Question

# Consider two portfolios consisting of two stocks each. The portfolios are identical in every way (e.g., the

proportion of money invested in each stock, the expected returns of the stocks, and the variances of the stocks), except that in the first portfolio (call it A) the returns of the two stocks are negatively related, while in the second portfolio (B) they are positively related. Which of the following statements about the variances of the portfolios would be true?

A) Because the means and variances of the two stocks are identical, the variances of the portfolios would also be the same.

B) Portfolio A would have the larger variance because the negative relationship will cause positive values in one stock to be associated with negative values in the other, which will spread the returns out and thus make the variance higher.

C) Portfolio A would have the smaller variance because because the negative relationship means that lower returns in one stock will be offset by higher returns of the other, so that when the stocks are combined (i.e., are averaged) in the portfolio the overall risk will be lower.

D) Portfolio B would have the smaller variance because the positive relationship will make the two stocks very similar so that the portfolio will have less variability.

E) Portfolio B would have the larger variance because the positive relationship will cause positive values in one stock to be associated with negative values in the other, which will spread the returns out and thus make the variance higher