For EOC qns 2 reading 17(principles of asset allocations) the ans states that higher-risk assets should hve a wider corridor to avoid frequent rebalancing.
However, in reading 32 ( monitoring and rebalancing in exhibit 8, under asset class volatility, it states higher the volatility of a given asset class, narrower the optimal corridor.
Isn’t high-risk asset = high volatilty asset class? Am I missing anything here? If not, can someone advise how do we interpret the difference between these 2 situations? Thanks!!
Would also like to get people’s thoughts on this. Page 104 of Reading 16 in Schweser also states “In general, the greater the vol of the individual asset class, the tighter the corridor”.
I’m sure I read higher volatility means a wider corridor, but some past AF threads over the years state the corridor should be narrower so deviations can be dealt with ASAP.
I believe the former is correct for the purpse of the exam but I welcome someone debating otherwise!
Below factors are positively related to the optimal corridor size:
Risk Tolerance
Correlation of asset classes
Transaction Costs
Below factors are inversely related to the optimal corridor size:
Volatility of asset class
Volatility of the rest of the portfolio
The explanation behind this is “a given move away from the target is potentially more costly for a high-volatility asset class, as a further divergence becomes more likely.”
High volatility asset in general should have a narrower corridor (assuming that rebalancing did not involve high transaction costs) , but illiquid assets that are highly volatile should have a wider corridor because the transaction cost is higher than than the expected utility losses.
in CFA Curriculum, reading 32, page 91 “A higher volatility should lead to a narrower corridor, all else equal”.
in CFA Curriculum, reading 17, question 2: “higher-risk assets should have a wider corridor to avoid frequent, costly rebalancing.”
So, maybe higher volatility doesn’t mean higher risk? If not, at least one author of CFA Curriculum should lose his CFA, IMO
IMO the key is this paragraph.
CFAI Curriclum conclusions–> “An asset class’s own volatility involves a trade-off between transaction costs and risk control. The width of the optimal tolerance band increases with transaction costs for volatility-based rebalancing”.
CFAI Curriclum conclusions–> “An asset class’s own volatility involves a trade-off between transaction costs and risk control. The width of the optimal tolerance band increases with transaction costs for volatility-based rebalancing”
My perspective is high transaction costs widen the corridor for a higher volatility asset, while low transactions costs allow for cheaper rebalancing and allows a narrower corridor. I see it as a tradeoff between the two, driven by transaction cost.
Just my 2 cents, from a guy who failed level 3 in 2021…
