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N. Instefjord

FN3023, 2790023

2011

Undergraduate study in

Economics, Management,

Finance and the Social Sciences

This subject guide is for a 300 course offered as part of the University of London

International Programmes in Economics, Management, Finance and the Social Sciences.

This is equivalent to Level 6 within the Framework for Higher Education Qualifications in

England, Wales and Northern Ireland (FHEQ).

For more information about the University of London International Programmes

undergraduate study in Economics, Management, Finance and the Social Sciences, see:

www.londoninternational.ac.uk

This guide was prepared for the University of London International Programmes by:

N. Instefjord, PhD, Associate Graduate Director, Essex Business School, University of Essex.

This is one of a series of subject guides published by the University. We regret that due to

pressure of work the author is unable to enter into any correspondence relating to, or arising

from, the guide. If you have any comments on this subject guide, favourable or unfavourable,

please use the form at the back of this guide.

Publications Office

Stewart House

32 Russell Square

London WC1B 5DN

United Kingdom

Website: www.londoninternational.ac.uk

Published by: University of London

University of London 2009

Reprinted with minor revisions 2011

The University of London asserts copyright over all material in this subject guide except where

otherwise indicated. All rights reserved. No part of this work may be reproduced in any form,

or by any means, without permission in writing from the publisher.

We make every effort to contact copyright holders. If you think we have inadvertently used

your copyright material, please let us know.

Contents

Contents

Subject guide structure and use .................................................................................... 1

Aims and objectives ...................................................................................................... 1

Learning outcomes ....................................................................................................... 2

Syllabus ........................................................................................................................ 2

Reading advice ............................................................................................................. 3

Online study resources ................................................................................................... 4

Examination structure ................................................................................................... 5

Chapter 2: Financial markets and instruments ...................................................... 7

Learning outcomes ....................................................................................................... 7

Essential reading ......................................................................................................... 7

Further reading ............................................................................................................. 7

Guide to readings ......................................................................................................... 7

Introduction ................................................................................................................. 7

Money and bond markets ............................................................................................. 8

Money market instruments ........................................................................................... 9

Bond market instruments ............................................................................................ 10

Equity markets ............................................................................................................ 11

Equity instruments ...................................................................................................... 12

Derivatives markets ..................................................................................................... 13

Managed funds .......................................................................................................... 13

Exchange traded funds ............................................................................................... 14

Exchange trading and over-the-counter (OTC) trading .................................................. 14

Clearing, settlement, margin trading, short sales and contingent orders ....................... 15

Working out the profitability of margin trades ............................................................. 15

Regulation of financial markets ................................................................................... 17

Summary .................................................................................................................... 17

Activities .................................................................................................................... 17

A reminder of your learning outcomes ......................................................................... 18

Sample examination question ..................................................................................... 18

Chapter 3: The history of financial markets ........................................................ 19

Learning outcomes ..................................................................................................... 19

Essential reading ........................................................................................................ 19

Further reading ........................................................................................................... 19

Introduction ............................................................................................................... 19

A history of financial innovation ................................................................................. 19

Recent financial innovations ....................................................................................... 20

Investment returns in equity and bond markets ........................................................... 23

The equity premium puzzle ......................................................................................... 24

Summary .................................................................................................................... 25

Activities .................................................................................................................... 25

A reminder of your learning outcomes ......................................................................... 26

Sample examination question .................................................................................... 26

23 Investment management

Learning outcomes ..................................................................................................... 27

Essential reading ........................................................................................................ 27

Further reading ........................................................................................................... 27

Introduction ............................................................................................................... 27

Historical mutual fund performance ............................................................................ 28

Market effciency and behavioural finance .................................................................... 29

Return based trading strategies ................................................................................... 31

Hedge funds ............................................................................................................... 32

Performance of hedge funds ....................................................................................... 34

Algorithmic or program trading (statistical arbitrage) .................................................. 34

Summary .................................................................................................................... 36

Activities .................................................................................................................... 37

A reminder of your learning outcomes ......................................................................... 38

Sample examination question ..................................................................................... 38

Chapter 5: Market microstructure ....................................................................... 39

Learning outcomes ..................................................................................................... 39

Essential reading ........................................................................................................ 39

Further reading ........................................................................................................... 39

Introduction ............................................................................................................... 39

Limit order markets ..................................................................................................... 40

Bid-ask bounce: the Roll model ................................................................................... 41

Glosten-Milgrom ........................................................................................................ 42

Kyle ............................................................................................................................ 45

Discrete version of the Kyle model ............................................................................... 47

Why market microstructure matters ............................................................................. 48

Summary .................................................................................................................... 49

Activity ....................................................................................................................... 49

A reminder of your learning outcomes ......................................................................... 50

Sample examination question ..................................................................................... 50

Chapter 6: Diversification .................................................................................... 51

Learning outcomes ..................................................................................................... 51

Essential reading ........................................................................................................ 51

Further reading ........................................................................................................... 51

Introduction .............................................................................................................. 51

Expected portfolio return and variance ......................................................................... 52

Definition of risk premium .......................................................................................... 53

Numerical example ..................................................................................................... 53

Asset allocation: Two assets ........................................................................................ 54

Meanvariance preferences ........................................................................................ 55

Optimal asset allocation with a risk free asset ............................................................. 56

CARA utility and normal returns .................................................................................. 56

The portfolio frontier .................................................................................................. 57

Expected returns relationships .................................................................................... 59

Estimation issues ........................................................................................................ 59

Diversification: The single index model ........................................................................ 60

The TreynorBlack model ............................................................................................ 61

Factor models ............................................................................................................. 63

ii

Contents

Summary .................................................................................................................... 65

Activities .................................................................................................................... 65

A reminder of your learning outcomes ......................................................................... 65

Sample examination question ..................................................................................... 66

Chapter 7: Portfolio immunisation ...................................................................... 67

Learning outcomes ..................................................................................................... 67

Essential reading ........................................................................................................ 67

Introduction ............................................................................................................... 67

Bond maths ................................................................................................................ 68

The term structure ...................................................................................................... 70

Duration ...................................................................................................................... 70

Numerical example ..................................................................................................... 72

Convexity ................................................................................................................... 73

Immunisation of bond portfolios ................................................................................. 74

Convexity and immunisation ....................................................................................... 75

Immunisation of equity portfolios ................................................................................ 76

Hedge ratios futures trading .................................................................................... 78

Summary .................................................................................................................... 79

Activity ....................................................................................................................... 79

A reminder of your learning outcomes.......................................................................... 79

Sample examination question ..................................................................................... 80

Chapter 8: Risk and performance measurement ................................................. 81

Learning outcomes ..................................................................................................... 81

Essential reading ........................................................................................................ 81

Further reading ........................................................................................................... 81

Introduction ............................................................................................................... 81

Types of risk ............................................................................................................... 82

Risk decomposition ..................................................................................................... 83

Value-at-Risk .............................................................................................................. 83

The Sharpe ratio ......................................................................................................... 84

Treynors ratio ............................................................................................................. 85

More portfolio performance measures ......................................................................... 86

Sharpe vs Treynor ........................................................................................................ 87

Changing risk ............................................................................................................. 88

Market timing ............................................................................................................. 89

Summary .................................................................................................................... 90

Activity ....................................................................................................................... 90

A reminder of your learning outcomes ......................................................................... 91

Sample examination question ..................................................................................... 91

Chapter 9 Risk management ............................................................................... 93

Learning outcomes ..................................................................................................... 93

Essential reading ........................................................................................................ 93

Further reading ........................................................................................................... 93

Introduction ............................................................................................................... 93

Risk management for investors ................................................................................... 94

Risk management for corporations .............................................................................. 94

Risk management for banks ........................................................................................ 95

Put option protection .................................................................................................. 95

Put protection vs VaR .................................................................................................. 96

iii

23 Investment management

Non-linear pay-offs ..................................................................................................... 98

Extreme risk ............................................................................................................... 99

Hedging credit risk ................................................................................................... 100

Hedging volatility ..................................................................................................... 101

Risk capital allocation ............................................................................................... 102

Summary .................................................................................................................. 102

A reminder of your learning outcomes ....................................................................... 103

Sample examination question ................................................................................... 103

Chapter 10: Important concepts......................................................................... 105

Investment returns .................................................................................................... 105

Averages: geometric vs arithmetic ............................................................................. 106

Taylor approximation ................................................................................................ 107

Optimisation ............................................................................................................ 107

Regression methods ................................................................................................. 108

Utility theory ............................................................................................................ 109

Risk aversion coefficient ............................................................................................ 109

Expected utility maximisation .................................................................................... 110

Variance aversion and the portfolio frontier ............................................................... 110

Standard normal distribution .................................................................................... 112

American vs European options .................................................................................. 113

Chapter 11: Sample examination paper ............................................................ 115

Appendix 1: Technical terms ............................................................................... 119

Averages: geometric vs arithmetic .............................................................................. 119

Investment returns .................................................................................................... 119

A review of regressions methods................................................................................ 121

Utility theory ............................................................................................................ 122

Risk aversion coefficient ............................................................................................ 123

Expected utility maximisation .................................................................................... 123

CARA utility functions ............................................................................................... 123

iv

Chapter 1: Introduction

Chapter 1: Introduction

Finance is essentially about pricing financial assets, but in this subject

guide we will focus more on what we use pricing theory for from an

investment perspective. We will seek to apply pricing theory (among other

things) to tell us something about how to invest our money optimally in

financial assets rather than for pricing itself. We will spend some time

looking at how to protect our investments using techniques from the area

of risk management. For those who want a more thorough overview of

pricing theory, see the subject guide for course 92 Corporate finance.

This subject guide is not a course text. Wider reading is essential as you

are expected to see the area of study from an holistic point of view, and

not just as a set of limited topics. The structure of the subject guide is as

follows.

Chapter 2 introduces you to financial markets and instruments.

Chapter 3 surveys some of the history behind the innovation of new

financial markets and instruments and the return that investors have

historically achieved from holding various classes of financial assets.

Chapter 4 surveys some of the empirical findings regarding active fund

management and investment strategies. We look at the performance

of mutual funds, the performance of certain popular contrarian and

momentum investment strategies, and finally we look at the investment

strategies of hedge funds.

Chapter 5 surveys some of the literature on market microstructure,

with the emphasis on how the bid-ask spread is formed in financial

markets and on how speculators seek to optimally benefit from their

information advantage.

Chapter 6 discusses optimal investment for investors using optimal

diversification strategies.

Chapter 7 discusses risk immunisation strategies to remove some or all

risk factors from the investors portfolio.

Chapter 8 discusses risk and performance measurement.

Chapter 9 looks at portfolio insurance strategies and value-at-risk based

risk management strategies.

This subject guide is designed to introduce you to the investment

environment in the role of a private or professional investor. This course

does not cover pricing theory, which is a major part of 92 Corporate

finance. Instead, it emphasises the use of pricing theory in investment

management. It aims to:

provide an overview of institutional details linked to financial markets

and the trading process

provide an overview of historical trends and innovations in financial

instruments and trading processes

1

23 Investment management

provide insight into the use of finance theory in investment

management

provide a guide to the measurement and analysis of risk of financial

investments

provide a guide to the measurement of performance of fund

management

address key issues in risk management.

Learning outcomes

At the end of this course, and having completed the Essential reading and

activities, you should be able to:

list given types of financial instruments and explain how they work in

detail

contrast key characteristics of given financial instruments

briefly recall important historical trends in the innovation of markets,

trading and financial instruments

name key facts related to the historical return and risk of bond and

equity markets

relate key facts of the managed fund industry

define market microstructure and evaluate its importance to investors

explain the fundamental drivers of diversification as an investment

strategy for investors

aptly define immunisation strategies and highlight their main

applications in detail.

discuss measures of portfolio risk-adjusted performance in detail and

critically analyse the key challenges in employing them

competently indentify established risk management techniques used by

individual investors and corporations.

Syllabus

Exclusions: This course has replaced course 121 International

financial markets and may not be taken if you are taking or have

passed course 121 International financial markets. If you have

failed course 121 and wish to transfer to course 23, your fail on course

121 will count as one of the three chances you have to pass the new

course.

Prerequisites: If you are taking this course as part of a BSc degree, you

must have already taken course 24 Principles of banking and

finance (or course 94 Principles of banking for students registered

before 1 September 2005). Course 92 Corporate finance must also be

taken with or before this course.

The syllabus comprises the following topics:

1. Financial markets and instruments: money and bond markets;

equity markets; derivative markets; managed funds; margin trading;

regulation of markets.

2. History of financial markets: historical and recent financial innovation;

historical equity and bond market returns; equity premium puzzle.

2

Chapter 1: Introduction

performance; market efficiency and behavioural finance; return based

trading strategies; hedge funds.

4. Market microstructure: types of markets; bid-ask bounce: the Roll

model; Glosten-Milgrom model; Kyle model; discrete version of the

Kyle model; limit order markets; statistical arbitrage (algorithmic

trading, program trading); why market microstructure matters.

5. Diversification: expected portfolio return and variance; definition of

risk premium; asset allocation two assets: mean-variance preferences;

optimal asset allocation with a risk free asset; CARA utility and normal

returns; portfolio frontier; expected return relationships; estimation

issues; diversification the single index model; Treynor-Black model;

factor models; statistics of asset allocation.

6. Portfolio immunisation: bond math; term structure; duration;

numerical examples; immunisation of bond portfolios; convexity and

immunisation; immunisation of equity portfolios.

7. Risk and performance management: types of risk; risk decomposition;

hedge ratios; Value-at-Risk; Sharpe ratio; Treynors ratio; more

portfolio performance measures; Sharpe vs Treynor; portfolios with

changing risk; market timing; non-linear pay-offs; extreme risk.

8. Risk management: risk management for investors; risk management

for corporations; risk management for banks; delta hedging; put option

protection; put protefction vs VaR; portfolio insurance with calls;

hedging credit risk; hedging volatility; risk capital allocation.

Reading advice

At the start of each chapter in this subject guide your recommended

reading appears in two categories, Essential reading and Further reading,

to be found in both textbooks and journal articles.

Essential reading

The course uses two essential textbooks as listed below:

Bodie, Z., A. Kane and A.J. Marcus Investments. (Boston, Mass.; London:

McGraw-Hill Irwin, 2008) eighth edition [ISBN 9780071278287].

Elton, E.J., M.J. Gruber, S.J. Brown and W.N. Goetzmann Modern Portfolio

Theory and Investment Analysis. (New York; Chichester: John Wiley & Sons,

2010) eighth edition [ISBN 9780470505847].

Detailed reading references in this subject guide refer to the editions of the

set textbooks listed above. New editions of one or more of these textbooks

may have been published by the time you study this course. You can use

a more recent edition of any of the books; use the detailed chapter and

section headings and the index to identify relevant readings. Also check

the VLE regularly for updated guidance on readings.

Further reading

Please note that as long as you read the Essential reading you are then free

to read around the subject area in any text, paper or online resource. You

will need to support your learning by reading as widely as possible and by

thinking about how these principles apply in the real world. To help you

read extensively, you have free access to the virtual learning environment

(VLE) and University of London Online Library (see below).

23 Investment management

Books

Allen, F. and D. Gale Financial Innovation and Risk Sharing. (Cambridge, Mass.;

London: MIT Press, 1994) [ISBN 9780262011419].

Campbell, J.Y. and L.M. Viceira Strategic Asset Allocation. (New York: Oxford

University Press, 2002) [ISBN 9780198296942] Chapter 2.

Duffe, D. and K.J. Singleton Credit Risk: Pricing, Measurement and Management.

(Princeton, NJ: Princeton University Press, 2003) [ISBN 9780691090467]

Chapter 1.

Embrechts, P., C. Kluppelberg, and T. Mikosch Modelling Extremal

Events. (New York; Berlin; Heidelberg: Springer-Verlag, 1997) [ISBN

9783540609315]. Note that this book is very advanced and is not really

drawn on except for some initial observations made in the very beginning

of Chapter 8 of the guide.

Grinblatt, M. and S. Titman Financial Markets and Corporate Strategy. (Boston,

Mass.; London: McGraw-Hill Irwin, 2008) [ISBN 9780077119027]. Please

note that at the time of going to print there is a new edition of this textbook

due to be published.

Hasbrouck, J. Empirical Market Microstructure. (Oxford: Oxford University

Press, 2007) [ISBN 9780195301649]. A relatively current textbook on

market microstructure which forms the basis for the chapter on market

microstructure.

Lo, Andrew W. Hedge Funds. (Princeton, NJ: Princeton University Press, 2008)

[ISBN 9780691132945].

Pole, Andrew Statistical Arbitrage. (Hoboken, NJ: Wiley Finance, 2007)

[ISBN 9780470138441].

MacKenzie, Donald An Address in Mayfair. (London Review of Books) www.lrb.

co.uk/v30/n23/mack01.html

Stultz, R. Risk Management and Derivatives. (Mason, Ohio: Thomson SouthWestern, 2003) [ISBN 9780538861014]. This book specifically deals with

risk management.

Journals

There are a number of important journal articles that deal with investment

management - those listed here are just a few:

Elton, E.J. and M.J Gruber Modern portfolio theory: 1950 to date, Journal of

Banking and Finance 21(1112) 1997, pp.174359.

Elton, E.J., M.J. Gruber and C.R. Blake Survivorship bias and mututal fund

performance, Review of Financial Studies 9(4) 1996, pp.1097120.

Mehra, R. and E.C. Prescott The Equity Premium: A Puzzle, Journal of

Monetary Economics 15(2) 1985, pp.14561.

Sharpe, W.F. Asset Allocation: Management Style and Performance

Measurement, Journal of Portfolio Management 30(10) 1992, pp.716.

In addition to the subject guide and the Essential reading, it is crucial that

you take advantage of the study resources that are available online for this

course, including the virtual learning environment (VLE) and the Online

Library.

You can access the VLE, the Online Library and your University of London

email account via the Student Portal at:

http://my.londoninternational.ac.uk

You should receive your login details in your study pack. If you have not,

or you have forgotten your login details, please email uolia.support@

london.ac.uk quoting your student number.

4

Chapter 1: Introduction

The VLE

The VLE, which complements this subject guide, has been designed to

enhance your learning experience, providing additional support and a

sense of community. It forms an important part of your study experience

with the University of London and you should access it regularly.

The VLE provides a range of resources for EMFSS courses:

Self-testing activities: Doing these allows you to test your own

understanding of subject material.

Electronic study materials: The printed materials that you receive from

the University of London are available to download, including updated

reading lists and references.

Past examination papers and Examiners commentaries: These provide

advice on how each examination question might best be answered.

A student discussion forum: This is an open space for you to discuss

interests and experiences, seek support from your peers, work

collaboratively to solve problems and discuss subject material.

Videos: There are recorded academic introductions to the subject,

interviews and debates and, for some courses, audio-visual tutorials

and conclusions.

Recorded lectures: For some courses, where appropriate, the sessions

from previous years Study Weekends have been recorded and made

available.

Study skills: Expert advice on preparing for examinations and

developing your digital literacy skills.

Feedback forms.

Some of these resources are available for certain courses only, but we

are expanding our provision all the time and you should check the VLE

regularly for updates.

The Online Library contains a huge array of journal articles and other

resources to help you read widely and extensively.

To access the majority of resources via the Online Library you will either

need to use your University of London Student Portal login details, or you

will be required to register and use an Athens login: http://tinyurl.com/

ollathens

The easiest way to locate relevant content and journal articles in the

Online Library is to use the Summon search engine.

If you are having trouble finding an article listed in a reading list, try

removing any punctuation from the title, such as single quotation marks,

question marks and colons.

For further advice, please see the online help pages: www.external.shl.lon.

ac.uk/summon/about.php

Examination structure

Important: the information and advice given here are based on the

examination structure used at the time this guide was written. Please

note that subject guides may be used for several years. Because of this

we strongly advise you to always check both the current Regulations for

relevant information about the examination, and the virtual learning

5

23 Investment management

changes. You should also carefully check the rubric/instructions on the

paper you actually sit and follow those instructions.

Remember, it is important to check the VLE for:

up-to-date information on examination and assessment arrangements

for this course

where available, past examination papers and Examiners commentaries

for the course which give advice on how each question might best be

answered.

The Investment management examination paper is three hours in

duration and you are expected to answer four questions, from a choice

of eight. You should ensure that you answer four questions, allow yourself

an approximately equal amount of time to answer each question and

attempt all parts or aspects of a question. Remember to devote some time

to planning your answer.

A full sample examination paper appears at the end of this guide. You are

required to answer any four of these eight questions, each of which carries

25 marks. A typical question contains three sub-questions which may not

be drawn from the same area, the first of which is relatively less diffcult

than the other and carries a weight of five marks against 10 marks for the

other two.

instruments

Learning outcomes

By the end of this chapter, and having completed the Essential reading and

activities, you should be able to:

accurately distinguish key characteristics between equity and debt

claims

clearly express the main differences between IPOs (initial public

offerings) and SPOs (seasoned public offerings)

contrast exchange traded securities and OTC (over-the-counter)

securities in detail

adequately describe given money market and bond market instruments

differentiate clean and dirty bond prices and aptly explain how

accrued interest is calculated

cogently discuss the importance of financial markets regulations

Essential reading

Bodie, Z., A. Kane and A.J. Marcus Investments. (Boston, Mass.; London:

McGraw-Hill Irwin, 2008) Chapters 1, 2, 3, 4, 14, 20, 22 and 23.

Elton, E.J., M.J. Gruber, S.J. Brown and W.N. Goetzmann Modern Portfolio

Theory and Investment Analysis. (New York; Chichester: John Wiley & Sons,

2010) Chapters 2 and 3.

Further reading

Grinblatt, M. and S. Titman Financial Markets and Corporate Strategy. (Boston,

Mass.; London: McGraw-Hill Irwin, 2008) Chapters 1, 2 and 3.

Guide to readings

This chapter is an introductory chapter and contains a great deal of

background readings from both the Essential and the Further readings.

The Essential reading for the general material in this chapter is contained

in Bodie, Kane and Marcus Chapters 1 through to 4. Here you can read the

material relatively quickly as there are few technical details to remember.

Some of the more technical material in this chapter is covered in Bodie,

Kane and Marcus Chapters 14, 20, 22 and 23. Here you can be more

selective in your reading, but you may also have to read the material more

carefully so that you are sure you understand it properly.

Introduction

Financial assets are distinct from real assets in that they do not generate

a productive cash flow that is what real assets do. Examples of real

assets are: a block of flats that can be let to provide the owner with future

rental income; the rights to manufacture and sell a particular product

generating future sales revenue; or a particular piece of computer software

that generates future sales and registration income. Examples of financial

assets are: a loan that is used to fund the acquisition of the block of

7

23 Investment management

flats and whose payments are financed by the rental income; or equity

capital used to fund the research and development costs for the consumer

software products mentioned above. The equity holders benefit in terms of

future dividends or capital gains that are generated from the future sales

income of the products. From the point of view of cash flow generation,

therefore, financial assets do not have much of a role to play. Financial

assets are not neutral in the sense that they transform the cash flow of real

assets for the holder. For instance, the loan generates a relatively stable

income even though the underlying cash flow is risky. Also, the loan might

have enabled the investor to raise suffcient funds for investment in the

first place. We trade financial assets, therefore, to repackage or transform

the cash flow of real assets, either through time or across states of nature.

Financial assets also do another important job they enable us to separate

the functions of ownership and control of real assets. As a rule, real assets

do not just passively generate a cash flow they need to be managed.

A company owns a collection of real assets. The job of managing these

is highly specialised and it is necessary that it is done by a professional.

This individual may or may not be the owner of the real assets, so it

makes sense for the company to keep the ownership and control functions

separate. This can be done by issuing equity with claims on the real assets

of the company the owners of the companys equity then become the

owners of the company so that the company can hire a professional

manager to manage its pool of real assets.

Who uses financial markets? There are three key sectors:

The household sector you and me who need to invest for retirement

income or mortgages for house acquisitions and various insurance

products, for instance.

The business sector consisting of firms that need to issue financial

claims on their future cash flow to finance current investments which

need to manage the risk of their business through derivatives trading

and insurance products.

The government sector that has a need to finance public expenditure.

This sector is special as it sometimes also intervenes in financial

markets to provide a public policy objective for instance, influence

the interest rate to manage inflation and additionally by acting as a

regulator of the activity in financial markets.

On the other hand, financial markets are not the only way these sectors

are served by financial instruments. Financial intermediaries also provide

services. These are companies such as banks and investment houses which

can lend money to, and help companies issue securities, and collect

deposits or lend to households, or manage households and companies

funds. In this chapter, we shall discuss a relatively broad range of financial

assets (also known as financial instruments), and their key defining

characteristics.

The simplest form of claim is a bond. A bond is a fixed claim meaning

that it promises a particular cash flow normally a coupon payment that

is an annual or semi-annual payment measured as a percentage of the

principal amount, and then ultimately at maturity the principal repayment

is made. For instance, a 10-year 5% bond with principal 100, will pay

a coupon payment of 5% of 100 each year until maturity, or five, and

additionally at maturity, in year 10, it pays the principal of 100.

8

The cash flow promised to bond holders comes from the cash flow

generated by real assets. Since the cash flow of real assets is often risky, it

may be that there is not enough to pay the promised amount at all times.

If this happens, the bond may default. In the example above, for instance,

the coupon promises a cash flow of 100 to be paid to the bond holders, but

if the corporate cash flow available in year 10, after coupon repayments

are made, is only 70 the bond holders stand little chance of receiving their

promised repayment of 100. The bond defaults, therefore, and the bond

holders can expect to receive at most only 70. Some bonds are, however,

practically default-free for instance, bonds issued by the government

(government bonds they are often called treasury bonds in the USA

and gilts in the UK). Bond instruments are traded in the money market

or the bond market. The distinction between these markets is essentially

that of the original maturity of the instrument. If a bond was issued with

very short maturity normally less than six months it will be traded in

the money market. If a bond has longer maturity it is traded in the bond

market. Another distinction is the denomination of the claim.

Normally, money market instruments are traded in large denominations

so as to be out of reach of normal households. They are used by banks and

corporations to lend and borrow in the short term. Bonds, on the other

hand, can be held by households.

The money market consists of fixed-income instruments of relatively short

maturity. This market also tends to be highly liquid, and instruments can

be in very high denominations, making it impractical for ordinary people

to trade. The players who operated in this market are normally private

banks, the central bank and corporations. There are a number of risk

free instruments traded, which are issued by the government, such as US

treasury bills, certificates of deposits and commercial papers.

Treasury bills (T-bills) initially have a maturity of 28, 91 or 182 days

(approximately one, three and six months). Treasury bills have two

atypical characteristics that set them apart from many of the other money

market instruments. They normally sell in low denominations of US$

10,000, making them tradeable by individuals.

A certificate of deposit (CD) is a deposit with a bank that has a clearly

defined time limit, so cannot be withdrawn on demand. These are,

therefore, very similar to T-bills except they are issued by a private bank

instead of the government. CDs are in denominations of US$100,000 or

greater, and in maturities of three months or shorter. Although there is a

theoretical default risk on CDs, they are treated as normal bank deposits,

so will be subject to governmental deposit insurance schemes.

A commercial paper is another short term fixed income security that is

similar to the ones we have looked at above but is issued by corporations.

There is a default risk associated with these instruments, but often they

are backed up by a bank line of credit so the borrower can access funds to

pay off the commercial paper at maturity. These instruments are also often

rolled over at maturity, such that the old commercial paper is paid off by

issuing a new one. The denominations are in multiples of US$100,000 so

commercial papers are rarely traded by individuals.

An important source of very short term financing used to trade

government bonds is the repo market (and the mirror reverse market).

A repo (RP) is a repurchase agreement where a dealer sells government

9

23 Investment management

the next day at a given (and slightly higher) price. The transaction is,

therefore, equivalent to a one-day loan agreement, since the agreement

provides a cash inflow today to the seller (as will be the case with a loan)

against a specified cash outflow tomorrow (as will be the case when

repaying a loan). These agreements are also very secure to the buyer in

the agreement (in this case he plays the role of a lender), who holds the

government bond overnight which serves as collateral in case the borrower

cannot raise suffcient funds to buy back the bond as promised. A reverse

repo is the mirror image, a buy transaction held overnight under the

promise of selling the securities the next day. Longer agreements are called

term repos, and are used for loans up to 30 days or more.

Another important short term financing market is the market (the London

Interbank Offered Rate) which is the rate at which large banks in London

are willing to borrow and lend money. Access to this LIBOR market is

of course restricted, but the LIBOR rate has become very important as

a reference rate, and many short-term fixed income instruments with

a floating rate tie their rates to the LIBOR (i.e. the rate is LIBOR plus a

margin).

The bond market also offers fixed income securities, only at longer

maturities than the money market instruments. A very large part of this

market consists of government bonds which are debt instruments with

payments guaranteed by the government. These bonds are important

because they offer investors claims that are in effect risk free, and they are

important to the government because they provide an important source

of borrowing. Common bonds are Treasury bonds and bills (issued by

the US government) and gilts (issued by the UK government). The UK

government bond market also trades two very unique types of bonds:

consol bonds (bonds with no redemption date, they are in effect a

perpetual loan that pays a coupon rate forever); and index linked bonds

(bonds where the repayments coupons and capital repayments are

index linked to the inflation rate). The yield of index linked bonds is the

closest we get to a direct estimate of the real interest rate.

Zero-coupon bonds are bonds that have no coupon payments. These bonds

always trade below par value (the nominal value of the loan) because of

the time value of money. If the interest rate is 5%, the value of a five-year

zero coupon bond equals the discounted capital repayment. If the par

value is 100, the current price of the bond is 78.35:

Price = 78:35 =

100

1.055

the clean price. This means that the bond price you actually pay is in

general not equal to the bond price that is quoted in the financial pages.

The price you pay is the quoted price plus the accrued interest the

dirty price. The adjustment for accrued interest involves stripping the

bond price of the first coupon payment. Consider two bonds: one bond

has maturity 11 years less one day and the other maturity 10 years plus

one day. Both bonds have an annual coupon with rate of 5% prices the

holders of the first bond has just received a coupon payment one day ago,

and the holders of the second bond is due a coupon payment shortly in

one days time. Suppose the discount rate is also 5%. The actual prices of

the two bonds are:

10

100 + 5

1.05364/365

100 + 5

1.051/365

At the time of the next coupon payment, the bonds trade at exactly par

value since the coupon rate equals the discount rate. But because of the

difference in the timing of the coupon the actual prices are different. The

accrued interest for the two bonds is given by the formula:

days since last coupon payment

Accrued interest = coupon payment

We find, therefore, the following quoted prices for the two bonds:

1

= 100.00

365

364

= 100.00

365

The adjustment for accrued interest makes the prices comparable. Bonds

are fixed securities but they often feature call provisions. Gilts often have

call provisions determining the redemption date so that the UK

government may retain flexibility to redeem the bond within given time

intervals. It is common in these circumstances to treat the redemption date

as the first date in the redemption interval if the coupon rate is greater

than the current market rate (so that the loan is relatively expensive

compared to the current rate for the UK government) and conversely as

the last date in the redemption interval if the coupon rate is less than the

current market rate.

Equity markets

Equity is, as opposed to a fixed claim like a bond, a residual claim. This

means that it has a cash flow that is in the form of the residual cash flow

of the real asset after all fixed claims with promised payments are paid

off. For instance, if a business is financed by a 10-year bond in addition

to its equity, the equity holders have a claim on the business net of the

cash flow that is promised to the bond holders. The equity claim is the

means by which ownership and control for corporations are separated.

When we refer to the owners of a corporation we mean the owners of the

corporate equity and not the owners of the corporate debt, although both

have claims on the cash flow of the firm. The owners of the equity are,

however, normally not directly involved in the running of the corporation

this is the job of the executive manager who is hired to do precisely

this job. Therefore, the ownership is separated from the control function

in corporations. The manager is hired on a long-term basis (although he

may be fired at short notice) whereas the owners of the equity can decide

for themselves whether they wish to invest long-term or short-term in

the corporation. The separation of ownership and control is, therefore, a

simple way to achieve a long-term stable management structure even if

the owners of equity are all short-term investors. In partnerships (such

as many accounting and legal practices) it would create a great deal of

operational upheaval to have ongoing ownership changes taking place.

