4. An investor forms a portfolio out of two risky assets. The correlation coeffi

Question

4. An investor forms a portfolio out of two risky assets. The correlation coefficient between these two assets is 1. Which of the following statements is true? A. There are diversification benefits: the portfolio standard deviation is lower than the weighted average standard deviations of the two risky assets. B. There are no diversification benefits: the portfolio standard deviation is higher than the weighted average standard deviations of the two risky assets. C. There are no diversification benefits: the portfolio standard deviation is the same as the weighted average standard deviations of the two risky assets. D. There are diversification benefits: the portfolio standard deviation is higher than the weighted average standard deviations of the two risky assets.

Explanation / Answer

correct answer is C, If correlation is 1 portfolio’s standard deviation is simply a weighted average of the standard deviations of the two assets and as such a portfolio’s risk is unchanged with the addition of assets with the same risk parameters.Portfolio risk falls, however, when the two assets are not perfectly correlated. Sufficiently low values of the correlation coefficient can make the portfolio riskless under certain conditions.

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