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Investment management

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.

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Published by: University of London
University of London 2009
Reprinted with minor revisions 2011
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Contents

Contents

Chapter 1: Introduction .......................................................................................... 1


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

Chapter 4: Fund management and investment ................................................... 27


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

Asset allocation over longer time horizons ................................................................... 64


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
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23 Investment management

Portfolio insurance with calls ....................................................................................... 97


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.

Subject guide structure and use


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.

Aims and objectives


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
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23 Investment management

provide an overview of various financial instruments


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

3. Fund management and investment: historical mutual fund


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

Other useful texts for this course include:

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.

Online study resources


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.

Making use of the Online Library


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

environment (VLE) where you should be advised of any forthcoming


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.

Chapter 2: Financial markets and instruments

Chapter 2: Financial markets and


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.

Money and bond markets


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

Chapter 2: Financial markets and instruments

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.

Money market instruments


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

securities overnight to an investor and promises to buy the security back


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).

Bond market instruments


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 convention in quoting bond prices is to adjust for accrued interest


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

Chapter 2: Financial markets and instruments

Price first bond = 100.013 =

100 + 5
1.05364/365

Price second bond = 104.986 =

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

days separating coupon payments

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

Quoted price first bond = 100.013 5

1
= 100.00
365

Quoted price second bond = 104.986 5

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

Chapter 2: Financial markets and instruments

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

the fund he needs to trade with existing investors. Units in closed-end


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.

Exchange traded funds


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.

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


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

Chapter 2: Financial markets and instruments

Clearing, settlement, margin trading, short sales and


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.

Working out the profitability of margin trades


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

which yields a rate of return of approximately 22%.


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

Chapter 2: Financial markets and instruments

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

which is a loan with an interest rate of approximately 46.4%. You can


learn more about margin trading by reading Chapter 3 of Elton, Gruber,
Brown and Goetzmann.

Regulation of financial markets


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?

A reminder of your learning outcomes


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

Sample examination question


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

Chapter 3: The history of financial markets

Chapter 3: The history of financial


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.

A history of financial innovation


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.

Recent financial innovations


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.

Case study 1: Floating-rate debt


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.

Case study 2: Zero-coupon bonds


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

Chapter 3: The history of financial markets

and there may be considerable risk tied to these reinvestment strategies. A


zero-coupon bond has no reinvestment risk.

Case study 3: Poison pill securities


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.

Case study 4: Swaps


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.

Case study 5: Futures trading


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.

Case study 6: Credit default swaps


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.

Case study 7: Collateralised debt/loan obligations


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

Chapter 3: The history of financial markets

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.

Investment returns in equity and bond markets


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%

Long-term treasure bonds

5.38%

5.68%

US T-bills

3.78%

3.82%

Inflation

3.05%

3.14%

Table 2.1

For a review of geometric and arithmetic averages, see Appendix 1. If we


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%

Long-term treasure bonds

5.68%

8.24%

US T-bills

3.82%

3.18%

Inflation

3.14%

4.37%

Table 2.2

Among asset classes, therefore, there is a clear relationship between risk


and return (inflation is not an asset). The more risk the investor takes on,
23

23 Investment management

the greater is the compensation in terms of expected or average return.


This can be explained by risk aversion - that investors are unwilling to take
(actuarially) fair risk.

The equity premium puzzle


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

Chapter 3: The history of financial markets

he would be indifferent between paying 49 and keeping 51 for sure, and


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

A reminder of your learning outcomes


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).

Sample examination question


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

Chapter 4: Fund management and investment

Chapter 4: Fund management and


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.

Historical mutual fund performance


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

Chapter 4: Fund management and investment

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.

Market effciency and behavioural finance


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

The efficient market hypothesis comes in three different versions, the


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

Chapter 4: Fund management and investment

(three- or 12-month holding period) tend to outperform other stocks. The


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.

Return based trading strategies


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
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23 Investment management

where wi, t1 is the dollar amount to be invested in stock i, N is the total


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:

wi, t1 = 1 Ri, t1 1 Rm, t1 = Rm, t1 Rm, t1 = 0

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

In a study of momentum strategies, Chan, Jegadeesh and Lakonishok find


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

Chapter 4: Fund management and investment

expected to tighten (the short position would now be in a 29.5-year bond


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

became, briefly, the biggest company in the world measured by market


capitalisation).

