Chapter 15 Flashcards
What is a dominant investment strategy
One with the same level of risk but a greater expected return
What does ex ante mean
Risk and return calculated before investing period
Ex post meaning
Actual value ps after investing period
Most common risk measure for securities and portfolios
Ex post Standard deviation
Limitations of standard deviation
Based on historical prices so may not represent future
Measure of upside movement and downside, only concerned about downside
Assumes upside equally likely as downside
Vol is not the only risk, inflation risk is example of alternative risk
Alternative risk measures
Semi variance
Probability of shortfall
Expected shortfall
What is semi variance
Only measures returns in period that go below the mean - downside measure of risk
What is a probability of a shortfall
Probability of return falling below target level
What is expected shortfall
Measure of expected loss at a given probability level
Example in 5% worst cases, the firm loses 5 million
When does standard deviation understate the risk
When there is any form of auto correlation present in returns
What VaR (value at risk)
Used to estimate the capital loss on a portfolio or individual asset over a given time period that will be exceeded with a given frequency or probability
3 key features of VaR
Time period
Confidence or prob level
Loss amount/percentage
If a portfolio has a value of 100mn and we expect it to lose 10mn in one occasion out of 100 in 24 hrs then what is the var
1/100 = 1%
Var in this occasion is 99%
3 ways to calibrate Var
Historical returns
Variance covariance method
Monte Carlo approach
If the lowest 1% of daily retruns is all below minus 5% then what is var and explain
Var is 99% confidence that the worst daily loss will not exceed 5%
Losses of greater than 5% occur 1% of the time.
What assumption does variance covariance method for var use
Assumes returns are normally distributed
What does fat tails mean
Probability of extremes occur more commonly than predicted by distributions
Var limitation
Not a reliable guide to future losses
Sd (monthly) formula=
Sd (daily) x sqrt(time)
= Sd (daily) x sqrt(20)
20 bd in month average
Average trading days in a year
250
What is stochastic model and example of one
Vehicle for estimating probability distributions of the range of potential outcomes by allowing random variation in inputs over time
Monte Carlo
Deterministic model what is it
Output is determined by the parameter values and initial conditions
Drawdown
Decline in price form historical peak value of an investment, max amount of investment that could have been lost when at highest price
Limitations to drawdown
Longer the time series, the more likely to have a large drawdown
Max drawdown is a single number and will therefore have a large uncertain error distribution
Related drawdown
Measure drawdown relative to a particular benchmark
Tracking error what is it
Difference between portfolio return and bench mark iis meant to match or beat
Tracking error equation
Sqrt ( sum of difference in return squared / n -1)
What impacts the degree of tracking error
Degree to which benchmark and portfolio have securities in common
Difference in timing or market cap
Difference in weighting of assets
Fees
Why are portfolios periodically rebalanced
Due to inflows and outflows from investors
What does low tracking error mean
Portfolio is closely following the benchmark
What percentage of observations lie within 2 standard deviations of the mean
95%
What is another factor that impacts the tracking error
Vol of benchmark and hence vol of underlying assets
What does price vol cluster mean
Periods periods of high vol in asset prices tend to follow each other closely, similarly for low vol periods
What is active share
How relative weights of portfolio compare to relative weights of benchmark
Active share formula
1/2 x abs( sum of difference in weights)
What does an active share of 0 and 100 percent mean
0% = perfectly tracking index
100% = no overlap at all
What percentage is a closet tracker
20-60% active share, charge higher fees than index funds
Explain active stock picker, concentrated funds and closet index funds
Active - take large but diversified positions away from index
Concentrated funds - combine active stock selection with substantial exposure to unsystematic risk
Closet = neither high active share or tracking error
What is total risk
Unsystematic plus systematic risk
If. A share has total standard deviation of 14% with systematic risk of 10%
What is the unsystematic risk
14^2 = 10^2 + x^2
X= 9.8%
Two ways to reduce risk in portfolio
Well diversified reduced unsystematic risk
Adding assets to portfolio which offset systematic risk, as one stock goes up, another goes down
How does correlation affect diversification
The lower the correlation, the greater the diversification
Correlation formula
= covariance (x,y)/ (standard deviation of x and y multiplied together)
Limitations of correlations
Extreme market movements result in correlations converging to positive 1
