Lecture 4

Question 1

What is the beta of a market-neutral fund?

Answer 1

0

Question 2

What is the excess return of a market neutral fund equal to?

Answer 2

Alpha.

Question 3

What is the adjusted beta?

Answer 3

The adjusted beta is the raw beta adjusted to reflect the tendency of a beta to be mean-reverting. On average the beta of stocks seem to move toward 1 over time.

Question 4

What is the most common formula for the adjusted beta

Answer 4

Adjusted beta = 1/3 + 2/3 * raw beta.

Question 5

What does classical finance teach us with respect to beta investing?

Answer 5

Buy high beta and sell low beta stocks, becasue theoretically there is a positive relation between risk and return.

Question 6

What does empirical finance teach us with respect to beta investing that is opposite from theory?

Answer 6

Security market line is too flat. High beta stocks generate negative abnormal returns and low beta stocks generate positive abnormal returns. Strong anomaly that persisted for more than 40 years.

Question 7

What does betting against beta strategy suggest?

Answer 7

Buy low beta stocks and sell high beta stocks to generate positive abnormal returns.

Question 8

How does betting against beta work for different asset classes, markets and time periods?

Answer 8

Strategy is applicable across all asset classes, different markets and different time periods.

Question 9

What are the 2 possible explanations for betting against beta?

Answer 9

1) Leverage constraints: investors that cannot leverage (mutual/pension funds) have only one way to increase expected return and that’s to buy high beta stocks. This tilting towards high-beta assets implies that risky high-beta assets require lower risk-adjusted returns than low-beta assets, which require leverage.
2) Lottery stock: high tendency to buy highly risky stocks that behave as lotteries.
Both explanations push the price of high beta stocks up, flattening the SML.

Question 10

How are betas typically estimated?

Answer 10

From monthly data over the previous five years (60 observations).

Question 11

What are the possible ways of weighting low-beta stocks and high-beta stocks in a portfolio?

Answer 11

When beta weighting and equal weighting of stocks is applied, portfolios that buy low-beta stocks perform very well.
When value weighting, in contrast, higher average returns come from portfolios that sell high-beta stocks short.

Question 12

How to know if positive alpha is just luck or skill?

Answer 12

If its t-stat is above 2 it is skill and if it is below 2 it is luck.

Question 13

Is the market risk (only one beta) in general enough to explain the return?

Answer 13

Not really. There are many factors that proved to be meaningful in explaining market risk. HML (high-minus-low) value strategy based on B/M values. SMB (small-minus-big) size strategy based on market cap.

Question 14

What are the 5 factors in the Fama and French 5 factor model?

Answer 14

1) Market beta
2)HML
3) SMB
4) CMA: conservative minus agressive.
5) RMW: robust minus weak

Question 15

How is Sharpe Ratio calculated? What does it measure?

Answer 15

SR = E(rm-rf)/STDof (rm-rf). It measures the ‘reward’ (expected return over risk-free rate) for taking risk (STD of return), per unit of risk that you take. Also called reward-to-variability ratio.

Question 16

What are the advantages of the Sharpe Ratio?

Answer 16

1) Easy to compute and understand.
2) Good for comparing similar stocks/strategies affected by the same risks.
3) The SR of different assets can be put together.
4) Similar to t-statistic: e.g. a SR of 2.5 means that you need a 2.5 deviation against you to lose.
5) Most used and understood. Industry standard.

Question 17

What are the disadvantages of the Sharpe Ratio?

Answer 17

1) Implies a normal distribution. Based on mean-variance theory, hence suitable only for normal returns. Valid only if risk is adequately measured by STD. In reality, short term and risky investments are very far from normal distribtuions.
2) Accounts for positive and negative volatility in the same light!
3) Subject to manipulation (selling the upside return potential, creating high left-tail risk that is not captured by the model).

Question 18

How is Information Ratio Calculated? What does it measure?

Answer 18

IR = E(R-Rb)/STD(R-Rb). IR measures if the strategy/manager beats the benchmark per unit of tracking error (denominator) risk. Sometimes, Rb =0, if funds use cash as benchmark. Used to get a better IR.

Question 19

When should we use SR and when IR?

Answer 19

SR is used to value single investments or portfolios.
IR is used to value multi-asset portfolios or the investor’s total portfolio.

Question 20

Which ratio is more valuable over time, SR or IR?

Answer 20

IR because it indicates the persistence of manager skill, whereas SR is typically just higher over long term due to lower volatility for longer periods.

Question 21

What are the 2 limitations of the SR and IR?

Answer 21

1) They do not account for the impact of leverage.
2) They are based upon the mean-variance theory, hence cannot account for non-normalities.

Question 22

How is Alpha-to-Margin Ratio calculated? What does it measure?

Answer 22

AM = alpha/margin. AM computes the return on a maximially leveraged version of a long/short strategy.

Question 23

How is the Risk-Adjusted Return on Capital Ratio (RAROC) calculated? What does it measure?

