NISM Certifications · NISM-Series-X-A: Investment Adviser (Level 1) · Introduction to Modern Portfolio Theory
Two securities have a correlation coefficient of -1 between their returns. What does combining them in suitable proportions achieve in a portfolio?
With a correlation of -1, appropriate weights can reduce portfolio risk to zero. Because the two securities move in exactly opposite directions, their fluctuations cancel out completely, giving the maximum diversification benefit possible.
- APortfolio risk can be reduced to zeroCorrect
- BPortfolio risk equals the weighted average of the individual risks
- CPortfolio risk always exceeds the higher individual risk
- DPortfolio expected return falls to the risk-free rate
Explanation
With perfect negative correlation, the movements fully offset, so a suitable weight mix gives zero standard deviation. Weighted average risk applies to correlation of +1. Risk never exceeds the higher individual risk when correlation is at most 1.
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