Portfolio Management

Fama French 3 Factor Model (multi factor model)

sensitivity of security returns are estimated based on three factors: 1. firm size 2. firm book value to market value ratio 3. excess return on the mkt portfolio (return on the market portfolio minus the risk-free rate) Carhart added a fourth factor that measures price momentum using prior period returns. these models explain US equity returns better than the market (single index) model

investment objectives

should include both risk and return objectives bc of the tradeoff bw risk and expected return

arithmetic mean return

simple average of a series of periodic returns arithmetic mean return= (R1+R2+...+Rn)/n

Types of Investors

+Individual investors +Institutions +An endowment fund - foundations +A bank +Insurance companies +Investment companies - mutual funds +Sovereign wealth funds

Systematic risk (market risk)

- caused by macro factors: interest rates, GDP growth, supply shocks - measured by covariance of returns w returns on the mkt portfolio - only systematic risk is rewarded by the market with higher expected returns

Big Data Challenges

- Analysts must ensure that the data they use is of high quality, accounting for the possibilities of outliers, bad or missing data, or sampling biases - The volume of data collected must be sufficient and appropriate for its intended use - The need to process and organize data before using it can be especially problematic with qualitative and unstructured data

Advantages of Technical Analysis

- based on observable trade data (actual price and volume data), whereas fundamental analysis is based on accounting values/estimates, is subject to assumptions or restatements, and might not be available at all for assets such as currencies or commodities -Technical analysis can also be useful when financial statement fraud occurs --> Price and volume may reflect the true value of the company even before the fraud is widely known and before the financial statements are restated - it can be applied to the prices of assets that do not produce future cash flows (dividends or interest), such as commodities --> dont need to discount CFs in technical analysis - dont have to learn accounting

Distributed Ledger Technology (DLT)

- database that is shared on a network so that each participant has an identical copy - distributed ledger must have a consensus mechanism to validate new entries into the ledger - Distributed ledger technology uses cryptography to ensure only authorized network participants can use the data Distributed ledgers can take the form of permissionless or permissioned networks 1) permissionless networks - all network participants can view all transactions (users have equal access) - no central authority --> which gives them the advantage of having no single point of failure - The ledger becomes a permanent record visible to all, and its history cannot be altered (short of the manipulation described previously). - This removes the need for trust between the parties to a transaction 2) permissioned networks - users have different levels of access - ex) a permissioned network might allow network participants to enter transactions while giving government regulators permission to view the transaction history - A distributed ledger that allowed regulators to view records that firms are required to make available would increase transparency and decrease compliance costs

defined benefit pension plan

- employer promises to make periodic payments to employees after retirement. - contribution is usually based on the employee's years of service and the employee's compensation at/near retirement - ex) an employee might earn a retirement benefit of 2% of her final salary for each year of service. Consequently, an employee with 20 years of service and a final salary of $100,000, would receive $40,000 ($100,000 final salary × 2% × 20 years of service) each year upon retirement until death. - employer bears the investment risk (bc the employee's future benefit is defined) - employer makes contributions to a fund established to provide the promised future benefits --> Poor investment performance will increase the amount of required employer contributions to the fund - separate legal entity manages plan assets

Machine Learning

- important development in artificial intelligence - "learn" to make decisions based on historical data --> analyze historical data and make a prediction - a computer algorithm is given inputs of source data, with no assumptions about their probability distributions, and may be given outputs of target data - The algorithm is designed to learn, without human assistance, how to model the output data based on the input data or to learn how to detect and recognize patterns in the input data (identify structure and patterns without human help) - requires vast amounts of data --> begins with a training dataset in which the algorithm looks for relationships. A validation dataset is then used to refine these relationship models, which can then be applied to a test dataset to analyze their predictive ability.

Mutual Funds

- liquidity needs: high (must meed redemption requirements from shareholders) - time horizon, risk tolerance, income needs all depend on the type of fund and fund objective

Treynor Ratio (risk adjusted return measures)

- measure of portfolio performance - analogous to sharpe ratio Treynor ratio = (RP− Rf)/βP - interpreted as excess returns per unit of systematic risk (beta), and represented by the slope of a line - if treynor measure for portfolio is higher than treynor measure for the market, then outperforming the market (compare to the slope of the SML) differs from sharpe ratio bc it uses beta (systematic risk) instead of standard deviation (total risk) as a measure of risk - use treynor ratio when talking about well diversified investors

Hedge Funds (pooled investment)

- pools of investor funds that are not regulated to the extent that mutual funds are - not registered or offered to the public - limited in the number of investors who can invest in the fund and are often sold only to qualified investors - high minimum investment, can use high leverage and derivatives - many strategies are used (long/short, global macro, event driven

The market model (simplified form of a single index model)

- single risk factor is the return on the market - the asset's beta is the sensitivity of its returns to this risk factor - asset returns are a linear function of market returns - used to estimate a security's (or portfolio's) beta and to estimate a security's abnormal return (return above its expected return) based on the actual market return. the form of the market model is as follows: Ri = αi + βiRm + ei Ri = return on Asset i Rm = market return βi = slope coefficient αi = intercept ei = abnormal return on Asset i - in the market model, the factor sensitivity or beta for Asset i is a measure of how sensitive the return on Asset i is to the return on the overall market portfolio (market index).

Strategic Asset Allocation

- specifies the percentage allocations to the included asset classes. - occurs After having determined the investor objectives and constraints through the exercise of creating an IPS - it is The set of exposures to IPS-permissible asset classes that is expected to achieve the client's long-term objectives given the client's investment constraints - based on risk, returns, and correlations of asset classes correlations of returns within an asset class should be relatively high --> indicating that the assets within the class are similar in their investment performance. correlations of returns between asset classes should be low --> leads to risk reduction through portfolio diversification. equities can be divided into asset classes by whether the issuing companies are domestic or foreign, large or small, or whether they are traded in emerging or developed markets. - ex) of specifying asset classes is world equities. A U.S. investor may want to divide world equities into different regions. With bonds, we can divide the overall universe of bonds into asset classes based on maturities or on criteria such as whether they are foreign or domestic, government or corporate, or investment grade or speculative (high yield). Overall, the asset classes considered should approximate the universe of permissible investments specified in the IPS.

Supervised Learning

- the input and output data are labelled - the machine learns to model the outputs from the inputs - then the machine is given new data on which to use the model

Unsupervised Learning

- the input data is not labelled and the machine learns to describe the structure of the data - detect and recognize patterns in input dataset - algorithm explains relationships without an outcome variable to guide the process

Exchange Traded Fund (ETF) (pooled investment)

- typically index funds (passively managed) - trade like shares of closed-end funds --> purchases/sales are made in the market rather than with the fund itself - can be sold short, purchased on margin, and traded at intraday prices (whereas open-end funds are typically sold and redeemed only daily, based on the share NAV calculated with closing asset prices) - Investors in ETFs must pay brokerage commissions when they trade, and there is a spread between the bid price at which market makers will buy shares and the ask price at which market makers will sell shares. - for ETFs dividends typically paid out to investors while open-ended funds offer the alternative of reinvesting dividends in additional fund shares - market prices are very close to their NAVs bc there are special redemption provisions for ETFs (unlike closed-end funds, where the market price of shares can differ significantly from their NAV due to imbalances between investor supply and demand for shares at any point in time) - may have tax advantage over open-ended index funds (bc investor sales of ETF shares do not require the fund to sell any securities. If an open-end fund has significant redemptions that cause it to sell appreciated portfolio shares, shareholders incur a capital gains tax liability)

calculating beta

- use CAPM - be a is the slope of a regression of asset returns on market returns (characteristic line) βi=covariance of Asset i's return with the market return/ variance of the market return= Covi,m/σm^2 βportfolio = weighted avg of individual betas βmarket = 1 beta > mkt (1) : aggressive asset, if you think mkt is going to go up invest in high beta assets (tech stocks, luxury good providers) beta < mkt (1): defensive asset, as mkt goes up, security goes up a little (utility companies)

