Assets subject to thin trading or appraisal-based valuation are difficult to model...

(b) If you perform portfolio optimization for a long-term investor based on monthly returns, what are the potential problems? (4 marks)

(c) Describe a method that you can use to address the problems in part b. (3 marks)

Assets subject to thin trading or appraisal-based valuation are difficult to model in asset allocation largely because the commonly used risk measures, such as standard deviation and correlation, are misleading to quantify the true underlying risk. The table below shows the correlations of returns of Australian Equity, Australian Listed Property and Australian Unlisted Property on various measurement horizons. AE vs LP AE vs DP LP vs DP 0.62 -0.01 0.05 0.62 -0.02 0.06 Monthly Quarterly Yearly 3-year 5-year 0.63 0.01 0.13 0.66 0.32 0.27 0.69 0.51 0.32 Note: AE = Australian Equity LP = Listed Property DP = Direct Property (or unlisted property) (a) The correlations in all 3 columns grow as the measurement horizon increases. Especially, the correlations in the last 2 columns (i.e. AE vs. DP and LP vs. DP) have significant increases from monthly returns to 5-year returns. Explain why this is the case. (3 marks) Assets subject to thin trading or appraisal-based valuation are difficult to model in asset allocation largely because the commonly used risk measures, such as standard deviation and correlation, are misleading to quantify the true underlying risk. The table below shows the correlations of returns of Australian Equity, Australian Listed Property and Australian Unlisted Property on various measurement horizons. AE vs LP AE vs DP LP vs DP 0.62 -0.01 0.05 0.62 -0.02 0.06 Monthly Quarterly Yearly 3-year 5-year 0.63 0.01 0.13 0.66 0.32 0.27 0.69 0.51 0.32 Note: AE = Australian Equity LP = Listed Property DP = Direct Property (or unlisted property) (a) The correlations in all 3 columns grow as the measurement horizon increases. Especially, the correlations in the last 2 columns (i.e. AE vs. DP and LP vs. DP) have significant increases from monthly returns to 5-year returns. Explain why this is the case