Chartered Financial Analyst Level 2
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For Asset 1 and Asset 2, and 15% for Asset 3. The manager compiles the following correlation matrix for the assets' returns:
| Asset 1 | Asset 2 | Asset 3 | |
|---|---|---|---|
| Asset 1 | 1.0 | -0.1 | -0.2 |
| Asset 2 | -0.1 | 1.0 | 0.3 |
| Asset 3 | -0.2 | 0.3 | 1.0 |
If the manager wishes to maximize risk-adjusted returns, the largest portfolio position is most likely to be in:
Exam-Like
A
Asset 1.
B
Asset 2.
C
Asset 3.
Explanation:
Explanation
To maximize risk-adjusted returns, we need to consider both the expected returns and the diversification benefits from the correlation structure.
Key Analysis:
-
Expected Returns:
- Asset 1: Not specified but implied to be higher than others
- Asset 2: Not specified but implied to be higher than Asset 3
- Asset 3: 15%
-
Correlation Analysis:
- Asset 1 has negative correlations with both Asset 2 (-0.1) and Asset 3 (-0.2)
- Asset 2 has positive correlation with Asset 3 (0.3)
- Asset 3 has positive correlation with Asset 2 (0.3)
-
Diversification Benefits:
- Asset 1 provides the best diversification benefits due to its negative correlations with both other assets
- Negative correlations reduce portfolio risk significantly
- Assets 2 and 3 have positive correlation, meaning they tend to move together
-
Risk-Adjusted Returns:
- Asset 1 likely has the highest Sharpe ratio due to:
- Potentially higher expected returns
- Strong diversification benefits from negative correlations
- Lower contribution to overall portfolio risk
- Asset 1 likely has the highest Sharpe ratio due to:
Conclusion: Asset 1 should receive the largest portfolio allocation because it offers the best combination of expected return and diversification benefits, leading to superior risk-adjusted returns.
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