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Copy of ST5/F105

Notes for F105 course
by

Sung-Min Lee

on 14 June 2013

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Transcript of Copy of ST5/F105

ST5/F105
Finance and Investment

Environmental Influences
Overview and Environment
Central banks
Primarily concerned with Monetary Policy
can be independent SA/USA or semi UK
Can also be involved with:
Banking Regulation
implementation of Government borrowing
Performance and integrity of financial markets
intervention in currency markets
printing money
taxation
Extent of involvement depends on division of power between central bank,govt & other regulatory bodies
Main Investor Classes
households
financial intermediaries
businesses
foreign investors
Households
diversification key consideration
Financial Intermediaries manage mass savings products
Advantages:
Pooling of resources
Diversification
Expertise
Lower costs
Businesses use investment banks to issue securities to maximise amount of finance raised at best terms
Investment Banks:
Advise on price charged
handle marketing of the issue
verify the quality of info supplied
innovate security design and packaging
Government also influence markets eg by issuing securities through regulation
Foreign Investors Concerns
Treatment similar to local investors
Exchange Rate
Withholding Tax
Government Policy
Main Forms:
Monetary Policy (key)
Fiscal Policy (key)
national debt management policy
exchange rate Policy
prices and income policy
All policy should be considered together to ensure they aren't working against each other
Since 70's Monetary policy has been key as controlling inflation has become prime objective for most governments
Interest rates affect:
Personal sector expenditure
Business sector investment and economic growth prospects
Corporate profitability
The balance of payments
Regulation of Financial Services
Aims of Regulation
correct market inefficiencies and promote efficient and orderly markets
protect consumers of financial products
maintain confidence in the system
reduce financial crime
Regulatory Regimes
Possible forms
prescriptive regimes
freedom with publicity
out-come based regime
Main types:
unregulated markets
voluntary codes of conduct
self regulation
statutory regulation
Legislative & Regulatory Framework Applications
Trust Law
a trust is an agreement where one party has legal ownership of a certain property that they use for the benefit of another party
trustee has fiduciary duty to beneficiary
terms of the agreement are set out in a trust deed
e.g pension funds, medical aids set up by trusts
Provides mechanism for collective representation
Corporate Governance
- High level framework with in which managerial decisions are made in a company
- Good corporate governance involves management in a way that reflects interests of various stake holders
It's achieved by:
remunerating management so their interests are aligned with shareholders interests
non-executive directors, to provide an independent voice on behalf of shareholders
Role of Listing Authority
ensures new share issues are done in orderly and fair manner (manages post listing as well)
To achieve this the authority regulates:
Information made available to public at issue
issue process
information made available post-issue
conduct of listed security (to ensure it is fair to all participants)
conduct of listed company
Environmental and ethical issues
SRI on the rise.
Asset managers paying increasing attention to it
UK Managers must state policy
Competition, fair trading controls and monopoly regulators:
economies of scale has led to wave of mergers
complicated by multi-national mergers
Investment restrictions in investment agreements
Common Mandate Restrictions
prohibit certain asset classes
limitations on how assets are used e.g. no derivatives for speculative purposes
max holdings on sectors or classes
restrictions on self-investment
ethical or social limitations
Regulation may also impose restrictions eg:
must hold government bills or bonds
must match by currency
restrictions on asset classes
admissibility regulations (certain assets allowed to show solvency others not)
Regulation may require a statement of investment principles be prepared. This is done to:
protect beneficiaries
encourage market confidence
encourage investment
Provision of Financial Services
Key principles of Financial Legislation:
Integrity
Skill, care & diligence
Market Practice (compliance with codes/standards)
Information about customers
Information for customers (for decision making)
Conflicts of interest
Customer assets
Financial resources
internal organisation
relations with regulators
Institutional investment practice
Key principles: Regulation of Institutional Investors:
effective decision making
