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Questions and Answers
What is the diversification benefit when the correlation between two assets is 1?
What is the diversification benefit when the correlation between two assets is 1?
- There is no diversification benefit. (correct)
- Diversification benefit is maximized.
- Diversification benefit is minimal.
- Diversification benefit is moderate.
As the correlation between two assets decreases, what happens to the diversification benefit?
As the correlation between two assets decreases, what happens to the diversification benefit?
- The diversification benefit fluctuates randomly.
- The diversification benefit decreases.
- The diversification benefit remains the same.
- The diversification benefit increases. (correct)
What does a correlation of -1 between two assets indicate?
What does a correlation of -1 between two assets indicate?
- Perfect negative correlation and maximized diversification benefit. (correct)
- Perfect positive correlation.
- Minimal diversification benefit.
- No correlation.
Consider a portfolio with two assets. Which correlation coefficient provides the greatest diversification benefit?
Consider a portfolio with two assets. Which correlation coefficient provides the greatest diversification benefit?
If a portfolio is equally weighted between Asset A and Asset B, and the correlation between them is $1$, what does this imply about the returns of the two assets?
If a portfolio is equally weighted between Asset A and Asset B, and the correlation between them is $1$, what does this imply about the returns of the two assets?
Flashcards
Correlation
Correlation
A statistical measure that shows the strength and direction of the relationship between two variables. It ranges from -1 to 1, where 1 indicates perfect positive correlation, -1 indicates perfect negative correlation, and 0 indicates no correlation.
Positive Correlation
Positive Correlation
When two variables move in the same direction. If one increases, the other is likely to increase as well.
Negative Correlation
Negative Correlation
When two variables move in opposite directions. If one increases, the other is likely to decrease.
No Correlation
No Correlation
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Diversification
Diversification
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Study Notes
Correlation Lesson Notes
- Correlation measures the relationship between two variables
- Standard deviation depends on the correlation between paired securities
- Diversification reduces portfolio risk by lowering correlation between assets
- Diversification is not about maximizing returns, but rather managing risk
- Diversification involves investing in different assets across varying companies, industries, and sectors
Diversification by Lowering Correlation
- Diversification seeks to avoid perfect correlation
- Perfect correlation indicates identical movements of paired assets
- Negative correlation (assets moving in opposite directions) maximizes diversification benefits
- Assets with no correlation (uncorrelated assets) mean one asset's movement has no impact on the other's
- Diversification aims to reduce portfolio risk
Negative Correlation
- Negative correlation reduces portfolio volatility, producing lower standard deviation
- The relationship between assets should reduce the portfolio's overall risk
Correlation as Linear Assocation
- Pearson correlation measures linear relationship between assets
- Spearman correlation ranks data points and measures the consistency of the relationship between data
- Kendall correlation is less susceptible to outliers than Pearson and Spearman correlations, and can be used for ordinal and not just quantitative data
Pearson Correlation
- Pearson correlation measures the linear relationship between two variables
- The formula for calculating Pearson correlation involves covariance and standard deviations of the two variables
- Covariance and standard deviation are used to determine the correlation coefficient
- The value of Pearson correlation ranges from -1 to 1
- A correlation close to 1 indicates a strong positive linear relationship (correlated assets)
- A correlation close to -1 indicates a strong negative linear relationship (assets moves in opposing directions)
- A correlation of 0 indicates no linear relationship
Spearman Correlation
- Spearman correlation examines the relationship between ranks of the data points
- Spearman's correlation coefficient measures the monotonic relationship between two variables
- It captures the relationship between assets without strictly requiring linearity
Kendall Correlation
- Determines the ratio concordant to discordant pairs of data points in a dataset
- Ranks the data points to determine correlation
- More resistant to outliers compared to Pearson and Spearman correlation
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Description
This quiz covers the concepts of correlation and diversification in finance. You'll learn how these principles affect portfolio risk and the importance of managing asset relationships. Explore the impact of negative correlation and uncorrelated assets on investment strategies.
