Answered

How does correlation between assets influence portfolio risk?



a.) Correlation has no effect on risk

b.) High correlation eliminates diversification benefits

c.) Positive correlation reduces risk.

d.) Negative correlation reduces risk.

Verified Answer :

Final answer:

Correlation between assets significantly influences portfolio risk. High correlation reduces diversification benefits, leading to increased risk, while negative correlation enhances diversification, thus lowering overall portfolio risk. Understanding these dynamics is crucial for effective portfolio management.


Explanation:

Correlation Between Assets and Portfolio Risk

Understanding how correlation between assets affects portfolio risk is essential for effective investment management. Correlation measures how asset prices move in relation to each other, which can significantly influence the risk profile of a portfolio.

Effects of Correlation

  • High Correlation - When assets are highly correlated, they tend to move together in price. This scenario can lead to reduced benefits from diversification. If one asset declines, others with high correlation will likely decline as well, keeping the overall portfolio at high risk.
  • Low or Negative Correlation - Conversely, assets that have low or negative correlation can offer diversification benefits. Negative correlation implies that when one asset increases in value, another decreases. This balancing effect can reduce overall portfolio risk.

Therefore, while positive correlation can lead to increased portfolio risk, negative correlation effectively lowers risk by spreading it among different assets.


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