Question

Diversification is the most effectivewhen the correlation coefficient between two assets’ return is _________ .

     A) positive

     B) negative

     C) +1

     D) 0

     E) -1

  

Based on investors’ relative degrees of risk aversion,

     A) investors will hold varying amounts of the risky asset in their portfolios.

     B) all investors will have the same portfolio asset allocations.

     C) investors will hold varying amounts of the risk-free asset in their portfolios.

     D) A and C.

     E) none of the above.

Answer 1

Answer 1: Option E) -1

Diversification is most effective when the correlation coefficient between different asset class returns is -1.

This is because the purpose of diversification is to reduce adverse effects on the portfolio by investing in multiple asset classes.

Example: Let us say there are two asset classes A & B. Now, if both these asset classes have a positive correlation of return, then, in case of any adverse movement, the returns of both asset class would reduce. Hence, no benefit achieved. However, if the correlation was negative, then if asset class A is giving negative return, asset class B should give positive returns. Hence, its beneficial to have a negative correlation between asset classes.

Answer 2: Option D) A & C

Every investor has a different degree of risk tolerance. Based on that risk tolerance, the investor needs to allocate certain portion of the portfolio to risk free assets and the balance to risky assets. Hence, based on varying degree of risk aversion, different investors would have different allocation to risky and risk-free assets.

Option B is wrong because if the degree of risk aversion is different then the allocation to risky and risk free asset cannot be the same.