Emerging topics 1.8 - An Introduction To Portfolio Rebalancing Strategies Flashcards
Define
Payoff diagram (Portfolio Value X Equity Value) of
Buy-and-Hold (BH)
Constant Mix (CM) and
Constant Proportion Portfolio Insurance (CPPI)
1.6 - An Introduction to Portfolio Rebalancing Strategies
BH - linear
CM - concave
CPPI - convex
1.6 - An Introduction to Portfolio Rebalancing Strategies
Formula
Target equities investment
of the
CPPI re-balance
1.6 - An Introduction to Portfolio Rebalancing Strategies
Target equities investment = M x (Portfolio Value - Floor Value)
M = multiplier (constant proportion, higher than 1)
1.6 - An Introduction to Portfolio Rebalancing Strategies
List
2 unique risks
of pursuing CPPI
1.6 - An Introduction to Portfolio Rebalancing Strategies
- Gap risk - risk of violating the floor (not time enough to re-balance)
- Absorption risk - risk of missing a rising market after equity exposure is reduced to zero
1.6 - An Introduction to Portfolio Rebalancing Strategies
Formula
Return of Illiquid asset
(in dynamic rebalancing strategy,
using a liquid financial instrument, like future)
1.6 - An Introduction to Portfolio Rebalancing Strategies
return on illiquid asset ‘t’ = R’f’ + α + (β × Futures’t’ ) + ε
R’f’ = risk-free rate of return
α = alpha of the illiquid asset portfolio
β = beta of the illiquid asset relative to futures
ε = tracking error
1.6 - An Introduction to Portfolio Rebalancing Strategies
Formula
Weight of Futures in a
dynamic rebalancing using futures
1.6 - An Introduction to Portfolio Rebalancing Strategies
F’t’ =[ (α / R’F,t’) + β ] * ( k’t’ - w’t’ )
F’t’ = weight of futures position (i.e., the proxy)
R’F,t’ = expected return on the futures
k’t’ = optimal weight of risky asset
w’t’ = current weight of the illiquid risky asset
Example: CPPI for Illiquid Asset
A portfolio is currently comprised of $1,000 in real estate and $1,000 in cash. The portfolio manager wants to implement a CPPI strategy with M = 2 and floor = $400. The real estate portfolio has a beta of 1.10 relative to the futures on a REIT index. The index expected return is 6% while the risk-free rate is 2.5%. The manager’s historical alpha (relative to the index) is 1%. Calculate the allocation to futures to implement the CPPI strategy.
Answer:
The current weight of real estate in the portfolio = wt = 1,000 / 2,000 = 50%
CPPI allocation to real estate = M × (V0 – F) = 2 × (2,000 – 400) = $3,200
Optimal weight of risky asset = kt = 3,200 / 2,000 = 160%
Ft= ( (α/RF,t)+β ) (kt−wt)
= ( (0.01/0.06)+1.10 ) (1.60−0.50)
= 1.39
1.6 - An Introduction to Portfolio Rebalancing Strategies
What is the difference between the buy-and-hold and constant mix strategies
Lo 1.8.1
The buy-and-hold (BH) strategy is a passive strategy that does not require portfolio rebalancing.
Under a constant mix (CM) strategy, the initial portfolio allocation is established. As the value of the asset classes change through time, the portfolio is periodically rebalanced to re-establish the strategic asset allocation.
Describe a constan-proportion portfolio insurance (CPPI) strategy
LO 1.8.1
Under a constant-proportion portfolio insurance (CPPI) strategy, the amount invested in risky assets is established by a formula. A minimum (or floor value) for the portfolio is specified, and some constant proportion of the difference between the portfolio value and the floor value is invested in risky assets.
Desrcibe and option-based portfolio insurance (OPBI) strategy
LO 1.8.1
The option-based portfolio insurance (OBPI) strategy is implemented by determining an investment horizon and a floor value at the end of the horizon. The floor value is invested in Treasury bills, while any assets in excess of the floor value (i.e., the cushion) are invested in options.
How will convex strategies perform vs concave strategis in different markets
LO 1.8.2
Convex strategies (e.g., CPPI) are trend following and outperform concave strategies in trending markets. Concave strategies (e.g., constant mix) are contrarian and outperform convex strategies in flat, oscillating markets.
