Unit 3: Discussion Questions 2 Each unit you will find discussion questions related to the chapters covered. Please answer one of the assigned questions from each assigned chapter. Each unit you will find a “Discussion” thread to be used to post your answers to the chapter discussion questions. Please select a question, develop a complete answer, and post it in the thread. You should also respond to a fellow student’s answered question by reinforcing their work or adding additional information or ask for clarification in regards to their answer. Chapter 6: What is the relationship between diversification and portfolio risk? How are covariance and correlation used in asset allocation? What is meant by efficient diversification? How is the composition of the optimal portfolio determined? What is meant by a single factor asset model?

Covariance and correlation used in asset allocation

Covariance is a measure in the field of statistics that are used to determine how the one investment changes in relation to the other. If two investments are compared and it is noted that the two are up and down at the same time, then the covariance of the investments are positive. On the other hand, if the two investment moves coincidentally against each other, then the investments are said to be perfect positive (Janovsky, 2001). Conversely, if one investment moves high while the other is low, then the organization is said to be negative covariance. If one low investment coincides with the high at the same time then it is perfect negative covariance.

The correlation coefficient is used because the covariance covers a wide range of values hence affected by the outliers. Correlation compares the covariance of the negative covariance and positive covariance. It measures the degree of correlations that range from the one perfect positive correlation to one negative correlation. Therefore, the correlation coefficient is the best to use while allocating assets. This is because of the minimal deviation from the mean value.

During the resource allocation, the correlation coefficient is critical in determining the change in the stock market. Positive correlation coefficient indicates that there is optimistic dependence.  This is because the correlations change over time in relations to diversity in the stock market.

Reference

Janovsky, A. E. (2001). Asset Allocation, Performance Measurement, and Downside Risk. diplom.de.