If two investments are perfectly negatively correlated
A) Diversification is not effective at reducing risk
B) Bets are perfectly hedged and risks are canceled out
C) Diversification reduces risk without changing the expected payoff
D) Diversification reduces both risk and the expected payoff

Question

Quizplus · Accepted Answer

If two investments are perfectly negatively correlated, it means that they move in opposite directions depending on the market conditions. Therefore, if an investor invests in both assets equally, the returns from one investment will offset the losses from the other. This means that the bets are perfectly hedged, and the risks are canceled out. Therefore, diversification is not effective at reducing risk in this case, as the investments are already hedged.

If Two Investments Are Perfectly Negatively Correlated