Suppose stocks offer an expected rate of returns of 10% with a standard deviation of 20%, and gold offers an expected return of 5% with a standard deviation of 25%. (i) If the correlation between gold and stocks is sufficiently low, gold be held as a component in the optimal portfolio. (ii) If the correlation coefficient between gold and stocks is 1.0, then gold be held as a component in the optimal portfolio.

A)  (i) will; (ii) will not

Explanation:

The optimal portfolio should be one where the assets are diversified such that returns can be made regardless of the direction the economy is going. For this to happen, asset classes need to have a low correlation with one another.

If the correlation between gold and stocks is low therefore, gold should and will be held as a component in the portfolio. If the correlation between gold and stocks is 1.0 - this means that they are perfectly correlated and move together - gold should not be in the optimal portfolio as it would be too risky.

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