Performance of hedge funds


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

Monthly mean return

1.4%

3.6%

Monthly standard deviation

3.6%

5.8%

Minimum monthly return

8.9%

18.3%

Maximum monthly return

14.0%

27.0%

1.39

2.15

Annual Sharpe ratio


Table 4.2

This table shows a fund that apparently outperforms the index


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.

Algorithmic or program trading (statistical arbitrage)


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

Chapter 4: Fund management and investment

units of B giving proceeds of 110xB. Say xB = 80, then:


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)

Todays spread St below


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:

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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

Chapter 4: Fund management and investment

The chapter concluded by looking at evidence of hedge fund performance,


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

3. Now evaluate whether it is possible to make momentum profits


by trading the asset you think may not satisfy the efficient market
hypothesis in the previous activity.

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23 Investment management

A reminder of your learning outcomes


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.

Sample examination question


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

Chapter 5: Market microstructure

Chapter 5: Market microstructure


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

Many prices: In normal models of markets we idealise the


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.

Limit order markets


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

Chapter 5: Market microstructure

Buy quantity

Buy limit price

Limit buy

100

100

Limit sell

Market buy
Market sell

Order

Sell quantity

Sell limit price

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.

Bid-ask bounce: the Roll model


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

to (mt + c) (mtc ) = 2c. In general, the transaction price at time t can be


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

Chapter 5: Market microstructure

Informed speculator sells

Uninformed noise trader sells

Uninformed noise trader buys

Uninformed noise trader sells

Uninformed noise trader buys

1
1

Informed speculator buys

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 ))

Some simple algebra demonstrates that:


(1 + )

Pr(V = V |Bid) =

1 (1 2)

The probability of a low value, conditional on a bid transaction, is


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)

Chapter 5: Market microstructure

where k(Ask) is the conditional probability of low value in round k given


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:
~

E( (v)) = E(v( + (x + u )))x


~

= (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

which yields the optimal market order:


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
~

To work out E( vy) we make use of a linear projection theorem: if ~y


~
~ ~
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) +

We can work out the unknown on the right hand side:


~

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

= p0 (we continue with the next paramenter using this result...)


=

2 20
2u + 220
1
22

2u +
1
46

20
1
2
42 0

(again we can rearrange to find ...)

Chapter 5: Market microstructure

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

The equilibrium prices are, therefore, given by:


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

and the coefficient a is found by taking expectations on both sides of the


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.

Discrete version of the Kyle model


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.

Why market microstructure matters


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

Chapter 5: Market microstructure

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

A reminder of your learning outcomes


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.

Sample examination question


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

are caused by macroeconomic shocks that affect a large number of other


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.

Expected portfolio return and variance


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

wiwj Cov(ri , rj) = w2i Var(ri) + wjwi Cov(rj , ri)


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

there is an identical covariance term going in the opposite direction


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).

Definition of risk premium


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%

Marks & Spencer

8%

8%

Also, we assume the covariance structure is given by the following matrix:


BT

Lloyds Bank

BT

Lloyds Bank

5%

Marks & Spencer

2%

3%

Marks & Spencer

53

23 Investment management

The portfolio return is, therefore:


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

Asset allocation: Two assets


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

We notice that if we work with standard deviation instead of variance, the


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

The graph shows the investment opportunity set in the P P plane


(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

By rearranging the first order condition, we find that:


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.

Optimal asset allocation with a risk free asset


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

The optimal portfolio weight comes out, therefore, as a parameter that


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.

CARA utility and normal returns


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

where is the risk aversion coeffcient. We find here:


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.

The portfolio frontier


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

The graph shows the investment opportunity set in the plane


(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.

Expected returns relationships


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

reduces to a set of equations (which we do not show here) of the form:

Cov(ri, rM) = Eri rF


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.

Diversification: The single index model


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.

The TreynorBlack model


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

max = w + 2w(1 w) PA+ (1 w)22P


w
The solution is given by:
A
w*= A (1 A) + (ErP rF) Var (eA)
2P

It is clear that if A is zero, we put zero weight in the portfolio, and if A is


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

A geometric illustration of the TreynorBlack model. If the active portfolio


has unit beta, we find the optimal weight as:
/Var(eA)
w* = A
(ErP rF) / P2
62

Chapter 6: Diversification

It is also possible to illustrate the optimal portfolio geometrically. In Figure


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.

