Chapter 22 Flashcards
Historical tracking error
Retrospective
Annualized
Difference
Portfolio
Benchmark
Observed
Forward-looking tracking error
Prospective
Forward-looking
Estimate
Standard deviation
Might
Quantitative
Assumptions
Volatility
Correlations
Information ratio
To combine historical risk and historical return (relative to a benchmark) a commonly used statistic is the information ratio - the ratio between the relative return and the historical tracking error.
Strictly speaking, the information ratio relates to the mean of the relative return, the historical tracking error, to the standard deviation of the relative returns, where both are calculated over the same period.
Information ratio = mean(relative return)/standard deviation(relative return)
In managing an investment fund established to cover liabilities, what two conflicting objectives do managers face?
To ensure security (solvency) and stability of costs
To achieve high long-term investment returns (in order to reduce costs)
Stage 1 of portfolio construction
Appropriate mix
Strategic
(or policy)
Relative
Stage 2 of portfolio construction
Selection
Managers
Active (or manager or implementation)
Stress testing definition
VaR methodology
Simultaneous
Asset return
Extreme
Process of financial stress testing
Risks
Extreme market
Subjecting
Underlying
Sensitivities
The first type of financial stress test
“Weak areas”
Portfolio
Effects
Combinations
Second type of financial stress test
to gauge the impact of major market turmoil affecting all model parameters, while ensuring consistency between correlations while they are “stressed”
Risk budgeting process
Define the feasible set
Choose the initial asset allocation using some risk/return optimization process
Monitor risk exposures and changes in volatilities and correlations
Rebalance the portfolio in response to short-term conditional volatility and correlations of assets
