Portfolio Management: Instructor: Feng

Portfolio Management
Level 2 -- 2017
Instructor: Feng
Brief Introduction
Topic weight:
Study Session 1-2 Ethics & Professional Standards 10 -15%
Study Session 3 Quantitative Methods 5 -10%
Study Session 4 Economics 5 -10%
Study Session 5-6 Financial Reporting and Analysis 15 -20%
Study Session 7-8 Corporate Finance 5 -15%
Study Session 9-11 Equity Investment 15 -25%
Study Session 12-13 Fixed Income 10 -20%
Study Session 14 Derivatives 5 -15%
Study Session 15 Alternative Investments 5 -10%
Study Session 16-17 Portfolio Management 5 -10%
Weights: 100%
Brief Introduction
Content:
Ø SS 16: Process, Asset Allocation, and Risk Management
ü Reading 47: The Portfolio Management Process and The
Investment Policy Statement
ü Reading 48: An Introduction to Multifactor Models
ü Reading 49: Measuring and Managing Market Risk
Brief Introduction
Content:
Ø SS 17: Economic Analysis, Active Management, and Trading
ü Reading 50: Economics and Investment Markets
ü Reading 51: Analysis of Active Portfolio Management
ü Reading 52: Algorithmic Trading and High-Frequency
Trading
Brief Introduction
考纲对比:
Ø 与2016年相比，2017年的考纲变化比较大。
ü 新增Reading 49: Measuring and Managing Market Risk；
ü 新增Reading 52: Algorithmic Trading and High-Frequency
Trading。
Brief Introduction
推荐阅读:
Ø 投资组合管理
üJohn L. Maginn, Donald L.
Tuttle, Jerald E. Pinto,
Dennis W. Mcleavey
üISBN: 978-7-111-38719-0
ü机械工业出版社
Brief Introduction
学习建议:
Ø 本门课程难度不大，但知识点比较杂，概念比较多；
Ø 章节之间比较独立，可以对重点章节重点学习；
Ø 适当做题，不需要刷题；
Ø 最重要的，认真、仔细的听课。
Brief Introduction
成功了，可以高兴但不可狂妄；
失败了，可以悲伤但无需绝望！
Portfolio Management Process and IPS
Tasks:
Ø Describe the steps of the portfolio management
process;
Ø Explain the role and elements of the investment
policy statement;
Ø Define and distinguish investment objectives and
constraints.
Portfolio perspective
Ø Focus on the aggregate risk-return tradeoff of all the
investor’s holdings: the portfolio.
üIf we evaluate the prospects of each asset in isolation, we
will likely misunderstand the risk and return prospects of
the investor’s total investment position-our most basic
concern.
Steps of portfolio management process
Ø Planning
üIdentifying and specifying the investor’s objectives and
constraints;
üCreating the investment policy statement (IPS);
üForming capital market expectations;
üCreating the strategic asset allocation.
Steps of portfolio management process (Cont.)
Ø Execution
üSpecifying the investment strategy and asset allocation;
üSpecifying the security selection;
üPortfolio constructions and revisions.
Ø Feedback
üMonitoring and rebalancing;
üPerformance evaluation.
Definition of IPS
Ø An IPS is a written planning document that governs all
investment decisions for the client.
Role of IPS
Ø The IPS serves as the governing document for all investment
decision-making.
Elements of IPS
Ø A brief client description;
Ø Purpose of of establishing IPS;
Ø Duties and investment responsibilities of parties involved;
Ø Statement of investment goal, objectives and constraints;
Ø Schedule for review of investment performance and IPS;
Ø Performance measures and benchmarks to be used;
Ø Considerations for strategic asset allocation;
Ø Investment strategies and investment styles;
Ø Guidelines for portfolio rebalancing.
Investment objectives and constraints
Ø Investment objectives
üRisk objective
üReturn objective
Ø Investment constraints
üLiquidity constraints
üTime horizon constraints
üTax constraints
üLegal and regulatory factors
üUnique circumstances
Risk objectives
Ø Types of risk objective:
üAbsolute (e.g. std dev.) vs. relative (e.g. tracking risk);
üDownside risk (e.g. VaR).
Ø The risk objective limits how high the investor can set the
return objective.
Risk objectives
Ø Risk tolerance: combination of ability and willingness to
take risk:
Ability
willingness
Below average Above average
Below average Resolution
Below average
risk tolerance needed
Below average
Above average Above average
risk tolerance
Risk objectives
Ø Factors that affect ability to accept risk:
üRequired spending needs
üLong-term wealth target
üFinancial strength
üLiabilities
Investment objectives (Cont.)
Ø Return objective
üTypes of return objective:
• Nominal return vs. real return;
• Pre-tax return vs. after-tax return;
• Desired return vs. required return.
üTotal return perspective:
• Consider both income and capital gain.
üReturn objective must be consistent with risk objective.
Investment time horizons
Ø Investors may have short or long investment horizons, or
some combination of the two when multiple investment
goals are identified.
Ø The longer the time horizon the more risk the investor can
take.
üInvestors may allocate a greater proportion of funds to
risky assets when they address long-term as opposed to
short-term investment objectives.
Investment time horizons (Cont.)
Ø With a focus on risk, even investors with a long-term
objective may limit risk taking because of sensitivity to the
possibility of substantial interim losses.
Ø The investment policy must be designed to accommodate all
time horizons in a multistage horizon case (Short-, medium-,
and long-term goals).
Strategic asset allocation
Ø Combine the IPS and capital market expectations to
formulate target weightings on acceptable asset classes.
üTactical asset allocation is allowed for temporary shifts.
Strategic asset allocation (cont.)
Ø Forecasts of risk-return characteristics are required for asset
classes that are included in the investor’s portfolio so that
the expected risk-return profiles is well understood;
Ø An investor with a shorter investment time horizon will
often choose a strategic asset allocation that is relatively less
risky, with a smaller allocation to equities.
Ethical responsibilities of portfolio manager
Ø Ethical conduct is the foundation requirement for managing
investment portfolios.
üThe portfolio manager must keep foremost in mind that he
or she is in a position of trust, requiring ethical conduct
towards the public, client, prospects, employers,
employees, and fellow workers.
Summary
Ø Importance: ☆
Ø Content:
ü Portfolio management process;
ü Role and elements of IPS;
ü Investment objectives;
ü Investment constraints.
Ø Exam tips:
ü 不是考试重点。
Arbitrage Pricing Theory (APT)
Tasks:
Ø Describe APT, including its underlying assumptions;
Ø Determine whether an arbitrage opportunity exists
with APT model;
Ø Calculate the expected return on an asset with APT
model.
Review: CAPM
Ø E [ R i ] =R f  β i [E(R m - R f )]
üThe expected returns (required return) of assets vary only
by their systematic risk as measured by beta (β);