63

23 Investment management

Asset allocation over longer time horizons


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?

A reminder of your learning outcomes


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.

Sample examination question


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

Chapter 7: Portfolio immunisation

Chapter 7: Portfolio immunisation


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

Whereas most of the diversification material relates to equity portfolios,


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

Chapter 7: Portfolio immunisation

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

69

23 Investment management

1 + f1 =

1.0522 (1 + r2)2
=
1.05
1 + r1

In general, the year t one-year forward rate f t1 is given by:


1 + f t1 =

(1 + rt+1)t+1
(1 + rt)t

and the year t, n year forward rate f nt is given by:


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 term structure


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

Chapter 7: Portfolio immunisation

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

this is a negative quantity reflecting the inverse relationship between prices


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:

71

23 Investment management

D = dt t = dTT = T
t

so the duration is exactly equal to the maturity T. If we return to the


formula for the price of the bond we find:

P=

cT
c2
c1
+ (1 + r)2 + . . .+ (1 + r)T + 1
1+r

Now, if we take the derivative with respect to the yield we find:


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

is sometimes called the modified duration and is written

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

for t = 5: d5 = 100 . The numbers are d1 = 0.04762, d2 = 0.04535, d3 =


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

Actual bond price

Predicted bond price


r
Figure 7.1
72

Chapter 7: Portfolio immunisation

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)

Therefore, the relative change in the bond price is approximated by:


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:
73

23 Investment management

P 4.33 (0.01) + 11.97 (0.01)2 = 4.45%


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.

Immunisation of bond portfolios


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

Total assets 100

Total liabilities 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

Zero coupon bond x

Bond 100

Equity 100

Total assets 100 + x

Total liabilities 100 + x

The duration on the asset side is now:


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

where we can simplify the equation by multiplying through by 100 + x and


solve with respect to x:
x=

74

100 (4.55 Duration equity)


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

Chapter 7: Portfolio immunisation

An alternative to holding the proceeds from the short sales in cash is to


reinvest in the original bond. If we do this the balance sheet will end up
looking this way:
Assets

Liabilities

Bond 100 + x

Zero coupon bond x


Equity 100

Total assets 100 + x

Total liabilities 100 + x

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

which inflates the balance sheet more than five-fold

Convexity and immunisation


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:
75

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

Now suppose we were to find an amount x that we short in the zero


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

which yields x = 100,000 9.52 = 45,460 . If we looked at convexity effects


only, we would try to solve the equation:
100,000 11.97dr2 = x 49.89dr2
11.97

which yields x = 100,000 49.89 = 23,990. If we were to take into account


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.

Immunisation of equity portfolios


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

Chapter 7: Portfolio immunisation

Assets

Liabilities

Risky portfolio with


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

Risk free loan x1 + x2


at a rate of rF
Equity

Total assets 1 + x1 + x2

Total liabilities 1 + x1 + x2

The total return on the asset side is now:


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

Risky portfolio with with return


(1 + x1 + x2) at return ri
Risky investments of x1
at return r1 and x2 at
return r2

Equity

Total assets

Total liabilities

In this case, the total return on the asset side is:


(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
77

23 Investment management

which has solution x1 =

bi1
1 bi1 bi2

and x2 =

bi2
1 bi1 bi2

. A potential problem

arises in this case if 1 x1 x2 becomes negative, as this implies that our


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.

Hedge ratios futures trading


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:

Delta for factor portfolio i = dr = bi


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

Chapter 7: Portfolio immunisation

Sell 100,000 h = 100,000 Cov(S, F)


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?

A reminder of your learning outcomes


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
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23 Investment management

explain and competently design immunisation strategies for stocks and


equity portfolios
confidently calculate hedge ratios and successfully apply them in
derivatives based immunisation strategies.

Sample examination question


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

for 0 < x < 1).

1x

Chapter 8: Risk and performance measurement

Chapter 8: Risk and performance


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

an investment is intimately linked to the risk of the investment, so a


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

Chapter 8: Risk and performance measurement

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

possible for a given time horizon. This measure is an asymmetric measure


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

The normal density function. The probability of ending up in the tail


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.

