Global Asset Management and Portfolio Theory
Domain 5 tests portfolio construction and performance appraisal across currencies. Expect efficient-frontier logic, beta and alpha decomposition, risk-adjusted ratio selection, and the treatment of currency as a separate return component in a global portfolio.
Core theory toolkit
- Markowitz diversification produces the efficient frontier; the minimum-variance portfolio is not the maximum-Sharpe portfolio.
- CAPM: E(R) = rf + β(E(Rm) − rf). Beta captures systematic risk; alpha is the residual return unexplained by beta.
- Performance ratios: Sharpe uses total volatility, Treynor uses beta, the information ratio uses active risk. Choose the ratio that matches the portfolio's role.
- Currency is a return component. Unhedged foreign return = (1 + local return)(1 + currency return) − 1. A fully hedged return approximates local return plus the domestic-foreign short-rate differential.
Worked example
A US bond returns 4.0% locally while the dollar depreciates 3% against the won. The unhedged won return is 1.04 × 0.97 − 1 = 0.88%, not the 1.00% that adding returns suggests - the arithmetic shortcut overstates by 12bp and the error grows with larger moves. If instead the position is hedged with a one-year forward when the won rate is 3.5% and the dollar rate is 5.0%, the hedged return is roughly 4.0% + (3.5% − 5.0%) = 2.5%: hedging is not free, it costs the rate differential.
Traps that cost marks
Adding returns arithmetically instead of compounding; using Sharpe for a sleeve inside a larger fund where marginal risk is beta; forgetting that a hedge has a carry cost; comparing managers without correcting for survivorship and backfill bias; ignoring IPS constraints such as liquidity, liability matching and permitted instruments.