Hi everyone,
The Trading book (Reading 30, Monitoring and Rebalancing), P92 Example 8 #5, says that volatility of domestic bonds increased, therefore the tolerance band for international equities should be narrower.
Can someone please explain?
If Domestic bond volatility rises then the corridor should be narrower, but why would international equities corridor be narrower as well? Wouldn’t international equities volatility be less than bonds = wider corridor?
Thanks guys
look at the table just above …
exhibit 8
direct correlation with width
transaction costs increase - corridor width increases - due to higher hurdle rate that must be overcome by the rebalancing
risk tolerance increases - corridor width increases - higher risk tolerance means less sensitivity to divergence from target
correlation with the rest of portfolio increases - corridor width increases - when asset classes move in sync (due to the higher correlation - there is less chance of diveregence from target
==================
indirect correlation with width of corridor
both have to do with volatility
asset class volatility increases - width decreases - a move away from target is more expensive for a higher volatility asset.
volatility of rest of the portfolio increases (this is the case for the equity part of the portfolio above) - width decreases - because there is a higher chance of moves away from the strategic allocation
Thank you again! never realized that the bond volatility increase actually increases the entire portfolio voaltility indicating a narrower corridor for the other asset class (equity). Appreciate it.
The correlation between domestic bonds and international equities needs to be close to the absolute value of 1 for that to happen, all else equal. So it’s not a given. Fundamentally, volatility of Intl equities might go down in tandem with rising volatililty in domestic bonds.
Mr Smart - that is NOT what the curriculum says… So for the next 60 odd days - please keep ONLY the above exhibit 8 in mind.
exhibit 8
direct correlation with width
transaction costs increase - corridor width increases - due to higher hurdle rate that must be overcome by the rebalancing
risk tolerance increases - corridor width increases - higher risk tolerance means less sensitivity to divergence from target
correlation with the rest of portfolio increases - corridor width increases - when asset classes move in sync (due to the higher correlation - there is less chance of diveregence from target
==================
indirect correlation with width of corridor
both have to do with volatility
asset class volatility increases - width decreases - a move away from target is more expensive for a higher volatility asset.
volatility of rest of the portfolio increases (this is the case for the equity part of the portfolio above) - width decreases - because there is a higher chance of moves away from the strategic allocation