IPS& BHF | Cognitive: belief perservance - Conservatism: maintain initial information, belief perservance, maintain prior view or forecast by inadequately incorporating new info
- confirmation
- Representative: misclassification, miscaterogize, focus on recent result only
- Illusion control: cognitive, personal influence on success of something , overestimate the degree of control
- Hindsight: selectively remember things
Cognitive: information procession - anchoring: tendency to continue use past information even though availability of new information, take initial information as it is and adjust it according don’t judge if the initial info is correct or not.
- Mental accounting: classify source of wealth into different purpose/investment, separate investment by source of fund, follow different strategy with each source
- Frame biases: how data is presented affect decision making
- Frame dependency: loss aversion is one of kind
- Availability: easy to recall, mental shortcut, decision based on whatever hears with no supporting evidence
Emotional - Loss aversion:
- Overconfidence:
- Self-control: pursue long term goal rather than short term satisfaction (emotional)
- Status quo bias (do nothing), endowment bias (value owned more than selling), regret aversion → lead to hold what you have
- Endowment :
- regret aversion: influence of past decision like poor investment performance on current decision, to avoid recurrence of regret experience after past decision
- Gamble’s fallacy: expected short term reverse to mean based on small amount of data
- Behavior portfolio theory: max expected wealth s.t safety constraint, concentrate on riskless asset and highly speculative assets
- Investors type: cautious, methodical, individualistic, spontaneous (risk tolerance from low to high), feeling, thinking, thinking, feeling
- Goal based decision: construct portfolio based on goad into different layers, each layer has different goal and risk level, different bucket, personal risk bucket, market risk bucket, aspirational risk bucket
- Concentration: objective: reduce risk of concentrated portfolio, generate liquidity to meet diversification and spending need, optimize in tax efficient way; constraints: tax liability, attachment, lost control,
- 3 ways: outright sale (tax liability), monetize the asset (borrow against its value and use the load proceeds to accomplish objective, hedge the asset value (to limit downside risk, short sale (long/short asset, enter sell equity forward, sell calls and buying puts (collar), total return equity swap, buy protective put, prepaid variable forwards( similar to collar and loan dealer pay owner price lower than current MV, the load will be paid by delivery the shares if below the MV, will need to delivery smaller portion if mv goes up), yield enhancement with cover call (short call to collect premium)
- Estate tax freeze: transfer future appreciation and tax liability to future generation. Involves partnerships or corporate structure, gift tax would be due when asset is transfer, but exempt from future estate and gift tax in future appreciation, any tax owed is frozen
==================================================== - Ability to take risk: source of wealth, measure of wealth, stage of life (time horizon, size of spending relative to portfolio, important of goal, flexibility, liquidity needs, other source of income), willingness of take risk: source of wealth, stated shortfall, nature of asset allocated
- Ability to take risk fro DB: fund status, sponsor financial situation, common risk exposure, plan feature, workforce feature
- Liquidity: ongoing, emergency (max 3 months), one time (positive or negative), illiquidity asset, own a home
- Why donor pay the gift tax is more favorable, because donor pay the tax, add the benefit of reducing the estate by amount of gift taxes which reduces future estate tax
- Tax jurisdiction: credit (taxed paid up to max(td, tf), exemption(income earned in foreign country exempt from domestic tax), deduction method(domestic income can be deducted by amount of foreign tax paid)
- DB: company bears all investment risk, take fiduciary responsibility. DC: employees bear all investment risk, make all investment decision self. Cash balance: DB, esop: DC allow to buy company’s stock
- life insurance: less inflation risk, bank: risk aversion
- When cal bond equivalent yield, need to take coupon reinvestment (total return) into account
- Flat& light: flat on OIT, favorable on Int, div, CG; flat& heavy: flat on OIT, favorable on INT, not favorable on div and CG
- When there is realized CG, need to cal R*, T*
- Cash reserve will be deducted from investable portfolio right away
- Factors impact foundation’s risk objective: perpetual time horizon, receive ongoing contribution, no contractually defined liability
- Trust: an arrangement created by a settlor who transfer asset to a trustee. Who holds and manages the assets for the benefit of beneficiary (keep private, protect asset within trust from claim against grantor, avoid dispute within family, responsible stewardship of asset while beneficiary are minors afterward if they are unable to manage the asset)
- Donor pay the gift tax is better than receiptant pay the tax (numerator adds Tg*Te)
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Equity | - long-short is pure alpha strategy with zero beta vs. portable alpha is with short some manager with active return and long market exposure, beta on index market, alpha in long/short manager
- Investment style regardless P/E ratio, which is market-orientated.
