Financial Markets and Investments

Year 3 Sem 1 // AY 2022-23

Introduction
Real vs Financial Assets
Financial Markets
Types of Fin Markets
Fixed Income (FI)
Money Markets
Capital Markets
Equities
Foreign Exchange
Derivatives
The Investment Process
Capital Allocation
Risk & Risk Aversion
Mean-Variance Criterion
Indifference Curve
Allocating Assets
Passive Strategies
Optimal Risky Portfolios
Types of Risk
Returns, Risk, Correlation
The Optimal Portfolio
Combining the Graphs…
Markowitz Optimisation Model
Risk & Diversification
Single-Index Models
The Model
Finding Risk
Estimating Beta
Portfolio Construction
Steps (Ref: Formula List)
Active Portfolio, A, ONLY

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 Overall Optimal Portfolio
Information Ratio & Sharpe Ratio
Capital Asset Pricing Model (CAPM)
CAPM’s Idea of Equilibrium
Security Market Line (SML)
Limitations of CAPM
Extensions to Mitigate Limitations
APT & Multifactor Models
Multifactor Models
Arbitrage
APT and CAPM
A Multifactor APT
Fama-French 3-Factor Model
Testing CAPM
Factors in Multifactor Models
Equity Premium Puzzle
Efficient Market Hypothesis (EMH)
Versions of the EMH
Portfolio Management
Event Studies
Tests for EMH Versions
Interpreting Anomalies
Behavioural Finance (BF)
Investor Irrationalities
Limits to Arbitrage
Technical Analysis & BH
Smart Beta Investing
Investment Funds
Net Asset Value (NAV)
Types of Investment Companies
Mutual Funds
Mutual Funds: Fees
Mutual Funds: Information
Exchange Traded Funds (ETFs)
Hedge Funds
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 Hedge Funds: Style / Strategies
Portable Alpha
Performance Measurement
Fee Structure
Bond Portfolios
Corporate Bonds
Preferred Stock
International Bonds
Other Bonds
Bond Pricing
Bond Yields
Credit/Default Risk
Credit Default Swaps (CDS)
Collateralised Debt Obligations (CDOs)
Managing Bond Portfolios
Interest Rate Sensitivity
Duration
Convexity
Callable Bonds
Duration & Convexity
Passive Bond Management
Indexing Strategy (Bond-Index Funds)
Immunisation
Active Bond Management
Portfolio Evaluation
Performance Attribution Procedures
Using Derivatives to Hedge Risk
Managing Risks
Futures
Futures Pricing
Hedging
Forwards
FOREX Futures
Interest Rate Futures
Costs of Hedging
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Introduction

Real vs Financial Assets

Real Assets Financial Assets (** focus of this course)

● Used to produce G&S ● Does not contribute directly to the productive

● E.g. Land, buildings,
intellectual property,
machines
capacity of the economy
● Claims on income:
○ Generated by real assets
○ From the government
● E.g. Stocks, bonds

Patents Intellectual property ⇒ real asset

Lease obligations “Obligation” ⇒ a promise to pay ⇒ financial asset

Customer goodwill Produces demand for your product ⇒ real asset

College Education Used in the future to get a job + directly contributes to the productive
capacity of the economy ⇒ real asset

$5 bill Serves as a “claim”, you use it to obtain G&S + useless in other

countries ⇒ Financial asset

Financial Markets
● Nature = groups of institutions that facilitate the transfer of funds between entities
● Financial intermediation

○
● Plays important roles in the economy
○ Information + Signalling
■ Capital flows to companies with the best prospects → stock price increases,
showing that stock price is associated with potential
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 ○ Consumption timing
■ Switch your consumption to prep for periods of low/high earnings
■ Use securities to store wealth, transfer consumption to future → during low
earnings period, you can sell such assets for liquidity
○ Allocation of risk
■ Varying levels of risk associated with the large # of securities available in the
market → there’s something for everyone
■ Companies can then issue securities at the best possible prices
○ Separation of ownership & management
■ Agency problems ⇒ the market offers some mitigating solutions
● Some compensation plans tie managers’ salary to stock perf
● Stock screening by external analysts & large investors
● Monitoring BODs + threat of takeovers
○ Corporate governance & Ethics
■ There will only be efficiency allocation of resources if the market +
investors are acting/signalling based on accurate information
● E.g. misleading / overly optimistic / insider reports may lead to
investors making wrong decisions

Types of Fin Markets

Fixed Income (FI)

● Bonds are also FI securities based on these properties:
○ Fixed stream of income in the form of coupon payments
○ Fixed par value at maturity

Money Markets
● Where short term debt instruments are traded (≤1 year maturity)
● Liquid securities with smaller price fluctuations
● Used to earn interest on surplus funds that they are temporarily holding
● Major components
○ Federal funds market (where banks borrow from each other to meet the
required fed funds ratio) & repurchase agreements (the agreement for
smaller banks to offer some collateral to make sure they can repay loans
from bigger banks)
○ Time deposits + saving deposits
○ T-bills + money market mutual funds + commercial paper (unsecured LT debt
instrument)
● Special rate quoting conventions
○ Discount yields (id): annual i/r quoted as a % of redemption price/ face value
■ For t-bills and commercial paper rates

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 ■ Pf = face value ; P0 = disc price ; n = # days to maturity
○ Single payment yields (isp): annual i/r quoted as a % of purchase price
■ Where interest is only paid at maturity
■ For negotiable (or jumbo) CDs or fed funds

■ To get EAR (yield), convert to ibe first.

■
○ Bond equivalent yield (ibe): compare discount securities to bonds with this

■ ⇒ EAR: effective annual yield

● Listing of T-bills (how to read the table): Bank discount method
○ Listing shows the yields based on prices
○ No coupons, so the price paid for it = discount from par value (id), and the
difference implies an “interest” earned over the investment period
○ Sell @ BID price and buy @ ASK price

Capital Markets
Longer term securities, liquid, low-risk (but not as low as money market)
1. LT government bonds
○ Notes – maturity up to 10 years, Bonds – maturity 10-30 years
○ Par value $1000 ; Quotes at % of par
○ Semi-annual interest payments
2. Corporate bonds
○ Issued by private firms, usually semi-annual interest payments
○ Larger default risk than government securities
■ Unsecured bonds (debentures) have no collateral
○ Options in corporate bonds offer shareholders some rights
■ Callable → company is able to buy back the bond
■ Convertible → bond holder has the option to convert to equity
3. Mortgage backed securities
○ Proportional ownership of a mortgage pool / specified obligation secured by a pool →
produced by securitising mortgages

Equities
● Common stock
○ Ownership + residual claim + limited liability: shareholders only lose their
original investment
● Preferred stock
○ No voting rights + priority over common stock + acts like a perpetuity

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 ● Indices
○ Stock market indices represents the movement of the whole stock market in
that country (sg = STI, uk = FTSE, us = NYSE, NASDAQ, S&P 500, Dow
Jones Industrial Average)
● Popular ratios to use when trading equities
○ Dividend yield: yearly dividend / purchase price
○ Capital gains (losses): share price increase (decrease)
○ P/E ratio: price per share / earnings per share

Foreign Exchange
● Exchange rate volatility caused by demand and supply factors
● Adjustments to exchange rates caused by:
○ Price differences (inflation)
○ Interest rate differences
● Law of one price
○ If the law holds, the exchange rate between 2 currencies will adjust to reflect
the changes in price levels in the 2 countries. Differences in prices (inflation)
drive trade flows and the DD & SS of currencies.