clear objectives
focus on asset allocation
expert advice
explicit mandates
activism
appropriate benchmarks
performance measurement
transparency
regular reporting
Role & responsibility of directors
Directors are responsible for:
Solvent trading of company and compliance with legislation
Production of Accounts
Appointment of management
approving dividend payments
Try align director's and shareholder interests by for example:
formal audit committees
independent remuneration committees
a proposed extension of director's liability
Development of International Accounting standards (IAS):
Due to growth in multinationals
globalisation of markets
EU Legislation
Needed to integrate financial markets in EU
Main barriers to integration:
Different types of product
prohibitive cost of regulation
different tax systems for local and foreign products
different cultural preferences
EU launched Financial services action plan to help integrate markets
Finance Theory
Finance involves 2 basic issues:
Capital Budgeting (What real assets to invest in)
The financing decision (How the cash is raised)
Main Parties:
CFO
Treasurer/Financial Controller
Agency theory:
Principal/Agent problem
Principal(Investor) vs Agent (manager)
Agency costs:
Managers don't maximise shareholder value
Cost of monitoring management
Conflicts of interest:
Owners vs Managers
Lenders vs Shareholders
Mergers & acquisitions
3 forms:
Horizontal
vertical
conglomerate
Motives Horizontal:
Economies of scale
access to opportunities that would otherwise be unavailable
access to complementary resources
elimination of inefficient resources
Motives vertical:
improved co-ordination & administration
access to complementary resources
Motives Conglomerate:
utilisation of unused tax benefits
utilisation of surplus funds
protection against takeover
diversification
enhancement of earning per share
exploitation of lower financing costs
Behavioral Finance
Psychology that drives financial decision making. 8 Main Themes:
anchoring and adjustment
prospect theory
framing (and question wording)
myopic loss aversion
estimating probabilities
overconfidence (hindsight bias, conformation bias)
mental accounting
effect of options
Limits of Arbitrage:
Other pillar of behavioral finance
Has limits:
market constraints e.g short selling
arbitrageur avoidance of the most risky markets
limited funds
Financial Planning
Sensitivity analysis should be used
Distinguish between long term vs short term
Taxation
Taxation of Investments
Individuals & Institutional Investors maximise returns net of tax
Depends on:
Total rate of tax on investments
Split between income and capital gains
when tax is paid
whether tax is deducted at source
extent at which tax deducted at source can be reclaimed
extent at which gains and losses can be offset between investments over different time periods
Above factors affected by:
overall tax system eg tax rates, exemptions
rules for different assets
investor's tax status
investor's financial position
tax-efficiency of vehicle used to hold assets
Income vs capital gains
If taxed differently will influence investor's preferences
If not tax liability based on total return
Corporate Taxation
Three main systems:
Classical system. Profits taxed in company and investor hands
Split-rate system. Different rates for distributed profits and retained profits. taxed in company hands
Imputation system. Tax paid by company is deemed to cover some of the investor's tax liability
Can get very complex
Asset Classes & Valuation
Derivatives
Futures Markets
futures contract
standardized
marketable
promise to trade underlying asset
on future date
at set price
futures exist for:
bonds
interest rates
currencies
stock market indices
commodities
Futures can be sold via electronic trading system or open outcry
Clearing house to an exchange fulfills following roles:
counter party to all trades
guarantor of all deals
registrar of deals
holder of deposited margin
facilitator to the mark to market process
Credit risk to the exchange controlled by:
initial margin
variation margin
price limits
Delivery- settlement of future.
If delivery over range of dates short party chooses
Most contracts are "closed out" prior to delivery. Done by entering into an equal and opposite trade prior to delivery.
Open Interest- number of contracts that have not been closed out at a particular time
Option Markets
Traded options
standardized
marketable
traded in similar way to futures
clearing house plays same role as with futures market
Option-gives holder right but not obligation
call right to buy
put right to sell
american-can be exercised any time up to delivery
Party buying option is taking long position. Seller(writer) takes short position
OTC Markets
Over the counter markets facilitated by investment banks and other institutions.
