Which of the following statements is TRUE? Multiple Choice Diversification can reduce the systematic risk component....

Which of the following statements is TRUE?

Multiple Choice

Diversification can reduce the systematic risk component.
The slope of the security market line (“SML”) is the beta coefficient.
Maximum benefit from diversification occurs when the correlation coefficient for pairs of stocks is minus one.
Beta coefficient measures the unsystematic risk.

Solutions

Expert Solution

The correct answer is Maximum benefit from diversification occurs when the correlation coefficient for pairs of stocks is minus one.

Correlation refers to the strength of liner relationship between two variables. It lies between -1 and +1. Lower the correlation, greater the benefit of diversification in the form of risk reduction. Therefore maximum benefit from diversification will occur when correlation coefficient is -1.

Why other options are incorrect

Diversification can reduce the Unsystematic risk component.

Systematic Risk is the volatility of a stock on account of economy wide factors. It affects all stocks in the same direction with unequal sensitivity. It is the risk which is inherent to the market and it cannot be avoided through diversification.

Unsystematic Risk - It is the volatility of a stock on account of internal company specific factors. This risk can be avoided through diversification. The greater the number of stocks in the portfolio the greater is the chance of Unsystematic Risk getting cancelled out. Thus diversification can reduce the Unsystematic risk component.

The Slope of the Security Market Line (SML) is the Market Risk Premium (Rm - Rf).
Beta coefficient measures the Systematic Risk.

jeff jeffy answered 1 year ago

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