Derivatives
● A security that gets its value from the value of another asset (e.g. commodity prices,
bond/stock prices, market index values)
● Derivatives can be used by hedgers, speculators, arbitrageurs (for risk management)
○ Stock price risks  futures / options
○ Interest rate risks  futures
○ Forex risks  futures / forwards

The Investment Process

 Asset Allocation  choose among broad asset classes (forex, FI, equities)
 Security Selection  choice of securities within each asset class

Capital Allocation
● Long = buy security now to sell for more later (hope that prices rise)
● Short = borrow security to sell now, buy it back later to ‘return’ (hope that prices fall)
● Hedging = find a derivative that’s equivalent to what you want to hedge (i.e. mitigate
ESG risks) against

Risk & Risk Aversion

Speculation Gambling

● Assume considerable risk to obtain ● Bet on an uncertain outcome

commensurate gain ● Risk is taken on simply because it’s a
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 ● Occurs in spite of the risk involved part of the process → for the enjoyment
(you think the return (risk premium) of the risk itself
will be worth the risk you take on)

Each person’s degree of risk aversion is different & affects their portfolio of risky assets.
● Each investor will assign a “utility”/“welfare” score to compare portfolios

○
■ U = utility value
■ A = index of investor’s risk aversion (larger A = more risk averse)
○ This function allows you to penalise the risk (variance) against the level of risk
aversion
○ As long as U > risk free rate, then you can recommend this portfolio
● Risk-neutral investors (A=0) only consider expected return. Risk is irrelevant.
● Risk-lovers (A<0) are willing to accept lower E(r) on assets with more risk
● You can estimate A through…
○ Questionnaires
○ Observe how their portfolio composition has changed over time
○ Average degrees of risk aversion from groups that the individual is in
● A security is considered risk-free with real returns guaranteed if
○ Its price is indexed
○ Maturity is equal to investor’s holding period

Mean-Variance Criterion
● One of many criteria to compare and choose a dominant portfolio
● Choose based on the trade-off between risk and return
○ Choose portfolio with the highest E(r) for a given level of risk (standard
deviation) or lowest risk for a given E(r)

● For A to be dominant,
○ At least 1 equality is strict, to rule out indifference between the portfolios

Indifference Curve
“Equal” (based on risk & reward) lie on the indifference curve
● It connects all the points with the same utility value (U) ⇒ A is kept constant

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 ●
● Conversely, more risk averse ⇒ steeper curve, requires higher risk premium to take on the
same amount risk as less risk averse peers

Allocating Assets
● Simplest way to control risk is to change the ratio of risky assets to risk-free
money market securities (assumed to be T-bills / gvmt issued bonds)
○ Let y = funds allocated to risky portfolio P. (1-y) = weight of risk-free assets
● Find the CAL line by plotting E(r) of the portfolio against s.d. of the portfolio
○ Shows you all possible combinations of risk-free & risky assets
○ Gradient = sharpe ratio = risk premium / risk (s.d.)

○
○ However, lenders will not let you borrow $ (to leverage) at the risk free rate.

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 ○
● Choose an optimal portfolio, that balances risk & return, from CAL
○ Based on level of risk averseness, plot CAL along investor’s indifference curve, find
tangent ⇒ that point gives you the optimal E(r) and std deviation
■ From there you can find y (or, you can do it the other way, where you
already have y)

○ New expected return =

○ New variance =

Passive Strategies
● Avoids any direct or indirect security analysis
○ Candidate for a passively held risky asset = diversified portfolio of stocks
● Capital market line (CML) = when you use the market index as the risky portfolio
○ CML is a special case of CAL where the risky portfolio = market portfolio
○ Slope = sharpe ratio of market portfolio
○ ** market portfolio = theoretical bundle of investments that includes every
type of asset available, where each asset is weighted in proportion to its total
presence in the market (based on market cap?)

Optimal Risky Portfolios

The investment decision is a top-down process:

● + need to consider Efficient diversification & LT vs ST investment horizons

Types of Risk
1. Systematic Risk (market risk / nondiversifiable risk)
a. Stems from market-wide risk sources
b. Remains even after diversification
2. Non-systematic Risk (firm-specific risk / diversifiable risk)
a. As n (# assets) increases, this usually decreases till it is negligible
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Returns, Risk, Correlation
To simplify the process, assume you can only invest in debt or equity.

● Expected portfolio return,

● Portfolio variance,

○ Covariance of the assets,

○ ρ DE = correlation coefficient
■ When =0, portfolio’s variance may be less than the individual s.d. of
each asset (minimum-variance portfolio  ** not to be confused with
mean-variance portfolio!)
■ When =1, no risk reduction is possible
■ When =-1, a perfect, riskless, hedge is possible. Sub ρ DE=-1 and σ

Portfolio = 0 into variance equation and rearrange to get:

The Optimal Portfolio

Next, plot CAL with the opportunity set of risky assets.
● Objective is to find the intercept that has the highest slope (sharpe ratio)

● Objective function = Max

○ You want to minimise risk  use this to find the minimum variance portfolio

After getting the optimal risky-portfolio allocation, bring in the individual investor’s risk
aversion. Find the % of your total funds to allocate to the risky portfolio, y*. The rest will be
allocated to risk-free assets

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Combining the Graphs…

Markowitz Optimisation Model

● Security selection
○ All portfolios that lie on the min-variance frontier (from the global min-var
portfolio and upwards) provide the best risk-return combinations
■ This portion of the min-var line ⇒ efficient frontier

■
○ Search for CAL with highest sharpe ratio (steepest slope) & touching the
efficient frontier
■ Individual investors chooses their own mix of risk-free and risky
portfolio P (based on their A score)
● “Separation” property of allocating capital
○ Determination of optimal risky portfolio P is purely technical while allocation of
capital to P vs to risk-free portfolio is based on the individual’s risk level
● Power of diversification

○ portfolio’s var →0 if average Cov=0. Variance of a

highly diversified portfolio depends on the Cov of its component securities.

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Risk & Diversification
● Risk pooling VS risk sharing
○ Example: health insurance risk pool = group of individuals whose medical
costs are combined to calculate premiums. Pooling risks together allows the
higher costs of the less healthy to be offset by the relatively lower costs of the
healthy, either in a plan overall or within a premium rating category.
○ Similarly, E.g. you have $1000 in one stock, then you add another $1k and
put it into another stock. Is this diversification?
■ No! Simply adding capital = risk pooling = variance of average returns
decreases with increased # of stocks but variance of the total, overall,
return becomes more uncertain.
■ For diversification, the amount of capital to be allocated is fixed.
● Time diversification =/= true diversification
○ Idea that the volatility of risky assets falls over long periods of time

Single-Index Models
● Problems with the Markowitz model
○ Requires large number of estimates to fill the covariance matrix
○ Does not provide guide you on how to estimate covariances or risk premiums
● Emerged as a simplification of Markowitz
○ You just use the covariance of each stock with the market (so only need n
number of estimates), represented by BETA
○ Specialisation of effort in security analysis

■ , beta being the sensitivity coefficient

■ M = market factor, measuring unexpected macroeconomic
happenings
■ E = firm-specific random variable
● The single-index model splits up macro and security analysis, and decreases
estimation risk brought on by the full-covariance matrix in Markowitz’s model (even
though this model is better in principle)
● Disadvantage
○ Assumption that return residuals (e) are not correlated. This assumption will
be incorrect if the index fails to acknowledge a significant risk factor.

