Stocks A and B each have an expected return of 12%,a beta of 1.2,and a standard deviation of 25%.The returns on the two stocks have a correlation of +0.6.Portfolio P has 50% in Stock A and 50% in Stock B.Which of the following statements is CORRECT?
A) Portfolio P has a beta that is greater than 1.2.
B) Portfolio P has a standard deviation that is greater than 25%.
C) Portfolio P has an expected return that is less than 12%.
D) Portfolio P has a standard deviation that is less than 25%.
E) Portfolio P has a beta that is less than 1.2.

Question

Quizplus · Accepted Answer

Since stocks A and B have the same beta, the portfolio's beta remains 1.2, not higher or lower. The expected return of the portfolio is the weighted average of the returns of the stocks, which is also 12%, not less. The key factor is the correlation coefficient between the stocks. A correlation of +0.6 indicates that the stocks do not move perfectly in sync, allowing for diversification benefits. This diversification reduces the portfolio's overall risk (standard deviation) below that of the individual stocks, assuming they have identical volatilities and weights in the portfolio.

Stocks a and B Each Have an Expected Return of 12%,a