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Explanation:
Portfolio diversification would most likely fail and lead to losses. This is because during a financial crisis, the correlation between various assets tends to increase. This phenomenon was observed during the 2007/2008 financial crisis. When the correlation between assets increases, the returns on these assets tend to move in the same direction. This effectively diminishes the benefits of diversification. Diversification is a risk management strategy that mixes a wide variety of investments within a portfolio. The rationale behind this technique is that a portfolio constructed of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio. However, in a financial crisis, this strategy may fail as the correlation between assets increases, causing them to move in the same direction and leading to potential losses.
Choice A is incorrect. While diversification is a key strategy in risk management, it does not guarantee immunity from losses during a major economic crisis. Even though the fund managers have constructed well-diversified portfolios, they are still exposed to systemic risk which affects all sectors of the economy and cannot be eliminated through diversification.
Choice C is incorrect. The assertion that the returns from the fund would most likely beat other similar funds during an economic crisis is not necessarily true. The performance of a fund during a crisis depends on various factors including its asset allocation, risk management strategies and market conditions among others. Therefore, it's not guaranteed that this particular fund would outperform others.
Choice D is incorrect. As explained above, both choices A and C are inaccurate statements in the context of an economic crisis hence option D which states 'None of the above' cannot be correct as option B correctly states that portfolio diversification could fail leading to losses in such scenarios.
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Q.2380 Country A is a developed economy with a vibrant financial sector. It witnessed a major financial crisis around 15 years ago. The economy recovered quite well and has consistently registered positive economic growth over the years. A recent survey conducted by an equity research firm indicated that the country’s fund managers have built a well-diversified portfolio inclusive of all the sectors of the economy. The survey also highlighted the fact that the fund managers generally used historical data of the last 10 years and mean-variance utility to determine the correlations between the different assets. Asked why they preferred data from the last 10 years, most managers were of the view that recent data was the best estimator of the correlation between the different assets.
Suppose the country faces a major economic crisis, which of the following is the most appropriate statement?
A
The fund managers would not be affected as their portfolios are well diversified.
B
Portfolio diversification would most likely fail and lead to losses.
C
The returns from the fund would most likely beat other similar funds.
D
None of the above.