Question

A) Differentiate between perfect negative correlation and perfect positive correlation.

B) Explain the concept of diversification in investment portfolio.

C) What are the two (2) advantages of Payback Period?

Answer 1

1.
Positive correlation describes the relationship between two variables which change together i.e., if one increases the other also increases and if one decreases the other also decreases. While an inverse correlation describes the relationship between two variables which change in opposing directions i.e., if one increases the other decreases and if one decreases the other increases.

2.
Diversification is practice of spreading investments in such a way that exposure to any one type of asset/security is limited. This practice helps reduce volatility of portfolio over time by smoothing out unsystematic risk events in the portfolio-positive performance of few investments neutralizes negative performance of others. Diversification benefits only if securities in portfolio are not perfectly positively correlated.

3.
Advantages of payback period:
1. Simple to understand
2. Favors liquidity
3. Quick evaluation of projects
4. Useful in case of uncertainty