üExpected return (required return) obtained from the
CAPM is used for assets valuation by investors and capital
budgeting to determine economic feasibility of projects .
15
Review: assumptions of CAPM
Ø Investors are risk averse, utility-maximizing, rational
individuals;
Ø Markets are frictionless, including no cost and no taxes;
Ø Investor plan for the same single holding period;
Ø Investor have homogeneous expectations or beliefs;
Ø All investments are infinitely divisible;
Ø Investors are price takers.
Arbitrage pricing model
Ø A linear model with multiple systematic risk factors.
E(RP ) = RF + βP,1 (λ 1 ) + βP,2 (λ 2 ) +...+ βP,k (λ k )
üβp,j = the sensitivity of the portfolio to factor j;
üλj = the expected risk premium for risk factor j; or the risk
premium for a pure factor portfolio for factor j.
• A portfolio with sensitivity of 1 to factor j and sensitivity
of 0 to all other factors;
• Also called factor risk premium.
Assumptions of APT
Ø A factor model describes asset returns;
Ø There are many assets, so investors can form well-diversified
portfolios that eliminate asset specific risk;
Ø No arbitrage opportunities exist among well-diversified
portfolios.
Arbitrage pricing model (Cont.)
Ø APT provides an expression for the expected return of asset
assuming that financial markets are in equilibrium;
Ø APT makes less assumptions than CAPM and does not
identify the specific risk factors as well as the number of risk
factors.
üCAPM can be regarded as a special case of APT with only
one risk factor (market risk factor).
Example
Ø Calculate the expected return for a portfolio with following
information using the APT model. The risk free rate is 5%.
Risk factor 1 Risk factor 2
Factor betas 1.8 0.9
Factor risk premiums 1.5% 2%
Answer:
Ø E(R) = 5% + 1.8*1.5% + 0.9*2% = 9%.
Arbitrage opportunity
Ø An opportunity to conduct an arbitrage: earn an expected
positive net profit without risk and with no net investment
of money.
üIf two portfolios with identical risk factors and factor
sensitivities have different return, there is an arbitrage
opportunity.
Example
Ø Suppose we use a one-factor APT model to evaluate assets,
and we observe the following information, identify the
arbitrage opportunity.
Portfolio Expected Return Factor Sensitivity (Beta)
A 0.075 0.5
B 0.07 0.4
C 0.08 0.45
Answer:
Ø We can create a portfolio D with 50% A and 50% B:
Factor Sensitivity
Portfolio Expected Return
(Beta)
A 7.5% 0.5
B 7.0% 0.4
C 8.0% 0.45
D
7.25% 0.45
(0.5A+0.5B)
Answer (Cont.):
Ø As Portfolio D (0.5A+0.5B) has the same factor sensitivity as
Portfolio C but a different expected return, then an arbitrage
opportunity exists: Portfolio C is undervalued.
üBy buying Portfolio C and short-selling Portfolio D, we
expect to earn a riskless 0.75% return.
Summary
Ø Importance: ☆☆☆
Ø Content:
ü APT model and its consumptions;
ü Arbitrage with APT model;
ü Asset return with APT model.
Ø Exam tips:
ü 常考点1：APT模型的consumption和interpretation；
ü 常考点2：根据APT模型算资产回报。
Multifactor Models: Introduction
Tasks:
Ø Describe and compare macroeconomic factor
models, fundamental factor models, and statistical
factor models.
Multifactor models
Ø Macroeconomic factor model
üRisk factors: surprises in macroeconomic variables.
• E.g.: GDP, interest rate, inflation, credit spreads, etc.
Ø Fundamental factor model
üRisk factors: attributes of stocks or companies.
• E.g.: P/B ratio, P/E ratio, earning growth rate, etc.
Ø Statistical factor model
üUse statistical methods to explain asset returns.
Macroeconomic factor models
Ø Ri = ai + bi1F1 + bi2F2 + ... + biKFK + εi
üRi = the return to asset i;
üai = the expected return to asset i;
üFk = the surprise in the factor k, k = 1, 2, ..., k;
• Difference between realized value and predicted value.
übik = the sensitivity of the return on asset i to a surprise in
factor k, k = 1, 2, ..., k;
üεi = an error term.
Ø Example: Ri = E(Ri) + bi1FINFL + bi2FGDP + εi
Fundamental factor models
Ø Ri = ai + bi1F1 + bi2F2 + ... + biKFK + εi
üRi = the return to asset i;
üai = regression intercept necessary to make the
unsystematic risk of asset equal to zero;
üFk = return associated with the factor k, which are asset
attributes that are important in explaining cross-sectional
differences in stock prices;
übik = standardized beta of attributes of the asset.
Value of attribute k for asset i- Average value of attribute k
bik =
σ(values of attribute k)
Macroeconomic vs. Fundamental factor models
Ø Interpretation of factors
üMacroeconomic factor models: surprises in the
macroeconomic variables;
üFundamental factor models: return associated with asset
attributes.
Ø Interpretation of factor sensitivities
üMacroeconomic factor models: regression slope estimate;
üFundamental factor models: standardized beta.
Macroeconomic vs. Fundamental factor models (Cont.)
Ø Interpretation of intercept term
üMacroeconomic factor models: the asset’s expected return
based on market expectations (e.g. APT);
üFundamental factor models: regression intercept.
Macroeconomic vs. Fundamental factor models (Cont.)
Ø Data processing
üMacroeconomic factor models: develop the factor (surprise)
series first and then estimate the factor sensitivities
through regressions;
üFundamental factor models: specify the factor sensitivities
(attributes) first and then estimate the factor returns
through regressions.
Statistical factor models
Ø These models make minimal assumptions but the factors are
difficult to interpret economically, in contrast to
macroeconomic models and fundamental models.
Summary
Ø Content:
ü Macroeconomic factor models;
ü Fundamental factor models;
ü Statistical models.
Ø Exam tips:
ü 很总要的考点，主要考概念题，特别是
Macroeconomic factor models和Fundamental factor
model的解读与对比。
Multifactor Models: Application
Tasks:
Ø Explain sources of active risk and interpret tracking
risk and the information ratio;
Ø Describe uses of multifactor models and interpret
the output of analyses based on multifactor
models.
Applications of multifactor models
Ø Performance attribution
üReturn attribution
üRisk attribution
Ø Portfolio construction
Ø Strategic portfolio decisions
Return attribution
Ø Multifactor models can be used to attribute portfolio return
to different factors.
üActive return = RP - RB
• RP = portfolio return
• RB = benchmark return
Return attribution (Cont.)
üActive return = Factor return + Security selection return
• Factor return: return earned by taking different factor
exposures compared to the benchmark;
k
Factor return =  β
i=1
P,i -βB,i  ×λi
βP,i : factor sensitivity for i th factor in th e active portfolio;