Portfolio Construction

- use risk, return, and correlations of asset classes to construct an efficient frontier - use objectives and constraints from IPS to select an optimal portfolio (strategic asset allocation) - tactical asset allocation (deviations from strategic allocation) and security selection as permitted and appropriate --> A manager who varies from strategic asset allocation weights in order to take advantage of perceived short-term opportunities is adding tactical asset allocation to the portfolio strategy - Security selection refers to deviations from index weights on individual securities within an asset class. - risk budgeting sets an overall risk limit for the portfolio and allocates permitted risk to strategic allocation, tactical allocation, and security selection

Sharpe Ratio (risk adjusted return measures)

- used to consider both risk and return in evaluating portfolio performance (with risk that differs from that of a benchmark portfolio) - one of the main tools for evaluating money managers The Sharpe ratio of a portfolio is its excess returns per unit of total portfolio risk Sharpe ratio = E[Rportfolio]-Rf/σportfolio - Higher Sharpe ratios indicate better risk-adjusted portfolio performance - The Sharpe ratio is based on total risk (standard deviation of returns), rather than systematic risk (beta). For this reason, the Sharpe ratio can be used to evaluate the performance of concentrated portfolios (those affected by unsystematic risk) as well as well-diversified portfolios (those with only systematic, or beta, risk) - the value of the Sharpe ratio is only useful for comparison with the Sharpe ratio of another portfolio. - the Sharpe ratio of a portfolio is the slope of the CAL for that portfolio and can be compared to the slope of the CML, which is the Sharpe ratio for portfolios that lie on the CML --> if the sharpe ratio of a portfolio is higher than the sharpe ratio of the CML (means the CAL is steeper than the CML), means superior money manager

Deep learning

- uses layers of neural networks to identify patterns, beginning with simple patterns and advancing to more complex ones - may use supervised or unsupervised learning - Some of the applications of deep learning include image and speech recognition

Variance (Standard Deviation) of Returns for an Individual Security

- variance and standard deviation of returns are common measures of investment risk - higher the variance, the greater the risk/spread of outcomes - Both of these are measures of the variability of a distribution of returns about its mean or expected value. s^2=∑(Rt−R)^2/T−1

Portfolio Standard Deviation

- when correlation = +1 (results in the greatest portfolio risk) --> portfolio standard deviation is a weighted average of the standard deviations of the individual asset returns - the highest the portfolio standard deviation can be is the weighted avg of the sd of the individual assets - any time the correlation is less than +1 there will be some diversification of risk and portfolio SD is reduced Varportfolio=(w1^2)(σ1^2)+(w2^2)(σ2^2)+(2w1)(w2)(Cov1,2) or since Cov1,2=(ρ1,2)(σ1)(σ2), can substitute this term if covariance isn't known: Varportfolio=(w1^2)(σ1^2)+(w2^2)(σ2^2)+(2w1)(w2)(ρ1,2)(σ1)(σ2) - to get SD take square root of variance portfolio risk falls as the correlation between the assets' returns decreases - The lower the correlation of asset returns, the greater the risk reduction (diversification of risk) - If asset returns were perfectly negatively correlated, portfolio risk could be eliminated altogether for a specific set of asset weights.

Risk Management Framework

1) Establishing processes and policies for risk governance 2) Determining the organization's risk tolerance 3) Identifying and measuring existing risks 4) Managing and mitigating risks to achieve the optimal bundle of risks 5) Monitoring risk exposures over time 6) Communicating across the organization 7) Performing strategic risk analysis

Applications of fintech relevant to investment management

1) Text analytics - analysis of unstructured data in text or voice forms - ex) analyzing the frequency of words and phrases - In finance industry, text analytics have the potential to partially automate specific tasks such as evaluating/interpreting company regulatory filings 2) Natural language processing - use of computers and artificial intelligence to interpret human language (Speech recognition and language translation) - applications in finance could be to check for regulatory compliance in an examination of employee communications, or to evaluate large volumes of research reports to detect more subtle changes in sentiment than can be discerned from analysts' recommendations alone 3) Risk governance -. Financial regulators require firms to perform risk assessments and stress testing - The simulations, scenario analysis, and other techniques used for risk analysis require large amounts of quantitative data along with a great deal of qualitative information - Machine learning can be useful in modeling and testing risk, particularly if firms use real-time data to monitor risk exposures --> apply machine learning to scenario analysis in stress testing 4) Algorithmic trading - algorithms may be designed to enter the optimal execution instructions for any given trade based on real-time price and volume data - Algorithmic trading can also be useful for executing large orders by determining the best way to divide the orders across exchanges - high-frequency trading that identifies and takes advantage of intraday securities mispricings 5) Robo-advisors - automated investment advice based on a client's answers to survey questions about their financial position, return objectives, risk tolerance, and constraints such as time horizon and liquidity needs. - Robo-advisory services tend to offer passively managed investments with low fees, low minimum account sizes, traditional asset classes, and conservative recommendations - advantage: low cost to clients, which may make advice more accessible to a larger number of investors - disadvantage: the reasoning behind recommendations may be unclear to clients --> Without a human investment advisor to explain the reasoning, customers may hesitate to trust the appropriateness of a robo-advisor's recommendations, particularly in crisis periods - Regulation of robo-advisors is still emerging but services are subject to same regulations and registration requirements as any other investment advisor

Objectives of Risk Management

1) identify the risk tolerance of the organization 2) identify and measure the risks that the organization faces 3) modify and monitor these risks risk management doesnt seek to avoid or minimize risk but to identify which risks an organization is best able to take on - The organization may increase its exposure to risks it decides to take because it is better able to manage and respond to them - The organization may decrease its exposure to risks that it is less well able to manage and respond to by making organizational changes, purchasing insurance, or entering into hedging transactions - Through these choices the firm aligns the risks it takes with its risk tolerances for these various types of risk

Measuring Risk Exposure for Derivatives

1. Delta - sensitivity of derivatives values to the price of the underlying asset. 2. Gamma - sensitivity of delta to changes in the price of the underlying asset 3. Vega - sensitivity of derivative value to the volatility of the price of the underlying asset 4. Rho - sensitivity of derivative value to changes in the risk-free rate

primary areas where fintech is developing include:

1. Increasing functionality to handle large sets of data that may come from many sources and exist in a variety of forms 2. Tools and techniques such as artificial intelligence for analyzing very large datasets 3. Automation of financial functions such as executing trades and providing investment advice 4. Emerging technologies for financial recordkeeping that may reduce the need for intermediaries

Portfolio Management Process

1. Planning - Understand client needs and constraints (analyze the investor's risk tolerance, return objectives, time horizon, tax exposure, liquidity needs, income needs) - Write investment policy statement (IPS) - Develop an investment strategy consistent with IPS - Specify performance benchmark 2. Execution - Analyze risk/return characteristics of asset classes - Analyze market conditions to identify attractive classes - Identify attractive securities within classes - Construct portfolio: target strategic asset allocations, individual securities weightings, risk management 3. Feedback - Monitor and update investor's needs - Monitor and update market conditions - Rebalance portfolio as needed --> adjusting the allocations to the various asset classes back to their desired percentages. - Measure and report performance

Assumptions of Capital market theory (CAPM)

1. Risk aversion - To accept a greater degree of risk, investors require a higher expected return. 2. Utility maximizing investors - Investors choose the portfolio, based on their individual preferences, with the risk and return combination that maximizes their (expected) utility - investors only consider mean and variance 3. Frictionless markets - There are no taxes, transaction costs, or other impediments to trading - unlimited lending and borrowing at the risk free rate - no inflation, interest rates are constant 4. All investors have the same one-period time horizon. 4. Homogeneous expectations - All investors have the same expectations for assets' expected returns, standard deviation of returns, and returns correlations between assets. 5. Divisible assets - All investments are infinitely divisible. 6. Competitive markets - Investors are price takers --> take the market price as given and no investor can influence prices with their trades. - capital markets are in equilibrium