Answer 23

RAROC = E(R-rf)/VaR or = E(R-rf)/ES. RAROC is used if a strategy has tail risks (as volatility is not a good indicator). Economic capital is the amount you need to set aside to sustain worst-case losses on the strategy with a certain confidence, e.g. VaR or ES.

Question 24

How is the Sortino Ratio calculated? What does it measure?

Answer 24

S = E(R-Rb)/STDdownside. S measures the downside risk and is calculated as the STD of returns tuncated above some minimum acceptable return. This ratio only penalizes the downside volatility below a specified target = semivariance.

Question 25

How is the Drawdown Ratio calculated? What does it measure?

Answer 25

It measures the cumulative loss, since the loss started and is defined as: DD = (HWMt-St)/ HWMt. HWM is the highest price achieved in the past - this quantity is called the high water mark.
It measures the amount lost since the peak.
DD=0 at the peak, and always positive otherwise. Used by hedge funds. Curical for hedge funds to have small DD, as large ones lead to money redemption from investors and margin increases form exchanges.

Question 26

What is the problem with illiquid securities and their mark-to-market practices?

Answer 26

Illiquid securities (typically held by hedge funds) often do not trade. Hence,their month end prices are ‘stale’. Similar there is not public price for OTC securities. Prices of such securities do not reflect all the volatility of the market. Their co-movement with the market is mis-measured.
In other words, hedge funds with such securities seem to generate alpha because the returns from previous periods are reported with a delay (in current period) seemingly generating value.

Question 27

How can we adjust the performance measures for illiqudity risk and stale prices? (2 ways).

Answer 27

1) Use longer-term data. Too simple.
2) Include past market returns in the regression: multivariate regression over lagged periods. Alpha in such a regression accounts for stale market exposure - it captures the hedge fund’s value added beyond its exposure to both current and past market moves.

Question 28

What happense to the real betas and SR of hedge funds once illiquid assets are considered?

Answer 28

Betas increase sharply.
SRs decrease sharply, in some cases even become negative.

Question 29

What does it mean for markets to be in equilibrium level of informational inefficiency?

Answer 29

Makrets must reflect enough information to make it difficult to make money, but they must be inefficient enough that at least some people want to collect information and trade on it.

Question 30

One of alpha sources is information. Explain how alpha can be earned from PRODUCTION of information.

Answer 30

Involves performing fundamental analysis of companies and their future profit prospects, giving the management ideas on how to improve a company or cut costs, serving on boards and creditor committees, and discovering frauds (short-bias strategy).

Question 31

One of alpha sources is information. Explain how alpha can be earned from ACCESS to information.

Answer 31

It involves searching for smart and legal (no insider trading) sources of information.

Question 32

One of alpha sources is information. Explain how alpha can be earned from NEWS that travel slowly into prices.

Answer 32

Phenomena such as post-earnings-announcement drift, intitial under-reaction and delayed overreaction, trends and momentum, and limits to arbitrage (is what might prevent news to travel immediately into prices).

Question 33

What is fundamental risk?

Answer 33

Risk that rare events can make an under/overvalued stock even cheaper/more expensive. Example of LTCM fund collapse due to the Asian and Russian financial crisis, where crisis and panic destroyed the expected convergence of bonds.

Question 34

What is noise trader risk?

Answer 34

Millions of little traders don’t have access to the same information that professional, specialised arbitrageurs do.
They have a lower ability to use this information - they can’t distinguish between relevant and irrelevant information.
They are more prone to behavioural biases.
Such investors are called noise traders and they keep the price away from its fundamental - this inefficiency can be exploited by more sophisticated investors.

Question 35

What are bubble riders?

Answer 35

Investors that ride instead of trade against the bubble. Bubbles emerge as investors are willing to hold assets, even when their prices exceeded their fundamental value. This is because they hope to sell at an even higher price to some other investor in the future. Each investor is reluctant to lean against the bubble and might even prefer to ride it. Thus, price corrections only occur with delay, and often abruptly. Bubbles are observes across time periods, differently developed economies, asset classes…

Question 36

To which psychological study can a financial bubble be compared to?

Answer 36

Asch’s study on a ‘vision’ test where all but one unaware participant was instructed to answer the length of a series of lines incorrectly (it was obvious that the answer was wrong) . The aim was to observe how the unaware test subject will respond. In 33% cases the test subject agreed with the incorrect answer despite its best judgement. Control subjects had no problems giving the correct answer.

Question 37

In summary, what are the different ways of generating profit/alpha from information? (7)

Answer 37

1) Search for overlooked information.
2) Search for different ways to mix/combine information.
3) Use new/alternative information sources.
4) Search for faster way to obtain information.
5) Search for information not fully reflected in the price.
6) Search for attention induced price anomalies.
7) Search for bubbles.

Question 38

What is market liquidity risk?

Answer 38

Risk that you cannot sell without incurring high transaction costs.

Question 39

What is funding liquidity risk?

Answer 39

Risk that you are forced to sell the position.
Risk that a hedge fund cannot fund the position throughout the entire life of the trade.
Risk of being forced to unwind positions as the fund hits/nears a margin constraint.

