SAA question - if the required return is < market port

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elite708

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if the required return is less than the Market Portfolio (highest Sharpe portfolio), do we use the Market Portfolio combined with the RFR
or two corner portfolios?
- ie, if required return is 7%„, and highest sharpe portfolio has a return of 9%„ do you use the market portfolio and the risk free portfolio or still use the two corner portfolio?
and do we always calcualte the Standard Deviation as the weighted average of the two portfolio SD? (which is the maximum because not taking into considering correlation effects etc)?
THANKS
 
Yes, the foundation is always centered on the highest sharp portfolio and either long rf or short rf to reach the required return.
as for your second question, i vaguely remember covering it but the wavg would only be used if the assumed corr is 1.
 
whatsyourgovt wrote:
Yes, the foundation is always centered on the highest sharp portfolio and either long rf or short rf to reach the required return.
Click to expand...
ONLY IF THE IPS permits shorting …
 
elite708 wrote:
and do we always calcualte the Standard Deviation as the weighted average of the two portfolio SD? (which is the maximum because not taking into considering correlation effects etc)?
Click to expand...
i’m not clear on this point in the curriculum either. it’s not the maximum, that’s for sure. When you take the weighted average, you assume that correlation is 0. The maximum SD would be for the case when correlation is 1. Moreover, I highly doubt that correlaiton would be 0, when you consider that corner portofolios are adjacent portofolios that can have similar asset classes.
Nontheless the formula is unclear to me. The curriculum & Schwester presents it as:
w1*SD1+w2*SD2
why is it not:
(w1*SD1)^2+(w2*SD2)^2? after which you take square root to convert from variance to SD.
 
the w1sd1 + w2sd2 will be higher than any other combination. If you assume the two Corner portfolios are not correlated (have corr < 1) then the total std dev will be lower. a Correlation coeff of 1 gives you w1sd1+w2sd2 which will be the higher (more conservative) estimate of std dev for the combination.
 
cpk123 wrote:
the w1sd1 + w2sd2 will be higher than any other combination. If you assume the two Corner portfolios are not correlated (have corr < 1) then the total std dev will be lower. a Correlation coeff of 1 gives you w1sd1+w2sd2 which will be the higher (more conservative) estimate of std dev for the combination.
Click to expand...
this formula still doen’t make sense to me. See also here, where someone else asked themselves the same question: http://www.analystforum.com/forums/cfa-forums/cfa-level-iii-forum/91256616
i’ll just take it as they say in the curriculum though, even if it makes little sense.
 
if x=w1sd1, y=w2sd2
x+y = sqrt((x+y)^2)
(x+y)^2 = x^2+y^2+2xy
and 2 x y = 2 * 1 * x * y => correlation = 1
does what I wrote above now make sense? If the two are highly correlated - then correl will be 1, and x+y will be the highest std dev of the portfolio of combination.
for any other situation - the std dev of the combined will be lower. so by taking correl = 1 - you are being more conservative.
 
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