The Model

● Regression Equation →
○ This is also the Security Characteristic Line (SCL)
■ Plot Ri(t) against RM(t) ; beta = coefficient
○ a = expected excess return when excess market return Rm(t)=0 (y-int)
○ e(t) = firm-specific surprise in the month t (residual)
● Regression statistics
○ r2 = how many % of the total risk can be explained by systematic risk
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 ■ Where total risk is represented by each point’s deviation from the line
■ When =1, all risk present is systematic, non-diversifiable risk (no
deviation, all points lie on the SCL)
○ If t-stat <2, means that beta is generally not significant, and you need to use
another model (not covered in this course)

● Relationship between beta & E(R) → a = y-int, not Rf

Finding Risk

● Total risk = systematic + firm-specific risk

● Covariance = betas * market-index risk

● Variance of equally-weighted portfolio (firm-specific risk)

○ As n → inf, this risk becomes negligible
○ Hence index models also supports/proves diversification

Estimating Beta
● Why are betas important?
○ Can use it in CAPM  find cost of equity and discount rates  helps you do
stock valuation
● Betas tend to drift to 1 over time
○ Make adjustments to predict future beta
■ E.g. Growth stocks may have high beta now but their risk may
decrease and stabilise as they grow)
● Useful variables for estimating
○ Variance of earnings/cash flow
○ Growth in EPS
○ Market capitalization (as an indicator of firm size)
○ Dividend yield
○ Debt-to-asset ratio

Portfolio Construction
● Inputs that you need:
○ Factual data: E(Rm), rf, σ m
○ n sets of estimates of: Beta, Stock residual variance (e), alpha
● Use the general formula (expected return-beta relationship & variance), and change
it to reflect the summations of weight*beta/residual/alpha
● Optimal risky portfolio, P, in the single-index model is a combination of
○ A = active portfolio
○ M = market-index, passive portfolio

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Steps (Ref: Formula List)

Active Portfolio, A, ONLY

1. Compute the initial position of each security in A
○ Assume all stocks have a>0
○ Higher a = undervalued = put more funds into it ; penalise risk
2. Scale positions so that summation of w = 1
3. Compute alpha and residual variance (e) for A
4. Compute alpha, residual variance, and beta for A
○ Summation of weight * alpha/residual variance/beta of each security
5. Compute initial position (w0A) in A
6. Adjust initial position in A

*
○ ~ When beta=1, w0A = w A

Overall Optimal Portfolio

7. Obtain weight of passive, market-index portfolio

○ You can also get weight of each security in A:

8. Calculate risk premium and variance of P

Information Ratio & Sharpe Ratio

Refer to step #4 (computing initial position in A, w0A).
● This ratio = alpha / std of diversifiable risk
○ Measures the extra return we can obtain from security analysis
○ Add this to the index portfolio’s sharpe ratio

Capital Asset Pricing Model (CAPM)

Predictions concerning equilibrium E(r) for risky assets, based on 2 assumptions:
1. Individual behaviour
a. Investors are rational (optimizes to get a mean-variance portfolio)
b. All relevant information is publicly available and used by investors as inputs
c. Investing is done on a single-period horizon
2. Market structure
a. All assets are publicly held and trade on public exchanges
b. No taxes or transaction costs
c. Investors can borrow/lend at a common risk-free rate

Simplify  All investors hold the same portfolio for risky assets (market portfolio)
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 This contains all available securities
 Proportion of each stock in this portfolio is according to market cap

CAPM’s Idea of Equilibrium

● Market risk premium is proportional to risk & risk aversion,

○
● E(Ri) is proportional to that security’s contribution to the overall portfolio risk
○ All investments should offer the same risk-reward ratio

Security Market Line (SML)

● Derived from the CML (plots E(r) against stdev)  SML plots against beta instead
● An alpha-positive stock is represented by the point which deviates positively (higher
return for the same risk/beta) from the SML.

Limitations of CAPM
 Built on unrealistic and restrictive assumptions
o E.g. CAPM combines systematic and firm-specific risk (into beta) when there
are fundamental distinctions between them
 Difficult to test CAPM
o Alpha, beta and residual variance are time-varying
o Impossible to pin down the market portfolio as you cannot observe all
tradeable assets

Extensions to Mitigate Limitations

1. Identical inputs → in the absence of private information, alpha values should be 0
2. Zero-beta model
a. Helps to explain positive alphas on low beta stocks and vice versa
3. Labour income & other non-traded assets
a. E.g. Private businesses, human capital
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 4. Multiperiod model
5. Consumption-based CAPM
a. Investors allocate wealth between todays and future consumption
6. Liquidity (ease & speed which the asset in question can be sold at a fair value)
a. There are transaction costs that inhibit trades
b. Illiquidity can be partly measured by the discount from fair value the asset has
to be sold at, to be sold quickly
c. During financial crises, liquidity can dry up quickly  liquidity in stocks tend to
drop when that in 1 stock drops (all fall together)  hence, investors demand
for more compensation (higher return) for liquidity risks
i. Concept of “liquidity betas”

APT & Multifactor Models

Multifactor Models
Single-Factor Model

 , F = deviation of the common factor from its expected

value, e = non-systematic risk components
 Problem  there may be other sources of risk (e.g. inflation, i/r, volatility)
Multifactor Models
 Considers several systemic and firm-specific risk factors

o Example:
 Takes into account sensitivity to GDP and interest rates

Arbitrage
 Such opportunities exist when we can earn riskless profits without making a net
investment (e.g. a stock sells for different prices on 2 exchanges)
 Capital market theory basis = well-functioning security markets rule out arbitrage
opportunities. But, theory =/= real life.
 Generalisation of SML from CAPM to get more insights to the risk-return relationship
o  Arbitrage pricing theory (APT), based on 3 assumptions
 Security returns can be described by a factor model
 There are enough securities to eliminate non-systematic risk
 Well-functioning security markets do not allow for persisting arbitrage
opportunities
 Law of one price for arbitrage opportunities
o if arbitragers see that there is mispricing, they will engage in arbitrage activity
 demand and supply factors  until the mispricing is eliminated

Example Opportunity

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APT and CAPM
 APT is less restrictive and less idealistic
Built on the foundation of well-diversified Built based on the “market portfolio”
portfolios  Which is inherently unobservable
 An observable market index is used
Cannot assume that the expected return- Provides an unequivocal statement on the
beta relationship will not be violated expected return-beta relationship
 Higher beta MUST = higher returns
Does not assume that investors are mean-
variance optimisers

A Multifactor APT
 Benchmark portfolios in the APT are factor portfolios (specific to 1 of F only)
o B = 1 for one factor and 0 for any other factors
o Factor portfolios track a particular source of macroeconomic risk and not
correlated with other sources of risk (“tracking portfolio)”

Fama-French 3-Factor Model


 SMB = small minus big
o E(r) for portfolio with small stocks – E(r) for portfolio of large stocks
 HML = high minus low
o E(r) of portfolio with high book-to-market ratio – that of low book-2-mkt ratio
o Book value doesn’t usually change; what changes is the market value 
higher ratio indicates some market distress (mkt value goes down)
 Those that stick it out are rewarded if the company overcomes the
market challenges (these value stocks historically give more returns
than growth stocks which have low book-to-market ratios)

Testing CAPM
 Arguments against CAPM

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 o Risk-return relationship could entail multiple sources of systematic risk
o Non-risk-related considerations could lead to variations in E(r) too
o Behavioural finance issues leading to security mispricing
 Estimating the SCL to test for expected return-beta relationship
o First pass regression gives you the index model’s time series equation
o Second pass regression = plot the portfolio returns against the beta obtained
from first pass regression (the initial slope)
 This new slope measures the reward for bearing systematic risk
during that time period
 Expected results / Hypotheses for 2nd pass regression: y-int = 0 (@
B=0, you earn risk free rate  excess returns = 0) & slope = <excess
return> on index portfolio (market return over risk free rate)
 Limitations with the approach used for testing
o Stock returns are very volatile  diminished precision of average return data
o Approach not aligned with CAPM’s assumptions
 Market index used is not the “market portfolio” + Investors cannot
borrow @ risk free rate
 Betas from the 1st pass regression are estimated with sampling error
 Implications  slope coefficient of 2nd pass regression will be
biased downwards while intercept is biased upwards
 Results of testing
o Inconsistent with CAPM (slope of SML is too flat, y-int is too large)
 Could be because of the sampling error when determining beta
o Roll’s Critique (in defence of CAPM)
 Approach is not accurate to the CAPM’s assumptions  using market
proxies like S&P500 will not suffice
 All other implications of CAPM are not independently testable
 Hence, the 2nd pass regression may be meaningless
 Solution to the measurement error in beta
o Construct portfolio with a large dispersion of beta (Fama and MacBeth, 1973)
 This verified the CAPM
 Relationship between average excess returns and beta is truly
linear
 Non-systematic risk does not explain average excess returns
(thus it is not included in the CAPM)

