Asset Allocation / Intl. Diversification - R21/22 Flashcards
Contrast the asset-only and asset/liability management (ALM) approaches to asset allocation and discuss the investor circumstances in which they are commonly used.
Explain the advantage of dynamic over static aset allocation and discuss the trade-offs of complexity and cost.
ALM is determined in conjunction with modeling the liabilities of the investor. Tailored to meet liabilities and to maximize the surplus given an acceptable level of risk.
Asset-only strategic asset allocation (SAA), the focus is on earning the highest level of return for a given (acceptable) level or risk.
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Dynamic asset allocation takes a multi-period view of the investment horizon.
- more complex and costly
- Static asset allocation ignores the link between optimal asset allocations across different time periods.
What is the formula for Utility-Adjusted Return?
Up = Rp - 0.005(A)(σp2)
What is the formula for Roy’s Safety-First Measure?
RSF = Rp - MAR / σp
MAR = Minimum Acceptable Return
If Portfolio A has an expected return of 10% and standard deviation of 15%, while portfolio B has a mean return of 8% and a standard deviation of 5%, and the investor is willing to invest in a portfolio that maximizes the probability of a return no lower than 0%:
SFRatio(A) = [10 − 0]/15 = 0.67,
SFRatio(B) = [8 − 0]/5 = 1.6
Investor would choose B.
Asset classes are appropriately specified if:
- Assets are similar from a descriptive and statistical prespective.
- They are not highly correlated so they provide the desired diversification
- Individual assets cannot be classified into more than one class.
- They cover the majority of all possible investable assets.
- They contain a sufficiently large percentage of liquid assets.
Evaluate the theoreical and practical effects of including additional asset classes in an aset allocation.
*What is the formula for identifying whether to add international securities to a portfolio or not? It involves:
- sharpe ratio of the existing portfolio
- sharpe ratio of the asset class
- the correlation between the two
Exlain the major steps involved in establishing an appropriate asset allocation.
After specifying and listing IPS-permisible asset classes, asset allocation involves steps on the capital markets side and the investor side.
- Observe capital market conditions
- Formulate a prediction procedure
- Obtain expected returns, risks, and correlations from the prediction
- Observe the investor’s assets, liabilities, net worth, and risk attitudes
- Formulate the investor’s risk tolerance function
- Obtain the investor’s risk tolerance.
- Optimizer (Optimization approach)
- Investor’s Asset Mix
- Returns (are observed)
Discuss the strengths and limitations of the following approaches to asset allocation:
- Mean-variance
- Resampled efficient frontier (REF)
- Black-Litterman
- Monte Carlo simulation
- Asset-Liability Mgmt Efficient Frontier
- Experience-based
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M-V involves selecting the efficient portfolio that best satisifies risk/return objectives/constraints.
- Disadvantage; uncertainty of inputs
- Monte Carlo overcomes the 1-period (static) nature of typical M-V analysis
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REF is an averaging process, where the most efficient portfolio is at the center of a distribution.
- (2) Advantages: More stable (than M-V). Better diversified portfolios.
- Disadvantage: Lacks sound basis.
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Black Litterman (UBL and BL) reverse engineers the expected returns from a diversified portfolio, adjusting the weights based on her view of expected returns. Narrower distribution = stronger views.
- Advantages: Well diversified. Incorporates the investor’s view (on asset returns).
- ALM attempts to maximize the surplus between assets and liabilities at each level of risk.
- Experience-based: Beliefs that 60/40 S/B, >bonds w/ > risk aversion, >stocks w/ > time horizon, young = more stocks.
For an investor who invests overseas, the return from a foreign asset is:
R$ = RLC +S + (RLC)(S)
Where:
R$ = return on the foreign asset in US dollar terms
RLC = return on the foreign asset in local currency terms
S = percentage change in the foreign currency
What is the formula for calculating the risk of a foreign asset?
The formula for the risk of a foreign asset is much the same as for portfolio risk, except the weights of both the asset and the currency are 1.0.
σ$2 = σLC2 + σs2 + 2σLCσSþLC,S
where:
σ$2 = variance of the foreign asset returns in US$ (domestic) terms
σLC2, σLC = variance and sd of the foreign asset in LC terms
σs2, σs = variance and sd of the foreign currency
þLC,S = correlation between the returns for the foreign asset in LC terms and movements in the FC.
The difference between the risk of the investment in US$ terms and in local currency is referred to as the:
Contribution of currency risk.
= σ$ - σLC
Currency risk only slightly magnifies the volatility of foreign investments because:
- Currency risk is about half that of foreign stock risk
- Foreign asset risk and currency risk are not additive
- Currency risk can be hedged
- Currency risk will be diversified away in a portfolio of many foreign assets
Which factors cause economies to behave independently and their resulting correlations to be low?
- government regulations
- technological specialization
- fiscal policies
- monetary policies
- cultural and sociological differences
Bond market correlations across countries are relatively low due to:
- Fiscal policies
- Monetary policies
What is the formula to determine variance and standard deviation for a 2-asset portfolio?
Determine the covariance for a 2-asset portfolio
