FRM Part I · FRM Exam Part I · The Building Blocks of Risk Management
A two-asset portfolio holds equal weights in Asset A and Asset B. Each asset has a return volatility of 20%. The correlation between them is 0.40. What is the portfolio volatility?
Portfolio volatility is about 16.73%. Variance equals 0.01 plus 0.01 plus the covariance term 0.008, which is 0.028, and its square root is 16.73%. Because correlation is below one, volatility is lower than the 20% of each asset.
- A20.00%
- B16.73%Correct
- C14.14%
- D12.00%
Explanation
Variance = 0.5^2(0.04) + 0.5^2(0.04) + 2(0.5)(0.5)(0.4)(0.2)(0.2) = 0.01 + 0.01 + 0.008 = 0.028. Square root = 16.73%. 14.14% would be the result for zero correlation (variance 0.02), and 20% assumes correlation of 1.
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