Factors in Multifactor Models

 Types of factors that affect the market risk factor (beta)
o Factors hedging consumption against uncertainty in prices (e.g. housing,
energy)
o Factors hedging future investment opportunities (e.g. i/r, mkt volatility)
o Factors hedging assets missing from the market index (e.g. labour income,
private businesses) – omitted asset categories
 Omitted asset categories

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 o Many assets are not traded  most notably, human capital
o Value of proprietary businesses  households with more investments in
private businesses reduce their fraction of total wealth in equity
 Momentum as a 4th factor to FF model
o WML = Winners minus losers (winners/losers based on past returns)
 Liquidity & Asset Pricing
o Liquidity involves: trading costs, ease of sale, price concessions to make a
quick transaction, market depth, price predictability
o Study shows that price changes can be explained by traders who make
concessions to complete the trade quickly
 Liquidity is a priced factor!!!

Equity Premium Puzzle

 Systematic consumption risk is very low. But historical market risk premiums are so
high?!?! Only justifiable if we assume implausibly high levels of risk aversion.
o Recent research uses consumption-tracking portfolios  improved estimation
 Cross section of stock returns (2nd pass regression)
o Plot excess returns against consumption betas
o Capital gains significantly exceed dividend growth rate in modern times. Thus,
equity premium may be due to unanticipated capital gains.
 Survivorship bias
o We only estimate risk premiums based on stable markets (countries) like the
US, which has highest average returns
 Ignoring stock markets that did not survive for that full sample period
o High realised equity premium may not be indicative of required returns
 Liquidity as an explanation to the puzzle!!!
o Part of the average excess return is almost certainly compensation for
liquidity risk (rather than just the systematic volatility of returns)
 Behavioural explanations to the puzzle
o Premium results from irrational investor behaviour
 Loss aversion
 Narrow framing  investors evaluate each risk in isolation

Efficient Market Hypothesis (EMH)

 Security prices fully reflect available information
o All stocks in the market has been priced correctly  then you should just buy
the market index since extra security analysis gives you no reward
 Investors should expect to obtain an equilibrium rate of return
o You should only make normal returns (alpha = 0)
 Selection bias issue
o Good investment strategies are kept private  lack of information
 Lucky event issue
o For every big winner, there are big losers (but we never hear from them)
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There was no predictable pattern found in stock prices  prices follow a random walk. So
how can we explain random price changes?
 Competition for information as the source of efficiency
o Higher returns motivates information gathering
o Small marginal returns on research activity  only large portfolio managers
will find it useful pursing
o Investors competing to discover relevant information on whether to buy/sell
stocks before the rest of the market becomes aware of the information

Technical Analysis
 Identify mispriced securities by focusing on recurrent and predictable stock price
patterns + proxies for buy-sell pressure in the market
 EMH implies that technical analysis should be fruitless because the past cannot
predict the randomness of the future (random walk)
o But you may be successful if there is sluggish response of prices to
fundamental supply-demand factors (you respond faster than other investors)

Fundamental Analysis (for semi-strong form)

 Assess firms’ value based on earnings, dividend prospects, risks, cash flow, future
interest rates  Seeks to find mispriced securities
 Big market cap stocks are well covered by analysts  adjustments to the price are
efficient as there will be more information on them
o Neglected funds (usually small mkt cap stocks) are less efficient  possible
arbitrage opportunities
 EMH predicts that most fundamental analysis will fail since prices will reflect all
information quickly

Resource Allocation
 Inefficient markets result in systemic misallocation of resources
o Overvalued firms can raise capital very cheaply (investors are flocking to it)
o Undervalued firms may pass up profitable projects since cost of capital is high

Relevant Example

21
Versions of the EMH
 Differences in the forms = what information is/isn’t useful
 Prices should reflect available information in all versions!!!
o Weak form == stock prices already reflect all currently available data
 Technical analysis CMI because history will not repeat itself
o Semi-strong form == prices already reflect all publicly available information
 Prices will quickly adjust based on new information (e.g. news, analyst
reports)
 Fundamental analysis CMI because prices adjust very quickly
o Strong form == prices reflect all relevant information, including insider
(private) information
 No investors can beat the market on a risk-adjusted basis consistently
(for the same amount of risk, they cannot get higher returns)
 Illegal. All insiders must register their trading activity

Portfolio Management
Active Portfolio Management
 Expensive strategy
 Suitable for large portfolios
Passive Portfolio Management
 E.g. Index funds, ETFs
 Accepts EMH, no attempt to outsmart the
market
 Low cost strategy

Relevance of portfolio management in efficient markets:

1. Diversification
2. Tax considerations
3. For investors of different risk profiles

Event Studies
 Measures the impact of an event on stock returns
o Abnormal return caused by the event = actual return – proxy for return if the
event did not occur

Tests for EMH Versions

Weak-form tests
 Returns over short horizons follow that of past periods  momentum effect
o This means that past data can be used to predict future returns for that short
time period  EMH anomaly
 But over long horizons, performance tends to reverse  reversal effect
Semi-strong-form tests
 Use predictors of broad market returns, for example:
o High dividend yields  higher return on the overall stock market
o Earnings yield
o Bond spreads
22
  SMB factor in the FF model holds (smaller firm = higher returns)
 HML factor in the FF model kind of holds

 Efficient market anomalies…

o Post-earnings-announcement price drift
 Found that response to such announcements is sluggish  market
appears to adjust gradually  sustained periods of abnormal returns
o P/E effect  low P/E ratio stocks provided higher returns
o Neglected firm effect  less well-known stocks gave abnormal returns
o Liquidity effect  illiquid stocks have strong tendency to exhibit abnormally
high returns

Interpreting Anomalies
 Do the anomalies mean markets are inefficient? (Do they negate EMH?)
 Anomalies over time…
o Should be eliminated in well-functioning markets
o Liquidity & low trading costs facilitate efficient price discovery
 Bubbles and market efficiency
o Rapid increase in prices  expectation that price will continue to rise 
increase will stop eventually and the bubble ends in a crash
 Investigating performance of mutual funds
o Professionally managed portfolios don’t seem to be beating the market
consistently
 Conventional performance benchmark today is a 4-factor model (3 FF
factors + momentum factor)
o Performance persists over short horizons but usually reverse in future periods
o Skilled managers will attract new funds until the costs of managing those
extra funds drive alphas down to 0 (suggests an equilibrium?)
 Enough anomalies exist to justify the search for mispriced securities
o But the market is competitive enough that you can only win if your information
is superior enough

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Behavioural Finance (BF)
 EMH says that security prices already reflect available information  prices will
reach equilibrium since prices are informationally efficient
o But BF assumes that investors are not rational  security prices will thus not
be efficient after all
o Arbitrageurs are limited (time and cost intensive to continuously look for
mispricing)  not enough to force prices to match intrinsic value / reach eqm