11

23 Investment management

We can say, however, that the equity holders have more influence on the

running of the company than the debt holders. The direct influence of an

individual equity holder is nonetheless limited. An equity holder normally

gets the right to vote in general meetings. This means in practice that

he gets the chance to influence a few very important decisions such as

large investment projects or decisions related to corporate mergers and

takeover through his vote, and also to influence the choice of who sits

on the non-executive board of directors (NED). The NED has a direct

oversight on the executive management team of the corporation, and it

is essentially through representation on the NED that shareholders have

their main influence in the running of the firm. A lot of measures aimed at

strengthening corporate governance are aimed at making the NED more

effective in overseeing the executive management team.

Initially, companies issue equity that is owned privately (i.e. it is not

listed on a stock exchange) by an entrepreneur, a family, or by venture

capitalists. The process of making private equity public normally involves

the corporation seeking listing of its equity on a stock exchange. The

equity can thereafter be traded freely by all investors. The first time

a company seeks a listing is called an Initial Public Offering (IPO).

Subsequent equity issues are called seasoned issues, and these are much

less involved than the IPO since the equity has been traded for a while

before the issue. If the company sells existing equity (for instance, if the

government sells equity that is already issued but fully state owned) in the

IPO or during a seasoned issue, we call it a secondary issue. If new equity

is issued, we call it a primary issue. Sometimes the company needs to raise

additional capital when it goes public, and in this case it is necessary to

make some of the issued equity a primary issue. Otherwise, the issue is

primarily a process of transferring equity from the initial owners to the

new investors.

Equity instruments

Equity instruments consist of stocks common stocks or preferred stocks

in publicly traded companies. The two most distinctive features are that

they are residual claims and that an owner can exercise the right to limited

liability (i.e. the owner can decide to relinquish his claim on the real

underlying assets and instead hand these over to the other claim holders).

A residual claim is a claim that is unspecified, it will be determined as the

residual of the total corporate cash flow net of all fixed claims. Therefore,

if the corporate cash flow is 100m, on which the debt holders have a

fixed claim of 75m, the residual cash flow due to the equity holders is

the residual 100m 75m = 25m. The implication of the fact that equity

is a residual claim is that its value can never exceed the value of the total

real assets of the firm. The implication of the fact that the equity holders

can exercise the right to limited liability is that the value of the equity

can never become negative. Common stock and preferred stock differ in

two respects. First, common stock holders normally have voting power in

general meetings whereas preferred stock holders have not. Second, the

claim of preferred stock holders has seniority over that of common stock

holders. Thus, if the company wishes to pay dividends to its common stock

holders it must first pay a dividend to its preferred stock holders.

Common stock is often split into two classes (dual-class shares), usually

called A and B shares. These classes differ in their voting power, where

one class (normally A shares) have superior voting power relative to

the other class. The reason dual-class share structures are introduced is

12

that a controlling family may wish to retain the majority of the voting

power whilst at the same time may diversify by selling B shares to outside

investors. Dual-class share structures are relatively rare in the USA and the

UK but can frequently be found in Europe and Japan.

Derivatives markets

Bonds and equity claims are claims that perform a dual role. For the issuer

(businesses, banks or governments), these claims are a means of raising

capital used for investment or expenditure. For the investors, these claims

are means of smoothing real cash flows across time and states. Derivatives

are instruments that do not really play a direct role as a means of raising

capital that is, these instruments are in zero net supply. If no buyer exists

for a particular derivative instrument, then also no seller exists. Derivatives

are, therefore, almost exclusively used for risk management purposes.

Derivatives are also sometimes called contingent claims. The cash flow of

derivatives is almost always linked to the price of a primary asset such as a

bond or an equity claim the underlying asset. In this sense, therefore, the

cash flow is a function of, or contingent on, what happens to the price of

the underlying asset. However, recently we also observed derivatives that

had a cash flow contingent on other events, such as the event that a bond

defaults (credit derivatives), or the event that the weather is bad (weather

derivatives).

There are three broad types of derivative claims: futures (forwards),

options and swaps.

If you enter into a futures or forward agreement, you effectively

undertake the obligation to buy or sell an asset at a specified price in

the future.

An option is like a futures agreement, except that you have the right

to buy or sell rather than an obligation. This implies that you have

the right to opt out of the transaction if you own an option, but must

always carry out the transaction if you own a futures contract.

A swap is an undertaking to swap one cash flow for another cash flow.

Managed funds

Managed funds represent, in essence, a delegation of the investment

decision from the individual investor to a professional fund manager. We

distinguish between active and passive funds, fixed income and equity

funds, and open-end and closed-end funds.

An active fund is one where the fund manager typically makes investment

decisions that are in the form of bets the manager might think that

certain sectors or certain stocks are better bets than others and influences

the investments of funds to these sectors or stocks. A passive fund is

one where the fund manager typically attempts to mimic a broad stock

market index (like the FTSE 100 in London and the Standard & Poor 500

in New York). This normally amounts to physically holding the index or

a large number of stocks in the index. Open-end funds are funds where

the investors clear their holding directly with the fund. Therefore, if a

new investor comes in to buy units of the fund the fund simply issues

new units. The price the investor pays is the Net Asset Value (NAV) less

charges. The NAV is calculated as the total net value of the fund divided by

the number of units issued to investors. Closed-end funds are funds which

have a fixed number of units issued. If an investor wishes to buy units in

13

23 Investment management

funds have, therefore, a value which is independent of the value of the

assets held by the fund. There have historically been price discrepancies

between the total value of outstanding units, and the total net value of

assets held by the fund, where units have traded at a considerable discount

relative to their theoretical value.

A fairly new innovation for private investors is the so-called exchange

traded funds (ETFs). These are typically index tracker style funds, but they

are exchange traded like a stock. This makes it possible for small investors

to hold an index cheaply and effciently without having to physically

diversify by trading a large number of stocks in small quantities. Examples

of exchange traded funds are the DIAMONDS fund on the NYSE, which

delivers the Dow Jones Industrial Average Stock Index, and the iFTSE100

fund on the London Stock Exchange, which delivers the FTSE 100 Index.

The process by which financial assets are traded can be divided, broadly

speaking, into exchange trading and over-the-counter (OTC) trading.

Exchange trading involves investors submitting buy-and-sell orders that

are aggregated into some system that allows buyers and sellers to be

matched directly. OTC trading involves investors submitting buy-and-sell

orders to a dealer who acts as an intermediary in the trade. The dealer

will normally take proprietary positions in the stock and thereby expose

himself to inventory risk, but over time these inventories cancel out as

investors execute trades at both the buy and sell side of the dealers

inventory. Large stock markets such as the NYSE (New York Stock

Exchange) and the LSE (London Stock Exchange) are executing exchange

trading of securities, whereas the NASDAQ stock market is an OTC market

with a panel of dealers offering bid and ask prices for the listed stocks. In

a perfect world in which each trader is able to trade at the competitive

prices at all times the difference in market structure does not translate

into any real differences in the execution of the trade. However, the OTC

market structure has been criticised for allowing trading at the bid and

ask prices when there exist limit orders inside the spread that could trade

at a better price (so-called trading through), and large markets such as

the NASDAQ market are working to improve their system. In 1997, the

LSE carried out a conversion from OTC trading (much like the NASDAQ

market structure) to exchange trading using a fully computerised limit

order system (the SETS system). There is no intermediary at all in this

market. The NYSE operates a system in which a limit order book executes

most trades but that also a significant portion of the trading volume is

executed by an intermediary (the so called specialist) who might improve

on the quotes implied by waiting limit orders. The benefit of having such

an intermediary is that relatively competitive quotes are also offered

in stocks that are thinly traded. Chapter 3 of Bodie, Kane and Marcus

describes the securities trading process in more detail.

14

contingent orders

The trading process of stocks has become increasingly sophisticated.

All transactions taking place on a stock exchange are cleared once a

day, where the net positions are to be settled. If, for instance, you both

buy and sell the same security over the course of a single day, it is only

the net trading that needs to be settled. Settlement takes place within

three working days on the NYSE, so that if you have bought net stock on

Monday, you will receive your share certificates and pay the outstanding

amount on Thursday. You can also trade stock on margin, which means

that you only pay for a part of the purchase price and you borrow the rest

from your broker. The broker normally has a working relationship with a

bank or a financing house to finance loans made through margin trading.

A margin needs to be maintained over time. For instance, if you purchase

shares initially worth 10,000 on a 60% percentage margin, you need to

pay only 6,000 and you borrow the remaining 4,000 from your broker.

Suppose your account stipulates a 50% maintenance margin. If the shares

decline in value, suppose they drop to 7,000, your margin would have

decreased below 60% also. The margin is now (7,000 4,000)/7,000 =

43%, so you need to inject more money into your account to maintain a

margin of 50%. After the repayment, your margin is worth 3,500 and the

loan is 3,500.

You can sell a stock you do not own to take advantage of price drops.

Technically, it is illegal to sell a stock you do not own but you can

circumvent these rules by borrowing share certificates from somebody

who already owns the stock, which are then short sold. The owner of the

share certificates will normally demand a fee. Fund managers who manage

large funds (such as pension funds) are often lending their certificates

to investors who wish to go short in the stock, since these funds do not

normally plan to sell the stock anyway. Short selling is used particularly by

hedge funds as an integral part of the investment strategy.

You can also instruct your broker to execute contingent buy-and-sell

orders. The most common of these are called limit orders, where you

instruct your broker to buy a certain amount of stock as long as the

purchasing price is below a certain limit, or to sell a certain amount of

stock as long as the selling price is above a certain limit. You can also use

so-called stop loss and stop buy orders. A stop loss order is an instruction

to sell a quantity of a stock as long as the price remains below a certain

limit, and a stop buy order is an instruction to buy a quantity of a stock as

long as the price remains above a certain limit. These are used to limit the

loss potential of long and short positions. For instance, if you own a large

quantity of a stock that has already appreciated in value, you may wish to

protect your profit by giving a stop loss order. The sell order comes into

effect if the stock price goes below a certain limit. Similarly, if you have a

large short position and you wish to protect the existing profit you may be

giving a stop buy order.

When you are trading on margin you are in effect taking a leveraged

position, where the total return is shared between the broker (who

borrows or lends money from you on his margin account) and yourself.

It can become complicated sometimes to work out the return on these

trades, so we will go through a couple of examples here of a long trade

15

23 Investment management

(and we need to work out the return on our initial equity position) and a

short trade (which is a loan, and we are interested in the implied loan rate

on our net loan, taking into account the deposit on our margin account).

First consider a long position. You buy 1000 shares of a stock at an initial

price of 100p per share, and one year later the price is 60p per share.

During the year, you receive dividends worth 10p per share. You hold the

position for another year, where you receive dividends of 8p per share, and

then finally at the end of year two you sell the position at a price of 110p

per share. The initial margin is 60%, and the maintenance margin is 40%.

There are three steps to the calculations here. First, you need to work out

the gross cash flows. In year 0, the investment cost is 1000 (1000 units

times the price of 100p). Then in year one, the cash flow is the dividend

payment of 100 (1000 shares times 10p) which we assume arrive at

the end of the year (this may not be the case of course but it is the most

conservative estimate). Finally, in year two, the cash flow is 1100 from

the proceeds of the sale, plus 80 from the dividend payment, a total of

1180. So the gross cash flow is (1000; +100; +1180). Next, we need

to work out the net cash flow. The initial margin is 60%, which means we

can borrow 40% on a margin loan. This gives us a cash inflow in year 0 of

400. Following the initial position there is a maintenance margin of 40%,

which means we have to keep 60% at the minimum as equity. We do not

need to check the end of year two as the margin loan is unwound in any

case, so lets look at year one. Here, the value of the position is 600, and

the margin loan is 400, i.e. an equity position of 200, which is 33.3%.

We need to maintain a 40% equity, so the maximum margin loan is 360.

Therefore, we need to pay off 40 of our margin loan. At the end of year

two the loan is repaid, and if we assume zero interest the cash flow is

360. The margin cash flow is, therefore, (+400; 40; 360). Therefore,

the net cash flow is ( 1000; +100; +1180) + (+400; 40; 360) =

( 600; +60, 820). The final step is to work out the rate of return on our

net investment. Here we use the familiar internal rate of return (IRR)

formula from course 92 Corporate finance:

600 +

60

820

+

=0

1+ IRR (1+ IRR)2

Now consider a short position. You short 1000 shares of a stock at an

initial price of 100p, and one year later the price is 160p per share.

During the year there is a dividend payment of 10p per share. You hold

the position for another year, where there is a second dividend payment

of 8p per share, and then finally at the end of year two you buy back the

1000 shares at a price of 60p per share. The initial margin is 60%, and the

maintenance margin is 40% (in practice, it is diffcult to short on a margin

less than 50% but it can be useful to have a margin percentage different

from 50% to illustrate which direction the margin requirement pushes).

As above, the first step is to work out the gross cash flows. In year 0, the

proceeds from the short sale raises 1000. In year one, you have to make

good a dividend payment of 100 (this is now a cash outflow since you

are short in the stock). In year one, you buy back the 1000 shares at a cost

of 600, and you have to make good another dividend payment of 80.

The total gross cash flow is, therefore, (+1000; 100; 680). Now let us

look at the margin cash flows. The initial margin is 60%, which means that

you have to deposit at least 60% of the short liability on a margin deposit

account. This means that you have to put 600 in the margin account with

the broker. You have to maintain a 40% maintenance margin throughout,

16

and as above it suffces to check year one only as you are unwinding the

position in year two. In year one the liability is 1600, and 40% of this

is 640. Since you have only 600 deposited, you need to put another

40 in the margin account. Ignoring interest rates on the margin account,

therefore, the margin cash flows are ( 600, 40, +640). The net cash

flow is (+1000, 100, 680) + ( 600, 40, +640) = (+400, 140;

40). The internal rate of return formula gives us here:

400

140

40

=0

1+ IRR

(1+ IRR)2

learn more about margin trading by reading Chapter 3 of Elton, Gruber,

Brown and Goetzmann.

Financial markets are heavily regulated laying down rules to the way

trade can be conducted. Because we often speak of the free market it

is easy to forget how strict the rules are that govern financial trading.

Regulation is both in the form of self-regulation (where the organisers of

the market set the rules) and government regulation (where a regulator

appointed by the government sets the rules). The reason for regulation is

primarily to provide protection to market participants, particularly those

who are relatively vulnerable to abuse or fraud by other investors, brokers

or exchanges. What are the main objectives of regulation? The first is to

stop companies releasing information to investors that is inaccurate or

misleading, or released in a way that gives some investors an advantage

over others. The second is to make sure unsophisticated investors are not

taken advantage of by more professional or sophisticated investors or by

advisers or institutions involved in the trading process.

Summary

This chapter has outlined some basic facts on financial claims and

markets.

There was an overview of bond and money markets in which we trade

fixed claims, and an overview of equity markets in which we trade

equity claims which are residual claims (the exact opposite of fixed

claims).

There was an overview of derivatives markets, managed funds and

exchange traded funds.

The chapter also dealt with margin trading and how margin accounts

work.

Finally, there was a short discussion of regulation of financial markets.

Activities

1. Discuss why we need regulation of markets. Try to look for arguments

to support your discussion by looking up, for instance, issues related

to regulation on the websites of the London and New York stock

exchanges: www.londonstockexchange.com or www.nyse.com.

17

23 Investment management

2. If you buy an asset on a 50% margin, how much would you have to pay

initially if the price is 126p per share and you buy 1000 shares? How

much more do you need to pay if the price went down to 115p per

share?

3. Consider a short sales transaction on a 70% initial margin requirement

and 60% maintenance margin. You keep the transaction over five

months, and you trade 1000 shares of a stock. The initial price is 100p

per share. The price at the end of the first, second, third and fourth

month is 95p per share, 120p per share, 140p per share and 110p

per share, respectively. The price at the end of the fifth month is 98p

per share. Calculate the gross monthly profit, and the net monthly

profit taking into account the margin deposit. You can assume the

margin deposit account is interest free. What is the net monthly profit

if the deposit account pays 0.1% monthly interest rate? What is the

net monthly profit if the commission on the sale and the repurchase

transaction is 0.5% of the transaction amount?

Having completed this chapter, and the Essential reading and activities,

you should be able to:

accurately distinguish key characteristics between equity and debt

claims

clearly express the main differences between IPOs (initial public

offerings) and SPOs (seasoned public offerings)

contrast exchange traded securities and OTC (over-the-counter)

securities in detail

adequately describe given money market and bond market instruments

differentiate clean and dirty bond prices and aptly explain how

accrued interest is calculated

cogently discuss the importance of financial markets regulations

1. a. Explain the difference between exchange trading and over-thecounter (OTC) trading of an asset. Explain the typical characteristics

of, and the differences between, debt claims, equity claims and

derivative securities.

b. Explain the reasons why financial markets are regulated.

c. You short 1000 shares of a stock at a price of 100 on a 70% initial

margin. The maintenance margin is 50%. At the end of the first year

the price of the stock increases to 140, and at the same time there is

a dividend payment of 10. At the end of year two the price has gone

down to 80 and you buy back the stock. What is the return on your

short transaction?

18

markets

Learning outcomes

By the end of this chapter, and having completed the Essential readings

and activities, you should be able to:

broadly identify established examples of financial innovations and their

fundamental characteristics

discuss the main benefits financial innovations provide to investors

confidently explain the notion of equity premium puzzle in the context

of financial markets

clearly define risk aversion and the risk aversion coefficient

aptly characterize constant absolute risk aversion utility functions

(CARA).

Essential reading

Bodie, Z., A. Kane and A.J. Marcus Investments. (Boston, Mass.; London:

McGraw-Hill Irwin, 2008) Chapters 4 and 5.

Further reading

Allen, F. and D. Gale Financial Innovation and Risk Sharing. (Cambridge, Mass.;

London: MIT Press, 1994) Chapter 2.

Introduction

In this chapter we look at the historical and empirical evidence

surrounding financial markets and assets. The first part surveys the

innovations regarding financial instruments and the trading process in

financial markets. The second part surveys the history of investment

returns on financial assets. Three questions are addressed in particular:

What return can investors expect to earn when investing in various

types of financial assets?

What are the risk characteristics of these returns?

Are returns and risk characteristics linked?

An interesting issue is the historic relationship between the risk and return

on various instruments. If investors are risk averse we expect to find they

demand compensation for holding risky portfolios. This will be discussed

in relation to the so-called equity premium puzzle.

Many early civilisations made use of loan agreements between individuals,

and in the old Babylonia and Assyria, several thousand years BC, there

were at least two banking firms in existence. Equities and bonds were

developed during the sixteenth century. Convertible securities also have a

long history. In continental Europe in the sixteenth century there existed

equity issues that could be converted into debt if certain regulations

19

23 Investment management

were broken. Similarly, preferred stock has been in use for a long time.

Exchange trading of financial securities also has a surprisingly long history.

Equity was traded in Antwerp and Amsterdam in the 1600s. Moreover,

options and futures (called time bargains at the time) were traded on the

Amsterdam Bourse after it was opened in 1611.

Many of the European stock markets experienced major stock market

bubbles in the eighteenth century. A famous example is the South Sea

Bubble (1720) where the price of the South Sea Company rose from

131% of par in February to 950% by June 23, then fell back to 200%

by December. This bubble led to the so called Bubble Act which made

it illegal to form a company without a charter or to pursue any line of

business other than the one specified in the charter.

We also know of early examples of speculative bubbles.

The 1960s witnessed a number of innovations driven by regulatory

constraints. The Eurobond market emerged where non-US companies

could borrow in US$. At the time foreign borrowers were excluded from

the US markets. Similarly, currency swaps were developed during this

period to circumvent UK exchange controls. The 1970s witnessed the

introduction of floating-rate instruments (bonds with coupons tied to

a floating rate such as the LIBOR rate in London), and the trading of

financial futures, such as futures on foreign currency, futures on interest

rates and futures on stock market indicies.

Often, the innovation of new securities is initially driven to circumvent

regulatory constraints or to exploit market demand for new types of

claims. Once they become established, however, the investors find they

have other, broader, advantages that make them a useful addition to

the financial system. Below you can find a few case studies of new

innovations.

Floating-rate notes were first issued in 1970, and it was an instrument that

was linked to a floating reference rate the London Interbank Offered Rate

(LIBOR). These instruments came in during a period when inflation risk

became a serious threat, so the nominal rate would fluctuate dramatically.

Allowing loan rates to vary in accordance with these fluctuations was

a natural response. In the mid-1970s the market for floating-rate debt

started growing significantly, and these instruments were fairly widely

used in the early 1980s. Most floating-rate debt is issued in the European

market, and these instruments have never been particularly popular in the

USA. A spin-off innovation is floating-rate preferred stock, a preferred stock

in which the dividend yield is linked to variations in the reference rate.

Zero-coupon bonds were first issued in the 1960s, but they did not become

popular until the 1980s. The use of these instruments was aided by an

anomaly in the US tax system, which allowed for deduction of the discount

on bonds relative to their par value. This rule ignored the compounding of

interest, and lead to significant tax-savings when the interest rates were

high or the security had long maturity. Although the tax-loophole was

closed fairly quickly, the bonds were desirable to investors because they

were very simple investment tools. For a bond that has interim coupon

payments the investor would have to reinvest these coupon payments

20

zero-coupon bond has no reinvestment risk.

The popularity of corporate acquisitions and mergers has promoted the

emergence of a number of anti-takeover techniques. Some of these have

taken the form of financial innovations. One of the earliest was the socalled preferred stock plans. With these, the target company (the one that

the bidding company seeks to acquire) issues a dividend of convertible

preferred stock to its shareholders, which grants certain rights if the

bidding company buys a large position in the target firm. These rights

might be in the form that the stockholders can require the acquiring firm

to redeem the preferred stock at the highest price paid for common stock

in the past year. If the takeover actually goes through, the highest price

will almost certainly be the takeover price, and the acquiring company

must, therefore, issue a number of new stock at the takeover price in

exchange for the old preferred stock already issued. This will, obviously,

dilute the gains of the takeover to the acquiring party and reduce the

likelihood of a takeover.

Another poison pill security is the so-called flip-over plan. This consists of

the issue of a common stock dividend consisting of a special right. This

right enables the holder to purchase common stock at an exercise price

well above the current market price. Normally, nobody would exercise

these rights as the exercise price is high compared to the current market

price. However, in the event of a merger, they flip-over and give the right

to purchase common stock at an exercise price well below the current

market price. Again, this makes takeovers costly as the bidders profits

from the takeover are heavily diluted by the exercise of the flip-over plans.

The first swaps that emerged in the 1960s were currency swaps, and

they emerged like many other innovations on the back of regulation.

In this case, a UK-based multinational company might have a surplus

of funds in the UK that it wished to invest in a US subsidiary but was

prevented due to UK exchange controls. A counterparty in the USA with

the opposite problem, a surplus of US funds but a need to invest in a UK

subsidiary, could often be identified. Since regulation prevented a straight

transfer within each company, the companies could circumvent the rules

by simply using parallel loans the US firm promised to lend dollars to

the UK subsidiary against the UK firm promising to lend pounds to the

US subsidiary. A major problem with these arrangements soon emerged,

however, which was that there was a considerable amount of counterparty

risk involved. A company might have entered into the agreement fully

solvent but might experience problems in the interim period before expiry.

If one party defaulted, would the other party still be obliged to fulfil their

part of the arrangement? This deficiency could be overcome by the swap

agreement, where, in principle, the companies deposited money with each

other and paid the interim interest payments to each other according to

the prevailing interest rates in the two currencies, and finally the principal

amount is cleared at the end of the agreement. The interim payments are

normally netted out using the prevailing exchange rate, so there is only

one payment made.

The swap agreement has also been modified to agreements involving

swapping cash flows of adjustable (floating) rate loans and cash flows

of fixed rate loans. In this case, principal payments are not made in the

21

23 Investment management

same way as currency swaps these are also netted out so that the swap

agreement effectively consists of a series of single payments.

The standardised financial futures contracts are a relatively recent

innovation, in contrast to the older, forward style agreements that have

existed since the emergence of a financial system. An important feature

of this contract is the way it is traded, which makes it easy for investors

to enter and exit existing futures agreements in between the start of the

contract and the maturity date of the contract. More importantly, however,

is that futures trading allows investors to shift large amounts of risk

with very little investment. Futures trades are, therefore, highly levered.

For example, margin trading of equity typically involves a margin of

50%, so even if the investor can borrow he still needs to finance half the

investment cost (and further margin calls if the stock price goes down).

With futures positions, investors normally maintain margins less than 10%

of the face value of the futures contract. The futures contract is marked

to market each day, so the investor can unwind his position (sell if the

original transaction was a buy and vice versa) and his account is settled

with no further cash flows taking place.

The credit default swap is a derivative security that does not use a

financial asset as the underlying security, but rather the credit event

associated with a bond or money market instrument. The buyer of the

credit default swap undertakes to pay a given amount to the seller until a

credit event occurs. The credit event could be a default of the underlying

bond instrument, but it could also be a ratings downgrade. If a credit event

occurs, the seller must pay the buyer an amount according to the credit

default swap agreement. What is special about these instruments is that

they provide insurance against default. If you are an institution lending

money to a company, for instance, you can safeguard your investment

(since you are lending money the loan is an asset) by simultaneously

buying a credit default swap on the same bond or loan. If the company is

unable to repay you the money they owe, therefore, you can claim money

from the seller (or writer) of the credit default swap.

Traditionally, an institution providing a loan to a company would hold

the asset to maturity. This is of course a good idea, since it forces the

institution that makes the decision to lend to stick to it till the end. If the

institution is bad at assessing the risk of the loan it is likely to suffer the

loss as well. However, it can also be a bad idea, as it can be constraining

for financial institutions that historical lending decisions dictate what

they are currently doing. For instance, a financial institution which is

good at marketing loans to companies in a particular industry should

continue using their expertise in future lending decisions. However, if the

industry is facing a downturn with increasing default rates it may be that

losses on loans that are made earlier will prevent future lending. In this

case, lending to the industry is likely to be serviced by other institutions

with less expertise. The idea of selling off loans or bonds is, therefore, a

natural one to consider. Collateralised debt or loan obligations is a way

of doing just that. The institutions typically packages loans or bonds into

large portfolios, then sell off the loans portfolio bit by bit. The way this

is done is by issuing tranches of securities written against the cash flow

of the loans or tranches bond portfolio. The senior tranches (typically top

22

rated instruments) have priority claim to this cash flow. The mezzanine

tranches (with intermediate rating) have seniority after the senior tranches

are serviced, and finally the equity tranche carries the residual claim.

It is commonplace that the financial institution selling off loans or debt

portfolios in this way retains the equity tranche.

It should be mentioned here that collateralised loan or debt obligations

have been cited as one of the factors causing the so-called credit crunch

which started in late 2007 and has continued to the time of writing. A

problem with collateralised loan or debt obligations is that if the financial

institution knows it will be able to sell the loan in the secondary market to

outside parties, there is little incentive to make sure its lending decisions

are sound. The liquidity in the market for collateralised loan or debt

obligations did dry up considerably in late 2007.

What returns have investors historically made in the bond and equity

markets around the world? We have about a hundred years of data on

stock market returns, and the brief answer globally is that the countries

most devastated by the Second World War had the lowest long-run

cumulative returns Italy, Belgium, Germany and Japan. The countries

that experienced the least damage, in contrast, have the highest long

run cumulative returns: Australia, Canada and the USA. However, the

real returns (corrected for inflation) are pretty much similar across all

countries.

A major theoretical prediction from pricing models is that the expected

or average return on assets is linked to the risk of holding these assets.

Again, the overall empirical evidence supports this prediction. Looking, for

instance, to the US experience from 1926 to 2002, we find the following:

Asset type

Geometric average

return

Arithmetic average

return

Small-company stocks

11.64%

17.74%

Large-company stocks

10.01%

12.04%

5.38%

5.68%

US T-bills

3.78%

3.82%

Inflation

3.05%

3.14%

Table 2.1

compare the numbers in Table 2.1 against the variance of returns, we find

the following:

Asset type

Arithmetic average

return

Standard average

return

Small-company stocks

17.74%

39.30%

Large-company stocks

12.04%

20.55%

5.68%

8.24%

US T-bills

3.82%

3.18%

Inflation

3.14%

4.37%

Table 2.2

and return (inflation is not an asset). The more risk the investor takes on,

23

23 Investment management

This can be explained by risk aversion - that investors are unwilling to take

(actuarially) fair risk.

The return on equity is greater than the return on bonds because the

risk is smaller. What has been found, however, is that the difference (the

so-called equity premium) appears to be bigger than should be expected.

The following example from US stock and bond markets is compelling. A

person who invested $1000 in Treasury bills on 31 December 1925 and

kept it in safe US Treasury bills until 31 December 1995 would have an

investment in 1995 worth $12,720. If the money were invested in the

stock market the corresponding number is $842,000 (66 times the amount

for T-bills). Considering that the equity investment would have survived

two large stock market crashes (in 1929 and in 1987), the difference is

strikingly large.

How should we compare a risky investment with a risk-free one? One

way to do this is by assuming a risk averse investor holds both risk-free

T-bills and risky equities in his portfolio (for a review of utility theory

and risk aversion, see Appendix 1). The premium on the equity is then

compensation for his risk aversion. The greater the premium, the greater

the risk aversion of the investor must be. Using historical data, we can

therefore make inferences about the risk aversion of investors. Risk

aversion is measured by the risk aversion coeffcient, formally derived from

the utility function by the relationship:

Risk aversion coefficient =

u (x)

u (x)

If the investor has CARA (constant absolute risk aversion) utility the utility

function takes the form u(x) = exp( x). The risk aversion coefficient is in

this case (as the CARA name suggests), the constant .

If asset returns are, moreover, normally distributed, we can write the

expected utility function as:

Var(x)

Expected utility = E(x)

2

Suppose a CARA investor is indifferent between holding large-company

stocks and long-term US Treasury bills over a long period of time. Then

the following expression must hold:

0.03182

0.20552 = 0.0382

0.1204

2

2

which is solved for a risk aversion coefficient of 4. This is a fairly

reasonable number, but asset returns are not normal so we cannot use

this simple model to estimate the implied risk aversion coeffcient. This

is the motivation for Mehra and Prescotts study. They fit a rigorous

theoretical model to data on the return on stock market investments and

government bonds. The model generates the risk aversion coefficient of a

representative investor (see Appendix 1 for a review of risk aversion and

the risk aversion coeffcient). They found that a reasonable estimate for the

risk aversion coefficient is between 30 and 40. This is way too high, as a

risk aversion coefficient of 30 implies, for instance, that if the investor is

facing a gamble where he has a 50% chance of doubling his wealth and a

50% chance of halving his wealth, he would be willing to pay up to 49%

of his current wealth to avoid the gamble, i.e. if his current wealth is 100,

24

a gamble where there is a half chance of receiving 50 and a half chance

of receiving 200. In practice, it would be diffcult to find anybody not

preferring the gamble in this case.

Can the equity premium puzzle be resolved? Mehra and Prescott might

have sampled data that were special in two senses. First, it might have

been too short so there is a possibility that the period was in some sense

too special to make safe inferences about the implied risk aversion

coeffcient. Their work has been extended to include data all the way back

to 1802. The main finding of this exercise is that the real returns of shortterm fixed income have fallen dramatically over time. The real excess

return on equity would, therefore, on average be about one percentage

point lower than that reported by Mehra and Prescott. This will of course

reduce the magnitude of the risk aversion coefficient but it is doubtful that

the puzzle would be completely resolved.

The second way the data might have been special is that the time series

are too long. This might lead to survivorship bias in the data. When

collecting masses of data we inevitably sample those data-series that have

survived for a long time. The long-surviving data series would also tend to

be healthier and show average returns that are higher than the perceived

expected returns at historical points in time. Investors might reasonably

worry about the risk of a crisis or catastrophe that can wipe out the entire

market overnight. And indeed, of the 36 stock exchanges that operated at

the early 1900s, more than one-half experienced significant interruptions

or were abolished outright up to the current time. Hence, the equity

premium might include some bias if estimated by long time series of data.

Again, survivorship bias might be a source of some errors in the estimation

of the risk aversion coefficient but it is unclear how much it contributes.