βB,i : factor sensitivity for i th factor in th e benchmark portfolio;
λ i : factor risk premium for factor i .
• Security selection return: earned by allocating different
weights to securities compared to the benchmark.
Risk attribution
Ø Active risk: the standard deviation of active returns.
Active risk = σ(Rp – RB)
• Also refers to tracking risk, or tracking error.
Ø Information ratio (IR): standardized average active return.
RP - RB
IR =
σ RP -RB 
• A tool for evaluating mean active returns per unit of active
risk.
Risk attribution (Cont.)
Ø The active risk of a portfolio can be separated to two parts:
Active risk squared = Active factor risk + Active specific risk
ü Active factor risk: the active risk resulting from the
portfolio’s different-from-benchmark factor exposures;
ü Active specific risk: the active non-factor or residual risk
assumed by the manager, resulting from the portfolio’s
different-from-benchmark weighting for specific securities.
• Also refers to security selection risk.
Example:
Ø Decomposition of active risk squared:
Example (Cont.):
Ø Decomposition of active risk squared (re-stated by %):
Example (Cont.):
Ø Conclusions:
ü Portfolio A assumed substantial active industry risk,
whereas Portfolio B was approximately industry neutral
relative to the benchmark.
ü By contrast, Portfolio B had higher active bets on the style
factors representing company and share characteristics.
Example (Cont.):
ü Portfolio C assumed more active factor risk related to the
style factors, but B assumed more active specific risk. It is
also possible to infer from the greater level of B’s active
specific risk that B is somewhat less diversified than C.
ü Portfolio D appears to be a passively managed portfolio,
judging by its negligible level of active risk. Its risk
exposures very closely match the benchmark.
Portfolio construction
Ø Multifactor models permit the portfolio manager to make
focused bets or to control portfolio risk relative to the
benchmark’s risk.
üPassive management: selecting a sample of securities from
the index, replicating an index fund’s factor exposures, and
mirroring those of the index tracked;
üActive management: predicting alpha or relative return, or
establish a specific desired risk profile for a portfolio.
Example:
Ø The following table shows the risk factors and the factor
sensitivities for the portfolios:
Example (Cont.):
Ø A portfolio manager wants to place a bet that real business
activity will increase. Which portfolio is most appropriate
and what position should be chosen?
Answer: B
Ø Portfolio B is the factor portfolio for business cycle risk
because it has a sensitivity of 1 to business cycle risk and a
sensitivity of 0 to all other risk factors. The manager should
take a long position in Portfolio B.
Example (Cont.):
Ø A portfolio manager wants to hedge an existing positive
(long) exposure to time horizon risk. Which portfolio is most
appropriate and what position should be chosen?
Answer: D
Ø Portfolio D is the factor portfolio for time horizon risk
because it has a sensitivity of 1 to time horizon risk and a
sensitivity of 0 to all other risk factors. The manager should
take a short position in Portfolio D.
LOS 48.g; Describe (☆☆)

