Correlation and Portfolio Risk in MPT

Hard Portfolio Risk And Return Modern Portfolio Theory

In the context of Modern Portfolio Theory (MPT), consider a simple two-asset portfolio consisting of Stock A and Stock B. Stock A has an expected return of 10% and a standard deviation of 15%, while Stock B has an expected return of 8% and a standard deviation of 10%. The correlation coefficient between the returns of Stock A and Stock B is 0.3.

Using MPT principles, which of the following statements accurately describes the implications of the correlation coefficient on the risk and return profile of the portfolio?

A lower correlation between assets in a portfolio generally increases the potential for achieving higher returns while minimizing risk.

The correlation coefficient has no effect on the risk and return trade-off within a portfolio.

A higher correlation between portfolio assets reduces the benefits of diversification, thus increasing portfolio risk while not impacting returns.

Hint

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