Investor Irrationalities
1. Information Processing
o Investors make wrong predictions about the probability distribution of
security returns…
 Limited information processing and attention span + under/over-
reaction to changes in the market
 We are overly confident in the precision of our forecasts + our abilities
to make good investment decisions
o Extrapolation and patten recognition
 Representative heuristic bias (under uncertainty, we think that market
events are more correlated than they actually are – i.e. the past
represents the future well, when it actually doesn’t)
 We are overly prone to thinking these patterns are likely to persist
2. Behavioural biases
o Even when given a probability distribution of returns, humans may make
suboptimal or inconsistent decisions…
o Mental accounting
 People separate decisions and compartmentalise their portfolios
 E.g. xx money is meant for children  should be invested in
something that has low risk. But for optimal portfolios, we have to pool
our funds and not separate them!
o Differences in framing
 Decisions are affected by how choices are described
 E.g. Potential gains from low original value VS potential losses from a
high original value (but the original value is the same!)
o Regret avoidance
 Investors have more regrets over a decision that turned out badly if
that decision was an unconventional one
o Prospect theory
 Loss aversion (people are more sensitive to losses than gains)
 Utility depends on changes in wealth from current levels, and not
actual wealth levels

Behavioural biases would not matter if rational arbitrageurs could fully exploit the
mistakes of irrational investors…

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Limits to Arbitrage
(in mitigating behavioural biases)
 Fundamental risk of solvency / losses if you make a wrong move
o Violation of Law of One Price  Royal Dutch / Shell  arbitrage
opportunities persisted for over 40 years despite lack of restrictions on
arbitrage activities
 Implementation costs
o Transaction costs + restrictions on short selling
o Violation of Law of One Price  Equity carve out, 3Com sold part of its
shares in Palm  blatant mispricing but, because most of Palm’s shares
were held by retail investors, arbitrageurs could not borrow the shares to
short
 Model risk
o What if your model is bad and the intrinsic value is already reflected in prices?
 Violation of Law of One Price
o Closed-end funds (investment funds whose shares are traded on markets) 
the fund then takes this money raised to invest in whatever
 Different from when you buy a fund’s products of ETF  that pricing is
based on the underlying assets’ value (NAV)
o These funds can sell at premium or discount to NAV of the assets they end
up investing in
 But may also be explained by rational return expectations and the
additional costs charged by these closed-end funds

Technical Analysis & BH

 Disposition effect (loss aversion / prospect theory)
o Result: Average winning trade < average losing trade
o Demand for shares depends on historical prices
o Can lead to momentum in stock prices
 Trends and corrections
o Bullish signal = shift from a falling to a rising trend
 Relative strength
o Ratio = security’s price : price index of market / industry
 Measure of extent to which a security has under/over performed the
market or its industry
o Ratio = industry’s price index : market price index
 Measure of industry’s strength to that of the market
 Breadth
o Extent to which movement in the market index is reflected the price
movements of all its constituent stocks
o Most common measure = spread between # stocks that rise & fall in price
 # stocks advanced - # declined
 # stocks advanced / # declined
 Sentiment indicators
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 o Trin statistic = (Number refers to # of
stocks, Volume refers to # of individual shares from the relevant stocks)
 Trin > 1 indicates bearish market
 Note! Rising volume in a rising market =/= more buyers than sellers
o Confidence index
 <yield of 10 top-rated corporate bonds> / <yield on 10 mid-rated>
 Ratio will always be <1 (bc top rated = more credit worthy, so
investors allow lower yields), but higher values are bullish signals
o Short interest
 Total # of shares of a particular stock currently sold short
 Higher interest reflects negative sentiment about the firm’s prospects
o Put/call ratio
 Outstanding put options : outstanding call options
 Higher ratio = more put options = more people want to sell = negative
sentiment in the market

Smart Beta Investing

 Goal = obtain alpha / lower risk / increasing diversification
o Should be achieved at costs lower than active management & just a bit higher
than pure index (passive) investing
 Benefits
o Combines the benefits of passive & active investing
o Combination of EMH and value-investing
 How it works
o Constructs an index based on alternative rules, differing from the traditional
market-cap weighted indices
 SB strategies track indices but also consider these weighting factors:
volatility, liquidity, size, value, quality, momentum, etc
o Smart beta funds focus on areas where there are exploitation opportunities
 Can get risk-adjusted returns!

Investment Funds
Investment companies pool funds from individual investors together and invests in securities
or other assets. Investors choose this instead of actively managing their own portfolios as:
 Record keeping & admin work
 Diversification and divisibility
 Professional management
 Lower transaction costs (more $ = split txn costs amongst investors)

26
Net Asset Value (NAV)
NAV of these companies  they need to divide claims (to the assets they have invested in)

among these investors 

Types of Investment Companies

 Unit investment funds
o Pool of money is invested in a portfolio that is fixed for the life of the fund
o Portfolio is unbalanced/unmanaged. Dividends are used to pay for expenses
first, and the remaining is distributed to shareholders.
o Cannot take $ out, only can sell shares in the secondary market
 Managed investment companies
o Closed-end funds
 Like UITs, doesn’t redeem or issue shares after the initial IPO (you
can only sell your shares to other investors). But unlike UITs, the
portfolio changes regularly.
 Priced at a premium or discount to NAV
o Open-end funds (priced at NAV)
 They can redeem or issue shares at the NAV at any time
 Mutual funds (common name for open end funds)
 Buy side  invests in securities on behalf of clients
 As opposed to sell side (brokerages for buying and selling
securities, IBs for IPOs and listings)
 Commingled funds
o Partnerships of medium net-worth investors pool funds to set up family offices
 REITs (invest in income generating real estate)
 Hedge funds
o Only for high net worth, accredited individuals (private investors)
o Mutual funds’ investment prospectus must be approved by the country’s
central bank before the fund can be marketed to the public
 HF’s don’t need approval as they are selling to private investors

Mutual Funds
 Types of investment policies
o Money market (commercial paper, CDs, repurchase agreements…)
o Equity (stocks primarily)
o Bonds (fixed income sector)
o Hybrid/balanced (debt & equity in stable proportions)
o Sector (focus on certain theme, sector, countries)
o Region scope (regional market, emerging market, global…)
o Asset allocation & flexible funds (stocks and bonds, engaged in market
timings  higher risk)
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 o Index (tries to match the performance of a market index)
 How are funds sold?
o Directly  fund underwriter
o Indirectly  brokers acting on behalf of the fund (they receive commission)
 Potential conflict of interest...? Multiple funds to be sold...?
o By financial supermarkets like morningstar

Mutual Funds: Fees

1. Operating expenses
2. Front-end load == $ paid to marketing agent, is not invested in the fund
3. Back-end load == penalty for withdrawing funds before a stipulated time
4. 12 b-1 charges (this is on top of management fees)
5. Turnover fee (for countries that charge tax on capital returns, like USA)
a. “Pass-through” status (USA tax code)  tax paid by investors, not the fund
itself  but investors do not control when trades are made (funds do that…)
b. High turnover = more trades made = more tax charged to fund = pay more fees

Example:

Mutual Funds: Information

 Prospectus  states the investment objectives, people managing the fund, fees and
costs
 Statement of additional information (SAI)
 Annual report
 MorningStar, ICI, Yahoo Finance…

Exchange Traded Funds (ETFs)

 Most ETFs are passive investments, pegged to a specific market index
 Advantages
o Trades continuously like stocks  Can be sold short or purchased on margin
o Cheaper than mutual funds
o More tax efficient  the ETF manager accommodates inflows and outflows
using “creation units”  investor is not exposed to as much capital gains on
underlying assets in the portfolio
 Disadvantages
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 o Prices can depart from NAV (prices depend on demand & supply factors)
o Must be purchased from a broker for a fee

Hedge Funds
 Prospectus has limited disclosure of investment strategy and portfolio composition
 Strategies are more flexible  funds can act opportunistically
o Greater use of shorting, leverage & options
 Investors’ POV: funds are less liquid
o Often impose lock-up periods or require advance redemption notices
 Compensation structure includes incentive fee for managers who meet high targets

Hedge Funds: Style / Strategies

** Market-neutral  strat is designed to profit regardless of whether that market is expected
to rise or fall in the future.

