MIP Ch 5: Asset Allocation Flashcards
How can it be determined if adding a new asset to a portfolio makes it more efficient?
EpRNewqRF
New
¡ p
EpRPqRF
P
q CorrpRNew,RPq
What is the formula for the Safety First Ratio in Roy’s Safety First Criterion?
SFRatio
EpRPqRL
What are some critieria for selection of asset classes?
Assets within an asset class should be relatively homogenous
Asset classes should be mutually exclusive
Asset classes should be diversifying
The asset classes as a group should make up a preponderance of world
investable wealth
The asset class should have the capacity to absorb a significant fraction of the
investor’s portfolio without seriously affecting portfolio liquidity
What are some examples of asset classes?
Domestic equity
Domestic fixed income
Nondomestic equity
Nondomestic fixed income
Real estate
Cash and cash equivalents
Describe corner portfolios.
Corner Portfolios - endpoints of a part on the efficient frontier where all interior
portfolios on the efficient frontier are composed of the same assets.
What are the two properties needed for a constrained mean-variance frontier?
Asset-class weights must be (1) non-negative (no shorting) and (2) sum to one
State the corner portfolio theorem.
In a sign-constrained optimization, the asset weights of any minimum-variance
portfolio are a positive linear combination of the corresponding weights in the two
adjacent corner portfolios that bracket it in terms of expected return.
State some advantages of segmentation.
- Focus for meeting return objectives by product line / line of business
Different investment horizons
Different liquidity requirement - Easily allocate investment income by line of business
- More accurate measurement of profitability by line of business
- Better management of interest rate risk by product line
- Assist senior management in assessing the suitability of investments
- Establishes multiple acceptable asset allocations that are appropriate
- Promote competitive crediting rates for each segment
State some approaches/techniques that can be used to mitigate estimation error.
Sensitivity analysis
Resampled efficient frontier
Black-Litterman approach
State some special strategic asset allocation considerations for a bank.
The bank’s security portfolio plays a key role in:
Managing the balance sheet’s overall interest rate risk
Managing liquidity
Producing income
Managing credit risk
Regulatory considerations
Explain the Role of Strategic Asset Allocation in Relation to Systematic Risk
A key cornerstone of investment analysis is that systematic risk is rewarded
Strategic asset allocation helps align a portfolio’s risk profile with the investor’s
objectives
In the long run, investors expect compensation for bearing risk that they cannot
diversify away
Measuring portfolio risk begins with an evaluation of the portfolio’s systematic risk
Systematic risk usually accounts for most of a portfolio’s change in value in the
long run
Exposure to systematic risk over long time periods is rewarded
Groups of assets that are relatively homogenous should predictably reflect
exposures to a certain set of systematic risk factors
Groups of assets that are distinct/differentiated should have distinct exposures to
factors and/or exposures to different factors
The strategic asset allocation specifies the desired exposure to systematic risk
Describe what is meant by the term cross-sectional variation of returns
Cross-sectional variation of returns - the proportion of the variation among funds’
performance explained by funds’ different asset allocations
Describe the analysis from Kritzman and Page (2003).
Kritzman and Page (2003) explored asset allocation versus security selection in terms
of hypothetical potential to affect terminal wealth.
The conclusions from Krtizman and Page are:
Active security selection led to greater potential dispersion in final wealth than did
varying asset allocation
Skillful investors have the potential to earn higher incremental returns through
security selection than through asset allocation
Skill as a security selector may be highly valuable
Security selection’s potentially higher incremental returns come at the cost of
greater risk; thus, not only the investor’s skill, but also risk aversion must be
considered
When does the ALM approach tend to be favored over the AO approach?
The investor has below-average risk tolerance
The penalties for not meeting the liabilities or quasi-liabilities are very high
The market value of liabilities or quasi-liabilities are interest rate sensitive
Risk taken in the investment portfolio limits the investor’s ability to profitably take
risk in other activities
Legal and regulatory requirements and incentives favor holding fixed-income
securities
Tax incentives favor holding fixed-income securities
State special issues to consider when investing internationally
- Currency risk
- Increased correlations in times of stress
- Emerging market concerns
