Chapter 4 Flashcards
1
Q
What is Asset Liability Management (ALM)
A
Strategy to meet future contingent liability
2
Q
What is the MVO model?
A
The Mean-Variance Optimisation model
3
Q
What are the limitations of the MVO model? (3)
A
- allocations are extremely sensitive to model inputs
- small change in input can alter the allocations drastically
- Very sensitive to expected returns
4
Q
How does expected returns sometimes limit the MVO?
A
Can generate unreasonable allocations
5
Q
How can difficulties on MVO be countered?
A
- Re-run the MVO procedure many times over around target allocations and permitted ranges
- assess sensitivities of performance outcomes
6
Q
What did Black and Litterman propose to help with sensitivity of MVO to estimates of expected returns? (3)
A
Use expected returns from observed market prices
This assumes asset pricing models such as CAPM holds
current market prices are converted into expected return estimates
7
Q
What is portfolio insurance?
A
Technique for limiting potential loss on a portfolio
8
Q
What is the idea behind portfolio insurance strategies? (2)
A
maintain certain level of wealth
while allowing investor to participate in rising equity market
9
Q
What theory is portfolio insurance strategy based on?
A
Options theory
10
Q
What is the risk/reward profile of call options?
A
unlimited exposure to any potential profits but limited exposure to losses
11
Q
What is a put options and how does it become more valuable? (2)
A
- right to sell stock at a specified price in the future
- if asset falls in value, then can get more for selling
12
Q
What condition are put options bad? (4)
A
- falling/bearish market
- put options very expensive
- large premium
- costs passed to investors
13
Q
What do Leland and Rubenstein propose for an option-based portfolio? (2)
A
- Buying a portfolio of risky assets
- a put option written on it
14
Q
How does Leland and Rubensteins’ option-based portfolio help investors?
A
- Put option hedges downside risk of equity investment
15
Q
What is CPPI?
A
Constant proportion portfolio insurance
16
Q
What is the CPPI strategy?
A
a trading strategy that dynamically allocates assets between a risk-free asset and a portfolio of risky assets
17
Q
How does CPPI help investor? (2)
A
- can get gain in favourable market conditions
- limits loss
18
Q
What are the advantages of selling futures contracts for portfolio insurance? (3)
A
- lower cost
- greater efficiency
- less portfolio disruption
19
Q
What are the shortcoming of using futures for portfolio insurance? (3)
A
- Hard to get same risk characteristics
- Hard to know when to enter and exit the futures contract
- Calculating the number of futures contract to sell
20
Q
What is it hard to get the same risk characteristic of a portfolio for futures contract?
A
might not have a suitable index with the same risk characteristic
21
Q
How does synthesising a portfolio with call options work?
A
- hold cash / shor-dated government bonds
- buy call options for requisite instruments
22
Q
What is the upside of a synthesised portfolio with call options? (2)
A
- price of instrument rise, exercise call option
- the price of the instrument falls, only the price of call options is lost
23
Q
What are the drawbacks of a synthesised portfolio using call options? (4)
A
- call option premiums expensive
- needs rolling over
- often not available on many investments
- call option doesn’t allow to participate in total returns of actual investment
24
Q
How is net worth of an ALM portfolio calculated?
A
Net worth = PV of assets in portfolio - PV of liabilities
25
What is risk parity?
different assets have the same level of risk contribution
26
What is the problem with risk parity? (3)
low returns as high bond allocation
heavy quantitative approach
leverage might be expensive to boost returns
27
What are the critiques on risk parity?
- assumes risk is represented by volatility
- proved flaws in VaR methodologies
- no views on future returns
- can include asset classes with 0 or -ve risk premiums
28
What is risk budgeting for portfolio construction? 🗓️
setting long-term plan about risks they plan to take on investments place in portfolio
29
What are the three basic steps in risk budgeting?
- set a tolerable risk target
- construct portfolio that matches risk profile
- implement and monitor to maintain risk within target level
30
What is market timing
taking advantage of short-term opportunities to enhance returns
31
What is implication of market timing regarding EMH? (2)
- rejects strong form EMH
- accepts that assets can be mispriced at least in the short term
32
How can you adjust beta for a fixed income portfolio?
- if bullish, increase duration
- if bearish, decrease duration
33
How can you use beta of equities for market timing?
- if bullish, include higher beta stocks
- if bearish, include lower beta stocks
34
what is the disadvantage of adjusting beta for market timing? (2)
transactions costs expensive
better way might be using derivative instruments
35
For pensions, What are the other reasons and strategies for market timing? (3)
- pension funds timing inflows and when to invest
- could do pound cost averaging (PCA)
- or delay and wait until right time to invest
36
What are the four market timing spread measures?
