8006 Exam Dumps : Exam I: Finance Theory Financial Instruments Financial Markets - 2015 Edition

When assets are uncorrelated, variances are additive. But volatility (which is standard deviation) is not. In the given situation, the total variance of the portfolio will be equal to the the square root of the sum of the variances of the assets in the portfolio weighted by the square of their weights. Its volatility will be the square root of this variance. Thus Choice 'c' is the correct answer.

(This is because V(cA + dB) = c^2 V(A) + d^2 V(B) - refer tutorial on combining variances.)

Choice 'a' is incorrect as it describes the calculation of variance, not volatility. Also, the presence of a large number of uncorrelated assets does not create a portfolio with volatility equal to zero or that of the market. The other choices are therefore incorrect.

The effectiveness of the hedge is solely determined by the correlation between the position being hedged, and the position being used as the hedge. A hedge can be perfect when correlation is 1, and will be less than perfect when it is anything other than 1.The effectiveness of the optimal hedge is given by the formula √(1-ρ2), where ρ is the correlation between the two. Therefore Choice 'c' is the correct answer. Standard deviations affect the hedge ratio, not the effectiveness of the hedge.

The put-call parity can be expressed as:

Call – Put = Spot – PV of exercise price

Note that a negative sign above means a short position. The 'term PV of exercise price' is the same as a bank deposit placed today equivalent to the PV of the exercise price so that we will have the cash flow on the exercise date to exercise the option.

Therefore only Choice 'd' is the correct answer as rearranging the above gives us Buying a call + Bank Deposit = Buying the stock + Buying a put.

Choice 'd' is therefore the correct answer.