- Equity portfolio indexing: full replication(less than 1000 stocks, liquid, ample funds, low tracking risk, less rebal. But costly), sample stratified(match index in 2 or more dimension, large than 1000 stocks, can be illiquid, lower cost than full, but higher tracking error than full), optimization(use factors model to match the factor exposure of index, account for covariance, lower tracking error than sample, but changing sensitiveness, skewed sample data, frequent rebal.)
- Style box info needed: AUM, holding data, style
- Bond-yield-plus-RP method to forecast the equity return=long US treasury+ equity premium
- Grinold-Kroner: Equity return= (dividend yield+ repricing)+(inflation + real corporate earnings growth) +( p/e multiple change) where share outstanding decline increase equity return
- 2013q4: index construction criteria (index breath as % of market cap), float adjustment, objective or subjective r.t transaction cost
- 2013q4: style index construction (value or growth) vs turnover: no overlap, exclude holding company, no buffering will increase turnover, but multiple characteristics will reduce turnover
- Yadeni solve 2 questions: equity risk premium and earning growth
- Issue new regulation: short term will reduce the total factor of productivity, and lower the growth rate of GDP, but in long term will be equilibrium
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Eco | - appraised/smoothed date→ underestimated the volatility
- Omit failed date→ survivorship bias
- Weighted average of 2 system data→ shrinkage estimator bias
- Scale back the estimate due to conservatism→prudence trap
- Things happened in the pass, doesn’t mean could happen in the future→ time period bias
- Add more variables to increase the predictive ability→ data mining
- High frequency data, more missing data, more sensitive to asynchronism and then tend to produce lower correlation with other estimates
- Using ex post risk(historical, actual data)to explain ex ante risk(survey, more volatile), historical return not good for future(data mining or regime change)
- Labor based g= change in employment ( population growth+ participant)+ change in productivity( total factor productivity growth + spending on new capital inputs)
- Singer-Terhhar: ERP= correlation(i,m) * SD(i)* ERP+ any other RP if available of market if assumed integrated market, then ERP= SD(i)* ERP+ any other RP if available of market if assumed segregated market
- beta= correlation (i,m) * SD(i) /SD(m)= cov(i,m)/SD(m)^2, covariance (I, j)= beta (i) *beta (j) * SD(m)^2
- multifactor model: need to add residual risk (variance)
- inflation: negative for bond, good for real estate, good for equity when inflation is at or below expectation, high inflation is good for cash
- deflation: good for bond(increasing purchase power), bad for equity and real estate(reduce value of real assets with debt), bad for cash
- restrictive monetary and stimulative fiscal will show flat yield curve and eco is not clear but stimulative monetary and restrictive fiscal→ yield curve is moderately steep and eco is not clear
- PPP (long term): movement in a FX should offset any difference in inflation. IRP(short term): longer term, higher yield on currency asset will offset the depreciation of that currency
- When inflation is high, IR will be raised then stock and bond all go down, cash go up
- Short term investment rate lower than long term→ eco expanding→ stock favorable
- Stock return for emerging market is positively correlated with developed market
- Stock: recession→ noncyclical stock and utility better than cyclical stock(more sensitive to business cycle), early expansion→ stock up, p/e high, IR low, earning prospect high, later expansion→ stock down, p/e down
- Repo rate high→ when quality of collateral low, longer term, no physical delivery, availability is not limited, fund rate high
- Cyclical output when market strengthen, low quality bond outperform when market strengthen
- FX forecast: relative PPP (higher inflation, weaker), relative econ(strong econ, stronger), capital flow(flow into, stronger), saving investment(investment > saving, inflow, stronger)
- Deflation→ negative for RE(leverage magnify losses) positive for bond (improving purchase power)
- Inflation: rising in later stage of expansion, falling in recession and initial recovery,
- bond price up, during recession when inflation and IR are down
- equity provide inflation protection when inflation is moderate, high inflation is problematic
- declining inflation or deflation is harmful b/c result in declining eco growth
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AA | - Monte Carlo: include variability at input level, take cash inflow and outflow into account (path dependence), provide probability of results with different asset allocation (tradeoff of ST and LT risk exposure)
- Using MC to formulate asset terminal value should incorporate expected CME, and asset not asset class
- Resample vs MVO: resample generate portfolio more stable, more diversified
- BL vs MVO: BL incorporate investor’s view, more diversified
- MC vs MVO: tax effect, cash flow in& out path dependency
- Situation suits more for ALM: if not meet, penalty, loss aversion or below average risk tolerance, hold IR sensitivity liability
- 2008essay: ALM reduce risk by explicitly considering risk exposure of pension plan(liability), AO can result in exposure to excessive &unrewarded risk relative to liability, ALM typically result in an optimal portfolio with higher fixed income allocation
- When RR exp.return of tangency and allow to borrow, use rf and tangency with negative weight. When RR> exp. Return of tangency and can’t borrow, use 2 corners.