Strategic portfolio decisions
Ø By introducing more risk factors, multifactor models enable
investor gain from taking more/less exposures to risks that
they have a comparative advantage/disadvantage;
Ø By considering multiple sources of systematic risk,
multifactor models allow investors to achieve better-
diversified and possibly more efficient portfolios.
Summary
Ø Importance: ☆
Ø Content:
ü Applications of multifactor models:
• Return attribution and risk attribution;
• Portfolio construction;
• Strategic portfolio decisions.
Ø Exam tips:
Value at Risk (VaR)
Tasks:
Ø Compare the parametric, historical simulation, and
Monte Carlo simulation methods for estimating
VaR;
Ø Describe advantages, limitations and extension of
VaR.
Value at Risk (VaR)
Value at Risk (VaR)
Ø The minimum loss that would be expected a certain
percentage of the time over a certain period of time given
the assumed market conditions.
Ø Example: the 5% VaR of a portfolio is €2.2 million over a one-
day period.
üInterpretation: the minimum loss that would be expected
to occur over one day 5% of the time is $2.2 million.
Value at Risk (VaR)
Methods to estimate VaR
Ø Parametric (variance–covariance) method
Ø Historical simulation method
Ø Monte Carlo simulation method
Value at Risk (VaR)
Parametric method
Ø Assumes that the return distributions for the risk factors in
the portfolio are normal;
Ø Uses the expected return and standard deviation of return
for each risk factor to estimate the VaR.
üVaR(X%) = E(R) - ZX%×σ
üVaR(X%)dollar = [E(R) - ZX%×σ]×asset value
Value at Risk (VaR)
Parametric method (Cont.)
Ø Advantage:
üSimple and straightforward.
Ø Disadvantage:
üIts estimates will only be as good as the estimate of the
parameter (mean, variance, covariance).
üThe usefulness is limited when normality assumption is not
reasonable.
• E.g.: when the investment portfolio contains options.
Value at Risk (VaR)
Historical simulation method
Ø Re-prices the current portfolio given the returns that
occurred on each day of the historical lookback period and
sort the results from largest loss to greatest gain.
Ø Example: you have accumulated 100 daily returns for your
$100M portfolio. After ranking the returns from highest to
lowest, you identify the lowest six returns: -0.0011, -0.0019,
-0.0025, -0.0034, -0.0096, -0.0101.
üVaRdaily(5%) = 0.19% or $190,000
Value at Risk (VaR)
Historical simulation method (Cont.)
Ø Advantage:
üNo normality or any other distribution assumption;
• Available to estimate the VaR for portfolio with options.
ü Based on what actually happened, so it cannot be
dismissed as introducing impossible outcomes.
Value at Risk (VaR)
Historical simulation method (Cont.)
Ø Disadvantage:
üNo certainty that a historical event will re-occur, or that it
would occur in the same manner or with the same
likelihood as represented by the historical data.
• If data in the lookback period is more volatile, VaR will be
over-estimate;
• If data in the lookback period is less volatile, VaR will be
under-estimate.
Value at Risk (VaR)
Value at Risk (Cont.)
Ø Both parametric and historical simulation methods has a
shortage that all observations are weighted equally.
üImprovement: giving more weight to more recent
observations and less weight to more distant observations.
Value at Risk (VaR)
Monte Carlo simulation method (Cont.)
Ø The user develops his own assumptions about the statistical
characteristics of the distribution and uses those
characteristics to generate random outcomes that represent
hypothetical returns to a portfolio.
Value at Risk (VaR)
Monte Carlo simulation method (Cont.)
Ø Advantage:
üIt can accommodate virtually any distribution, and can
accurately incorporating the effects of option positions or
bond positions with embedded options.
Ø Disadvantage:
üComplex
üAssumptions of inputs are critical for accuracy of estimates.
Value at Risk (VaR)
Advantages of VaR
Ø Simple concept
Ø Easily communicated concept
Ø Provides a basis for risk comparison
Ø Facilitates capital allocation decisions
Ø Can be used for performance evaluation
Ø Reliability can be verified
Ø Widely accepted by regulators
Value at Risk (VaR)
Limitations of VaR
Ø Subjectivity
Ø Underestimating the frequency of extreme events
Ø Failure to take into account liquidity
Ø Sensitivity to correlation risk
Ø Vulnerability to trending or volatility regimes
Ø Misunderstanding the meaning of VaR
Ø Oversimplification
Ø Disregard of right-tail events
Value at Risk (VaR)
Extensions of VaR
Ø Conditional VaR (CVaR): the average loss that would be
incurred if the VaR cutoff is exceeded.
üAlso named expected tail loss or expected shortfall.
Ø Incremental VaR (IVaR): the difference in VaR between the
“before” and “after” VaR if a position size is changed relative
to the remaining positions.
Value at Risk (VaR)
Extensions of VaR (Cont.)
Ø Marginal VaR (MVaR): the change in VaR for a small change
in a given portfolio holding.
ü Strictly, MVaR is the slope of VaR-weight curve for a
security in the portfolio;
ü Approximately, MVaR is the change in VaR for a $1 or 1%
change in the position for a security in the portfolio.
Value at Risk (VaR)
Extensions of VaR (Cont.)
Ø Relative VaR: a measure of the degree to which the
performance of a given investment portfolio might deviate
from its benchmark.
üAlso named ex ante tracking error.
Summary
Ø Content:
ü Definition and interpretation of VaR;
ü Method to estimate VaR:
• Parametric method; historical simulation method,
Monte Carlo simulation method.
ü Advantages, limitations, and extensions of VaR.
Ø Exam tips:
ü 常考点1：VaR的定义和解读，概念题；
ü 常考点2：VaR估计的方法对比，概念题。
Sensitivity and Scenario Risk Measures
Tasks:
Ø Describe sensitivity risk measures and scenario risk
measures;
Ø Describe advantages and limitations of sensitivity
risk measures and scenario risk measures;
Ø Explain constraints used in managing market risks.
Sensitivity risk measures
Ø Examine how portfolio value responds to a small change in a
single risk factor.
Scenario risk measures

