The table below is the Monthly return Correlation Coefficients between two stocks: RIO & ANZ 0.6162...

The table below is the Monthly return Correlation Coefficients between two stocks:

RIO & ANZ	0.6162
RIO & WES	0.7593
RIO & TLS	-0.6850
ANZ & WES	0.5970
ANZ & TLS	-0.1865
WES & TLS	-0.5192

Required:

a. Which pair of two stocks have the highest and lowest correlations?

b. Suggest some economic reasons to explain the high and low correlation between these stocks. If you were to form a portfolio of two stocks, which ones would you choose to maximise the benefits of diversification? Give reasons for your answer.

Solutions

Expert Solution

a) The stock pair RIO & TLS have the lowest correlation since they have the most negative value for correlation out of all, while the stock pair RIO & WES have the highest correlation since they have the highest positive value of correlation out of all.

to maximize the benefits of diversification , we should choose stocks with the lowest correlation , i.e. the stock pair RIO &TLS, since a negative correlation between stocks will lead to a lower standard deviation / risk of the portfolio than the individual risk for the stocks.

A change in economy / market trend affects stocks differently , similar types of companies are affected by a market trend more or less in the same way and hence usually have a higher correlation between them.

A change in market for companies in a different line of business usually will not be affected at the same degree and hence the correlation between such stocks will be lower.

jeff jeffy answered 4 days ago

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