Summary

This chapter surveyed the historical perspective on the financial system

and, in particular, financial innovations of various types. There was a

survey of examples of major financial innovations such as swaps and

collateralised debt obligations.

The second part of the chapter dealt with the long term return on

various classes of assets, where a strong relationship between risk and

return was uncovered.

This part also covered some controversial issues related to the

difference between equity returns and government bond returns

issues related to the so-called equity premium puzzle.

Activities

1. Explain the role of poison pill securities and discuss whether this is a

helpful innovation of financial securities.

2. The historical evidence points to the fact that riskier securities have a

greater average return. Explain why. We also know that the expected

prize in lotteries is smaller than the cost of participating (an example is

UKs Lotto: A $1 lottery ticket has an expected prize payment of around

$0.45). Can you think of a reason why people are reluctant to accept

risk in financial markets but happy to pay for risk in lotteries?

25

23 Investment management

Having completed this chapter, and the Essential reading and activities,

you should be able to:

broadly identify established examples of financial innovations and their

fundamental characteristics

discuss the main benefits financial innovations provide to investors

confidently explain the notion of equity premium puzzle in the context

of financial markets

clearly define risk aversion and the risk aversion coefficient

aptly characterise constant absolute risk aversion utility functions

(CARA).

1. a. What is a zero-coupon bond? What makes a zero-coupon bond often a

more attractive investment vehicle for investors than a coupon bond?

b. Explain, in words, the equity premium puzzle. Can bias in the data

explain this puzzle? Explain.

c. Give four examples of recent financial innovations. Explain how

they work, and what reasons there are for investors making use of

the innovations.

26

investment

Learning outcomes

By the end of this chapter, and having completed the Essential reading and

activities, you should be able to:

describe fundamental trends in historical mutual fund performance

confidently explain the efficient market hypothesis and fully distinguish

between its many forms

cogently discuss the existence of common cognitive biases in human

information processes, and concisely explain how these biases can lead

to effects (momentum and reversals) that violate the efficient market

hypothesis

describe how the effects of momentum and reversals can be translated

into profitable investment strategies in detail

clearly identify distinctive characteristics of hedge funds in the context

of the investment management industry

briefly discuss the problems related to evaluating hedge fund

performance

adequately define algorithmic trading or statistical arbitrage.

Essential reading

Bodie, Z., A. Kane and A.J. Marcus Investments. (Boston, Mass.; London:

McGraw-Hill Irwin, 2008) Chapters 4 and 13.

Further reading

Lo, Andrew W. Hedge Funds. (Princeton, NJ:Princeton University Press, 2008).

Pole, Andrew Statistical Arbitrage. (Hobaken: Wiley Finance, 2007) Chapter 2.

MacKenzie, Donald An Address in Mayfair. (London Review of Books)

www.lrb.co.uk/v30/n23/mack01.html

Introduction

Investors do not always invest directly in financial assets. Sometimes they

use portfolio or fund managers to invest on their behalf. Professional

investors or fund managers now control the bulk of private investment

in financial assets, and its sheer size has made this sector a subject of a

lot of research. This chapter will provide an overview of the empirical

evidence of fund management and investment strategies. In particular,

we will discuss whether there is an empirical foundation for the notion

that fund managers provide value for money, and whether various types

of investment strategies (e.g. technical trading strategies, or the so-called

contrarian or momentum strategies) yield abnormal returns.

Among all the evidence surrounding investment strategies to gain long

term sustainable trading profits, we find a long list of anecdotal stories

of individuals making huge trading profits in inventive, ad hoc, ways.

They are of course interesting in their own right, but it should be noted

that they deal normally with trading opportunities that can be exploited

27

23 Investment management

only once. The Economist 2004 Christmas Special surveys some cases of

exceptionally profitable single trades. An interesting observation is that

the cases fall into one of two categories a normal trader spotting an

unexpected arbitrage opportunity, or a large trader using a window of

opportunity to exploit his market power. An example of the former is the

case of the Italian national Ludovico Filotti who worked for Barings Bank

in London. While on holiday in Italy in 1993 Mr Filotti discovered a new

savings scheme, guaranteed by the Italian government and issued by Italys

Post Offce offering a very high return relative to the Italian government

bonds. Although aimed at ordinary investors, the Post Offce had not

barred institutions from investing in such bonds. Having borrowed by

selling Italian government bonds, Mr Filotti flew personally to Italy with a

bankers draft of $50m to invest in the Post Offce bonds. The trade made

a huge profit and is a classic example of an arbitrage transaction where

a trader buys an asset cheaply in one market and sell it expensively in

another. An example of a large trader exploiting market power is the case

of George Soros who in 1992 betted against the UK Pound Sterling staying

in the European Exchange Rate Mechanism (ERM). He borrowed heavily

in pounds to invest in other currencies, forcing the Bank of England to use

its reserves to buy pounds to prop up the exchange rate. Eventually, the

pressure on the Bank of England reserves became so huge the government

decided to withdraw the pound from the ERM, netting Soros a profit of

around $1bn after unwinding his position.

These cases are atypical and one view is that they are also likely to become

less frequent as the financial system becomes more integrated and global,

and as the capital markets become more effcient. This view is supported by

the evidence of active portfolio management.

There is a long-standing academic literature that has analysed the

performance of fund managers. We discuss the measurement problems

associated with this task later on in this subject guide, but note here that

it is in general very hard to obtain accurate assessments of fund managers,

despite the fact that the outcome of their decisions (the return on the

portfolio) is normally very easy to obtain. The diffculties are linked to

two factors. First, it is diffcult to lay out exactly what the benchmark for

normal or expected performance should be. We know that in financial

markets, expected returns depend on the risk of the asset. A good way

to boost the average return is, therefore, simply to take more risk. This

is of course not necessarily a good decision. Second, there is an awful

lot of noise in financial markets that makes investment returns very

uncertain regardless of whether the investment decision was a good one.

A good decision may, therefore, easily end up losing money over a given

time period, and a bad decision might easily yield a profit. To sift the

good investment decisions from the bad ones in such an environment is,

therefore, very diffcult. Nonetheless, the broad picture from the USA is

the following. Measuring mutual fund performance against a broad stock

market index shows that more often than not the broad stock market

index outperforms the median fund manager. In addition, of course,

investors investing in a mutual fund will pay management fees which

they are not liable for when holding the index. Since 1971 the compound

return on a broad stock market index has been 12.2% versus 11.11% for

the average fund. Over such a long period, and excluding management

fees, this difference is very large.

28

Although the average fund might not provide much value for money

for the investor, it may be that the best funds can. Several studies have

examined whether funds which perform better than the average over a

two-year period are also likely to perform better than the average in the

subsequent two-year period.

Study

Initial period

Top half

successive period

Bottom half

successive period

Goetzmann/

Ibbotson

Top half

Bottom half

62.0%

36.6%

38.0%

63.4%

Malkiel 1970s

Top half

Bottom half

65.1%

35.5%

34.9%

64.5%

Malkiel 1980s

Top half

Bottom half

51.7%

47.5%

48.3%

52.5%

Table 4.1

These results demonstrate that whereas winners and losers among fund

managers have a tendency to remain within their group over time, the

effect seems to be vanishing over time. The study based on the 1980s data

set shows that past winners are almost equally likely to become future

winners as future losers. Similarly, past losers are almost equally likely

to be future winners as future losers. Fund management performance

appears, therefore, to have become more and more associated with luck

than with skill.

The results need to be evaluated against our view of the market. So

far, we have implicitly been thinking about the market as a rational

price setting mechanism (somewhat similar to the market maker in the

Glosten-Milgrom model outlined in Chapter 5). This view of the market

is formalised in the efficient market hypothesis, which stipulates that the

prices are so-called random walks relative to the current information

set embedded in the prices. The random walk hypothesis is very easy to

understand if the market thinks the price should go up in the future,

it will adjust immediately to reflect this information. The future price

becomes, therefore, equally likely to go up as to go down from the current

level. There is no predictability about the price movements any more. It is

also easy to see where the efficient market hypothesis should come from. If

there were predictability in price movements, investors would immediately

compete against each other to buy assets that they predict will go up in

price and sell assets they predict will go down. Consequently, competition

drives prices towards the efficient price levels.

This notion has been formalised into the so-called efficient market

hypothesis, which states that prices follow a so-called discounted

martingale process:

pt = E

pt+1 + dt+1

It

1+ r

where E denotes the expectations operator, pt+1 + dt+1 is the sum of next

periods price and dividends, respectively, and r is the discount rate. The

set It contains the current information. An implication of the efficient

market hypothesis is that future price innovations are unpredictable, i.e.

future prices are the forecasted price (todays price inflated by the discount

rate) plus an unpredictable pricing error.

29

23 Investment management

weak-form, the semi strong-form, and the strong-form, depending on how

much information goes into It:

The weak-form efficient market hypothesis states that stock prices

reflect all information in past and current prices and transaction

volumes. Future price movements are, therefore, unpredictable on the

basis of information about these. This rules out, among other things,

making consistent trading profits on the basis of so called technical

analysis. We know that technical trading is very popular among

practitioners, but of course the efficient market hypothesis does not

predict that profits cannot be made at all, only that you make roughly

the same number of profitable trades as you make losing trades

The semi strong-form efficient market hypothesis states that stock

prices reflect all publicly available information, which includes,

in addition to past and current prices and volumes, company and

industry data such as accounting and market data as well as broad

economic indicators such as interest rates, currency rates, inflation,

and unemployment. Semi strong efficiency rules out making consistent

trading profits on the basis of so called fundamental analysis

Finally, the strong-form efficient market hypothesis states that all

information, public and private, is reflected in the current prices. There

are both practical and theoretical reasons why we should not expect

markets to be strong-form efficient. On the practical side, there are

many restrictions on insider trading making it difficult for those who

have private information to benefit from speculation. Thus, there are

barriers in place preventing private information to reach the market.

On the theoretical side, if we assume prices are strong-form efficient,

there is no incentive to spend resources acquiring private information.

There is reason to believe, therefore, that prices can never reach strongform efficiency (this is the so called Grossman-Stiglitz paradox).

What are the implications of the efficient market hypothesis on fund

management performance? Only if professional fund managers have better

information (or a finer information set) than is currently embedded in the

prices, should they reasonably expect to make trading profits. A trader

in possession of superior information who trades against an uninformed

market expects to make superior trading profits. Of course, there will be

some information leakage due to the fact that trading activity is detectable

by the uninformed market participants but this process is not perfect so

some private information remains hidden, and this is the basis for the

superior trading profits. An assessment of the performance of mutual

funds within this framework is, therefore, essentially an assessment of

whether the fund manager is in possession of a sufficient amount of

hidden private information to make substantial trading profits. The private

information needs to come from somewhere, however, and fund managers

spend enormous resources on acquiring such information (through research,

fundamental and technical analysis) each year. It is, therefore, perhaps

unreasonable to expect that fund managers should easily be able to make

trading profits over and above the holding profits of a broad index.

The efficient market hypothesis is itself subject to criticism, however.

Empirical evidence demonstrates certain patterns of predictability in

asset prices, the most prominent being momentum (prices that have

gone up tend to increase further and prices that have gone down tend to

decrease further) and overreaction to news and events. For instance, a

study found that portfolios of the best-performing stocks in the recent past

30

performance of individual stocks remains highly unpredictable. The fads

hypothesis asserts that the stock market overreacts to news, leading to

positive autocorrelation over shorter time horizons while the stock market

and a reversal or negative autocorrelation over longer time horizons.

Although there is empirical evidence to support short run momentum

effects, the long run reversal effect has less conclusive empirical support.

Studies have found, nonetheless, that when ranking stocks into groups

based on their five-year past performance, the loser portfolio (the bottom

35 stocks) outperformed the winner portfolio (the top 35 stocks) by

an average of 25% over the subsequent three-year period. Where do

these patterns come from? The growing field of behavioral finance has

built a systematic foundation for the momentum and reversal effects

based on imperfections in the human ability to process new information

rationally. There is substantial evidence to suggest that we tend to add

too much weight to recent evidence, that we tend to be overconfident (a

famous study of drivers in Sweden found that 90% of those asked ranked

themselves better-than-average), that we are also sometimes too slow to

react to news, and finally that our choices are affected by a phenomenon

called framing. An individual might reject a bet when it is posed in terms

of the risk surrounding the potential gains, but may accept the same bet

when it is similarly posed in terms of the potential losses. In this case,

his decision is affected by framing i.e. the framework within which the

prospect is outlined.

You can learn more about efficient markets and behavioural finance by

reading Chapters 11 and 12 of Bodie, Kane and Marcus.

There is now a rapidly growing literature to assess the profitability of

contrarian and momentum trading strategies. Jagadeesh and Titman

find in a study that stock prices react with a delay to common factors,

but overreact to firm-specific information. In Chapter 8 we discuss

factor models of stock returns, and the decomposition of the variance of

stock returns into systematic factor-driven risk and idiosyncratic firmspecific risk. This study incorporates, therefore, both the overreaction

element in the stock markets response to firm-specific news, as well as

the conservatism in incorporating new information about factor risk.

This study finds that most of the short-term profits that can be made by

following contrarian trading strategies are due to the tendency of stock

prices to overreact to firm-specific news. The contrarian strategy tested

was based on buying and selling stocks over one month, based on the

previous months return. Losers were bought and winners were sold.

In another study, Conrad and Kaul analyse a wide spectrum of trading

strategies that are based on past return patterns, and they find that a

momentum strategy is usually profitable at the three- to 12-month holding

horizon, whereas a contrarian strategy would generate substantial profits

over long horizons prior to 1947 but not after. The return based trading

strategies can be represented by the following weighting of individual

stocks. Consider investing over the holding period [t 1, t] based on the

return over the time interval [t 2, t 1]. Portfolios are constructed at

time t 1 on the basis of a weighting scheme using an equally weighted

market index. The weights are constructed on the basis of the following

formula:

wi, t1 = 1 (Ri, t1 Rm, t1)

N

31

23 Investment management

number of stocks considered, Ri, t1 is the return of stock i over the

time interval [t 2, t 1], and Rm, t1 is the corresponding return of the

equally weighted index. The sign is chosen to reflect the strategy used

(plus for momentum strategies and minus for contrarian strategies). By

construction, the investment cost of the portfolio following this weighting

scheme is zero:

N i

N

Since the weights are proportional to the deviation of the assets

performance relative to the equally weighted market index, they capture

the idea that the more extreme deviations lead also to more extreme

reversal and momentum effects.

i

that that underreaction to information might lead to momentum trading

profits. In particular, they find that past returns and past earnings surprises

can each predict large drifts in future returns after controlling for the

other. The drifts cannot be explained by market risk, size effects or bookto-market effects. Interestingly, they also find little evidence of a future

reversal of the returns process. They conclude, therefore, that the market

reacts slowly to new information about the earnings flow.

Hedge funds

Hedge funds have become increasingly popular investment vehicles,

despite the high profile collapse of the Long Term Capital Management

hedge fund (LTCM) in 1998. Hedge funds have no specific definition,

but their activity is characterised by very flexible investment strategies

involving both long and short positions, often in complex securities.

Moreover, investors are often asked to commit their capital for a fixed term

such that the hedge fund managers can pursue their investment strategy

without the need to worry about investor redemptions. The essential

difference between hedge funds and other financial institutions is that

they are not heavily regulated.

One of the first hedge funds was set up in 1949: A.W. Jones & Co.

developed an investment strategy based on long/short positions in

equities. The idea is to buy stocks you think will do well and sell (or short)

stocks you think would do badly. If the market moves in the meantime,

the long and short positions will move together to maintain your net

portfolio value, and you make money if your stock picking is correct (in

bull as well as bear markets). As the sophistication of hedge funds grew,

so did they turn to other markets. One of the investment strategies in fixed

income (bond) markets is the on-the-run/off-the-run strategy employed

by LTCM. The on-therun/off-the-run strategy employed by LTCM is based

on the institutional feature of the US government bond market which

issues new bonds every six months. Every new auction brings, say, a new

30-year government bond to the market which investors compete to buy

(the bond goes on-the-run). When the bond is six months old, it becomes

a 29.5-year bond and a new 30-year bond is issued. The old bond goes

off-the-run. LTCM observed that the difference between a 30-year bond

and a 29.5-year bond is almost imperceptible, so they should have the

same yield. In practice, however, there was a spread that was caused by

the fact that when the new bond went on-the-run its price was bid up.

Therefore, LTCM sold short the new 30-year bond and bought the old 29.5year bond to unwind its position six months later when the spread was

32

that is off-the-run and the long position in a 29-year bond, also off-therun). We have also seen hedge funds going from status as active traders but

passive owners in stocks to also become active as owners. An active owner

is a shareholder who takes an interest in the running of the company and

seeks to influence the management and important decisions. Traditionally

fund managers have stayed away from this type of activity. An example

is the recent Deutsche Brses attempt at a takeover of the London Stock

Exchange. A bid, tabled in early 2005, was later withdrawn under pressure

from one of Deutsches shareholders, a large London-based hedge fund. The

fund had allegedly taken long positions in Deutsche and short positions in

the London Stock Exchange, since they figured that the announcement of

a withdrawal of Deutsches bid would cause the London Stock Exchanges

stock price to fall and the Deutsches stock price to increase. Their long-short

position in Deutsche and London Stock Exchange would, therefore, generate

considerable short term trading gains. Do all hedge funds hedge? The

investment strategy involving market neutral long-short positions (similar

to LTCMs on-the-run/off-the-run strategy above) is relatively safe and

profitable. As long as the spread between the cheap asset held long and the

expensive asset held short tends to narrow over time, the position makes

money regardless of other market movements. This is a position, moreover,

with little net investment of wealth (there are normally margin requirements

so it is impossible to have a zero net investment) and little exposure to

outside risk factors. Research into hedge fund returns shows, however,

that the idea that hedge funds on the whole engage in long-short market

neutral arbitrage trading is misleading. Hedge funds are a surprisingly

heterogeneous group of funds adopting a number of different styles. They

are, in fact, diffcult to define in terms of their trading strategies. What seems

often to be the idea behind hedge fund strategies is, however, that they

carefully manage and target their speculative activity, choosing to hedge

some risk and take a targeted bets on other risk.

Hedge funds may take similar positions, where they cause large market

movements and may put the market under a squeeze. These types of trades

are called consensus trades or crowded trades. An example of large price

movements caused by such a squeeze is the recent stock price movements in

the German car maker Volkswagen. In early 2008 Volkswagens preference

shares were worth half the value of ordinary stock. Whereas ordinary stock

has voting power, preference shares have priority to dividend payments,

so it seemed preference stock was cheap relative to ordinary stock. A large

number of hedge funds bought preferred stock and sold ordinary stock.

At the same time the car maker Porsche, which already owned 42.5% of

Volkswagen, had been buying call options on Volkswagen stock which,

if exercised, would take their ownership to 74.1%. A further 20.2% of

Volkswagen ordinary stock is owned by the government of Lower Saxony,

which effectively made the free float in the stock market for Volkswagen

ordinary stock only 5.7% of the total. The hedge funds had collectively sold

short (presumably not knowing the extent of their collective action and

Porsches call option position) 12.9%. When the hedge funds were going to

unwind their short position they would need to buy shares that were not

available on the free float, i.e. they had to buy from Porsche, which already

had a large long position in the stock and could, in effect, put a squeeze

on the hedge funds. The resulting panic among hedge funds resulted

in a massive increase in Volkswagen ordinary stock share price (which

at some point was trading at a price/earnings multiple of over 90 and

33

23 Investment management

capitalisation).

How well do hedge funds do? A problem is that it is very diffcult to figure

out exactly what a hedge fund is doing, and without knowledge of the

funds portfolio decisions it can be diffcult to assess correctly the funds

performance. An example is the following, taken from Los book about

hedge funds. The following table summarises Los example.

S&P 500

Hedge Fund

1.4%

3.6%

3.6%

5.8%

8.9%

18.3%

14.0%

27.0%

1.39

2.15

Table 4.2

considerably. The average return is greater for the fund, and although the

standard deviation (and therefore also the risk) is greater, the risk reward

ratio given by the Sharpe ratio (which you will learn about in Chapter 8

of this guide) is superior for the hedge fund. What is interesting, however,

with this example is that it is constructed on the basis of real asset prices

and it assumes no privileged information on the part of the hedge fund

manager. In fact, the trading strategy is very simple. Each month, the fund

shorts put options on the S&P 500 index. The put options are chosen such

that the strike price is approximately 7% below the current level, and

the maturity is less than three months. The capital of the fund is used as

collateral to cover the potential loss on put options. In most months, the

puts expire still out of the money, so the hedge funds will simply collect

the price of the puts without incurring any extra liability. Therefore, for

most of the months the trading strategy provides a stable cash inflow.

Some months there are large index movements, and the hedge fund

will lose money on puts that are exercised. The problem here is that the

trading strategy involves a risk that is asymmetrical: small but frequent

gains are measured against large but infrequent losses. Therefore, a

statistical analysis of the funds performance will underestimate the risk of

the fund.

Statistical arbitrage aims at exploiting patterns in price movements to

make trading profits, normally using computers to identify buy and sell

signals (hence the synonymous algorithmic or program trading label). It is

easiest to explain statistical arbitrage by way of the so-called pairs trading

rule that was developed in the 1980s. The idea is simple: try looking for

two stocks (or portfolios of stocks) that behave similarly in terms of prices.

When the two diverge, place a bet on convergence by buying the cheaper

stock and shorting the expensive stock. For example, suppose two stocks, A

and B, normally have similar prices, but currently A is trading at 80 and B

is trading at 110. Buy xA units of A at a cost of 80xA financed by shorting xB

34

xA =

110

110

x =

80 = 110

80 B 80

The net cost of this strategy is zero, and suppose we hold the position until

the two stocks have the same price. If they converge when the price of

both A and B is 120, the profit is:

120xA 120xB = 120(110) 120(80) = 120(110 80) = 120(30) = 3600

If they instead converge when the price of both A and B is 50, the profit is:

50xA 50xB = 50(110) 50(80) = 50(110 80) = 50(30) = 1500

Regardless, if the prices converge we make a trading profit.

We shall now go through a trading strategy which takes advantage of

deviations of spreads (or differences) between two rates or assets. The

idea is that if todays spread is lower than the average spread you should

bet that it will widen tomorrow, and if the spread is higher you should

bet that it will narrow tomorrow. Under certain assumptions, this strategy

yields a profit 75% of the time, i.e.

Pr(St > St 1 and St1 < E(St)) + Pr(St < St 1 and St 1 > E(St)) = 75%

To see this, consider the following diagram:

St

Todays spread St

above yesterdays

spread St 1

E(St)

Yesterdays spread St 1

above the mean E(St 1)

Yesterdays spread

St 1 below

the mean E(St 1)

yesterdays spread St 1

St 1

E(St 1)

From the figure we can see where profits are not made. We do not make

profit if yesterdays spread is above the mean, and todays spread is also

above yesterdays spread, and we do not make profits if yesterdays spread

is below the mean, and todays spread is also below the mean. This area is

highlighted in the next diagram:

35

23 Investment management

St

E (St)

St 1

E (St 1)

Let us assume that the spread each day is an independent draw from the

same distributions. It follows that each of the four areas of the diagram to

the left or to the right of E(St 1) and above or below E(St) (the four

rectangular shapes separated by the mean spread) has probability 25%, and

the loss-making areas exactly cuts two of these areas in half. Therefore, the

probability of making a loss is only 25% and the probability of making a

gain is the complementary probability 75%.

You should be careful with an illustration such as this, however, as the

assumption that the spread is drawn each day from the same distribution

is in fact not innocent. If the spread is unusually large one day, it is likely

to be large for a reason, and it is likely that this reason also causes the

spread the next day to be high (in expectation). Therefore, the conditional

expected spread E(StSt 1) is likely not to be equal to the long term average

E(St) (which, to those of you who are familiar with the laws of statistics,

is given by the double or iterated expectation E(St) = E(E(St St 1))). The

observation of a high spread should not, therefore, necessarily mean that

we expect the spread to narrow the following day. In fact, what happened

around the collapse in LTCM (as was also the case with Volkswagen shares)

was that spreads that were seen as unjustifiably large did not narrow over

time but kept widening further. There just is no simple way of making

money in financial markets.

Summary

This chapter took an investor perspective on the history of finance, and looked

at the historical evidence of the performance of the managed fund industry.

The main finding was that managed funds do not, on average, outperform

broad stock market indices, which is indicative that markets tend to be

informationally effcient.

The chapter went on to discuss critics of the efficient market hypothesis who

use arguments based on behavioral finance. Some trading strategies based on

behavioural finance (momentum and reversal effects) were outlined.

36

and finally looked at some trading strategies based on so-called algorithmic

(program) trading.

Activities

1. Describe the efficient market hypothesis. If the efficient market

hypothesis is really true, but traders nonetheless keep searching for

trading strategies that can beat the market, do you think they would

find useful trading strategies? Suppose we can construct trading

strategies that yield symmetrical risk profiles where abnormal gains

and losses are similar in magnitude and frequency, and strategies that

yield asymmetrical risk profiles where abnormal gains are small but

frequent and losses are large but infrequent. Which strategy do you

think we would be more likely to find in an efficient market if we were

out to beat the market?

2. Consider the asset prices given in the table below. One is generated

under the efficient market hypothesis and the other is not. Your task is

to identify which is which.

Asset A

Asset B

100.00

100.00

98.58

100.25

97.78

101.57

99.78

101.62

97.83

105.35

99.64

112.38

101.07

114.89

102.70

122.21

99.61

134.35

102.48

142.81

106.77

154.47

109.24

168.91

107.79

184.15

111.04

191.92

116.00

196.27

118.65

200.51

122.66

199.74

128.39

197.06

128.30

201.85

122.00

215.77

by trading the asset you think may not satisfy the efficient market

hypothesis in the previous activity.

37

23 Investment management

Having completed this chapter, and the Essential reading and activities,

you should be able to:

describe fundamental trends in historical mutual fund performance

confidently explain the efficient market hypothesis and fully distinguish

between its many forms

cogently discuss the existence of common cognitive biases in human

information processes, and concisely explain how these biases can lead

to effects (momentum and reversals) that violate the efficient market

hypothesis

describe how the effects of momentum and reversals can be translated

into profitable investment strategies in detail

clearly identify distinctive characteristics of hedge funds in the context

of the investment management industry

briefly discuss the problems related to evaluating hedge fund

performance

adequately define algorithmic trading or statistical arbitrage.

1. a. Explain what we understand by a hedge fund.

b. Momentum and contrarian trading strategies are so-called returns

based trading strategies. Describe what this means in words, and

also design a weighting scheme to determine how much to invest in

assets based on such strategies.

c. Demonstrate that, if the spreads between two rates or asset prices

are identically and independently distributed random variables in

successive trading sessions, you make a profit 75% of the time by

betting on a reduction in spreads if the current spread is above the

average, and on an increase in spreads if the current spread is below

the average.

38

Learning outcomes

By the end of this chapter, and having completed the Essential reading and

activities, you should be able to:

describe established objectives of market microstructure analysis

describe key aspects of limit orders

aptly discuss the implications of the bid-ask spread to negative

autocovariance in transaction prices

explain inventory effects on the bid-ask spread

thoroughly review adverse selection effects on the bid-ask spread

and sensibly relate them to the formation of bid and ask prices in the

Glosten-Milgrom model

carefully explain the Kyle model of optimal insider trading, both in the

original formulation and in a simplified discrete framework

correctly identify the reasons why market microstructure matters to

investors.

Essential reading

Bodie, Z., A. Kane and A.J. Marcus Investments. (Boston, Mass.; London:

McGraw-Hill Irwin, 2008) Chapter 3.

Elton, E.J., M.J. Gruber, S.J. Brown and W.N. Goetzmann Modern Portfolio

Theory and Investment Analysis. (New York; Chichester: John Wiley & Sons,

2010) Chapter 3.

In this chapter I have listed Chapter 3 of Bodie, Kane and Marcus as the

Essential reading, but clearly for much of the analytical material in this

chapter you will probably find Hasbroucks book listed below of much

greater relevance. The reason Hasbroucks book is not Essential reading is

that market microstructure is still a relatively new area in finance, and has

yet to find its place in asset pricing and investment management.

Further reading

Hasbrouck, Joel Empirical Market Microstructure. (Oxford: Oxford University Press,

2007) Chapters 1, 2, 3, 5 and 7.

Introduction

This chapter looks at the microstructure of markets, which essentially

studies the trading mechanisms for financial securities. The microstructure

of markets deal with a number of issues:

The reasons for trade: Trade involves exchange of cash for an

asset with (generally) unknown value. The private value of assets may

be different from the cash equivalent that can be exchanged for the

asset, which motivates trading behaviour. This is normally captured by

market microstructure models where informed traders operate.

The protocol for trading: Market microstructure models are

normally very specific about the rules of the game for trading financial

securities.

39

23 Investment management

single price of the market as the market clearing price. In market

microstructure models there is normally no such price instead there

are many prices depending on whether you wish to buy or sell the

asset, how much you wish to trade, etc.

Liquidity is an important characteristic of securities markets, and market

microstructure models normally allow a study of this concept. One aspect

of liquidity is elasticity which captures the propensity for prices to move

in response to quantity shocks. In infinitely elastic markets (which is at

the liquid extreme) there is no price impact following quantity shocks

whereas in infinitely inelastic markets (which is at the illiquid extreme)

all impact of quantity shocks is captured by price changes. In practice,

however, this does not capture all aspects of liquidity. Another aspect

deals with trading costs. In liquid markets we expect trading to be very

cheap. Trading costs come in several forms there are direct trading

costs associated with broker commission, etc. but there are also indirect

trading costs associated with the difference in price depending on whether

you want to buy or sell the asset. Even ignoring the direct trading costs,

if you buy a certain quantity of the stock and then sell immediately, you

expect to lose money since typically you buy at a price close to the higher

ask price and sell at a price close to the lower bid price. The bid-ask spread

is, therefore, also an indirect measure of liquidity.

Transparency is another characteristic of markets. How much information

traders have when submitting an order is a measure of transparency. This

typically applies to markets such as limit order markets, described in more

detail below. In this type of markets traders submit limit orders and market

orders, and whereas market orders tend to be executed fairly quickly if

orders exist on the opposite side, limit orders are not necessarily executed

as there is a possibility that no opposite order exists which matches the

limit order. In this case, the limit order is loaded onto the system to

provide liquidity for future orders. The data about waiting limit order is,

therefore, an important source of information for traders who contemplate

submitting a new order onto the system. Normally, limit order markets

allow new traders to observe one or two tiers of the waiting limit orders in

a market.

The most common type of stock market today is the limit order market.

A limit buy order is an order that states that the investor is willing to buy

any quantity up to qB at a price not exceeding pB a buy order can be

represented by the pair (qB, pB). A market buy order is an order that states

that the investor is willing to buy a quantity up to qB at any price so a

market order can be represented as the limit order (qB, ) i.e. a limit

order with a limit price equal to infinity. A limit sell order is, similarly, the

pair (qS, pS), and a market sell order the pair (qS, 0).

Limit order markets contain a system for collecting and executing these

orders. Some orders are collected before the market opens, and typically

the market performs a routine to generate an open price on the basis of

these orders. Let us consider an example. Suppose the market has received

the following orders at the time it is due to generate an open price.

40

Buy quantity

Limit buy

100

100

Limit sell

Market buy

Market sell

Order

Sell quantity

50

110

20

80

The open price is generated on the basis of price priority. To illustrate the

orders received above, we can draw the following graph.

Price

110

100

Quantity

20

80

120

The buy orders are ordered from the highest price to the lowest (where

the highest price will stand the greatest chance of being executed first),

and the sell orders are ordered from the lowest price to the highest (where

the lowest price will stand the greatest chance of being executed first). The

lines cross at a quantity of 80 and a price of 100, so the open price will be

100. Therefore, all of the market sell order will be executed at the price of

100, and all of the market buy plus 60 units of the limit buy will also be

executed at the price of 100. This all happens at the open, and the limit

orders not executed will remain in the system to meet new incoming

orders. The limit order book will, therefore, consist of a limit buy of 40

units at a limit price of 110, and a limit sell of 50 units at a price of 100.

