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Systematic Investments > 1 - Introduction > Flashcards

1 - Introduction Flashcards

1
Q

If markets are efficient, only way to get higher returns is….

A

Taking on more risk

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2
Q

Proofs against EMH

A

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

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3
Q

What is Systematic/Quant investing?

A

Strategies with high returns (seem to in backtests) without taking on too much risk

Constant portfolio rebalancing (systematic), based on observable characteristics

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4
Q

Stat used for Alpha statistically significant?

A

t-stat > 2

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5
Q

Sharpe Ratio =

A

E (R - Rf) / vol (R - Rf)

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6
Q

Information Ratio =

A

alpha / vol. residuals (in a model)

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7
Q

Information Ratio (against benchmark) =

A

E (R - Rb) / vol. (R - Rb)

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8
Q

Sortino Ratio =

A

E (R - Rf) / vol. downside

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9
Q

vol. downside =

A

vol for returns below MAR (minimum acceptable return)

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10
Q

Drawdown =

A

(HWM - P) / HWM

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11
Q

Hedge Fund Leverage =

A

Long Positions / NAV

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12
Q

Gross Leverage =

A

(Long + Short Positions) / NAV

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13
Q

Net Leverage =

A

(Long - Short Positions) / NAV

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14
Q

P&L =

A

(Return x Investment on Long) - (Return x Investment on Short) + Financing

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15
Q

Financing =

A

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

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16
Q

Robustness Tests

A

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

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17
Q

Other practicalities in Evaluating Trading Strategies

A

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)

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18
Q

Needs to perform Backtest

A

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

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19
Q

Data and time lags in backtesting

A

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

20
Q

Signal Research:

A

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…

21
Q

Measure of Transaction Costs:

A

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

22
Q

Investors tend to compare earnings yield to bond yield. What does this ignore

A

Earnings Yield -> Real Returns (account for inflation)
Bond Yield -> Nominal Returns

23
Q

What are cyclically adjusted earnings?

A

Account medium-term fluctuations in terms of earnings

Shiller’s CAPE takes 10-yr average of inflation adjusted earnings

24
Q

Bond returns =

A

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.

25
Q

Credit return corresponds to…

A

Approximately the return on a CDS.

Basically is the portfolio composed of longing a corporate bond and shorting a government bond

26
Q

Credit Spread =

A

Yield corporate bond - Yield government bond

27
Q

Return on corporate - Return on government

(Bonds)

A

Approx.

+ Credit Spread
- Valuation and rating risk (may devalue if rating goes up and is considered safer -> reduces the credit spread)
- loss from default

28
Q

Currency returns =

A

Carry + Foreign Currency Appreciation + Adjustment

Carry = Foreign Interest Rate
Foreign Currency Appreciation = Change in Spot Rates
Adjustment = Carry x FCA (disappears with cont. comp.)

29
Q

What does the Uncovered Interest rate parity (UIP) say? Does it hold?

A

Higher foreign interest rates -> Lower future exchange rates

Does not hold empirically. Carry trade has worked on average.

30
Q

What is the premium associated with investments in illiquid and real assets (real estate, private equity, etc.)?

A

Liquidity risk premium

31
Q

What is Liquidity Based asset allocation?

A

Takes into account liquidity requirements. Allows long-term investors with stable financing to earn liquidity premium.

32
Q

What is MVO?

A

Mean-Variance Optimization -> basically means optimizing for targets such as return and risk.

33
Q

What is constant rebalancing (context of Strat. Allocation Approach)?

A

To always be targeting a certain proportion to a certain asset class. Most common example is the 60/40.

34
Q

Risk Parity

A

Leveraging up or down different asset classes to achieve equal risk contribution across strategies/classes

35
Q

Credit Yield =

A

Interest Rate + Credit Spread

With CS ~ Prob of Default x Loss Given Default

36
Q

Duration =

A

Linear approx. of how bond price changes for a given change in yield

37
Q

What is the relationship between duration and yields and why?

A

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.

38
Q

Relationship between coupon rates and convexity.

A

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.

39
Q

What is effective duration (context of bonds/credit)

A

Duration adjusted for optionality.

We can decompose the discount rate of payments in 2: rf interest rates and spreads from credit

40
Q

What is Effective (modified) Duration?

A

Duration that captures the change in rf interest rates, holding spreads fixed

41
Q

What is Spread Duration?

A

Duration that captures the change in credit spreads, holding yield fixed (1+rf)

42
Q

Dirty Price

A

Price including accrued interest since last coupon payment

Dirty Price = Clean Price + Accrued Interest

Mostly quoted in european bond markets

43
Q

Other considerations in Fixed Income Markets

A

Currency Hedging (common practice)
Home Bias (higher than in equities)
Better to focus on tracking error than active share because of liquidity

44
Q

What is a CDS and players roles

A

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

45
Q

Common misunderstandings in CDSs

A

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)

46
Q

Benefits of CDSs

A

“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

47
Q

Benefits of corporate bonds relative to CDSs

A

Deeper market, larger capacity

Cash security (it’s not a derivative)

Ideal for buy and hold, long only strategies

Systematic Investments (4 decks)

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