F T F
I would mark all answers as False 
1) Higher covariance (BTW What does mean “improved covariance”?) means higher correlation: cor(1,2) = cov(1,2)/[var(1)*var(2)] 2) High volatility doesn’t mean more diversification in any case. This is the most confusing point. My idea is that more diversification means lower variance of portfolio. I did calculations and realized that an asset with very large variance if added to portfolio increase the variance of portfolio even with correlation of -1! For example, Portfolio st.dev = 5%, add 30% of asset with st.dev = 35% and corr = -1. And we get portfolio st.dev. of 7%! 3)During period of stress I think the true correlation is close to zero, becouse the markets are driven by emotions (biases). IMHO, of course
FTF
FTF
this thread is scary!
Not sure why so many people are saying false to Statement 1. Think about integration of markets - when barriers get opened up, markets begin trading more freely and it is not as risky to invest in the underdeveloped economy. As a result, risks to invest in this economy decrease, as do expected returns. Statement 1 is all about that. Improved covariance relationships means an opening up of new markets, which will lower stand-alone risk and return. TRUE. The other 2 statements are true also, imo. There seems to be little debate on statement 2, as most of the answers appear to be true. Statement 3 - I’m sticking to my guns and using the example of the current European crisis as support.
FFT We’re so screwed.
We Nedd the answers to this! *but* comments anyway: mp2438 Wrote: ------------------------------------------------------- > Not sure why so many people are saying false to > Statement 1. Think about integration of markets - > when barriers get opened up, markets begin trading > more freely and it is not as risky to invest in > the underdeveloped economy. As a result, risks to > invest in this economy decrease, as do expected > returns. > > Statement 1 is all about that. Improved covariance > relationships means an opening up of new markets, > which will lower stand-alone risk and return. > TRUE. 1. If your starting point is you have an international portfolio, admittedly it becomes easier to include those securities in markets that are opening up. However, because the covariance of these markets with international markets increases, doesn’t that negate some of the diversification benefit? That’s why I answered False. > The other 2 statements are true also, imo. There > seems to be little debate on statement 2, as most > of the answers appear to be true. > 2. Still not convinced about higher volatility being good. Surely the whole point of diversification is to reduce volatility. -Ve correlation is a no-brainer. 3. True, agreed. I’m sure I remember some small print saying that yes the correlation measure over measures, but even if you account for this there’s still some there. > Statement 3 - I’m sticking to my guns and using > the example of the current European crisis as > support.
As per CFA guideline answers , all three statements are True. Statement 3 contradicts with Schweser answer in mock exam. Schweser says correlation does not increase but CFA says it increases.
F ??? (Assuming improved Cov means +Cov) F (Higher volatility -->more risk) F (due to manifestation of higher volatility, not true correlation) Please explain what is Improved Covariance-- Have mostly heard about whether it is +/- or High/low degree.
Oh no. I need to read the whole chapter again. mp2438 has explained well up there.
I still disagree with 1 and 3. #1- I still believe this is absolutely false. All this talks about is the benefit of diversification. Think of the formula for port standard deviation, and explain to me how increasing the covariance does anything but increase the St Dev. If this brought into question the cost of capital decreasing then the answer would be different require a calculation as opposed to a conceptual question. #3- I just have trouble with the word “true”. Correlations most definitely increase in a time of crisis, but that is due to the volatility. When you add the word the “true” it makes me think of the underlying situation which has not infact increased. Again wording… Not really sure on #2, but why would a high volatility = the best. Neg correlation aspect is obvious, but i would prefer low volatility + neg correlation. If anyone could explain this one, I would appreciate it. If am wrong anywhere, please correct me.
I guess the confusion is more on the wording of the statements. I’ll explain my reasoning. #1 - Increasing covariance in general will increase your portfolio’s standard deviation, however, in the context of the statement, I took it to simply mean adding international securities to your portfolio or not. If not, then you have stand alone variance of that market, which will be higher than the covariance between an international market and a more developed one. That’s why I took improved covariance relations to NOT mean increasing covariance, but rather, moving from a segmented economy to a more integrated one. #2 - Look at formula for the last term of standard deviation of portfolio: 2*w1*w2*std dev1*std dev2*correlation coefficient. This last term is what gives it a diversification effect. You want this term to be as large and negative as possible, so having a negative correlation coefficient will help you with 1 part, since it flips the sign from “+” to “-” inside the big square root formula, then if you have a large volatility, it would magnify the amount you subtract from the rest of the formula. #3 - tricky wording. Perhaps I was just a bit naive in my first reading of the quote and thought about it with the perspective of the crisis, not giving much thought on the word “true.”
Excellent point on the second one. mp2438! Well done.
does this exercise mean that depth of knowledge/knowing the intricacies too much is not positively correlated with exam success? This could be the reason why smart people cramming for a month and pass.
mp2438: Thx on explanation of #2. I knew the fundamental concept, but a bit thrown with the high volatility aspect. Ok on to studying for things that might actually impact my final result. I dont mind missing a few tricky ones assuming I am in the concensus.