- Nominal fixed bond (coupon→ deflation protected, principal→ deflation protection)
- Nominal floating bond (coupon→ inflation protected, principal→ deflation protected)
- TIPS (coupon→ inflation protected, principal→ inflation and deflation protected)
- Real bond protect inflation, yield of real bond reflect risk premium and inflation
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Fixed Income | - Emerging market debt show negative skewness, difficult to recovery, more frequent default
- Select fix income manager: use style analysis to see if adding active risk, low correlation of alpha between 2 managers add diversification, decomposing the historical return may not work well to see persistent performance when taking fees and expense into account
- When parallel shifting is a concern, could apply functional duration or key rate duration to match liability. Shock one tenor at each time not simultaneously
- 2013q8: cash flow matching is ineffective than classifical imm when unexpected cash flow in timing and amount. Classical imm required less capital to fund liability because Cash flow matching use conservative required of return for short term cash balance, cash balance may be substantial occasionally, while classical immunization is fully invested at the remaining horizon duration. Funds from a cash flow matching portfolio must be available when each liability is due. Cf matching require fund be available on or before each liability due date which reduce assumed rate of return.
- Duration mismatch is active management, enhance indexing is still to match duration, mismatch on minor risk factor
- Reinvestment risk/immunization risk (when immunized portfolio will fall short of its target value as a result arbitrary changes in interest rate. low for bullet, high for barbell)
- Moving from indexing to active management: market value risk varies directly with maturity. Greater the risk aversion, the lower acceptable market risk, shorter duration. Income risk varies indirectly with maturity (more dependent the client is upon a reliable income stream, the longer the maturity of the benchmark. Credit risk match to index, liability framework risk
- Interest rate risk/market value risk are for fixed leg(IR negative impact on value of fixed securities), cap risk/cash flow risk are for floating leg( cap on adjustment to the coupon on a floating rate security),
- Contingent claim risk/prepayment risk/call risk are for callable bond
- “Market value risk should be similar for the portfolio and the benchmark. The longer duration, the greater the total return potential because rates are low and the yield curve is so steep”. (wrong, long duration higher YTM, but price drop more)
- If the bond portfolio has a YTM equal to target yield and a maturity equal to investment horizon, does not assure target value will be achieved (can only be assured if rate of coupon reinvested stay the same as YTM, yield curve doesn’t change).
- Total return of bond( coupon will be reinvested and rolled to future, bond equivalent yield= I/Y*2, Effective annual return= (1+i/y)^2-1
- When spread widen/narrow, allocate to shorter/longer duration of corporate bond
- Cyclical changes refer to changes in the number of new bond issues. Increase in number of new bond issues (higher supply) associated with narrow spread and higher returns which is counter-intuitive but which means higher supply attract more demand. Corporate bond outperform during period of heavy supply/ secular changes refer to all intermediate-term bullets (non-callable, putable or sinkable) dominate the corporate bond market, but except high yield market, which callable issues dominates.
