Correlation, Alternative Returns, and Performance Measurement

Question 1

What are the 4 common measures of relationship among asset returns

Answer 1

Correlation, Covariance, Beta, and autocorrelation

Question 2

What normally complicates calculation of AI Returns?

Answer 2

Unique features such as

• unusual cash flow patterns,
• waterfall distributions.
• iiliquidity,
• notional principal

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Question 3

Why is Spearman’s Rank correlation used

Answer 3

To address the outlier problem

Question 4

What is meant by auto correlation

Answer 4

Correlation over time is called auto correlation.

1st order auto correlation is called serial correlation.

Question 5

What is Drubin-Watson statistic?

Answer 5

Test for the existence of serial correlation. DW = 2 (1-ROW t,t-1). If DW is less than 1 or greater than 3, there is serial correlation.

Question 6

In the context of capm, what does Beta measure?

Answer 6

The sensitivity of the asset’s return to changes in the broad return

Question 7

Name the 3 types of IRR

Answer 7

LIP -Interim and Point to Point use APPRAISALS

Lifetime IRR or overall IRR,

Interim or since inception IRR, assumes an appraisal terminal value, T occurs prior to the end of the investment.

Point to point IRR is the IRR if the time 0 and time T are appraised cash flows or are other cash flows during investment’s life time.

Question 8

How is the IRR interpretation affected by borrowing type cash flow

Answer 8

High IRR is NOT desirable, it reflects the cost of borrowing

Question 9

In the IRR calculation, what reinvestment assumption is made?

Answer 9

All cash flows are reinvested in the original investments and earn a return equal to the original investment’s IRR.

Question 10

What about the sensitivity of IRR to AI’s Terminal Cash Flow?

Answer 10

High -ve IRR’s are more sensitive to appraisal terminal value than positive IRR’s

Question 11

IRR is also known as

Answer 11

$ weighted return or money weighted return

Question 12

Time weighted return

Answer 12

Geometric mean return

Question 13

Returns based on Notional Principal

Answer 13

Face amount on the underlying asset in the case of a derivative instrument. This is misleading.

Fully collateralized & Partially collateralized

Rfcoll = Rfr + ln(1+R), R is the return on the derivative instrument, p=100%

Rpcoll = Rfr + l X ln (1+R), where l=1/p, p is the % of notional principal set aside. (p,smaller the better).

Rfr=2%. R=5%, collateral (own money) = 30%, Partially collaterateralized return = 18.25%

Question 14

Cash waterfall

Answer 14

How cash is distributed to the providers of capital, i.e. investors or Limited Partners and decision makers or Investment manager or general partner

Question 15

The hurdle rate or preferred rate

Answer 15

Return to be distributed to the Limited partners before any distribution is made to the General Partner. Hurdle rates are typically between 5% and 10%.

Question 16

What the General Partner makes

Answer 16

Incentive fee, Carried Interest, or Performance Fee

Question 17

Carried Interest

Answer 17

% split of the profits GP makes after minimum hurdle rate and is on top of management fee. Carried interest is typically up to 20%

Question 18

Management fees

Answer 18

paid to GP to cover Fund’s operating costs, ususally 1-2% of fund’s size

Question 19

Ratio based performance measures used in Alternative Investmetns, 5 of them.

Give formula for each

Answer 19

S T S I Rv

Sharpe, Treynor, Sortino, Information ratio and Return on Value at Risk

a) Sharpe Ratio: used for standalone portfolio: -Expected excess return per unit of total risk
b) Treynor ratio: useful when comparing components of a well-diversified portfolio:Expected excess return per unit of systematic risk
c) Sortino: excess return over target return per unit of downside risk (TSSD);
d) Information Ratio = Active Return/Active Risk (Active risk is also called the tracking error)
e) Return on VaR: E(Rp)/ VaR

Question 20

Non - Ratio based performance measures

Answer 20

JMA

Jensen’s Alpha: or alpha is the difference between the portfolio mean return and capm ex post mean return.

The M squared approach: the expected return on a portfolio that has the same standard deviation as the market portfolio. Msquared = Rf+sigmam/sigmap x (E(Rp-Rf)

The Average Tracking error is the numerator of the Information Ratio.

Question 21

What is correlation? Describe the formula for correlation?

Answer 21

Correlation measures the linear relationship between the return of 2 assets. It is the covariance between 2 returns divided by the product of the 2 s.ds

Question 22

Serial correlation

Answer 22

1st order autocorrelation is the correlation between a value and lagged value of itself.

Question 23

What is Beta in CAPM

Answer 23

The sensitivity of an asset’s return to changes in the market’s return

Question 24

What is soft hurdle rate? What is hard hurdle rate?

Answer 24

Soft hurdle rate is the rate of return if made, the General Partner can share in all the profits.

Hard hurdle rate is the rate of return if made, the General partner can only share in the excess.