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Unformatted text preview: Two Extreme Examples : First Example: Correlation = +1 perfect positive correlation Variables move in perfect tandem Second Example: Correlation = -1 perfect negative correlation Variables move in exactly opposite directions The LOWER the correlation among assets in a portfolio (i.e. closer to -1) the GREATER the risk reduction possibilities for the portfolio. Diversification : Investing in more than one security to reduce risk . Relationship #1: If two stocks are perfectly positively correlated , diversification has no effect on risk . Relationship #2: If two stocks are perfectly negatively correlated , the portfolio can be perfectly diversified and basically eliminate nonsystematic (i.e. firm specific) risk . Example: Two RISKY assets can create a riskless portfolio if the two RISKY assets are perfectly negatively correlated....
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- Summer '11