Asset Allocation Flashcards
Asset Allocation Approaches
- Asset-Only: manage risk/ return of assets
- Liability-Relative: manage assets in relation to liabilities
- Goals-Based: manage subportfolios to meet goals
Factor Portfolio
isolate systematic risk exposure
Risk Budgeting
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
Rebalancing
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 (-)
Mean Variance Optimization
- 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
MVO Criticisms
- GIGO
- concentrated AA
- diversification
- ignores liabilities
- single period
- ignores skewness/ kurtosis of returns
MVO Improvements
- reverse opt - derive weights from expected return of global market port
- Black-Litterman model - reverse opt adjusted for investor exp
- add more constraints
- resample MVO - Monte Carlo Sim; less extreme weights, includes all asset classes
- include skewness/ kurtosis in utility function; use an asymmetric definition of risk (conditional VAR)
Utility Maximization Equation
Um = E(r) - 0.5 * λ * Var
Roy’s Safety First Criterion
probability of portfolio exceeing min threshold return (want highest)
SF ratio = [E(RP) - RL ]/ σP
RL = min level of portfolio return
Sharpe Ratio
excess return per unit of risk (want highest)
( Rm - Rf )/ σm
ERPm / σm
Illiquid Assets and MVO
- calc MVO w/o illiquid assets classes, include in portfolio w/ set specific allocations for illiquid assets
- calc MVO w/ illiquid assets
- calc MVO w/ illiquid asset classes, include in portfolio w/ alt inv indexes
Incorporating Client Risk Pref in AA
- specifying additional constraints
- specifying a risk aversion factor for the investor
- monte carlo simulation
Factor-Based AA
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
Contribution to Total Risk
MCTR (marginal): βac*σp
ACTR (abs): w*MCTR
opt allocation: excess return/ MCTR for each asset class = portfolio Sharpe Ratio
ALM
asset liability management
- surplus optimization (pension funds)
- hedging/ return-seeking approach (insurance companies, overfunded pensions) > mimics the liabilities it’s funding (fully hedge = conservative)
- integrated asset-liability approach (banks)
Strategic AA
- reflects desired systematic risk exp
- set target weights for portfolio
- longer-term capital market expectations to inc portfolio value
Tactical AA
use perceived short-term opportunities in the market to inc portfolio value; inc risk
- discretionary vs systematic (value or momentum)
TAA Performance Evaluation
- 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
Mark to Market
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 + LIBORn-t )
Put Option
right to sell the underlying sec if P < X
gains value delta closer to -1, loses value delta closer to 0
Call Option
right to buy the underlying sec if X < P
gains value delta closer to 1, loses value delta closer to 0
Domestic Currency Return
RDC = RFC + RFX + RFC*RFX
RDC = ( EV - BV )/ BV
Domestic Currency Risk
σ2RC = σ2RC + σ2RF + 2σRCσRFρ(RFC,RFX)
corr = pos = inc volatility of returns
coor = neg = dec volatility of returns
Currency Management Strategies
- passive hedging: benchmark
- discretionary hedging: benchmark w/ slight deviation
- active curr management: greater deviation from benchmark
- currency overlay: seperate manager for currency
Influences on Whether to Fully Hedge Currency Position
- time horizon
- risk aversion
- liquidity needs
- FX bond exposure
- hedging costs
- opportunity costs
Economic Fundamentals
assumes LT currency value will converge w/ fair value
inc value of currency
- undervalued relative to FV
- inc in FV
- higher real or nom int rates
- lower inflation
- dec risk premium
Technical Analysis
- past price data can predict future
- patterns repeat: overbought/ sold reverse, support/ resistance levels, moving avg
- don’t need to know value of currency, just where it will trade
Carry Trade
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
Covered Interest Rate Parity
F = S ( 1 + ip )/ ( 1 + ib )
Volatility Trading
profit from changes in volatility
expect inc volatility: long straddle (call, put in the money), long strangle (call, put out of the money)
Vega
change in value of option b/c change in volatility of underlying
inc volatility = inc value of options = inc price
Roll Yield
roll yield = hedged curr return = F/S - 1
hedge = locks in forward price
- S > F; iB < iP: long B = pos roll yield > yes hedge
- S < F; iB > iP: long B = neg roll yield > no hedge
Hedging
- dynamic - change hege to cover additional exp
- depens on trans costs, risk aversion
- discretionary - imperfect hedge uj
- hedge long curr exp = sell forward
Hedging Types
- cross hedge: hedge w/ proxy deriv (not perfectly corr)
- macro hedge: hedge portfolio w/ deriv based on basket of curr
- MVHR: min var hedge ratio: reg to find % to hedge, min volatility of RDC
