Portfolio Management Flashcards
What are the three steps in the portfolio management process?
1) Planning
- Objectives and constraints
- Create IPS
- Form capital markets expectations
- Create strategic asset allocation
2) Execution
- Portfolio selection
- Portfolio implementation
3) Feedback
- Monitoring and rebalancing
- Performance evaluation
What are the differences between performance measurement, attribution and appraisal?
- Measurement: calculation of rate of returns
- Attribution: analysis of those rates
- Apprasail: how well the manager performed in absolute terms or relative to a benchmark
What are the major assumptions of the arbitrage pricing theory (APT)?
1) Asset returns are described by a factor model
2) There are many assets, so asset-specific risk can be eliminated
3) Assets are priced such that there are no arbitrage opportunities
What are the three groups of stocks that tend to have higher returns than those predicted solely by their sensitivity to the market return?
1) Small-cap stocks
2) Low price-to-book (value)
3) Stocks whose prices have been rising (momentum)
What are the characteristics of macroeconomic factor models?
Factors are surprises in macroeconomic variables (interest rate, inflation, business cycle, GDP growth)
What are the characteristics of fundamental factor models?
Factors are attributes of stocks (P/E, market capitalization, etc.). Factors are calculated as returns rather than surprises.
Standardized beta exists only for fundamental
What are the characteristics of statistical factor models?
Statistical methods are applied to a set of historical returns.
Factor analysis models: return covariances
Principal-component models: return variances
What are the two components of active return and what is the formula?
1) Factor returns
2) Security selection
Active return = ∑[(Portfolio sensitivity)−(Benchmark sensitivity)]×(Factor return)+Security selection
What is the tracking error?
Also called tracking risk or active risk (standard deviation of active returns)
= SD Rp - SD Rb
What is the formula for the information ratio (IR)?
IR = (Rp - Rb) / Tracking error
Affected by the use of cash/leverage
For unconstrained portfolio, it is unaffected by aggressiveness of active weight
What is a Value at Risk (VaR)?
Minimum loss, expected to be incurred, a certain % of the time, over a certain period of time
What are the components of VaR?
1) Time period
2) Confidence level
3) Minimum loss amount
What is the parametric method (VaR)?
VaR estimate from the left tail of a normal distribution
Simple but poor estimate when returns are not normally distributed (options)
What is the historical simulation (VaR)?
Uses historical returns
Can accommodate options
Incorporate events that actually occurred
Only useful if future resembles the past
What is the Monte Carlo simulation (VaR)?
Requires specificaion of a statistical distribution of returns and generation of random outcomes from that distribution
What are the variations of VaR?
1) Conditional VaR: average loss conditional on exceeding VaR cutoff
2) Incremental: measures changes in portfolio VaR of adding/deleting positions
3) Marginal: change in VaR given a small change in portfolio
What are the steps of the parametric model?
1) Multiply portfolio standard deviation by 1.65 (if 95% confidence level) (or 2.33 if 99%)
2) Substract answer in step 1 from expected return
3) VaR is absolute; change sign in step 2
4) Multiply result in step 3 by value of portfolio
What are the discount rate components?
1) Real default-free interest rate
2) Expected inflation rate
3) Risk premiums
What is the inter-temporal rate of substitution?
Marginal utility of consumption in the future / Marginal utility of consumption today
Covariance with expected future prices of asset is negative
How can we interpret marginal utility of consumption?
High when economy is bad
Low when economy is good
Average level of real short-term interest rates is:
Higher when growth is high and volatile
Lower when growth is low and stable
What is the Taylor rule formula?
Policy rate = Real ST interest rate + 1.5(rate of inflation) - 0.5(target rate of inflation) + 0.5(output gap)
Which bonds perform best when credit spreads are narrowing?
1) Lower-rated corporate bonds
2) Higher-rated corporate bonds
3) Government bonds
Which stocks perform best in economic expansion?
Growth stocks outperform value stocks
Which stocks perform best in economic recession?
Value stocks outperform value stocks
Small stocks underperform
Cyclical companies have sharp declines in earnings
What is the Sharpe ratio?