- Callable bond has negative convexity, when IR falls below the coupon rate, the noncallable bond’s price will continue to rise but callable bond’s price will be capped. When IR increase above the coupon rate, callable is the same as noncallable. When IR stays low and start rising, callable bond will decrease less than noncallable bond. (callable is less sensitivity than noncallable)
- lower treasury rate, high quality of collateral, scare of collateral → lower repo rate
- initial safety margin= MV-MV *(1+ RR)/(1+IMM) >0, use MV to invest a bond, assume FV=MV, I/Y= yield, N, PMT=MV*coupon, cal the PV, need to add the reinvestment of coupon if time elapse, if PV of bond+ reinvest of coupon >pv of liability → active managed
- Secondary trading→ yield curve pickup, credit upside, defense, new issue, sector rotation, curve adjustment, structure trade, cash flow reinvestment. Secondary not trade→ portfolio constraints, story disagreement, buy& hold, seasonality.
- 2013q9: top-down( review macro economics data &industry without review company specific info). Bottom-up(focus on company specific such as rating, revenus, etc, search for undervalued securities)
- credit spread change impact yield curve change (when credit spread tighten, yield curve upward)
- New issue bond→ on the run→ higher liquidity. 5yr→ off the run
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RMDA | - VAR ignore positive value which is credit risk, increase time span will increase the VaR
- adv of analytical VaR(simple) disadvantage( assume normality), adv of historical(non –parametric) and dis(apply historical to current)
- credit derivative can be used to manage credit risk, credit swap when derivative is negative to your side, you need to post collateral
- Cancel a pay fixed swap: either using a receive fixed swap with maturity to match the remaining term of original swap or enter a receiver swaption which give the right to enter a receive fixed swap
- Covered call= underlying+ short call, limit upside but don’t have downside protection, receive premium
- Protective put= underlying + long put, limit downside and also provide upside potential but need pay premium
- Straddle= V shape= long call and long put at same strike no underlying
- Bull spread= long call@ low +short call @ high (flat-> up-> flat, no underlying)
- Bear spread= long put @high + short put @ low (flat-> down->down, no underlying)
- Put spread= long put @high + short put@ low (up->flat-> up, with underlying) (cheaper b/c only provide downside protection between 2 strikes)
- Collar= shape is like bull spread =long put @low + short call@ high + underlying
- Seagull = short call @low+ long put@ medium+ short call @high + underlying (up->flat->up->flat)
- Butterfly= flat, up, down and flat= long low call + short 2 medium call+ long high call (no underlying)
- Calculation of effective annual rate of loan using interest rate call/put, the premium of call/ put is also part of loan which add/deduct from initial loan amount (add/deduct is determined by the receive or payout, direction is the same as the loan, then add to initial loan amount, vice versa. Call/put payout need to add/deduct from ending loan + loan interest ( interest on loan is D/360, but annual rate is 365/D)
- Equity/bond exposure switch, from equity to cash (using futures) and then cash to bond
- Risk management process: select policies /procedure, define risk tolerance, identify risk, measure risk, adjust risk
========================================= Credit risk - Current credit risk is the possibility of default on current obligation vs. potential credit risk is potential default on future obligation. Creditor can file claims based on face value of current obligations and present value of future obligation.
- Ways of controlling credit risk: netting, mark to market, do business with SPV, collateral and transfer credit risk using credit derivative ( Total return swap: receive cash flow over the life of swap based on floating return and pay the total return on holding asset, credit spread options receive payment when rates on assets exceeds a reference yield by more than a specified spread, credit spread forward which always be a payment by one party, credit spread swap receive payment when a specified event occurs)
- A cross-default-provision specifics borrower is in default of that agreement if it defaults on any of its borrowing/credit agreements which potential credit risk needs to consider, while jump-to-default: is another name of current credit risk.
========================================== Currency risk - Cross hedge: deliver FC1 for FC2 when FC2 appreciate against DC more than FC1. Proxy hedge: deliver FC2 for DC when FC2 is highly correlated with FC1
- FC traded at a forward premium when cash rate of DC- cash rate of FC >0
- Yield advantage: for the longer duration bond, the yield increased will wipe off its yield advantage which makes the shorter duration bond and longer duration bond are equivalent. = % difference of 2 bond prices (-% difference of 2 bond yields between longer duration and shorter duration) divided by negative of the longer bond duration.
