Question

A portfolio consists of three securities Forge, Petro and Wimco with the following Parameters:

Forge Petro Wimco Corr.:

Expected return (%) 15 25 10

Standard deviation (%) 12 5 3

Correlation (Cor.):

Forge & Petro -0.40

Petro & Wimco -0.20

Forge & Wimco +0.75

An investor can either invest in Portfolio 1 or Portfolio 2 in the proportion given below.

Portfolio proportions (%)

Forge Petro Wimco

Portfolio: 1 70 20 10

2 35 25 40

Required: (a) Calculate the expected return and standard deviation for each of the two portfolios (2 decimal places).

(b) Explain the diversification effect and the relationship between correlation of assets.