Advantages of OTC Markets:
Tailor make requirements
Disadvantages:
low marketability
high dealing costs
lack of market values(transparency low)
counter party credit risk
Other derivative products
guaranteed equity products: Offer return linked to equity index, but with minimum guaranteed return
structured notes eg LYONS and PRIDES- similar to fixed interest bonds except payment vary with another security or index. may contain options
Forward contracts
Forward contract- Non standardized contract between two parties
Popular for foreign exchange
Long party-agreed to purchase underlying asset
Short party agreed to deliver underlying assest
Pay off diagrams ignore:
timing
taxes
transaction costs
income from underlying asset
margin payments
Specialist Asset Classes
Money Markets
Most instruments issued at discount and redeemed at par
Money Market Instruments
Treasury bills-short term government securities
Commercial paper- issued by companies
Repos (repurchase agreement)- Form of lending where investor buys T-bill from dealer who agrees to by back at (higher) price (over night repos very common
Gov't agency securities
Bank time deposits-Fixed deposit
Banker's acceptances and eligible bills - trade invoice with bank guarantee
Companies looking to borrow in money markets can:
issue commercial paper
issue eligible bills
arrange a term loan from the bank
arrange line of credit (evergreen)-fixed limit no fixed maturity date
arrange line of credit (revolving)-fixed limit and term
arrange a bridging loan- used to pay for a specific item (eg machinery)
arrange international bank loans
factoring (factor pays percentage of receivable and gets full payment from buyer in your stead
Nonrecourse takes on the credit risk
Recourse goes back to you if they are not paid
Corporate Debt and Credit Derivatives
Corporate Debt
Expected default loss =value of treasury bond - value of corporate bond
The above value tends to be greater than can be justified by historical defaults (risk aversion & marketability main reasons)
Credit derivatives
Credit default swap- provides payment if a particular credit event occurs
Total return swap- Returns from one asset swapped for returns from another
Credit spread option- Option on the spread between the yields earned two assets. Provides a pay off is the spread exceeds some level
Swaps, Swaptions, Options & Forwards
Swap - Agreement between two parties to exchange cashflows in in the future. Principle is not exchanged except in currency swap
Other types of Swap:
amortizing-principle reduces
step-up-principle increases
deferred or forward -interest payment deferred
RPI and LPI -fixed for index
cross-currency or currency coupon-fixed in one currency for floating in another
extendable - one party can extend the life of the swap
puttable - one party can end the swap early
equity- equity index for interest rate
commodity- cash flows based on commodity prices
Swaption:
gives one the right to enter into a swap
Bond Options
swaption can be considered as a type of bond option
puttable bond- gives the bond holder right to demand payment early
callable bond-gives the bond issuer right to pay early
Forward rate agreement- A forward contract where where a certain interest rate will apply to a certain principal amount during a specified future time period. An interest rate agreement can be considered a series of FRAs
Portfolio Construction Management & Evaluation
Industry Classification
FTSE classification system
(FT MUG IS HOT)
Oil and gas-Risky, independent of stock market, depend on dollar gas prices
Basic materials- Affected by state of economy and commodity prices
Industrial-tend to be cyclical
Consumer goods - tend to be less cyclical. depend on brand names
healthcare - non cyclical
Consumer services - Labour intensive, mainly domestic based
Utilities- stable, depend on domestic market and subject to regulation
Telecommunications- Type of utility, less regulated hence more volatile
Financial- mixed though, capital intensive
Technology - Low profits and dividends and largely intangible assets
Other classifications. S&P (US) and Morgan Stanley Capital International system for global equities
Investment Indices
Measures relative change index constituents
Construction of indices
Weighted arithmetic index
Formula taking chain linking into account
ex-dividend adjustment
Total return index
Total return if xd is unavailable
Geometric Index
Uses of Indices
Uses:
Measure of short term market movements
proving history - market movements and levels
tool for forecasting future movements
benchmark against which to assess investment performance
valuing notional portfolios
analysising market sub-sectors
as a basis for index funds
basis for derivative instruments
For gov't bond indices (summarise the yield curve):
Standard against which yields of other fixed interest investments are assessed
approximate valuation of fixed interest portfolio
providing picture of yield structures of fixed interest portfolio
a measure of the yield gap between bonds and equities
UK equity Indices
FTSE UK Series includes:
market cap weighted
total return
average net dividend cover
price earnings ratio
ex-dividend adjustment
FTSE indices:
FTSE All share (98%) (350 +smallcap)
FTSE 100 (80%)
FTSE 250
FTSE 350 (100 + 250)
FTSE SmallCap
FTSE Fledgling
FTSE Aim (traded on the UK AIM. too small to list)
International Equity Indices
FTSE Global Equity Index Series includes:
arithmetic free float market cap weighted
in US dollar and local currency
Market type and regional indices
Covers 98% of world equity market
FTSE All-World index covers 2700 stocks from Global equity series
other indices:
Morgan Stanley capital international indices
Dow Jones industrial average-price weighted
s&p 500, NASDAQ composite
Nikkei stock average 225- unweighted
Topix (japan weighted)
CAC General - France
DAX-total return index
FTSE Eurotop 100 (Europe)
VIX measures equity volatility
UK Bond Indices
FTSE Gilts Index Series includes:
conventional
index linked
each category includes:
index number
accrued interest
XD adjustment for the calendar year to date
International Bond Indices
More complicated than for equities
subject constraints like bond rating and duration
Produced mostly by brokers
eg FTSE global bond index series, Markit iBoxx, investment banks also produce some
Also iTraxx and CDX credit derivative indices exist
Property Indices
Difficult to maintain:
lack of up to date price data
property very heterogeneous
Problems with getting market values:
each property is unique
market value known only when property sold
estimation subjective, expensive
valuations carried out at different points in time
sales of certain investment properties infrequent
prices between buyers and sellers confidential
Portfolio based property indices-measures rental values, capital values and total returns of actual rented properties, split according to size,region spread and sector weighting
Barometer property indices- aim to track movement at large by estimating maximum full rental values of a number of a number of hypothetical rack-rented properties
IPD-provides commercial property indices
Private Debt
Bonds that are not listed. Usually with covenant feature like bank loans
Not actively traded
generally medium to long term
issued by small and medium sized companies that don't want the expense of public issue (no credit rating required)
Asset-backed securities & securitisations
Securitisation - Issue of securities, bonds usually.
