Question

Maximum diversification benefit can be achieved if one were to form a portfolio of two stocks whose returns had a correlation coefficient of:

Answer 1

Answer:

-1.0

Explanation:

Diversification in a portfolio can be regarded as spreading of investments by investors so that risk can be minimized. The correlation coefficient "r" that exist between two securities allows us to know how return that's gotten from one security is related to returns from another security. For instance, it is possible for two securities within same sector to move in the same direction, i.e it is possible to be positively correlated, in this sense when price of one goes up , the other price also goes up this might not be with the same margin.

As regards negative correlation, there is movement of security returns in opposite directions, in this sense there is least relationship between the securities. Hence with r= 1 there is movement of the two stocks in opposite direction hence Maximum diversification.

It should be noted that Maximum diversification benefit can be achieved if one were to form a portfolio of two stocks whose returns had a correlation coefficient of -1.0