 Directional strategy
o Bets that certain sectors will outperform other sectors
 Non-directional (market neutral)
o Focus is on exploiting temporary misalignments in relative pricing
o Usually involves longing 1 security and shorting another related security
 Fund of funds / feeder funds
o Fund allocates its cash to several other hedge funds to be managed
o Invest in other funds instead of directly in securities
 Dedicated short bias
o Net short position (usually in equities) as opposed to pure short exposure
o Exhibit substantial negative betas on the market index
 Event driven
o Attempts to profit from situations like M&A, bankruptcy, restructuring, etc
 Equity market-neutral funds
o Usually uses long/short hedges & leverage. Controls for industry, sector, size
and other exposures, while establishing market-neutral exposure.
o Uniformly low and statistically insignificant factor betas
 Distressed-firm
o Has significant exposure to credit conditions as well as the market index
 Fixed-income arbitrage
o Tries to profit from mispricing in i/r-related securities (to limit i/r risk). E.g.
Interest rate swap arbitrages, mortgage backed arbitrage…
o Shows positive exposure to differential return on corporate vs treasury bonds
 Global macro
o Involves long & short positions in global capital / derivative markets. Portfolio
represents views on broad market conditions & major economic trends!
 Statistical arbitrage

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 o Use of quantitative systems to identify misalignments in relative pricing &
ensure profits by diversifying across all these small bets
 Pairs-trading (stocks are paired based on underlying similarities, then
long/short positions are established for each pair)
 Data mining (sort through historical data to find patterns)

Statistical arbitrage is facilitated by rapid-trading technology, while other strategies are

dependent on high frequency trading.
 Electronic news feeds, electronic market making (the fund quotes both a buy and sell
price, hoping to make profits on the bid-ask spread)

Portable Alpha
Invest in positive alpha positions  hedge systematic risk of that investment  establish
market exposure where you want it by using passive indexes.
 Also called alpha transfer (you transfer the alpha from the sector you found it to the
asset class where you establish exposure)
 Decreases risk by separating the riskier alpha portions from the stable market beta
investments  allows investors to consistently outperform a market index

Use derivatives / futures to establish market exposure but using much less capital.
 Reduces the costs of funds, then allocate the freed-up capital to the alpha portion (to
generate excess returns)
 Combined, you get beta returns (from market exposure) + alpha

Performance Measurement
 Hedge funds generally outperformed passive indices in the past
o 2013-2018: average alpha and shape ratio across indices was slightly
negative (indicating returns < risk-free rate)
 However, several factors make their performance difficult to evaluate…
o Hedge funds tend to hold more illiquid assets than other institutional investors
 Alphas exhibited by hedge funds may be inclusive of liquidity premium
(which is negative since their assets are illiquid)
o Hedge fund returns tend to exhibit significant serial correlation despite EMH!
o Backfill bias
 Funds can choose to disclose performance  only those that do well
will disclose  performance of funds included in the sample may not
be representative of typical performance
o Survivorship bias
 Unsuccessful firms need to close shop and their performance is thus
not recorded  only the successful funds are left behind
o Changing factor loadings
 Funds can change their risk profiles
 If risk is not constant, estimated alphas will be biased
 If risk changes together with E(rm), evaluation will be tougher
 Tail events (extreme but rare losses)
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 o Probability of this happening falls into the far-left tail of the distribution

Fee Structure
 Annual management fee (1-2% of assets under management)
 Incentive fee (20% of profits beyond a stipulated benchmark performance)
o Call option  they don’t lose anything if NAV falls

 High water mark  previous portfolio NAV that must be reattained before the fund
can charge incentive fees
 Take note of the various incentive fees for fund of funds

Bond Portfolios
 Debt (fixed income) security  fixed / predetermined (by formula) stream of income
 Characteristics
o Par (face) value  payment @ maturity date
o Coupon rate  interest payments (as a % of par value)
o Bond indenture  contract between issuer and bondholder
o Maturity (T-notes = 1-10 years, T-bonds = 10-30 years)

Corporate Bonds
 Callable (company can redeem the bond within the stipulated time period)
 Convertible (can exchange bond for shares)
 Put bond (option to exchange for par value at XX date / extend for XX years)
 Floating-rate bond (i/r is reset periodically according to a specified market rate)

Preferred Stock
 Considered equity, but often included as a fixed income asset since it promises to
pay a specified cash flow stream
o But failure to pay PMT does not result in bankruptcy of the issuer (dividends
just accumulate and you get it at a later date)

International Bonds
 Foreign bonds
o Issued by a foreign, non-domestic entity

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 o Denominated in the currency that the bond is selling in
o Samurai bonds (yen denominated bonds issued in Tokyo by a non-Jap
issuer), Dimsum bonds (issued in HK by Chinese companies)
 Eurobonds
o Usually denominated in the issuer’s currency ; sold in other national markets
o Euroyen bonds (jap bonds issued in London), Eurodollar bonds (US issuers
selling bonds to other countries, usually London)
o Not regulated by US federal agencies

Other Bonds
 Inverse floaters ~= floating rate bonds, but coupon rate falls when i/r rises
 Asset-backed bonds (e.g. Mortgage-backed)
o Uses income from a certain group of assets to service the debt
 Catastrophe bonds (final payment depends on if there has been a catastrophe)
 Indexed bonds (e.g. Treasury Inflation Protected Securities, TIPS)
o Payments are tied to a general price index or commodity price
o FV must be adjusted to consider the inflation rate  from there, find the PMT


Bond Pricing

o R = yield to maturity (YTM) = average return if bond is held to maturity)

 First term = PV of annuity (the recurring coupon payments)
 Second term = PV of single payment, par value
 Main source of risk in FI market = INTEREST RATES
o Longer maturity = bond price is more vulnerable to changes in i/r

Bond Yields
 Current yield & bond prices  Inverse relationships
 (Current) Yield vs Yield to Maturity (YTM) vs Coupon Rates
o Yield = PMT (i.e., annual coupon payment) / Price

32
 o NOT = to YTM (bond’s internal rate of return, proxy for average return)
 Premium bonds: Coupon rate > current yield > YTM
 Discount bonds: Coupon rate < current yield < YTM
 Realised Compound Return (RCR) vs YTM
o YTM = RCR if all coupon payments are reinvested until maturity
o Horizon analysis = forecasting the RCR over various periods
 YTM vs Holding Period Return (HPR)
o YTM can be calculated using the formula (all inputs are obtainable)
o HPR = rate of return over a particular investment period
 depends on the bond’s price at the end of the holding period you are
looking at (which can only be forecasted)
 Callable bonds & Interest rates
o Low market i/r  bond gives higher returns, not worth for them  more likely
to call back the bonds (they would rather call back than reduce prices)
o High i/r  risk of call is negligible (they will reduce their bond prices)

Credit/Default Risk
 Risk that the bond will not make all its promised payments
 Rating agencies – Moody’s, S&P, Fitch
o Investment grade bonds are rated above BBB/Baa
o ^ The rest are speculative grade bonds / junk bonds
 Factors affecting credit risk (bond safety)
o Coverage ratios (can assets cover liabilities?)
o Leverage ratios (e.g. D/E ratio)
o Liquidity ratios (how fast can they sell their assets to repay debts?)
o Profitability ratios
o Cash flow to debt ratio

