Portfolio risk can be reduced through diversification only if the returns of the loans in the portfolio are negatively correlated.

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BlackTom AI · Accepted Answer

The statement concerns whether diversification reduces portfolio risk only when loan returns are negatively correlated. 
Option 1 (TRUE): This is not correct. While negative correlation between assets helps diversification by offsetting each other’s movements, diversification can still reduce risk even if returns are uncorrelated or only weakly positively correlated. The core idea of diversification is to spread idiosyncratic (asset-specific) risk, and this reduction is possible across a wide range of correlation structures, not exclusively under negative correlation. 
Option 2 (FALSE): This is the correct interpretation. Diversification lowers overall portfolio risk primarily by absorbing some of the idiosyncratic risk from individual loans; this risk reduction does not require every loan’s return to move in opposite directions. Positive or zero correlations still allow diversification benefits, though the magnitude of risk reduction depends on the correlation levels. If all loans were perfectly positively correlated, diversification would offer little to no risk reduction, but real-world portfolios typically exhibit varying degrees of correlation, enabling meaningful diversification benefits. 
In summary, the blanket claim that diversification works only when returns are negatively correlated is too strong and overlooks scenarios where uncorrelated or weakly positively correlated assets still reduce risk through diversification.

BU.232.715.51.SP25 HW4

Portfolio risk can be reduced through diversification only if the returns of the loans in the portfolio are negatively correlated.

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BU.232.715.51.SP25 HW4

Portfolio risk can be reduced through diversification only if the returns of the loans in the portfolio are negatively correlated.

View Explanation

Log in for full answers

Similar Questions

You can best reduce investment risk by investing in

Holding a portfolio of 30 selected stocks eliminates all risk for an investor.

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Part 1Which of the following is a benefit to an individual purchasing a mutual​ fund? Part 2 A. An opportunity to free ride B. Diversification C. Increased risk D. Higher transaction costs

Which one of the following terms best refers to the practice of investing in a variety of diverse assets as a means of reducing risk?

………… could be eliminated by portfolio diversification.

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Part 1Which of the following is a benefit to an individual purchasing a mutual fund? Part 2 A. An opportunity to free ride B. Diversification C. Increased risk D. Higher transaction costs