Risk Assessment Methods

1. Stress Testing - examines the effects of a specific (usually extreme) change in a key (single) variable such as an interest rate or exchange rate 2. Scenario Analysis - effects of a set of changes in multiple variables - refers to a similar what-if analysis of expected loss but incorporates changes in multiple inputs - A given scenario might combine an interest rate change with a significant change in oil prices or exchange rates - if multiple factors move against us what is that going to do to our solvency

trends in the asset management industry

1. The market share for passive management (index funds) has been growing over time (to about 20% of AUM). - - This is due to the lower fees passive managers charge investors, and in part to questions about whether active managers are actually able to add value over time on a risk-adjusted basis, especially in developed markets that are believed to be relatively efficient. 2. investment in information technology to capitalize on big data - The amount of data available to asset managers has grown exponentially in recent years - This has encouraged them to invest in information technology and third-party services to process these data, attempting to capitalize on information quickly to make investment decisions. 3. emergence of Robo-advisors - technology that can offer investors advice and recommendations based on their investment requirements and constraints, using a computer algorithm - These advisors increasingly appeal to younger investors and those with smaller portfolios than have typically been served by asset management firms - help individuals structure well thought out portfolios at a very low cost

Types of Mutual Funds

1. money market mutual funds - invest in short-term debt securities - provide interest income with very low risk of changes in share value - NAVs are typically set to one currency unit, but there have been instances in which the NAV of some funds declined when the securities they held dropped dramatically in value - differentiated by the types of money market securities they purchase and their average maturities 2. bond funds - invest in fixed-income securities - They are differentiated by bond maturities, credit ratings, issuers, and types - ex) government bond funds, tax-exempt bond funds, high-yield (lower rated corporate) bond funds, and global bond funds. 3. stock funds - actively managed funds vs. index (passive) funds

factors affecting risk tolerance

1. psychological factors 2. personal factors: - age, family situation, existing wealth, insurance coverage, cash reserves, income

Investment Policy Statement (IPS)

A written planning document that describes a client's: - investment objectives and constraints - risk tolerance over a relevant time horizon - imposes investment discipline on client and manager - identifies risks - identifies a benchmark portfolio consistent w client preferences

risk averse investor

An investor prefers less risk to more risk and requires higher rates of return as an inducement to buy riskier securities - Given two investments that have equal expected returns, a risk-averse investor will choose the one with less risk (standard deviation, σ) - when two investments have equal risk, investors prefer the one w higher expected return - risk-averse investor will hold very risky assets if he feels that the extra return he expects to earn is adequate compensation for the additional risk - investors do not minimize risk, they will take more risk for higher expected return (its a trade-off)

Asset Management Industry

Buy side firms that manage investments for clients - Full-service asset managers: offer a variety of investment styles and asset classes - Specialist asset managers: focus on a particular investment style or asset class - multi-boutique firm: holding company that includes a number of different specialist asset managers may focus on traditional or alternative asset classes

CML vs SML

CML: - uses total risk = σp on the x-axis - only efficient portfolios will plot on the CML - only 2 assets will plot on the CML (market portfolio and risk free asset) --> dont have any undiversifiable risk - slope of the CML is the sharpe ratio --> Rmkt-Rf/σmkt SML: - uses beta (systematic risk) on the x-axis - under CAPM, all properly priced (in equilibrium) securities and portfolios of securities will plot on the SML

geometric mean return

Compound Annual Rate - When periodic rates of return vary from period to period, the geometric mean return will have a value less than the arithmetic mean return: geometric mean return=n√(1+R1)×(1+R2)×...×(1+Rn)−1

implications on portfolio selection

Consider this gamble: A coin will be flipped; if it comes up heads, you receive $100; if it comes up tails, you receive nothing. The expected payoff is 0.5($100) + 0.5($0) = $50 -A risk-averse investor would choose a payment of $50 (a certain outcome) over the gamble - A risk-seeking investor would prefer the gamble to a certain payment of $50 - A risk-neutral investor would be indifferent between the gamble and a certain payment of $50

Financial applications of DLT

Cryptocurrencies: - an electronic medium of exchange that allows participants to engage in real-time transactions without a financial intermediary - Cryptocurrencies typically reside on permissionless networks - Demonstrating the impact cryptocurrencies are already having in finance, companies have raised capital through initial coin offerings, in which they sell cryptocurrency for money or another cryptocurrency - this reduces the cost and time frame compared to carrying out a regulated IPO, and initial coin offerings typically do not come with voting rights. - Investors should note that fraud has occurred with initial coin offerings and they may become subject to securities regulations. Automated clearing and settlement: - DLT has the potential to bring about real-time trade verification and settlement - this would reduce trading costs and counterparty risk Smart contracts: - electronic contracts that could be programmed to self-execute based on terms agreed to by the counterparties (execute automatically) - ex) an options contract could be set up to be exercised automatically if certain defined conditions exist in the market Tokenization: - refers to electronic proof of ownership of physical assets, which could be maintained on a distributed ledger - ex) ledger could potentially replace the paper real estate deeds currently filed at government offices. - has the potential to streamline transfers of physical assets such as real estate

Multi-factor models (return generating models)

E(Ri) − Rf = βi1 × E(Factor 1) + βi2 × E(Factor 2) + ....+ βik × E(Factor k) - multiple factors that can explain the excess return - the factors are the expected values of each risk factor - the betas are the asset's factor sensitivities or factor loadings for each risk factor Risk factors of 3 types: 1. macroeconomic: GDP growth, inflation, or consumer confidence 2. fundamental: earnings, earnings growth, firm size, and research expenditures 3. statistical: no basis in finance theory

Elliot Wave Theory (cycles)

Financial market prices can be described as a series of interconnected cycles - The cycle periods range from a few minutes (a "subminuette" cycle) to centuries (a "Grand Supercycle") "Waves" refer to chart patterns associated with Elliott wave theory - In uptrend, prices go up 5 waves and down in 3 waves - In downtrend, prices go down 5 waves and up 3 waves Size of waves thought to correspond with Fibonacci ratios - Fibonacci numbers are found by starting with 0 and 1, then adding each of the previous two numbers to produce the next (0, 1, 1, 2, 3, 5, 8, 13, 21, etc) - Elliott wave theorists believe that the ratios of Fibonacci numbers are useful for estimating price targets - ex) a down leg can be 1/2 or 2/3 the size of an up leg, or a price target can be 13/8 of the previous high - Ratios of consecutive Fibonacci numbers converge to 0.618 and 1.618 as the numbers in the sequence get larger - These two values are commonly used to project price targets

Fundamental vs. Technical Analysis

Fundamental Analysis: - attempts to determine the intrinsic value of an asset (what prices should be) - uses the company's financial statements and other information to analyze its financial position and determine its value - based on anticipated financial results and estimates of future cash flows Technical Analysis: - tries to predict price changes through analysis of past trade prices and volume - uses only the firm's share price and trading volume data to project a target price. - Technical analysis is not concerned with identifying buyers' and sellers' reasons for trading, but only with the trades that have occurred

Private Equity Funds (pooled investments)

LBO and venture capital funds invest in portfolios of companies, hope to restructure, improve cash flows, develop a business often with the intention to resell them later in public offerings (IPO) for a profit - may use high leverage (LBOs) - Managers of funds may take active roles in managing the companies in which they invest

Problems w Artificial Intelligence/Machine Learning

Machine learning can produce models that overfit or underfit the data Overfitting: - when the machine learns the input and output data too exactly - machine creates too complex of a model - treats noise as true parameters and identifies false patterns and relationships Underfitting: - when the machine fails to identify actual patterns and relationships - treats true parameters as noise - machine creates a model that is not complex enough to describe the data (too simple) A further challenge with machine learning is that its results can be a "black box," producing outcomes based on relationships that are not readily explainable.

