Discuss how diversification affects risk and how correlation between s
QUESTION
Discuss how diversification affects risk and how correlation between securities affects portfolio risk.
es correlation measures the relation between the return on two securities through correlation coefficient. If the return on two securities has a correlation coefficient of 1 it implies that the return on the two securities is perfectly correlated. If the return on one security moves up or down the other security will follow the same direction. It implies that the relative prices of the two securities move in the same direction. On the other hand if the return on securities is negatively correlated then the fall in the price of one security is accompanied by the rise in the price of the other. Thus the negative correlation between the securities reduces the portfolio risk.
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