These orders form the bid-ask spread of the market, which is the ask price

of 110 and the bid price of 100. Following the open, new orders are

collected and executed according to two priority rules. First priority is as

before on price: the buy orders with the highest price and the sell orders

with the lowest price have always the greatest chance of execution. Next,

orders are ordered on submission time, where the oldest orders (given the

same price) have the greatest chance of execution. Fully electronic limit

order markets have now become a very popular way of organising trading

activity on stock exchanges around the world.

Some background readings on limit order markets can be found in Elton,

Gruber, Brown and Goetzmann Chapter 3, which will probably be useful

when reading the more technical material in Hasbrouck Chapter 2.

Suppose there exists an informationally efficient price mt for an asset

at a specific time t. Since this price is informationally effcient, the price

innovations in mt are i.i.d. (identically and independently distributed) with

zero mean:

mt = mt1 + ut

Now suppose this asset is traded in a market where the dealer incurs a

cost c per trade. Therefore, if the dealers behave competitively, the price at

the bid would be mtc and the price at the ask mt + c, with a spread equal

41

23 Investment management

expressed as:

pt = mt + qtc

where qt = +1 if the trade is at the ask and qt = 1 if the trade is at the bid.

We shall also assume that buys and sells are equally likely and serially

independent.

The variance of price changes can now be calculated as:

Var(pt) = E(pt)2

= E(pt pt1)2

= E(mt + qtc mt1 qt1c)2

= E(ut + (qt qt1)c)2

= E(u2t + 2ut(qt qt1)c + (qt qt1)2c2)

= E(u2t ) + c2E(qtqt1)2

= E(u2t ) + c2[E(q2t ) + E(q2t1)]

since ut, qt, and qt1 are all uncorrelated. The variance of the fundamental

price innovations ut is 2u, and the variance of qt is 1:

Var(qt) = 12 + 12 02 = 1.

Therefore, the variance of the transaction price innovations pt is:

Var(pt) = 2u + 2c2 = 0

Now lets turn to the autocovariance of price changes, i.e. the covariance

between pt and pt1. Here we find:

Cov(pt-1, pt) = E(pt-1 pt)

= E((mt1 + qt1c mt2 qt2c)(mt + qtcmt1 qt1c))

= E((ut1 + qt1c qt2c)(ut + qtcqt1c))

= c2Eq2t1

The autocovariance is, therefore:

Cov(pt1, pt) = c2 = 1

The parameters 0 and 1 can be estimated directly from transaction data.

We find that the half-spread c = 1 and the variance of fundamental

price shocks is 2u = 0 + 21. Since both parameters 0 and 1 can be

estimated directly we can always find an estimate of spreads and

fundamental price variance which are clean of market microstructure

effects. From the NYSE, a study from 2003 finds that the implied spread

using the above method gives us 2c = $0.034, against the actual spread

measured directly from the bid-ask prices of $0.032 (which is pretty close).

The Roll-model is covered in some detail in Hasbrouck Chapter 3.

Glosten-Milgrom

, where Pr(V = _V )

There is a security with pay-off V which is either _V or V

= . The population of traders consists of uninformed noise traders and

informed speculators, with the proportion of informed speculators equal

to . The market maker (or dealer) quotes bid and ask quotes, B and A,

respectively. The traders are drawn randomly from the population. If

and sells if

an informed speculator is drawn, the trader buys if V = V

V = _V . If the trader is an uninformed noise trader, the trader buys or sells

with probability one half each. The market maker cannot tell whether

the trader drawn is informed or not. We find, therefore, the following

probability structure for this model:

42

1

1

Figure 5.1: The tree shows the probability structure of the Glosten-Milgrom

model

A buy transaction always takes place at the ask price A, and a sell

transaction always takes place at the bid price B. The probability of a

low asset price _V and a sell transaction at the bid price B by an informed

speculators is , and the probability of a low asset price _V and a sell

transaction at the bid price B by an uninformed noise trader is (1) .

The market makers problem is to determine bid and ask prices B and A,

such that the market maker makes zero profit on the transaction. This does

not mean the market maker is going to set the same price as the bid ask

price, however. The market maker thinks it is more likely that somebody

is willing to buy the asset at the ask when the value is high, since an

informed trader will never sell when the value is high. The event that

somebody wants to buy at the ask is, therefore, good news and the event

that somebody wants to sell at the bid is bad news, caused by so-called

adverse selection. The prior beliefs of the market maker is that the value

is low with probability and high with probability 1 , and a bid or an

ask transaction leads to revision of the market makers beliefs. The revision

process is governed by Bayes law:

Pr(V = _V )Bid)Pr(Bid) = Pr(BidV = _V )Pr(V = _V )

which yields:

Pr(V = V |Bid) =

Pr(Bid|V = V ) Pr(V = V )

Pr(Bid)

Here, the probability of a bid transaction given a low asset value is (that

an informed trader wants to sell at the bid) plus (1 ) (that an

uninformed noise trader wants to sell at the bid). The unconditional

probability of a bid transaction is ( + (1 ) ) (that there is a bid when

the asset value is low) plus (1 )(1 ) (that there is a bid when the

asset value is high). We notice that the unconditional probability of a bid

transaction is:

) Pr(V = V

)

Pr(Bid) = Pr(BidV = _V )Pr(V = _V ) + Pr(BidV = V

The unconditional probability is, therefore, simply the sum of the

conditional probabilities weighted by the unconditional probabilities of the

event on which we are conditioning. Putting it all together, therefore, we

find:

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23 Investment management

Pr(V = V |Bid) =

( + (1 ) )

( + (1 ) ) + (1 ) (1 ))

(1 + )

Pr(V = V |Bid) =

1 (1 2)

therefore always greater than the unconditional probability . We notice

that if is close to zero, the conditional probablility will be close to since

this means there are no informed traders in the market from which to infer

information.

We can also work out the conditional probability of low values given that

the first transaction is a buy at the ask:

Pr(V = V |Ask) =

(1 )

1 + (1 2)

The formula for the bid and ask prices are, therefore:

B=

A=

(1 + )

V +

1 (1 2)

(1 )

1 + (1 2)

(

(

V +

1

(1 + )

1 (1 2)

(1 )

1 + (1 2)

)

)

The bid ask spread is defined as the difference between the higher ask

price and the lower bid price:

Bid-Ask Spread = AB

(

(

(

[(1 )]

1 + (1 2)

[(1 + )]

1 (1 2)

[(1 + )]

) (

) (

V +

V +

1

1 (1 2)

(1 )

1 + (1 2)

(1 + )

1 (1 2)

(1 )

1 + (1 2)

) )

) )

V

(V V )

Let 0 denote the initial beliefs of the market maker and set 0 = . If the

first transaction is at the bid, the market maker must set bid and ask prices

also for the second round. The market maker has at this stage revised his

beliefs to Pr(V = _V )Bid) = 1. The bid-ask prices in the second round can

then be worked out by repeating the process above setting 1 = as the

market makers prior beliefs. In general, therefore, we find the

relationship:

k(Ask) =

k(Bid) =

44

k1(1 )

1 + (1 2k1)

k1(1 + )

1 (1 2k1)

prior beliefs of k1 and an ask transaction in round k, and k(Bid) is the

conditional probability of a low value in round k given prior beliefs of k1

and a bid transaction in round k.

There is more detail about the Glosten-Milgrom model in Hasbrouck

Chapter 5, sections 5.2 and 5.3

Kyle

The Kyle model is a dynamic model of security prices where the market

maker is setting informationally efficient prices (as in the GlostenMilgrom) model, but where additionally an informed trader chooses

optimal trading strategies. This extends the Glosten-Milgrom model in the

sense that the insiders can choose how much to trade in the Kyle model

in the Glosten-Milgrom model they simply trade a single unit of the stock

as they are drawn to trade.

We consider a security with value which is distributed v~N(p0;20) (i.e.

normally distributed with mean p0 and variance 20). A single informed

trader knows the realisation of v, and submits a market order x(v). There

are also other traders in the market who do not know v and who trade

for reasons independent of v. The net market orders from these traders

the liquidity traders is u ~ N(0, u2) (i.e. normally distributed with mean

zero and variance u2). The market maker observes the total net order

flow y = x + u and sets a price p(y) (notice the price is not a function of

x and u separately the market maker can only see the net order flow).

The market maker is risk neutral and is facing perfect competition, so in

clearing the market, the market price p(y) must be equal to the expected

asset value conditional on y:

p(y) = E(v\y)

The informed trader assumes the market maker uses a linear price setting

strategy: p(y) = + (y E(y)). The profits of the informed trader are

(v) = (v p)x. Using the fact that the price depends on y and not on x, the

trading profits are stochastic because the market price is stochastic:

~

~

~

(v) = (v ( + y))x = (v ( + (x + u ))) x . Taking expectations, the

expected profits equal:

~

~

= (v ( + (x + E(u ))))x

= (v ( + x))x

= vx x x2

Maximising the expected profits, we find (the first order conditions for

maximum is that the derivative (in x) is set to zero):

~

d E((v))

= v 2x = 0

dx

x = (v)

(v )

2

We notice that this leads to a linear strategy also for the informed trader:

1

x = + v, where = 2 and = 2 . What we need now is to tie the linear

trading strategy to the linear price formula, using the condition that prices

~

are informationally effcient: p(y) = E( vy). First, however, we notice that

~

~

~

~

x ~ N( + p0, 220 ), and also that y = u + x ~ N( + p0, 220 + u2).

45

23 Investment management

~

~

~ ~

and v are bivariate normal (bivariate means that y, x and any linear

~

~

combination of my + nx , are all normally distributed), then:

~ ~

~

Cov(v, y) (y E(y))

~

Var(y)

E(v| y) = E(v) +

~

E( v) = p0

~

E( y) = + p0

~

Cov( v, y ) = Cov( v, u + x )

~

= Cov( v, u + + v)

~

= Cov( v, v) = Var( v)

2

= 0

~

Var( y) = Var(u + x )

~

= Var(u + + v)

~

= Var(u ) + 2Var( v)

= 2u + 220

so we find:

20

~

E(v|

y) = p0 +

= p0

(y p0)

2u + 220

2 20

2u + 220

20

2u + 220

20

2u + 220

We also know that + y = E( vy) so our guess that pricing rule is linear is

satisfied. Now we just need to put all the information together. Our

information is that:

= 2

1

=

2

(

(

) (

= p0 1

= p0 1

1

42

2u +

20

1

2

42 0

2 20

2u + 220

1

42

2u +

= p0 1

1

42

2u +

20

1

2

42 0

20

1

2

42 0

)

)

)

20

2u + 220

1

2

22 0

(which, rearranging, leads to...)

2 2 + 1 2

2

u

4 0

=

2 20

2u + 220

1

22

2u +

1

46

20

1

2

42 0

2u +

1 2

1 2

4 0 = 2 0

2u =

1 2

4 0

2 =

2

1 0

4 2u

1 0 (an then everything unravels from top and the model is solved ...)

2 u

=

=

p0 u

0

u

0

p(y) = p0 +

1 0

y

2 u

and the equilibrium trading strategy by the informed investors is given by:

u

v

x(v) = p0 u +

0

0

We notice that as the variance of noise trading increases relative to the

variance of the asset pay-off, the more aggressive trading will be observed

by the informed trader as there is an increase in the coefficient on v. At the

same time, however, the market prices become less sensitive to the order

flow as the coefficient on y decreases. A market with a lot of noise trade

has, therefore, one of the characteristics of a liquid market: traders can

trade large quantities without moving prices a great deal.

We can also work out the equilibrium using a regression interpretation

on the projection (actually, a linear regression model is just a linear

projection). If we imagine the market maker can regress asset pay-offs v on

order flow y, the expected price conditional on order flow is given by:

~

E( vy) = a + by + e

where a and b are regression coeffcients and e is an error term with zero

expectation. The regression coefficient is given by:

b=

~ ~

Cov(v,

y)

=

Var(y~ )

20

+ 220

2

u

regression and rearranging:

~

~

a = E(v)

bE(y)

= p0

20

(a + p0 )

+ 220

2

u

which corresponds to the findings above and the rest of the model follows.

There is more detail on the Kyle model in Hasbrouck Chapter 7.

The original Kyle set-up is somewhat complicated so we illustrate the main

idea using a much simpler, discrete, version in this section. Consider an

asset with pay-off:

x = +1 with probability

1 with probability

47

23 Investment management

The variance of the asset pay-off is, by construction, equal to one. Consider

a single noise trader who trades the asset in the quantity:

q = + with probability

with probability

The constant represents the standard deviation of noise trade. To see

this, work out the variance:

1

1

Var(q) = 2 + 2 = 2

2

2

and the standard deviation is just the square root of 2 which is .

There exists an insider who has perfect knowledge of the realisation of x,

and who wants to trade to benefit from his privileged information. Let y

denote the order of the insider. The noise trader and the insider submit

their order to a market marker, who is risk neutral and will clear the

market at a price p which is informationally efficient given the order q

and y:

p = E(x|q, y)

The problem for the insider is to pick y such as to maximise expected

trading profits, and the problem for the market maker is to make rational

inferences given the observation of the order flow.

It is easiest to consider the market makers problem first. The market

maker observes q and y, and since the absolute value of q is known:

|q| =

the market maker can identify the insiders order, provided:

|y|

In this case, therefore, the market price will always be fully revealing, i.e.

p = E(x|q, y) = x, so the insider cannot ever make trading profits. Therefore,

it is optimal for the insider to set |y| = also.

Now we consider the market makers problem. Since |q| = |y| = , the

market maker observes one of three aggregate orders: (i) the insider and

the market maker both submit orders of so the aggregate order is 2.

In this case the market maker knows the insider is buying, so the market

price p = E(x|, ) = 1 is fully revealing; (ii) the insider and the market

maker submit orders that offset each other, so that the aggregate order is

= 0. In this case the market maker cannot tell whether the insider is

selling or buying (both equally likely) and does not infer anything from

the order flow. Therefore, the market price p = E(x|, ) = E(x| , ) = 0

reveals no information; and finally (iii) the insider and the market maker

submit orders so the aggregate order is 2. In this case the market

maker knows the insider is selling, so the market price p = E(x| , ) = 1

is fully revealing.

There are at least two reasons why market microstructure is important

to investors. The first relates to prices: the price of financial assets may

not only reflect the underlying fundamental value of the asset but also

components that are specific to the environment in which they are traded.

Prices may become depressed when there is a temporary lack of buyers

in the market and inflated when there is a temporary lack of sellers. This

has two implications for investors. The market may not be as liquid as

we like and the costs of trading may be high if bid-ask spreads are high.

If prices are depressed when we need to sell, or if prices are inflated

48

when we are planning to buy, we will incur liquidity costs that reduce

the return on our investments. The second implication is that when

deviations from the fundamental value occur, we may be fooled into

making judgements about assets that are incorrect. An example is the

market squeeze in Volkswagen stock that occurred in 2008 (described

briefly in the Hedge funds section in Chapter 3), that made Volkswagen

briefly the largest company in the world. In such situations we are right

in being sceptical about asset prices. A good strategy for protecting

yourself against liquidity effects and the risk of price deviations from

fundamentals is never to trade in such a way that you may need to carry

out a fire-sale of your portfolio, and never to trade too large a quantity at

any one time. A cautious trading strategy where you keep a liquid reserve

of funds available for liquidity shocks, and placing small amounts in the

market at regular intervals is likely to protect you against these market

microstructure effects.

Second, if you are a relatively unsophisticated trader with poor

information, you are likely to incur specific costs of trading against more

sophisticated traders, the so-called adverse selection cost of trading.

There is no obvious way of detecting and protecting yourself from the

activity of well-informed investors as they tend to be clever at hiding

their information as they trade (as predicted by the Kyle model). This is

of course not necessarily an argument against trading per se, but it is an

argument against trading very often (e.g. frequent buy-sell transactions)

as, in this case, you increase the likelihood of ending up at the opposite

side of a clever, well-informed investor.

Summary

This chapter dealt with market microstructure which, broadly speaking,

is the process by which investors intention to trade is ultimately

transformed into actual transaction volume and price.

The chapter had a brief outline of the workings of a limit order

market, which is now a common market structure for exchange-traded

instruments such as bonds and equities.

The Roll, the Glosten-Milgrom and the Kyle models were briefly

outlined, and these models contain most of the relevant concepts that

appear in relation to market microstructure.

There was also a relatively simple discrete outline of the Kyle model to

complement the original set-up, which is somewhat technical.

Finally, the chapter discussed why market microstructure is relevant for

investors.

Activity

1. Imagine the following game show format: you are invited to choose

one box out of three, where one of the boxes contains a prize.

Before you open your box, the game show host opens one of the two

remaining boxes that he knows does not contain a prize, and invites

you to swap your box with the remaining unopened box. When this

game show is run the majority of people keep their original box and

refuses the swap. However, explain why you maximise your chances of

winning the prize by making the swap. Explain also how this relates to

adverse selection and market microstructure, where if you buy assets

you are more likely to trade an overvalued asset than if you sell.

49

23 Investment management

Having completed this chapter, and the Essential reading and activities,

you should be able to:

describe established objectives of market microstructure analysis

describe key aspects of limit orders

aptly discuss the implications of the bid-ask spread to negative

autocovariance in transaction prices

explain inventory effects on the bid-ask spread

thoroughly review adverse selection effects on the bid-ask spread

and sensibly relate them to the formation of bid and ask prices in the

Glosten-Milgrom model

carefully explain the Kyle model of optimal insider trading, both in the

original formulation and in a simplified discrete framework

correctly identify the reasons why market microstructure matters to

investors.

1. a. Explain why market microstructure matters to investors.

b. There is 80% probability of noise traders trading in the market, who

buy and sell with 50% probability each. The rest of the time we

expect informed investors to trade, and we assume these will buy if

they have good information about the asset pay-off and sell if they

have bad information. The asset is worth 110 or 90, each equally

likely as seen by uninformed agents, and where the realisation

is known perfectly by the informed investors. Work out the bidask spread in the first round of trading in the Glosten-Milgrom

framework.

c. Demonstrate that assets whose fundamental price follows

a random walk will nonetheless contain autocovariance in

transaction prices, using the Roll model.

50

Chapter 6: Diversification

Chapter 6: Diversification

Learning outcomes

By the end of this chapter, and having completed the Essential reading and

activities, you should be able to:

accurately compute the expected return, risk premium, variance and

the standard deviation of a risky portfolio

accurately compute the expected return, risk premium, variance and

the standard deviation of a combination of a risky portfolio and a risk

free asset

clearly define mean-variance preferences and coherently explain how

investors with mean-variance preferences choose portfolios

derive the optimal portfolio with the knowledge of the investors' risk

aversion coefficient with confidence

define the portfolio frontier in detail

formally explain how the existence of a portfolio frontier on which

investors choose their optimal portfolios implies that the CAPM pricing

formula holds

concisely define the concepts of systematic and unsystematic risk, and

cogently explain how these concepts are used to simplify the problem

of estimating the covariance between asset returns

discuss the implications of the single index model to effective

diversification in detail

review the Treynor-Black model

thoroughly define factor models, and illustrate well-established pricing

formulas

knowledgeably explain why myopic portfolio choice may sometimes be

optimal even though the investors have a long investment horizon.

Essential reading

Bodie, Z., A. Kane and A.J. Marcus Investments. (Boston, Mass.; London:

McGrawHill Irwin, 2008) Chapters 6, 7, 8, 9, 10 and 27.

Elton, E.J., M.J. Gruber, S.J. Brown and W.N. Goetzmann Modern Portfolio

Theory and Investment Analysis. (New York; Chichester: John Wiley & Sons,

2010) Chapters 4, 5, 6, 7, 8, 9, 12 and 13.

Further reading

Campbell, J.Y. and L.M. Viceira Strategic Asset Allocation. (New York: Oxford

University Press) Chapter 2.

Introduction

Now we turn to the problem of using the underlying pricing theory

(which is not reviewed in this guide but is extensively outlined in the

Corporate finance subject guide) as a tool for investment analysis.

The topic for this chapter is the principle of diversification. Investors

can eliminate free of cost a great deal of portfolio risk by spreading

their investment to a broad portfolio. Some movements in stock prices

51

23 Investment management

stocks as well, and some movements are caused by idiosyncratic shocks

that affect only a single stock. The process of diversification tends to wash

out all idiosyncratic risk shocks from portfolios, thereby narrowing the

risk of the portfolio to broad market risk factors. In everyday life we refer

to diversification as 'not putting all your eggs in one basket. Why should

we diversify? The obvious answer that by diversifying we eliminate

idiosyncratic or spurious risk factors is nonetheless one which needs

to stand up to rigorous analysis. This is something the framework of the

Capital Asset Pricing Model (CAPM) can accommodate. The Capital Asset

Pricing Model is outlined in more detail in the subject guide for course

92 Corporate finance, and the exposition here is focused on the

implications of this model for optimal investment and diversification.

This framework assumes meanvariance preferences, that is, that investors

(everything else being equal) prefer higher expected return and lower

variance of return on their portfolios. Appendix 1 reviews some aspects of

utility theory and risk and variance aversion. The fact that investors are

variance averse does, in itself, not imply that they should hold diversified

portfolios. What makes diversification optimal is that the variance

covariance structure of the return of individual assets is of such a nature

that portfolio variance is reduced if the investor invests in a large cross

section of individual assets.

If you invest money across a number of assets, you can represent

your investment by portfolio weights, which are defined by the pound

investment in the individual assets divided by the total pound investment

(for a review of investment returns, see Appendix 1). For instance, if

you invest 30,000 in BT, 50,000 in Lloyds Bank and 20,000 in Marks

& Spencer, your portfolio consists of a 30% investment in BT, a 50%

investment in Marks & Spencer, and a 20% investment in Lloyds Bank. The

expected rate of return and the variance of the return on your portfolio

can be expressed in terms of these weights.

The following formulas are important for this chapter:

E(rP) = wi E(ri)

i

where E(rP ) is the expected return of the portfolio, wi is the weight of asset

i in the portfolio, and E(ri) is the expected return on asset i. In our example

above, we find that the expected return is given by:

E(rP) = 30%E(rBT)+50%E(rLloyds Bank)+20%E(rMarks & Spencer)

The next important formula is the one that expresses the variance of the

return on a portfolio. Here we find:

Var(rP) =

i

j

ji

where we sum over all assets i = 1, 2, ..., n and j = 1, 2, ..., n. The righthand

side can be written in two ways. The most familiar way to express the

variance of a portfolio of assets is as the sum of the variances of the assets

multiplied by the portfolio weights squared, plus two times the sum of all

covariances multiplied by the two corresponding portfolio weights. This

corresponds to the rightmost expression in the formula above. However,

the variance of the return on an asset is simply the covariance of the

return with itself so we can express all variance terms as covariance terms.

Also, for each covariance term between the return on asset A and asset B,

52

Chapter 6: Diversification

between the return on asset B and asset A. We can, therefore, write the

portfolio variance as simply the sum of all possible covariance terms

multiplied by the corresponding two portfolio weights. This corresponds to

the middle term above. Again, in our example above, we find that

Var(rP ) = (30%)2Var(rBT)

+ (50%)2Var(rLloyds Bank)

+ (20%)2Var(rMarks & Spencer)

+ 2(30%)(50%)Cov(rBT, rLloyds Bank)

+ 2(30%)(20%)Cov(rBT, rMarks & Spencer)

+ 2(50%)(20%)Cov(rLloyds Bank, rMarks & Spencer)

We notice that the portfolio variance consists of many more terms than the

portfolio expected return, and this is why it is not an obvious exercise to

combine assets in order to diversify (reduce variance).

A good starting point to diversification can be found when looking at

investors attitude to risk. As seen by the data in the previous part, there

is overwhelming evidence that investors demand compensation for taking

on risk. This phenomenon that investors dont like risk is called risk

aversion. To compensate investors for holding risky assets the asset must

offer a premium over and above the regular risk free return. There are

of course many ways in which this premium can be defined, but the

definition we will adopt is the following. The risk premium of an asset is

defined as the expected return on the asset minus the risk free return:

Risk Premium = E(r) rF

where E(r) is the expected rate of return on the asset and rF is the risk free

return. In specific cases we know what this risk premium looks like. For

instance, if the CAPM is true, the risk premium is:

Risk Premium under CAPM = (E(rM) rF)

where is the betafactor of the asset, and (E(rM) rF) is the risk premium

on the market portfolio (or the market index). We will get back to the

derivation of the CAPM model later on in this chapter.

Numerical example

Consider the three stocks BT, Lloyds Bank and Marks & Spencer given

above. Suppose the expected return of the stocks and the variance are:

Stock

Expected return

Variance

BT

10%

9%

Lloyds Bank

13%

16%

8%

8%

BT

Lloyds Bank

BT

Lloyds Bank

5%

2%

3%

53

23 Investment management

E(r) = (30%)(10%) + (50%)(13%) + (20%)(8%) = 11.1%

and the variance is:

Var(r) =(30%)2(9%) + (50%)2(16%) + (20%)2(8%)

+ 2(30%)(50%)(5%) + 2(30%)(20%)(2%) + 2(50%)(20%)(3%)

=7:5%

The portfolio has, therefore, lower variance than any of the stocks

individually. The reason for this is that the correlation between the stocks

is imperfect, so that some of the risk in one stock will be offset by the risk

in the other stocks. The formula for covariance between the return on two

stocks r1 and r2 is:

Cov(r2, r1) = 1212

where 12 is the correlation coefficient between r1 and r2, and 1 and 2

are the standard deviations of r1 and r2, respectively. The correlation

coefficient between BT and Lloyds is, therefore,

BT, Lloyds Bank =

5%

= 0.42

9% 16%

which implies that if you mix BT and Lloyds in a portfolio some of the risk

in the individual stocks will be offset by the fact that the correlation

coefficient is not perfect (i.e. it is not 1).

A portfolio that consists of a fraction w invested in A and the remaining

fraction 1 w invested in B, has expected return E(r) = wE(rA) + (1 w)E(rB)

and variance of return Var(r) = w2Var(rA) + 2w(1 w)Cov(rA, rB) +

(1 w)2Var(rB). If E(rA) = E(rB), an investor with meanvariance preferences

chooses to hold A and B such that the variance is minimised. We know that

the minimum variance portfolio has first derivative with respect to w equal

to zero, so we find the first order condition which implies:

w=

B (B ABA )

(B A )2 + 2AB (1 AB)

where we use the fact that 2i = Var(ri) and ABAB = Cov(rA, rB).

If we consider two assets A and B with expected return 10% and variance

16% and 9%, respectively, with correlation coefficient 0.5, the minimum

variance portfolio consists of:

w=

30%(30% 0.5(40%))

(30% 40%)2 + 2(40%)(30%)(1 0.5)

= 0.23

Investors do not in general choose between only two assets, but this

framework is nonetheless useful for establishing an understanding of

optimal investment under risk aversion. Let r be the risky rate of return

and rF the risk free rate of return. Also, let the investor choose a portfolio

with weight w in the risky asset and 1 w in the risk free asset: rP = wr +

(1 w)rF . The expected return on the portfolio is then given by:

E(rP ) = rF + w(E(r) rF )

i.e. the risk free rate of return plus the risk premium of the risky asset

times the portfolio weight in the risky asset. The variance of the portfolio

equals:

Var(rP ) = w2Var(r)

54

Chapter 6: Diversification

expected return and the standard deviation of return on the portfolio are

both linear in the portfolio weight in the risky asset:

E(rP) = rF + w(E(r) rF ) P = w

where P denotes the standard deviation of the portfolio and the

standard deviation of the risky asset. Therefore, in the case where

investors choose an asset allocation strategy investing in a risky and a

risk free asset, their portfolios have a linear expected return and standard

deviation in the weight on the risky asset.

ErP

Er

Er rF

rF

Figure 6.1

(expected return and standard deviation place). It demonstrates that the

investment opportunity set is linear, with a slope equal to Er rF .

Meanvariance preferences

This section assumes some knowledge of utility theory. If you are

unfamiliar with utility theory you should first consult Appendix 1

which has a brief outline of this theory. If investors have meanvariance

preferences they have a utility function over portfolios that take the

form u(, 2) where is the expected return of the portfolio and 2 is the

variance of the return of the portfolio. This function is increasing in and

decreasing in 2. A rational investor picks a portfolio that maximises his

utility, that is, a portfolio that has an optimal riskreturn tradeoff. This

tradeoff can be found in the following way (using standard optimisation

techniques). Consider a general twoasset example where = w1 + (1 w)

2 and 2 = w221 + 2w(1 w)12 + (1 w)222 (here i is the expected return on

asset i, 2i is the variance of asset i, and 12 is the covariance between 1 and 2).

The first order condition for utility maximisation (see Appendix 1) is:

2

+ 2

=0

w

w

We find by working out the derivatives in the second brackets of the two

terms above and rearranging, that:

= (1 2)

w

and

2

= 2w (21 21212 + 22) 22(1 121)

w

55

23 Investment management

1 2

u/2

=

2

u/

2w (1 21212 + 22) 22(1 121)

The left hand side is positive and states the marginal rate of substitution

between risk and return. If the marginal increase in expected return over

the marginal increase in portfolio variance on the left hand side exceeds

the marginal rate of substitution on the right hand side, the investor will

increase both the return and the risk of his portfolio. At the optimal point,

the left hand side exactly balances out the right hand side.

The important point about this is that the investors choose portfolios in

order to balance expected return against portfolio variance. Everything

else being equal, they choose portfolios that have lower variance, or they

choose portfolios that have higher expected return.

The CAPM gives us more, however. This framework tells us also that

investors pick portfolios on the portfolio frontier, and that the portfolio

frontier can be spanned by two known portfolios, the risk free asset and

the market portfolio. This phenomenon is called twofund separation.

When investors can achieve the same utility from the asset allocation

problem of balancing their investment across a small number of funds

as they would from investing in all assets freely, we say that portfolio

separation obtains. Twofund separation indicates simply that investors

can choose the simpler asset allocation problem between two funds as the

more involved portfolio selection problems using all available assets. In

the CAPM framework, the two funds are the risk free asset and the market

index. Therefore, for any arbitrary portfolio rP , there exists a mixture

portfolio xrM + (1 x)rF such that:

rF + x(ErM rF) ErP and Var(rF + x(ErM rF )) Var(rP)

where at least one inequality is strict unless rP is also a mixture portfolio

of the risk free asset and the market portfolio. If we consider the optimal

portfolios, therefore, we can set the parameter 1 = ErM and 1 = M, and

similarly 2 = rF and 2 = 0, and we find that under the optimal allocation:

u/2

=

u/

ErM rF

2w2M

depends on the marginal rate of substitution between risk and return (the

left hand side) and the risk premium on the market portfolio relative to its

variance.

We can go further and solve for the marginal rate of substitution on the

left hand side if we make specific assumptions about the utility function.

This section assumes some knowledge of utility theory and in particular

CARA utility functions. See Appendix 1 for a survey of these. Recall that

the optimal asset allocation is given by the marginal rate of substitution

above. In the case where investors have CARA utility (constant absolute

risk aversion) and portfolio returns are normal, we can write all utility

functions in the following way:

u(, 2) = 2

2

56

Chapter 6: Diversification

u

=1

and

u

=

2 2

such that the marginal rate of substitution between risk and return is:

u/2

=

u/

2

and if we put this into the left-hand side in the relationship above, we find

the optimal weight on the market portfolio as:

ErM rF

1

w* = =

2M

The more risk averse the individual is, therefore, the smaller the weight he

puts on the market portfolio, as the risk aversion coefficient enters into the

denominator on the right hand side.

You can read more about this approach to selecting among optimal

portfolios in Elton, Gruber, Brown and Goetzmann Chapter 12.

So far we have discussed the benefits of diversification when diversifying

across two risky assets, and on the optimal asset allocation when investing

in a risky asset and a risk free asset. These two concepts are linked

through the derivation of the portfolios that have the smallest variance

for any given level of return the socalled portfolio frontier. In this

section we outline a geometric derivation of the portfolio frontier with and

without a risk free asset. We have already worked out the key ingredients

above. The first is that when we diversify across risky assets we achieve

a diversification benefit. This implies that the set of risky portfolios is

convex, as illustrated in the following figure:

Figure 6.2

(expected return and standard deviation place) when there is no

investment in the risk free asset.

