CFA Level I · CFA Level I Exam · The Return and Risk of a Financial Portfolio
Holding asset weights and standard deviations constant, a decrease in the correlation between two risky assets in a portfolio will most likely:
A lower correlation will most likely reduce portfolio variance. The covariance term in the variance formula falls when correlation falls, while weights and standard deviations are fixed. Expected return is unaffected because it depends only on the weights and the assets' expected returns.
- Areduce the portfolio varianceCorrect
- Bleave the portfolio expected return lower
- Cincrease the portfolio variance
Explanation
Portfolio variance includes a covariance term equal to the weights times the correlation times both standard deviations. Lowering correlation reduces this term and so variance. Expected return depends only on weights and asset expected returns, so it is unchanged.
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