Section 3: Stocks and Bonds

Stocks A and B should give you the biggest diversification benefit because their correlation is the lowest. E(RP(B,C)) = 0.5 × 0.055 + 0.5 × 0.005 = 0.03 (3%) First find the returns on the portfolio for each state of nature: E(RP(B,C)|Depression) = 0.5 × 0.05 + 0.5 × -0.05 = 0.0 (0%) E(RP(B,C)|Recession) = 0.5 × 0.2 + 0.5 … ................
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