Corridor and Correlations

Would like to understand why high correlation within asset should set high corridor for portfolio rebalancing?

Because if your asset classes have high correlations, as one moves, the others will move by roughly the same amount and they won’t change in relative amounts to the total portfolio.

even going back to original material, i have a hard time conceptualizing it. it seems like some of the stuff is counter-intuitive, meaning here comes memorization. … although i complain alot, i have more confidence here that it’s my lack of understanding that is the real problem

This is an example of when you have to bring together a couple of parts of the curriculum. First, asset allocation is a manifestation of the desired systematic risk exposures of the client in the IPS. It is a function of the return and risk objective of the client. Second, we are assume a constant target mix for the asset allocation, or the Constant Mix strategy (CM). Lastly, since we don’t want to deviate too far from out policy targets we have to set these corridors. Now suppose you have only two asset classes, A and B. If you start out with a 50/50 mix and they are both perfectly positively correlated and we assume the same returns then after a period of time, no matter what the returns they are still at 50/50. Even if you assume different returns they will still be close to the policy mix. Therefore, WIDER corridors can be tolerated will still keeping the desire systematic risk exposure desired for the RR objectives of the IPS. Conversely, if A and B are negatively correlated with equal returns after a certain period we might end up with a 60/40 mix instead of 50/50. This drift is not acceptable as per the IPS risk objective. Therefore, you have to have NARROWER corridors to account for the fact that the mix can “get out of whack” sooner when assets are negatively correlated. If you can’t see it make up an excel spreadsheet. Hope this helps.

here is what helped me to remember on the exam. With exception of volatility, all other aspects of portfolio characterisitc has a postive relationship to corrdior width. High volatility===>low corrdior width. High transcation cost===>high corrdior width. High corrleation===>high corrdior width. You get the idea…

it makes a lot of sense . what is unclear to me is why would you NEED wider corridors if the asset moves together with the portfolio? I mean if you set narrow corridors for a negatively correlated asset class, for sure you don’t need to go wider for asset classes that are positively correlated. My only explanation is that positive correlation - can mean SHORT term deviations but on longer term the allocation would get ‘in line’ with the portfolio - so you can have wider corridors when the asset class deviates because longer term it will tend to ’ adjust itself’ to the value of portfolio you think that would be correct?

There are two factors to consider in rebalancing: 1) deviation of your portfolio from desired asset allocation creates risk that we want to minimize 2) cost of rebalancing that we want to minimize As a portfolio manager you want to lower risk from deviation from desired asset allocation at reasonable costs. High vol -> higher deviation -> smaller corridor High corr -> smaller deviation (as mwtv explained) -> larger corridor High cost -> higher cost of rebalancing -> smaller corridor I hope that helps.

florinpop Wrote: ------------------------------------------------------- > it makes a lot of sense . what is unclear to me is > why would you NEED wider corridors if the asset > moves together with the portfolio? when assets are highly correlated, deviation is going to be small and benefit from rebalancing is going to be relatively small. It’s somewhat similar to the concept of smaller sensitivity of stocks of exporter to currency because economic and translation risks are negatively correlated.

florinpop Wrote: > > My only explanation is that positive correlation - > can mean SHORT term deviations but on longer term > the allocation would get ‘in line’ with the > portfolio - so you can have wider corridors when > the asset class deviates because longer term it > will tend to ’ adjust itself’ to the value of > portfolio > i think thats exactly correct… lets say you have allocation to oil ETFs and Gas ETFs, both are highly correlated with each other, and if you want a 50/50 portfolio of the two, lets say there is one random news report of an oil tanker spill, oil might shoot up temporarily, but you shouldnt go and rebalance because they will normalize at some point.

Positive correlation (say r around 1) does not mean that things grow at the same rate. It just means that they grow consistently in the same direction at the same time. The magnitudes of the growth can be different. Suppose that whenever asset A grows at 10%, asset B grows at 6% and whenever asset A grows at 7%, asset B grows at 5% (so I’ve set RFR=4% betaA=3 and BetaB=1, and r=1). In this case, asset A is growing faster than asset B and will still need to be rebalanced if you have a target allocation to rebalance to. It’s also true that if correlation=1, you don’t need to diversify, but I chose an extremely high correlation just so you could see how high correlation doesn’t mean that the proportions necessarily stay constant.

yes mike so basically you would have volatility(short term performance) and correlation(long term performance) in relation to the portfolio.

High cost -> higher cost of rebalancing -> smaller corridor wouldnt you want a wider corridor, as when u balance it will be pricy, and you want ot avoid trading Thanks

I thought high cost is wide corridor too…

sbmfj Wrote: ------------------------------------------------------- > High cost -> higher cost of rebalancing -> smaller > corridor > > > wouldnt you want a wider corridor, as when u > balance it will be pricy, and you want ot avoid > trading You are absolutely correct. I had a mental typo :slight_smile: