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!"#$#%& !"#$%& !" !!! !""#$%&! !" !!! !"#$% !" !!! !"#$%!
!"#$% !" !!! !"#$%
The maintenance margin is the minimum amount required by the broker to hold the position. If the
margin of the account goes dangerously low we will receive a margin call to add equity or liquidate
our position.
The return will be the following:
=
10,000
10,000
Liabilities
Equity=0.6*10,000
Loan
6000
4000
10,000
6000
=
= 60%
10000
Suppose the maintenance margin is 30%, how much would the price have to go down to trigger a margin call?
1000 4000
=
= 0.3; = 5.71
1000
How much it has been lost (assuming 10% interest)?
5710 4400 10000
=
= 86.9%
10000
=
1+
where R is the Nominal interest rate, r is the real interest rate and I is inflation
3.2. What is return?
Returns can be defined as all the gains perceived in an investment. In other words, it includes not
only capital gains (the change in the price) but also dividends. Mathematically,
+
=
! =
1
where rf(T) is the total return, PAR is the face value, P(T) is the current price
A problem we may encounter is that the time horizon is not the same. If we use empirical data, we
see that the longer we hold a zero coupon bond, the higher are the returns and thus, we need a
measure to compare.
Annual Percentage Rate (APR): It is just adjusting the interest to fit a year period. For
example, if they offer 6% seminally, we just multiply by 2.
Effective Annual Rate (EAR): It is a measure that shows the return adjusted in annual
periods assuming we reinvest the proceeds at the same interest. (Compound Interest)
() !"#$%& !" !"#$%&'(&) !"#$%&'
= (1 +
)
1
3.4. Returns more closely
Returns largly depened on the revelation of the state of the nature. That is, events that are beyond the
control of the investors. Knowing that, we can express the return as:
=
! !
where E is the expected return, pi is the probability of the state i to occur and ri is the return if the state i
occurs.
Yet, in the real world is impossible to predict all the state that can affect the price of a financial asset
and associate them a probability. Because of that, we use historical data to express the return:
Arithmetic mean: It is used when we assume that there is no relation between observations.
r=
1 n
r ( s)
n s =1
Geometric mean: Most of the cases, it is fair to assume that returns may be related. Then, we
use geometric men.
Then, a question may arise. Why do people invest in bonds? An answer can be risk. A common
agreement says that the risk can be defined as the movement in price of a given asset. Mathematically,
we use variance to calculate the risk:
! =
! (! )!
= !
If we do not have the whole set of data, we can use sample variance to approximate the real ones.
2 =
1
n
r (s) r
n 1 s =1
If we take a historical perspective of risk, we can state that bonds are less risky than stocks:
Period: 1926 - 2001
Average Real Returns
Standard Deviation
T-bills
0.70%
4.10%
T-bonds
2.10%
10.70%
Stocks
6.90%
20.30%
Hence, we may assume those investors are risk averse. That is, in order to
assume more risk, they require more return. This is called risk premium
(difference between expected return and the risk free return).
You may argue that volatility is not enough to measure risk. For example,
mean and variance assume a normal distribution. This assumption might not
be fulfilled. In order to check for normality, we use skewness. If a distribution
is left-skewed, large negative returns are more likely and bad surprises are
more likely to be extreme. On the other hand, right-skewed distribution large
positive returns possible and bad surprises are less likely. Kurtosis is another
measure investors may be interested in. It measures the umber of observations centred around the
mean.
! !
where rp is the portfolio return, wi is the weight invested in the stock i and ri is the return of the stock i
Similarly we can compute the risk of a portfolio:
2 2
2
2
p 2 = w1 1 + w2 2 + 2 w1w2 cov(r1 , r2 )
whre e(rp) is the reruen of the portfolio, w is the weight in the risky asset, ri is the return of the risky asset, rf is the return of the risk free asset and!! is the
variance of the risky asset
The first equation is the expected return given the weights in each type of assets. The second one is
the risk of the portfolio. Note that it only includes the risky assets because by definition the variance
of the risk-free asset is 0. Re arranging terms we can state the Capital Allocation Line (CAL):
= ! +
! !
!.
Note that the slope is the extra reward for each extra unit of risk. This ratio is called the Sharp ratio. In
fact, the formula above assumes that the risk-free return is constant.
E (r rf )
var(r rf )
Can we get more return than the one given by the risky asset? The answer is yes. We can borrow
money at the risk free rate (or short the risk-free asset) in order to invest more money in the risky
asset.
Now, as economists try always to maximise utility, we can be interested in asses which is the best
portfolio in the Capital Allocation Line. It is a mathematical optimisation given the utility function as
a function of the risk. For the most common utility function decribed above:
= ! 0.5!!
= + 0.5 2 !!
= ( () ) / ( !! )
An imlicit assumption above is that we can borrow at the risk free rate which is not conisntant with
the relaity. If that is not the case, we need to adjust the CAL aabove the risky asset for the extra
interest we have to pay.
Historically, a broad category of risky assets
accounted for approx. 74% of the total wealth in the
U.S. economy. Implying a risk aversion coefficient of
approx. 2.6
Risky assets do not just mean stocks. It includes real
estate, private businesses, commodities, etc.
The Capital Allocation Line is top-down strategy,
implying a more diversifies portfolio with lower
transaction costs yet not taking into account the
quality of the securities included.
E ( rp ) = wD E ( rD ) + wE E ( rE )
2
2
2
2
p 2 = wD D + wE E + 2 wD wE cov(rD , rE )
Lets look closer to the concept of Covariance: D and E are the two risky assets (denoting two
portfolios of bonds and stocks). Recall also that:
cov(rD , rE ) = DE D E
The correlation coefficient measure how related are the two risky assets. Note that, if the variables are
not correlated (I.e. the correlation coefficient is 0) a reduction in risk. Similarly, if it is negative the risk
is reduced. Even if it is positive, as long as it is less 1 there is also a reduction in risk.
Hence, the first type of portfolio we are interest in is the minimum variance portfolio. When there is
only two risky assets, we can use the following formula:
2 2 1 2 1, 2
w1 = 2
1 + 2 2 2 1 2 1, 2
w2 = 1 w1
This portfolio is the one that would minimize risk the most and thus, it will also be the efficient
portfolio with less return.
When there are only two risky assets, the optimal risky
portfolio is determined by the minimum variance
frontier portfolio opportunity set and the indifference
curve. That is, there exists a portfolio that maximizes
the risk reward for risk (sharp ratio) and we call it
optimal risky portfolio.
Graphically, this is the point on the combination line
where the slope of the indifference curve is equal to the
slope of the portfolio opportunity set.
5.2. Can we be even more efficient? The introduction of the risk-free asset
When we introduce the risk free asset, we are able to draw a Capital Allocation Line in order to
decide how much we want to invest in a risky portfolio and in the risk-free. The question is: which
risky portfolio should we chose? Well, know that we are able to allocate our capital, it seams obvious
that we should chose the portfolio that rewards the risk the most. That is, the Optimal Risky Portfolio.
When there is only 2 assets we can use the following formula:
2
w1 =
[ E ( r1 ) rf ] 2 [ E ( r2 ) rf ] 1 2 1, 2
2
[ E ( r1 ) rf ] 2 + [ E ( r2 ) rf ] 1 [ E ( r1 ) rf + E ( r2 ) rf ] 1 2 1, 2
2
E ( R1 ) 2 E ( R2 ) 1 2 1, 2
2
E ( R1 ) 2 + E ( R2 ) 1 [ E ( R1 ) + E ( R2 )] 1 2 1, 2
Know, we are able to assume the risk we want along the Capital Allocation Line combining the risk
free asset and the optimal portfolio to achieve the wished risk. Now, we are able to use the utility
function to choose the Portfolio that suits us the most. That is, the optimal complete portfolio.
How to solve a typical problem:
1. First find the weights in the tangency
portfolio
2. Then, find the expected return, variance
and sharp ratio
3. After, solve the utility function to see
how much an investor will invest in the
risky portfolio.
4. Know, we can build the characteristics of
the optimal complete poerfolio.
3 Case scenario
3
p2 = wi w j cov(ri , rj )
i =1 j =1
The names also change a little bit when all securities are included:
The optimal combinations result in lowest level of risk for a
given return minimum-variance frontier
The optimal trade-off is described as the efficient frontier.
These portfolios are dominant.
There are only three investors in the economy, 1, 2 and 3, with total wealth of 500, 1000,
1500 billion dollars, respectively. Their asset holdings (in billion dollars) are:
In equilibrium, the total dollar holding of each asset must equal its market value
y=
E (rM ) rf
A M2
That is, Y is the proportion that the investor will invest in the market portfolio. Since the risk-free
lending and borrowing is among the investors (i.e. already issued government debt), the net
borrowing (i.e. borrowing lending) , must be zero. Then,
y=
E (rM ) rf
A M2
= 1 E (rM ) rf = A M2
M2 = w j wk cov(rj , rk )
j =1 k =1
As said before, the each asset in contributing to the market will depend on the correlation amount
them and the weight in the portfolio. That is:
n
k =1
k =1
Thus, we can know analyse the reward-to-risk ratio of the individual asset as:
wS [ E (rS ) rf ]
wS cov(rS , rM )
E (rS ) rf
cov(rS , rM )
If we rearrange terms:
E ( rS ) rf =
cov(rS , rM )
M2
Contribution to variance
[E (r
) rf ] = S [E ( rM ) rf ]
Due to the diversification effect, investors will be compensated only for bearing systematic risk.The
CAPM is often stated as a expected return-beta relationship:
E (rS ) = rf + S E (rM ) rf
+ i RP( Factor )
ri = E (ri ) + i F + ei
Where F is the revelation of the state of the nature of factor F. Since we assume that is something
abnormal, F has always-mean 0. F is affecting everyone in the economy with a different degree. Ei is
the firm specific state of the natures
APT
APT equilibrium means no arbitrage
opportunities.
APT equilibrium is quickly restored even
if only a few investors recognize an
arbitrage opportunity.
The expected returnbeta relationship
can be derived without using the true
market portfolio.
CAPM
Model is based on an inherently
unobservable market portfolio.
Rests on mean-variance efficiency. The
actions of many small investors restore
CAPM equilibrium.
CAPM describes equilibrium for all
assets.
SMB = Small Minus Big, i.e., the return of a portfolio of small stocks in excess of the return on
a portfolio of large stocks.
HML = High Minus Low, i.e., the return of a portfolio of stocks with a high book-to-market
ratio in excess of the return on a portfolio of stocks with a low book-to-market ratio.
Current date
Matures
Oct 2014
Coupon
Bid price
Ask price
Bid-ask spread
Change since previous closing
Ask yield
2.375%
100:08 = 1008/32=
par
100:09 = 1009/32
of par
100.25% of
= 100.281%
/32 = 0.03125%
18
/32 = 0.5625
2.32%,
We must remember that there is a difference between the ask price and the actual price paid. That is
because the selling investor will require us to pay for the interest accrued sine the last interest
payment. After that, we will recive the full payment of interest.
Suppose coupon = 8%; paid semiannually
40 days have passed since last interest payment
Quoted price
= $990
Accrued interest = $40(40/182) = $8.79
Actual price paid
= $990+8.79 = $998.79
The bond purchase entitles the investor to receive the full 6-month coupon after holding it for just 142 days
PB =
t =1
Ct
Par Value
+
t
(1 + r )
(1 + r )T
1
1 Par Value
= C 1
+
when C is constant over time.
r (1 + r )T (1 + r )T
Where PB is Price of the bond, Ct is interest or coupon payments, T is the number of periods to maturity and r
is interest rate over one payment period
Example:
8% Coupon bond, paid semiannually,
30 years to maturity
Interest rate (or yield) is 8% (or 4% per 6 month)
60
40
1000
P =
+
t
1
.
