Optimal Corridor Width - Higher and Lower Correlations CFA AM 2010 Q8

CFA Level III
#1

My (obviously incorrect ) intuition is that greater correllations between assets should result in a *narrower* corridor since there is less diversification. I have memorized that higher correlations with the rest of the portfolio - for example in CFA AM 2010 Q8 - actually does result in a wider portfolio. The explanation given is that “when asset classes move together, further divergence from targets is less likely, allwing a wiser optimal corridor width…”

It seems obvious that, for example, higher transaction costs result in a wider corridor, but this isn’t as logical. Anyone have an inutitive way to approach this area?

#2

if you have 2 asset classes that are perfectly correlated, when one moves up, the other will follow. Thus, weighting of the 2 asset classes will remain similar since they both moved in the same direction.

very simple example, original allocation is 60/40 and experiences 10% jump to 66/44 which still is 60/40

#3

^ nice explanation.

Does that apply to volality as well? Somewhere in the text it says volatility results in tighter corridors which doesn’t make much sense to me.

#4

vol is the only factor that’s inversely related to corridor weights.

I guess one way to explain is that the more volatile asset is, it’s harder to predict movement and direction and thus might lose track; thus, setting lower corridor for higher vol assets might help you catch potential drifting before it gets too extreme.

1 Like
#5

Good explanation. Thanks.

#6

When asset classes move in synch, further divergence is less likely => wider corridor

Is it similar to less likely to make mistake, so we release some rules?

#7

Sorry, I’m not sure what you mean

#8

Sry, poor English… For example, good people is less likely to break the rule, so we don’t have that stringent rule for them. (high correlation asset class is less likely to break the corridor, so we set wider corridor.)

#9

I hope this helps shed some light on this topic:

THREE factors POSITIVELY-correlated with corridor: Higher Transaction Costs, Higher Risk Tolerance, High positive correlation with other asset classes (no need to rebalance if they move up/down together)

TWO factors NEGATIVELY-correlated with corridor: High volatility of the asset class and high volatilities of the other asset classes (highly volatile asset class means increasing risk, so you can set narrower ranges to control that risk)