Assume the correlation coefficient between the return on the existing project and the return on a proposed foreign project is 1. Also assume the returns on the existing project and the new project are equal, and that the existing project has a lower standard deviation than the proposed project. Under this scenario, undertaking the proposed project will ____ the variance of the firm's overall returns.
A) decrease
B) increase
C) decrease or increase, depending on the exact size of the returns and standard deviations
D) none of the above

Question

Quizplus · Accepted Answer

When the correlation coefficient is 1, the returns move perfectly together. Since the proposed project has a higher standard deviation, adding it will increase the overall variance of the firm's returns.

Assume the Correlation Coefficient Between the Return on the Existing