Extreme Events – Specimen Question
A.3.1(c) – Answer/Hints
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Q. What are the advantages
and disadvantages of using a linear combination of Index A and Index B to
backfill Index C, rather than using an either/or approach as per (b)?
The main advantage is that Index C may have some
similarities with both A and B, and so some blend of the two may better
characterise C than either in isolation.
The main disadvantages are:
(a) We are making
our model for C more complicated. This naturally means that we should expect it
to provide a better fit (as there are more degrees of freedom now available to
us). Use of techniques such as the Akaike
Information Criterion, that trade off model complexity against goodness of
fit, might be used to mitigate this issue.
(b) Adjusting the model in
this manner implicitly involves assumptions about idiosyncratic risks applicable
to C, see A.3.1(a).
(c) As with Question
point (b) could have important implications for the fine structure of asset
allocations deemed optimal, since selection of C versus A or B (or a combination)
depends heavily on the assumed characteristics of idiosyncratic risk expressed
by each asset class.
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