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Suppose you have two asset classes to invest in. The first is large-cap stocks, which has an expected return of 15% (per year) and volatility of 15%. The second is a government bond index, which has an expected return of 5% and volatility of 10%. The correlation between the two is 0.50.
*Calculate (manually) the return and volatility of a portfolio that is 75% invested in large-cap stocks and 25% invested in government bonds.
* On a spreadsheet, plot out expected return and risk trade-off as you range the weight from 0% to 100%. Be sure to plot expected return on the vertical axis and risk on the horizontal axis. •
*See how the plots change as you change the correlation to 0.00 and to –0.50.