Ø Provides an estimate of the impact on portfolio value of a
set of significant change in multiple risk factors.
Sensitivity risk measures
Ø Equity exposure measures: Beta (β)
CAPM: E(Ri) = RF + βi[E(RM) – RF]
üAssets with betas more (less) than 1 are considered more
(less) volatile than the market as a whole.
Sensitivity risk measures (Cont.)
Ø Fixed-income exposure measures: duration and convexity.
üGiven a bond priced at P and yield change of ΔY, the rate of
return or percentage price change for the bond is
approximately given as follows:
ΔP 1
= -Duration  ΔY +  Convexity   ΔY 
2
P 2
Ø Options risk measures: Delta (Δ), Gamma (Γ), Vega (Λ), etc.
üDelta: sensitivity of option price against the underlying
asset price;
üGamma: sensitivity of option delta against the underlying
asset price;
üVega: sensitivity of option price against underlying asset
price volatility.
1
 Gamma   ΔS  + Vega  ΔV
2
ΔPcall = Delta  ΔS +
2
Ø Advantage: can inform a portfolio manager about a
portfolio’s exposure to various risk factors to facilitate risk
management.
üIf too much/less risk exposure to a risk factor, the manager
can modify the exposure accordingly.
Ø Limitations:
üCan only be used to estimate the effects of small changes
in risk factors.
• Even combination of first-order and second-order effects
only provide approximation for large changes in risk
factors.
üTwo portfolios with same sensitivity risk measures can have
different risk due to different volatility of risk factors.
• E.g.: two fixed income portfolios with same duration but
different yield volatilities.
Scenario risk measures
Ø Historical scenario approach: use a set of changes in risk
factors that have actually occurred in the past.
üE.g.: change of risk factors in financial crisis.
Ø Hypothetical scenario approach: use a set of hypothetical
change in risk factors, not just those that have happened in
the past.
üStress tests: examine the impact on portfolio of a scenario
of extreme changes of risk factors.
Scenario risk measures (Cont.)
Ø Scenario analysis can be regarded as the final step in the risk
management process, after performing sensitivity analysis.
üScenario analysis can provide additional information on a
portfolio's vulnerability to changes of risk factors or the
correlations between risk factors.
üStress tests can determine the size of change on a certain
risk factor that could compromise the sustainability of the
investment.
Ø Advantage:
üScenario risk measures focus on extreme outcomes, but
not bound by either recent historical events or
assumptions about parameters or probability distributions.
üScenario analysis is an open-ended exercise that could look
at positive or negative events, although its most common
application is to assess the negative outcomes.
• Stress tests intentionally focus on extreme negative
events.
Ø Limitations:
ü Historical scenarios are not going to happen in exactly the
same way again; and hypothetical scenarios may
incorrectly specify how assets will co-move.
üHypothetical scenarios are difficult to create and maintain.
• It is very difficult to know how to establish the
appropriate limits on a scenario analysis or stress test.
Ø Limitations:
üThe more extreme the scenario, and the farther from
historical experience, the less likely it is to be found
believable by management of a company or a portfolio.
VaR vs. Sensitivity vs. Scenario risk measures
Ø VaR provides a probability of loss, and is a downside risk
measures;
Ø Sensitivity risk measures provide estimates of relative
exposure to different risk factors but no estimate of
probabilities, and are not downside risk measures;
Ø Scenario risk measures provide estimates of effect to
simultaneous changes of multiple risk factors, but no
estimate of probability.
VaR vs. Sensitivity vs. Scenario risk measures
Ø They are best used in combination because no one measure
has the answer, but all provide valuable information that can
help risk managers understand the portfolio and avoid
unwanted outcomes and surprises.
Choices of risk measures
Ø The choices of risk measures by an organization is mainly
decided by the types of risks it faces, the regulation that
govern it, and whether it uses leverage.
üBanks
üAsset managers
üPension funds
üinsurers
Banks
Ø Banks need to balance a number of competing aspects of
risk to manage their business and meet the expectations of
equity investors/analysts, bond investors, credit rating
agencies, depositors, and regulatory entities.
Ø The typical risk measures used by banks:
üSensitivity measures;
üScenario analysis and stress tests;
üLeverage risk measures;
üVaR .
Asset managers
Ø Traditional asset managers: focus on relative risk measures.
üPosition limits, sensitivity measures, scenario analysis,
active share, VaR.
Ø Hedge funds managers: focus on absolute return.
üSensitivity measures, leverage, VaR, scenario analysis,
drawdown.
Pension funds
Ø The risk management goal for defined benefit pension funds
is to be sufficiently funded to make future payments to
pensioners.
Ø The typical risk measures used by pension funds:
üSensitivity measures, surplus at risk.
Risk measures and capital allocation
Ø Capital allocation: the practice of allocating capital to fund
its various business units or activities, ensure sufficient
resource in areas in which it expects the greatest reward and
has the greatest expertise.
Ø Risk measures must be introduced when limit the overall
risk and allocate risk across the activities or business units by
risk budgeting.
LOS 49.k; Explain (☆)

Constraints in market risk management
Ø Risk budgeting: determining the overall risk appetite, and
then allocated to sub-activities or business units.
Ø Position limits: the maximum currency amount or
percentage of portfolio value allowed for specific asset or
asset class.
Ø Scenario limits: limits on expected loss for a given scenario.
Ø Stop-loss limits: require an investment position to be
reduced or closed out when losses exceed a given amount
over a specified time period.
Summary
Ø Importance: ☆
Ø Content:
ü Sensitivity risk measures vs. scenario risk measures;
ü Advantages and limitations of the risk measures;
ü Choice of risk measures;
ü Constraints in market risk management.
Ø Exam tips:
Economics and Investment Markets (1)
Tasks:
Ø Explain the notion that to affect market values;
Ø Explain the role of expectations in market valuation;
Ø Explain the relationship between the long-term
growth rate and the real short-term interest rates;
Ø Explain how business cycle affects policy rates.
Present value model (DCF model)
Ø The value of any asset can be calculated as the present value
of its expected cash flows.
n
CFi
P= i
i=1 (1+r)
ür: the discount rate

r = R + π + RP
• R: real risk-free rate;
• π: expected inflation;
• RP: risk premium.
Present value model (Cont.)
Ø If a economic factor affects an asset’s market value, it must
affect one or more of the following:
üThe timing and/or amount of the expected cash flows;
üOne or more of the discount rate components: default-free
interest rate, expected inflation, and risk premiums.
• Risk premiums are not only determined by the risk
magnitude, but also the investor’s perception of risk.
Role of expectation
Ø Asset values depend on the expectation of future cash flows,
which is based on current information that may be relevant
to forecasting future cash flows.
Ø Asset values may need to be adjusted due to the fact that
the unanticipated information arise, as the current asset
values only reflect the expected information.
Inter-temporal rate of substitution (ITRS)
Ø The ratio of the marginal utility of consuming 1 unit in the
future (Ut) to the marginal utility of consuming 1 unit today
(U0), denoted by mt.
ümt is always less than 1 because investor always prefer
current consumption over future consumption (U0 > Ut).
Real risk free rate
Ø Assuming a zero coupon, inflation-indexed, risk-free bond
with par value of $1, its price should be:
P0 = m t
Ø So, the real risk-free rate (unannualized) is:
1-P0 1
R= = -1
P0 mt
üThe higher the U0 relative to Ut, the lower the mt, the
higher the R.
GDP growth vs. real risk free rate
Ø Real risk free rate is positively related to GDP growth rate;
üHigher GDP growth rate → higher future income → lower
Ut relative to U0 (diminishing marginal utility of wealth) →
lower mt → higher real risk free rate.
• E.g.: China, India.
Ø Real risk free rate is also positively with the volatility of the
growth rate due to higher “risk premium”.
Inflation vs. nominal risk-free interest rate (r)
Ø In terms of nominal risk-free interest rate, the effects of
inflation should be considered:
üPremium for expected inflation (π);
üRisk premium for uncertainty about actual inflation (θ).
Ø The uncertainty for short-term inflation is negligible:
rshort-term = R + π
Ø For long term securities, risk premium for uncertainty of
inflation need to be included:
rlong-term = R + π + θ
Inflation vs. nominal risk-free interest rate (Cont.)
Ø Break-even inflation rate (BEI): the yield difference between
a non-inflation-indexed risk-free bond and the inflation-
indexed risk-free bond with the same maturity;
üThe BEI captures the effects of inflation on yield:
BEI = π + θ
Business cycle vs. policy rate
Ø Central banks can mitigate the business cycle by adjusting
the policy rate, the Taylor Rule addresses the central bank’s
policy rate to business cycle.
r = Rn + π + 0.5(π – π*) + 0.5(Y-Y*)
ür: central bank policy rate implied by the Taylor Rule;
üRn: neutral real policy interest rate;
üπ: current inflation rate; π*: target inflation rate;
üY: log of actual real GDP; Y*: log of target real GDP.
Summary
Ø Importance: ☆
Ø Content:
ü Market valuation and discount rate;
ü Inter-temporal rate of substitution and real risk free rate;
ü GDP growth vs. real risk free rate;
ü Inflation vs. nominal risk-free interest rate;
ü Business cycle vs. policy rate.
Ø Exam tips:
Tasks:
Ø Explain how business cycle affects the slope of the
term structure of interest rates, and asset’s market
valuation;
Ø Describe the factors that affect yield spreads,
including credit spread.
Business cycle vs. slope of yield curve
Ø During the recession, the slope of yield curve will increase;
üCentral bank tends to lower the policy rate;
üInvestors expect higher future GDP growth and higher long-
term rates as economic growth recovers.
Ø During the recession, short-term bonds generally perform
better than long-term bonds.
Business cycle vs. slope of yield curve (Cont.)
Ø Later stages of expansion often have negatively sloped
(inverted) yield curve.
üTypically, high inflation and high short-term interest rate;
üLow long-term rates due to expectations of decreasing
inflation and GDP growth.
Ø During the expansion, long-term bonds generally perform
better than short-term bonds.
Business cycle vs. credit spreads
Ø Credit spreads: the yield difference between a credit risky
bond and a default-free bond with same maturity.
Yield for credit risky bond = R + π + θ + γ
üγ: credit spread, or risk premium for credit risk.
Business cycle vs. credit spreads (Cont.)
Ø Credit spreads tends to narrow in times of robust economic
growth, when defaults are less common.
üCredit risky (lower-rated) bonds will perform better than
default-free (higher-rated) bonds.
Ø Credit spreads tend to rise in times of economic weakness,
as the probability of default rises.
üDefault-free (higher-rated) bonds will perform better than
credit risky (lower-rated) bonds.
Characteristics of market vs. credit quality
Ø During economic downturn, the spread on the consumer
cyclical sector rises more dramatically than it do for
corporate bonds in the consumer non-cyclical sector.
Ø Issuers that are profitable, have low debt interest payments,
and that are not heavily reliant on debt financing will tend to
have a high credit rating.
Business cycle vs. earning growth expectations
Ø Booming economy tends to lead to a rise of the earning
growth expectations; recession tends to lead to a decline of
the earning growth expectations.
Ø Earning growth rate tend to be relatively stable throughout
the business cycle for defensive or non-cyclical industries.
Business cycle vs. equity risk premium
Ø The equity risk premium is typically higher than credit risk
premium because equity is more risky than debt.
Yield for equity = R + π + θ + λ
üλ: equity risk premium (λ > γ).
Ø Consumption-hedging property: providing higher payoff
during economic downturns.
üAssets with more consumption-hedging property will be
more highly valued and have less risk premium.
Business cycle vs. equity risk premium (Cont.)
Ø Investors will demand a higher equity risk premium because
the consumption-hedging properties of equities are poor.
üEquities tend not to pay off in bad times.
Business cycle vs. valuation multiples
Ø Valuation multiples are positively related to expected
earning growth rate, and negatively related to required rate
of return.
Required rate of return = R + π + θ + λ
Ø Valuation multiples tend to rise during periods of economic
expansion and fall during recessions.
Business cycle vs. style strategy
Ø Value strategy vs. growth strategy
üA value strategy performs well during recession, while
growth strategy performs well during expansion.
Ø Capitalization
üSmall-cap stocks tend to underperform large-cap stocks in
difficult economic conditions.
• Less diversified business(earning streams);
• More difficulties in raising funds;
• Higher risk premium demanded by investors relative to
large-cap stock due to higher volatility.
Business cycle vs. rotation strategies
Ø During economic expansion:
üRotating into growth stocks when they are expected to
outperform value stocks;
üRotating into small-cap stocks when they are expected to
outperform large-cap stocks;
üRotating into cyclical stocks when they are expected to
outperform countercyclical stocks.
Business cycle vs. commercial real estate investment
Ø Commercial real estate investment have the following
characteristics:
üBond-like characteristics: steady rental income stream, like
cash flows of bonds;
üEquity-like characteristics: uncertain value of the property
at the end of the lease term;
üIlliquidity.
Ø Yield for commercial real estate = R + π + θ + λ + φ
üφ: risk premium for illiquidity.
Business cycle vs. commercial real estate investment
Ø Investors will demand a high risk premium for commercial
real estate investment due to weak consumption-hedging
properties.
üCommercial property value tend to decline in bad times.
Summary
Ø Importance: ☆
Ø Content:
ü Business cycle vs. slope of yield curve;
ü Business cycle vs. credit spreads;
ü Business cycle vs. equity risk premium;
ü Business cycle vs. investment style;
ü Business cycle vs. commercial real estate investment.
Ø Exam tips:
Value Added by Active Management
Tasks:
Ø Describe how value added by active management
is measured;
Ø Calculate and interpret the information ratio and
contrast it to the Sharpe ratio.
Measures of value added
Ø Active return
N N
RA= RP- RB=  Δw
i=1
i Ri=  Δw
i=1
i R A,i
üRP: return of actively managed portfolio;