33
 
 Discriminant analysis
o Using financial ratios to predict bankruptcy  firm is assigned a score based
on financials  if score exceeds a threshold value, they are credit worthy
 Altman Z-Score

o
 Types of bond indentures (agreements between issuer and bondholder)
o Sinking fund
 Issuer must have some money set aside to pay off the bond  they
will periodically repurchase some outstanding bonds prior to maturity
o Subordination clauses
 To restrict the amount of additional borrowing by the issuer
o Dividend restrictions
o Collateral (bondholders get this is if the firm defaults)
 YTM and default risk
o Promised YTM =/= expected YTM
o Promised YTM can only be realised if the issuer meets all payment
obligations // Expected YTM must consider possibility of default
o Default premium
 Compensates investor for purchasing a bond that has default risk

Credit Default Swaps (CDS)

 Allows lenders to buy protection against default risk
o You buy a bond. Then you buy CDS from another investor  he agrees to
reimburse you if the issuer of the bond defaults.
 Applicable for both corporate and sovereign debt
 Risk structure of i/r and CDS prices should be tightly aligned

Collateralised Debt Obligations (CDOs)

 To create a CDO, establish a legal entity to buy/resell a portfolio of bonds
o Structured Investment Vehicles (SIV)
 Loans and other assets are pooled and split into tranches  each tranche is given a
level of seniority re: its claim to the underlying asset pool
o Based on the level of credit risk assumed by the investor

34
 o
o If the bond defaults, the senior tranche gets paid first, etc etc

Managing Bond Portfolios

Interest Rate Sensitivity

 Bond prices and yields are inversely related
o Prices are more sensitive to changes in yield than YTM
 Prices of bonds with higher duration are more sensitive to changes in i/r than those
that mature quicker
o i/r risk is less than proportional to bond maturity
 I/r risk and coupon rate are inversely related

Duration
 Measure of the average maturity of a bond’s promised CF

o Macaulay’s duration
 t = # periods to maturity @ time t
 For zero coupon bonds, duration = maturity. Else, duration < maturity.
o Because some amount of the coupon payments is paid before maturity
o Holding maturity constant, higher coupon rate = duration deviates more
from actual maturity (higher % of payments paid before maturity)
 Duration as a measure of interest rate sensitivity
o Changes in prices are proportional to duration

o Modified duration, D* given changes in i/r and prices

 Duration for a level perpetuity (PMT never changes, payments are made forever)

35
 o where y = (effective) interest rates ; not necessarily yield


o With other factors constant, D rises when YTM is lower
o For constant coupon rate, D increases with time to maturity

Convexity
Relationship between bond prices & yields is not linear  duration is only a good approx. for
small changes in bond yields.
 Bonds with higher convexity exhibit higher curvature in the price-yield graph
 C = rate of change of slope of the price-yield curve (as a fraction of the bond price)


o Higher convexity: for increases in YTM, prices don’t fall too drastically // but if
YTM drops, prices increase more than linearly
o When i/r (and thus YTM) is more volatile, convexity is even more attractive
 Must pay a premium / accept lower YTM for bonds with higher convexity

Callable Bonds
 As YTM falls  price goes up UNTIL the ceiling (call price of callable bonds)
o The bond has to go through “price compression”

36
  (not in formula sheet)
o ED of 8 years means that bond price changes by 8% for a 1%-point change in
interest rates (baseline = current yield)

 Negative convexity shows

price compression

Duration & Convexity

Mortgage-backed Securities (MBS)
 Portfolio of callable amortising loans
o Homeowners can repay their loans at any time
o But the call price is not a firm ceiling on the bond’s value (homeowners do not
refinance when i/r drops  they don’t get new loans with lower i/r
 MBS have negative convexity
o Because their yield is usually higher than traditional bonds, so people are
willing to take on the increased i/r risk (due to the bad convexity) in order to
get the higher yield

Collateralised Mortgage Obligation (CMO)

 Same as CDO, but for MBS  creates tranches that allocates i/r risk to investors of
different risk profiles
o Different tranches may receive different coupon rates, or may be given
preferential treatment over who gets the payments first

Passive Bond Management

 Assume prices are fairly set  only seek to control risk

Indexing Strategy (Bond-Index Funds)

 Akin to stock market indexing
o Create a portfolio that mirrors an index measuring the broad market
 Challenges in construction
o Difficult to purchase each security in the index in proportion to market cap
37
 o Many bonds are very thinly traded (trade in low volumes)
o Difficult to rebalance
 Cellular approach (stratified sampling bond indexing)

Immunisation
 To shield overall financial status from interest rate risk
o Widely used by pension funds, insurers and banks (LT investors – LT bonds’
prices are more vulnerable to changes in i/r)
 Duration-matched assets & liabilities allow the portfolio to meet the firm’s obligations
despite interest rate movements
o They buy (assets) and sell (liabilities) FI securities @ the same time
o Balances re-investment rate risk & price risk
o Rebalancing is required to realign portfolio duration with duration of obligation
 CF matching
o A form of immunisation  match CF from assets with that of the obligation
 Imposes many constraints on the bond selection process (for assets)
o Matching on a multiperiod basis = dedication strategy
 Select EITHER 0-coupon bond OR coupon bonds with total CF in
each period matching with series of your obligations
 Do all the matching at one shot
 Portfolio construction
o Calculate duration of liability & asset portfolio separately
o Equate: duration of liability = duration of weighted asset portfolio to find
weights in each security in the asset portfolio
 Portfolio rebalancing
o See if obligation is still fully covered @ that point in time
 Examine PV of obligation vs the funds you have now from the assets
o Change portfolio weights
 Redo steps in portfolio construction to equate new durations!

Active Bond Management

 Sources of potential profit
o Substitution swap – swap bond for a better priced one with similar attributes

38
 o Intermarket spread swap – switch from 1 segment of bond market to another
(e.g. corporate to treasury)
o Rate anticipation swap – switch bonds of different duration (because you are
expecting i/r to change)
o Pure yield pick-up swap – move to higher yield, LT bonds to capture liquidity
premium (increases i/r risk…!)
o Tax swap – exchange 2 similar bonds to capture some tax benefit
 Sell a depreciated bond (take a loss) close to tax-year end  use loss
to offset capital gains
 Horizon analysis
o Forecast realised compound yield (RCY) over various holding periods
 Select some holding periods, predict yield curve @ end of each period
 Given the bonds’ time to maturity @ end of each period  get yield
from the predicted curve  calculate price @ end of the period
 You can then calculate your (annualised) rate of return from now till
the end of your investment horizon

Portfolio Evaluation
 Average returns as a means to evaluate portfolio performance
o Time-weighted average (geometric average)
 Each period’s returns are weighted equally
o Dollar-weighted returns (DCF approach)
 Internal rate of return of the investment (weighted by cash flow)
 Returns should be adjusted for risk
o Compare rates of return with other funds that have similar risk characteristics
 E.g. Managers who use similar investment styles
o Sharpe Ratio (reward to total risk)
 Use when choosing among portfolios to be the risky portfolio (when
you’re not v well diversified, so total risk Is still relevant)
o Treynor’s Ratio (reward to systematic risk)  use beta instead of stdev
 Use when ranking portfolios to be mixed to form overall risky portfolio

o Jenson’s Alpha
 Excess returns, using CAPM expected return (2nd term of the eqn)
o Information Ratio
 Abnormal return per unit risk that could be diversified away by holding
a market index portfolio

  uses non-systematic risk (“tracking error”)

 Use when deciding if a portfolio is to be mixed with the index portfolio
o M2 Measure
 Uses total volatility to measure risk, but adjusts risks such that it is
easy to compare relative to benchmark index
 Make the portfolio risk same as market risk, then compare returns

