“STRUCTURING THE GLOBAL INVESTMENT PROCESS” (STUDY SESSION 18) E) D...

1. “Structuring the Global Investment Process” (Study Session 18)

e) discuss the role of capital market expectations in strategic and tactical asset

allocation;

g) interpret capital market data and capital market expectations in the context of

strategic asset allocation for a global investor;

o) evaluate the implications of a portfolio performance analysis for a global investor.

Guideline Answer:

Part A

Hamid’s approach to developing capital market expectations has the following limitations:

• Economic conditions of the past, especially distant past, may not be relevant for the future.

• Past market performance may have resulted from non-repeating specific events, e.g.,

liberalization of economies, P/E ratio expansion or contraction.

• Past data may be of poor quality.

• Regulatory environment may have changed substantially.

• Correlations may have changed due to market integration over time.

• Asset classes may currently be mis-valued due to excess optimism/pessimism.

• Volatilities may have changed.

• Risk premiums may have changed.

Part B

Alternative assets such as real estate are characterized by infrequent trading, leading to the use of

appraised and/or out-of-date transaction prices. This problem results in return data that tend to be

smoothed over time, and in a significant downward bias in the measured risk for the asset class

in question. For example, correlations among alternative asset returns, or between alternative

asset returns and conventional asset returns, are often close to zero. This inaccurate measurement

of the true asset class risk causes biases in correlations used in forming expectations for real

estate investment.

Part C

Yeo should raise her expected long-term investment risk premiums. Structural economic changes

such as currency controls that reduce market integration have the effect of restricting local

investors (in this case Yeo) and reducing their diversification ability. These investors should

require higher risk premiums (primarily in the form of segmentation premiums) because of the

reduced diversification. It can also be argued that currency controls would reduce market

liquidity, thereby increasing the liquidity risk faced by investors, who in turn should require an

additional illiquidity premium.

LEVEL III, QUESTION 10

Topic: Portfolio Management-Behavioral Finance

Minutes: 9

Reading References: