So increased Volatility of one asset class leads to higher degree of deviations from asset allocations. I get it.
But why would that justify narrowing a corridor from say 5% to 3%? Like isn’t the entire point of a corridor/rebalancing limit to prevent an asset class from deviating too much? So no matter how volatile an asset class gets, it gets rebalanced at +/- 5%.
So whats the difference if an asset class deemed “less volatile” and another deemed “more volatile” both have a 5% corridor. 5% is either OK or its not.
Conversely the academic argument is that a “less volatile” asset class then can have a wider corridor of 7%…how does that make any sense? why is 6.9% versus 3% justifiable based solely on your expectation of volatility?
If anything I’d expect the exact opposite - more VOL should have a wider corridor to at least limit the costs of constantly rebalancing. When transactions costs go up its all about saving money so corridors can be wider. just seems like conflicting logic
With higher volatitlity assets there is more chance “they get out of control” and quickly go from -3% to -5% t0 =7%. It may also take time to trade. So you have tighter controls.
Just like if you a have welbehaved child and a naughy one. If give the less behaved child less leeway to do what they want.
Balanced against this si the cost (and with illquid assets ability) to trade.
The syllabus says :
In practice, corridor width is often specified to be proportionally greater, the higher
an asset class’s volatility, with a focus on transaction cost control. In volatility-based
rebalancing, corridor width is set proportionally to the asset class’s own volatility.
Thanks Mikey. The “time to trade” logic makes sense to me, thanks for that.
As for the syllabus language which competes with this, I just want to nail down what the answer is…
so when the basic question is posed as
Asset Class A is expected to be more volatile next year. Corridor widths should be:
(A) widened
(B) stay the same
(C) narrowed
I’m guessing the answer is always (C), as justified by tigther controls, time to trade etc ?