Suppose a liquid asset and an illiquid asset have the same true return in every period....

Suppose a liquid asset and an illiquid asset have the same true return in every period. (The true returns, though, do vary from period to period.) Suppose, however, that the true return on the illiquid asset is always reported one period late. What effect will that have on the correlation of returns between the two assets.

ENHANCE the correlation.
LEAVE UNCHANGED the correlation.
REDUCE the correlation.
ENHANCE or LEAVE UNCHANGED the correlation.
REDUCE or LEAVE UNCHANGED the correlation.

Expert Solution

c. Reduce the correlation.

Since the correlation of 2 assets with the same true returns will give correlation as 1. Any deviation from the perfect similarity will result in reduced correlation.

For eg. consider the case when illiquid asset reports return immediately with liquid asset

Liquid asset	Illiquid asset
12.00%	12.00%
13.50%	13.50%
11.60%	11.60%
25.00%	25.00%
3.00%	3.00%
9.00%	9.00%
5.00%	5.00%
2.00%	2.00%
15.00%	15.00%
16.00%	16.00%
9.00%	9.00%
6.00%	6.00%
80.00%	80.00%
9.00%	9.00%
43.00%	43.00%

In this case the correlation is 1

	Column 1	Column 2
Column 1	1
Column 2	1	1

Now consider the case where illiquid asset returns are report one period later

Liquid asset	Illiquid asset
12.00%	18.00%
13.50%	12.00%
11.60%	13.50%
25.00%	11.60%
3.00%	25.00%
9.00%	3.00%
5.00%	9.00%
2.00%	5.00%
15.00%	2.00%
16.00%	15.00%
9.00%	16.00%
6.00%	9.00%
80.00%	6.00%
9.00%	80.00%
43.00%	9.00%

	Column 1	Column 2
Column 1	1
Column 2	-0.19023	1

Here the correlation is -0.19023

jeff jeffy answered 2 years ago

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