Portfolio Risk and Correlation
The effect or interaction (co-variance and correlation) between returns on assets and portfolio risk is at the heart of modem portfolio theory. The degree and direction or correlation between asset returns have far-reaching effects on the reduction or portfolio risk through diversification. The correlation coefficient takes values between positive unity (perfect positive correlation) and negative unity (perfect negative correlation). The more negative (or less positive) is the correlation between asset returns, the greater is the risk-reducing benefits of diversification. Thus, for better understanding of the effect or correlation between asset returns on portfolio risk, we shall examine three special cases: (i) perfect positive correlation, (ii) perfect negative correlation and (iii) zero correlation.