Paid out of defined element of future cash flows owned by issuer
Main Classes of (ABS)
Residential and commercial mortgage-backed securities (MBS)
credit card receivables
collateralised loan, bond and debt obligations (CLO,CBO & CDOs)
Special Purpose Vehicle (SPV)-usually used for securitisations. Set up as separate legal entity to original company
Borrowing made in multi-tranche format. With different ranking levels of debt eg senior,mezzanine & equity
Private Equity
Private equity - Provision of equity capital where there is no immediate exit route via the secondary market ie unquoted securities
Forms of Private Equity
Venture capital- capital for businesses in the conceptual stage
Leveraged buy-outs - equity capital for acquisition or refinancing of a company
development capital - growth or expansion working capital for mature businesses
restructure capital - new equity for financially or operationally distressed companies
Management buy-out -form of leveraged buy-out where existing management buys out existing owners. Management buy-in when external management team is involved.
Private Equity funds appropriate where:
Risk profile unsuitable for pubic ownership
the cost of capital maybe reduced under private ownership (eg by high levels of gearing)
where valuation is difficult in the public arena
Private equity proponents claim:
Private equity out performs in the long term (survivorship bias?)
Loosely correlated asset which may be able to enhance portfolio performance without materially increasing risk
Investors can diversify risk by:
buying into quoted venture and development capital
have funds managed by private equity firms
Fund of funds (though usually double layer of fees)
Hedge Funds
Hedge funds-Privately organised, administered by professional managers not widely available to public
Have fewer restrictions on:
Borrowing
Short-selling
The use of derivatives
Main types:
Global funds - concentrate on international macroeconomic changes
Event driven funds - trade either distressed securities or securities of companies involved in mergers & acquisitions
Market-neutral funds -enter simultaneously into long and short positions, whilst taking no overall exposure to the market
Claims that hedge funds out perform measured but must take into account:
Survivorship bias - failures excluded from data
Selection bias - funds with good history more likely to want to be included
Marking to market bias -stale prices lead to under estimation of true variances and correlation (some strategies don't have market values)
One should look at the whole distribution as returns are far from normal
Currency
FX Market by far the largest in the world - trillions daily
Transactions either forward or spot
Infrastructure
Financing of long term infrastructure - Project paid back from cash from project
Economic Infrastructure
highways
water and sewage facilities
energy distribution
telecommunication networks
Social Infrastructure
Schools
universities
hospitals
public housing
prisons
Political risk
Commodities
Traded around the world. Chicago and London most famous. This is really about futures
Commodity Future
Future Price = Spot Price + cost of carry - convenience yield
Structured Products
Structure Product - pre-packaged strategy in terms of a single investment.
Typically two components:
A note -Zero coupon debt security for capital protection
A derivative - provides exposure to one or several assets
Index Funds
'Open ended' unitised collective investment scheme. Mimics performance of an index. Used in passive strategies
Exchange-traded funds
ETF "close ended" investment trusts
bought and sold on exchange like other shares
share represents ownership of in a unit investment trust of underlying portfolio
Contracts for differences (CFD)
Contract specifying seller will pay buyer for differences between current value of asset and value at specific time
Fundamental Analysis
Share prices
Price affected by demand and supply of shares
Key factors driving demand are expectations for:
future capital and dividend growth (depends on internal characteristics of the company and external economic influences)
risk
Fundamental Share Analysis
The study of economic and financial factors that affect a companies share price
Can be applied at an industry and economy level or other types of investment
Consists of two stages:
Construct model to estimate future cash flow and earnings
Use output to determine if shares are over valued or under valued by the market
Wide range of techniques used in practice
General factors to consider:
management ability
quality of products
prospect of market growth
competition
input costs
retained profits
history
To form a view on these factors fundamental analysts will investigate:
Financial accounts and accounting ratios
Dividend & earnings cover
Profit variability and growth
Level of borrowing
Level of liquidity
Growth of asset values
Comparative figures from other companies
Main sources of information:
Financial press and other commercial information providers
The trade press
Public statements but the company
The exchange where the company is listed
Government sources of statutory information that the company has to provide
visits to the company
discussions with company management
discussions with competitors
stockbroker's publications
credit ratings
Changing economic factors will change different companies to different extents. (cyclical vs defensive in trade cycle.