Technical Indicators

Measures used by technical analysts to forecast future movements in stock prices. 1. Price based indicators - moving average lines - bollinger bands 2. momentum oscillators - ROC -RSI - MACD 3. sentiment indicators - opinion - put/call - VIX 4. flow of funds indicators - ARMS index - mutual fund cash - equity issuance

Pooled Investments

Mutual funds are one form of pooled investments (i.e., a single portfolio that contains investment funds from multiple investors). - Each investor owns shares representing ownership of a portion of the overall portfolio - The total net value of the assets in the fund (pool) divided by the number of such shares issued is referred to as the net asset value (NAV) of each share. open-end mutual fund: - investors can buy newly issued shares and can redeem their shares (sell them back to the fund) at the NAV -number of shares changes w purchases and redemptions --> Newly invested cash increases the size of the fund (creates more shares) and is invested by the mutual fund managers in additional portfolio securities - fee (% of NAV) for ongoing management of the portfolio assets - Load funds charge either up-front fees, redemption fees, or both. - No-load funds do not charge additional fees for purchasing shares (up-front fees) or for redeeming shares (redemption fees). closed-end mutual funds: - professionally managed pools of investor money that do not take new investments into the fund or redeem investor shares - fixed number of shares - issued as an IPO - The shares trade like equity shares (on exchanges or over-the-counter) - fee (%) for ongoing management - actively managed - market prices differ from NAV - dont need to hold cash or sell shares to meet redemptions as open end funds do (so liquidity requirements are lower for closed end funds)

Choosing among risk modification methods

Organizations may use multiple methods of risk modification to reduce a single risk - criterion is always a comparison of the costs and benefits of risk modification - Some risks may be mitigated by diversification, some shifted by insurance where it is available and economical, some shifted though the use of derivatives, and some simply borne or self-insured - The end result is a risk profile that matches the risk tolerance established for the organization and includes the risks that top management has determined match the goals of the organization in terms of cost versus potential returns

important points of portfolio construction (in an IPS)

R - risk R - return T - time horizon T - tax situation L - liquidity L - legal restrictions U - unique constraints of a specific investor

Risk Governance

Refers to senior management's determination of the risk tolerance of the organization, the elements of its optimal risk exposure strategy, and the framework for oversight of the risk - risk governance seeks to manage risk to support organization's goals within its risk tolerance - should be done at enterprise level by senior management - risk management committee identifies specific risks that should be pursued, limited, or avoided

net return

Return after management fees

leveraged return

Return on cash investment - refers to a return to an investor that is a multiple of the return on the underlying asset - The leveraged return is calculated as the gain or loss on the investment as a percentage of an investor's cash investment - An investment in a derivative security, such as a futures contract, produces a leveraged return because the cash deposited is only a fraction of the value of the assets underlying the futures contract - Leveraged investments in real estate are very common: investors pay for only part of the cost of the property with their own cash, and the rest of the amount is paid for with borrowed money.

Common Chart Patterns

Reversal Patterns - prior trend expected to reverse direction - Head and shoulders --> This pattern suggests the demand that has been driving the uptrend is fading, especially if each of the highs in the pattern occurs on declining volume. - Double/triple top --> they indicate weakening in the buying pressure that has been driving an uptrend. =>Price Target = Neckline - (Head-Neckline) Continuation Patterns - Prior trend expected to continue in same direction; indicates change in ownership from one group of investors to another, suggests a pause in a trend rather than a reversal - Triangles --> when prices reach lower highs and higher lows over a period of time - Rectangles - Pennants --> triangles on short term charts - Flags --> rectangles on short term charts

Measuring Risk Exposure

Risk Measures: 1. standard deviation (equity portfolios) - measure of the volatility of asset prices and interest rates - Standard deviation may not be the appropriate measure of risk for non-normal probability distributions, especially those with negative skew or positive excess kurtosis (fat tails). 2. beta (equity portfolios) - measures the market risk of equity securities and portfolios of equity securities - considers the risk reduction benefits of diversification and is appropriate for securities held in a well-diversified portfolio, whereas standard deviation is a measure of risk on a stand-alone basis 3. duration (fixed income portfolios) - measure of the price sensitivity of debt securities to changes in interest rates

Modifying Risk Exposure

Risk management does not seek to eliminate all risks --> The goal is to retain the optimal mix of risks for the organization. - Once the risk management team has estimated various risks, management may decide to accept, avoid, prevent, transfer, or shift a risk Accept a risk: - ex) self insurance -> used to describe a situation where an organization has decided to bear a risk, simply means that it will bear any associated losses from this risk factor. - bear risk efficiently through diversification Avoid a risk: - don't engage in the activity with the uncertain outcome (that exposes the organization to that risk) - If political risks in a country are to be avoided, simply not investing in securities of firms based in that country or not expanding a business enterprise to that country would avoid those risks Prevent a risk: - The risk of a data breach can be prevented with a greater level of security for the data and stronger processes - the benefits of reducing or eliminating the risk are judged to be greater than the cost of doing so Transfer a risk (to another party): -. Insurance is a type of risk transfer - ex) The risk of fire destroying a warehouse is shifted to an insurance company by buying an insurance policy and paying the policy premiums - surety bonds (third party obligations)--> an insurance company has agreed to make a payment if a third party fails to perform under the terms of a contract or agreement with the organization - fidelity bonds (employee dishonesty) --> which will pay for losses that result from employee theft or misconduct - Managements that purchase insurance, surety bonds, or fidelity bonds have determined that the benefits of risk reduction are greater than the cost of the insurance Shift a risk: - a way to change the distribution of possible outcomes - typically with derivative contracts - ex) financial firms that do not want to bear currency risk on some foreign currency denominated debt securities can use forward currency contracts, futures contracts, or swaps to reduce or eliminate that risk --> A firm with a large position in a specific stock can buy put options that provide a minimum sale price for the securities, altering the distribution of possible outcomes (in this case providing a floor value for the securities)

systematic risk

Some securities' returns are highly correlated with overall market returns. Examples of firms that are highly correlated with market returns are luxury goods manufacturers such as Ferrari automobiles and Harley Davidson motorcycles. These firms have high systematic risk (i.e., they are very responsive to market, or systematic, changes). Other firms, such as utility companies, respond very little to changes in the systematic risk factors. These firms have very little systematic risk

Cycles

Some technical analysts apply cycle theory to financial markets in an attempt to identify cycles in prices cycle periods: - 4-year presidential cycles (related to election years in the US) - decennial cycle: 10-year cycles - 18-year cycles - Kondratieff wave: 54-year cycles

Measuring Tail Risk Exposure

Tail risk is the uncertainty about the probability of extreme (negative) outcomes. Commonly used measures of tail risk (sometimes referred to as downside risk) include: 1. Value at Risk - VaR: the minimum loss over a period that will occur with a specific probability - ex) one-month VaR of $1 million with a 5% probability --> means that a one-month loss of at least $1 million is expected to occur 5% of the time (in 5% of the months) 2. Conditional VaR - expected value of a loss, given that the loss exceeds a minimum amount - Relating this to the VaR measure presented previously, the CVaR would be the expected loss, given that the loss was at least $1 million - calculated as the probability-weighted average loss for all losses expected to be at least $1 million

