You are the risk manager in a major investment bank. The bank's current portfolio consists of U.S. stocks (50%), bonds (20%), and derivatives (30%). The expected returns and standard deviations of these investments are
Expected Return 13% 7% 25%
Standard Deviation 25% 9% 50%
A trader comes with a idea about investing in some new emerging markets: the markets of Polynesia, Micronesia, and New Caledonia. These markets have the following characteristics:
Polynesia Micronesia New Caledonia
Expected Return 18% 20% 22%
Standard Deviation 30% 35% 28%
Correlation with Stocks 0.4 0.2 0.6
Correlation with Bonds 0.3 0.1 0.2
Correlation with Derivatives 0.2 0.3 0.4
Your job as risk manager is to determine how this investment would affect the overall risk of the bank's portfolio. Based on risk considerations alone (i.e.. trying to minimize the risk of your final portfolio), which of the three emerging markets is the best investment, assuming you would only invest in one of the three? How does your answer depend on the fraction of your overall portfolio you plan to invest in the new asset? Make sure you show all of your work.