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 A.3.1(a), 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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