04
1
.04 60
t =1
1
1 1000
= 40
1
+
0.04 1.04 60 1.04 60
= $1000
When interest rate is 10%, whats the price?
60
40
1000
+
= $810.71
t
1
.
05
1
.0560
t =1
P =
Calculator:
40 PMT
60 N
4
I/Y
1000 FV
CPT PV
PB =
t =1
Ct
Par Value
+
(1 + r )t
(1 + r )T
Example:
Given: 8% coupon bond, payable semiannually
30 year maturity
Current price P0 = $1,276.76
YTM = r = ?
60
1,276.76 =
t =1
40
1,000
+
(1 + r ) t (1 + r ) 60
Calculator:
40
PMT
60
N
-1,276.76 PV
1000
FV
CPT
I/Y
wt =
CFt /(1 + y )t
T
CFt /(1 + y )t
;
bond price
w
1
=1
D = 1 t wt
9.5.1. Duration and price relationship
Lets analyse the interest sensitivity of the price of a bond:
T
P=
t =1
CFt
(1 + y )t
CF
dP
1 T
=
t t
dy 1 + y t =1 (1 + y )t
1 T
CFt
=
t
P P
t
(
1
+
y
)
1
+
y
t =1
dP
1
=
DP
dy 1 + y
dP
dy
= D
P
1+ y
P
y
= D
P
1+ y
If we want a more direct measure of the relationship between changes in bond prices and interest
rates, we can use Modified Duration, defined:
D* =
D
(1 + y )
P
= D *y
P
o
o
o
o
o
Duration is an important concept in bond management. First, it Measures sensitivity of bond price to
interest rate changes (price volatility).
Its important to remember that, since the price of a bond follows a convexity formula and duration is
a straight relationship, duration is a local concept.
9.6. Convexity
The convexity of the price formula of a bond can
be approximated by the second derivety with
respect to yield divided by the bond price. That
is:
2P
1
=
2 y (1 + y ) 2
CFt
(t 2 + t )
t =1
T
CFt
1 2P
1
Convexity =
=
(t 2 + t )
2
2
t
P y P(1 + y ) t =1 (1 + y )
(1 + y)
P
1
= D* y + Convexity (y ) 2
P
2
Bonds with greater curvature gain more in price when yields fall than they lose when yields rise.
The more volatile interest rates, the more attractive this asymmetry.
Bonds with greater convexity tend to have higher prices and/or lower yields, all else equal.
9.7. Passive vs Active management
There are two passive bond portfolio strategies. Both strategies see market prices as being correct, but
the strategies have very different risks.
o Indexing: have the same risk-reward profile as the bond market index to which it is tied
o Immunization: seek to establish a virtually zero-risk profile
Active management
o Interest rating forecasting
o Identification of relative mispricing within the fixed-income market
9.8. Immunization
Immunization is a strategy that matches the durations of assets and liabilities thereby minimizing the
impact of interest rates on the net worth.
Example
An insurance company must make a payment of $19,487 in 7 years. The market interest rate is 10%, so the
present value of the obligation is $10,000. The companys portfolio manager wishes to fund the obligation using
3-year zero-coupon bonds and perpetuities paying annual coupons. How can the manager immunize the
obligation?
1) Calculate the duration of the liability
o one single payment: duration = 7 years
2)
We next need to find the asset mix that sets the duration of assets equal to the duration of liabilities
Immunization: w * 2 + (1 - w) * 11 = 6,
w = 5/9
The manager now must invest a total of $11,000*(5/9)= $6,111.11 in the zero.
Mental Accounting: Investors may segregate accounts and take risks with
their gains that they would not take with their principal.
Regret Avoidance:
Investors blame themselves more when an
unconventional or risky bet turns out badly.
Prospect Theory: