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Which one of the following correlation relationships has the lowest risk reduction potential? 1. perfectly positive...

Which one of the following correlation relationships has the lowest risk reduction potential?

1. perfectly positive

2. positive

3. negative

4. perfectly negative

5. uncorrelated

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Answer #1

Answer: Option 1 is correct.
Perfectly positive correlation relationships has the lowest risk reduction potential.

Risk reduction potential means how much the variance or standard deviation (measures of risk) of a portfolio can be reduced when we have multiple assets in a portfolio. When the correlation between the assets are perfectly negative they (the prices or returns) move in opposite direction and this eliminates the risk and the risk reduction potential is the highest. However, when the assets in the portfolio are perfectly positively correlated they will move in same direction and this will increase the risk and the risk reduction potential will be lowest.

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