We know that any portfolio that has a risk free component and a risky

component lies along the linear segment in the plane. In the following

57

23 Investment management

figure we have illustrated three such combinations which all cross the

risk free asset and the risky portfolio. Here, any rational investor who

has meanvariance preferences will choose linear combinations of the

risk free asset and the tangency portfolio. The reason is that any other

portfolio he might think of either has the same or less expected return but

greater variance, or it has the same or greater variance but lower expected

return. The tangency portfolio is, therefore, the optimal risky portfolio for

investors to hold. This portfolio is normally a highly diversified portfolio,

and it achieves the minimum variance of portfolio return given its

expected return.

ErM

rF

Figure 6.3

The graph shows the investment opportunity set in the plane with

a risk free asset. We notice that the portfolio frontier is now linear, and

consists of a linear combination of the risk free asset and the market

portfolio. Also, we notice that the portfolio frontier is formed as a V lying

to the right, as there is not only a limit to the maximum return for any

level of risk, there is also a limit to the minimum return. From Figure 6.3

we can see that investors optimally choose to hold two funds only the

risk free asset and the market portfolio (or the tangency portfolio). This

property is called twofund separation. What is the market portfolio?

The law of supply and demand tells us that all stock issued must be held

by investors investing optimally in the market. Since all investors invest

optimally when they hold the tangency portfolio, this portfolio must

simply be the (valueweighted) index of all risky assets issued. Since this

portfolio is observable, we can estimate its expected rate of return. This

has further implications as we shall see below.

We can also find the optimal risky portfolio algebraically, although here we

will just sketch a method (a full derivation can be found in the appendix).

Suppose we know two risky portfolios on the portfolio frontier in Figure

6.2 say A and B. Then, an important property (that we do not prove

here) is that any portfolio that is formed by taking positions in A and B is

also a portfolio on the same frontier, with expected return

E(r) = wE(rA) + (1 w)E(rB)

where w is the weight on A. The standard deviation of the portfolio equals:

= w22A + 2w(1 w)ABAB + (1 w)22B

58

To find the frontier portfolio we need to maximise the risk premium per

unit of risk, i.e. we need to solve the problem:

max E(r) rF

w

Chapter 6: Diversification

Substituting for the expressions above, we can solve this programme and

find an exact expression for the optimal weights. This necessitates,

however, that we already have identified two frontier portfolios A and B.

In this case that may be unrealistic but we make use of this result below

when we look at optimal diversification in a framework where some assets

earn abnormal returns.

The CAPM contains more than just the benefits of diversification. It also

tells us the relationship between the risk premium on individual assets and

the risk premium on the market portfolio (the tangency portfolio).

E(r) r

F

When we wish to maximise the slope

the first order condition

where is a constant. Essentially, this condition tells us that the risk

premium for all assets is proportional to its covariance with the market

portfolio. Since this relationship holds for all assets, it must also hold for

the market portfolio itself:

Cov(rM, rM) (= Var(rM)) = ErM rF

so we can solve for the proportionality factor:

ErM rF

=

Var(rM)

If we substitute the proportionality factor back into the original equation,

we find, by rearranging:

Eri rF =

Cov(ri , rM)

Var(rM)

(ErM rF ) = i (ErM rF )

which is the CAPM pricing formula. This result tells us, therefore, what the

required expected rate of return on assets should be, given their risk

characteristics. The risk characteristics can be estimated through

estimating the beta factor for assets, and through estimating the aggregate

risk premium of the market portfolio. The market portfolio is simply the

index of all risky assets.

Estimation issues

This section contains an overview of the index model, which yields

considerable benefits in estimating the variancecovariance structure

of asset returns. If there are n assets, we need to work out n variances

and n(n 1)/2 covariances. If n is large this becomes computationally

demanding, and the index model gives us a simple method for reducing

the number of estimations. The idea behind index models is to decompose

the risk in asset returns into two types: the systematic (or market) risk and

the unsystematic (or idiosyncratic) risk. The systematic risk is the part that

is correlated with the risk of the market index, and the unsystematic risk is

uncorrelated with the risk of the market index. This model is very closely

related to the CAPM, and is indeed suggested by the CAPM expected

returns relationship above. The return on any risky asset can according to

the CAPM be written as:

ri = rF + i(rM rF) + i = (1 i)rF + i rM + i

where i is an error term with zero mean and zero covariance with rM. The

reason why the error term is uncorrelated with rM comes from the fact

59

23 Investment management

that rF + i(ErM rF) is the predictable part of the expected return on the

stock. Any error relative to the predictable part must be uncorrelated to

any random variable correlated with the predictable part. The single index

model is slightly more general as it states that asset returns are written as:

ri = ai + birM + ei

with ai a constant, bi is the regression coefficient with estimate equal to the

CAPM beta: Cov(ri , rM), and ei is an error term, again with zero mean and

Var(rM)

zero covariance with rM.

Taking the variance on both of the asset returns yields the following

relationship:

var(ri) = Var(i rM) + Var(i) = Var(birM) + Var(ei)

where the two last terms are identical as long as the estimated beta

bi is the same as the true CAPM beta i . This relationship allows the

decomposition of total risk into market risk and idiosyncratic risk:

(Total risk)Var(ri) = (Market risk)2Var(rM) + (Idiosyncratic risk)Var(i)

Market risk is sometimes called systematic risk, and idiosyncratic risk is

called unsystematic risk. We can now derive the fractions of market risk

and idiosyncratic risk:

Proportion market risk = 2Var(rM)

Var(ri)

and

Proportion idiosyncratic risk = Var(i)

Var(ri)

which gives us the decomposition into market risk and idiosyncratic risk in

percentage terms.

If we now assume that the idiosyncratic risk term i is uncorrelated with

the idiosyncratic risk term j for two assets i and j, we have the single

index model written in factor form (we will talk about factor models

later). The covariance between return on two assets can be written as:

Cov(ai +birM +ei, aj +bjrM +ej) = Cov(birM, bjrM) = bibjVar(rM)

since the error terms ei and ej are uncorrelated with all other variables.

The index model therefore yields a very effective method of estimating the

variancecovariance structure of asset returns as it relies mainly on beta

estimates. For n assets, the number of beta estimates is n, and in addition

we need to work out the variance of the market index. The variance

covariance structure can be constructed from n + 1 estimates, therefore,

instead of n + n(n 1)/2.

In practice it can be diffcult even if the investor wants to diversify fully

and passively in the market index to implement this strategy.

The sheer number of stock implies that the trading costs of investing in

the entire index can be considerable, particularly for smaller investors. In

this section we outline first a method for achieving diversification gains

independently of the index, and second a method for tracking the index

using a smaller number of stocks than is contained in the index. Suppose

you hold an equal amount of money in n stocks (i.e. portfolio weights are

all equal to 1/n). Then, the expected return on your portfolio equals:

60

Chapter 6: Diversification

E(r) = 1 E(ri)

n i

This portfolio has a beta factor equal to the average beta of the assets in

the portfolio. If we expand the right hand side and remove the

expectations operator, we find:

( )

r = 1 ai + 1 bi rM + 1 ei

n i

n i

n i

Letting A = 1n iai and B = 1n ibi and E = 1n iei we get r = A + BrM + E which

allows a risk decomposition Var(r) = B2Var(rM) + Var(E). If Var(ei) = i2 = 2

(i.e. the idiosyncratic risk term has the same variance across all assets), we

find:

2

() () ()

Var (E) = 1

n

= 1

n

i

2

i

= 1

n

i

2

n2 =

2

n

Therefore, the idiosyncratic risk of the portfolio will go towards zero for n

large, and we achieve full diversification. Provided the index model is true,

therefore, we can create a fully diversified portfolio by simply adding a

suffcient number of assets to our equally weighted portfolio.

How should an investor rebalance his portfolio to take advantage of

good information about individual portfolios? It makes sense to buy an

undiversified stake in the portfolio as it represents a good investment,

but how much should you buy? It seems inappropriate to invest too much

as the diversification loss may then offset the expected gains. Of course,

knowledge of such a portfolio should lead to a complete recalculation of

the portfolio frontier through a reassessment of the variancecovariance

structure and the expected returns; however, there exists a simpler

approach which we will outline here.

In this section we try to find a simple answer to how we should balance

the profits from stock picking against the benefits of diversification.

This section looks at the optimal deviations from the full diversification

strategy outlined above. The steps are as follows. First, estimate the risk

characteristics of individual assets and the risk premium of the market

portfolio. This enables us to calculate the required expected rate of return

for the asset, as given by the CAPM pricing relationship above. Next,

estimate the expected return on the assets directly. The difference between

the estimated expected return for the asset and the required expected

return for the asset is the socalled alpha factor for the asset:

= E(r) (rF + (ErM rF))

If the alpha is positive, it means the asset is located above the security

market line, so is earning a higher expected return than is predicted by the

CAPM. If we estimate the single index model for the asset: r = a + brM + e

we find that the estimate of the constant term a can be used to work out

the alpha of the asset through the relationship:

= a (1 b)rF

The degree of mispricing is, therefore, captured by the alpha factor,

which is the expected abnormal rate of return on the asset. Finally, we

need to rebalance our passive market portfolio to include active weights

in assets with nonzero expected abnormal return. These weights we

61

23 Investment management

expect are positive for positive expected abnormal return and negative for

negative expected abnormal return.

We know that if we hold a passive portfolio exactly replicating the index,

the unsystematic risk of all assets cancels out. Once we start to load up

on assets with positive alphafactor, however, we incur diversification

costs that are linked to the unsystematic risk component of that asset.

Therefore, our active portfolio weights must reflect this.

The starting portfolio is the market index, which we call P denoting the

passive portfolio with expected return ErP and standard deviation P .

Suppose a new active portfolio has been identified (for the time being we

do not go into details about how the only constraint is that this portfolio

is on the portfolio frontier) and lets call this portfolio A denoting an

active portfolio. The active portfolio has expected return ErA = A + (1 A)

rF + AErP and standard deviation A = A2 2P + Var(eA), where eA is the

idiosyncratic risk term of the active porfolio. The covariance between the

active portfolio and the passive portfolio is given by PA =AP2 .

The optimal risky portfolio is in this case neither the passive portfolio

P nor the active portfolio A, but some linear combination of the two.

Suppose we form a portfolio with weight w in the active portfolio and

1 w in the passive portfolio. Suppose further we wish to find the portfolio

that achieves the greatest expected risk premium given the standard

deviation is incurred. This portfolio is found as the solution to:

wErA + (1 w) ErP rF

2 2

A

w

The solution is given by:

A

w*= A (1 A) + (ErP rF) Var (eA)

2P

negative, we put negative weight in the portfolio. We can illustrate this

portfolio as follows:

Mixture portfolio

Active

portfolio

Passive portfolio

rF

Figure 6.4

has unit beta, we find the optimal weight as:

/Var(eA)

w* = A

(ErP rF) / P2

62

Chapter 6: Diversification

6.4, we have indicated the old market portfolio (passive portfolio) and the

new portfolio (active portfolio). We can see that it is optimal not to invest

in either portfolio, but rather a mixture portfolio which is a linear

combination of the two. The investor can then mix the risk free asset with

the new mixture portfolio to achieve a `new portfolio frontier outside the

old one.

Factor models

The index model can be interpreted as a onefactor model of asset returns.

It assumes that asset returns are influenced by a systematic risk factor that

is common to all assets, and unsystematic risk specific to each asset. This is

fairly restrictive since in reality there probably is more than one common

risk factor. The generalised factor model assumes, therefore, that asset

returns can be written as:

ri = ai + bi1 f1 + bi2 f2 + . . . + bik fk + ei

where bin are factor loadings for factor n = 1, 2, . . . k; fn are the factors; and

ei is the idiosyncratic risk term with zero expected value. The essential

assumption is that the covariance between any two idiosyncratic risks ei

and ej is always zero. It is also common to assume that the factors have

zero expected value. If we were to make the CAPM into a onefactor

model, therefore, we would have to create a factor f with zero mean. A

good candidate is the factor f = rM E(rM). It is easy to see that Ef = E(rM)

E(rM) = 0. Therefore, we find:

ri = (1 i)rF + i rM + i = (1 i)rF + i(f + E(rM)) + i = (rF + i(E(rM) rF))

+ i f + i

This illustrates that for factor models, the expected return is always

captured by the regression constant ai.

The arbitrage pricing theory tells us that if assets have a factor structure,

expected returns on stocks can be written as a linear combination of risk

premia, one for each factor, as in the kfactor case:

E(ri) = ai = rF + bi1 1 + bi2 2 + . . . + bik k

where n are the risk premia. The betas here are factor loadings.

Factor models can apply the principle of diversification to create portfolios

that contain a large number of assets (such as to reduce the unsystematic

risk term) and also to be immune to all but a single factor. To see how we

make use of such portfolios, consider a twofactor model and assume we

have already identified two fully diversified portfolios, A and B, that have

returns:

rA = aA + bA f1 and rB = aB + bB f2

These portfolios contain so many assets that the unsystematic risk

component simply vanishes. If we create a portfolio of these portfolios

with weight w in A and (1 w) in B, the return can be written as:

r = waA + (1 w)aB + wbA f1 + (1 w)bB f2

This portfolio is sensitive only to factor risk, since the original portfolios

are already fully diversified. The portfolios A and B can be used, therefore,

to diversify optimally and choose optimal factor loadings to suit the

individual investor.

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23 Investment management

We have looked at asset allocation in a oneshot model, where the market

portfolio has return ~

rM and the risk free asset has return rF. What if we

are looking for a longer term horizon where we balance our portfolio

over time to a series of market returns ~

rM (1), ~

rM (2), . . . , ~

rM (T), and the

risk free rate rF (1), rF (2), . . . , rF (T)? The question is whether investors

can afford to be 'myopic so that the asset allocation problem at time t

depends on the characteristics of ~

rM (t + 1) and rF (t + 1) only, or whether

the whole of the investment horizon should be taken into account. The

argument is that longlived investors can optimally bear more risk as they

will experience up and down movements over a longer time horizon than

shortlived investors who invest only over one period. Therefore, long

lived investors lose out by being myopic in their investment choice. What

is shown in Campbell and Viceiras book is that myopic asset allocation is

optimal for longlived investors in certain situations.

The condition is about risk aversion: if the relative risk aversion does not

depend systematically on wealth, then the investors tend to invest the

same fractions of their wealth risky and risk free, and will therefore not

need to take into account wealth effects from one period to the other. It is

only if there is a violation of this condition that longlived investors need

to look beyond the next period when making their asset allocation choices.

What is relative risk aversion? Recall that the absolute risk aversion

coefficient for a given utility function defined over wealth, u(w), where u is

utility and w wealth, is:

ARA = u''(w)

u'(w)

Then the relative risk aversion is:

RRA= u''(w) w = ARA w

u'(w)

What happens if ARA is constant? In this case investors take the same

absolute amount of risk regardless of wealth. So that if they choose to hold

half their wealth risky, they would keep only a quarter of their wealth risky

if they doubled their wealth. What happens if RRA is constant? In this case

investors take the same relative amount of risk regardless of wealth, so if

they keep half their wealth risky they still keep half risky even if they

doubled their wealth. Constant RRA would, therefore, justify myopic asset

allocation. A second question is whether it is plausible that RRA is

unrelated to wealth. Here, Campbell and Viceira argue that this

assumption is needed to explain the relative stability of interest rates and

asset returns over the last couple of hundred years we have records. The

lesson is, therefore, that we do not necessarily lose out by being myopic in

our asset allocation choices.

64

Chapter 6: Diversification

Summary

In this chapter we have seen how the principle of diversification arises

from the underlying fundamental pricing theory in finance.

Initially, we looked at how portfolios that include more than one risky

asset can reduce risk, and we expanded this simple example into a fully

fledged theory of optimal investment in risky and risk free assets.

We also looked at how we should accommodate abnormal asset returns

into this framework, and how to deal with factor models of asset

returns.

The final parts of this chapter looked at how to incorporate private

information in the diversification setup (in the context of the Treynor

Black model) and when it is permissible to incorporate a myopic

(static) perspective on asset allocation problems and when it is not.

Activities

1. Suppose you toss a coin, and let tails represent a gain of 1 and heads

a loss of 1. What is the expected pay-off of a single coin toss? What is

the variance?

2. Now suppose you toss the coin 100 times, and assume you receive

1

of the pay-off each time. What is the expected pay-off in this case?

100

What is the variance? Use these lotteries to explain diversification in

stock markets.

3. You can simulate risk using a computer package such as Microsoft

Excel. Try to simulate the effects of dependence between random

outcomes. For instance, if you use the formula RAND() in Excel it will

return a randomly chosen number between 0 and 1. If you generate

two random independent outcomes x and y using the RAND() function,

then you can generate a new random variable z = k(ax + (1 a)y)

(k 1)Ex for some numbers a and k. The expected value of z is k(aEx +

(1 a)Ey) (k 1)Ex = k(Ey + a(Ex Ey)) (k 1)Ex = kEx (k 1)Ex =

Ex = Ey. The variance of z is k2a2Varx + k2(1 a)2Vary (since x and y are

uncorrelated), which is k2(1 2a(1 a))Var(x) = k2(1 2a(1 a))Var(y). If

we choose k2(1 2a(1 a)) = 1, or k2 = (1 2a(1 a))1 the new random

variable z has the same expectation and variance as x and y. However,

in this case z is correlated with both x and y. Pick a value of a (and

work out k from the formula above), and make 100 draws of x and y

which enables you to generate 100 draws of z. Estimate the covariance

between x and y, and then the covariance between x and z. Are the

results what you expected?

Having completed this chapter, and the Essential reading and activities,

you should be able to:

accurately compute the expected return, risk premium, variance and

the standard deviation of a risky portfolio

accurately compute the expected return, risk premium, variance and

the standard deviation of a combination of a risky portfolio and a risk

free asset

clearly define mean-variance preferences and coherently explain how

investors with mean-variance preferences choose portfolios

65

23 Investment management

derive the optimal portfolio with the knowledge of the investors' risk

aversion coefficient with confidence

define the portfolio frontier in detail

formally explain how the existence of a portfolio frontier on which

investors choose their optimal portfolios implies that the CAPM pricing

formula holds

concisely define the concepts of systematic and unsystematic risk, and

cogently explain how these concepts are used to simplify the problem

of estimating the covariance between asset returns

discuss the implications of the single index model to effective

diversification in detail

review the Treynor-Black model

thoroughly define factor models, and illustrate well-established pricing

formulas

knowledgeably explain why myopic portfolio choice may sometimes be

optimal even though the investors have a long investment horizon.

1. a. Explain what we mean by the risk premium of an asset. Why do we

expect the risk premium to be positive? Can you think of assets where

the risk premium is negative? Explain.

b. Outline the TreynorBlack model. Why is this model of interest to

investors?

c. Suppose there are five stocks, each with a beta of one, and with

uncorrelated idiosyncratic risk equal to 2% each. The market portfolio

has variance 9%. What is the variance of an equally weighted portfolio

in the five stocks? Now suppose the idiosyncratic risk of stock number

one increases from 2% to 3%, and the idiosyncratic risk of stock

number two decreases from 2% to 1%. What would happen to your

portfolio? Would you like to increase your investment in stock number

two and decrease your investment in stock number one? Explain.

66

Learning outcomes

By the end of this chapter, and having completed the Essential reading and

activities, you should be able to:

formally relate the concepts of yield-to-maturity, spot rates, and

forward rates

clearly define the term structure of interest rates

cogently discuss given hypotheses that explain the shape of the term

structure

thoroughly define duration and the convexity for bonds and bond

portfolios

accurately compute duration and the convexity for bonds and bond

portfolios with autonomy

aptly explain and formulate immunisation strategies for bonds and

bond portfolios with little guidance

broadly identify the key challenges of incorporating convexity into a

bond immunisation programme

explain and competently design immunisation strategies for stocks and

equity portfolios

confidently calculate hedge ratios and successfully apply them in

derivatives based immunisation strategies.

Essential reading

Bodie, Z., A. Kane and A.J. Marcus Investments. (Boston, Mass.; London:

McGraw-Hill Irwin, 2008) Chapters 10, 14, 15 and 16.

Elton, E.J., M.J. Gruber, S.J. Brown and W.N. Goetzmann Modern Portfolio

Theory and Investment Analysis. (New York; Chichester: John Wiley & Sons,

2010) Chapter 21.

Introduction

In this chapter we outline the principle of immunisation. From the

previous chapter we recall that investors who invest in diversified

portfolios do nonetheless bear risk market risk. Sometimes, they may

find it useful to eliminate some or all of this risk as well. For instance,

bond portfolios denominated in foreign currency are affected by both

interest rate risk and currency risk. Both are types of market risk that

any such portfolio is exposed to. It may be that you want to take a bet on

the future developments in the interest rate market but at the same time

avoid the interfering effects of currency risk. To achieve this you need to

immunise your portfolio to currency risk; this can be achieved through

taking offsetting positions in the currency derivatives markets. How do

investors offoad risk from their portfolios to other investors?

We can achieve this through trading financial instruments, and we need to

make sure that our trading activity achieves the objective of transferring

the right type of risk without introducing new ones. This chapter discusses

immunisation strategies that make this type of trading possible.

67

23 Investment management

the immunisation material applies most readily to fixed income securities

such as government bonds. The reason is that these securities are

essentially free of cash flow uncertainty so we are left only with pricing

uncertainty. Equities are subject to both types of uncertainty, and arguably

the overriding problem is to identify the future cash flows rather than

the discount rates. We discuss towards the end of this chapter how

immunisation strategies can also be designed for equity portfolios.

Bond maths

Before we proceed we will review quickly some bond maths. A bond is

characterised by its future cash flows, which normally come in the form of

annual or semi-annual coupon payments, and a final capital payment. The

price of the bond is the sum of all future discounted cash flows receivable

to the bond holder. We can, therefore, link the prices on bonds to the future

cash flows through the yield-to-maturity of the bond. Assuming annual

coupons, the formula is given by:

c

P= c +

+ . . . + c + 100

1 + y (1 + y)2

(1 + y)T

for a T-year bond paying coupons of c per 100 nominal value. The quantity

y is the yield to maturity, and it belongs to the particular bond in question.

We may wish to define other quantities such as the spot rates, which can be

used to price all bonds. If we have all spot rates from the one-year rate to

the T-year rate, we can also write the bond price as:

P=

c

c +

+ . . . + c + 100

1 + r1 (1 + r2)2

(1 + rT)T

The spot rates r1, r2, . . . , rT will also price other bonds correctly, therefore

these rates belong to the maturity dates rather than to any particular bond.

How do we find the spot rates from the yields on bonds? The simplest case

is when we have available a large number of zero coupon bonds. A zerocoupon bond has only a single cash flow, the capital repayment in year T, so

in this case the yield-to-maturity must coincide with the T-year spot rate:

P=

100

= 100

(1 + y)T (1 + rT)T

so the T-year spot rate is given by the yield on a T-year zero coupon bond.

By looking, a zero coupon bonds across a wide range of maturities,

therefore, we can unravel the spot rates.

What if we have no zero coupon bonds available? There is no real problem

here; all we need to do is to make one up using coupon bonds. Consider the

following example: suppose we have three bonds available with cash flows

given by the following table:

Bond

Yr 1 cash flow

Yr 2 cash flow

Yr 3 cash flow

105

106

104

If we wish to receive a three-year zero coupon bond with cash flow 100, we

need to hold a portfolio consisting of xA units of A; xB units of B, and 1 xA

xB units of C such that:

105xA + 6xB + 4(1 xA xB) = 0

106xB + 4(1 xA xB) = 0

68

which yields a solution xA = 0.03880 and xB = 0.04074. The year one and

two pay-offs are zero (or close to zero since there is rounding error),

and year three pay-off is (1 + 0.03880 + 0.04074)104 = 112.27. We need to

100

hold 112.27 units of the portfolio above, therefore, to achieve a `synthetic

three-year zero coupon bond with pay-off 100 in year three. In practice,

statistical techniques are applied to bond prices to work out the spot rates

where as many bonds as possible are used. We will not go further into

this issue here apart from mentioning two key points. The first is that

many bonds are included to minimize the risk of estimation error due to

market mispricing, as the reliance of individual bond prices is reduced.

The second modification is done to tackle the problem that the cash flows

of different bonds do not fall on the same day. Therefore, the discount

rates we derive from the shorter bonds may not be directly applicable

when we seek to derive discount rates from longer bonds. The way to deal

with this problem is to fit a smooth curve of discount rates to a large set of

bonds. Individual bonds will determine certain points on this curve, and by

including a large number of bonds the scheme will smooth out the curve

to achieve the best fit. There is a variety of fitting schemes that can be

used for this purpose.

We note also that in the example above we could easily extract the term

structure from the prices of the bonds A, B and C. The price of bond A

would yield the one-year spot rate directly:

PA =

105

1 + r1

Then, using this rate and the price of bond B we can extract the two-year

spot rate:

PB =

106

6

+

1 + r1 (1 + r2)2

and finally, using r1 and r2 and the price of bond C we can extract the

three-year spot rate:

PC =

104

4

4

+

+

(1 + r3)3

1 + r1 (1 + r2)2

which give us the term structure up to year three. For instance if PA = 100

then r1 = 5.00%; if PB = 101 then also r2 = 5.47%; and if PC = 96 then also

r3 = 5.49%.

Once spot rates are extracted, we can work out the forward rates. Suppose

we work out that the one-year spot rate is 5% and the two-year spot rate is

5.2%. Suppose we can borrow 100 in one years time for one year against

paying a rate of 5.3%, i.e. repaying 105.3 in two years time. Should we

take this borrowing opportunity? The way we should look at this is that

100

to offset the loan agreement, all we need to do is to borrow 1.05

today on a

one-year deal, which generates a cash flow of 100 in year one. This cash

flow will be repaid on our loan agreement, so the net outflow in year one

is zero. Next, we invest 100 (1.053)

on a two-year deal, which generates a cash

2

1.052

flow of 100(1.053) in year two. This enables us to repay the loan, so the

net cash flow in year two is also zero. The current cash flow is

100 100 (1.053) = 0.09 which is positive. Therefore, the loan rate of 5.3%

2

1.05

1.052

offered is a good rate, and you would take the loan, offsetting it in the way

described above, and make arbitrage profits, again and again, until the

rate of 5.3% would change. What is the fair level? Let f1 be the one-year

forward rate implied by the loan agreement. Intuitively, the relationship is

1 + f1

1

that 1.05

must be equal to

to avoid arbitrage, or that:

2

1.052

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23 Investment management

1 + f1 =

1.0522 (1 + r2)2

=

1.05

1 + r1

1 + f t1 =

(1 + rt+1)t+1

(1 + rt)t

n

t

(1 + f ) =

(1 + rt+n)t+n

(1 + rt )t

1

n

We notice that all information about forward rates is fully embedded in the

spot rates and vice versa, therefore it does not matter whether we specify the

spot rates or the forward rates.

The collection of spot rates of various maturities are called the term structure

of interest rates. It is common to classify the term structure into four basic

shapes:

Normal or conventional shaped where there is a gentle increasing slope

as maturity increases

Upward-sloping, positive, or rising, in which short rates are very low,

with long rates substantially higher

Inverted, downward-sloping or negative, in which short rates are high

with long-term rates are significantly lower

Humped where short rates are high with the curve rising to a peak in the

medium term and sloping downward again towards the longer maturities.

There are several hypotheses put forward to explain the shape of the term

structure. For instance, the expectations hypothesis states that the slope

in term structure reflects the markets expectations about future interest

rates. Essentially, this means that the forward rates we observe today are

where we expect the future spot rates will be. Another theory explaining

the term structure is liquidity preference theory, which states that the

longer yields reflect higher risk, and must therefore offer higher returns

to the investors. A third theory is the money substitute hypothesis,

where short dated bonds are regarded as substitutes for cash. Since such

bonds are nearly cash they have negligible risk and offer low return. Finally,

there is the segmentation hypothesis, which suggests that activity in

the various segments of the market is unrelated to other segments. The

relative amounts of funds invested and borrowed at various maturities reflect

segmented demand and supply, and will therefore produce different yields for

instruments of different maturities.

You can read more about the term structure of interest rates in Bodie, Kane

and Marcus Chapter 15.

Duration

An important objective for a bank might be to immunise a bond portfolio

against movements in the term structure of interest rates. The simplest

form of immunisation is against upward or downward shifts in a flat term

structure. Suppose all spot rates are equal rt = r for all maturities t, so that all

bonds are have the same yield to maturity r. We are looking at the problem of

immunising a bond portfolio against movements in the yield.

70

There are several effects in play here. The first is that bond prices and yields

are inversely related as the yield increases the bond price falls. Therefore,

bond portfolios tend to fall in value following an increase in the yield.

Second, an increase in the portfolios yield results in a smaller value change

than a similar decrease in the yield. This phenomenon is called convexity

bond prices are convex in the yield to maturity. This can most easily be seen

by looking at a T-period zero coupon bond. The price is given by:

100

PT =

(1 + r)T

The change in the price corresponding to a change in the yield r is given by

the first derivative:

dPT

= T 100

dr

(1 + r)T +1

dr.. We note that

so that the dollar value changes by dPT = T 100

(1 + r)T + 1

and yields. The percentage change in the bond is equal to:

100

dPT

=

PT.

( )

T

T (1 + r)

PT.

dr

We notice that both the change in absolute (dollar value) terms and

relative (percentage) terms depend on the current yield r, and this

relationship is convex. The convexity property can be confirmed by taking

the second derivative:

d 2PT

= T (T + 1) 100T+2

dr 2

(1 + r)

which is positive. We also note that prices of long-term bonds are more

sensitive to interest rate changes than prices of short-term bonds, since

the value in the numerator depends on T in a positive way, and the value in

the denominator depends on T in a negative way (as it enters in the form

(1 + r)T+1).

The effects of yield changes are very easy to trace when working with

zero coupon bonds. It becomes more diffcult once we allow arbitrary

bonds into our portfolio. The duration concept makes this job easier. The

Macaulays duration concept is computed such as to generate a weighted

average of the maturity dates of the payments of the bond. Consider cash

flows ct received at time t = 1, 2, . . . , T. Compute the present value for each:

ct

PV(ct) =

(l+r)t

Add all cash flows together to compute the price of the bond:

P = PV(ct)

t

Then, work out the contribution of the individual cash flows relative to the

total price of the bonds. This is the duration weight:

PV(ct)

PV(ct)

dt =

=

P

t PV(ct)

Finally, find the weighted average of the maturity dates through the

calculation:

PV(ct)

D = dt t = t

t PV(ct)

t

t

D is the duration of the bond and it is a measure of the weighted average

maturity for the bond payments. If we are working with a zero-coupon

bond of maturity T (where ct = 0 for t = 1, . . . , T 1), we find that:

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23 Investment management

D = dt t = dTT = T

t

formula for the price of the bond we find:

P=

cT

c2

c1

+ (1 + r)2 + . . .+ (1 + r)T + 1

1+r

c1

cT

c2

dP

. . . T

2

=

3

2

(1 + r)T + 1

(1 + r)

(1 + r)

dr

If we divide by P on both sides and multiply by dr, we find the relative

change of the bond price:

dP

=

P

c1

cT

c2

. . . T

2

(1 + r)2

(1 + r)T + 1

(1 + r)3

P

dr

and we can now recognise the duration D of the bond inside the bracket:

dP

=

P

( )

The quantity

D

.

as D* =

1+r

D

1+r

dr = D*dr

1+r

Numerical example

Let us look at an example. Consider a five-year 5% annual coupon bond

with yield to maturity 5%. This bond is selling at exactly par value 100

(confirm for yourself), so the weights are for t = 1, . . . , 4: dt =

105/1.055

5

1.05t

100

, and

0.04319, d4 = 0.04114, d5 = 0.82270. We can confirm the sum of the weights

equals 1. The duration of this bond is:

D = 1(0.04762) + 2(0.04535) + 3(0.04319) + 4(0.04114) + 5(0.82270) = 4.55

If we expect the yield to increase to 6%, we can work out the percentage

change in the price of the bond as:

4.55 0.01 = 4.33%

dP

= 4.55 dr =

1.05

1.05

P

which corresponds to a drop in the price from 100 to 95.67. The actual

price would be:

P6% yield = 5 + 5 + . . . + 105 = 95.79

1.065

1.062

1.06

so the predicted price drop is greater than the actual price drop.