Valuation of Investments
Yields
Definitions
zero-coupon spot yield - rate of return on zero-coupon bond
bond yield- single interest rate so present value equals market value
par yield - coupon rate that makes theoretical value of bond equal to nominal value under prevailing pattern of zero coupon interest rates
Bootstrapping - technique used to create zero-coupon yield curve from observed prices of zero coupon bonds
forward interest rate- interest rate implied by current zero-coupon rates for a specified future time period
Instantaneous forward rate
Forward Rate agreements (FRAs)
Value of FRA
May want to do from first principles
Interest rate futures
Price = 10,000[100-0.25(100-Z)] where Z is price of contract (3 months)
Relationship between forward and future prices
Interest Rate Swaps
where
Arbitrage pricing
Hedging
Hedge - trade to reduce market risk
Basis risk if:
uncertainty around date of sale of asset
hedge require sale before expiration date
Optimal hedge ratio
Empirical characteristics of Asset Prices
Model assumptions that are violated:
normality of increments in log asset prices
independence of increments in log asset prices
constancy of parameters eg drift and volatility
Evidence that equity values, dividend growth and inflation are not correlated. (Problem for models that assume this). Maybe co-integrated
Interest rate derivatives
More difficult to value than equity:
Movement of interest rates more complicated than stock price
To value products must do whole yield curve
Volatilities on different parts of curve are different
Interest rate used for discounting as well as for determining pay off
Black model for european call option
Bond options can be valued using Black model. If given yield volatilities convert with:
Where D is modified duration
Interest rate caps and floors
Use black model
Floor valued as put option
Cap valued as call option
cap price =floor price + value of swap
European Swaption
Option on swap rate
pay fixed get floating (put option on fixed rate bond where strike price is principal) treat as call in formula
viceversa give call option on bond use put version of formula
Evaluating a securitisation
Depends on factors such as:
Lease terms
Rental prospects
degree of potential competition (eg from profit stream)
barriers to competitive entry
Evaluate using discounted cashflow approach. Key features:
Statistics (early repayment experience)
probability (default/recovery and timing
treasury management (payments in and out)
structuring and security issuance
major difficulty is the choice of discount rate to use
Evaluation of a credit derivative
Implied Prices:
Credit default swap -excess return on bond over risk free rate
Total return swap - Difference between the values of assets on both sides of the swap
Credit spread option - difference between market value of bond and its value at the strike spread
Value of bond allowing for credit risk can be found using V - E where V is current value of assets and E is give by formula and D is the amount of debt
Merton model similar to call option on equity (Black-Scholes)
Risk Control
Risk-Free Return
Rate of return for borrowing or lending where :
No credit risk.
