Explanation:
The mean-variance utility model assumes that the correlation between asset classes remains constant. This assumption is a significant limitation of the model. In reality, the correlation between asset classes can change over time due to various factors such as changes in market conditions, economic factors, and investor behavior. For instance, during periods of market stress, correlations between asset classes can increase significantly as investors sell off risky assets and move towards safer investments. This phenomenon, known as 'flight to quality', can lead to a breakdown in the diversification benefits of a portfolio. Therefore, the assumption of constant correlation can lead to inaccurate risk assessments and sub-optimal portfolio allocations. It is important for fund managers to be aware of this limitation when using the mean-variance utility model for portfolio diversification.
Choice B is incorrect. The mean-variance utility does not assume that the correlation between asset classes is not constant. In fact, it assumes the opposite - that correlations are constant over time, which can be a significant drawback as it may not accurately reflect changes in market conditions.
Choice C is incorrect. The mean-variance utility does not assume that the correlation between asset classes increases in a linear manner. This assumption would imply a predictable and steady increase in correlation, which is often not the case in financial markets where correlations can fluctuate based on various factors.
Ultimate access to all questions.
No comments yet.
Q.2382 Country A is a developed economy with a vibrant financial sector. It witnessed a major financial crisis around 15 years ago. The economy recovered quite well and has consistently registered positive economic growth over the years. A recent survey conducted by an equity research firm indicated that the country’s fund managers have built a well-diversified portfolio inclusive of all the sectors of the economy. The survey also highlighted the fact that the fund managers generally used historical data of the last 10 years and mean-variance utility to determine the correlations between the different assets. Asked why they preferred data from the last 10 years, most managers were of the view that recent data was the best estimator of the correlation between the different assets.
The major shortcoming of using mean-variance utility to implement diversification is that:
A
It assumes the correlation between assets classes is constant.
B
It assumes the correlation between asset classes is not constant.
C
It assumes the correlation between asset classes increases in a linear manner.
D
It assumes the correlation between asset classes increases exponentially.