I get why comment #2 is incorrect, but what is wrong with comment #1: “Comment #1: Correlations among global markets increase during periods of increased volatility. For example, if the U.S. stock market experiences sudden decreases in prices, the correlation with other global markets often increases. This indicates that diversifying fails the investor at exactly the time they need it the most.” I thought that was correct…perhaps it is wrong because it a definitive statement, rather that something that “can” happen (as in, doesn’t always happen). Does the explanation answer key shed any light?
They give some horses**t explanation that the increased volatility is due to a statistical aberration, caused by how the std dev’s are measured. Whatever. I have no recollection of this in the readings. Some joker at Kaplan trying to be clever…
CFAI is not consistent with this issue Increased in correlation during period of increased volatility are manifestations of higher vol…not increase in true corrlations ( true only for developed economies) If question is asking specifically about Emeging markets then yes correlations will increase during periods of higher vol between EM and developed economies if Vol/crisis is global. Then why do manager needs to invest in EM … bcos crisis specific to EM doesn’t spread to developed economies…opportunities of diversification benefit & higher return.
There is something in the readings which does state that the so-called contagion effect is partly to do with the fact that correlation increases as volatility increases, simply because of the way that correlation is calculated. check page 404 in CFAI book 4 - the first couple of paragraphs basically, once you strip out the fact that correlation increases due to this conditioning bias, there really was no contagion! i.e no increase in correlation! the sort of crap only a bunch of economists can come up with
My opinion is that the spirit of what they’re asking - whether the effect occurs or not - is correctly answered by A, not B. I’m not surprised they’re some sidebar in the readings that backs up the Schweser answer… .still, it’s a completely weasel answer.
It is in the reading, but my understanding was the correlation increases, but it is due to increased volatility rather than a co-movement relationship. Read page 373 of V3 in CFAI. Schweser couldn’t have made the comment any closer to specifically what the book says. That comment should have been correct on the exam, thus answer is wrong. From page 373: “Market volatility varies over time, but volatility is “contagious”. In other words, high volatility in the U.S. stock market tends to be associated with high volatility in the foreign stock markets, as well as other financial markets (bond, currency).” “The correlation across markets increases dramatically in periods of high volatility, for example during major market events such as the October 1987 crash.” page 374: “But what is really troubling is that correlation seems to increase dramatically in periods of crises, so that the benefits of international risk diversification dissappear when they are needed.”
Rakesh, I think the basic idea is that there aren’t really many safe harbors to weather a major storm. In normal times Intl Diversification offers the chance of diversification and ehanced return, but during MAJOR events everything is impacted (just look at the fall of 2008 as an example…about the only thing that did well was already being long treasuries or short everything else).
Sponge_Bob_CFA Wrote: ------------------------------------------------------- > It is in the reading, but my understanding was the > correlation increases, but it is due to increased > volatility rather than a co-movement > relationship. > > Read page 373 of V3 in CFAI. Schweser couldn’t > have made the comment any closer to specifically > what the book says. That comment should have been > correct on the exam, thus answer is wrong. From > page 373: > > “Market volatility varies over time, but > volatility is “contagious”. In other words, high > volatility in the U.S. stock market tends to be > associated with high volatility in the foreign > stock markets, as well as other financial markets > (bond, currency).” > > “The correlation across markets increases > dramatically in periods of high volatility, for > example during major market events such as the > October 1987 crash.” > > page 374: > “But what is really troubling is that correlation > seems to increase dramatically in periods of > crises, so that the benefits of international risk > diversification dissappear when they are needed.” yeah, but as I said, check page 404 in CFAI book 4 - the first couple of paragraphs
I’ll drop it, but even 404 talks about an increase in correlation during periods of excessive volatility. True they consider that change a contagion effect, but it still results in an increased correlation (just not one based on comovement). I understand what they are saying, but that is a dreadful way of wording the question as it can clearly be defended in the CBOK applicable to that topic.