Guaranteed payment
Asset- Liability Modeling (ALM)
Strategy assessed by modeling assets and liabilities using deterministic and stochastic models
Deterministic model - set assumptions. Scenario modeling then required to test if assets are the right type
Stochastic model - allows for random nature of some parameters. If assumptions are realistic a clearer picture of the appropriateness of the assets is possible
Modeling and controlling risk
Investors should monitor and control for different forms of financial risks:
Market risk-Change in value of portfolio due to change in market value of assets held. Can use Value at Risk( possible loss in value of fund with probability (p%) over time t)
Credit risk - risk that counterparty can't or won't pay. Can be controlled by:
Limiting credit worthiness of counter parties
Limiting total exposure to each counterparty
using credit derivatives
Operational risk - risk of loss due to fraud or mismanagement. Controlled by:
Appropriate internal reporting
Separation of front and back office functions
Ensuring management understands the risks of complex products
Liquidity risk - risk of not having enough cash to meet operational needs at all times. Can be measured by Liquidity Risk Elasticity (LRE) which is calculated by:
Calculating present value of assets and liabilities using "cost of funds" rate
Measure change in market value of equity for a change in the cost of funds (LRE)
Zero LRE = Zero liquidity risk by this measure. If sharply negative then should consider shortening maturity of assets and lengthening maturity of liabilities to increase liquidity
Relative performance risk - risk of under performing other comparable institutional investors. Measures and controlled same way as market risk
Portfolio Management
Management Styles &Structures
Main:
Growth managers - manage growth stocks i.e. stocks expected to experience rapid growth in earnings and therefore share price
Value managers - manage value stocks. Stock that appear under priced e.g. low price earning ratio or book value per share
Other styles:
Momentum - eg buying shares that have recently risen significantly in price on the belief that they will continue to rise to an upward shift in their demand curve
Contrarian - doing just the opposite to what most other investors are doing in the market in the belief that investors over react to news
Rotational - moving between growth and value depending on which style is believed to be attractive at a particular point in time
Construction Portfolios:
Top-down - Structured decision making process
First consider asset allocation
Then sector allocation
Then select assets
Bottom-up -Looks for best performing assets regardless of asset class, region or sector
Choice of asset allocation and stock selection:
fundamental analysis
quantitative techniques - e.g. multifactor models
technical analysis:
chartism
mechanical trading rules
relative strength analysis
Passive vs Active Management
Passive -typically index-trackers. No investment decisions. Track index. Maybe appropriate if particular market is efficient
Available approaches:
Full replication
Sampling
Synthesizing the index using derivatives
Active- Apply various types of judgement to portfolio selection with objective to out perform benchmark. Two groups:
multi-asset balanced mandates
specialist mandates
Core-satellite approach - Increasingly popular. Most of fund passive (core). Satellite managers employed to increase performance via active management
Bond Portfolio Management
Usually held to match liabilities. Bond investors still try to out perform using anomaly switches policy switches
Anomaly switching - Moving between stocks of similar volatilities taking advantage of temporary price anomalies. Low risk strategy. Techniques used to identify possible anomalies include:
yield differences
price ratios
yield models
price models
Policy switching - riskier than anomaly switching. Move between stocks of different volatilities. Trys to take advantage of changes in the shape or level of the yield curve. Policy switching can be aided by:
Bond volatilities
reinvestment rates
spot/forward rates
When matching liabilities, techniques to control risk might include:
immunisation
stochastic asset-liability modelling
value at risk calculations
multifactor modelling
ideas of policy and anomaly switching can be applied to other asset types
Portfolio construction
Portfolios are constructed to:
reduce risk
achieve higher long term investment returns
Conflict in practice
Establishing investment policy typically two stage process:
establishing strategic benchmark or investment strategy
tactical implementation of this strategy. choosing managers, risk budgeting
Risks involved in portfolio construction:
Strategic risk - risk of strategic benchmark relative to liabilities
active risk- risk taken by manager relative to the benchmark
structural risk - aggregate of individual manager benchmark does not equal the total benchmark of the fund
Use of multi-factor models
Can be used:
actively - to estimate required return on a share. see if it is cheap or dear
passively - to identify a suitable portfolio of shares to match liabilities or to replicate an index
Technical Analysis
chartism - examining charts of past market data
mechanical trading rules - whereby trading signals are given by set price movement
relative strength analysis - which examines the performance of a share relative to the market as a whole or its own sub sector
Relies on market being weak form inefficient
Risk Budgeting
Allocates risk to those areas of the portfolio where it is most efficient in terms of generating higher returns. It involves:
Deciding how to allocate the maximum permitted overall to total fund active risk and strategic risk
allocating the total fund active risk budget across the component portfolios
The following steps are involved:
define a feasible set of asset classes
choose an initial asset allocation using a risk optimiser and a Value at Risk assessment to determine risk tolerance
monitor risk exposure
rebalance the portfolio when necessary due to changes in risk appetite or changes in underlying volatility and correlation data
Measuring risk relative to a benchmark
Relative/Active return - difference between portfolio return and benchmark return
