Solutions to In Class Market Risk Question

Calculate the DEAR for the following portfolio:

Assets Estimated DEAR ρS,F X ρS,B ρF X,B

Stocks (S) $300,000 -0.19 0.75 0.2
Foreign Exchange (FX) $200,000
Bonds (B) $250,000

1. With the correlation coefficients (ρ) below:

Recall that the formula for the DEAR for a portfolio with three assets
is given by:
q
DEAR = σA2 + σB2 + σc2 + 2ρA,B σA σB + 2ρA,C σA σC + 2ρB,C σB σC

where σA represents the DEAR for asset A, and ρA,B represents the
correlation between the DEAR of assets A and B.

Using the values for the given portfolio we obtain:


DEAR = 300, 0002 + 200, 0002 + 250, 0002
+2(−0.10)(300, 000)(200, 000)
+2(0.75)(300, 000)(250, 000)
 21
+2(0.20)(200, 000)(250, 000)

1
= 313, 000, 000 2 = 559, 464

2. With perfect positive correlation between the various asset groups:

1
 U sing a value of ρ = 1 for all the correlations in the equation for
DEAR at the top of the page yields:

DEAR = 300, 0002 + 200, 0002 + 250, 0002
+2(1)(300, 000)(200, 000)
+2(1)(300, 000)(250, 000)
 12
+2(1)(200, 000)(250, 000)

2
1
= 300, 000 + 200, 000 + 250, 000 2
= 300, 000 + 200, 000 + 250, 000 = 750, 000

3. What is the gain from diversification?

T he gain from diversification is the difference between the DEAR

of a portfolio where the correlations between all pairs of assets is 1
(no diversification) and the DEAR of the portfolio with the actual
correlations. In this case, the gain from diversification is given by:

750, 000 − 559, 464 = 190, 436