CFA Level I · CFA Level I Exam · The Return and Risk of a Financial Portfolio
Holding the standard deviations and weights of two risky assets constant, the portfolio standard deviation is most likely highest when the correlation between the assets is:
Portfolio risk is highest when correlation is +1.0. The covariance term in portfolio variance grows with correlation, so at perfect positive correlation there is no diversification benefit and portfolio standard deviation equals the weighted average of the asset standard deviations.
- A-1.0
- B0.0
- C+1.0Correct
Explanation
Portfolio variance includes the term 2w1w2ρσ1σ2, which increases as ρ rises. At ρ = +1, the portfolio standard deviation equals the weighted average of the individual standard deviations, the maximum possible. Lower correlations provide diversification and reduce risk.
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