7.0200 = 57.8629
σ = 7.61
Sharpe = (6.72 - 2.5) / 7.61 = 0.55
Candidate discussion: 1 point for the correct E(R), 2 points for the correct standard deviation,
and 1point for setting up a correct Sharpe ratio calculation.
Remember how to and be prepared to compute return and standard deviation of a portfolio of
two assets as well as a Sharpe ratio.
(Study Session 8, LOS 17.a)
B. State which proposed asset class's Sharpe ratio, based on the historical data, is most
likely overstated and explain why.
Grading Guide
Answer for Question 3-B
Real estate is an illiquid security and the price data is subject to infrequent pricing and
smoothing. This lowers the reported standard deviation and increases the reported Sharpe ratio.
Real estate Sharpe is the most likely to be overstated.
Candidate discussion: 1 point for real estate. For a 2-point explanation, it must be clear the
candidate refers to infrequent pricing/smoothing of prices and this lowers the reported standard
deviation. If only one issue is included, only 1 point. The other asset classes are based primarily
on liquid traded securities and are unacceptable answers.
(Study Session 13, LOS 26.d, f, g)
C. State which Sharpe ratio, based on the historical data, is least likely to persist in the future
and explain why.
Answer for Question 3-C
Managed futures are not really an asset class, but they reflect the skill of the manager. They are
the least likely to exhibit persistent return characteristics so their Sharpe ratio is the least likely to
persist.
Candidate discussion: 1 point for managed futures. For a 2-point explanation, it must be clear
the candidate refers to manager skill issues and/or the lack of persistence in return parameters.
Referring to the generally shorter history of data for managed futures is not as good an
explanation and receives only 1 point.
(Study Session 13, LOS 26.d, t)
Before meeting with the Martins, Perry asks his assistant to review the characteristics of a valid
asset class and the issues of adding international assets. The assistant gathers the following
data.
Correlation:
Asset Class: Within Asset Class To Other Asset Classes
Global equity 0.63 0.51
International equity 0.87 0.49
Asset class "Z" 0.91 0.33
Small cap domestic equity 0.88 0.27
Global includes domestic and international
D. Determine whether it is more likely international bond or equity currency exposure should be
hedged and support your answer with one reason.
Answer for Question 3-D
Hedge the international bond currency exposure.
Bonds are less volatile than equity, making the currency volatility relatively a greater source of
risk of bonds (i.e., foreign currency would be a smaller contributor to return volatility for the
Martins in foreign equity than in foreign bonds).
Alterative reason: The correlation of foreign bond return to foreign currency is more positive than
the correlation between foreign equity and foreign currency. The + correlation contributes to
volatility for the investor in the foreign market and makes currency hedging more important in
foreign bonds.
Candidate discussion: 1 point for foreign bonds and 2 points for either explanation.
(Study Session 9, LOS 19.b)
E. Explain how contagion can be a problem if emerging market securities are added to the
Martins' portfolio and what tool Perry would use to manage the problem.
Answer for Question 3-E
Contagion refers to the observation that in crisis periods of market decline, correlations between
markets move upward towards +1 and the benefits of diversification are not present.
The tool used is conditional correlation matrices. One set of correlations is for normal conditions
and another higher set is for crisis conditions.
Candidate discussion: 1 point for explaining that correlations increase in declines, 1 for the
effect on portfolios, and 1 for using conditional correlation matrices. If the candidate says the
conditional matrices solve the problem, the last point is not awarded. They can be used to
quantify the issue or jointly optimize, but do not solve the underlying problem of convergence and
loss of diversification.
(Source: Study Session 9, LOS 19.i)
Perry also asks the assistant to analyze the effect on the Martins' portfolio of adding French
stocks to the portfolio if the currency risk is hedged or not hedged, based on the following
assumptions:
Stock market from the French investor
perspective:
Return: 12% Standard deviation:
29%
Risk-free rates:
French: 2% Australian: 5%
Standard deviation of the EUR: 14%
Expected change in value of the EUR: +2%
Correlation of French stock and EUR return: 0.30
F. Compute the return and standard deviation of a currency hedged and unhedged investment in
the French stocks for the Martins. There are four items to calculate. Approximate calculations are
acceptable.
Answer for Question 3-F
Unhedged return: 12 + 2 = 14%
Hedged return: 12 + 5 - 2 = 15%
Hedged currency standard deviation: 29%
Unhedged currency standard deviation:
Variance is: 12(0.29
2) + 1
2(0.14
2) + 2(1)(1)(0.3)(0.29)(0.14) = 0.1281
Making standard deviation: 0.3579 = 35.79%
Candidate discussion: 1 point each for the first three calculations and 2 points for the last.
Return is approximately R
FC + R
FX. R
FC is given as 12%. The projected unhedged R
FX is given as a
2% change in value of the EUR. This is 12 + 2 = 14%. With hedging, R
FX is determined by IRP;
lose the r
f of the currency sold forward (the EUR, so -2%) and gain the r
f of the currency
purchased forward (the AUD, so +5%). This is 12 - 2 + 5 = 15%. With hedging, the standard
deviation of R
FX is 0, and the unhedged standard deviation of the investment is the standard
deviation of R
FC, which is given as 29%. With currency unhedged, the standard deviation of
R
FX (given as 14%) is used in the standard variance formula, recognizing that the weights for both
R
FC and R
FX are 1.0 when investing in a foreign asset.
(Study Session 9, LOS 19.f)
QUESTION 4 HAS ONE PART FOR A TOTAL OF 8 MINUTES
Martina Edwards is retiring and stepping down from her position as portfolio manager at the
Huron Foundation, which funds undergraduate and graduate environmental science research.
She is currently training her replacement, Greg Matlock, who previously worked as the portfolio
manager for the defined benefit pension plan of a large corporation.
During training, Edwards makes the following statements to compare a typical foundation to a
typical defined benefit plan:
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