Problem
Suppose that as the chief investment officer for a global equity fund that currently has $100 million of assets under management, you are considering investing in an emerging market economy's stock market for the first time. You estimate that this country's stock index return will have a 0.25 correlation with the return of your existing holdings going forward, but that its standard deviation of return will be high, 0.35 per year compared to a 0.15 standard deviation for your existing portfolio.
I. Based on these estimates, determine the estimated standard deviation of your new portfolio's return if you sell $10 million of your existing assets and buy this emerging market country's stock index with the money.
II. Now suppose that, in addition to the parameters given above, the USD risk-free interest rate is 2% per year, your existing holdings provide an expected return of 10% per year and the emerging economy's stock index in question has an expected return of 14% per year. Determine the estimated Sharpe ratios of your portfolio before and after shift in part (I). Does the shift into this new asset appear to be a good idea? Briefly comment.