Suppose you have two stocks in your portfolio, Max and Min. The expected return of Max is 20% and the expected return of Min is 10%. The standard deviation of Max is 40% and the standard deviation of Min is 30%. The correlation between the two securities is zero. Suppose the riskless asset has an expected return of 4%.
1. Suppose the correlation between Max and Min is -1. If this were the case, there would be an arbitrage opportunity, since a combination of Max and Min exists that is riskless and yields a higher expected return than the riskless asset. Describe the characteristics of a portfolio strategy that would enable you to generate positive profits without having to bear any risk or put up any of your own money. Assume that there are no restrictions on short sales or margin requirements.