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 CEFA Endowment Asset Allocation BlueBox Reading 18 
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Example 10 in reading 18 on the CEFA endowment.
I have read through the explanation many times and I am still not sure why we do not use Portfolio 5 to calculate adjacent Corner Portfolios. In Example 9 (the BlueBox right before this question) we clearly used the two adjacent corner portfolios. In texample 10, they use one of the risky portfolios above the required rate of 6.5% and the risk-free rate. Why the risk-free rate? The case clearly says that “Exhibit 19 gives results from the sign-constrained MVO based on the inputs in Exhibit 18.” IF it is sign-constrained that means no shorting is allowed so why do they use the risk-free rate and omit Portfolio 5?
The solution says “Note that we need not consider the portion of the efficient frontier beginning at and extending below Corner Portfolio 5, because the portfolios on it do not satisfy CEFA’s 6.5 percent return objective”. The whole point of mixing two corner portfolios is to BLEND them in order to get the most mean-optimized average portfolio given a return requirement. We did the same thing in Example 9.
I even worked out the weights of Corner Portfolio 4 and 5’s standard deviations and the combined weighted value is still under the 12% standard deviation.
Can someone please have a look at this and tell me what I am missing? Did something miraculously change from Example 9 to Example 10?


07 Jul 2015
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1. A trustee has suggested that CEFA adopt the sole objective of minimizing the level of standard deviation of return subject to meeting its return objective.
given that - using the risk free asset with the minimum variance portfolio (highest sharpe ratio) would be the one.
11.65% + 0 combination < 11.65% + 7.89% combination.


07 Jul 2015
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In Example 9, Part 1A, the recommended strategic asset allocation was an efficient portfolio that was expected to just meet the return objective. With different capital market expectations and risk-free rates, however, that will not always be the case. For example, the expected return of the highest-Sharpe-ratio efficient portfolio (the tangency portfolio) may exceed the return objective, and if so, it may be optimal for the investor to hold the highest-Sharpe-ratio efficient portfolio in combination with the risk-free asset (as suggested in a capital allocation line analysis). On the other hand, as in Example 10, the highest-Sharpe-ratio efficient portfolio’s expected return may be below the return objective. Assuming that margin is not allowed, in such cases the highest-Sharpe-ratio portfolio is not optimal for the investor.
-
Curriculum


07 Jul 2015
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Cpk is right.
A trustee has suggested that CEFA adopt the sole objective of minimizing the level of standard deviation of return subject to meeting its return objective
To minimize risk without lowering the Sharpe ratio, we can combine the tangency portfolio with T-bills to choose a portfolio on CEFA’s capital allocation line. (We would lower the Sharpe ratio if we combined Corner Portfolio 4 with Corner Portfolio 5.)


07 Jul 2015
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This is no doubt a confusing couple of questions, here’s how I look at it. The objectives are:
1.) Maximise returns for level of risk taken. This means the Sharpe ratio needs to be maximised given all other objectives are met.
2.) 6.5% return is required
3.) Standard deviation of no more than 12%
Let’s go straight to the tangency portfolio (4) as it will have the highest Sharpe ratio. It meets both return and risk objectives, so is a good pick. The only way to improve given the constraint of objective 1 is to combine it with the risk free asset, as this will not decrease the Sharpe ratio (as it’s on the CAL).
We now need to choose between portfolio 4 and P4 with risk free asset. As suggested in the text, we use Roy’s safety first measure. The winner here is portfolio 4, so we go with that.
I’m unsure on Q2, would combining P4 and P5 give a lowed SD than combining P4 with the risk free asset? Correlations aren’t 1 so we can’t use a weighted average method to calculate standard deviation.


07 Jul 2015
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Kind of tag-along question here, from the paragraph immediately preceding example 10 (2015 curriculum, reading 18):
“On the other hand, as in Example 10, the highest-sharpe-ratio efficient portfolio’s expected return may be below the return objective. Assuming that margin is not allowed, in such cases the highest-Sharpe-ratio portfolio is not optimal for the investor.”
However, in example 10 the highest-sharpe-ratio corner portfolio IS greater than the return objective of 6.5%. Is this a typo???


07 Jul 2015
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