b) The covariance between stocks A and B is 0.0014, standard deviation of stock A is 0.032, and standard deviation of stock B is 0.044. Which of the following is the most appropriate to depict the risk-return characteristics of a portfolio consisting of only stocks A and B, and explain why? E(R) E(R) E(R) (A) (B) (C)
What is the answer to this question?
For this question I have seen 2 answers. So im not sure whats right.
Answer 1:
The most relevant figure is (a) that reflects the risk-return characteristics of stock A and stock B. an effective frontier is called relationship between risk (standard deviation) and expected return. The shape of risk-return features is
Figure b) is incorrect because the returns don’t rise in proportion to the risk assumed.
Figure c) is incorrect since both stocks stock A and stock B are risky, and thus a finite return cannot occur at standard deviation = 0
Answer 2
Answer - Graph B
Correlation = Covariance / (Standard deviation of A x Standard deviation of B)
Correlation = 0.0014 / (0.032 x 0.044)
Correlation = 0.99
Correlation of 1 means that there is a perfect correlation between 2 stocks which move together creating a linear line. Since correlation between A and B is 0.99, it means that they are perfectly positively correlated which makes a Linear relationship between both the stocks. Since Graph B Shows the Linear relationship between these stocks, Hence it is the most appropriate depiction of the risk-return characteristics of both the Stocks.
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