Lecture 5

Question 1

What is portfolio construction?

Answer 1

Choosing and sizing the various trades to achieve a good trade-off between risk and expected return.

Question 2

Which 6 elements constitute portfolio management?

Answer 2

1) Diversification.
2) Position and risk limits (at the level of securities, asset classes and overall portfolio).
3) Placing larger bets on higher conviction trades.
4) Sizing bets in terms of risk.
5) Correlations matter: for a long position - correlation with other long positions is bad, with short positions is good. Powerful to go long/short within each industry, diversify across industries.
6) Resize positions according to forward-looking risk and conviction.

Question 3

What is a simple approach of portfolio optimisation?

Answer 3

Take large positions for securities with large expected returns, low variance, and low correlation to other long positions.

Question 4

What are some challenges in portfolio optimisation?

Answer 4

Risk and expected returns are usually estimated with errors thus producing very noise and imprecise final outcomes. In other words, optimisations are hypersensitive and unstable. Real life portfolios are subject to many constraints and while these constraints can be added to the optimisation problem, they often distort the solution due to their non-linearities.
Optimal portfolios must account for transaction costs.

Question 5

Why do we need portfolio optimisation?

Answer 5

It helps reduce people behavioural biases and improvisations.

Question 6

What is value at risk?

Answer 6

It is the potential maximum loss of a stock/portfolio at a given confidence level over a fixed period of time.

Question 7

What are the 2 drawbacks of the VaR?

Answer 7

It is not coherent.
It neglects whatever is over the quantile.

Question 8

What is the conditional value at risk (expected shortfall)?

Answer 8

It is the expected loss given that the loss exceeds VaR. (From VaR until the end of the tail).

Question 9

What are the drawbacks of CVaR?

Answer 9

It is difficult if not impossible to backtest.

Question 10

When does Basel recommend to use VaR and CVaR?

Answer 10

VaR for backtesting and CVaR to compute risk.

Question 11

What are 3 measure estimations of VaR and CVaR?

Answer 11

1) Gaussian method: parametrically.
2) Historical Simulation.
3) Monte Carlo Simulation.

Question 12

What are stress loss and stress tests?

Answer 12

They simulate portfolio returns during various scenarios, such as significant past events (Lehman failure) or imagined future events (failure of a sovereign). They explore cases where you do not have enough data to estimate the risk accurately, as well as events that can play out over several dates. They aim to help investors gain discipline to survive what actually happens.

Question 13

What is perspective risk management?

Answer 13

It has the goal of controlling risk before a bad event occurs. It can be done through diversification, placing risk limits and position limits (in terms of notional exposure).

Question 14

What is reactive risk management?

Answer 14

It has the goal of saying what to do during a crisis. It is usually a form of a drawdown control. It seeks to limit losses as they evolve.

Question 15

Describe drawdown management.

Answer 15

It is an active risk control where a hedge fund wants to minimise the risk that its DD will become worse than its maximum acceptable DD. DD is relative to the historical best price, so that it measures how much has been lost since the peak. In the instance where the current DD surpasses the max allowed one, the hedge fund should reduce risk. As strategy recovers from losses, risk can be increased again.

Question 16

What does Drawdown Policy state?

Answer 16

That the risk must be small enough that losses do not push drawdown beyond the MADD with a certain confidence.

Question 17

What are the benefits of having a planned DD control?

Answer 17

Reduce risk earlier and increase risk earlier.

Question 18

What are the two main ways to buy/sell stock?

Answer 18

1) Limit order: pick the exact price you want. The price has to be big enough for selling and small enough for buying and order execution is not guaranteed. It is more complex than market order and has higher brokerage fees.
2) Market order: execute the trade at current best market price. Less control, but fastest approach. Usually also cheaper.

Question 19

What are the 3 components of transaction costs?

Answer 19

1) Bid-ask spread.
2) Market impact costs: price impact of trades.
3) Commissions and other direct costs.

Question 20

To which 3 categories can we classify assets in terms of their transaction costs?

Answer 20

Increasing, decreasing, and constant.

Question 21

Describe increasing transaction costs (as a function of trade size).