Types of technical analysis charts

Technical analysts primarily use charts of price and volume to analyze asset prices and overall market movement - Most of these charts have time on the horizontal axis - The time interval chosen (monthly, weekly, daily, or intraday periods) reflects the trading horizon of interest to the analyst - A technical analyst will typically start by observing longer-term trends on monthly and weekly charts, then look at recent activity on daily or intraday charts - If prices have changed exponentially (e.g., a stock index over several decades), an analyst may choose to draw charts on a logarithmic scale instead of the usual linear scale. 1. Line charts: - the simplest technical analysis charts - They show closing prices for each period as a continuous line 2. Volume charts: - vertical line for each period's trading volume 3. Bar charts: - each bar shows the high and low prices for each trading period and often include the opening price and closing price as well - Each period is displayed as a vertical line, with the closing price indicated as a point or dash on the right side of the line and opening prices on the left side of each vertical line 4. Candlestick charts: - use same data as bar charts but display a box bounded by the opening and closing prices - unfilled box if the closing price is higher than the opening price - filled box if the closing price is lower than the opening price (stock went down in that period) - Candlestick charts can make patterns easier to recognize 5. Point-and-figure charts: - helpful in identifying changes in the direction of price movements - price on the vertical axis --> The price increment chosen is the "box size" for the chart - horizontal axis is NOT time dependent --> instead, it represents the number of changes in direction - To determine when a change of direction has occurred, the analyst must choose a "reversal size" for the chart. A typical reversal size is three times the box size. -Starting from the opening price, the analyst will fill in a box in the first column if the closing price has changed by at least the box size. An X indicates an increase of one box size and an O indicates a decrease. If the price changes by more than one box size, the analyst will fill in multiple Xs or Os. If the price continues in the same direction in the next periods, the analyst will continue filling in the same column. When the price changes in the opposite direction by at least the reversal size, the analyst will begin the next column

Beta

The sensitivity of an asset's return to the return on the market index in the context of the market model - standardized measure of the covariance of the asset's return with the market return

Security Market Line (SML) (used in CAPM)

The line that shows the relationship between risk as measured by beta and the required rate of return for individual securities. - given that the only relevant (priced) risk for an individual Asset i is measured by the covariance between the asset's returns and the returns on the market, Covi,mkt, we can plot the relationship between risk and return for individual assets using Covi,mkt as our measure of systematic risk - β is a measure of systematic risk - β measures the relation between a security's excess returns and the excess returns to the market portfolio. - β is the standardized covariance of an asset's returns w returns on the mkt portfolio βi= Covi,mkt/(σmkt)^2 E(Ri)=Rf+β[E(Rmkt−Rf] assets are overvalued if E(R) < RR --> plots below SML --> sell asset - the stock's expected return is too low given its systematic risk assets are undervalued if E(R) > RR --> plots above SML --> buy asset - stock is offering an expected return greater than required for its systematic risk assets are properly valued if E(R) = RR --> plots on SML - stock is properly priced and offers exactly the return required on the investment given its risk

Separately Managed Account (SMA) (pooled investment)

a portfolio that is owned by a single investor and managed according to that investor's needs and preferences - No shares are issued, as the single investor owns the entire account - also called a wrap account

Relative Strength Analysis

To perform relative strength analysis, an analyst calculates the ratios of an asset's closing prices to benchmark values, such as a stock index or comparable asset, and draws a line chart of the ratios. - An increasing trend indicates that the asset is outperforming the benchmark (positive relative strength) and a decrease shows that the asset is underperforming the benchmark (negative relative strength).

Characteristics of Big Data

Volume: - The volume of data continues to grow by orders of magnitude - The units in which data can be measured have increased from megabytes and gigabytes to terabytes and even petabytes Velocity: - refers to how quickly data is communicated - low latency = Real-time data (stock market price feeds) - high latency = Data that is only communicated periodically or with a lag Variety: - The variety of data refers to the varying degrees of structure in which data may exist - ranges from structured forms such as spreadsheets and databases, to semistructured forms such as photos and web page code (HTML), to unstructured forms such as video.

unsystematic risk vs systematic risk

When an investor diversifies across assets that are not perfectly correlated, the portfolio's risk is less than the weighted average of the risks of the individual securities in the portfolio - The risk that is eliminated by diversification is called unsystematic risk - Because the market portfolio contains all risky assets, it must be a well-diversified portfolio. All the risk that can be diversified away has been. The risk that remains cannot be diversified away and is called the systematic risk (also called nondiversifiable risk or market risk). - Don't have to buy all the securities in the market to diversify away unsystematic risk --> as you increase the number of stocks in a portfolio, the portfolio's risk falls toward the level of market risk, once you reach a certain # of securities, the standard deviation remains constant and the remaining risk is systematic, or nondiversifiable, risk.

Capital Allocation Line (CAL)

a graph showing all feasible risk-return combinations of a risky and risk-free asset the line representing the risk/return of each possible combination of risk-free assets and a risky asset/portfolio - set of the possible efficient portfolios - The line of possible portfolio risk and return combinations given the risk-free rate and the risk and return of a portfolio of risky assets - starts at the risk free rate of return and extends through the optimal risky portfolio E(RP)=Rf+σP{[E(RM)−Rf]/σM}

defined contribution pension plan

a retirement plan in which the firm contributes a sum each period to the employee's retirement account. - the company defines their participation in terms of their contribution - the firm makes no promise to the employee regarding the future value of the plan assets (no guarantee of future benefits) - investment decisions are left to the employee, who assumes all of the investment risk.

Risk Budgeting

allocates the organization's desired amount of overall risk exposure among assets or investments based on: - organizations goals and risk tolerance - risk characteristics of assets or investments goal is to allocate the overall amount of acceptable risk to the mix of assets or investments that have the greatest expected returns over time. risk budget may be a single metric such as returns variance, portfolio beta, or portfolio duration Another way to allocate a risk budget is to identify specific risk factors that comprise the overall risk of the portfolio or organization. In this case, specific risk factors that affect asset classes to varying degrees, such as interest rate risk, equity market risk, and foreign exchange rate risk, are estimated and aggregated to determine whether they match the overall risk tolerance of the organization.

Two Fund Separation Theorem

an investors optimum portfolios will be made up of some combination of an optimal portfolio of risky assets and the risk-free asset. a risk-free asset has zero standard deviation and zero correlation of returns with those of a risky portfolio, this results in the reduced equation (if asset b is risk free): σportfolio=WAσA

Performance Evaluation (CAPM Applications)

analyze risk and return of an active manager's portfolio

Attribution Analysis (CAPM Applications)

analyze sources of the differences between an active manager's portfolio returns and the passive benchmark portfolio returns - part of performance evaluation - A portfolio with greater risk than the benchmark portfolio (especially beta risk) is expected to produce higher returns over time than the benchmark portfolio

money-weighted return

applies the concept of IRR to investment portfolios - The money-weighted rate of return is defined as the internal rate of return on a portfolio, taking into account all cash inflows and outflows - periods must be equal length, use shortest period w no significant CFs CF0 + CF1/(1+MWR) + ... + CFn/(1+MWR)^n = 0 Step 1: Determine the timing of each cash flow and whether the cash flow is an inflow (-), into the account, or an outflow (+), available from the account. - inflows = beginning value of the account and all deposits into the account - outflows = All withdrawals from the account the ending value Step 2: Net the cash flows for each time period and set the PV of cash inflows equal to the present value of cash outflows. - PVinflows = PVoutflows Step 3: Solve for r to find the money-weighted rate of return. This can be done using the IRR function on a financial calculator

Support and resistance

are price levels or ranges at which buying or selling pressure is expected to limit price movement -Commonly identified support and resistance levels include trendlines, whole number prices, and historical high and low prices. At a support level, buying is expected to emerge that prevents further price decreases. - price where buying pressure limits a downtrend At a resistance level, selling is expected to emerge that prevents further price increases. - price where selling pressure limits an uptrend

Nonfinancial Risk

arise from the operations of the organization and from sources external to the organization 1. Operational risk - This is the risk that human error, faulty organizational processes, inadequate security, or business interruptions will result in losses - ex) cyber risk, which refers to disruptions of an organization's information technology. 2. Solvency risk - This is the risk that the organization will run out of cash 3. Regulatory risk - risk that regulatory environment will change, imposing costs on the firm or restricting its activities 4. Governmental or political risk (including tax risk) - risk that political actions outside a specific regulatory framework, such as increases in tax rates, will impose significant costs on an organization 5. Legal risk - exposure to future legal action/lawsuits 6. Model risk - risk that asset valuations based on the organization's analytical models are incorrect 7. Tail risk - underestimating probability of extreme outcomes (those in the tails of the distribution of outcomes), especially from incorrectly concluding that the distribution of outcomes is normal 8. Accounting risk - risk that the organization's accounting policies and estimates are judged to be incorrect The various risks an organization faces are not independent; they interact in many ways

Passive management

attempts to replicate the performance of a chosen benchmark index - This may include traditional broad market index tracking or a smart beta approach that focuses on exposure to a particular market risk factor.