- Earnings yield
- Dividend yield
- GRY
- Flat yield
37
What is the formula for earnings yield spread?
Earnings yield spread (bps) = GRY - earnings yield
38
What can you tell when looking at the earnings yield spread? (5)
- GRY should be less than earnings yield
- equities tend to be higher risk than bonds
- if earnings yield spread becomes more negative
- could add more equities
- vice versa
39
What is the formula for the dividend yield spread?
Dividend yield spread = GRY - dividend yield
40
What can you tell when looking at the dividend yield spread? (3)
- GRY should be greater than dividend yield
- equity issuers tend to not pay our large sums of dividend
- prefer to reinvest into growth opportunities
41
What would a portfolio manager think if dividend spread is small and expanding? (3)
- equity growth rates will increase
- equity risks will fall
- increase equity holding
42
What are the benefits of using pooled TAA funds?
- access to futures contracts
- TAA managed funds can be riskier than benchmark
- Pooled funds have a limited liability status
- TAA funds can be used as a smaller sub-portfolio
43
What are the three main reasons for using derivatives?
- Hedging
- Speculation
- Arbitrage
44
How does derivates help with hedging?
reduce impact of adverse price movements
45
How does derivatives help with speculation? (2)
only margin is paid by counterparties to open positions
can speculate on both rising and falling asset prices
46
How does deritvatives help with arbitrage?
if price of derivative and underlying asset mismatched
- profit from pricing anomaly
47
What is a futures contract?
an agreement between a buyer and seller
48
What is the agreement in a futures contract?
- pre-specified price
- quantity of an asset
- future date
49
What are the two distinct features of futures contract?
Exchange traded
deal on standardised terms
50
Most futures that are opened are not delivered but are either...
closed out
settled physically
51
What does it mean by closing out a futures contract?
opening buyer avoid delivery by making a closing sale before delivery date
52
What does it mean settling physically a futures contract? (2)
settles by cash the monetary gain or loss to date on the underlying asset
know as CFDs
53
When would a buyer avoid settling physically a futures contract?
if the buyer is a financial institution that is simply speculating
54
What does it mean when a derivative is written covered? (2)
holding the underlying assets
typically done for hedging
55
What does it mean when a derivative is written naked?
doesnt hold the underlying asset
only speculating
56
How might a portfolio manager construct investments in multiple funds to achieve the projected asset allocation to best meet the return and risk objective? (3)
- investing directly in equities
- determine portfolio's exposure from analysis of securities
- asset class factor model
57
What are the difficulties of investing directly in equities? (3)
- need asset allocation and securities analysis skills
- Need high AUM to achieve desired diversification
- hard to justify time and effort to mange such accounts
58
How does a detailed analysis of the securities held by each of the prospective or actual funds within a portfolio work?
- breaking down funds into individual securities
- consolidate them into one fund
59
What are the disadvantages of fund of funds? (2)
time consuming
costly on ex-ante basis
60
What is asset class factor model?
- examine funds based on their type of exposure
61
What are the advantages of using asset clas factor model?
can use informatino from easily obtainable external sources
62
How does asset class factor model differ from fund of funds?
fund of funds usings information available from sources internal to the fund
i.e. all constituents and their weights
63
Give four examples of factors used in asset class factor model
European/Asian
Growth/Value
Large cap/Small cap
High quality/Low quality
64
In asset class factor model, the asset classes should be
EEDCIL
- mutually exclusive
- separable or exhaustive
- have different patterns of returns and standard deviations
- low correlations with one another
- not contain identical securities
- consist of a large number of securities
65
What are the pros of returns based style analysis? (2)
- quick to calculate
- doesn't need special info from fund manager
66
What are the cons of returns based analysis? (3)
- 'behaves like' only, no guarantee
- Historical data is used
- style is historical avg of returns from period analysed
67
What are the pros of holdings based style analysis? (3)
- detailed info
- can determine which style factors
- style analysis more timely and up-to-date
68
Issues relating to use of funds in asset allocation (4)
- a mismatch between SAA and available funds
- blending funds increases chance of beta of 1
- cash levels, risk and beta outside of control
- beta of funds fluctuate as money flows
69
Benefits of mutual funds (5)
- large AUM better opportunity for diversification
- top-quality management pool
- access to high-quality research and information sources
- cost efficient due to scale
- liquidity
70
Benefits of SMAs (5)
* portfolio customisation and approachability with managers
* voting rights for shares purchased on the account
* transparency of portfolio holdings and transactions
* portability of the underlying investment pool in the account, and
* charitable gifting of equities purchased on the account on a low-cost basis
