Question

Explain the correlation coefficient (CC). At what CC level is maximum diversification achieved?

Answer 1

Correlation coefficient shows the strength and direction of relationship between two variables.

Correlation coefficient is calculated as = Covariance / ( variance of one variable x variance of another variable )

It's Value range between -1 to +1,

where +1 represents strong positive relationship,

-1 represents strong negative relationship.

Zero (0) represents no correlation between two variables.

Maximum diversification achieved at -1 correlation, since if one stock moves up other stock moves down, which offset the risk. Thus maximum diversification achieved at -1 correlation.

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