From what I have read/understood, there are three broad asset classes – Equity, Fixed Income and Money Market Instruments. Assets reflecting similar financial characteristics are grouped together under the above mentioned asset classes. Thus, if you take two assets in an asset class say Equity, because these two assets have similar characteristics, it is natural that their risks and also their responses to the market movements will be similar and thus they will be highly correlated(as correlation > 0 reflects movement in the same direction). Also, an asset under any one of the above classes, will respond differently to the market when compared with an asset from another asset class because of the difference in their innate characteristics (like people you know.. a thin person would respond differently to the statement “You’ve put on weight.” on comparison with how a fat person would react to that statement!).Thus, if I want to reduce my risk, I must find a way in which, in case of a worst case scenario, all the assets in my portfolio do not suffer loss. Because then, I am doomed. To avoid / reduce the possibility of the impending doomsday 😉 , I would want assets that react differently to the market and also assets that bear different risks. How to I get that? By investing in assets among different classes such that their risks are different and their correlation is also low. This will enable me to achieve the highest return at the lowest possible risk (this risk is also dependent on the investors risk profile. One investor may be risk averse, one may not.) So to answer your first question, yes it is based on the explanation that you have stated.
Second question – As explained above, correlations are high within assets among the same asset classes. So, if you already have equity stock in your portfolio, and you add more equity stock in your portfolio, you may not achieve risk reduction and that’s ok, if your aim is not risk reduction at the moment. In a good economy, where equity stock is giving good returns, having an all equity portfolio may even be beneficial, inspite of being super risky. Like I said before, if something goes wrong, in such a scenario your stocks may come crashing down too!
3rd question – Yes, I think it would mean a different asset class simply because diversification benefits are the highest when the risk is the lowest. Risk is the lowest in a portfolio when there is the highest negative correlation between the assets in the portfolio i.e. correlation coefficient should be -1. Now as explained above, this is definitely not possible if assets belong to the same class. Thus, it’s possible only among assets belonging to different asset classes.
I hope that answers your question! Maybe you should tag Christine, Zee or Sophie and check their inputs. It’s better to confirm from them, since they’ve passed the exams long back and have been working in the field for many years, whereas I am a Level 1 candidate!
@Ankita The way I think about the 3rd question is that:
= if my general portfolio loses max money, my max diversification security should make max money
= max negative correlation
I don’t quite follow question 2, and I agree with yourself and @jessmat that the point is about lower correlation between asset classes.
1. most of the asset classes have low correlation between them – alternative investments, bonds, equity, to name a few, have low correlation
2. the question states that the purpose is to minimize diversification benefit, so the answer would have to be -1, irrespective of the asset class. For example, considering the equity class, let’s say the portfolio contains a stock which increases in value as interest rates increase. Now, if you add another stock which decreases in value with increase in interest rates, you will find that the two stocks in your portfolio have correlation of -1.
hope that helps…
Correlation within an asset class should be high. One of the main requirements for a group of assets to fall into the same asset class is that they should be highly correlated. If they aren’t they probably have very different characteristics, hence not being similar, hence cannot belong to the same asset class.
Correlation for assets within a portfolio (among different asset classes) must be low for diversification.
In the question mentioned it just says that adding an asset to a portfolio and NOT to an asset class within the portfolio. Hence the correlation should be low so it’s -1.
Just remember: Correlation within an asset class should be high. Correlation between asset classes within a portfolio should be low.Hey guys,
1. Calculate the value of the company’s debt portfolio using the data shown above. Assume that Celtic Dream Ltd. finances 70% of its balance sheet with its bonds.
2. Calculate the duration of each bond and explain what these duration values imply. Calculate the duration of the company’s bond portfolio.
The company’s debt portfolio consists of the following bonds.
Corporate Debt Portfolio
Bond Issue: Nominal Value (Euro €)
4.5% Celtic Dream Ltd. Corporate Bond 2016 200,000,000
5.0% Celtic Dream Ltd. Corporate Bond 2018 300,000,000
6.0% Celtic Dream Ltd. Corporate Bond 2020 500,000,000
7.5% Celtic Dream Ltd. Corporate Bond 2029 900,000,000
*** Assume all bonds follow calendar year. Eg 4.5% Celtic Dream Ltd. 2016 matures 31.12.2016, and that all bonds pay coupon semi-annually. (It is 1 January 2015)
The following interest rates currently apply in the market.
Zero- Interest Rates
Maturity: 6mths 12mths 18mths 24mths
Yield : 0.5% 0.65% 0.80% 1.10%
Corporate Bond Yields
Maturity: 2 yr 4yr 10yr 15yr
Yield : 1.0% 2.3% 2.8% 1.10%
Would appreciate all the help I can get. Thanks in advance.
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