Answer:
B. Both portfolios have the same expected return, but shorting LWI is better because we should seek to hold stocks that are negatively correlated to reduce volatility.
Step-by-step explanation:
Calculate the expected return and volatility for each portfolio:
Portfolio with shorting KBH:
Expected return: HGH (30%), KBH (5%)
Volatility: HGH (45%), KBH (20%)
Portfolio with shorting LWI:
Expected return: HGH (30%), LWI (5%)
Volatility: HGH (45%), LWI (20%)
Consider the correlation between each stock and HGH:
KBH correlation with HGH: +0.5
LWI correlation with HGH: -0.5
Choose the portfolio that reduces volatility by shorting a stock that is negatively correlated with HGH:
Shorting LWI (negatively correlated) would be better to reduce volatility.