Unsystematic risk (firm specific risk)

can be reduced or eliminated by holding well-diversified portfolios

Portfolio Choices Based on Investor's Indifference Curves

can combine the capital asset line with indifference curves representing an individual's preferences for risk and return to illustrate the logic of selecting an optimal portfolio (i.e., one that maximizes the investor's expected utility) - the less an investor's risk aversion, the flatter his indifference curves --> should optimally choose a portfolio with more invested in the risky asset portfolio and less invested in the risk-free asset. - the more risk averse the investor, the steeper his indifference curve - optimal investment is where the highest feasible indifference curve is just tangent to the capital allocation line

Bollinger Bands

constructed based on the standard deviation of closing prices over the last n periods - An analyst can draw high and low bands a chosen number of standard deviations (typically two) above and below the n-period moving average - The bands move away from one another when price volatility increases and move closer together when prices are less volatile useful for indicating when prices are extreme by on either the high or low side. Short term traders (contrarian strategy) --> one that buys when most traders are selling and sells when most traders are buying. Contrarians believe markets get overbought or oversold because most investors tend to buy and sell at the wrong times, and thus it can be profitable to trade in the opposite direction. - sell at prices at or above the top band - indicates that the security is overbought and the market is "too high" and likely to decrease in the near term - buy at prices at or below the lower Bollinger band - indicates an oversold market, one that is "too low" and likely to increase in the near term

ability to bear risk

depends on investor's financial circumstances - Longer investment horizons (20 years rather than 2 years), greater assets versus liabilities (more wealth), more insurance against unexpected occurrences, and a secure job all suggest a greater ability to bear investment risk in terms of uncertainty about periodic investment performance.

willingness to bear risk

depends on the investor's attitudes and beliefs about investments and their risks (various asset types) - The assessment of an investor's attitude about risk is quite subjective willingness > ability --> advisor should go w ability willingness < ability --> adviser may attempt to educate the investor about investment risk and correct any misconceptions that may be contributing to the investor's low stated willingness to take on investment risk, don't attempt to change personality/psychological characteristics

Blockchain

distributed ledgers that record transactions sequentially in blocks and links these blocks in a chain - Each block has a cryptographically secured "hash" that links it to the previous block. - you can see what happened to that bitcoin in every transaction which it was used over its entire history - everyone can see it so very secure --> cant claim something that isn't true - a blockchain is more likely to succeed with a large number of participants in its network - The high cost and difficulty of manipulating past records is a strength of blockchain technology

Portfolio Perspective

evaluating individual investments based on their contribution to the risk and return of an investor's overall portfolio (not in isolation) Modern portfolio theory concludes that the extra risk from holding only a single security is not rewarded with higher expected investment returns. Conversely, diversification allows an investor to reduce portfolio risk without necessarily reducing the portfolio's expected return. adding a risky asset can reduce portfolio risk - unless the returns of the risky assets are perfectly positively correlated, risk is reduced by diversifying across assets. can take a very risky limited partnership type inv that has high standard deviation but also low correlation w the existing portfolio, and put it in a pension portfolio to increase returns while decreasing risk

Intermarket analysis

examines the interrelationships among mkt values of various asset classes, such as stocks, bonds, commodities, and currencies - In the asset allocation process, relative strength analysis can be used to identify attractive asset classes and attractive sectors within these classes - After identifying attractive asset classes, an analyst can apply relative strength analysis to identify which assets within these classes are outperforming others - useful for comparing the relative performance of equity market sectors or industries, and of various international markets

Moving Average Lines

frequently used to smooth the fluctuations in a price chart - moving average is the mean of the last n closing prices - The larger the value of n, the smoother the moving average line (the more short-term fluctuations are removed from the line) -Moving averages for different periods can be used together, such as 20-day and 250-day averages - Points where the short-term average (more volatile) crosses the long-term average (smoother) can indicate changes in the price trend - When the short-term average crosses above long-term average (a "golden cross"), this is often viewed as an indicator of an emerging uptrend or a "buy" signal by technical analysts - The short-term average crossing below the long-term average (a "dead cross") is often viewed as an indicator of an emerging downtrend or a "sell" signal

minimum-variance and efficient frontiers of risky assets

given risky assets, we can come up w all possible portfolio combinations - For each level of expected portfolio return, we can vary the portfolio weights on the individual assets to determine the portfolio that has the least risk. - minimum variance portfolios: portfolios that have the lowest standard deviation of all portfolios with a given expected return - Assuming that investors are risk averse, investors prefer the portfolio that has the greatest expected return when choosing among portfolios that have the same standard deviation of returns. - portfolios that have the greatest expected return for each level of risk (standard deviation) make up the efficient frontier. - assets that lie on the efficient frontier have the highest return for any asset w the same amount of risk - The efficient frontier coincides with the top portion of the minimum-variance frontier - A risk-averse investor would only choose portfolios that are on the efficient frontier bc all available portfolios that are not on the efficient frontier have lower expected returns than an efficient portfolio with the same risk - the global minimum-variance portfolio: the portfolio on the efficient frontier that has the least risk

Efficient Frontier

graph representing a set of portfolios that offers the highest expected return at each level of portfolio risk (SD) - also the point where there are no more benefits to diversification

risk-neutral investor

has no preference regarding risk and would be indifferent between two such investments

Correlation and Risk Reduction

if you can find assets w lower correlations that will reduce the risk of the portfolio - this is the justification for alternative assets in a portfolio allocation --> alternatives may have higher expected returns but they have lower correlation w traditional assets than stocks and bonds have w each other

Investment constraints

include the investor's: 1. liquidity needs - ability to turn investment assets into spendable cash in a short period of time - Investor needs for money to pay tuition, to pay for a parent's assisted living expenses, or to fund other possible spending needs may all require that some liquid assets be held - for property and casualty insurance companies, claims arrive unpredictably to some extent and therefore their portfolios must hold a significant proportion of liquid (or maturing) securities in order to be prepared to honor these claims - illiquid investments in hedge funds and private equity funds, which typically are not traded and have restrictions on redemptions, are not suitable for an investor who may unexpectedly need access to the funds. 2. time horizon - the longer an investor's time horizon, the more risk and less liquidity the investor can accept in the portfolio - time until the proceeds of the investment are required 3. tax considerations - is the account taxable, tax deferred, or tax exempt - For a fully taxable account, investors subject to higher tax rates may prefer tax-free bonds (U.S.) to taxable bonds or prefer equities that are expected to produce capital gains, which are often taxed at a lower rate than other types of income. 4. legal and regulatory constraints - Trust, corporate, and qualified investment accounts (institutional investors) may all be restricted by law from investing in particular types of securities and assets - There may also be restrictions on percentage allocations to specific types of investments in such accounts - also applies to individual investors (IRAs) or personal taxable accounts 5. unique needs and preferences - may be nonfinancial considerations, which are commonly categorized as sustainable investing - Ethical preferences, such as prohibiting investment in securities issued by tobacco or firearms producers - Restrictions on investments in companies or countries where human rights abuses are suspected or documented would also fall into this category - Religious preferences - Unique investor preferences may also be based on diversification needs when the investor's income depends heavily on the prospects for one company or industry --> An investor who has founded or runs a company may not want any investment in securities issued by a competitor to that company.

