CFA Practice Question

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CFA Practice Question

For a two-stock portfolio, what would be the preferred correlation coefficient between the two stocks?
A. -1.00
B. 0.00
C. 1.00

User Contributed Comments 9

User Comment
brandsat So the returns would always cancel each other out ?
bmeisner Yeah but you could have different combo between each of the stocks and assuming no borrow cost it becomes an investment in risk free and 1 stock.
hannovanwyk ya, i also thought what's the point of diversifying all your returns away, but then i realized you should take the weightings into consideration...
Jaldendu The reason that the answer is -1 is because it is the most effective in reducing unsystematic risk
copus But this makes no investment sense. Stock goes up by 10% and stock B goes down by 10% so you make no money. It is like playing roulette and betting equal amounts on both red and black. You are not going to lose any money, but you will not make any money either. Better to invest your money in the post office savings account!!!!
C2inOC the variance can be reduced to be 0 (risk free), but the average expected return will be higher than what a risk-free T-bill yields, since each stock should yield higher than the T-bill. Preferred? certainly.

Investment is about minimizing risks given a certain return, or maximize returns given a certain level of risk.
steppennomade C2inOC

that is not true. If variance is reduced to zero, then the expected return will equal the risk-free rate. If this doesn´t hold then the corresponding stocks are not fairly priced.
Tanou if i understand well, with a correlation of -1 and a different weighting in the 2 asset you can synthetise a risk/return in 1 asset (the one with the more weight) + a risk free position. Is it really optimal? I am not sure.

Anyway the question should specify if the 2 assets are equally weighted.
lighty0770 LOS 44.f: The lower the correlation of asset returns, the greater the risk reduction (diversification) benefit of combining assets in a portfolio. If asset returns were perfectly negatively correlated, portfolio risk could be eliminated altogether for a specific set of asset weights.
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