Explain how modern portfolio theory can be applied to lower the credit risk of an FI’s portfolio.

The Bank of Tiny town has two $20 000 loans, which have the following characteristics: Loan A has an expected return of 10 per cent and a standard deviation of returns of 10 per cent. The expected return and standard deviation of returns for loan B are 12 per cent and 20 per cent, respectively.

a. If the covariance between A and B is 0.015 (1.5 per cent), what are the expected return and the standard deviation of this portfolio?

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b. What is the standard deviation of the portfolio if the covariance is −0.015 (−1.5 per cent)?

c. What role does the covariance, or correlation, play in the risk reduction attributes of modern portfolio theory?

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