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appraised and/or out-of-date transaction prices.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:
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