Correlation on captures linear relationships
Correlation does not imply causation
6 types of investment risk
Inflation
Currency
Liquidity
Fraud
Interest
Counterparty
What asset class is not ideal for correlation analysis
Probate markets as not easily observable market prices
Two methods for forecasting
Simply extrapolate historical correlations
Use the correlation between factors in CAPM or multi factor arbitrage pricing theory (APT)
Why do assets tend to converge in direction in times of stress
Risky assets are sold off together leading to highly correlated returns
Capm assumptions
Financial markets perfect competitive
All investors have homogeneous investment period and expectations
Can borrow and lend at risk free rate
Investors Try to max return with minimal risk
What is capm represented by
Security market line
Firm specific attributes that affect stock returns
Firm value and momentum
CAPM formula
Expected return on portfolio or asset =
Risk free rate+ B(portfolio)[Erm-rf]
What does the beta measure in the capm
Systematic risk
Beta equation for capm
Cov ( Rp, Rm)/ Var(Rm)
What does the slope of the regression line tell you
The beta
What does a beta of less than 1 mean
Portfolio less risky than the market
Prediction of capm when in equilibrium
All assets/portfolio lie on the security market line
What does it mean if stocks lie above and below the security market line
If stock above the line then price must rise = reduced future return
If stock below the security market line then price must rise = increased future returns
What does higher beta coefficient mean for expected returns
Higher returns expected
Portfolio beta =
Weighted average of individual betas
Total risk formula measure by variance
Var(portfolio) = B^2 x var(market) + var(unsystematic part of returns)
B is beta from capm of portfolio
Total risk formula measure by variance of well diversified portfolio
Var(portfolio) = B^2 x var(market)
Limitations of capm - similar beta
Smaller firms have higher returns than predicted by beta compared to large firms with similar beta
What are drivers of returns
Sources of risk that the asset is exposed to
What is APT
Expected returns of financial asset can be modelled as a linear function of various macro economic factor
Each factor affect on returns is shown by beta which shows sensitivity of returns to that facts
Macro factors that are important in explaining returns
Surprise…
Inflation
GNP
Investor confidence
Shifts in yield curves
What is a a factor
Attribute to a security which has been identified over time as persistent driver of returns
Factor investing what is it
Create portfolios based on what factors you think might do well
High exposure to oil if positive on oil, neutral on interest if unsure on I rate direction
Example so far security attributes
Size of stock
Dividend yield
Book to market value
Represent value investing
What does factor investing aim to do
involves selecting investments based on quantifiable characteristics, or “factors”, to generate long-term returns.
Smart beta investing
Delivery vehicle that captures return drivers through transparent and rules based methodologies
Where is smart beta investing usually done
Through etf.
Superior performance to passive funds
Lower transaction costs than active funds
Limitations of smart beta investing
Can we blend factors to negate down period
Can we market time between factors
Efficient market hypothesis
Idea that securities prices instantly reflect all available information,
Prices always reflect fair or fundamental value
Prices only chnage in responses to new information which is unpredictable = prices follow a random path
Three versions of efficient market hypothesis
Weak form
Semi strong form
Strong form
What is weak form efficient market hypothesis
Prices already reflect all info contained in the past history of market prices and volume
What is semi strong from emh
All public info about firm is contained in stock price
What is strong form emh
Proce reflect all Info public and private, if strong holds then so does semi and weak hold
Assumptions for emh
Large number of rational profit max investors
Arbitrage eliminates price deviations
Information free and widely available
Three factor capm include
Sizes and value beta plus traditional market beta
Noise trader risk
Refers to the unpredictable future actions of noise traders
What can irrational traders do
Act on incomplete info and create noise which is a source of risk that could block arbitrageurs
Reason for anomalies away from efficient market hypothesis
Behavioural finance
Modern portfolio theory asssumptiosn
Investors are rational
Markets efficient
Expected returns depend on risk alone
Investors design portfolios according to mean variance portfolio theory
Behavioural finance alternatives to modern portfolio assumptions
Investors not rational
Markets not efficient
Investors create portfolios according to rules of behavioural theory
Expected returns driven by a range of factors
