CFA EOC 17 question two discusses the corridor widths for asset classes and what should constitute a wider or narrower corridor. The answers to the question all look wrong to me, however it indicates to select which comment made by one of the investors is correct.
The answer mentions that the investor’s comment regarding higher volatility asset classes should have a wider corridors due to less costly rebalancing. The text says the opposite in that the corridor lengths should be narrower for higher volatility assets (i.e. to keep them from getting too far outside the range). I understand why the costs to rebalance would be higher in this situation, but the concept of maintaining SAA would make me think that this answer is incorrect. Is this a case of a poorly written question in that it should have specified the focus of their corridors was to reduce costs, or am I missing something conceptually here?
From Reading 17, Section 6, Portfolio Rebalancing in Practice:
…the higher the volatility of the rest of the portfolio, excluding the asset class being considered, the more likely a large divergence from the strategic asset allocation becomes. That consideration should point to a narrower optimal corridor, all else being equal. In the case of an asset class’s own volatility, “holding all else equal” is not practically meaningful. If rebalancing did not involve transaction costs, then higher volatility would lead to a narrower corridor, all else equal, for a risk-averse investor. Higher volatility implies that if an asset class is not brought back into the optimal range after a given move away from it, the chance of an even further divergence from optimal is greater. In other words, higher volatility makes large divergence from the strategic asset allocation more likely. However, reducing a corridor’s width means more frequent rebalancing and higher transaction costs. Thus, the effect of volatility on optimal corridor width involves a trade-off between controlling transaction costs and controlling risk. Conclusions also depend on the assumptions made about asset price return dynamics. In practice, corridor width is often specified to be proportionally greater, the higher an asset class’s volatility, with a focus on transaction cost control. In volatility-based rebalancing, corridor width is set proportionally to the asset class’s own volatility. In one variation of equal probability rebalancing (McCalla 1997), the manager specifies a corridor for each asset class in terms of a common multiple of the standard deviation of the asset class’s returns such that, under a normal probability assumption, each asset class is equally likely to trigger rebalancing.
The CFAI Errata list actually addresses this very issue. It says:
Reading 32: The coverage of volatility in Exhibit 8 (volume 6, page 92) is superseded by the analysis of it in the fourth and fifth paragraphs following Exhibit 48 in Reading 17 (volume 3, page 313).