Sentiment indicators

indicators of investor sentiment and capital flows to gain insight into potential emerging trends. - Market sentiment is said to be "bullish" when investors expect increasing prices and "bearish" when they expect decreasing prices Indicators can include: 1. opinion polls - try to measure investor sentiment directly 2. Put/call ratio - Put options increase in value when the price of an underlying asset decreases, while call options increase in value if the price of the underlying asset increases. - For financial assets that have actively traded options, the volume of put and call options reflects activity by investors with negative and positive outlooks, respectively, about the asset - Increases in the put/call ratio (put volume > call volume, ratio > 1) indicates a more negative outlook for the price of the asset - Decreases in the put/call ratio (put volume < call volume, ratio < 1) indicates positive sentiment - This ratio is generally viewed as a contrarian indicator - extremely high ratios indicate strongly bearish investor sentiment and possibly an oversold market - extremely low ratios indicate strongly bullish sentiment and perhaps an overbought mark 3. Volatility Index (VIX) - measures the volatility of options on the S&P 500 stock index - High levels suggest investors fear market declines - often interpret the VIX in a contrarian way --> views a bearish investor outlook as a bullish sign 4. Margin debt - Increases in total margin debt outstanding suggest aggressive buying by bullish margin investors (strong positive sentiment) - Increasing margin debt --> increasing market prices - decreasing margin debt --> decreasing prices 5. Short interest ratio - increases in shares sold short indicate strong negative sentiment - Short interest is the number of shares investors have borrowed and sold short - short interest ratio = short interest (# shares sold short) / avg daily trading volume - While a high short interest ratio means investors expect the stock price to decrease, it also implies future buying demand when short sellers must return their borrowed shares

Insurance Companies

invest customer premiums with the objective of funding customer claims as they occur - time horizon: long for life insurance companies, short for property and casualty (P&C) (bc claims are expected to arise sooner than for life insurers) - risk tolerance: low - income needs: low - liquidity needs: high

Banks

loans are assets, excess reserves are invested primarily in fixed income and money market securities, objective is to earn more on the loans and investments than the bank pays for deposits - time horizon: short - risk tolerance: low - income needs: must pay interest on deposits and cover operating expenses - liquidity needs: high (need adequate liquidity to meet investor withdrawals as they occur)

Momentum Oscillators

market price based indicators scaled so that they "oscillate" around a given value, such as zero, or between two values such as zero and 100 - makes extremes of market sentiment more clear - Extreme high values of an oscillator indicate that a market is overbought - extreme low values indicate a market is oversold Oscillator charts can be used to identify convergence or divergence of the oscillator and market prices: - Convergence --> occurs when the oscillator shows the same pattern as prices (e.g., both reaching higher highs) --> oscillator inc when price trend inc --> suggests the price trend is likely to continue - Divergence --> occurs when the oscillator moves opposite to the price trend (e.g., failing to reach a higher high when the price does) --> indicates a potential change in the price trend (price trends will reverse) Examples of oscillators include: 1. the rate of change (ROC) oscillator - 100 times the difference between the latest closing price and the closing price n periods earlier - oscillates around zero. 2. Relative Strength Index (RSI) - based on the ratio of total price increases to total price decreases over a selected number of periods - ratio is then scaled to oscillate between 0 and 100 3. moving average convergence/divergence (MACD) lines - drawn using exponentially smoothed moving averages, which place greater weight on more recent observations 4. stochastic oscillator - calculated from the latest closing price and highest and lowest prices reached in a recent period, such as 14 days - In a sustainable uptrend, prices tend to close nearer to the recent high, and in a sustainable downtrend, prices tend to close nearer to the recent low

Time-Weighted Return (TWR)

measures compound growth - annual time weighted returns are effective annual compound returns - holding periods can be any length - calculate HPRs for periods between significant CFs Step 1: Break the evaluation period into subperiods based on timing of cash flows. Step 2: Calculate the HPR for each holding period. Step 3: Find the compound annual rate that would have produced a total return equal to the return on the account over the n year period. - TWR = [(1+HPR1)(1+HPR2)]^(1/#yrs) - 1 the time-weighted rate of return is the preferred method of performance measurement bc it is not affected by the timing of cash inflows and outflows If funds are contributed to an investment portfolio just before a period of relatively poor portfolio performance, the money-weighted rate of return will tend to be lower than the time-weighted rate of return. On the other hand, if funds are contributed to a portfolio at a favorable time (just prior to a period of relatively high returns), the money-weighted rate of return will be higher than the time-weighted rate of return. - The use of the time-weighted return removes these distortions and thus provides a better measure of a manager's ability to select investments over the period. If the manager has complete control over money flows into and out of an account, the money-weighted rate of return would be the more appropriate performance measure.

Covariance

measures the extent to which two variables move together over time - positive covariance: the variables (e.g., rates of return on two stocks) tend to move together - Negative covariance: the two variables tend to move in opposite directions - covariance of zero: there is no linear relationship between the two variables Cov1,2=∑{[Rt,1−R1[Rt,2−R2]}/n−1 where: Rt,1 = return on Asset 1 in period t Rt,2 = return on Asset 2 in period t R1 = mean return on Asset 1 R2 = mean return on Asset 2 n = number of periods Covariance is an absolute measure and is measured in return units squared - bounded by pos and neg infinity - interpreting it is difficult bc it is in the unit of observation - The covariance of the returns of two securities can be standardized by dividing by the product of the standard deviations of the two securities (which gives you correlation)

real return

nominal return adjusted for inflation. - measures the increase in an investor's purchasing power: how much more goods she can purchase at the end of one year due to the increase in the value of her investments. = (1+nominal return/1+inflation) - 1

Indifference Curves

plots combinations of risk (standard deviation) and expected return among which an investor is indifferent. - slope upward for risk-averse investors bc they will only take on more risk (standard deviation of returns) if they are compensated with greater expected returns - An investor who is relatively more risk averse requires a relatively greater increase in expected return to compensate for a given increase in risk - a more risk-averse investor will have steeper indifference curves, reflecting a higher risk aversion coefficient. - The investor's expected utility is the same for all points along a single indifference curve.

risk seeking investor

prefers more risk to less and, given equal expected returns, will choose the more risky investment.

The M-squared (M^2) measure (risk adjusted return measures)

produces the same portfolio rankings as the Sharpe ratio but is stated in percentage terms. - direct measure of outperformance - M^2 = (RP−Rf)(σM/σP)−(RM−Rf) The first term is the excess return on a Portfolio P*, constructed by taking a leveraged position in Portfolio P so that P* has the same total risk, σM, as the market portfolio. the Sharpe is a slope measure and M2 is measured in percentage terms - M2is considered a measure of risk-adjusted performance (RAP) M2 is the additional % return for a (leveraged/active) portfolio (borrowing at Rf) with the same risk as the market portfolio

Endowments

provides ongoing financial support - time horizon: long - risk tolerance: high - income needs: low - liquidity needs: low

Sovereign Wealth Fund

refer to pools of assets owned by a government. - various investment goals - invest for future generations (long term) - manage foreign exchange reserves - manage govt assets (state pensions)

artificial intelligence

refers to computer systems that can learn and make decisions in a manner similar to the human brain --> they are capable of performing activities that require intelligence when they are done by people - ex) neural networks --> programmed to process information in a way similar to the human brain

FinTech (Financial Technology)

refers to developments in technology that can be applied to the financial services industry - fintech companies are firms that develop these technologies for the finance industry

utility function

represents the investor's preferences in terms of risk and return (i.e., his degree of risk aversion).

