Chapter 6, Problem 1PS

Summary Introduction

To determine:

True of the correlation coefficient in forming a portfolio of two risky investments between their returns in case their gains are ascertained from diversification

Introduction:

Portfolio involves financial asset grouping viz. currencies, commodities, bonds, stocks and cash equivalents. It also comprises of fund counterparts such as closed funds, exchange traded funds and mutual funds. Non-publicly tradable securities such as private, art and real estate investment are also part of portfolios.

Answer to Problem 1PS

The portfolio tends to benefit from diversification as long as the correlation coefficient stands to be less than 1.0.

Explanation of Solution

Correlation coefficient refers to the statistical measure that determines the relationship strength between relative movements associated with 2 variables. The correlation measurement stands to be incorrect if the correlation coefficient stands less than -1.0 and greater than 1.0. In this situation, the return pertaining to component securities does not move with respect to perfect lockstep. The standard deviation of the portfolio stands to be less in comparison to the weighted average of the component's security standard deviation.