Answer 21

Market impact costs. Present in liquid electronic markets with very small minimum tick size (equity and futures market today in the US). They are the main source of transaction costs for large traders. If you want to sell/buy a big amount it will move the market price strongly. Optimal trading strategy is to split up a trade into many small orders and trade these small orders patiently over time.

Question 22

Describe decreasing transaction costs.

Answer 22

OTC markets (where you need to call a dealer on the phone to trade). Time spent to set up a strategy is similar for big/small orders, although price impacts differ, so a dealer is more prone to let you pay more for small deals. Optimal trading strategy is to trade in chances that are worth the dealer’s time.

Question 23

Describe constant transaction costs.

Answer 23

Bid-ask spreads. Also called proportional transaction costs, since total transaction costs are proportional to trade size when average costs are constant. Optimal trading strategy is to trade only once in a while to save on trading costs, staying within a band of the desired position .

Question 24

In summary, when does a security have good market liquidity?

Answer 24

When it has a low bid-ask spread, small price impact, low commissions and other direct costs and is an easy search (for OTC markets).

Question 25

What is Gambler’s ruin?

Answer 25

It is the risk that you end up bankrupt despite having the odds in your favour. E.g. you can count cards but have limited capital. It means that the capital ends before you can exploit your edge over the casino. It is equivalent to funding liquidity risk.

Question 26

Forced liquidation is very costly. When does it tend to happen?

Answer 26

When investment opportunities are really good. Not at a a random time, more likely during a liquidity spiral.

Question 27

Describe a liquidity spiral.

Answer 27

It all starts with a possible market shock. Due to the negative event leverage investors lose money. This creates funding problems and investors are obliged to sell, thus moving prices down even further and far from fundamentals. Selling results in
a) higher margins (selling pressure leads to imbalances, higher volatility and overall illiquidity - who sells is usually also a liquidity provider, thus forcing brokers to increase margins).
b) This leads to even stronger losses on the market positions.
c) Which leads to tighter risk management: other risk levels might be triggered, forcing other sells.
d) Lastly, it leads to redemption of capital.
The spiral reaches the bottom when the deleveraging is complete. The price then rebounds to the fundamental level and reach an equilibrium with new entrants.

Question 28

What are the consequences of a liquidity spiral?

Answer 28

Forced liquidation can be very costly.
There exists a crash risk that is difficult to detect during normal trading days.
Return distributions are inherently non-normal: while price changes are driven on fundamental news on most days, they are driven by forced selling during liquidity spirals.
Cross correlations across securities can suddenly change and go wild. The prices of securities held by traders with funding problems start to co-move, even if their fundamentals are unrelated.
Liquidity crisis is contagious. Losses in one market can lead to fire sales in other markets, hurting more traders and spreading the crisis.

Question 29

What is predatory trading?

Answer 29

A particular type of trading that exploits the need of others to reduce their positions and/or induces it.

Question 30

Is moving prices a source of profit?

Answer 30

No, that’s a myth. Big institutions tend not to move the market because doing so incurs high liquidity risk.

Question 31

What are some examples of predatory trading?

Answer 31

Game stop. Pump and dump schemes. Last crypto euphoria.

Question 32

What are the reasons for a distressed large investor to unwind his position?

Answer 32

Hedge funds with (nearing) margin calls may need to liquidate.
Traders who use portfolio insurance, stop loss orders, or the risk management strategies can be known to liquidate in response to price drops.
A short-seller may need to cover his position if the price increases significantly or if his share is recalled (short-squeeze).
Certain institutions have an incentive to liquidate bonds that are downgraded or in default.
This is when these investors need liquidity the most.

Question 33

How does predatory trading work?

Answer 33

When other strategic traders initially trade in the same direction. That is, to profit from price swings, other traders conduct predatory trading and withdraw liquidity instead of providing it.
This predatory activity makes liquidation costly and leads to price overshooting.
Subsequently, once the price is low enough/the investor has completely liquidated the position, they buy back the asset.
This continues up to equilibrium.

Question 34

When is predation profitable?

Answer 34

If the market is illiquid and if the distressed trader’s position is large relative to the buying capacity of other traders. Further, predation is most fierce if there are few predators.

Question 35

What are potential side effects of predatory trading?

Answer 35

It can even induce the distressed trader’s need to liquidate, hence it can also enhance the risk of financial crisis. It also has risk spillover effects among different markets.