The greatest diversification effect is achieved between two assets if the correlation between the two assets is: A) 0 B) Between -1 and 0 C) -1 Go edit - the post title is incorrect as I decided to not make it T/F
a
C
C, fo sho.
C
c
Correct, the answer is C.
Why are you diversified if you have a perfect negative correlation? Wouldn’t this just be a perfect hedge and you only lose money on transaction costs? If they have zero correlation then any event that impacts one has absolutely no impact on the other… thats basically the definition of diverse…
JasonU Wrote: ------------------------------------------------------- > Why are you diversified if you have a perfect > negative correlation? Wouldn’t this just be a > perfect hedge and you only lose money on > transaction costs? > > If they have zero correlation then any event that > impacts one has absolutely no impact on the > other… thats basically the definition of > diverse… JasonU, read LOS 66 C
Is this question from CFAI or you made it up? I think you are confusing diversification and the increasing benefits from diversification. “when the correlation is -1 the minimum variance frontier has two linear segments. The two segments join at the global minimum variance portfolio which has a standard deviation of 0. With a correlation of -1 portfolio risk can be reduced to zero, if desired” this isn’t maximum diversification, this is zero risk which arbitrage free should equal all assets @ risk free treasury rate. If all your assets are in treasury equivalents you have no diversification, but you are maximizing the benefits of diversification
JasonU Wrote: ------------------------------------------------------- > Is this question from CFAI or you made it up? I > think you are confusing diversification and the > increasing benefits from diversification. > > “when the correlation is -1 the minimum variance > frontier has two linear segments. The two segments > join at the global minimum variance portfolio > which has a standard deviation of 0. With a > correlation of -1 portfolio risk can be reduced to > zero, if desired” > > this isn’t maximum diversification, this is zero > risk which arbitrage free should equal all assets > @ risk free treasury rate. If all your assets are > in treasury equivalents you have no > diversification, but you are maximizing the > benefits of diversification LOS 66.c. “The greatest diversification is achieved if the correlation between assets equals -1” Edited - this quote is from Schweser.
Jason, no time to discuss, take C as the answer. The lowere the correlation, better diversification Think about the standard deviation of a profolio. Lower the correlation, you get a low SD.
If I am long a portfolio of stocks and I am short a portfolio of the exact same stocks I have a correlation of -1, this does not make me diversified
Are you guys reading schweser or CFAI?
this is basic portfolio theory…
kochunni69 Wrote: ------------------------------------------------------- > Jason, no time to discuss, take C as the answer. > > The lowere the correlation, better > diversification > > Think about the standard deviation of a profolio. > Lower the correlation, you get a low SD. Yeah, think about the portfolio variance equation: End of variance of portfolio equation: w1^2*w2^2…2*w1*w2*Correlation*StdDev1*StdDev2 The end of it - if correlation is NEGATIVE, then that whole final piece DECREASES Portfolio variance. This decrease would be maxamized when correlation is -1.
RE: JasonU: Sure it does. You’ve completely diversified away all risk in that scenario 
The assets with -1 correlation do not have to be equally weighted. See Schweser book 3 page 206. They have a chart for the return and variance of a 2 stock portfolio when correlation is 1, 0, and -1.
no but it is the benefit from diversification not diversification itself. If you have one stock and you want to add another stock if the second stock has a +1 correlation, a perfect positive linear correlation, it adds zero BENEFIT from diversification, but it is potentially adding some diversification (if it is a different stock) if the second stock has 0 correlation, you are guaranteed to be adding maximum diversification but the BENEFIT from diversification does not improve if the second stock has -1 correlation, a perfect negative linear correlation, it adds maximum BENEFIT from increased diversification but not necessarily more diversification (if it is shorting the same stock)
I found this in CFAI EOC summary yesterday: Include asset in portfolio if Sharpe Ratio of Asset > (Sharpe Ratio of PF)*(Correlation with PF) Damn Schweser never mentioned this and CFAI has it in EOC Summary
I don’t have schweser, just read most of the cfai material. Its fine, if the question is worded like that I am still going to put 0… but don’t worry… Ill still sit for the afternoon session