Assume risk free rate is 1%, and the correlation between the current portfolio and emerging market equities is 0.79. Expected return of current portfolio return and standard deviation are 4.5% and 6.5% respectively. Expected return of emerging market equities return and standard deviation are 7.5% and 13.5% respectively. Based on mean-variance analysis, whether emerging market equities should be added to the current portfolio?
What do you think?
The answer is: add to the current portfolio if sharp ratio of new asset class > sharp ratio of current portfolio * correlation
So . . . what do you think?
I do not know how to answer this question. I do not think this formula is on the curriculum.
If it’s not in the curriculum, then ignore it.
Find the overall return after you combine the allocations
Find the overall standard derivation after you combine allocations
If the Return Before < Return After =====> Good
If the Sharpe Ratio before < Sharpe Ratio After =====> Good
Return After = w1xR1 + w2xR2
Variance after = w12σ12 + w22σ22 + 2w1w2σ1σ2ρ
in this case it’s:
SR: E® - rf/std dev
Current Portfolio => 4.5-1/6.5 = 0.538
EM SR => 7.5-1.0/13.5 = 0.48
As 0.538 > 0.48 => do not ad EM to your portfolio. But I don’t think formula is in the 2019 curriculum, it was in previous years.
I don’t believe this is correct. You have to account for the diversification effect, which would alter sharpe ratio of the combined portfolio. That’s why they give you correlation.
Follow my steps outlined above
oops, sorry forget to account for correlation as you’ve mentioned.
0.48 > (0.538*0.79)=0.425
>> add EM to your portfolio
but if it’s not in this year’s curriculum, so we won’t have to worry about it I guess