1 - Introduction Flashcards
If markets are efficient, only way to get higher returns is….
Taking on more risk
Proofs against EMH
Arbitrage Opportunities
Compensation for collecting information (think not everybody has access to all info)
Market crashes and bubbles (“overpricings”)
Trading volume and volatility too high (constant mispricings?)
Existance of investment funds and quant strategies
What is Systematic/Quant investing?
Strategies with high returns (seem to in backtests) without taking on too much risk
Constant portfolio rebalancing (systematic), based on observable characteristics
Stat used for Alpha statistically significant?
t-stat > 2
Sharpe Ratio =
E (R - Rf) / vol (R - Rf)
Information Ratio =
alpha / vol. residuals (in a model)
Information Ratio (against benchmark) =
E (R - Rb) / vol. (R - Rb)
Sortino Ratio =
E (R - Rf) / vol. downside
vol. downside =
vol for returns below MAR (minimum acceptable return)
Drawdown =
(HWM - P) / HWM
Hedge Fund Leverage =
Long Positions / NAV
Gross Leverage =
(Long + Short Positions) / NAV
Net Leverage =
(Long - Short Positions) / NAV
P&L =
(Return x Investment on Long) - (Return x Investment on Short) + Financing
Financing =
Cost of loan from Prime Broker to support Longs
Interest earned on cash collateral (shorts) held by securities lender (rebate)
Interest earned on additional cash in money market products
Robustness Tests
In-sample vs. Out-of-sample
Cross-Section: Assets classes and Geographies
Parameters: Robust to changes in parameters? think interest rate
Backtest vs. Live Performance: Transaction costs and fees
Capacity constraints: Performance decreases with more AUM, think market movements
Other practicalities in Evaluating Trading Strategies
Geometric vs. Arithmetic returns
Estimating future volatility (“easy”) and correlations (“hard”)
Annualizing performance
High Water Mark (can only charge fees when above it)
Adjust for liquidity (regressing considering lagged periods of entrance)
Needs to perform Backtest
Universe of securities
Signals
Trading Rules:
Objective function (maximize this, minimize that)
Frequency of trading
Implementation Shortfall (bid-ask spreads)
Constraints (position size, country, industries. often imposed by clients)
Risk Model: Target risk level and rebalanced based on it.
Transaction costs
Data and time lags in backtesting
Data must be available at time (account for release dates)
Not realistic to assume you can trade at closing price
More realistic to use closing price one or two days later
Signal Research:
Credible Hypothesis:
- Rationale
- Why market not pricing already?
- What information inefficiency or liquidity provision are we targeting?
Test Economic Mechanism:
- Is rationale risk-based or friction-based?
- Can signal forecast future fundamentals and not only returns? Are other participants making systematic errors?
Additivity:
- Does it add anything beyond market factors? Value, momentum, carry…
Measure of Transaction Costs:
TC (volume-weighted average price) =
Price execution - Price vwap
Compares price at which you traded to average price at which other people traded on the same day
Investors tend to compare earnings yield to bond yield. What does this ignore
Earnings Yield -> Real Returns (account for inflation)
Bond Yield -> Nominal Returns
What are cyclically adjusted earnings?
Account medium-term fluctuations in terms of earnings
Shiller’s CAPE takes 10-yr average of inflation adjusted earnings
Bond returns =
Yield to Maturity - Capital Appreciation due to Yield Change
YTM = yield if everything goes “normal”
Cap. App. = Modified Duration x Yield Change
Mod. Duration = Bond sensitivity to rate changes, how much bond valuation changes if interest rate up 1%
This is for the case we want to sell the bond, if we’re just holding to maturity, excess returns will go down, but impact isn’t that big.
Credit return corresponds to…
Approximately the return on a CDS.
Basically is the portfolio composed of longing a corporate bond and shorting a government bond
Credit Spread =
Yield corporate bond - Yield government bond
Return on corporate - Return on government
(Bonds)
Approx.
+ Credit Spread
- Valuation and rating risk (may devalue if rating goes up and is considered safer -> reduces the credit spread)
- loss from default
Currency returns =
Carry + Foreign Currency Appreciation + Adjustment
Carry = Foreign Interest Rate
Foreign Currency Appreciation = Change in Spot Rates
Adjustment = Carry x FCA (disappears with cont. comp.)
What does the Uncovered Interest rate parity (UIP) say? Does it hold?
Higher foreign interest rates -> Lower future exchange rates
Does not hold empirically. Carry trade has worked on average.
What is the premium associated with investments in illiquid and real assets (real estate, private equity, etc.)?
Liquidity risk premium
What is Liquidity Based asset allocation?
Takes into account liquidity requirements. Allows long-term investors with stable financing to earn liquidity premium.
What is MVO?
Mean-Variance Optimization -> basically means optimizing for targets such as return and risk.
What is constant rebalancing (context of Strat. Allocation Approach)?
To always be targeting a certain proportion to a certain asset class. Most common example is the 60/40.
Risk Parity
Leveraging up or down different asset classes to achieve equal risk contribution across strategies/classes
Credit Yield =
Interest Rate + Credit Spread
With CS ~ Prob of Default x Loss Given Default
Duration =
Linear approx. of how bond price changes for a given change in yield
What is the relationship between duration and yields and why?
The lower the yield, the higher the duration.
Simple math, if rates are lower, it takes longer for the bond to pay the principal back.
Relationship between coupon rates and convexity.
Higher coupons mean lower convexity.
Higher coupon rate, means that bond pays a larger proportion of its interest payments earlier in its life. So, amount of cash flows that are affected by changes in interest rates later in the bond’s life is smaller. This makes the bond less sensitive to changes in interest rates and reduces its convexity.
What is effective duration (context of bonds/credit)
Duration adjusted for optionality.
We can decompose the discount rate of payments in 2: rf interest rates and spreads from credit
What is Effective (modified) Duration?
Duration that captures the change in rf interest rates, holding spreads fixed
What is Spread Duration?
Duration that captures the change in credit spreads, holding yield fixed (1+rf)
Dirty Price
Price including accrued interest since last coupon payment
Dirty Price = Clean Price + Accrued Interest
Mostly quoted in european bond markets
Other considerations in Fixed Income Markets
Currency Hedging (common practice)
Home Bias (higher than in equities)
Better to focus on tracking error than active share because of liquidity
What is a CDS and players roles
Contract that provides protection against debt issuer’s default
Buyer makes periodic payments
Seller collects payments and makes the buyer whole in case of default
Common misunderstandings in CDSs
Protection is written on bond issuer, not specific bonds. (Insure against US govt, not just 5yr bills)
CDS maturity is length of protection and not bond maturity
CDS spread refers to protection premium, quoted as basis points of protection amount. (technically it’s not a spread over anything)
Benefits of CDSs
“Pure” exposure to credit risk (minimal interest rate exposure)
Standardized across issuers (fixed coupons and maturity)
Easy to short / get leverage
Ideal for long/short, relative value strategies -> go long on good debt and short on bad
Benefits of corporate bonds relative to CDSs
Deeper market, larger capacity
Cash security (it’s not a derivative)
Ideal for buy and hold, long only strategies
