Portfolio Management

Question 1

Describe the portfolio approach to investing:

Answer 1

• Select securities wrt to their contribution to the characteristics of the whole portfolio.
  1. Choose lowest risk
  2. Highest return
• Reducing risk
• Systematic risk = market risk
• Non-systematic risk = Diversification

Question 2

Describe types of investors and distinctive characteristics and needs of each:

Answer 2

1. Individual Investors: safety-growth, short & long- term, risk averse to risk tolerant.
2. Institutional Investors:
   - Pension Plans = moderate risk, low liquidity, long-term, income growth
   - Endowments = moderate-high risk, low liquidity, long-term, income growth
   - Banks = low risk, high liquidity, short-term, income
   - Insurance Companies = low risk, moderate-high liquidity, safety - income
   - Investment Companies = varies, growth
   - Sovereign Wealth Funds = safety-income

Question 3

describe defined contribution and defined benefit pension plans:

Answer 3

• Defined Contribution = employer contributes % or $, benefit depends on amount, length, and performance of investment.
• Defined Benefit = employer has obligation to pay a prespecified benefit on retirement.

Question 4

Describe the steps in the portfolio management process:

Answer 4

1. Planning: KYC (objectives & constraints + IPS
2. Execution: asset allocation + security analysis + Portfolio construction
3. Feedback: portfolio monitoring + rebalancing + performance measuring & reporting

Question 5

Describe mutual funds and compare them with other pooled investment products:

Answer 5

• All income passes through unit holders
• NAV, calculated daily
• Open-end fund accepts new units & is traded at NAV
• Closed-end fund has fixed # of units & traded at discount, premium, or NAV

Question 6

Define risk management:

Answer 6

The process by which the level of risk that should be taken is compared to the level of risk that is actually being taken, and brings the two into congruence.

• Taking acceptable risk
• Being prepared for unacceptable risk
  1. Identification
  2. Assessment
  3. Mitigation
  4. Monitoring

Question 7

Describe features of a risk management framework:

Answer 7

The infrastructure, processes, and analytics required to support the RM function.

1. Risk governance
2. Risk identification & measurement
3. Risk infrastructure
4. Defined policies & processes
5. Risk monitoring, mitigation, and management
6. Communication
7. Strategic analysis or integration

Question 8

Define risk governance and describe elements of effective risk governance:

Answer 8

Board of directors
=> risk committee
=> defines risk appetite in alignment with goals

Question 9

Explain how risk tolerance affects risk management:

Answer 9

= Defines the risk appetite

• willingness to experience losses or opportunity costs
• Internal factors (expertise, liquidity) ->greater agility
• External factors (interest rates, forex

Question 10

Describe risk budgeting and its role in risk governance:

Answer 10

Qualifying and allocating tolerable risks to various activities/investments.
- Single dimensions: S.D., VaR
- Multi dimensions: portfolio margining (based on risk of underlying assets)
=> risk budgeting: based on security risk contribution
=> capital budgeting: based on security return contribution

Question 11

Identify financial and non-financial sources of risk and describe how they may interact:

Answer 11

Financial:

• Market risk
• Liquidity risk (having to sell an asset < FV)
• Credit risk

Non-financial:

• Settlement risk
• Legal
• Compliance
• Model risk (tail risk, black swan)
• Operational risk
• Solvency risk

Individuals: theft, health, mortality, accident, wealth

Question 12

Describe methods for measuring and modifying risk exposures and factors to consider in choosing among the methods:

Answer 12

• Probability, S.D.(portf not asset), Beta (systematic risk)
• Delta:
  Gamma:
  Vega:
  Rho:
• Bonds = duration
• VaR: measure financial risks across all assets classes
  _amount_probability_timeperiod (at least)
• Scenario analysis, credit ratings
  1. Risk acceptance: loan-loss reserve, diversification
  2. Risk transfer: insurance, buying premium index puts
  3. Risk shifting: derivatives
  4. Risk prevention/avoidance:

Question 13

Calculate and interpret major return measures and describe their appropriate uses:

Answer 13

1. HPR = Income Div + (End of Period Value – Initial Value) / Initial Value
2. MWR = IRR
3. Annualized returns = (1+Rdays)^365/days
4. Portfolio return = W1*R1
5. Gross return = return- trading fees
6. Net return = gross return - admin&mgnt fees
7. Real returns: nominal (1+r) * real risk free (1+Rf) * inflation premium (1+π) * risk premium (1+Rp)
   => Nominal = real * inflation
   => E(R) = Rf + ß( Rmarket - Rf )
   => Rp = Rm-Rf = equal to excess market return
8. Pre-tax return =

Question 14

Describe characteristics of the major asset classes that investors consider in forming portfolios:

Answer 14

Cash
Bonds
Equities
=> Returns on asset class = exposure to sets of systematic factors
=> tactical asset allocation: deliberately deviate from policy
=> Core satellite approach: passive/low active and minority of assets is managed aggressively in smaller portfolios.

Question 15

Calculate and interpret the mean, variance, and covariance (or correlation) of asset returns based on historical data:

Answer 15

Variance for risk-free asset = 0
Beta = Cov/VAR or = Corr * stDev/stDevm
Avg Beta = 1

Question 16

Explain risk aversion and its implications for portfolio selection:

Answer 16

U = E(r) - 0.5*σ^2*A
1. Higher return => higher U
2. Higher risk => lower U
A > 0 then risk averse
A = 0 then risk neutral
A < 0 then risk seeking

Question 17

Calculate and interpret portfolio standard deviation:

Answer 17

1. Equal-weighted portfolio
2. Sqr = W1var + W2var + 2(
3. CoVAR: has most influence on StDev of portfolio with large amount of assets

Question 18

Describe the effect on a portfolio’s risk of investing in assets that are less than perfectly correlated:

Answer 18

Diversification

Risk-free & risky asset => Cor = 0

Question 19

Describe and interpret the minimum-variance and efficient frontiers of risky assets and the global minimum-variance portfolio:

Answer 19

1. Efficient frontier: set of all attainable risky assets with lowest/highest expected risk/return for a given level or return/risk.
2. Global minimum variance portfolio = portfolio w lowest stDev
3. Markowitz efficient frontier = set of portfolios that dominates all sets of portfolios below the global minimum-variance.

Question 20

Explain the selection of an optimal portfolio, given an investor’s utility (or risk aversion) and the capital allocation line:

Answer 20

1. Mean-variance portfolio theory: CAL = Rf asset & Risky asset portfolio.
2. Optimal risky portfolio: CAL = efficient frontier line
3. Optimal risky portfolio: Dominant CAL = risk free asset + optimal risky portfolio
4. Individual investor’s = risk preference to determine optimal portfolio
5. Capital market theory: investors optimal portfolio = highest indifference curve
6. Market portfolio: risky assets = tradable +investable assets
7. Systematic risk = priced, non-systematic risk= unavoidable