Relative/Active risk - most commonly measure using tracking error (annualised standard deviation of the relative returns). Can be estimated looking forward or backwards
Active money -difference between the portfolio holding and benchmark holding. gives crude indication of active risk
Information ratio
mean(relative return)/standard deviation(relative return)
Downside risk measures
downside semi standard deviation
shortfall probability
expected shortfall
value at risk - assesses potential losses on a portfolio over a given future time period with a given degree of confidence
Stress testing - used to identify and investigate the impact of extreme market events
Role of the custodian
Custodians perform a variety of services, including:
income collection
tax recovery
cash management
security settlement
foreign exchange
stock lending
Global custodians operate internationally and use sub custodians where they do not have a presence
Use of swaps
Swaps can be used for:
reduce risk by matching assets and liabilities
reduce the cost of borrowing, if there is a comparative advantage
swap exposure between different asset classes without disturbing underlying assets
Counterparties to a swap face two risks:
Market risk
Credit risk
Futures and options can be used for:
hedging to reduce market risk
speculation to increase returns
generating arbitrage profits
transition management
synthesizing an index
to generate additional income e.g covered call
Use of futures and options
Risk to consider when hedging:
Basis risk - basis of the future can't be predicted with certainty
Cross hedging risk - If actual assets differ from those underlying the future
To hedge via options. Need hedge ratio which is equal to the reciprocal of the delta of the option
Currency forward contacts to hedge overseas investment returns
Main problems with currency hedging:
it is possible to hedge only expected returns
many investments are of a longer term than available on the market so must be rolled over at unknown rates
it may be relatively expensive to hedge small cashflows
Currency hedging with forwards
To reduce risk associated with derivatives appropriate reporting of exposure is important. This should include:
Listing derivatives individually
Valuing derivatives at market value
including additional explanations to ensure that fund position is understood
Derivative reporting
main problem with making large changes to the asset allocation are:
Possibility of shifting market prices
time needed to effect the change and difficulty in making sure timing of change is advantageous
dealing costs involved
crystallization of capital gain tax
Changing the strategic asset allocation
Dealing in the cash market
Transaction costs may be reduced by:
Implementing the transition in stages
investigating share exchanges between old and new investment managers
investigating crossing -where investment bank looks among clients for buyers and sellers of stock
using the investment cashflows as a way of rebalancing the portfolio
Actuarial Techniques
Asset Pricing Models
Modern asset pricing models derive from the notion that price equals expected discounted pay offs from an asset. They are used:
To determine whether an observed price is "wrong" - whether an asset is mispriced
To determine the price of of assets that cannnot be observered
Absolute pricing - prices assets by reference to exposure to fundamental sources of macroeconomic risk eg consumption based models and general equilibrium models (CAPM)
Relative pricing considers the value of an asset given the price of some other assets eg Black-Scholes option pricing and arbitrage pricing theory
Asset pricing can be summarised into two equations where
p = asset price
x = asset payoff
m = stochastic discount factor (or state price deflator)
Consumption based models
where
CAPM
Intertemporal CAPM
Arbitrage pricing theory
Asset Liability Modelling (ALM)
In banking ALM is used to ensure mismatches between assets & liabilities are not so large as to expose the bank to serious risk if there is a sudden sharp market movement
Actuaries us ALM to project the assets and liabilities over several years to review investment policy
The main stages in an ALM exercise include the following:
Clarify the key objectives of the investment and funding policy
agree suitable assumptions to use in the study
collect the data to be used to carry out the projections
consider the overall nature of the liabilities
analyse how the scheme might progress in the future if different investment strategies were adopted
analyse different asset mixes in more detail
summarise and present the results
presentation of ALM results usually in graphic format
State price deflators can be used to place a value on cashflows accruing to various stakeholders under different investment strategies. Deflators are used to produce values that are:
market consistent
arbitrage free
contingent upon economic conditions
Also adjust returns for risk automatically
Asset liability mismatch reserving
Asset liability mismatch reserving involves projecting emerging asset liability position under a range of possible conditions in order to establish the extent to which assets and liabilities are mismatched. Appropriate supplementary reserves can then be set up to cover the possible levels of shortfall identified
Resilience testing considers the impact of an immediate change in market conditions
Credit rating an entity
Canons of lending:
reason for borrowing (purpose)
expected source of repayment (payback)
risks that could jeapordise repayment (risks)
structure of the borrowing (structure)
Ratings are:
reviewed annually and following significant events
based on quantitative and qualitative evaluation of a company's financial strength,operating performance and market profile
Financial tests assess:
financial strength -operating leverage, financial leverage, asset leverage, capital structure, liquidity
operating performance - profitability, revenue composition
market profile - market risk, competitive market position, spread of risk, event risk
Liability hedging
Involves selecting assets that perform exactly like the liabilities in all states. eg choice of assets to hedge unit linked liabilities
Problems may arise when:
underlying assets are valued daily but traded through out the day
the assets held are not the same as those underlying the value of liabilities eg when the liabilities are linked to an external fund or an external index