P

r

Figure 7.1

72

The figure shows the effects of convexity for a 20-year zero coupon bond.

We notice that for large changes in the yield there is a big discrepancy

between the predicted bond price change and the actual bond price

change. If we were to consider a change in the yield from 5% to 4%, the

predicted price change would be a 4.33% increase in the bond price (since

everything in the formula above stays the same except dr = 0.01 instead

of dr = 0.01) from 100 to 104.33. In this case, the actual price would be

P4% yield = 5 + 5 + . . . + 105 = 104.45

1.045

1.042

1.04

so we are in this case undershooting the true price change. This is due to

the effect of convexity. We can illustrate this geometrically; see Figure 7.1.

Convexity

If the current yield is r0 and the current bond price P(r0) is known, we

know from Taylor approximations that the price of the bond for nearby

yields r is:

P(r) P(r0) + P'(r0)(r r0) + 1 P''(r0)(r r0)2

2

We recap the bond price and work out the derivatives:

P(r0) =

c1

(1 + r0 )

P'(r0) =

P''(r0) =

c1

(1 + r0 )2

2 c1

(1 + r0 )3

cn

c3

c2

+. . .+

+

(1 + r0 )n

(1 + r0 )3

(1 + r0 )2

3 c3 . . . n cn

2 c2

(1 + r0 )n + 1

(1 + r0 )4

(1 + r0 )3

3 2 c2

+

(1 + r0 )4

4 3 c3 + . . . + (n + 1) n cn

(1 + r0 )n + 2

(1 + r0 )5

According to this, therefore, the absolute change in the bond price P(r0) =

P(r) P(r0) is:

P(r0) P'(r0) (r r0) + 1 P''(r0) (r r0)2

2

and the relative change, which is more interesting for our purposes:

P(r0) P'(r0) (r r ) + 1 P''(r0) (r r )2

0

0

P(r0)

P(r0)

2 P(r0)

Here, we recognise the modified duration:

P'(r0)

D* =

P'(r0)

and we define the convexity as:

C* =

1 P''(r0)

2 P(r0)

P(r0) = D* (r r0) + C* (r r0)2

P(r0)

In the example above, we found D* = 4.33, and we can work out the

convexity as:

C* =

1

2

2 5 + 3 2 5 + 4 3 5 + 5 4 5 + 6 5 105

1.053 1.054

1.055

1.056

1.057

1

= 11.97

100

Therefore, the relative bond price for a yield change from 5% to 4%, is:

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23 Investment management

P

which is very close (accurate using two decimal places) to the actual price

change.

You can read more about convexity in Appendix D of Elton, Gruber, Brown

and Goetzmann Chapter 22.

By working out the duration of a bond portfolio we can predict fairly

accurately the way in which the value of the bond portfolio changes in

response to interest rate changes. This can be used to take positions that

immunise the portfolio against interest rate risk. We extend our example

to show how this can be done. Suppose we hold the bond above, priced at

100, as our only asset. The balance sheet will look as follows:

Assets

Liabilities

Bond 100

Equity 100

The risk on the asset side from movements in interest rates will feed

through to the equity, so the equity has duration equal to the duration

on the asset side, i.e. 4.55. If the equity holders are unhappy with this

high exposure, they can reduce it by selling (i.e. borrowing) a bond on

the liability side. Suppose the equity holders seek to reduce the duration

by selling a five-year zero coupon bond. Since the company will receive

cash when taking the short position, it will have to decide what to do

with the proceeds. Suppose the company decides to hold the proceeds

in cash (with zero duration as cash values are insensitive to interest rate

movements). Then the balance sheet takes the following form:

Assets

Liabilities

Cash x

Bond 100

Equity 100

x

0

Duration assets = 100 4.55 +

100 + x

100 + x

and the duration on the liability side is:

x

5 + 100 Duration equity

Duration liabilities =

100 + x

100 + x

These must of course balance out, so:

100 4.55 =

x

5 + 100

100 + x

100 + x

100 + x

Duration equity

solve with respect to x:

x=

74

5

If we decide on our target duration for our equity exposure (say we wish

to reduce the duration of the equity to 2) then we can find the required

short position x:

100

(4.55 2) = 20(2.55) = 51

x=

5

reinvest in the original bond. If we do this the balance sheet will end up

looking this way:

Assets

Liabilities

Bond 100 + x

Equity 100

The duration on the asset side now remains at 4.55 since we hold 100%

in the original bond, and the duration on the liability side is as above.

Balancing them out we find:

4.55 =

x

5 + 100

100 + x

100 + x

Duration equity

or

(100 + x)4.55 = 5x + Duration equity 100

Solving with respect to x we find:

x = 100(4.55 Duration equity)

5 4.55

If our target is still 2, we can solve for x:

x=

100(4.55 2)

= 255

0.55

5 4.55

= 463.6

The job of immunising or reducing the interest rate exposure of bond

portfolios becomes much more complicated when we also need to take

into account term structure effects i.e. the risk that the term structure

bends and twists in unexpected ways and the interest rate changes are

different for different spot rates. The simple example above assumes that

the term structure is completely flat, which of course is not likely to be the

case. Even with symmetrical movements in a flat term structure we find

misleading results because of convexity if the movements are large.

It is diffcult, however, to take into account convexity effects in the

immunisation procedure. Suppose, for instance, that we have invested

100,000 in a five-year, 5% coupon bond, and we wish to hedge our

exposure using a 10-year zero coupon bond. The price of the coupon bond

is 100 per 100 nominal capital (since yield is equal to the coupon rate)

100

and the price of the zero coupon bond is 1.0510 = 61.39 per 100 nominal

capital. The modified duration and convexity of the coupon bond are,

respectively:

D* =

1

100

C* =

1 1

2 100

5 + 2 5 + . . . + 5 105

1.052 1.053

1.056

= 4.33

2 5 + 3 2 5 + . . . + 6 5cdot105

= 11.97

1.053 1.054

1.057

For the zero coupon bond we find the modified duration and convexity

equal to:

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23 Investment management

D*z =

1 10 100

= 9.52

61.39 1.0511

C* =

1

1 11 10 100

= 49.89

2 61.39

1.0512

coupon bond to offset the movements in our 100,000 investment in the

coupon bond. If we looked at duration effects only, we would try to solve

the equation:

100,000 4.33dr = x 9.52dr

4.33

only, we would try to solve the equation:

100,000 11.97dr2 = x 49.89dr2

11.97

both effects, we need to solve the equation:

100,000 (4.33dr + 11.97dr2) = x (9.52dr + 49.89dr2)

We can get rid of one of the dr terms, to reduce the equation to:

100,000 (4.33 + 11.97dr) = x (9.52 + 49.89dr)

but this is really just now one equation with two unknowns, x and dr.

Therefore, we cannot really improve on our immunisation strategy without

knowing more about the statistical properties of the remaining dr term.

In many instances we may wish to change the risk exposure of equity

portfolios. A typical situation is when the investor is investing in a

portfolio which aims at holding takeover target companies. Usually, when

a takeover of a company is announced the target company (that being

bought by the bidder) will experience a large jump in its stock price, so

if you are able to identify such companies you will be able to reap huge

gains when takeovers are announced. The problem is, however, that

holding such a portfolio will expose you to general market risk. Even if

you make a 10% gain due to takeover announcements it is no good if you

at the same time experience a 10% loss due to the fact that the market has

gone down over the holding period. To illustrate immunisation of equity

portfolios we shall assume a factor model, which generalises the standard

CAPM model.

Suppose risky asset returns are generated by a two-factor structure:

ri = ai + bi1 f1 + bi2 f2 + ei

where ri is the return on the asset, ai is the expected return on the asset,

bi1 and bi2 are the two factor loadings, f1 and f2 are the two factors, and

ei is the idiosyncratic risk of the asset. Suppose also there exist two well

diversified portfolios (with no idiosyncratic risk):

r1 = a1 + f1

and

r2 = a1 + f2

which have unit factor loadings and are subject to only one type of factor

risk. We wish to use these portfolios to strip the original portfolio from

factor risk. The original balance sheet takes the form:

76

Assets

Liabilities

return ri

Equity

Total assets

Total liabilities

Now consider a rebalancing of the asset side where we borrow risk free

at the rate rF and invest a fraction x1 of our wealth in portfolio one and a

fraction x2 in portfolio two. The net loan is x1 + x2. The balance sheet now

looks like:

Assets

Liabilities

Risky portfolios

x1 at return r1

and x2 at return r2

Risky portfolio with

with return r1

at a rate of rF

Equity

Total assets 1 + x1 + x2

Total liabilities 1 + x1 + x2

ri + x1r1 + x2r2 = (ai + x1a1 + x2a2) + (bi1 + x1)f1 + (bi2 + x2)f2 + ei

There is no factor risk on the liability side, so we can set:

bi1 + x1 = 0 and bi2 + x2 = 0

to strip the entire balance sheet of factor risk. This involves putting

x1 = bi1 and x2 = bi2, so in fact the investment in the two risky portfolios

is actually likely to be a short sale transaction (or a loan) and the loan

at the risk free rate is likely to be a risk free investment, as the factor

loadings of the original portfolio are likely to be positive. The net result is

nonetheless that the equity position is now stripped of all risk except the

idiosyncratic risk ei to which we would like to be exposed.

It is also possible to strip the risk by taking offsetting positions in the

original portfolio instead of taking offsetting positions in the money

market at the risk free rate. In this case the balance sheet would look as

follows:

Assets

Liabilities

(1 + x1 + x2) at return ri

Risky investments of x1

at return r1 and x2 at

return r2

Equity

Total assets

Total liabilities

(1 x1 x2)ri + x1r1 + x2r2 = ((1 x1 x2)ai + x1a1 + x2a2)

+ ((1 x1 x2)bi1 + x1) f1

+ ((1 x1 x2)bi2 + x2) f2

+ (1 x1 x2)ei

To strip out factor risk we now need to set:

(1 x1 x2)bi1 + x1 = 0

(1 x1 x2)bi2 + x2 = 0

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23 Investment management

bi1

1 bi1 bi2

and x2 =

bi2

1 bi1 bi2

. A potential problem

final position is negatively exposed to the idiosyncratic risk term ei. In

this case we need to short the final position in order to achieve a positive

exposure again. Another problem arises if 1 bi1 bi2 = 0, as in this case

there exists no solution to the system above.

For risk management purposes, it may be possible to hedge all or parts

of the factor related variance in the futures or forward market. Consider

a regression model where we regress the return on a portfolio r on the

returns on a number of factor portfolios r1, . . . , rk:

r = a + b1r1 + b2r2 + . . . + bkrk + e

where a, b1, . . . , bk are regression coeffcients and e is an error term. This

model implies deltas or hedge ratios of:

dri

such that if you hold a $1 exposure of the underlying asset you sell bi units

of factor portfolio fi you offset the risk that this factor portfolio has on the

original portfolio. However, factor risk is not necessarily traded, so we

need a more general method outlined below.

First, a recap of futures pricing. A futures contract is a derivative

instrument on an asset, typically a currency or a stock market index, that

promises to deliver the difference between the price of the asset and the

futures price F at maturity:

Futures pay-off = ST FT

where ST is the price of the asset at maturity T, and FT is the time T futures

price (this is a long futures, a short futures is just the opposite FT ST ).

Futures are re-priced to zero each day, so that they are cheap to enter

into for buyers and sellers. They are, moreover, easy to price. The futures

contract is, moreover, very easy to value. Taking the present value at time

t of the time T pay-off (here we use an annually compounded rate but

we could also use continuously compounded rates it would make no

difference):

FT

PV(ST FT ) = PV(ST) PV(FT) = St

(1 + rF )(T t)

Using the convention that PV(ST FT) = 0, we find FT = St(1 + rF )T t i.e. the

futures price is just the forward value of the current asset price. Futures

contracts are, therefore, often easier to trade than taking long or short

positions in the underlying asset.

If we observe a spot change ST that we wish to hedge using a futures

position FT , we can regress the spot price changes on the future price

changes:

S = Constant + hF + error

and use the hedge ratio:

h = Cov(S.F)

VarF

to derive the optimal hedge. If you have a spot portfolio of 100,000 and

wish to use the futures contract F to hedge this exposure, you simply sell h

units of the futures for each unit of spot, i.e.

78

VarF

This method does not rely on a factor structure or that factor risk can be

traded directly.

The fact that spot and futures rates have moved closely together in the

past does not imply that they will continue to do so in the future. The

famous case of Metallgesellschaft illustrates this point. This German

company went into a crisis in late 1993 because they had lost a lot of

money on oil futures that were designed to hedge their underlying

business that was highly exposed to the oil price through selling refined

oil products to retail customers on very long term fixed contracts. The

main vehicle for hedging this exposure was, however, short oil futures

contracts which were much more liquid than the long term contracts. The

correlation with the long contracts were so high that this was not seen as

a problem. It did become a problem when the short futures prices started

to detach themselves from the historical pattern, and what was set up as a

hedge actually became a speculative position, and the company lost over

$1 billion on its derivatives trading, leading to the firing of the CEO and a

massive debt and asset restructuring to salvage the company.

Summary

This chapter looked at risk immunisation, which deals with specific

trading strategies that can eliminate or reduce all or part of the risk of

portfolios.

The first part dealt with immunisation of interest rate risk of bond

portfolios, using duration (and to some extent convexity).

The second part dealt with immunisation of equity portfolios, including

the use of hedge ratios and futures trading.

Activity

1. Try to find data on bond yields over various maturity dates, for instance

from Bloomberg: www.bloomberg.com/markets/rates/index.html.

What shape best describes the term structure?

Having completed this chapter, and the Essential reading and activities,

you should be able to:

formally relate the concepts of yield-to-maturity, spot rates, and

forward rates

clearly define the term structure of interest rates

cogently discuss given hypotheses that explain the shape of the term

structure

thoroughly define duration and the convexity for bonds and bond

portfolios

accurately compute duration and the convexity for bonds and bond

portfolios with autonomy with autonomy

aptly explain and formulate immunisation strategies for bonds and

bond portfolios with little guidance

broadly identify the key challenges of incorporating convexity into a

bond immunisation programme

79

23 Investment management

equity portfolios

confidently calculate hedge ratios and successfully apply them in

derivatives based immunisation strategies.

1. a. Describe the relationship between yield-to-maturity, spot rates and

forward rates.

b. Work out the price, the duration, and the convexity of a five-year, 4%

coupon bond when the yield-to-maturity is 4%. Use your answer to

predict the price of the bond if the yield goes down to 3%.

c. Over the foreseeable future, your company has a risk free liability of

$100,000 each year to maintain the pension fund of its employees.

The current interest rate is 5%. Work out the duration of this portfolio

(hint: you may like to apply the formula x + x2 + x3 + . . . x and

x + 2x2 + 3x3 + . . . =

80

x

(1 x)2

1x

measurement

Learning outcomes

By the end of this chapter, and having completed the Essential reading and

activities, you should be able to:

broadly categorise and clearly explain given types of risk

competently apply regression analysis to decompose risk into various

factors

effectively define Value-at-Risk and accurately describe its key

applications

clearly define and accurately compute the Sharpe ratio, Treynors ratio,

Jensens alpha, the M2 measure, and the Information ratio

aptly relate the Sharpe ratio to Treynors ratio

explain the implications of the variability in a funds risk taking strategy

to bias in the estimation of the Sharpe ratio in detail

adequately define market timing and discuss given methods to

measure it.

Essential reading

Bodie, Z., A. Kane and A.J. Marcus Investments (Boston, Mass.; London:

McGraw-Hill Irwin, 2008) Chapters 24 and 27.

Elton, E.J., M.J. Gruber, S.J. Brown and W.N. Goetzmann Modern Portfolio

Theory and Investment Analysis(New York; Chichester: John Wiley & Sons,

2010) Chapters 25 and 27.

Further reading

Grinblatt, M. and S. Titman Financial Markets and Corporate Strategy. (Boston,

Mass.; London: McGraw-Hill Irwin, 2008) Chapter 22.

Embrechts, P., C. Klppelberg, and T. Mikosch Modelling Extremal Events.

(Berlin: Heidelberg; New York: Springer Verlag, 1997) Note: this book is

very advanced and is not really drawn on in this chapter except for some

initial observations made in the very beginning.

Introduction

This chapter discusses the problem of measuring the risk. For most of

the time we will talk about the risk of a portfolio, which is particularly

relevant in situations where investors delegate their portfolio decisions to

a professional fund manager. Investors have a fundamental choice between

direct investment (the DIY alternative) and delegated investment (the

fund management alternative). Any decision to hand over your money to

a fund manager should be judged on the value added compared to direct

investment. It should be said, however, that the problem of measuring risk

is more general than that, and we will talk briefly about other types of risk

as well.

Even if we restrict ourselves to talking about portfolio risk, the problem

is not as easy as it sounds. In financial markets the expected return on

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23 Investment management

simple way of increasing expected returns for a fund manager is simply

to increase the risk of the portfolio. This, however, should not be seen

as value added as this is something direct investment could achieve very

easily. We need, therefore, to search for non-trivial factors that can increase

the value added of delegated investment. The problem of assessing

the performance of individuals managing an investment portfolio is,

nonetheless, much more diffcult than it sounds. Assets that are traded in

the market tend to trade at fair prices. Portfolios that consist of such assets

consist, therefore, of investments that have a value that is close to their fair

value. We do not necessarily expect, therefore, that a portfolio picked by a

monkey throwing darts necessarily underperforms a portfolio picked by a

highly paid professional fund manager. The market has already done a lot

of the job in making the investment cost of portfolios (i.e. the asset prices)

fair. We know, however, that an arbitrary portfolio might contain risk that

is diversifiable and hence not compensated for. Therefore, a lot of the

issues in portfolio management deal with how to measure the performance

of a given portfolio, taking into account its risk characteristics.

A second problem in portfolio performance evaluation is associated

with consistency. Recall that active trading can yield two types of gains

(over and above the regular compensation for the time value of money

and portfolio risk). The first consists of gains that can be attributed to

exceptional skill and knowledge by the fund manager. These gains are

likely to be consistent over a long period of time. The second consists of

gains that can be attributed to chance the fund manager might be in the

right place at the right time to spot an arbitrage opportunity. These gains

are normally of a one-off type and cannot be repeated. Most of the work

on portfolio performance evaluation attempts to identify consistently high

performance but ultimately luck will play a role and it can sometimes be

hard to separate luck from skill. Additionally, many professionally and

actively managed portfolios cost much more to investors (in the form of

management fees) than simple index tracker funds or exchange traded

funds. These management fees obviously eat up quite a lot of the superior

gains that actively managed funds make. A relevant comparison of fund

performance should, therefore, be made net of the relevant management

cost of the funds.

Types of risk

A fund manager can be exposed to a whole range of different types of

risk, and obviously we have to make a choice which types of risk we aim

to discuss here. Often we separate risk into five categories, although these

are not entirely mutually exclusive:

market risk: risk of unexpected changes to asset prices or rates such

as exchange rates and interest rates

credit risk: risk of changes in value that comes from unexpected

changes in credit quality of trading counterparties

liquidity risk: risk that the cost of adjusting a portfolio will

increase unexpectedly, or that access to credit becomes unexpectedly

significantly more costly

operational risk: the risk of fraud or failures in operations due to

systems breaking down or human errors being made

systemic risk: the risk of meltdown in the financial system, for

instance caused by a chain reaction of events causing liquidity crises or

defaults.

82

In this chapter we focus primarily on market risk that is the risk that the

asset values of the fund managers portfolio will change unexpectedly. For

financial firms it has traditionally been the case that risk management has

essentially been identical to the management of market risk. For industrial

firms, in contrast, the traditional role of risk management has been to

manage operational risk and also, to some extent, liquidity and credit

risk (particularly ensuring that creditors are able to pay on time, and that

credit lines or working capital is available when necessary). In recent

years we have witnessed a convergence of risk management practices

where financial firms are increasingly aware of credit risk, liquidity risk

and operational risk, and where industrial firms are increasingly aware of

market risk. Here, we restrict our discussion mainly to the management of

market risk. Market risk is measured in terms of investment returns (see

Appendix 1), so all discussions about risk management will deal with the

management of the variations of investment returns. We discuss various

methods of measuring this variability in the following pages.

Risk decomposition

When interested in measuring the exposure of investment returns to

risk we are keen to work with measures that are relevant and have clear

meaning. Unfortunately, there are many measures available each are

relevant in their own way and have their own meaning but there exists

no all-encompassing risk measure that generalises all the other. One of

the most intuitive and flexible ways of measuring risk is by decomposing

the risk of an investment portfolio into risk that is correlated with

outsider factors (such as the market index) and risk that is idiosyncratic.

A convenient way to do such decomposition is by regression methods

(see Appendix 1 for a review of such methods). Suppose the return on

a portfolio depends on a number of known factors, for example the $/

exchange rate and the return on the FTSE 100 stock market index. The

regression model where we regress the return of a portfolio r on the return

on the market index rM of the type:

r = a + brM + e

provides estimates of the coeffcients that can be useful measures of the

risk of the portfolio. In particular, this regression model will decompose

the risk of the portfolio into market risk with variance Var(brM) = b2Var(rM)

and idiosyncratic risk Var(e). If we use factor portfolios instead of the

market index, we get a regression model of the type:

r = a + b1 f1 + b2 f1 + . . . + bk fk + e

which allows a similar decomposition, only in this case we get:

Market risk = Var(b1f1 + . . . + bk fk)

and

Idiosyncratic risk = Var(e)

The residual risk e will be uncorrelated with all of the factors f1, . . . , fk

but the factors may be correlated so it is not necessarily the case that

we can decompose the market risk into its individual components as the

covariance terms may not vanish completely.

Value-at-Risk

The Value-at-Risk (VaR) method for measuring risk exposure has become

one of the most popular, particularly as a measure of risk in corporations

and financial institutions. The VaR measure is defined as the worst loss

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23 Investment management

as it focuses on losses (the left tail of the probability distribution). Variance

or volatility is a symmetric measure as both upside and downside risk

contributes. The 1%, one-year VaR of a portfolio is 100m, if the loss over

the next year is less than 100m 99% of the time and may exceed 100m

1% of the time. The VaR measure needs to specify both the time horizon

over which it measures the risk, and the probability by which losses may

exceed a value. If we know exactly the probability distribution of portfolio

returns, the VaR measure can easily be calculated as the tail-distribution.

This can be illustrated by the following figure:

f(x)

1.28

1.65

1.96

2.33

x

Figure 8.1

left of one standard deviation less than the mean is around 16%. The

probability of ending up to the left of 1.28 less than the mean is 10%;

1.65 is 5%; 1.96 is 2.5%; and finally 2.33 is 1%.

The main problem with VaR calculations is, however, that the distribution

function is normally not known as the returns of most assets are,

empirically, not normally distributed. The return distribution for financial

assets has fatter tails than a corresponding normal distribution with

the same mean and variance. A VaR calculation based on the normal

distribution will in this case underestimate the true risk. The case of Long

Term Capital Management, the US hedge fund that collapsed in the late

1990s, illustrates this well. The loss experienced by this hedge fund was

approximately 16 times the standard deviation of its return distribution.

The probability that we should experience a loss of this magnitude with a

normal density function is virtually zero.

When we seek to measure performance of financial investments we

measure these against the risk of the investment. We know that financial

investments tend to compensate the investors for risk taking. This is due

to the fact that most investors tend to be risk averse (see Appendix 1) and

must be paid compensation for carrying risk. The compensation comes

in the form of excess return, that risky investments have an average

return that is greater than the return on risk free investments. Therefore,

the easiest way to boost the expected return of a portfolio is to increase

the risk of the portfolio. This, however, does not in itself constitute

performance enhancement. There exists a collection of performance

84

measures that adjusts the performance of a given portfolio for the risk

it takes. The first is the Sharpe measure which is the ratio of the excess

return to the standard deviation of the portfolio:

Sharpe ratio = Er rF

where Er is the expected return of the portfolio, rF is the risk free return,

and is the standard deviation of the portfolio. The Sharpe ratio for a

portfolio needs to be measured against the Sharpe ratio of the market

index, which forms a benchmark:

Sharpe ratio for the market = ErM rF

M

This comparison tells us whether the portfolio lies above, on, or below, the

capital market line. The capital market line is illustrated in the following

figure:

rF

Figure 8.2

To see why the Sharpe ratio works this way, consider an arbitrary portfolio

on the capital market line, which has expected return E(rCML) = (1 CML)

rF + CMLErM where CML is the beta of our arbitrary capital market line

portfolio. The expected excess return of the portfolio is:

Expected excess return = (1 CML)rF+CMLErM rF = CML(ErM rF)

The standard deviation is:

Standard deviation = Var(CMLrM) = 2CMLVar(rM) = CMLM

The Sharpe ratio of the arbitrary capital market line portfolio is, therefore:

Sharpe ratio =

= Sharpe market

=

CMLM

Any arbitrary capital market line portfolio has, therefore, the same Sharpe

ratio.

Treynors ratio

The second is Treynors measure which measures the expected excess

return on the portfolio relative to the beta risk of the portfolio.

E r

Treynor ratio = r F

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23 Investment management

and this measure should also be measured against the market index

(which has unit beta):

Treynor ratio for the market =

ErM rF

1

= ErM rF

It is easy to see that Treynors ratio is really a test of whether the asset is

on the security market line. The CAPM model predicts that assets should

be priced according to the formula:

Er = rF + (ErM rF)

which gives us the security market line. By rearranging, we find:

Treynor for asset =

Er rF

rF

Figure 8.3

The graph shows the security market line in the plane. The security

market line has a slope equal to ErM rF.

If the asset has a Treynor ratio that is greater than the market, then it is

located above the security market line, and vice versa. Assets with Treynor

greater than the market are considered good buys, but they may carry

idiosyncratic risk for which the investor is not compensated.

A version of the Treynor measure is Jensens alpha:

Jensens alpha = = Er (rF +(ErM rF))

which is the average return on the portfolio over and above that predicted

by the CAPM.

A version of the Sharpe ratio is the M2 measure, which is generated by

an imaginary mixing of the portfolio in question with the risk free asset.

This imagined mixing process enables us to scale up or down the standard

deviation of our portfolio. Let 1 x be the imaginary weight in the risk

free asset, and x the weight of our original portfolio. Suppose the original

portfolio has standard deviation . Then the standard deviation of the

mixed portfolio is:

Standard deviation = x

The purpose is to set the standard deviation of the mixed portfolio equal to

the volatility of the standard deviation of the market index:

86

which is solved for:

x= M

The mixed portfolio has now the same risk as the market portfolio, and we

can compare the return of the mixed portfolio with the market portfolio.

The difference is the M2 measure:

M2 = 1

) r +

Er ErM

so that it is easy to evaluate the over or under performance.

Yet another measure is the information ratio, and is given by the ratio of

the portfolios alpha measure to the standard deviation of the idiosyncratic

risk:

Information ratio = P

of the idiosyncratic risk we can use the single index model to compute the

beta of the portfolio. The variance of the idiosyncratic risk term is:

2 = P2 = P2 M2

i.e. the difference between total risk and market (systematic) risk. The

standard deviation is found by taking the square root of the variance:

= 2.

Sharpe vs Treynor

What is the connection between the Sharpe ratio and the Treynor ratio?

To see this, we note that in order to compare two portfolios with different

risk characteristics it is important that the risk premium is linear in the

risk measure. We know that this is true for the Sharpe ratio if we use

standard deviation of total risk as the risk measure. We shall now see that

this is true for the Treynor ratio if we use beta risk (i.e. the market risk, or

systematic risk, component of total risk) as the relevant risk measure, and

if the investor already holds a large diversified portfolio with the same risk

characteristics of the market portfolio.

Consider an investor who holds a large portfolio P with return rP and is

considering making a small investment m in a new portfolio Q with return

rQ, by borrowing at the risk free rate rF . His new position is:

r = rP + m(rQ rF)

The marginal expected return from this operation is:

lim ErP + m(ErQ rF) ErP = dErP + m(ErQ rF) = ErQ rF

m

dm

m0

m

dm

Since the variance of the new position is Var(rP) + 2mCov(rP, rQ) + m2Var(rQ),

the derivative is:

m0

dm

Here, the variance term disappears as m 0.

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23 Investment management

rP = rM, we can write the covariance Cov(rP, rQ) = Cov(rM, rQ) = QVar(rM), so

we find that the marginal variance equals:

dVar(rP + m(rQ rF)) = 2QVar(rM) = 2Q 2M

dm

The ratio of marginal return to variance of the new investment is,

therefore:

Marginal expected return

1 ErQ rF

Return to variance =

=

Marginal variance

2M2

Q

If the new portfolio is a linear combination of the risk free asset and the

market portfolio, i.e. (1 x)rF + xrM, the marginal expected return is x(ErM

rF), and the marginal variance is:

2Cov((1 x)rF + xrM, rM) = 2xVar(rM) = 2xM2

so the benchmark investment yields a return-to-variance ratio of:

x(ErM rF)

2x

2

M

1 (Er r )

M

F

2M2

variance are linear in x, therefore, it is possible to make a comparison

between portfolios, and the comparison is between:

ErQ rF

versus ErM rF

Q

i.e. between the portfolios Treynor ratio and the Treynor ratio of the

market. What is important here is that we have taken into account total

risk only, but when we look at small portfolios on top of a large diversified

portfolio, total risk is roughly equal to market or systematic risk.

Whether we should use Sharpe or Treynor depends, therefore, on the

current situation were in. If we look at a portfolio as a stand-alone

investment we should use Sharpe (or some other measure that is based

on total risk). If we look at a portfolio as an additional investment on

top of an already diversified holding, we need to consider the marginal

contribution to variance from the new investment, and this may be

better evaluated using Treynor rather than using Sharpe. It is clear that

no measure is general enough to encompass all intermediate cases, and

a great deal of judgement may be necessary to carry out an adequate

evaluation of portfolio performance in these cases.

Changing risk

Most funds change their portfolios significantly, perhaps as often as once a

year, which means that the process of measuring the long-run performance

is complicated further by the discontinuities in the asset allocation

decisions of the fund. In effect, a significant rebalancing of the asset

allocation decisions will change the corresponding return distributions

also, and consequently the performance measures discussed above may

give misleading results.

Consider the following example. Suppose the Sharpe ratio of the market

index is 0.4. A fund manager follows a low risk strategy for his fund

over the first year, where he takes an annual expected excess return of

1% against a standard deviation of 2%. This yields a Sharpe ratio of

0.5, which beats the market. Over the following year, the fund manager

switches to a high risk strategy where he takes an annual expected excess

return of 9% against a standard deviation of 18%. The Sharpe ratio is still

88

0.5, so he still beats the market. Suppose we break the returns down into

quarterly returns, where the fund earns (in annualised returns) 1%, 3%,

1%, and 3% in the first year. This is consistent with an average return

of 1% and a standard deviation of 2%. The following four quarters the

numbers are 9%, 27%, 9% and 27% (again consistent with a mean of

9% and a standard deviation of 18%). If we now take the average return

and standard deviation of the full two-year period, ignoring the structural

break caused by the switch in investment strategy, we find that the fund

earns an average return of 5% against a standard deviation of 13.42%,

which yields a Sharpe ratio of 0.37. This looks inferior to the market

index. The bias is caused by the fact that we are calculating our Sharpe

ratio on the basis of aggregating both low-risk and high-risk periods. Since

the aggregate variance is going to be biased towards the high risk period

(just like outliers get a disproportionate weight when working out the

sample variance), so the aggregate variance is too high compared to the

aggregate return.

Market timing

Market timing is the practice of switching between safe and risky portfolios

at different points in time. For instance, a fund manager might decide

to switch a large portion of his capital into safe government bonds if he

thinks the stock market on the whole is overvalued and the risk of a stock

market correction is imminent. Similarly, he might switch back again when

he thinks the market is undervalued. If market timing is significant, we

should expect that the market risk of the fund is greater in periods where

the excess return of the market is high, than in periods where the excess

return of the market is low. This suggests a convex relationship between

the excess return on the fund and the excess return on the market. For

a fixed portfolio, the CAPM predicts that this relationship is linear (and

given by the beta of the portfolio). To identify market timing, therefore,

we can use a regression based methodology where we regress the excess

return of the fund on the excess return of the market plus a second

variable which tends to be high when the excess return of the market is

also high. There are two obvious candidates of this regression.