- Exchange rate risk: economic exposure (less certain, harder to hedge, the loss of sales that a domestic exporter might experience if the domestic currency appreciates relative to a foreign currency), translation exposure (effect of exchange rate on the income statement and balance sheet, not hedged, decline in the value of assets that are denominated in foreign currencies when those foreign currencies depreciated) and transaction exposure (transactions already entered into and the amount to hedge is known, most commonly hedged, exchange rate fluctuate). Derivatives are used most often to hedge transaction exposure.
- Economic heavily depends on import, return of FX and FC positively correlated→need to hedge to reduce the volatility of return of DC, econ heavily depends on export, return of FX and FC negatively correlated→ doesn’t need to hedge, naturally reduce the volatility of return of DC
- Expected return on foreign bond if hedged= return in local currency+ (rd-rf), expected return on foreign bond if unhedged= return in local currency + expected appreciation
================== ERM, VaR - Good ERM requires independent risk management, back office fully independent from front office
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PEMR | - Style return= bk-market index, active return= actual-bk, p=market+ style+ active =M+(B-M)+(P-B), where active=p-B= true active return + misfit active return = P-M +(M-B) where M is manager BK.
- Inputs for macro attribution: policy allocation, benchmark return, fund return valuation and external CF
- 6 levels of macro: net contribution, risk free asset, asset category, benchmark, investment manager, allocation effect
- micro: pure sector= (wPj-wBj)*(rBj-rB), within sector=wBj*(rPj-rBj)
- attribution for fixed income return: effect on external IR (return on default from bk, return due to change in IR), contribution of management process (return from IR management effect, return from sector/quality, return from selection, return from trading activity)
- IS: minimize the weighted average of market impact opportunity cost of delay or missed trade, trade quickly.
- VWAP: strategy match expected volume over trading day, if market up, trade over day will lead to a higher average trade price , higher opportunity cost
- TWAP: assume trading volume is constant, if market up, trade over day will lead to a higher average trade price, higher opportunity cost
- Rebalance strategy depends on market expectation(flat or trending) and risk tolerance level(risk aversion or risk seeking)
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Alternatives | - Commodity: determinants of commodity return (business cycle related supply and demand, inflation, affected by short term expectation, decline during weak eco), convenience yield (inventory low, high cy, term structure of forward price volatility declines with time to maturity of future contract), real options under the uncertainty ( real options to decide produce or not produce depending on if future prices are below the current spot price, downward-sloping term structure, backwardation, can earn positive return by simple buy-and-hold strategy, because when maturity, future price will rise to converge with higher spot price)
- Hedge fund bias: popularity-bias in value-weighting (can’t be solved by equal-weighting)
- Direct: commodity future, commodity index future, indirect: commodity equity index fund
- The primary distinguishing differences between hedge funds and man- aged futures is that, for the most part, managed futures trade exclusively in derivative markets (future, forward, or option markets) whereas hedge funds tend to be more active in spot markets while using futures markets for hedging.
- Due diligence check: decision risk is more for individual investors than institutional
- CTA is systematic trading strategy refers to apply set of rules to trade according to or contrary to short, intermediate or long-term trends. A discretionary CTA trading strategy generates returns on the managers’ trading expertise, like active portfolio manager.
- Backwardation: term structure of future price is negative, means longer term contracts have lower prices than the shorter term contracts. When time passed, maturity of long-term contracts shortens and its price rises to that of a shorter term contract. Thus, an investor can go long a long-term contract and profit as time passes if term structure is backwardation.
- Using indirect method of buying stock of those companies to gain commodity exposure is not necessarily to gain exposure of commodity because those companies always hedge their exposure. Agricultural tends to be negatively correlated with inflation. But broad commodity indices have been positively correlated with inflation.
- Maximum potential credit risk is typical midlife of the swap except currency swap which is at maturity because of changing notional
- VC’s average return is lower than the buyout, VC has more upside potential
- Criteria for benchmark index (UIMARSO) unambiguous (name and weight clearly noted), investable(can go passively), measurable(cal return), appropriate(consistent with manager style or area of expertise), reflective of current investment opinion(have opinion, investable knowledge), specific in advance (known), owned (accountability)
- Asset class: asset in one class should be homogenous, between class should not highly corrected, individual asset can’t be classified into more than 1 class, cover majority of all possible investable assets, contain sufficient large % of ilquidity asset
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