Asset Allocation

Question 1

Asset Allocation Approaches

Answer 1

1. Asset-Only: manage risk/ return of assets
2. Liability-Relative: manage assets in relation to liabilities
3. Goals-Based: manage subportfolios to meet goals

Question 2

Factor Portfolio

Answer 2

isolate systematic risk exposure

Question 3

Risk Budgeting

Answer 3

where/ how much risk to take

• specify how risk is distributed regardless of expected returns
• how much additional risk the investor is willing to take relative to benchmark

Question 4

Rebalancing

Answer 4

when to rebalances to benchmark; calendar or percentage-range based

drift corridor width based on

• transaction costs (+)
• risk tolerance (+)
• correlation w/ porfolio (+)
• volatility of portfolio (-)

Question 5

Mean Variance Optimization

Answer 5

• approach to determining AA
• lowest standard deviation for a given level of expected return
• constraints: budget, no non-neg weights, client constraints
• find optimal weights: max utility, efficient frontier, min return, max SD

Question 6

MVO Criticisms

Answer 6

1. GIGO
2. concentrated AA
3. diversification
4. ignores liabilities
5. single period
6. ignores skewness/ kurtosis of returns

Question 7

MVO Improvements

Answer 7

1. reverse opt - derive weights from expected return of global market port
2. Black-Litterman model - reverse opt adjusted for investor exp
3. add more constraints
4. resample MVO - Monte Carlo Sim; less extreme weights, includes all asset classes
5. include skewness/ kurtosis in utility function; use an asymmetric definition of risk (conditional VAR)

Question 8

Utility Maximization Equation

Answer 8

U_m = E(r) - 0.5 * λ * Var

Question 9

Roy’s Safety First Criterion

Answer 9

probability of portfolio exceeing min threshold return (want highest)

SF ratio = [E(RP) - R_L ]/ σ_P

R_L = min level of portfolio return

Question 10

Sharpe Ratio

Answer 10

excess return per unit of risk (want highest)

( R_m - R_f )/ σ_m

ERP_m / σ_m

Question 11

Illiquid Assets and MVO

Answer 11

1. calc MVO w/o illiquid assets classes, include in portfolio w/ set specific allocations for illiquid assets
2. calc MVO w/ illiquid assets
3. calc MVO w/ illiquid asset classes, include in portfolio w/ alt inv indexes

Question 12

Incorporating Client Risk Pref in AA

Answer 12

1. specifying additional constraints
2. specifying a risk aversion factor for the investor
3. monte carlo simulation

Question 13

Factor-Based AA

Answer 13

multi-factor regression to derive return w/ MVO

• use risk factors instead of asset classes
• corr btwn factors typically lower than corr btwn asset classes

Question 14

Contribution to Total Risk

Answer 14

MCTR (marginal): β_ac*σ_p

ACTR (abs): w*MCTR

opt allocation: excess return/ MCTR for each asset class = portfolio Sharpe Ratio

Question 15

ALM

Answer 15

asset liability management

1. surplus optimization (pension funds)
2. hedging/ return-seeking approach (insurance companies, overfunded pensions) > mimics the liabilities it’s funding (fully hedge = conservative)
3. integrated asset-liability approach (banks)

Question 16

Strategic AA

Answer 16

• reflects desired systematic risk exp
• set target weights for portfolio
• longer-term capital market expectations to inc portfolio value

Question 17

Tactical AA

Answer 17

use perceived short-term opportunities in the market to inc portfolio value; inc risk

• discretionary vs systematic (value or momentum)

Question 18

TAA Performance Evaluation

Answer 18

• compare Sharpe Ratio to SAA
• compare realized risk/ return to SAA efficient frontier
• calc info ratio/ t-stat of excess returns relative to SAA
• attribution analysis to determine excess return

Question 19

Mark to Market

Answer 19

PV of any g/l that would be realized if the forward contract was closed early w/ an offsetting contract position

Value = (g or l)/ ( 1 + LIBOR^n-t )

Question 20

Put Option

Answer 20

right to sell the underlying sec if P < X

gains value delta closer to -1, loses value delta closer to 0

Question 21

Call Option

Answer 21

right to buy the underlying sec if X < P

gains value delta closer to 1, loses value delta closer to 0

Question 22

Domestic Currency Return

Answer 22

R_DC = R_FC + R_FX + R_FC*R_FX​

R_DC = ( EV - BV )/ BV

Question 23

Domestic Currency Risk

Answer 23

σ²_RC = σ²_RC​ + σ²_RF + 2σ_RC​σ_RFρ_(RFC,RFX)

corr = pos = inc volatility of returns

coor = neg = dec volatility of returns

Question 24

Currency Management Strategies

Answer 24

1. passive hedging: benchmark
2. discretionary hedging: benchmark w/ slight deviation
3. active curr management: greater deviation from benchmark
4. currency overlay: seperate manager for currency

Question 25

Influences on Whether to Fully Hedge Currency Position

Answer 25

1. time horizon 2. risk aversion 3. liquidity needs 4. FX bond exposure 5. hedging costs 6. opportunity costs

Question 26

Economic Fundamentals

Answer 26

assumes LT currency value will converge w/ fair value inc value of currency 1. undervalued relative to FV 2. inc in FV 3. higher real or nom int rates 4. lower inflation 5. dec risk premium

Question 27

Technical Analysis

Answer 27

1. past price data can predict future 2. patterns repeat: overbought/ sold reverse, support/ resistance levels, moving avg 3. don't need to know value of currency, just where it will trade

Question 28

Carry Trade

Answer 28

borrow lower int rate currency (developed), invest proceeds in higher int rate currency (developing) RISK: higher int rate durrency depreciates by more than the diff in spot rates

Question 29

Covered Interest Rate Parity

Answer 29

F = S ( 1 + i_p )/ ( 1 + i_b ​)

Question 30

Volatility Trading

Answer 30

profit from changes in volatility expect inc volatility: long straddle (call, put in the money), long strangle (call, put out of the money)

Question 31

Vega

Answer 31

change in value of option b/c change in volatility of underlying inc volatility = inc value of options = inc price

Question 32

Roll Yield

Answer 32

roll yield = hedged curr return = F/S - 1 hedge = locks in forward price * S \> F; i_B \< i_P: long B = pos roll yield \> yes hedge * S \< F; i_B \> i_P: long B = neg roll yield \> no hedge

Question 33

Hedging

Answer 33

* dynamic - change hege to cover additional exp * depens on trans costs, risk aversion * discretionary - imperfect hedge uj * hedge long curr exp = sell forward

Question 34

Hedging Types

Answer 34

1. cross hedge: hedge w/ proxy deriv (not perfectly corr) 2. macro hedge: hedge portfolio w/ deriv based on basket of curr 3. MVHR: min var hedge ratio: reg to find % to hedge, min volatility of R_DC