üRB: return of benchmark portfolio;
üRi: return of security i;
üΔwi = wP,i – wB,i, active weights;
• Sum of active weights for all securities equal to zero;
• Over-weighted: positive; under-weighted: negative.
üRA,i = Ri – RB, active security return.
Measures of value added (Cont.)
Ø Ex-anti active return: based on expected return;
Ø Ex-post active return: based on realized return.
Measures of value added (Cont.)
Ø For portfolio with multiple asset classes, active return can
be decomposed to two sources:
üActive asset allocation: active weights of asset classes
against benchmark portfolio;
üSecurity selection: active weights of security within asset
classes.
M M
R A =  Δw jR B,j + w R A,j
P,j
j=1 j=1
• RA,j: active return of asset class j.

Review: sharp ratio (SR)
Ø Sharp ratio measure the total risk-adjusted value added, and
calculated as excess return per unit of risk.
Rp - Rf
SR =
σP
üSharp ratio is unaffected by the addition of cash or leverage
because excess return and risk will change proportionally.
Information ratio (IR)
Ø Information ratio measure the relative risk-adjusted value
added, and calculated as mean active returns per unit of
active risk.
Active return R Active R p - R B
IR = = =
Active risk σ (R Active ) σ(R p - R B )
üEx-anti IR: based on expected return;
üEx-post IR: based on realized return.
• Can be used for performance evaluation: the higher, the
better.
Sharp ratio vs. information ratio
Sharp ratio Information ratio
Relative risk-adjusted value
Total risk-adjusted value added
added　
Unaffected by the addition of Affected by the addition of

cash or use of leverage cash or use of leverage
Affected by the aggressive Unaffected by the aggressive

active weight active weight
Two ratios would be equal if the benchmark is risk-free asset
Information ratio (IR)
Ø Information ratio can be used for investment manager
selection:
üManager with higher IR is preferred;
üHigher IR also means higher SR.
Ø Information ratio can also be used to determine the
expected active return for a given target level of active risk.
E(RA) = IR * σA
Summary
Ø Importance: ☆☆
Ø Content:
ü Definition of active return;
ü Sharp ratio vs. information ratio.
Ø Exam tips:
ü 常考点：information ratio的定义与计算。
The Fundamental Law
Tasks:
Ø State and interpret the fundamental law of active
portfolio management;
Ø Describe the practical strengths and limitations of
the fundamental law of active management.
The Fundamental Law
The fundamental law of active management
Ø The fundamental law is a framework for thinking about the
potential value added through active portfolio management;
üThe most common use is the description and evaluation of
active management strategies.
Ø The law itself is a mathematical relationship that relates the
expected information ratio of an actively managed portfolio
to a few key parameters.
The Fundamental Law
The fundamental law of active management (Cont.)
Ø The correlation triangle
The Fundamental Law
The fundamental law of active management (Cont.)
Ø Realized value added is the sum of the products of active
weights and realized active returns.
üThe value of this sum is ultimately a function of the
correlation coefficient between the active weights, Δwi,
and realized active returns, RA,i. (base of the triangle)
üThe correlation can be examined by the correlations on the
two vertical legs:
• Information coefficient (IC);
• Transfer coefficient (TC).
The Fundamental Law
Information coefficient (IC)
Ø Correlation between the forecasted active returns, μi, and
the realized active returns, RA,i;
R μ 
IC = Corr  A,i , i 
 σi σ i 
üA measure of manager’s forecasting accuracy (also called
signal quality).
• Ex-ante IC: must be positive;
• Ex-post IC: either positive or negative.
The Fundamental Law
Transfer coefficient (TC)
Ø Correlation between the forecasted active returns, μi, and
the active weights, Δwi;
μ
TC = Corr( i , Δw i σi ) = Corr  Δw *i σ i , Δw iσ i 
σi
μ
Δw *i : = 2i , optimal active weights.
σi
The Fundamental Law
Transfer coefficient (Cont.)
Ø Measures the degree to which the investor’s forecasts are
translated into active weights, or the extent to which
constraints reduce the expected value added of the
investor’s forecasting ability.
üFor portfolios without any constraints, TC equals to 1;
üFor portfolios with constraints, TC < 1.
The Fundamental Law
Breadth (BR)
Ø The number of independent active decisions make per year
by the investor in constructing the portfolio.
ü“Independent” in this context means that the active
decisions should not be based on highly correlated (or
identical) information sets;
üA measure of how much efforts the manager has put into.
Ø E.g.: if a manager takes active position in 10 securities per
month, then BR = 10*12 =120.
The Fundamental Law
The fundamental law of active management (cont.)
Ø For actively managed portfolios, the full fundamental law is
expressed in the following equation:
IR = (TC)(IC) BR E(RA ) = (TC)(IC) BRσ A
üFor portfolio without any constraints, TC = 1.