Question 40

What is demand pressure?

Answer 40

Risk of being contrarian. Sometimes a security faces unusual buying pressure, while other securities may be abandoned. A contrarian trading strategy becomes profitable providing liquidity by buying low and selling high.

Question 41

Why does the standard CAPM model not work well in practice?

Answer 41

Due to liquidity risk. Investors care about a security’s return net of its transaction cost. CAPM model needs to be adjusted: the required excess return is expected relative illiquidty cost. The model yields 3 additional betas that can be interpreted as 3 forms of liquidity risks.

Question 42

Investors want to be compensated for taking market liquidity risk. How are they compensated?

Answer 42

Illiquid securities are cheaper and earn higher average gross return than liquid ones.

Question 43

What is the first beta (commonality in liquidity effect) of the liquidity adjusted CAPM?

Answer 43

It states that the return increases with the covariance between the asset’s illiquidity and the market illiquidity.
That is because investors want to be compensated for holding a security that becomes illiquid when the market in general becomes illiquid.

Question 44

What is the second beta (premium for securities that become illiquid when the market falls) of the liquidity adjusted CAPM?

Answer 44

It states that the return decreases because investors are willing to accept a lower return on an asset with high return in times of market illiquidity.

Question 45

What is the third beta (premium for securities that drop in value during liquidity crisis) of the liquidity adjusted CAPM?

Answer 45

It states that investors are willing to accept a lower expected return on a security that is liquid in a down market. When markets decline, investors are poorer and the ability to sell easily is especially valuable.

Question 46

The liquidity-adjusted CAPM shows what happens during a liquidity crisis. What happens?

Answer 46

Transaction costs increase. The required return increases as investors need even higher compensation for market liquidity risk. As a result, prices drop sharply.

Question 47

When does it make sense for a hedge fund to trade illiquid securities and earn the market liquidity risk premium?

Answer 47

If the trading costs are low enough and the holding period is long enough.

Question 48

Describe the process of market making?

Answer 48

Since the order flow can be fragmented and price bounces around the fundamental value, market makers cantake advantage of that and provide liquidity. They take the other side of these trades and smooth out the price fluctuations. They are compensated for the liquidity risk by the bid-ask spreads and market impacts.

Question 49

Describe the model of MARGIN CAPM.

Answer 49

Since some securities are difficult to finance due to their high margin requirements, the margin CAPM model estimates a margin premium. This margin premium typically occurs when it’s the best time for buying - depressed markets where many investors are obliged to sell pushing the prices down. This is called a liquidity spiral.

Question 50

Do market and funding liquidity risk operate separately?

Answer 50

No. They operate at the same time and even re-enforce each other and create the liquidity spiral.
We can combine the two adjusted CAPM models to account for both risks.

Question 51

What are the 3 typical scenarios under which demand pressure is likely to occur?

Answer 51

1) Hedging: large hedging demand for buying index options, especially put options (option overprice).
2) Institutional frictions: certain investors cannot hold non-investment grade bonds (e.g. mutual funds), if a bond is downgraded, there will be demand pressure to sell.
3) Behavioural biases: some securities may capture investors’ imaginations and create a demand for their shares, while others may go overlooked.

Question 52

What is a backtest and what are its 4 components?

Answer 52

A backtest is a simulation of a trading strategy using past data. Its 4 components are:
1) Universe: of securities to be traded.
2) Signals: the data used as input, the source of data and how the data are analysed.
3) Trading rule: how to trade on your signals, including how frequently you review them and rebalance your positions and their sizes.
4) Time lags: making sure the trading rule is implementable.

Question 53

What are the 2 crucial elements while trading?

Answer 53

1) Portfolio rebalancing: how/when to update a position.
2) Entry/exit point. For each asset determine when to enter a new trade and how to size the initial position. Determine how the position is resized over time, depending on the circumstances. And then determine when to exit the trade.

Question 54

What happens to the need to rebalance the portfolio if assets are correlated?

Answer 54

The need is lower as highly correlated assets tend to move together keeping their asset allocation weights intact.

Question 55

What does volatility imply for rebalancing need?

Answer 55

Higher volatility implies a greater need to rebalance because asset classes can move away from target more easily.

Question 56

What do differences in expected returns of portfolio holdings mean to the need for rebalancing?

Answer 56

The more significant are the differences among the expected returns of portfolio holdings the greater the need to rebalance, because different expected returns also imply different volatilities.

Question 57

What does the time horizon imply for the need to rebalance?

Answer 57

A long time horizon increases the likelihood of a portfolio drifting from its target allocation, which increases the need to rebalance. But, there is also more time to recover the rebalancing costs.
For a portfolio with a finite time horizon, in the presence of costly rebalancing, the optimal rebalancing frequency declines as the terminal investment date approaches.

Question 58

What happens to the average excess returns and volatility of a portfolio with highly correlated holdings with increasing frequency of rebalancing?

Answer 58

The excess returns decrease with increased frequency of rebalancing. The volatility of excess returns decreases with more frequent rebalancing.
It means better risk control but lower excess returns.