Halfway between absolute matching and immunisation
Liability hedging example
Government bonds to maturity to meet pre - specified stream of future payments
Difficult because:
bonds may not be available
funds may be insufficient to purchase all the required bonds
timings of liabilities might not be known
Alternatively use derivatives. Swaps can get around gaps in bond market and require less money upfront. But increased counterparty risk and transaction costs
Liability Driven Investment (LDI)
Liability driven investment is where asset allocation is determined in whole or in part by a specific set of liabilities
LDI is an approach to setting investment strategy
LDI strategies are typically aimed at hedging the two main risks faced by funds:
interest rate risk
inflation risk
Cointegration
Two difference stationary time series are said to be cointegrated if there exists a linear combination of them that is stationary. This relation then represents the long run equilibrium between the two series
The relation can be captured with the following error correction model:
Often more appropriate than correlations which require series to be stationary
Dynamic Liability benchmarks
Dynamic Liability benchmarks vary according to the changing nature of liabilities. Their use reflects an intermediate position between conventional "static" benchmarks and full liability hedging
Often used in respect of currencies
Performance measurement
Rates of Return
When calculating returns consider:
timing and size of all cashflows
differentiating between investment income and new money
taxes and expenses
Money weighted rate of return found by equating PV of money in vs PV of money out. Actual return of fund. Affected by timing and size of cashflows
Time weighted rate of return found by link returns of inter-cashflow periods. not affected by timing or size of cashflows
Linked internal rate of return. Approximation of time weighted. found but linking internal rates of return over short periods
Assessing portfolio performance
Benchmark portfolio. Can be use to determine sector and stock selection profits achieved by portfolio. Done by producing hybrid notional fund based on actual sectors and the notional stocks
Sector selection profits arises from differences between the fund's proportions in various sectors and proportions in benchmark portfolio
Use notional funds as a yard stick. Can be based on one or more indices.
Stock selection profits arise when selected stocks with a particular sector in perform better or worse than the sector as a whole
Can allow for risk through measures based on standard deviation of return or portfolio beta
Treynor measure
Sharpe measure
Jensen measure
pre-specified standard deviation
Risk-adjusted performance
Uses of performance measurement
help improve performance
compare actual performance against target rates
compare actual performance against a benchmark portfolio or other portfolio
limitations of performance measurement
past may be poor guide to future
difficulty of allowing for risk
possibility of spurious / misleading results if invalid comparisons are made or time periods that are too short are considered
different funds may have different objectives
measurement may influence the actions of fund managers in ways that are inconsistent with the funds long term objectives
it adds to the cost of investment
Comparisons against benchmarks generally more appropriate than comparisons against a single index or against other funds. benchmark can be made to be consistent with the overall objectives of the fund
Portfolio risk and return analysis
Usually involves plotting TWR against a risk measure. Checks if superior returns are at expense of greater risk or by superior manger skill
Problems with regular risk and return analysis include:
creeping change in portfolio composition
a successful manager may be treated unfairly by the measurement system
manager may simply disagree with market view of stock or market prospects
It is important that a manager can demonstrate a realistic and convincing rationale for investment decisions
Equity market price
Changes in market price of an equity usually used to measure success or failure of investment decision to include in portfolio however:
dividend income must be allowed for
price may be influenced by short term concerns whereas most investors are more concerned about the long term
Net present value
NPV of an investment may be of limited use for performance measurement as it depends on many assumptions which can produce a wide variety of results
Estimates may differ from market price due to:
differences between particular investor and average investor eg (tax attitude to risk)
other differences in underlying assumptions between investor and the market
However a trend of NPV estimates in relation to market prices may be helpful
Net asset value
NAV only one component of overall value
NAV is an accounting number. Import to understand how it has arisen and make appropriate adjustments
sensible comparisons of NAV between companies in different sectors are difficult to make
Risk adjusted return on capital
CAPM suggests that if capital assets are priced correctly then:
returns in excess of the risk free rate will only be generated from taking risk
the risk adjusted return on capital should be equal to the risk free rate
high risk adjusted return implies successful creation of shareholder value. however it is difficult to identify appropriate return and capital figures for a rigorous CAPM - type required return on capital calculation.
When calculating capital include and value:
goodwill from mergers/take overs
internally generated goodwill
any other intangible assets
all intangible assets
when calculating return
add back to profits any investment in the creation of new intangible assets and in the expansion and purchase of tangible assets
continue to deduct any expenses incurred defending and servicing existing tangible and intangible assets
More about assessing company performance rather than equity performance
The best measure of the capital in a company including all the intangibles as required by CAPM is probably the market capilisation
For returns net of tax (T will differ on tax status of investor)
Cross hedging risk:
Asset hedged not the same as underlying asset in contract
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