= (Rp - Rf)/STd(Rp)
Large Sharpe ratios are better
Unaffecred by amount of cash
What is the basic fundamental law formula?
E(RA)∗=(IC)(√BR)(σA)
What is the full fundamental law formula?
E(RA)∗=(TC)(IC)(√BR)(σA)
What is the formula for Information Ratio using fundamental law elements?
IR = (IC)(√BR)
What are the four elements of the fundamental law?
1) Skill: measured by the information coefficient
2) Structuring: measured by the transfer coefficient (1 if no constraints)
3) Breadth: measured by the number of independent decisions per year
4) Aggressiveness: measured by the benchmark tracking risk
What is the formula to find the optimal amount of active risk that maximizes Sharpe Ratio?
STD(Ra) = (IR/SRb) x STD(Rb)
What are the two types of algorithms?
1) Execution algorithms: minimize the market impact of large orders
2) High-frequency algorithms (what, when, how)
What are the different types of execution algorithms?
1) Volume-weighted average price (VWAP): order executed in-line with volume on market: reduce transaction costs
2) Implementation short fall: difference between decision price and final execution price; low as possible for max liquidity
3) Market participation algorithms: partial orders according to defined participation ratio and volume
What are the positive impacts of HFT?
1) Minimized market impact of large trades
2) Lower cost of execution
3) Improved efficiency in certain markets
4) More open and competitive trading markets
5) Improved and more efficient trading venues
What are some concerns about HFT?
1) Fear of an unfair advantage
2) Acceleration and accentuation of market movements
3) Gaming the market
4) Increased risk profile
5) Algorithms gone wild
6) Potential for market denial-of-service-style attacks
7) Additional load on trading venues
8) Increased difficulty of policing the market
What is risk budgeting?
Allocation of the total risk appetite across sub-portfolios
What is a scenario limit?
Limit on the estimated loss for a given scenario, which, if exceeded, would require corrective action in the portfolio.
What is a stop-loss limit?
Requires a reduction in the size of the portfolio when a loss of a particular size occurs in a specified period. Best for managing trending.
What are position limits?
Limits on the market value of any given investment. Best constraint for overconcentration.
What are the components for a nominal short-term interest rate on Treasury bond?
1) Real risk-free rate
2) Expected inflation
3) Premium for inflation uncertainty
In the aftermath of a recession, which stocks tend to outperform other stocks?
1) Value tends to outperform growth investing
2) Cyclical tends to outperform non-cyclical
3) Small tends to outperform bigger
Between equities and high-quality bonds, which one is the better consumption-hedge?
High quality bonds ; this is why equities require a higher risk premium
The risk premium for real estate investment is _____ correlated with _______.
Highly correlated with equities and corporate bonds.
In the commodity market, what is the spread?
Spread = Current price - Future price
Positive: Backwardation
Negative: Contango
An asset’s risk premium is high when there is a _______ relationship between its future payoff and investors’ marginal utility from future consumption
Negative
The relationship between the real risk-free interest rate and real GDP growth is…
Positive
The relationship between the real risk-free interest rate and the volatility of real GDP growth is
Positive
What financial instrument is best suited to the study of the relationship of real interest rates with the business cycle?
Default-free inflation-indexed bonds
The yield spread between non-inflation-adjusted and inflation-indexed bonds of the same maturity is affected by…
1) Risk premium for future inflation uncertainty
2) Investors’ inflation expectations
The prices of one-period, real default-free government bonds are likely to be most sensitive to changes in…
Expected volatility of economic growth
Default-free real interest rates tend to be relatively high in countries with high expected economic growth because investors…
Increase current borrowing
During a recession, the slope of the yield curve for default-free government bonds is most likely to…
Steepen
What is the formula to find the highest squared Sharpe ratio of an actively managed portfolio?
SR^2P = SR^2B+IR^2
What does the transfer coefficient measure?
Correlation between:
1) Anticipated (ex-ante), risk adjusted returns
2) Risk-adjusted active weights
What are the characteristics of a closet index?
1) Very low active risk
2) Sharpe ratio very close to the benchmark
