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Example exam questions and answers, Asset Allocation
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11) What is Equity Under-participation and why is it a Puzzle? How can (myopic) loss aversion and probability weighting
help understand the puzzle?
Equity under participation: the tendency of investors to allocate less of their portfolio to equities then what traditional
financial models might suggest.
Puzzle: equities have positive returns....
Loss aversion: investors focus on ST losses and do not like the risks of equities
Probability overweighting: individuals assess the likelihood of bad risks higher, which makes equity even less attractive
(2) Make the case for International Diversification (or not). Why have return correlations across developed markets
trended upwards? How are short and long-term correlations different?
Internatinal diversification reduces portfolio risk and provides exposure to other economic cycles, industries and
currencies, enhancing risk-adjusted returns
Return correlations across developed markets trended upwards due to globalization and interconnected financial
markets.
ST correlations can be influenced by market sentiment and economic shocks, but LT correlations are influenced by
fundamental economic relationships, structural changes and policy decisions.
(3) Make the case (or not) for investing in emerging markets?
High growth potential, diversification benefits, untapped markets and industries, demographic trends, valuation
opportunities, globalization of supply chain, infrastructure development
(4) Despite that it is not clear that Private Equity outperforms Public Equity investments consistently, still a lot of money
flows into the PE market. What (other than performance) can explain this?
Illiquidity premium
Diversification (more investment opportunities since many firms are not public)
(5) How is the private equity industry affected by increasing interest rates (both in value, as well as on the financing
side)?
Valuation: discount rate to future CF goes up, which impacts the value of investments.
Higher interest rates increases the cost of debt financing, which may affect profitability of PE transactions
(6) Explain the Urban Doom Loop, and its potential consequences for local governments and the stability of the banking
system.
Urban doom loop: negative cycle in urban areas results in a decrease in overall well being.
Recently, more offices are empty. There is less tax flowing into the government, which may result a decline in the ovreall
demand for buildings, again resulting in less tax revenue.
Consequences for local governments: economic decline, e.g. reduced public services and more financial pressure
Consequences for the stability of the banking system: less money flowing, less investments so higher financial risks
(7) Discuss the inflation-hedging and safe asset qualities of gold.
Gold as an inflation hedge: this is not actually true, but it is said that in times of inflation, the value of gold may increase
as it retains purchasing power over time.
Safe asset qualities of gold: in bad times, sometimes gold did work as a safe-haven asset, but in some bad times it did
now. ‘bad times’: times of economic uncertainty of high volatilities.
(8) How does inflation cyclicality influence the correlation between equity and treasury bond returns?
What explains the current shift back to positive stock-bond return correlations?
Inflation can impact both equity and bond returns. The real value of fixed-income securities is eroded, which affects
treasury bond returns, but equities may benefit from times of inflation.
Correlations can shift based on economic conditions. In times of positive inflation, equities and bonds had negative
correlations.
, (9) Explain inflation-linked bonds – how do they work – what is break-even inflation? – why are TIPS interesting to
particularly long-term investors? Why are Nominal Bonds NOT a safe asset for long term investors?
TIPS adjust their principal and interest payments based on changes in inflation. This protects investors from the negative
effects of inflation on purchasing power.
Break even inflation: where TIPS and nominal bonds have equal returns. This is the market expectation for future
inflation.
TIPS are interesting particularly to LT investors since they preserve real purchasing power over the LT, creatin wealth
preservation.
Nominal bonds are not a safe asset for LT investors since they result in a loss of purchasing power in the LT. They offer
no protection against inflation.
(10) Discuss the (flawed) capital market assumptions that HMC was making in its MV optimization. How can the Black-
Litterman model help (this is discussed in the BL slides)?
HMC relies on historical returns and volatility assumptions, overlooking market complexities and uncertainties. BL
adjusts MVO by incorporating views, combining market equilibrium with investor views, providing a more realistic asset
allocation.
(11) From a set of assumptions on the components of risk premia, you should be able to build up the set of expected
returns from its building blocks (real rate, inflation/real premium, market risk premium).
Real return on
(12) Despite that they protect against increasing inflation, inflation-linked bonds have not done well over the last year.
Why is that?
TIPS underperformed due to sensitivity in changes in real interest rates. If they rise faster than expected, market value of
TIPS declines. Also, ST fluctuations in market sentiments may affect performance of TIPS and the performance of TIPS is
also affected by real yields.
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