When making financial decisions, bahviorual finance suggests
People do not use all information or process all the info available
People make suboptimal decision leading to mispricing which will persist if there is limited arbitrage activity
Memory bias
Like recency bias, give too much weight of though to recent events when forecasting
Confirmation bias
Individual more open to info which confirms pre existing thoughts
Conservatism bias
Investors too slow to update their own beliefs
Endowment effect
Price higher for asset if they owned it rather than if they didn’t own it
Prospect theory / loss aversion
Value gains and losses differently
Anchoring
Place too much emphasis on irrelevant fact s
Faulty framing
Normal investors fail to make their stocks to market prices and maintain them at purchase price in mental accounts
Hindsight bias
What is clear in hindsight sight must be c,ear in foresight
Mental accounting
Agents segregate decision
How does conventional finance and behavioural finance interpret the market j
Conventional interprets it as a source of risk
Behaviorual beleives it is a reflection of emotions and cognitive bias
Why does arbitrage not work for behavioural finance theory
Implementation costs, model risk and uncertain time horizon required for correction
Financial amnesia
Agents act in a way in which they have forgotten the lessons of financial market history
Why is market discipline not maintained
Failure of corp governance
Why does corp structure fail
Incentive structures encourages unsustainable activity
Moral hazard - too big to fail
Behavioural finance
Overconfidence
What is a bubble
When financials value moves away from fundamentals
When is Fair value used
Value of an asset or liability which is not easily determined bc market. For item doesn’t exist
What rule used for fair value
FASB 157
Three levels of judgement in FASB157
Level 1 - observations from identical market s
2 - use prices form similar assts
3 use assumptions by market participants
Advantage and disadvantage of fasb 157
Captures difficult to value assets and increases transparency
If actual price much lower than og price then lead to large write downs on the asset
Threshold capacity
Aum that allows strategy to reach objective returns
Wealth maxing capacity
Aum that max wealth
Terminal capacity
Aum that reduces alpha to zero
Two ways to assess capacity
Look at the impact of trading -
Impact of accumulating large positions
What is bread ratio used for
Determine necarssay breadth/ concentration to achieve desired alpha
How is capacity worked out when you know the breadth
Portfolio breadth x maximum free float of stock
What is soft closing
Only existing clients can add to positions
What Is bottom up and top down approaches to portfolio
Bottom up - only consider securities on their own merits and builds portfolio from specific stocks
Top down - wide asset classes specified with long term strategic proportions, short term deviations allowed
Tactical and staratgic allocations .
Tactical is is more short term and allocations can deviate
Strategic is more long term and based on average over time
When should tactical asset allocation ranges be narrowed
When transaction costs are higher or if managers skills are limited
How is success of a tracking fund determined
Cost to run the fund and the tracking error with the fund it is tracking
What approach combines both passive and active management and what is it
Portfolio tilting
Holding the constituents of an index in different proportions
Eg overweight on tech if bull on tech
Value investors , what are they and what. Do they do
Identify companies perceived to be undrpervalue
Generally look at companies with low P/E ratios and high dividend yields, also like to look at price to book and price to sales ratio
3 sub styles of value investors and what do they do
1 - investors who invest in low pe relative to earnings or future earnings ( defense and cyclical)
2 - contrarian = low share prices relative to book value, companies hoping for cyclical rebound
3 - high yielding stocks offering high dividends
Two management styles of portfolios
Value and growth
What is growth investing
Look to identify a over average growth firms
Consumer p, service, healthcare, tech
What growth investors prepared to do that value investors may not
Pay higher for high pe firms whose earnings are expected to grow faster than market
What does market oriented mean
No conscious leaning towards value or growth but can sway one side depending on the conditions
Typical characteristics of small cap fund style
Below market dividend yields
High betas
High firm specific risk
Lack of stock research
Limitations of having a style to portfolio management
Might make portfolio too concentrated leading to lack of diversification
What is general case with growth stocks with regards to 1. size of stock and 2.makret direction
Smaller stocks outperform larger ones but have high exposure to market risk and have higher vol
Returns above average in rising markets and below average in falling markets.