The first looks at measuring market timing for a portfolio P:

(rP rF) = aP + bP (rM rF) + cP (rM rF)2 + eP

The model regresses the excess return of the portfolio (the left hand side)

on the excess return of the market (the right hand side). Thus far, this is

the standard CAPM model. The regression model then includes a second

variable which is the squared of the excess return of the market. This

variable is never negative, and tends to be high when the excess return of

the market is also high and positive, and low when the excess return of the

market is low and positive. If the coefficient cP in this regression turns out

significant and positive, then that is indicative that the fund manager is

successfully implementing a market timing strategy as he takes advantage

of positive market movements and does not suffer negative returns for

negative market movements.

The second regression model measures market timing for a portfolio Q:

(rQ rF) = aQ + bQ(rM rF) + cQ(rM rF)D + eQ

This model is structured in exactly the same way as the first, only that the

second variable on the right hand side is equal to the excess return of the

market multiplied by a dummy variable which is zero when the excess

return of the market is negative, and one otherwise. This specification

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23 Investment management

takes care of the cases where the excess return of the market is negative by

loading weight onto the constant term. A significantly positive regression

coefficient cQ is also here indicative of the implementation of a successful

market timing strategy.

Summary

This chapter dealt primarily with recognising and classifying risk

in financial investments, and how to take risk into account when

measuring the performance of the investment.

There was a brief outline of the VaR risk measure.

The bulk of the chapter looked at the various versions of the Sharpe

ratio and the Treynor ratio. The relationship between these two

measures was discussed, as well as problems associated with using

these measures in situations with changing risk.

Finally, the chapter discussed various aspects of market timing.

Activity

1. Try to measure the Sharpe ratio of a portfolio which contains

asymmetric risk. A way to do this is a portfolio where you top up your

investment by selling deep out-of-the money options. For instance, you

start with a capital of 100 which you invest in the index. You sell put

options and invests the proceeds risk free. At the end of the period you

will most likely have both your original investments in the index plus

the proceeds from the sale of the puts - i.e. you have boosted your risky

investment which is likely to boost the Sharpe ratio of your portfolio.

Here is how you can simulate the results:

start with simulating the index return this can be done by a

binomial approach for instance, assume the index increases by

20% or decreases by 10% per four months, which implies that

over the year there is a 18 probability it increases by 72.8%; a 38

probability it increases by 29.6%; a 38 probability it decreases by

2.8%; and a 18 probability it decreases by 27.1%. These numbers can

be simulated by the RAND() function in Microsoft Excel a draw

between 0.0000 and 0.1250 represents a decrease of 27.1%; a draw

between 0.1251 and 0.5000 represents a decrease of 2.8%; a draw

between 0.5001 and 0.8750 represents an increase of 29.6%; and

finally a draw between 0.8751 and 1.0000 represents an increase of

72.8%.

next simulate the option prices. Suppose you pick an initial index

value of 100, and work out the value of a one-year put option with

exercise price 80 (the subject guide for course 92 Corporate

finance tells you the details of how this is done). If the risk free

return per four months is 1%, the option price is:

3

1 19

(80 72.9) = 1.75

p(80) =

1.01 30

i.e. for each 100 you invest in the index you can invest an additional

1.75 risk free.

simulate your portfolio returns for each draw of the index you

can work out the pay-off of your index investment, the pay-off of

your put position (remember you sell the put), and the pay-off of

the risk free part of your investment. Each period you recalibrate

your investment to 100 and work out the return, and eventually

90

you will have a return time series of which you can carry out a

statistical analysis. Finally, work out the Sharpe ratio of the index,

and the Sharpe ratio of your portfolio. Which is greater? Did you

have outcomes where your put-investment came up with a negative

pay-off (there is only a one-in-eight chance this happens in any one

year)?

Having completed this chapter, and the Essential reading and activities,

you should be able to:

broadly categorise and clearly explain given types of risk

competently apply regression analysis to decompose risk into various

factors

effectively define Value-at-Risk and accurately describe its key

applications

clearly define and accurately compute the Sharpe ratio, Treynors ratio,

Jensens alpha, the M2 measure, and the Information ratio

aptly relate the Sharpe ratio to Treynors ratio

explain the implications of the variability in a funds risk taking strategy

to bias in the estimation of the Sharpe ratio in detail

adequately define market timing and discuss given methods to

measure it.

1. a. What do we mean by market timing? How can we measure market

timing for a fund manager?

b. Define the Sharpe ratio and the Treynor ratio. Outline the

relationship between the Sharpe and Treynor ratios by looking at

the marginal increase in variance for a small investment on top of a

fully diversified portfolio.

c. A portfolio has an expected return of 14%. The risk free asset earns

5% return, and the market index earns an expected 12% return. For

what value of beta does the portfolio earn a fair return? Explain.

Suppose the true beta is 15% lower than the beta you just worked

out. How large can be variance of the idiosyncratic risk of the

portfolio be to ensure an M2 measure of at least zero?

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23 Investment management

Notes

92

Learning outcomes

By the end of this chapter, and having completed the Essential reading and

activities, you should be able to

comprehensively explain investors, corporations and banks varying

approaches to risk management

clearly explain the concept of put protection, and how it differs from

VaR-based portfolio insurance

explain the equivalence of put protection to an investment strategy

involving call investments

discuss the problem of non-linear pay-offs in complex risk management

strategies

review the concept of extreme risk, and explain when it may be an

important concern for risk management

explain the mechanisms by which financial institutions can hedge

against credit and volatility risk.

Essential reading

Bodie, Z., A. Kane and A.J. Marcus Investments (Boston, Mass.; London:

McGraw-Hill Irwin, 2008) Chapter 27.

Elton, E.J., M.J. Gruber, S.J. Brown and W.N. Goetzmann Modern Portfolio

Theory and Investment Analysis(New York; Chichester: John Wiley & Sons,

2010) Chapter 27.

Further reading

Grinblatt, M. and S. Titman Financial Markets and Corporate Strategy. (Boston,

Mass.; London: McGraw-Hill Irwin, 2008) Chapters 21 and 22.

Duffe, D. and K.J. Singleton Credit Risk: Pricing, Measurement and Management.

(Princeton, NJ: Princeton University Press: 2003) Chapter 1.

Stulz, R. Risk Management & Derivatives. (Mason, Ohio: Thomson SouthWestern, 2003) Chapters 2, 3 and 4.

Introduction

We buy accident insurance because losses associated with accidents may

be detrimental to our financial situation. The same argument goes for

portfolio insurance. Portfolio managers care much more about losses to

the value of their portfolios than they care about corresponding gains.

Sometimes, therefore, they choose trading strategies that offer an implicit

insurance effect against losses whilst keeping the potential for making

portfolio gains (as opposed to portfolio immunisation which protects

against both upside and downside potential). This chapter looks at

strategies that offer such insurance effects.

What is the economic rationale for insuring against losses? Utility theory

(see Appendix 1) argues that when individuals are risk averse they are

willing to pay to avoid the risk. If insurance is available from individuals

who are less risk averse, it is possible to transfer the risk away from the

individuals who are more risk averse to those who are less risk averse,

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23 Investment management

(for instance, a futures transaction or a swap transaction). Therefore,

risk management serves the role of redistributing the risk of the economy

such that it is borne by those who are the least averse to risk. In effect,

risk management serves the role of promoting efficient risk sharing in the

economy.

The rest of this chapter looks at various trading strategies that offer

insurance against portfolio losses in the sense that the resulting pay-off

corresponds to coincide with losses incurred on the portfolio. Towards the

end we also look at some broader effects that risk management strategies

can have on fund management. This is done in the context of the Basak/

Shapiro model where optimal portfolio insurance strategies designed to

meet value-at-risk targets can reduce the incidents of portfolio losses, but

can increase the expected loss in the rare events where the fund does not

meet its VaR targets.

Investors manage risk primarily because they are risk averse. Even

though all assets are prised correctly there are some portfolios that are

sub-optimal and should be avoided. The key tools for managing risk

are diversification and asset allocation, and indeed holding portfolios

that consist of a risk free investment and the market index, where both

diversification and asset allocation play important roles, is the optimal

strategy if investors are variance-averse and if myopic portfolio selection

strategies are optimal (see Chapter 5). It is not necessarily true that

investors should not deviate from this strategy, however, and if they

come across portfolios with superior Sharpe or Treynor ratios they should

incorporate this information in their investment strategy. In doing so,

however, they should balance superior return against the additional risk

incurred. We have also seen examples of how this should be done, for

instance in the context of the Treynor-Black model described in Chapter 6.

Corporations are not risk averse. They may be owned by risk averse

investors; however, the investors manage investor risk privately and

should not manage investor risk actively through corporate risk

management. A corporate risk management transaction adds value

to investors only if it has positive net present value, but this is unlikely

if the risk management transaction is achieved through buying options

or futures since market based transactions tend to have zero net present

value. Corporate risk management needs to be justified, therefore, on

grounds other than through managing risk for its owners.

What does justify risk management for corporations is, however, the

value of avoiding a shortfall of funds. Corporations are often much more

prone to incur extra costs when they are short of capital than when they

have a surplus of funds. For instance, shortfall of funds may be caused

by operational losses. If a loss is incurred, valuable tax-deductions (such

as interest payments on debt) may not be exploited, so that corporate

costs increase. Next, operational losses can lead to an increase in the

costs of financial distress. Financial distress costs come in many forms,

but it is common to distinguish between direct bankruptcy costs

(legal costs etc. incurred in the actual bankruptcy process) and indirect

bankruptcy costs (costs associated with managing the corporations

'near bankruptcy for instance, costly negotiations with suppliers and

94

creditors who may call outstanding debt, and costs associated with the loss

of the value of products and services sold by the company). All these costs

make it important for the company to hedge against large losses.

The main source of funds for corporations in a situation of crisis is

operational earnings. Therefore, corporate risk management aims to

protect against operational losses an approach that is called CaR cash

flow at risk in Stulzs book on risk management. Operational losses

can occur when the market conditions for the firms products deteriorate,

but can also be caused by large currency movements if key markets are

overseas. In some cases operational losses can be caused by idiosyncratic

risk events for instance, a food company that learns that toxins are

contaminating some its products (which typically leads to large headlines

in the business press) may suffer a large negative impact on its brand

value and may incur substantial costs in rebuilding consumer confidence

in its products.

Banks and financial firms do not rely so much on operational losses

for cash flows, but rather on values of portfolios. Many assets held by

banks are highly liquid and can be transformed to cash at short notice,

therefore banks can raise funds by liquidating assets rather than relying on

operating cash flows. Therefore, banks (and financial firms in general) are

much more concerned with protecting the market value of portfolios, i.e.

the VaR value at risk when designing their risk management strategy

than with operational cash flows. Banks risk management strategy has,

therefore, been based on allocating risk capital (a capital charge) against

its assets. If losses occur on particular portfolios the capital acts as a buffer

against these losses. There are several approaches to this problem outlined

in the so-called Basel regulations. One approach is based on viewing each

asset group as a separate firm and allocating risk capital as necessary to

each group, aggregating all asset groups into a single risk capital charge

for the bank as a whole. Another approach is based on recognising

offsetting risk. The risk of the whole firm is likely to be less than the

sum of the risk of each asset group, because of diversification effects and

because the bank may be long and short at the same time in certain types

of risk. For instance, if a bank owns a bond portfolio in US$ at the same

time as it is short in the US currency in the forward or futures market,

some of the currency risk in the bond portfolio is covered by the short

position in the forward/futures market, so there should not necessarily be

the need to allocate extra capital for the currency exposure.

Put options are ideally suited to generate a portfolio insurance effect as

they have a pay-off when the asset value is lower than the exercise price.

Consider a stock index put option on the FTSE 100 index. The option pays

the difference between a given, pre-specified, level of the FTSE 100 index,

say X, and the actual index S, multiplied by a given amount in pound

sterling, say 1, at some given future date, if this difference is positive.

If the difference is negative the put option pays nothing. The pay-off can

be written as where P(S, T) is the put pay-off at the maturity date T as a

function of the FTSE 100 index level S. Suppose you currently have 1m

invested in the index, or an exchange traded index tracker fund, and you

want to ensure that your portfolio has a value that is at least as high as

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23 Investment management

1m in one years time. You can buy a one-year put option that offers

perfect protection to your portfolio losses below 1m if you buy 1m/X

units of the put option above with T = 1 year and X equal to the current

index level. If the current index level is 4800, we set X = 4800, and the

portfolio pay-off equals either 1m (if the put option is in the money and

X > S) or the value of the unprotected portfolio which is (S=X)m (if

the put option is out of the money and S > X), whichever is greater. The

portfolio earns, therefore, either the percentage increase in the index, if

positive, or guarantees a pay-off of the initial value of 1m. The initial

investment cost of the protected portfolio is, however, more than 1m

since the put option is costly to acquire at the outset.

We will now go through an example where we estimate the costs and

benefits of put protection vs VaR protection. Suppose we have a portfolio

with value V that follows a geometric Brownian motion:

dV = dt + dZ

V

where is the instantaneous return and is the instantaneous standard

deviation or volatility. The increment dt denotes time, whereas the

increment dZ denotes the increments of a standard Brownian motion (with

zero drift and unit variance). The risk free rate of return is r. In this case,

the log-value of the portfolio follows an arithmetic Brownian motion:

d ln V = 1 2 dt + dZ

2

The increments of the log-value ln VT ln Vt are then normally distributed:

ln VT ln Vt N

((

1 2 (T t), 2(T t)

2

From the above it follows that a 1%, 30-day VaR is given by the solution y* to:

N x

(y

1 2 30

365

2

30

365

= 0.01

noted here that it is often a convention (when estimating volatility) to

scale using trading days only. So if there are 20 trading days over the

30-day period, and 252 trading days over the full year, that we use the

relationship:

30

(y 12 2) 365

= 0.01

N x

20

252

The motivation for this is that there is much less volatility during nontrading days than during trading days. Also, we still use the correct days in

the numerator as the difference in expected return between trading days

and non-trading days is negligible.

Consider the following data: = 0.10 (expected return is 10%

continuously compounded roughly 10.5% annually compounded); =

0.3 (volatility or standard deviation is 30%), which yields (using 30=365

in the numerator and 22=252 in the denominator):

N x

96

y 0.00452

0.0845

= 0.01

y* 0.00452

= 2.33

0.08864

y* 0.0192

VT

ln VT ln Vt = 0.192

= e 0.202 = 0.82

Vt

so the actual 1% 20-day VaR is 18% of the portfolio value (there is a 1%

chance we will lose more than 18% of our value). If our target VaR is

5%, we need to cover 13% of the losses below 5%. This can be done by

investing cash risk free, where we put PV(0.13Vt) in the money market

now and recover 0.13Vt in 30 days time. This is money we will use to

offset losses beyond 5%, but we also receive the money if we dont lose

that much. Therefore, the method of allocating risk capital does not

discriminate between future states where the money is needed or not.

In contrast, if we hedge the exposure using a put option, we can buy a

put option with exercise price 5% below the current portfolio value. This

strategy will have a pay-off if we lose more than 5%, and it provides a

perfect hedge in the sense that there is no chance we lose more than that,

but will not have pay-offs in the states where we do not need the hedge.

Therefore, put protection provides a targeted hedge whereas allocating

risk capital simply provides a cash buffer to cushion losses.

Why dont we simply use put options? There are at least two reasons.

First, we may not be able to trade puts on the actual portfolio this is

typically the case where banks seek to protect loans or mortgage portfolios

for which there is not a fully developed options market. Second, puts

particularly puts that are deep out of the money tend to be expensive.

The reason for this is probably that this segment of the options market

consists of hedgers buying puts to protect their investment but is served

by a limited number of speculators who are able to exercise market power.

Both imply that the market for deep out of the money puts is very thin.

Holding a stock portfolio and buying put-option protection is, according

to put-call parity, equivalent to investing risk free and buying a call. Recall

that put-call parity is the relationship:

c +PV (X) = p + S

On the left hand side, we have a portfolio that consists of a call option

c on the stock, S, and a risk free investment worth the present value of

the exercise price X, denoted PV (X). At maturity, this portfolio delivers a

cash flow that consists of X (the risk free investment) and the difference

between the stock and the exercise price if this is positive, i.e. the cash

flow of max(S X, 0). On the right hand side, we have a portfolio that

consists of a put option p on the stock and an investment in the stock itself.

This portfolio has a pay-off that equals the stock price S plus the difference

between the exercise price X and the stock price S, if this is positive, i.e.

max(X S, 0). The pay-offs of both can be written as max(S,X), so the

pay-offs are the same. Therefore, the price must also be the same, and this

is put-call parity. It should be noted that put-call parity does not in general

hold with options. Recall that European options can be exercised only at

maturity, whereas US options can be exercised at any time leading up to,

and including, the maturity date.

We will give an example of portfolio insurance with puts, and demonstrate

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23 Investment management

how we can replicate this using call options. Suppose we hold a portfolio

which is currently worth $100,000 and we are interested in buying a put

option which guarantees that the value of our portfolio is at least equal

to $100,000 also in one years time. The cost of this is a put option with

exercise price $100,000, which gives us a net pay-off of:

pay-off in one years time = X + (100,000 X) = 100,000 if X < 100,000

X

if X 100,000

+ P(100,000), i.e. the current value plus the value of the put. By put

call parity, this is equal to C(100,000) + PV(100,000), i.e. a call on the

portfolio plus a risk free investment which pays off 100,000 in one years

time. The pay-off of the alternative portfolio is

100,000

if X < 100,000

pay-off in one years time =

(X 100,000) + 100,000 = X if X 100,000

Non-linear pay-offs

Some portfolios contain assets with non-linear risk, normally derivative

securities, which creates particular problems for risk management. To

illustrate the problem with non-linear risk, we shall consider an example

of the risk of a call option on a stock. Suppose the stock has constant risk

where it either increases by 40% or decreases by 10% each year. If the

current stock price is 100, next years price is either 140 or 90, and year

two price is either 196, 126 or 81. Assume the up-movements and the

down-movements are equally likely. The expected return on the stock is

always 12 (40% 10%) = 15%, and the variance of the stock is

1

(0.4)2 + 12 (0.1)2 0.152 = 6.25%. This is true regardless of the price

2

of the stock. Suppose the risk free rate is 5% and the market index has

expected return 15%, implying the stock has a beta of 1.

Consider a two-year call option on the stock with exercise price 100.

This option can be priced by the Cox-Ross-Rubinstein binomial pricing

model, where we can make use of the risk-neutral probabilities. These

probabilities take the value

q = 1.05 0.9 = 3

1.4 0.9

10

for up-movements and

1q= 7

10

for down-movements. We can verify that these probabilities are correct

by pricing the stock. The current price of 100 should be year ones

expected price discounted by the risk free rate if we use the risk neutral

probabilities:

100 =

1

1.05

7

3

90

140 +

10

10

C0 =

1

1.052

(( )

3

10

(196 100) + 2

( )( )

3

10

98

())

7

7

(126 100) +

10

10

= 17.74

CU1 =

1

1.05

3

7

(126 100)

(196 100) +

10

10

= 44.76

CD1 =

1

1.05

3

7

0 = 7.43

(126 100) +

10

10

If we want to work out the expected return on the call, we find that the

expected return currently is:

1 44.76 + 1 7.43 1 = 47.09%

2 17.74 2 17.74

the expected return after one up-movement is:

1 96 + 1 26 1 = 36.28%

2 44.76 2 44.76

and finally, the expected return after one down-movement is:

1 26 + 1 0 1 = 75.00%

2 7.43 2

We notice that these numbers change all the time. The expected return on

the call tends to increase if the stock price decreases, and decrease if the

stock price increases. We can use the expected return to calculate the beta

of the call option. Currently, the beta of the call is given by:

C0 = 47.09 5 = 4.2

15 5

If the stock price increases in the following period, the beta of the call

becomes:

36.28 5 = 3.1

CU

1 =

10

and if the stock price decreases, the beta becomes:

75 5 = 7.0

CD

1 =

15 5

What is common in situations like these is to work out the current hedge

ratio and use this to hedge the exposure over a short time interval i.e. to

estimate the local beta of the asset. In the example above, we should start

out hedging the call as a 4.2 beta asset, then be prepared to rebalance

our hedge to a 3.1 beta hedge or a 7.0 beta hedge depending on the

movements of the underlying stock. Only if there is little variation in

hedge ratios over time can you increase the duration of the hedge.

Extreme risk

There are certain situation in which we really only care about extreme

events and we are happy to ignore the more regular variability. An

example is flood-defences. The regular variability in water-levels caused

by tidal flows is not really of interest to us, what we want to know is the

probability of extreme floods caused by high waves or storm surges. In this

case we often need to use a special statistical method to make inferences

as by the nature of the problem almost all observations are within the

regular but uninteresting range. This applies also to the world of finance.

The risk we are exposed to in normal times tend to be different from the

risks we are exposed to in extreme situations, and often it can be hard

to estimate the behaviour of the probability distribution in these extreme

circumstances.

99

23 Investment management

argue that evidence from the insurance industry suggest three common

characteristics of extreme events: their financial impact is considerable;

they are diffcult to predict ahead of time; and the are, within the

context of a large set of data, rare events. The next question is: what

sort of stochastic process typically describes extreme events? The answer is

that there must be suffcient mass in the tail of the probability distribution.

Suppose we observe n draws of returns of a portfolio, and we take the

sum of the returns r1 + r2 + ... + rn. Next, we take the maximum of the draws

max(r1, r2, ..., rn). How does the distribution of the sum of returns compare

to the distribution of the extreme (maximal) outcomes? Well, if the sum

has a much smaller likelihood in the tail than the extreme events, then an

investor may ignore the extreme risk as it is a small probability event, but

if the sum has roughly the same likelihood in the tail as the extreme events

the investor should worry about extreme risk as they are likely to play a

role for the return of his portfolio. To use algebra:

Pr (r1 + r2 + rn > r)

lim

r

Pr (max (r1, r2,,rn) > r)

signifies a probability distribution for extreme events. A useful test, for

instance, of whether stock market crashes are extreme events: have stock

market crashes had an impact on the stock market index over a long

holding period? We probably have to answer yes to this question, which

suggests that our hedge or risk management strategy should build in an

element of managing crashes or extreme events as well as normal market

movements.

Credit risk is the risk that a payment obligation is not honored. Credit

risk arises, therefore, in markets where payment obligations are traded

debt or bond markets and will not be a part of markets such as equity

markets. Recall that the general pricing formula for any claim is:

pt + Et

pT

(1 + r)T t

It

i.e. the price of a claim with an expected cash flow (at time t) of its

future cash flow (at time T), Et pT , discounted by some discount rate r. In

general, the discount rate r is risk adjusted if we take expectations with

respect to actual probabilities, but is equal to the risk free rate if we take

expectations with respect to the so-called risk-neutral probabilities. A

payment obligation cT has actual cash flow ~c T at time T, implying that we

should write the current value ct = Et (~c T (1 + r)Tt It), where the expected

cash flow typically is less than the actual payment obligation, i.e. Et ~c T cT.

This is, however, not standard. Instead we write the pricing formula:

cT

ct =

(1 + y)T t

where we do not work out the expected cash flow Et ~c T at all but use the

contractual payment obligation. This necessitates, however, that we make

adjustments to the discount rate, which now typically is not equal to risk

adjusted (buy-and-hold) discount rates nor equal to the risk free rate, but

is equal to the yield-to-maturity which is the risk free rate plus a premium:

y = rF + credit spread

100

where the premium represents the credit spread. If there is no chance the

debtor will default on the payment obligation, the credit spread is zero,

as in this particular case Et ~c T= cT and the risk adjustment to the discount

rate is zero. This is, however, a very special case that only applies to

government issued payment obligations (government debt).

Investors are typically interested in hedging one of two things related

to credit risk. First, they want to hedge against a shortfall in cash flow

linked to the failure of receiving the full amount of the contractual

payment obligation. This can be achieved by buying so-called credit

default swap instruments triggered by the occurrence of credit events.

Second, they want to hedge against sudden changes (typically increases)

in the credit spreads of debt obligations that are not yet due. This can be

achieved by buying credit-spread based derivatives, which give the

holder the right or the obligations to make certain transactions triggered

by movements in the credit-spreads of the underlying asset or a reference

asset. The trading of such instruments makes it feasible to hedge a whole

new class of risks in addition to the usual risks linked to the movements in

asset prices.

Hedging volatility

Often, risk management strategies involve trading derivative securities

such as options, as we have seen above. We know from the pricing

literature on options that their prices are sensitive not only to the price

of the underlying asset (the asset whose price ultimately determines the

pay-off of the option), but also to the volatility of the underlying asset.

Consult, for instance, the subject guide for 92 Corporate finance for

an explanation of this. Active option trading strategies can, therefore,

be constructed to be equivalent to buying and selling volatility of the

underlying asset.

We illustrate this with an example using the Black-Scholes option pricing

formulas. Recall that the Black-Scholes call option price can be written as:

c = SN (d1) Xe r (T t) N (d2)

where S is the current stock price; X is the exercise price; T t is time to

maturity, and r is the risk free rate (continuously compounded). The two

parameters d1 and d2 are given by:

d1 =

ln( XS

) + (r + 12 2 T t)

T t

d2 = d1 T t

By put-call parity, the put price is:

p = c + Xe r (T t) S

= SN(d1) Xe r (T t) N(d2) + Xe r (T t) S

= Xe r (T t) (1 N(d2)) S(1N(d1))

= Xe r (T t) N(d2) SN(d1)

We wish to purchase x calls and y puts, so that our portfolio consists of:

Option portfolio = xc + yp

= S(xN (d1) yN (d1))

Xe r (T t) (xN (d2) yN (d2))

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23 Investment management

Delta =

dOption portfolio

= xN (d1) yN (d1)

dS

x N(d1)

y = N(d )

1

For small changes in the stock price, therefore, the change in the value

of the option portfolio will be zero. The portfolio is, in effect, immunised

against small changes in the underlying stock price. The portfolio is,

however, not immunised against volatility changes. If there is an increase

in the volatility of the underlying stock price, the value of the portfolio

increases, so the portfolio yields a volatility hedge.

Banks across the world are now almost universally adopting the Basel

framework for risk management, where they allocate risk capital for their

various asset classes. The key tool for risk capital allocation is the VaR

calculation. The VaR is normally calculated on the basis of a 1% VaR for a

10-day (i.e. two weeks we count only working days) holding period. The

risk capital that is to be allocated depends on the VaR calculation on this

day, and also possibly on the VaR calculations over the 60-day preceding

period, and there may also be an additional capital charge for idiosyncratic

risk factors. The formula is:

Required capital for day t +1 = max(VaRt (1%, 10 days),

St

1

60

i=1

+ SRt

where VaR(1%; 10 days) is the 1%, 10-day value at risk for day t, the

number St is a multiplier, and the charge SRt is the additional capital charge

for idiosyncratic risk. We notice that the average VaR over the 60-day

period is used, and the multiplier St is used to compensate for the accuracy

of the banks VaR model. This multiplier should be worked out on the basis

of past data. If the bank consistently gets it wrong it will normally show up

by some backtesting routine, and adjustments can be made to the banks

capital charge by making adjustments to this multiplier.

Summary

This chapter studied risk management, from the perspective of

investors, corporations and banks or financial firms.

Some risk management strategies were outlined and contrasted, such

as, for instance, put option protection and value at risk.

Next, some problem areas were highlighted, such as the problem of

portfolios with non-linear risk, extreme risk and credit risk.

The chapter also looked at a simple strategy for hedging changes in

volatility (as opposed to changes in market values).

Finally, there was a brief outline of the capital allocation mechanism

common for the bank regulatory framework outlined in the Basel

accord.

102

Activity

1. Suppose you have a 10% after tax discount rate, and you have a profit stream of 1, 0,

3, and 2 over the next three years. The tax rate is 30% and you can accumulate losses

to offset next years profits against taxes. Work out the value of a risk management

programme where you can transfer profits over time at the discount rate (assume, for

instance, that you can create a maximum loss (profit) of 1 today by creating an offsetting

profit (loss) next year of 1.1 these transfers are priced by the 10% discount rate so will

be zero NPV projects on a before tax basis however, you should be able to save on the

total tax bill by carrying out such transfers cleverly).

2. Why might a straddle trading strategy ahead of announcements (such as scheduled

earnings announcements) not yield long-run abnormal average profits? Explain.

3. Discuss whether VaR based risk management might be preferable to standard portfolio

insurance.

Having completed this chapter, and the Essential reading and activities, you

should be able to

comprehensively explain investors, corporations and banks varying

approaches to risk management

clearly explain the concept of put protection, and how it differs from VaRbased portfolio insurance

explain the equivalence of put protection to an investment strategy

involving call investments

discuss the problem of non-linear pay-offs in complex risk management

strategies

review the concept of extreme risk, and explain when it may be an

important concern for risk management

explain the mechanisms by which financial institutions can hedge against

credit and volatility risk.

1. a. Explain why investors and corporations take a different approach to

risk management.

b. What do we mean by non-linear risk? Can you explain using an

example how non-linear risk may affect the hedging strategy of your

portfolio?

c. You have a portfolio with current value $1m. The return distribution is

described in the table below:

Probability

Return

1%

-15%

4%

-5%

5%

0%

20%

5%

40%

10%

20%

15 %

5%

20%

4%

25%

1%

30%

103

23 Investment management

What is the expected return on this portfolio? Suppose you can hold risk

capital at a risk free return of 4%. How much capital should you hold if

your target is to lose at most 5% of your portfolio value with probability

99%?

104

In this last chapter we will briefly review a few important concepts that

are used in this subject guide. This serves mainly as support material to

the main chapters in the guide. Some of the material is very basic and is

included as an aid to understanding the material that is covered in the

main part of the subject guide for instance, the material on investment

returns. Some of the material is, on the other hand, more advanced than

the material covered such as the material on the portfolio frontier.

It is not expected that you should know this material for the examination,

but it may be helpful for you to see this material as it can help your

understanding of basic principles when you see how they are applied in a

more rigorous framework.

Investment returns

To work out investment returns, we review an important formula from

corporate finance the internal rate of return (IRR) formula for a

T-period investment that costs I0 and has cash flows c1, c2, ..., cT:

cT

c2

c1

...

0 = I0 +

1 + IRR + (1 + IRR)2 + + (1 + IRR)T

For one-period investments the application of this formula is particularly

simple:

IRR =

c1

1

I0

techniques to find the return. Also, we know that for longer investment

projects there may be multiple IRRs so we may have to use judgement to

identify the correct one.

The IRR identified by the formula above is the annually compounded

return of the investment. Sometimes we are interested in the continuously

compounded return or log return. This is found in the same way as above,

only using continuous discounting:

0 = I0 + c1e IRRc + c2e 2IRRc + ... + cTe TIRRc

For a one-period investment we find:

c1

= 1n c1 1n I0

IRRc = 1n

I0

Returns are useful in the sense that they aggregate easily across assets. For

instance, the return on a portfolio is simply the weighted average returns

on the individual assets.

It is, however, generally not true that the log return on a portfolio can be

worked out as the weighted average of the log return on the individual

assets.

Log returns are useful in the sense that they aggregate easily over time.

The log return over two periods, for instance, is simply the sum of the

log returns over the two individual periods. This is generally not true for

returns.

105

23 Investment management

where you invest 100,000 in two assets, A and B, with the original

investment split equally between the two assets. A and B are both priced

at 100 initially, and the price of A is 110 at the end of the first year and

105 at the end of the second year. Similarly, the price of B is 90 at the end

of the first year and 95 at the end of the second year. The value of the

portfolio is as follows:

Value Initially = 100,000

Value year 1 = 50,000 110 +50,000 90

100

100

= 100,000

Value year 2 = 50,000 110 105 + 50,000 90 95

100110

100 110

= 100,000

The return on the portfolio is, therefore, 0% across any individual period,

and also over the entire two-year horizon. Looking at the data for the

individual assets, we find that we can recover the portfolio returns by

taking a weighted average across assets, and that we can recover the longrun return of the assets by summing the log returns over time. The return

and log returns of the two assets are

Asset

Year

Annual return

log return

10%

9.53%

-4.55%

-4.65%

-10%

-10.54%

5.56%

5.41%

The initial portfolio is split 50:50 between the two assets, so the annual

return on the part invested in A is exactly offset by the part invested in B,

so the total return over year 1 is (50%)10% + 50%(10%) = 0. At the

end of the first year, the amount invested in A is 55,000, so the split now

is 55:45. The return for year two is, therefore (55%)(4.55%) + (45%)

(5.56%) = 0. We have here made use of the annual returns.

