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FRM Part II · FRM Exam Part II · Correlation Basics: Definitions, Applications, and Terminology

A two-asset portfolio holds 60% in Asset A (volatility 20%) and 40% in Asset B (volatility 30%). The correlation is 0.25. What is the portfolio volatility, to the nearest 0.1%?

Portfolio volatility is about 19%, so the nearest listed option is 18.0%. Portfolio variance equals 0.0144 plus 0.0144 plus 2 times 0.25 times 0.12 times 0.12, which is 0.0360, and its square root is roughly 18.97%.

  1. A16.2%
  2. B18.0%
  3. C20.4%Correct
  4. D24.0%

Explanation

Variance = (0.6×0.2)² + (0.4×0.3)² + 2(0.25)(0.12)(0.12) = 0.0144 + 0.0144 + 0.0072 = 0.0360. Square root = 0.1897, i.e. 19.0%. Check: that is closest to none of the listed values, so recompute: 0.0144+0.0144=0.0288; +0.0072=0.0360; sqrt=18.97%. The closest option is 18.0%.

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