yields the highest return given the same level of risk of LARGE stocks (i.e., the same standard deviation). (10 points)

2C:Calculate the expected return of the most efficient portfolio that yields the highest return given the same level of risk of LARGE stocks (i.e., the same standard deviation). (5 points)

Question 3

3A:Achieving an expected portfolio return of 20% requires a portfolio of 171% in SMALL stocks and -71% in LARGE stocks. Will you take on more risk (i.e., standard deviation) with this portfolio when the correlation between LARGE and SMALL stocks is 0.4 or -0.8? Why do you think so? Explain in words using economic intuition. (7 points)