Reading 58 - Residual Risk and Return Flashcards
Define what alpha (residual return) is ……
**Critical Concept**
The return of a portfolio in excess of its benchmark (adjusted for risk difference between the portfolio and benchmark)
***i.e. excess risk adjusted return
What does ex-ante mean?
looking forward
What does ex-post mean?
looking backward
What is an ex-post alpha?
alpha measured after actual results become available.
What is an ex-ante alpha?
is a forward-looking forecast of residual return
In general terms, what is the information ratio?
Is a ratio of (annualized) residual return to (annualized) residual risk.
**Information Ratio increases with the time horizon due to how it is calculated**
How is the information ratio calculated?
**Critical Concept**
**The notion of success is captured and quantified by the IR. The IR says how good you think you are***
Who do you calculate the residual return (αp)?
αp = IR * ωp
IR = Information Ratio
ωp = residual risk
A manager can achieve an expected residual return of 2% with a residual risk of 5%. Compute the expected residual return given a risk tolerance of 8% for residual risk…
Step1: manager’s information ratio = 2% /5% = 0.4
Step2: residual risk target = 8%
Step3: expected residual return = (0.4)8% = 3.2%
What is a residual frontier?
a plot of residual return versus risk for a given information ratio
**which are “opportunities available to the active manager”
What is the alpha and residual risk of the benchmark portfolio
0 for both
Since the information ratio can be viewed as a budget constraint, what is the only way a manager can increase their active return?
**Critical Concept**
By increasing residual risk
a = IR * w
What is the ultimate objective of active management?
To maximize value added from residual return
aka certainty equivalent return
Define what Value Added is ….
**Critical Concept**
It measures the tradeoff between active return and active risk
What is the formula to calculate Value Added if given the residual return?
**Critical Concept**
**** Return and risk figures should be in % form, not decimal**
Jackie Schroff is a value manager with First Partners. Schroff estimates that he can generate residual return of 3% annually. Schroff’s residual risk is 6.5%
Compute the value added for:
A. An aggresive investor (0.05 risk aversion)
B. Moderately risk averse investor (0.10)
C. Conservative investor (0.15)
What is the formula to derive the implied level of risk aversion when given information ratio and optimal level of residual risk?
**Critical Concept**
How can Value Added (VA) be calculated if given the information ratio and level of risk aversion?
**Critical Concept**
How can Value Added (VA) be calculated if given the information ratio and the optimal level of residual risk?
**Critical Concept**
w* = optimal level of residual risk
Explain the relationship between the value added amount and IR and the risk aversion…….
Value added increase with information ratio regardless of the risk aversion.
How do you calculate Value Added when given the follow pieces of information?
**Critical Concept**
Formula was incorrect
is equation 9 on page 213
What does the parameter ⋋ refer to?
it measures the aversion to residual risk (ie risk aversion)
What is the equation for the optimal level of residual risk which maxImizes value added?
