University of Central Florida (UCF) FIN2100 Personal Finance and Investments Midterm 2 Practice Exam

The concept of perfect correlation refers to a situation in statistics where two variables move in relation to each other perfectly in the same direction. In this context, a correlation of 1 indicates that as one variable increases, the other variable also increases in a perfectly linear fashion, and the same holds true for decreases. This means that there is a direct and unbreakable relationship between the two variables, making the correlation coefficient of 1 represent the strongest positive correlation possible.

In financial applications, understanding perfect correlation is critical when assessing asset relationships in a portfolio. If two assets have a perfect positive correlation, it implies that they will always move together, which is an important consideration for diversification strategies. If you have perfect correlation, adding another asset that is perfectly correlated will not reduce risk; it simply reinforces the existing movement.

Other values for correlation do not indicate this perfect relationship: a correlation of 0 suggests no relationship, while -1 indicates a perfect negative correlation, where one variable moves in the opposite direction of the other. A correlation of 2 is not a valid correlation coefficient, as correlation values must fall within the range of -1 to 1. Thus, the answer representing perfect correlation is indeed 1.