Question

Explain why the correlation coefficients between securities are the key determinants of a portfolio's degree of diversification.

Answer 1

Correlation is relationship between asset prices.It is represented by a coefficient that measures , on a scale of -1 to 1.It shows how price of two securities will move together.How likely it is that they will go up and they will go down.If two securities have correlation value of 1 , it means they have perfect positive relationship.Perfect negative correlation has a value of -1 and would mean that the securities move in opposite direction.Correlation value of 0 means that the securities equally like to move together as they are to move in opposite direction.

Using correlation information helps to diversify your portfolio.The lower the correlation coefficient , the better the diversification.Positive correlation describes a relationship where an increase in one variable is associated with an increase in another.Negative correlation means a relationship where an increase in one variable is associated with decrease in another.Perfect correlation means relationship where change in one variable exactly matched by change in another.Correlation coefficient measures the degree to which two variables are associated and move in relation to one another.