When it comes to the assets return over the entire two-year period we find

that the log returns are more accurate. The log return of asset A over the

entire two-year period is given by:

Log return A = 9.53% 4.65% = 4.88%

so the 50,000 invested in A has grown to 50,000e0.0488 = 52,500.

Similarly, the log return of asset B over the entire period is:

Log return B = 10.54% + 5.41% = 5.12%

so the 50,000 invested in B has grown to 50,000e 0.0512 = 47,500.

The holding in A and B aggregate to 100,000.

The geometric average return of an investment over N years is defined by

the formula:

(1+rt )

t=1

1

N

N

1

r

Arithmatic average return=

N t=1 t

106

These averages do not give the same result. To see this, consider a stock

that has a starting price of 100, then goes up to 110, and then down

again to 99. The return in the first period is 10%, and the return in the

second period is 10%. The arithmetic average is, therefore, equal to 0. The

geometric average is, in contrast, less than zero since:

1

((1.10)(0.90))2 1 = 0.005%

The arithmetic average is a useful measure for investments that have the

same starting balance in every period, whereas the geometric average is a

useful measure for an investment that carries its starting balance in every

period over from the previous period.

Taylor approximation

In many instances we might be able to work out the price of a bond for

a given yield accurately; however, realising that the yield may change

we need to have a general formula for the bond price in `nearby

yields as well. To do this we can use a mathematical tool called Taylor

approximation. For a function f (x), if the value f (x0) is known we can

approximate the value at x close to x0 with infinite accuracy by:

f (x) f (x0) + f ' (x0) (x x0) + 1 f ''(x0) (x x0)2 + 1 f '''(x0) (x x0)3

2

6

+ ... + 1 f (n)(x0) (x x0)n + ...

n!

where f ', f '', f ''' and f (n) are the first, the second, the third and the nth

1

1 is one over n factorial, or

derivative of f; and where n!

123 n

Since the distance x x0 is small, the term (x x0)n will quickly vanish as n

increases, therefore, we can ignore the higher order terms. It is common

to end at n = 1 or n = 2. For bonds, for instance, we work out bond prices

using duration only (where we stop at n = 1) and sometimes for increased

accuracy using duration and convexity (where we stop at n = 2).

Optimisation

In economics we frequently need to work out problems where we seek to

maximise or minimise something, and sometimes we need to maximise

or minimise something subject to not violating some constraint (e.g.

maximise the expected utility from our investment strategy, subject to not

investing more money than we have available). Optimisation is an area

that is highly mathematical, where we can make use of the full power of

calculus. Here we will review the basics of optimisation (without going

into too much detail).

The objective function is what we want to optimise, f(x) if we have one

variable x we wish to adjust to make f(x) as large or small as possible, and

f(x1 x2,..., xn) if we wish to simultaneously adjust n variables x1,..., xn to make

f() as large or small as possible. The fundamental method is the same:

we are at an optimum point (maximum or minimum) if we are moving

sideways only for small changes to x or x1,..., xn. This is where we use

calculus: going sideways is equivalent to putting the derivative to zero. In

the case of maximising or minimising f(x), therefore, it is necessary that:

f '(x) = 0

In the case of maximising or minimising f(x1, ..., xn), it is necessary that:

f

f

f

=

==

=0

x1

x2

xn

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23 Investment management

optimum.

In the case where we have constraints, for instance: max f (x) subject to g(x)

= k where g(x) is a function that represents the optimisation constraint,

and k is a constant. In this case it is no longer necessary that f moves

sideways as it may be that we could increase f further but that we cannot

manage that without violating the constraint that g(x) = k. This is where

we use the technique of Lagrange. We form a function that is equal to the

objective function but somehow takes into account the constraint. This is

the Lagrangian:

L = f (x) ,(g(x) k)

where we include an extra variable , into the maximisation problem.

Then we maximise L over x and , in the usual way:

L

L

=

=0

x

respect to ) generates the condition that k g(x) = 0 which of course is

the original constraint that g(x) = k. Therefore, at the optimum point the

constraint is satisfied, so that the term (g(x) k)g(x) k) equals 0, and

therefore the function value of L(x, ) is equal to the function value of f (x)

at the optimal point.

Regression methods

When making observations of two random variables, we are often

interested in measuring the relationship between them. Simple ways of

doing this constitutes correlation or covariance measures, which measures

the degree of relatedness in the variability of the two random variables.

We have used these terms in several places within this guide and technical

definitions can be found towards the end of Bodie, Kane and Marcus in an

appendix. Regression methods can best be understood as a more advanced

and powerful method of measuring the relationship between two random

variables than is possible through correlation or covariance. Regression

models attempt to pick up linear relationship between two random

variables of the type:

yt = a + bxt + et

Here, denotes a series of observations of a (dependent) random variable

yt over time and a series of corresponding observations of another

(independent) random variable xt. The regression coeffcients a and b are to

be determined by the regression analysis, and the error term et measures

the deviations between the actual value of yt and the predicted value a

+ bxt. The crucial question is how the coeffcients a and b are determined.

There are two criteria the regression analysis uses to determine these

coeffcients. The first is that the error term is on average zero. The second

is that the sum of the squared errors te2t is minimised. These two criteria

determine uniquely the coeffcients a and b. The coefficient b is given by

the formula:

Cov (yt , xt)

b=

Var (xt)

We can extend the regression model to multiple independent random

variables that yield the multiple regression model:

yt = a + b1x1t + b2x2t + + bkxkt + et

where the coeffcients a, b1,..., bk are to be determined.

108

Utility theory

Utility theory is a concept used in economics to model human behaviour

using mathematical functions called utility functions. These functions can

be defined over many goods and services, but when talking about financial

investments we define these functions over money. If an individual,

through some investment choice, ends up with a final cash balance of w,

we say his utility is u(w), where u is the utility function. If w is a random

variable, we measure his utility by the expected utility, which in general

is not equal to the utility of his expected cash balance. In fact, if the

individual is risk averse the expected utility is always lower than the utility

of the expected cash balance:

E(u(w)) < u(E(w))

Where do utility functions come from? Utility functions are not an

inherent characteristic of human beings; they should rather be thought of

as a representation of preferences over outcomes. Why do we use utility

functions? The simple answer is that utility functions are a lot easier to

handle than preferences. What utility theory does, essentially, is to show

that when our preferences are suffciently structured (or, perhaps more

accurately: rational) we can represent these by a utility function. An

example of the type of structure we impose on rational preferences is the

so-called transitivity property. If an individual prefers A to B and also B to

C, it follows that he also prefers A to C. This property is fairly obvious, but

sometimes the structure we impose is more subtle (and controversial), and

there is evidence that what we assume about preferences in utility theory

may not be empirically true.

One of the big advantages of using utility functions to represent

preferences is that we can easily make the decision maker risk averse. Risk

aversion indicates a property of preferences where agents are unwilling to

take on actuarially fair lotteries (lotteries with zero expected gain such as

tossing a coin with heads-you-win and tails-you-lose). Risk aversion can

be modelled by concave utility functions. These functions put less weight

on gains than on losses, so that the expected utility of a risky outcome is

always less that the utility of the expected outcome.

How do we measure risk aversion? Again, this is fairly simple using utility

functions, as we can simply measure the curvature of the concavity of the

utility function. We know that the first derivative of the utility function

measures the slope of the function at a given point, and that the second

derivative measures the change in the slope. Combining the two, we can

measure curvature by the so-called absolute risk aversion coefficient:

ARA =

u''(w)

u'(w)

which is minus the second derivative over the first derivative. If the utility

function is linear, the risk aversion coefficient is zero, indicating risk

neutral preferences.

The relative risk aversion coefficient is defined by:

RRA =

u''(w)

w = ARA w

u'(w)

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23 Investment management

Whereas the absolute risk aversion coefficient tells us how much risk

we are prepared to bear in absolute terms, the relative risk aversion

coefficient tells us how much risk we are prepared to bear in relative terms

(relative to wealth). Therefore, if we experience a doubling of our wealth,

we will still bear the same amount of risk if we have a constant absolute

risk aversion coeffcient, but we will double the amount of risk if we have

constant relative risk aversion coeffcient.

When investors pick investments we expect that they choose the portfolios

that give them their preferred return. This is not necessarily the portfolio

with the highest expected return, as this may also be the riskiest portfolio.

When investors have utility functions, we can solve their portfolio problem

using standard optimisation techniques from calculus. Thus, we seek

solutions to the following problem, where p is their portfolio choice, and

r(p) is the return that is associated with this portfolio. We demonstrate a

solution to this problem for the case of CARA utility functions below.

Some preferences have the same risk aversion for all wealth levels, i.e.

the utility function representing the preferences has constant absolute risk

aversion (CARA) coeffcient. Such preferences can be represented by the

simple utility function defined over wealth w:

u(w) = exp( w)

and some simple algebra shows that this utility function has the risk

aversion coefficient equal to the constant. If an individual has CARA

preferences and his wealth w is normally distributed with mean m and

variance v, it follows that the individual is variance averse with expected

utility equivalent to:

v

2

E(w) = m

easy to state: the individual seeks to maximise the expected wealth minus

the variance of his wealth times half his risk aversion coeffcient.

Suppose a risk free asset has return r0 and n risky assets have expected

return r1,..., rn, respectively. If agents choose portfolios x1, x2,..., xn among n

risky asset and make the residual risk free investment x0 = 1 ni =1 xn the

expected return on his portfolio is:

m

E(r) = r0+

x (r r )

i

i =1

If we collect the expected returns in a vector r = (r1, ..., rn) and the

portfolio weights in another vector x = (x1,..., xn), we can write the

expected return as:

E(r) = r0 + x(r r01)

where 1 = (1, 1, ,,,, 1). Suppose the variance of each asset i is ii and the

covariance between any two assets i and j is ij. Let us collect all variancecovariances in:

11 12 . . . 1n

...

2n

...

..

.

...

n1 n2

...

nn

...

110

21 22

2(r) = x x

A portfolio making an investment in the capital market will seek to minimise

the variance for all levels of expected returns , and will carry out a

minimisation programme (we use the Lagrangian see above also note

we choose to minimise half the variance instead of all of the variance, the

reason being that the first order conditions contain 2s everywhere so by

multiplying by one half we get rid of these)

min 1 x x (x(r r01) ( r0))

x 2

x = (r r01)

and the optimal portfolio:

x* = 1(r r01)

If we multiply the portfolio by (r r01) we should get the expected return

on the risky part, i.e. r0, therefore:

=

r0

(r r01) 1(r r01)

The right hand side contains only known quantities, the (r r01) vector is

just the vector of excess return for the risky assets, and the quantity 1 is

the inverse of the variance-covariance matrix. Therefore, we are able to

work out the optimal portfolio:

r0

1(r r01)

x* =

(r r01) 1 (r r01)

The variance of x* is:

2 = x* x*

=

x* (1 (r r01))

r0

(r r01) 1 (r r01)

( r0)2

(r r01) 1 (r r01)

so, if we take the square root on both sides to find the expected return as a

function of standard deviation, we find:

= r0 (r r01) 1 (r r01)

which indicates a linear relationship between the standard deviation and

expected return on portfolios along the portfolio frontier.

The tangency portfolio can be found at the point where x0 = 0, or ni =1 xi = 1,

which implies a Lagrange multiplier such that:

1x* = T1 1(r r01) = 1

so the tangency portfolio is:

x*T = T1 (r r01) =

1

1 (r r01)

1 1 (r r01)

respectively, are linked by the following relationship:

T2 and T

T2 = xT* x*

= T( T r0 )

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23 Investment management

x*T= T(r r01)

is a vector containing all covariances between the individual risky assets

and the tangency portfolio. If we divide by T or equivalently divide by

T2

then we find:

(T r0)

r r01 = xT*

T r0

T2

Row i of this equation states that the expected return less the risk free rate

on the left hand side, ri r0, is equal to the covariance of asset i with the

tangency portfolio divided by the variance of the tangency portfolio times

the expected return of the tangency portfolio minus the risk free rate:

ri r0 =

Cov(ri , rT )

(T r0)

T2

The density function for a standard normal random variable takes the

form:

1

e

f (x) =

2

x2

2

defined as the probability that a standard normal random variable x is less

than or equal to t: N(t) = Pr(x t). We can derive this probability from the

density function above through integration:

t

N(t) =

1

e

2

x2

2

dx

but unfortunately there exists no exact function for this integral. Normally,

we use tables or some approximation algorithm to get a numerical

expression for the function N(t).

A simple versatile algorithm is:

1

N

where p(t) = t(1.5976 + 0.070566t2)

Simple(t) =

1 + e p(t)

and a more complicated one is:

N

1

e

2

1

z=

1 + pt

Complicated(t) = 1

t2

2

p = 0.2316419

b1 = 0.319381530

b2 = 0.356563782

b3 = 1.781477937

b4 = 1.821255978

b5 = 1.330274429

Whereas NSimple(t) can be used for any value of t over the entire range

< t < , the function NComplicated(t) works only for the positive range

112

function is symmetrical around 0, so that N(t) = 1 N(t). We can therefore

apply the rule:

N(t)

if t 0

N(t) =

1 N(|t|)

if t < 0

What do we do if the normally distributed random variable is not

standard? In general, a normally distributed random variable y has

expected value (mean) and variance 2, and there is no guarantee that

= 0 and = 1 which holds for a standard normally distributed random

variable x. There is in this case a simple transformation that does the trick.

Suppose we make use of the transformation:

y

x=

If y is normal, so is x as x is just a linear transformation of y. Moreover, we

find:

E (x) =

E (y)

=

=0

and

Var (x) =

1

2

=1

2 Var (y) =

What if y ~ N [,] and we wish to work out Pr[y t]? We can in this case

make use of the transformation above, and work out:

Pr [y t] = Pr [y t ]

y

t

= Pr x

[

[

= Pr

Pr [y t] = N

The Black-Scholes option pricing formula for calls and puts, respectively:

c = SN (d1) Xe r (Tt) N (d2)

evaluate this, we can plot the values of the European option against the

pay-off from exercise (which is max(S X, 0) for the call and max(X S, 0)

for the put). The following diagram applies to the call:

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23 Investment management

Figure 10.1

This graph shows the pay-off of a European call prior to maturity against

the value of exercise max(S X, 0). Figure 10.1 shows that it will never be

optimal to exercise an American call early if the underlying stock does not

pay dividends. The value of the European call is always higher than the

value you will get through exercise. When the stock pays dividends this

may change, however, as a dividend payment leads to a jump in the stock

price at the ex-dividend day. For American calls deep in the money, the

value of exercising the option prior to the jump may exceed the value of the

European call after the jump.

We now turn to puts, where the picture is different. For puts deep in the

money, the European put value is actually lower than the value you get

through exercise. The reason for this is that the American put option has

a maximum value X which is reached for S = 0. If the stock price goes

low enough, therefore, it is impossible to earn more from the put option.

Therefore, if S goes suffciently low, it is optimal to exercise the American

put early. The American put is, therefore, worth more than the European

put, and put-call parity will not hold for American options. This is

illustrated in the following figure.

p

Figure 10.2

This graph shows the pay-off of a European put prior to maturity against

the value of exercise max(X S, 0).

114

Important note: This Sample examination paper reflects the

examination and assessment arrangements for this course in the

academic year 20082009. The format and structure of the examination

may have changed since the publication of this subject guide. You can

find the most recent examination papers on the VLE where all changes to

the format of the examination are posted.

Time allowed: three hours Candidates should answer FOUR of the

following EIGHT questions. All questions carry equal marks.

A calculator may be used when answering questions on this paper and it

must comply in all respects with the specification given in paragraph 10.6

of the General Regulations.

1. a. Explain what we mean by market microstructure. Why is market

microstructure important to investors?

b. You short 1000 units of a stock currently trading at $8 per share.

The initial margin requirement is 60% and the continuation margin

requirement is 50%. There is zero interest on the margin account.

Next year, suppose the stock pays dividends of $1 per share and

the stock is trading at $11 per share. Two years from now, suppose

the stock is trading at $6 per share. Work out the net cash flows

of your investment, taking into account that your margin account

is maximally utilised. Next, work out the two-year return on your

investment.

c. A portfolio earns on average a return of 12%. The market index

earns on average a return of 10% with variance 9%, and the risk

free return is 4%. The idiosyncratic variance of the portfolio is 2%.

Find the beta-range for which the portfolio has a Sharpe ratio which

is greater than that of the market. Next, find the beta-range for

which the portfolio has a Treynor ratio which is greater than that of

the market. If you were to advise a client about the attractiveness of

the portfolio, when might there be ambiguity in your advice, and in

this case, what additional factors are relevant? Explain.

2. a. What is the definition of the risk premium of an asset? What are the

historical trends regarding the return on stocks and bonds?

b. Derive the Kyle model of asset prices, where you work out the price p

as a function of the order flow y

p(y) = a + by

where a and b are constants. You should assume the asset value is

v ~ N(0,2) and the noise trade is u ~ N(0, 2). How would you

interpret the constant b (which depends on the and the )?

Explain.

c. Return based strategies are investment strategies aimed at

exploiting momentum and reversal effects in stock prices. Why do

we believe such effects occur naturally in capital markets? Outline

the details of a strategy aimed at capturing momentum effects,

and show how you would implement the strategy for a situation

where the return in the previous period was 5%, 1%, and 4%,

respectively, for three given stocks?

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23 Investment management

3. a. What are the various types of risk? How does our perspective on

risk management change with whether we are individual investors

or corporations?

b. There are three bonds available in the market, the data are given in

the table below.

Bond

Price

100

105

99.6

4.75

104.75

101

5.25

5.25

105.25

Work out the yield to maturity, the spot rates, and the one-year

forward rates, using the bond data in the table.

c. Suppose you are given the following option prices on a stock that is

currently trading at a price of 100 per share.

Exercise price

90

100

110

Call price

14

10

Put price

12

embedded in these prices. How would you exploit such

opportunities if they exist? Explain.

4. a. What do we understand by the term structure of interest rates?

What hypotheses describe the shape of the term structure?

b. The Treynor-Black model outlines how we optimally take advantage

of privileged information when we make investment choices.

Outline this model and explain the optimal investment strategy for

an investor.

c. A bond is currently trading at a yield-to-maturity of 4%. The bond

is a three-year bond with an annual coupon rate of 5%. What is the

price of the bond? What is the duration of the bond? What is the

convexity of the bond? Estimate, using duration and convexity, the

change in the price of the bond for a change in the yield from 4% to

4.5%.

5. a. Demonstrate put-call parity.

b. Give three examples of financial innovations, and explain briefly

how they work and what role they play.

c. Suppose the spread between two rates is independently and

identically distributed over time, and that you implement a trading

strategy whereby you take a position which earns money if the

spread increases in the next period if the current spread is below the

average, and earns money if the spread decreases in the next period

if the current spread is above the average. How often do you make

a profit with this trading strategy? Is it reasonable that you can

implement such a strategy in practice? Explain.

6. a. Explain how we measure Value-at-Risk (VaR). Outline diffculties

in generating accurate VaR measures.

b. Stock returns are explained by a three-factor structure. Explain

what this means. You hold 100,000 in a portfolio with factor betas

1, 0 and 2, and you seek to immunise the portfolio completely of

all factor risk. Explain how this can be done, and outline, using an

example, the details of your immunisation strategy.

116

equity and bond markets? You do not need to reproduce numbers,

but you should outline the main relationship between average

returns and the riskiness of the asset groups. How do we explain

these findings in terms of investor preferences? What is the equity

premium puzzle? Why do we believe this is a puzzle? What sort of

bias in the data might resolve this puzzle?

7. a. Explain the difference between exchange trading and over-thecounter trading of financial assets. Explain how trading on margin

account works.

b. Explain why using long time series of portfolio returns increases the

risk of bias, and short time series increases the risk of estimation

error, when estimating Sharpe ratios. You may use an example to

illustrate your answer.

c. Outline what strategy you can use, investing in calls and puts, for

hedging volatility. Suppose you wish to hedge against an increase in

volatility of a stock market index and you have a call option and a

put option available for trading. The delta of the call is 0.7 and the

put has the same exercise price as the call (the delta of the call C

(put P) is the first derivative with respect to the stock price S i.e.

P

C

Call = S (Put = S )).

What does your optimal trading strategy look like in this case?

8. a. What do we understand by convexity in the context of bond prices?

How can we make use of convexity when estimating bond price

changes following yield shifts?

b. A portfolio has expected return 12%, total variance 16% and

beta 0.8. The market portfolio has expected return 10% and total

variance 9%, and the risk free rate of return is 4%. What is the

Sharpe-ratio, the Treynor ratio, the M2 measure and the Jensens

alpha of this portfolio? If you are to advise investors about the

attractiveness of this portfolio, what would you advice be? Explain

whether you would make use of the Treynor-Black model in your

advice.

c. We have witnessed several corporate failures caused by securities

trading based on sound risk management or arbitrage arguments,

and the subject guide briefly mentions two of these cases: the case

of hedge funds taking positions in Volkswagen in early 2008 and

the crisis of Metallgesellschaft in 1993 related to hedge positions in

oil futures. Explain why, in both cases, the trading positions can be

described as sound, and also explain what when wrong.

END OF PAPER

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23 Investment management

Notes

118

This appendix aims to explain a number of technical terms that we

encounter at various stages in this study guide.

The geometric average return of an investment over N years is defined by

the formula:

(1 + annual return n) 1

Geometric average return = N n

1

Arithmetic average return = annual return n

N n

These averages do not give the same result. To see this, consider a stock

that has a starting price of 100, then goes up to 110, and then down again

to 99. The return in the first period is 10%, and the return in the second

period is 10%. The arithmetic average is, therefore, equal to:

1

(10% 10%) = 0%

2

The geometric average is, in contrast, less than zero since:

2

(1.10)(0.9) 1 = 0.5%

The arithmetic average is a useful measure for investments that have the

same starting balance in every period, whereas the geometric average is

a useful measure for investments that carries its starting balance in every

period over from the previous period.

Investment returns

For one-period investments the definition of investment returns is simple.

The return on an investment is simply the total proceeds from holding the

asset over the period divided by the initial investment cost, minus 1:

Total proceeds

Dividends + Sales price

Dividends + Capital gains

1=

1=

Return =

Initial price

Initial price

Initial price

where we have used the fact that Capital gains = Sale price Initial price.

When we consider a multi-period framework we need to consider interim

investments and asset sales also.

The log-returns are similarly defined as:

Initial price

Total proceeds

= ln

Initial price

Log Return = ln

Returns are useful in the sense that they aggregate easily across assets. For

instance, the return on a portfolio is simply the weighted average returns

on the individual assets. It is generally not true that the log return on a

portfolio can be worked out as the weighted average of the log return

on the individual assets. Log returns are useful in the sense that they

aggregate easily over time. The log return over two periods, for instance,

is simply the sum of the log returns over the two individual periods. This

is also generally not true for returns. We illustrate this with the following

example. Consider an investment where you invest 100,000 in two

assets, A and B, with the original investment split equally between the two

119

23 Investment management

assets. A and B are both priced at 100 initially, and the price of A is 110 at

the end of the first year and 105 at the end of the second year. Similarly,

the price of B is 90 at the end of the first year and 95 at the end of the

second year. The value of the portfolio is as follows:

Initial value

100,000

100,000

100,000

The return on the portfolio is, therefore, zero percent across any individual

period, and also over the entire two-year horizon. Looking at the data for

the individual assets, we find that we can recover the portfolio returns by

taking a weighted average across assets, and that we can recover the longrun return of the assets by summing the log returns over time. The return

and log returns of the two assets are:

Return asset A

First year

Second year

10%

4.5%

9.5%

4.7%

Return asset B

10%

5.6%

10.5%

5.4%

recover the return on the portfolio. For instance, over the first year,

the portfolio holdings are (initially) 50,000/100,000 in asset A and

50,000/100,000 in asset B. This yields a portfolio return of:

Portfolio return first year =

1

1

10% = 0

10%

2

2

The average log return is, however, negative over the same period. Over

the second year, the portfolio holdings are (initially) 55,000/100,000 in

asset A and 45,000/100,000 in asset B. The second year portfolio return

is, therefore,

Portfolio return second year =

9

11

5.6% = 0 (excluding rounding error)

4.5% +

20

20

When it comes to the assets return over the entire two-year period we find

that the log returns are more accurate. The log return of asset A over the

entire two-year period is given by:

105

100

ln

and the log return of asset B over the entire two-year period is similarly

given by:

95

100

ln

by adjusting the way in which we take averages across time. For asset A,

the average return over the two periods is (104.5)%/2 = 2.75%. If this is

an accurate estimate, we expect to earn 2.75% by holding asset A over one

period. This does not mean that we expect to earn 2.75% each year if we

hold asset A over two periods. To obtain a reasonable estimate in this case

we need to work out the geometric average return, which is defined by:

Geometric average =

(1 + r ) 1

t

120

For asset A, the geometric average return over the two-year period is:

Geometric average asset A = (1.10)(0.955) 1 = 2.5%

The geometric average takes into account the compounding effect when

holding assets over several periods. The (arithmetic) average does not

take this into account and will consequently overestimate the return over

several periods.

When making observations of two random variables, we are often

interested in measuring the relationship between them. Simple ways of

doing this constitutes correlation or covariance measures, which measures

the degree of relatedness in the variability of the two random variables.

We have used these terms in several places within this guide and technical

definitions can be found towards the end of Bodie, Kane and Marcus in an

appendix. Regression methods can best be understood as a more advanced

and powerful method of measuring the relationship between two random

variables than is possible through correlation or covariance.

Regression models attempt to pick up linear relationship between two

random variables of the type

yt = a + bxt + et

Here, yt denotes a series of observations of a (dependent) random variable

over time t = 1,2,3,,T and xt a series of corresponding observations of

another (independent) random variable. The regression coefficients a and

b are to be determined by the regression analysis, and the error term et

measures the deviations between yt and a + bxt. The crucial question is

how the coefficients a and b are determined. There are two criteria the

regression analysis uses to determine these coefficients. The first is that

the error term is on average zero. Therefore, the observations of yt lie

on average above the line (a + bxt) the same amount as they lie below

the line. The second is that the sum of the squared errors ( et 2) is

minimised. These two criteria determine uniquely the coefficients a and b.

The coefficient b is given by the formula:

b=

cov(yt, xt)

var(xt)

What do we do when the true relationship is not linear? If, for example,

the true relationship between the two observations is given by:

yt = a + bxt 2 + et

the linear regression method above is not very good at picking up the

relationship. However, if we regress yt on ln(xt) instead, we are able to

capture the non-linear true relationship by a linear model:

yt = c + d ln(xt) + ut

where the coefficient are a = c and d = 2b. Therefore, the regression

method is a very powerful method to measure the relationship between

random variables in a simple and straightforward way.

We can also extend the regression model to multiple independent random

variables that yield the multiple regression model:

yt = a + b1x1t + b2x2t + ... + bKxKt + et

where K+1 regression coefficients a, b1, ,bK are to be determined.

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23 Investment management

Utility theory

Utility theory is a concept used in economics to model human behaviour

using mathematical functions called utility functions. These functions can

be defined over many goods and services, but when talking about financial

investments we define these functions over money. If an individual,

through some investment choice, ends up with a final cash balance of w,

we say his utility is u(w), where u is the utility function. If w is a random

variable, we measure his utility by the expected utility, which in general is

not equal to the utility of his expected cash balance:

Expected utility = E(u(w)) u(E(w))

Where do these utility functions come from? Utility functions are not an

inherent characteristic of human beings, they should rather be thought of

as a representation of preferences over outcomes. Why do we use utility

functions? The simple answer is that utility functions are a lot easier to

handle than preferences. What utility theory does, essentially, is to show

that when our preferences are sufficiently structured (or, perhaps more

accurately: rational) we can represent these by a utility function.

An example of the type of structure we impose on rational preferences is

the so called transitivity property. If an individual prefers A to B and also B

to C, it follows that he also prefers A to C. This property is fairly obvious,

but sometimes the structure we impose is more subtle (and controversial),

such as the so-called independence property. Consider the following

example. Suppose an individual can choose first between two lotteries,

lottery A paying 1m with 50% probability and 0 with 50% probability,

and lottery B paying 4m with 25% probability and 0 with 75%

probability. Then, the agent is asked to choose between a lottery C paying

1m for sure, and a lottery B paying 4m with 25% probability, 1m with

50% probability, or 0 with 25% probability. The independence property

states that if the individual chooses A before B then he also should choose

C before D. In practice, however, many people find these two choice

situations very different and may make contradicting choices.

The reason the agents should make the same choices is the following.

Consider lottery A and B. We can think of these situations by the following

table.

Outcome A

Probability A

Outcome B

Probability B

50%

50%

1m

50%

25%

4m

25%

Now look at the lotteries C and D. We can represent these by the following

table.

Outcome C

Probability C

Outcome D

Probability D

1m

50%

1m

50%

1m

50%

25%

4m

25%

We notice that the second and third lines are identical for both choice

situations, and that the first line gives the same outcome. Therefore, if our

preferences are sufficiently rational we should prefer C to D if and only if

we also prefer A to B.

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One of the big advantages of using utility functions to represent

preferences is that we can easily make the decision maker risk averse. Risk

aversion indicates a property of preferences where agents are unwilling to

take on actuarially fair lotteries (lotteries with zero expected gain such

as tossing a coin with heads-you-win and tails-you-lose). Risk aversion

can be modelled by concave utility functions. These functions put less

weight on gains than on losses, so that the expected utility of a risky

outcome is always less that the utility of the expected outcome.

How do we measure risk aversion? Again, this is fairly simple using utility

functions, as we can simply measure the curvature of the concavity of the

utility function. We know that the first derivative of the utility function

measures the slope of the function at a given point, and that the second

derivative measures the change in the slope. Combining the two, we can

measure curvature by the so-called risk aversion coefficient:

u''(x)

u'(x)

which is minus the second derivative over the first derivative. If the utility

function is linear, the risk aversion coefficient is zero, indicating risk

neutral preferences.

When investors pick investments we expect that they choose the portfolios

that give them their preferred return. This is not necessarily the portfolio

with the highest expected return, as this may also be the riskiest portfolio.

When investors have utility functions, we can solve their portfolio problem

using standard optimisation techniques from calculus. Thus, we seek

solutions to the following problem,

max p E(u(r(p)))

where p is their portfolio choice, and r(p) is the return that is associated

with this portfolio. We demonstrate a solution to this problem for the case

of CARA utility functions below.

Some preferences have the same risk aversion for all wealth levels, i.e.

the utility function representing the preferences has constant absolute risk

aversion coefficient. Such preferences can be represented by the simple

utility function:

u(x) = exp(x)

and some simple algebra shows that this utility function has the risk

aversion coefficient equal to the constant .

If an individual has CARA preferences and his wealth x is normally

distributed with mean m and variance v, it follows that the individual is

variance averse with expected utility:

v))

E(u(x)) = E( exp(x)) = exp((m

2

Therefore, this individuals expected utility maximisation problem is very

easy to state: the individual seeks to maximise the expected wealth minus

the variance of his wealth times half his risk aversion coefficient. Suppose,

for instance, that an individual with CARA utility and risk aversion

coefficient 2 seeks to maximise the expected utility from investing in

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23 Investment management

m(p) and the variance is v(p). The portfolio choice problem is:

max p exp(2(m(p) v(p))

which is solved by the first order conditions for maximum:

2 exp(2(m(p) v(p))(m'(p) v'(p)) = 0

or,

m'(p) = v'(p)

The investor picks a portfolio that has a marginal increase in its expected

return equal to its marginal increase in variance.

We employ variance averse utility functions in chapter 6 where we discuss

the Capital Asset Pricing Model and optimal diversification strategies.

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