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   P* = adjusted portfolio P (add t-bills to it to
make the risk = market risk)
o T2 Measure
 Similar to M2 measure but uses systematic risk (beta) instead of stdev
 Make portfolio beta = 1 by adding t-bills, then compare returns
 Alpha & Performance
o You can only beat the passive market index if alpha is positive. But positive
alpha does not guarantee that the portfolio will outperform the index.
o Realised Returns vs Expected Returns
 Regress Rp against Rm (graph = SCL) to estimate alpha (y-int)
 Compute t-stat of this alpha estimate to see its level of significance
and thus whether it can reliably indicate portfolio management ability
 Survivorship bias
o Limited sample of funds to compare performance  not representative
 Style analysis
o To measure the exposures of managed portfolios
o Regress fund returns on indexes representing a range of asset classes
(money market, equity, FI, REIT, etc)  do regression for each index
 Regression coefficient (R)  measures the fund’s allocation to that
style (higher r = more correlated = they are using this style)
 R2  % of deviation in returns attributable to style choice rather than
security selection
 Intercept  <return> from security selection of the portfolio
 Changing portfolio compositions
o Risk-adjustment tools assume same risk over the whole investment period
o Performance manipulation & MRAR
 Managers’ compensation depends on performance  they can try to
manipulate the numbers
 Use MRAR (morningstar risk-adjusted return)  makes it impossible
to manipulate returns
 Y = investors’ risk aversity
 Market timing
o Involves shifting funds between market-index portfolio and a safe asset
o Perfect market foresight = holding a call option on the equity portfolio (without
having to pay for it)

Performance Attribution Procedures

 Attribution studies decompose overall performance into different parts of the portfolio
selection process contributes to the performance
o Commonly used 3 components
 Broad asset allocation (choose between FI, equity, money markets)
 Industry (sector) choice within each asset market
 Security selection within each industry

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  Bogey
o Returns the portfolio would have if the strategy used was completely passive
o Passive meaning
 Allocation of funds across broad asset classes follows the “usual”
allocation across sectors (not sure what this means lmao)
 Within each asset class, the manager holds an indexed portfolio
o How to beat the bogey?
 Put more funds into markets that turn out performing well
 Put less into markets that do poorly

Using Derivatives to Hedge Risk

Managing Risks
We cannot possibly manage all risks (time + monetary effort)  need to identify material
risks to the company and hedge against that.
Financial Risks Non-Financial Risks
Market risk (represents systematic risks  linked to Political / Sovereign risk (risk of
DD/SS factors) doing business / investing in
 Equity price risk (systematic risk of the countries with poor ratings)
world economy)
 I/r risk Regulatory risk
 Exchange rate risk (free-floating currencies)
 Commodity price risk
Liquidity risk (may require large discounts in price Operational Risk (company’s
in order to sell that asset) systems/procedures fail due to
external events, e.g. human error)
Credit risk (risk of non-payment) Model risk (bad estimates, etc)
Accounting or Tax risk
Counterparty risk

 Qualitative Risk Assessment

o Identify risks material to the business by asking questions
 How much debt? Sources of revenue and drivers? Main value
proposition & competitive advantage of the company? Which countries
does the company operate or invest in? …
 Quantitative Risk Assessment
o Financial risk modelling to measure net exposure to various risk factors
o Decide whether to hedge or not (is it very material? Risk appetite of
company?)
 Analyse the risk profile of the company
o Risk monitoring
 After hedging, we still need to monitor risk exposures  adjust if
needed
 Strategies
o Speculators  seek to profit from price movement

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  Long = you think prices will rise
o Hedgers  seek protection from price movement
 Long hedge = protect from price increase & vice versa

Futures
An agreement to sell / buy an asset @ XX time (in the future) for XX price (futures price).
 Standardised contract (specifies quantity & quality of underlying asset + how it will be
delivered) sold on public exchanges
o Physical delivery / Cash settlement (counterparties net out cash difference in
the value of their positions)
 Contracts are marked to market daily (gains/losses are realised each day)
 Have margin requirements
o Need to deposit an initial margin to ensure that the contract will be met
 Initial margin = 110% * maintenance margin
o Must maintain a maintenance margin once a futures position is taken
 Investors will receive a margin call from the manager if the margin
account falls below this  need to top up to initial margin level
 Brokers can close your position if you don’t top up 
permanent loss on your position
 Futures contract is a zero-sum game between counterparties (one wins one loses)
o And you can close the position before maturity!
o Long position  you will purchase on the delivery date
 You will profit from asset price increasing
 Profit = Spot price (@ maturity) – Original futures price
o Short position  you will sell on the delivery date
 Profit = Original futures price – Spot price
 Convergence property of futures price
o At maturity, futures price (NOT ORIGINAL!) must = Spot price. If not, there’s
an arbitrage opportunity  arbitrageurs will push prices to equalise.
o FT = PT  Profits from futures = | F0 - PT | = | F0 - FT |
o Futures profits track changes in the underlying assets’ prices
 Clearing Houses
o Institution that oversees trading on the exchange, ensures all contracts are
met

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 o

Futures Pricing
 Deviation of futures price (F) from spot price (S)  opportunity costs (-) / benefits (+)
of owning the futures instead of the underlying asset
o (+) Carrying costs of owning the asset (e.g. storage costs)  c%
o (+) Opportunity costs of money  risk-free rate, r%
 Money is not tied up in the asset  you have this cash on hand to
earn interest (r)  so you should pay a premium for the future
o (–) Dividend yield that you can only get if you hold the underlying asset  d%
o (–) Convenience yield of owning the asset (e.g. intangible inflows)  v%


o F > S = “Contango” (better to own futures than the underlying asset) 
usually true for commodities
o F < S = “Backwardation”
 Basis = | FT – PT |
o Convergence property  FT = PT where T = maturity
o But if the asset & contract are liquidated early, there is basis risk

Hedging
 Take the opposite position as your underlying spot position in a futures contract
o Check your position on the spot: LONG = you’re happy if the price goes up

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 o Long the asset, short a futures contract. If asset price goes up, you benefit
from spot position but lose money in that future  give up potential upside in
the asset. If asset price falls, the future shelters you from the downside.
 Challenges in attaining fully hedged position
o Cannot find a future that has the same underlying asset as your spot asset
o Uncertainty wrt the date your asset will be sold/bought
o The hedge may require the future to be closed before the delivery month
 Challenges lead to basis risk

Forwards
 Similar to futures  agreements to buy/sell @ xx time for xx price
o But forwards are traded OTC, not in the exchange
o Forwards are NOT marked to market
 Assets are non-standardised
o Contracts are negotiated individually between buyer and seller
 Forex forwards are the most popular

FOREX Futures
 2 Types of Quotes
o Direct exchange rate quote  exchange rate expressed as US$ per unit of
foreign currency
o Indirect  expressed as foreign currency units per unit dollar
 Like convergence in the stock futures market, interest rate parity condition eliminates
arbitrage opportunities

o Example using Pounds & Dollars:

 F0 = forward exchange rate ($ needed to buy 1 pound @ time T)
 E0 = current exchange rate (^ today  this is the direct quote; $ per
unit of foreign currency)
 R = risk free rate
o “Forward premium”  if UK’s r > US’ r  but F < E, the dollar is worth more
in pounds in the forwards market (than in FOREX market today, i.e. you will
need less $ to buy 1 pound @ time T)  may offset the advantage of a higher
UK interest rate

Interest Rate Futures

 Volatile interest rates  fixed income securities will be affected

o Calculate based on //
o Find change in bond value given change in interest rates
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  “Basis points”  divide 100 to change to %  100 bp = 1%
o Price value of basis point for unprotected portfolio,

(denominator is in basis points)

 Hedge ratio = PVBP of unprotected portfolio / PVBP of hedge vehicle
o Tells you the # of futures contracts needed to hedge interest rate risk (offset
the bond portfolio’s interest rate exposure)

Costs of Hedging
 Fees are usually charged by the financial institutions offering hedging contracts
o For the structuring of the hedging strategies + portfolio management advice
 Cost = deposit of the initial margin @ when you buy into the futures contract

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