Question

For a N-stock portfolio, with N very large, the maximum reduction in risk occurs when the average correlation coefficient between the N stocks is:

a. +1

b. -0.5

c. -1

d. 0

Please explain why.

Answer 1

For stock portfolio maximum reduction is risk occurs when the correlation coefficient between the stock is -1

The reason behind this being -1 is when the correlation of stock is -1 the two security tends to more in opposite direction to each other and when it moves towards positive the security tends to move in same direction. Hence to arbitrage this situation in large portfolios the investor can use the negative correlation coefficient to book the profits although for the stock in the same segment group it always observed that the correlation coefficient is positive however to diversify the portfolio and hedge the risk negative correlation coefficient can be considered. Hence in the above given example to maximise reduction in risk the average correlation coefficient would be -1