Portfolio Management Flashcards
Return generating multifactor model
Fama and French
E(Ri) – Rf = βi1 × E(Factor 1) + βi2 × E(Factor 2) + ….+ βik × E (Factor k)
Fama and French estimated the sensitivity of security returns to three factors: firm size, firm book value to market value ratio and the return on the market portfolio minus the risk-free rate (excess return on the market portfolio). Carhart suggests a fourth factor that measures price momentum using prior period returns.
Execution Instruction
The most common orders, in terms of execution instructions, are market or limit orders. A market order instructs the broker to execute the trade immediately at the best available price. A limit order places a minimum execution price on sell orders and a maximum execution price on buy orders. The disadvantage of a limit order is that it might not be filled.
Stop (stop loss) orders
Stop (stop loss) orders are not executed unless the stop price has been reached. A stop sell order is placed at a “stop” price below the current market price, executes if the stock trades at or below the stop price, and can limit the losses on a long position. A stop buy order is placed at a “stop” price above the current market price, executes if the stock trades at or above the stop price, and can limit losses on a short position.
Validity Instruction
Validity instructions specify when an order should be executed. Most orders are day orders, meaning they expire if unfilled by the end of the trading day. Good- till-cancelled orders remain open until they are filled. Immediate or cancel orders (also known as fill or kill orders) are cancelled unless they can be filled immediately. Good-on-close orders are only filled at the end of the trading day. If they are market orders, they are referred to as market-on-close orders. These are often used by mutual funds because their portfolios are valued using closing prices. There are also good-on-open orders.
Sponsored depository receipt
Unsponsored depository receipt
The owner of a sponsored DR share has the same voting rights and receives the same dividends as the owner of a common share of the firm. With an unsponsored DR, the depository bank retains the voting rights. A global depository receipt may be sponsored or unsponsored.
Investment policy statement (IPS)
- Details the investor’s investment objectives and constraints.
- Specifies an objective benchmark (such as an index return).
- Should be updated at least every few years and anytime the investor’s objectives or constraints change significantly.
Financial risks
Financial risks are those that arise from exposure to financial markets. Examples are:
- Credit risk. This is the uncertainty about whether the counterparty to a transaction will fulfill its contractual obligations.
- Liquidity risk. This is the risk of loss when selling an asset at a time when market conditions make the sales price less than the underlying fair value of the asset.
- Market risk. This is the uncertainty about market prices of assets (stocks, commodities, and currencies) and interest rates.
Derivatives risks
- Delta. This is the sensitivity of derivatives values to the price of the underlying asset.
- Gamma. This is the sensitivity of delta to changes in the price of the underlying asset.
- Vega. This is the sensitivity of derivatives values to the volatility of the price of the underlying asset.
- Rho. This is the sensitivity of derivatives values to changes in the risk-free rate.
Tail risk (downside risk)
Tail risk or downside risk is the uncertainty about the probability of extremely negative outcomes. Commonly used measures of tail risk include value at risk (VaR), the minimum loss over a period that will occur with a specific probability, and conditional VaR (CVaR), the expected value of a loss, given that the loss exceeds a given amount.
Two methods of risk assessment
- Stress testing examines the effects of a specific (usually extreme) change in a key variable.
- Scenario analysis refers to a similar what-if analysis of expected loss but incorporates specific changes in multiple inputs.
Covariance between two portfolios using
Sharpe ratio and M-squared
Sharpe ratio and M-squared measure excess return per unit of total risk
Treynor measure and Jensen’s alpha
Treynor measure and Jensen’s alpha measure excess return per unit of systematic risk.
Tactical asset allocation
A manager who varies from strategic asset allocation weights in order to take advantage of perceived short-term opportunities is adding tactical asset allocation to the portfolio strategy.
Security selection
Security selection refers to deviations from index weights on individual securities within an asset class.
Utility Theory
The investor with a higher risk aversion (A) would calculate a lower utility (U).
U=E(r)−(1/2)Aσ2
Jensen’s Alpha
αp = Rp – [Rf + βp(Rm – Rf)]
Treynor ratio
Treynor ratio = (Rp − Rf) / βp
Risk Management Process
- Identify organization’s risk tolerance
- Identify and measure risks faced
- Modify and monitor risks faced
Risk Governance
Senior management’s role in determining risk tolerance, risk exposure strategy and framework.
Risk Budgeting
Allocating resources to assets/investments based on their risk characteristics and the organization’s risk tolerance
CAPM Assumptions
- Investors are rational, risk-averse, and maximize expected utility
- One-period time horizon
- Infinitely divisible assets
- Investors are price takers
- Homogeneous expectations: For each security, all investors have same return and risk expectations.
- Frictionless market: No taxes, transaction costs, or restrictions on short selling
Optimal Risky Portfolio vs. Global Minimum-variance Portfolio
- The optimal risky portfolio lies at the point of tangency between the capital allocation line and the efficient frontier of risky assets.
- The global minimum-variance portfolio is the left-most point on the minimum-variance frontier.
