Hi everyone,
Could someone please help me out with the following question:
Text
Hwang Soi makes monthly allocation decisions between consumer discretionary and consumer staples based on a proprietary model. The historical correlation between the returns of the two sectors is 0.30 and Soi’s bets have been correct 60% of the time. Further information is below.
Sector // E® // Standard deviation // Benchmark weight
Consumer staples // 10.8% // 3.0% // 65%
Consumer discretionary // 13.2% // 5.0% // 35%
Question: What is the expected annualized active return of Soi’s sector rotation strategy?
Answer : Active return from this strategy using a probability weighted average (given that Soi makes correct calls 60% of time) of combined risk is: (0.60)(0.05) + (0.40)(–0.05) = 0.01 or 1% per month. Annual active return = 1% × 12 = 12%.
My question: Can someone please explain where the 0.05 and -0.05 come from in the answer?
Thank you.