The EAFE is the international index comprising markets in Europe, Australia, and the Far East. Consider the following annualized stock return data:
Average U.S. index return: ............................. 14%
Average EAFE index return: ........................... 13%
Volatility of the U.S. return: .......................... 15.5%
Volatility of the EAFE return: ........................ 16.5%
Correlation of U.S. return and EAFE return: ............ 0.45
a. What would be the return and risk of a portfolio invested half in the EAFE and half in the U.S. market?
b. Market watchers have noticed slowly increasing correlations between the United States and the EAFE index, which some ascribe to the increasing integration of markets. Given that the volatilities remain unchanged, is it possible that the volatility of a portfolio that is equally weighted between the two indexes has higher volatility than the U.S. market?