# 2010 Exam Q5 Part D - Sharpe Ratio

Hi all, The answer on P 39 says “therefore, US high yield bonds should be added because the asset class Sharpe ratio = 0.33 which is higher than the Sharpe ratio of the existing portfolio multiplied by the correlation between the new asset class and the existing portfolio = 0.28”. I don’t understand why we would still add high yield bonds when we know that the combined portfolio will have a lower Sharpe ratio of 0.28 as a result? I thought we always consider the consequence of a portfolio as a whole in answering asset allocation question. Many thanks!

This was a formula we had to memorize at L2 (if you took it in 2010 or 2009 for sure).

The 0.28 figure is just the product of the existing Sharpe Ratio times the correlation with the prospective new asset. It doesn’t mean that the new Sharpe Ratio will be 0.28. The new Sharpe Ratio will be higher than the existing Sharpe Ratio. You can verify that on your own by calculating the new expected return and the new standard deviation.

Guys, where to get 2010 Exam? Thanks!

I am not sure which formula r u guys referring to in reading 26, Can you please specify the page no. I calculated the new sharpe ratio as 0.33 and decided not to include high yield bonds coz 0.33 < 0.46 (exiting sharpe ratio). Can someone please elaborate why is this approach wrong?

you can check 2010AM to know whether you are wrong

acer Wrote: ------------------------------------------------------- > I am not sure which formula r u guys referring to > in reading 26, Can you please specify the page > no. > > I calculated the new sharpe ratio as 0.33 and > decided not to include high yield bonds coz 0.33 < > 0.46 (exiting sharpe ratio). > > Can someone please elaborate why is this approach > wrong? Formula is on p244 of CFAI book3. I don’t remember seeing it in Schweser. I fell for this and did exactly the same as you. Our approach only works if corr==1. Otherwise need to compare with PortSharpe x Corr. Remember that Low Corr is good, so will increase chance of assets being added. Rule: Add new asset if… Sharpe Asset > Sharpe Port x corr(a,p)

Think of risk adjusted returns and correlation. The high yield bonds have a worse Sharpe ratio than the overall portfolio, but they offer good diversification because of the low correlation. Multiplying the correlation with the portfolio Sharpe ratio is a way of determining if the correlation benefit is large enough to offset the lower risk adjusted returns of high yield bonds.