Correlation, Alternative Returns, and Performance Measurement Flashcards
What are the 4 common measures of relationship among asset returns
Correlation, Covariance, Beta, and autocorrelation
What normally complicates calculation of AI Returns?
Unique features such as
- unusual cash flow patterns,
- waterfall distributions.
- iiliquidity,
- notional principal
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Why is Spearman’s Rank correlation used
To address the outlier problem
What is meant by auto correlation
Correlation over time is called auto correlation.
1st order auto correlation is called serial correlation.
What is Drubin-Watson statistic?
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.
In the context of capm, what does Beta measure?
The sensitivity of the asset’s return to changes in the broad return
Name the 3 types of IRR
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.
How is the IRR interpretation affected by borrowing type cash flow
High IRR is NOT desirable, it reflects the cost of borrowing
In the IRR calculation, what reinvestment assumption is made?
All cash flows are reinvested in the original investments and earn a return equal to the original investment’s IRR.
What about the sensitivity of IRR to AI’s Terminal Cash Flow?
High -ve IRR’s are more sensitive to appraisal terminal value than positive IRR’s
IRR is also known as
$ weighted return or money weighted return
Time weighted return
Geometric mean return
Returns based on Notional Principal
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%
Cash waterfall
How cash is distributed to the providers of capital, i.e. investors or Limited Partners and decision makers or Investment manager or general partner
The hurdle rate or preferred rate
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%.
What the General Partner makes
Incentive fee, Carried Interest, or Performance Fee
Carried Interest
% split of the profits GP makes after minimum hurdle rate and is on top of management fee. Carried interest is typically up to 20%
Management fees
paid to GP to cover Fund’s operating costs, ususally 1-2% of fund’s size
Ratio based performance measures used in Alternative Investmetns, 5 of them.
Give formula for each
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
Non - Ratio based performance measures
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.
What is correlation? Describe the formula for correlation?
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
Serial correlation
1st order autocorrelation is the correlation between a value and lagged value of itself.
What is Beta in CAPM
The sensitivity of an asset’s return to changes in the market’s return
What is soft hurdle rate? What is hard hurdle rate?
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.
