Problem: The Bank of Tinytown has two $20,000 loans with the following characteristics: Loan A has an expected return of 10% and a standard deviation of returns of 10%. The expected return and standard deviation of returns for loan B are 12% and 20%, respectively.
1) If the covariance between loan A and B is 0.015 (1.5%) what are the expected return and the standard deviation of this portfolio?
2) What is the standard deviation of the portfolio if the covariance is -0.015 (-1.5%)?
3) What role does the covariance, or correlation, play in the risk reduction attributes of modern portfolio theory?