Further assume that each of the two weather states

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Unformatted text preview: ice-cream producer is +15% if the weather is sunny and -10% if it rains. Similarly the manufacturer of umbrellas benefits when it rains (+15%) and looses when the sun shines (-10%). Further, assume that each of the two weather states occur with probability 50%. Expected return Variance Ice-cream producer 0.5·15% + 0.5·-10% = 2.5% 0.5· [15-2.5]2 +0.5· [-10-2.5]2 = 12.52% Umbrella manufacturer 0.5·-10% + 0.5·15% = 2.5% 0.5· [-10-2.5]2 +0.5· [15-2.5]2 = 12.52% - Both investments offer an expected return of +2.5% with a standard deviation of 12.5 percent - Compare this to the portfolio that invests 50% in each of the two stocks. In this case, the expected return is +2.5% both when the weather is sunny and rainy (0.5*15% + 0.5*-10% = 2.5%). However, the standard deviation drops to 0% as there is no variation in the return across the two states. Thus, by diversifying the risk related to the weather could be hedged. This happens because the returns to the ice-cream producer and umbrella manufacturer are perfectly negatively...
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