after tax nominal return

returns after deducting tax liability

Risk Tolerance

risk tolerance involves setting the overall level of risk exposure for the organization (maximum acceptable level of risk) by identifying the risks the firm can effectively take and the risks that the organization should reduce or avoid - effective risk management attempts to maximize expected returns for that level of risk Factors may include: - expertise in its specific lines of business - its skill/ability at responding to negative outside events - its regulatory environment - its financial strength and ability to withstand losses When analyzing risk tolerance, management should examine risks that may exist within the organization as well as those that may arise from outside. - weigh risk exposures against their expected benefits

Financial Risks

risks that arise from exposure to financial markets 1. Credit risk - uncertainty about whether the counterparty to a transaction will fulfill its contractual obligations 2. Liquidity risk - This is the risk of loss when selling an asset (sales price less than the underlying fair value of the asset) 3. Market risk - uncertainty about market prices of assets and interest rates

Trend Lines

tells us which direction the market has moved -can help to identify whether a trend is continuing or reversing uptrend: if prices are consistently reaching higher highs and retracing to higher lows - means demand is increasing relative to supply - trend line connects the decreasing lows in price downtrend: if prices are consistently declining to lower lows and retracing to lower highs - suggests supply (i.e., selling pressure) is increasing relative to demand - trendline connects the decreasing highs in price breakout/breakdown: - When the price crosses the trendline by what the analyst considers a significant amount, a breakout from a downtrend or a breakdown from an uptrend occurs - may signal the end of the previous trend

Holding period return (HPR)

the % increase in the value of an investment over a given time period HPR = (end of period value/beginning of period value) - 1 = (Pt + Div/P0) - 1

Capital Asset Pricing Model (CAPM)

the equation of the SML showing the relationship between expected return and beta (systematic risk) - CAPM is also used to determine the required return on an asset based on the asset's systematic risk (beta) - required return and expected return are the same in equilibrium

Big Data

the exponential growth in the volume, variety, and velocity of information and the development of complex, new tools to analyze and create meaning from such data refers to all the potentially useful information that is generated in the economy (includes data from traditional sources and alternative data from non-traditional sources) 1) data from traditional sources: - financial markets - company financial reports - government economic statistics 2) data from non-traditional sources: - Individuals who generate usable data such as social media posts, online reviews, email, and website visits - Corporate exhaust --> Businesses that generate potentially useful information such as bank records and retail scanner data - Internet of things --> sensors, such as radio frequency identification chips, are embedded in numerous devices such as smart phones and smart buildings

diversification ratio

the ratio of the risk of an equally weighted portfolio of n securities (measured by its standard deviation of returns) to the risk of a single security selected at random from the n securities. Std dev. of portfolio returns/average std dev. of returns on portfolio assets A lower diversification ratio indicates a greater risk-reduction benefit from diversification While the diversification ratio provides a quick measure of the potential benefits of diversification, an equal-weighted portfolio is not necessarily the portfolio that provides the greatest reduction in risk - Computer optimization can calculate the portfolio weights that will produce the lowest portfolio risk (standard deviation of returns) for a given group of securities. - Portfolio diversification works best when financial markets are operating normally; diversification provides less reduction of risk during market turmoil, bc During periods of financial crisis, correlations tend to increase, which reduces the benefits of diversification.

Technical Analysis

the study of collective market sentiment, as expressed in buying and selling of assets - based on the idea that mkt prices are determined by the interaction of supply and demand which are driven by both rational and irrational behavior - The market price equates supply and demand at any instant - Only participants who actually trade affect prices, and better-informed participants tend to trade in greater volume - technical analysts use price and trading volume to analyze changes in supply and demand (price and volume reflect the collective behavior of buyers and sellers) - security prices move in trends that persist for long periods and repeat themselves in predictable ways

Gross returns

total return on a portfolio before management fees

total risk

total risk = systematic risk + unsystematic risk

Active Management

use manager skill to attempt to outperform a chosen benchmark (fundamental or technical analysis) - higher fees than passive management

Return generating models

used to estimate the expected returns on risky securities based on specific factors - For each security, we must estimate the sensitivity of its returns to each specific factor

flow of funds indicators

useful for observing changes in the supply and demand of securities --> are ppl willing to invest in riskier assets or are they leaning towards safer assets 1. Arms Index/ST trading index (TRIN) - measure of funds flowing into rising and declining stocks - If index is near 1 then the market is in balance - If index > 1 then there is more volume in declining stocks 2. Margin debt - Increasing margin debt may indicate that investors want to buy more stocks - Decreasing margin debt indicates increased selling 3. Mutual Fund Cash Positions - low in uptrends, high in downtrends - ratio of mutual funds' cash to total assets - During uptrends, fund managers want to invest cash quickly because cash earns only the risk-free rate of return and thus decreases fund returns - During downtrends, fund cash balances increase overall fund returns - mutual fund cash positions tend to increase when the market is falling (downtrend) and decrease when the market is rising (uptrend) - contrarian indicator --> When mutual funds accumulate cash, this represents future buying power in the market --> high mutual fund cash ratio suggests market prices are likely to increase. - On the other hand, when mutual funds' cash is low, they are already invested and market prices reflect their purchases. 4. New equity issuance, secondary offerings - issuers tend to sell new shares when stock prices are thought to be high, increases in issuance of new shares may often coincide with market peaks

Disadvantages of Technical Analysis

usefulness of technical analysis is limited in... - markets where price and volume data might not truly reflect supply and demand --> illiquid markets and markets that are subject to outside manipulation (for example, currency market intervention by central banks) - For stocks of bankrupt companies, short covering can create positive technical patterns even when it is known that the stock price will go to zero - will not work if markets are weak-form efficient --> can we outperform the mkt just by looking at past price and volume mkt data

change in polarity

when support becomes resistance and vice versa refers to a belief that breached resistance levels become support levels and that breached support levels become resistance levels

calculating risk and return of a portfolio with a percentage weight invested in a risky portfolio and a percentage of weight invested in a risk-free asset.

where a = risky portfolio b= risk free asset Return: E(RP) = Wa E(a) + Wb E(Rb) Risk: σP= (Wa)(σa)

Capital Market Line

with homogenous expectations, all investors have the same optimal risky portfolio - When this is the case, that portfolio must be the market portfolio of all risky assets because all investors that hold any risky assets hold the same portfolio of risky assets. The same thing as a capital allocation line but the risky portfolio is now a portfolio of all the investable assets available in the market risk measure associated with the capital market line (CML) is total risk

Jensen's alpha (risk adjusted return measures)

αP = Rp − [Rf + βP(RM − Rf)] - the % of portfolio return above that of a portfolio (or security) with the same beta as the portfolio that lies on the SML - analogous to M^2 - measure of portfolio performance based on systematic (beta) risk rather than total risk

Correlation

ρ1,2 = Cov1,2/σ1σ2 ρ1,2 --> called the correlation coefficient between the returns of securities 1 and 2 - The correlation coefficient has no units - It is a pure measure of the co-movement of the two stocks' returns and is bounded by -1 and +1. -correlation coefficient of +1: deviations from the mean are always proportional in the same direction (perfectly positively correlated) -correlation coefficient of -1: deviations from the mean are always proportional in opposite directions (perfectly negatively correlated) - correlation coefficient of 0: there is no linear relationship between the two stocks' returns. They are uncorrelated (knowing the actual value of one variable tells you nothing about the value of the other)

Major components of an IPS

• Description of client circumstances --> income • Purpose of the IPS • Duties and responsibilities of all parties • Procedures to update IPS, resolve problems (deviations from mgmt of IPS) • Investment objectives and constraints • Investment guidelines--> asset types permitted, and leverage to be used • Evaluation of performance, benchmark used • Appendices: strategic asset allocation, permitted deviations, rebalancing procedures