# Asset Allocation

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?

And why?

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?

And why?

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.

1. Find the overall return after you combine the allocations

2. Find the overall standard derivation after you combine allocations

3. If the Return Before < Return After =====> Good

4. 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