IR = (IC) BR E(RA ) = (IC) BRσ A
The Fundamental Law
Market timing
Ø Market timing: simply bets on the market direction;
Ø Information coefficient for market timing:
IC = 2*(%correct) - 1
üIf the manager is correct 50% of the time, IC = 0.
üThis formula is also applicable to evaluate IC of active
sector rotation strategies.
The Fundamental Law
Limitations of the fundamental law
Ø Limitation: poor input estimates lead to incorrect evaluation.
üUncertainty in ex-ante measurement of skill.
• IC is difficult to justify due to existence of the bias, various
asset segments, or different time periods.
üAssumption of independence of active decisions.
• The number of individual assets is not an adequate
measure of strategy breadth (BR) when the active returns
between individual assets are correlated.
Summary
Ø Content:
ü The fundamental law of active management:
• Information coefficient (IC);
• Transfer coefficient (TC);
• Breadth (BR).
ü Limitations of the fundamental law.
Ø Exam tips:
ü 常考点：the fundamental law的计算公式。
Algorithmic Trading and High-Frequency Trading
Tasks:
Ø Distinguish between execution algorithms and
high-frequency trading algorithms;
Ø Describe the application of algorithmic trading.
Definition and Categories
Definition of algorithmic trading
Ø Algorithmic trading is “using a computer to automate a
trading strategy.”
ü In almost all cases, algorithms encode what traders can do
but with far higher speed.
Categories of trading algorithms
Ø Execution algorithms: break down large orders and execute
them over a period of time.
üThe goal is to minimize the impact that a large order has in
the market and to achieve a benchmarked price.
Categories of trading algorithms (Cont.)
Ø High-frequency trading (HFT) algorithms: refers to the
tracking of high-frequency streams of data, making decisions
based on patterns in those data that indicate possible
trading opportunities, and automatically placing and
managing orders to capitalize on those opportunities.
üThe goal is to earn profit.
Execution algorithms vs. HFT algorithms
Ø Execution algorithms
üHow to trade;
üThe goal is to minimize market impact and try to ensure a
fair price.
Ø High-frequency trading (HFT) algorithms:
üHow to trade; when to trade; and even what to trade.
üThe goal is to earn profit.
Types of execution algorithms
Ø Volume-weighted average price (VWAP):
üUses the historical trading volume distribution for a
particular security over the course of a day and divides the
order into slices, proportioned to this distribution.
Ø Implementation shortfall:
üDynamically adjusts the schedule of the trade in response
to market conditions to minimize the difference between
the price at which the buy or sell decision was made and
final execution price.
Types of execution algorithms (Cont.)
Ø Market participation algorithms:
üSlices the order into segments intended to participate on a
pro-rata basis with volume throughout the course of the
execution period.
Types of HFT algorithms
Ø Statistical arbitrage
üPairs trading
üIndex arbitrage
üBasket trading
üSpread trading
üMean reversion
üDelta neutral strategies
Types of HFT algorithms (Cont.)
Ø Liquidity aggregation and smart order routing
Ø Real-time pricing of instruments
Ø Trading on news
Ø Genetic tuning
Application
Trading algorithms for market fragmentation
Ø Market fragmentation refers to that the same security is
traded in multiple financial markets, this phenomenon
creates the potential for price and liquidity disparities across
different markets.
Ø Algorithmic methods can be used to address this issue, such
as liquidity aggregators and smart order routing.
Application
Trading algorithms for market fragmentation (Cont.)
Ø Liquidity aggregators offer a global-ordered view of liquidity
for each instrument regardless of which trading market
offers the liquidity.
Ø Smart order routing sends the orders to the relevant
markets with the best combination of liquidity and price.
Application
Trading algorithms for risk management
Ø Real-time pre-trade risk firewall:
üContinuously calculate risk exposures on the trades to
ensure that risk limits are not exceeded.
ü Trades exceeding limits are blocked.
Ø Back testing and market simulation:
üTesting algorithms to see how they perform under various
scenarios, including historical data and invented scenarios.
Application
Trading algorithms for regulatory oversight
Ø Regulators around the world have recognized that real-time
market monitoring and surveillance allows rapid action to
prevent or minimize any market impact.
Ø Suspicious trading includes:
üInsider trading
üFront running
üPainting the tape
üFictitious orders
üWash trading
üTrader collusion
Application
Positive impact of algorithmic trading
Ø Minimized market impact of large trades
Ø Lower cost of execution
Ø Improved efficiency in certain markets
Ø More open and competitive trading markets
Ø Improved and more efficient trading venues
Application
Negative impact of algorithmic trading
Ø Fear of an unfair advantage
Ø Acceleration and accentuation of market movements
Ø Gaming the market
Ø Increased risk profile
Ø Algorithms gone wild
Ø Potential for market denial-of-service-style attacks
Ø Additional load on trading venues
Ø Increased difficulty of policing the market
Summary
Ø Importance: ☆
Ø Content:
ü Definition and categories of algorithmic trading;
ü Applications of algorithmic trading;
ü Positive and negative impact of algorithmic trading.
Ø Exam tips:
ü 不是重要考点。

Portfolio Management: Instructor: Feng

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Portfolio Management: Instructor: Feng

Uploaded by

Copyright:

Available Formats

Portfolio Management

βP,i : factor sensitivity for i th factor in th e active portfolio;

Multifactor Models: Application

Scenario risk measures

Sensitivity and Scenario Risk Measures

ür: the discount rate

üRP: return of actively managed portfolio;

• RA,j: active return of asset class j.

Unaffected by the addition of Affected by the addition of

Affected by the aggressive Unaffected by the aggressive

üFor portfolio without any constraints, TC = 1.

You might also like