Which of the Statement 1 As long as two stocks are not in the same industry, all

Question

Which of the Statement 1 As long as two stocks are not in the same industry, all nsk can be diversified away if the correlation coefficient between the Statement 2 In order for diversification to occur in a two-asset portfolio, the two firms being combined must be less then perfecthy Statement 3 are true? two is 0. positively correlated (in other words, correlation must be less than 1). While adding more assets to a portfolio can result in beneficial diversification, the isk of a portfolio of nisky assets will still maintain market risk A Only Statement 1 is true B Only Statement 2 is true C Only Statement 3 is true D Only Statements 1 and 2 are true E Only Statements 1 and 3 are true F Only Statements 2 and 3 are true G All three statements are true H None of the statements are true Your answer

Explanation / Answer

1. Statement 1 is not true, as risk of the portfolio depends on the sum of risk of individual assets along with thier weights in the portfolio and the covariance of the assets, hence a zero correation can not eliminate the individual risk of assets. To completely eliminate the risk from the portfolio we need negatively correlated stocks.

2. Statement 2 is correct, as diversification is a process of risk reduction achieved by including in the portfolio a variety of investments having returns that are less than perfectly positively correlated with each other. Diversification of risk in the asset selection process allows the investor to reduce overall risk by combining negatively correlated assets so that the risk of the portfolio is less than the risk of the individual assets in it. Even if assets are not negatively correlated, the lower the positive correlation between them, the lower the resulting risk

3.Statement 3 is correct, as we add more assets to a portfolio the the negative correlation or less than perfect correlation reduces the risk of the portfolio, but entire risk of the portfolio can not be eliminated, it will have some market risk.

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