Applied Microeconomics Coursework 1
To derive and describe the effect of stock 2 and that of correlation between stock 1 and 2 prices on the overall portfolio risk.
Standard deviation (SD) is used to measure risk by determining the volatility of a stock. It is a statistical term that measures the amount of variability around an average mean price.
Correlation measures the relationship between two variables. Coefficient of Correlation can range between -1 and +1 depending on the degree and direction of the relationship. Positive correlation denotes that both stocks will follow similar movement whereas negative correlation denotes the opposite relationship.
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1). Firstly, I found that the lower the SD the quicker the risk fell.
As you can see from Figure 1, the opposite occurs when higher SD values are used. Every additional unit of Stock 2 would actually increase the portfolio risk result in an upward sloping curve.
Initially with an increase in proportion of stock 2 the SD of the portfolio was decreasing. However after a certain portfolio, the proportion of Stock 2 became so high that each additional unit of Stock 2 was adding to the portfolio risk, as the effect of diversification with stock 1 was wearing out.
Hence with a SD of 80 of stock 2 an ideal portfolio would be 9 units of Stock 1 and 81 units of Stock 2. This portfolio will have the lowest risk.
|QA |QB |Portfolio Risk AB |
|10 |80 |10924652.53 |
|9 |81 |10919149.82 |
|8 |82 |10919319.38 |
Changes in Coefficient of Correlation
Portfolio Risk = a2(sd1)2 + b2(sd2)2 + 2ab(sd1)(sd2)(r)
Where ‘a’ and ‘b’ represents the number of Stock 1 and 2 shares respectively...