Sectors that value firms focus on
Defensive
Cyclical
Those firms currently out of favour
Mixed investment
0-35% shares
20-60% shares
40-85% shares
What percentage for each group is fixed income and established currency
At least 45% fixed income, 80% established currency
30fixed income 60 established currency
50 % established currency
Bond portfolios can be managed with two objectives in mind
Matching some future liability
Achieving or surpassing a benchmark return
How to manage funds against liabilities
Cash flow matching
Or
Immunisation
What is cash flow matching
Purchase of bonds by firms like pensions so the income stream received through coupons exactly matches the outflow of the pension funds
Benefits of cash flow matching
No reinvestment rate risk or interest rate risk (no bonds sold before maturity)
Duration of a bond
Average maturity of the a bond
What is portfolio immunisation
Ceresting a bond portfolio that has a duration equal to the liability it needs to meet, therefore immunised form changes in reinvestment risk and interest rates
If th education of bond is two years then what is the maturity of the bond
Maturity is greater than two years except if it is a zero coupon then they have equal duration
How is immunisation affected with rising interets rates
Higher rates mean greater returns from reinvested coupons but a fall in the value of the bond
These two movement offset each other
Reinvestment risk and price risk offset
Immunisation assumptions
There’s no default on bonds or early redemption
Flat yield curve
What happens when duration of liability and portfolio diverge
Either frequently rebalance to minimise duration but high transaction costs
Don’t rebalance frequently and duration diverges but save on transaction costs
What is a bullet or focused bond portfolio
Portfolio comprising of bonds similar to desired duration
What is a barbell portfolio bonds
Portfolio holds much smaller and larger durations than the target duration
Contingent immunisation
Active portfolio management and discretion at what duration bonds to pick to match liability but if this goes poorly then portfolio switches to portfolio that matches liability and this remains this way till liability is met
How can bond manager match or surpass index
Ai:to match key risk characteristics like sector, duration and quality
What is riding the yield curve
Identifying and overweighting issues that trade in a portion of the maturity spectrum that is currently undervalued
What’s the riding the yyield curve example of two year bonds are undervalued relative to one year bonds
The relatively lower price of two year bond means higher yield for 2 year bond
So investor buys two year bond, holds for a year and then sells the bond at the one year price
What does riding the yield curve assume
Relative mispricing is maintained across the investment period
What strategy, barbell or bullet is more risky
Barbell is more risky as there is a greater degree of immunisation risk due to being able to select a greater range of bonds
What are immunisation risks
Non parallel shifts in the yield curve
Who is liability driven investment associated with
Insurance and pension fund
What does liability driven investment usually a combination of
Fixed income and swap together with alternatives or equity derivative
4 stages of LDI strategy
Cash flow forecasts to understand liability schedule
Determine acceptable risk degree
Assess the probability of outperformance given our asset allocation
Implementing strategy
How do LDI strategy and IB link
Banks become counterparties for creating risk reducing derivatives
The use of swaps requires exchange of collateral
So pension funds need to manage counter party risk which time consuming and costly
How can pension funds access bespoke swaps and why do they want this
Better approximate their future required income streams under an umbrella agreement with an AM
Do not have to swap collateral and take quicker time to sort
What is a swap spread
Variation in the Differnece between Gov bond yield and swap rates
How does demand for bonds affect swap spread
Fall in demand results in rising swap spread
Rise in demand results in falling swap spread
What do risk measures in the context of an LDI focus on
Plan surplus which is assets minus liabilities
And
The volatility of this surplus
What is SRI
Socially responsible investing p
Ethical or value based investing
Two Sri activities
Screening - understand is firm is esg good
Shareholder engagement and advocacy - use voting power to promote positive change
What is stewardship
Responsible allocation of capital to create long term value leading to sustainable benefits for the economy, environment and society
What is steward ship code
Published by FRC, offers a set of principles for investment decisions which enhance long term shareholder value
What is the principles of responsible investment and who supported by
Independent organisation
Aims to encourage responsible investment to enhance returns and better manage risk
Supported by the UN
Why is there demand for esg invetsing
Environmental and social concerns rising (diversity, climate change)
More data so people more informed on issues
ESG does not diminish returns
Greater access to ESG portfolios
Why is there a supply of ESG investing
High demand
Increase translaecency on ESG has improved transparency of investment choices
Standrds for ESG investing
Reputational risk
Financial risk
Challenges for ESG investment
Difficult to obtain comparable audited ESG information
Disclosure of companies esg progress usually trails reality (short investment time frames but long time frames for ESG issues to impact companies )
Key characteristics of impact investing
Intentionality - generate social or environmental impact through investments
Return on capital
Report impacts measurement of underlying investments
What is framing bias
Decisions influenced by how choices are framed
How is esg generally considered
ethically agnostic
