Topic 5: Risk and Risk Management Flashcards
After which event was single-stock circuit breakers introduced?
Single-stock circuit breakers were introduced into the industry after the 2010 Flash Crash (when the Dow fell about 9% within a very short period in a single day). Circuit breakers were designed to halt trading at specific points to enable markets to stabilize.
Which hedge fund suffered enormous losses on a strategy that involved borrowing at low short-term rates and investing the capital in Freddie Mac and Fannie Mae mortgage bonds?
Carlyle Capital’s strategy involved borrowing at low short-term rates and investing in long-term Freddie Mac and Fannie Mae securities. In early 2008, the value of these securities fell drastically, as investors fled to quality during the U.S. housing/credit crisis.
For which of the following hedge funds did the U.S. Federal Reserve reduce interest rates several times in an attempt to prevent the systematic effect of its collapse on financial markets?
LTCM
Describe the issues/causes with the following cases:
1. Dow Jones Flash Crash
2. Knight Capital
3. Caryle Capital
4. Lancer
5. LTCM
6. Bayou
7. Amaranth
8. XIV
- Dow Jones Flash Crash - spoofing by UK trader
- Knight Capital - tech glitch
- Caryle Capital - borrow short term rates to buy Freddie/Fannie Mae
- Lancer - Illegal window dressing, valuation done by own people
- LTCM - RV trades with high leverage; done for when Russia defaulted on bonds and caused a liquidity crisis
- Bayou - earned comms on trades by own brokerage firm; fraud in general
- Amaranth - divergent trade on winter contracts on natural gas
- XIV - short vol trade
Performance of systematic, trend-following strategies and their comparisons to the performance of diversified portfolios of actual trend-following CTAs?
- Passive trend-following indices are reasonable benchmarks for trend-following CTAs.
- Trend-following CTAs have LOW exposures to TRADITIONAL assets and LONG-ONLY commodity indices.
- LESS THAN HALF of the historical excess return earned by trend-following CTAs is attributable to their BETA to passive trend-following indices. More than half of the returns cannot be captured by passive indices.
- Discretionary CTAs have LOW exposures to traditional assets, long-only commodity indices, and passive trend-following indices.
- PEER GROUPS appear to be the most suitable benchmark for discretionary CTAs.
Which of the following is NOT true of listed private equity indices?
- They are made up of share prices of publicly-traded private equity firms.
- They reflect the assets in which institutional investors typically invest.
- They include fees earned by the underlying investments’ general partners.
NOT true: They reflect the assets in which institutional investors typically invest.
Most suitable benchmark for managed futures trading system:
1. Bloomberg Commodity Index
2. S&P Goldman Commodity Index
3. Mount Lucas Management Index
Since he is evaluating a trend-following trading system, a passive, trend-following index would be best. The MLMI is a passive benchmark that follows a trend-following strategy.
Side note: In addition, to assess the performance of managed futures, he should use a benchmark that incorporates long and short positions (since CTAs take both long and short positions).
The S&P GSCI and BCOM indices only use long futures positions.
The CAPM asserts that investors should only be rewarded for bearing which of the following types of risk?
The CAPM maintains that investors should only be rewarded for bearing systematic risk, since unsystematic (or diversifiable) risk can be diversified away by combining investments with low correlations.
EXCESS vs TOTAL return commodity indices
EXCESS: price movement of commodity futures contract
TOTAL: fully collateralised returns
Is S&P Goldman Sachs Commodity Index an example of value or production weighted index
Production
What are the characteristics of an appropriate investment benchmark?
appropriate investment benchmark has 7 characteristics: 1) unambiguous, 2) investable, 3) measurable, 4) specified in advance, 5) appropriate, 6) reflective of current investment opinion, and 7) owned.
What are the three key factors used to determine the weights of commodities when constructing a commodity index?
- World Production
- Liquidity
- Open Interest
Describe risk premium modelling
Risky asset’s expected return = Riskless rate + Risk premium.
Since the approach includes the current interest rate, which fluctuates due to inflation, this approach essentially adjusts expected returns for different levels of inflation and interest rates. The investment horizon determines the maturity of the riskless rate.
How to estimated returns from non-core / opportunistic real estate investments?
Risk Premium Approach
- Using observed cap rates – This yields inaccurate results since estimates of NOI for non-core real estate are less reliable than those of core real estate.
- Using absolute hurdle rates – This may be inappropriate since it does not account for changing interest rates and inflation.
- Using a risk premium approach – This is an effective approach for determining non-core properties’ expected returns (typically expressed relative to core real estate investment returns).
If stock returns are ___ in a Delta Neutral portfolio, what happens to underlying stock/option payout?
1. Upwards
2. Downwards
3. Mean-reverting
- Stock Upwards: Stock lose money; high option payout
- Stock downwards: Stock win money; option expire worthless
- Mean-reverting: Stock win money, option suffers time decay
Rebalancing yield contributes more to portfolio returns when components are stable/volatile and have high/low correlations with each other
Rebalancing yield contributes more to portfolio returns when components are VOLATILE and have LOW
correlations with each other
Rebalancing benefits higher/lower for commodity-based vs stock-bond portfolio (Erb and Harvey 2006)
Erb and Harvey (2006) found that the average correlation across several commodity futures was very low and the average volatility was high, which indicates that a commodity-based portfolio likely has greater rebalancing benefits (due to the mean-reverting trait of commodities) than a stock-bond portfolio (which has higher correlations between the portfolio assets).
For Delta Neutral portfolios, when is re-hedging positive?
- when there is negative autocorrelation (mean reversion)
- when options are short dated and near the money
In the context of delta hedging, what is a slack variable?
A slack variable is a variable that assumes any value to make an optimal solution feasible, without affecting the objective function’s value.
The delta of a position can be hedged using the underlying asset. This keeps the portfolio delta-neutral and does not affect its vega or gamma.
Six steps to monitor private partnerships
- Planned vs Implemented
- Review investment, valuation, divestment
- Effect of market trends
- Individual treatments to overall portfolio
- Performance against benchmark
- Legal and compliance status
How often should institutional investors typically make investment manager calls for risk measurement purposes?
Quarterly
How often should Third-party background and reference checks on each external manager be done
Once every three years
Which of the following issues on cybersecurity needs improvement?
- Untailored (e.g., vague) policies and procedures
- Lax firm adherence
- Inadequate system maintenance (e.g., outdated operating systems)
What sort of data should be collected daily, monthly, quarterly and annually?
DAILY: Values, returns, position size, volume, index and benchmark data, and keyword alerts.
MONTHLY: manager changes, position changes, and regulatory risks
QUARTERLY: manager calls and reports, and valuations of illiquid positions.
ANNUALLY: site visits, audits of illiquid positions, and reference updates.
