Question

Q15. Portfolio Choice (5 Points) In a two-assets allocation problem, what's the portfolio volatility if the return correlation between asset 1 and asset 2 is -1 (perfectly negatively correlated), 0 or 1 (perfectly positively correlated)? Q16. Describe some of the ways the CAPM is applied in practice (5 Points)

Answer 1

15) When the perfectly negative correlation exists between the two assets, the portfolio's volatility is low as risk is diversified between the two assets. If the return on asset 1 increases, the return on asset 2 decreases. Most of the investors are ready to invest in this type of portfolio as they know the level of risk tolerance associated with the portfolio and will follow the concept of high risk/return concept.

On the other hand, portfolio with perfectly positive correlation has high volatility as it includes asset which move in same direction i.e. if asset 1 increases, asset 2 will also increase. This type of portfolio doesn't follow the concept divesification as a loss in asset 1 will not be offset by the gain in asset 2.

16) Capital Asset Pricing Model (CAPM) is useful to know the expected return on the portfolio and how to measure the risk associated with the portfolio. CAPM is applied in practice in the following ways:

• Investment Management: CAPM model is widely used in investment management to diversify the risk of the portfolio. Inverstors may come to know the risk and return associated with the portfoilo and can identify the risky assets. Investment managet may also know the risk premium using the CAPM model.
• Corporate Finance: CAPM model is useful in corporate finance to know the cost of equity. Cost of equity means the cost attached to the equities in the form of dividends paid to the shareholders.