The Sharpe ratio


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

Chapter 8: Risk and performance measurement

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:

Capital Market Line

rF

Figure 8.2

The graph shows the capital market line in the plane.


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 =

CML(ErM rF) ErM rF


= 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

= ErM rF = Treynor for the market

The security market line is illustrated in the following figure:

Security Market Line

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.

More portfolio performance measures


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

Chapter 8: Risk and performance measurement

Standard deviation market = M = x


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

An advantage of this performance measure is that it is in terms of returns,


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

where P is Jensens measure given above. To find the standard deviation


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

Similarly, the marginal variance is:

lim Var(rP + m(rQ rF)) Var(rP) = dVar(rP + m(rQ rF))


m
dm
Since the variance of the new position is Var(rP) + 2mCov(rP, rQ) + m2Var(rQ),
the derivative is:
m0

dVar(rP + m(rQ rF)) = 2Cov(rP , rQ) + 2mVar(rQ) = 2Cov(rP , rQ)


dm
Here, the variance term disappears as m 0.
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23 Investment management

Now, if the original portfolio P is equivalent to the market portfolio,


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

which is independent of x. Since both marginal return and marginal


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

Chapter 8: Risk and performance measurement

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
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Chapter 8: Risk and performance measurement

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)?

A reminder of your learning outcomes


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.

Sample examination question


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?

91

23 Investment management

Notes

92

Chapter 9: Risk management

Chapter 9 Risk management


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

via mutually beneficial trading of an appropriate financial instrument


(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.

Risk management for investors


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.

Risk management for corporations


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

Chapter 9: Risk management

customers regarding terms of payment, costly negotiations with banks and


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.

Risk management for banks


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 option protection


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.

Put protection vs VaR


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

where x is a standard normally distributed random variable. It should be


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

Chapter 9: Risk management

Next, we know that N(x 2.33) = 0.01, so:


y* 0.00452
= 2.33
0.08864

y* 0.0192

Therefore, the VaR can be found by converting back to portfolio value:


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.

Portfolio insurance with calls


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

for a portfolio pay-off of X. The current value of this portfolio is 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

which is exactly the same as above.

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

which we can confirm. Therefore, the call is currently priced at:


C0 =

1
1.052

(( )
3
10

(196 100) + 2

( )( )
3
10

The call, after an up-movement, is priced at:


98

())

7
7
(126 100) +
10
10

= 17.74

Chapter 9: Risk management

CU1 =

1
1.05

3
7
(126 100)
(196 100) +
10
10

= 44.76

and, after a down-movement, is priced at:


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.
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23 Investment management

But how would we define an extreme event in finance? Embrechts et al.


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.

Hedging credit risk


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

Chapter 9: Risk management

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

The delta of the option portfolio is equal to:


Delta =

dOption portfolio
= xN (d1) yN (d1)
dS

and if we put the delta equal to zero we find:


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.

Risk capital allocation


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

0VaRti (1%, 10 days))

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

Chapter 9: Risk management

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.

A reminder of your learning outcomes


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.

Sample examination question


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

Chapter 10: Important concepts

Chapter 10: Important concepts


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

but for longer investment projects we may need to use numerical


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

We now discuss how we can make use of investment returns.


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

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 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.

Averages: geometric vs arithmetic


The geometric average return of an investment over N years is defined by
the formula:

(1+rt )
t=1

Geometric average return =

1
N

and the arithmetic average return is defined by the familiar formula:


N
1
r
Arithmatic average return=

N t=1 t

106

Chapter 10: Important concepts

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
107

23 Investment management

These conditions dont guarantee optimum, but they need to be satisfied in


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

We notice that the second partial derivative (differentiating L with


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

Chapter 10: Important concepts

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.

Risk aversion coefficient


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.

Expected utility maximisation


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.

Variance aversion and the portfolio frontier


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

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 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

Chapter 10: Important concepts

Then the variance of the portfolio is (confirm this for yourself):


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

The first order conditions are:


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)

The variance and the expected return of the tangency portfolio,


respectively, are linked by the following relationship:

T2 and T

T2 = xT* x*

= T( T r0 )
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23 Investment management

Also, we can confirm that:


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

which is the CAPM pricing relationship.

Standard normal distribution


The density function for a standard normal random variable takes the
form:

1
e
f (x) =
2

x2
2

and is defined from to +. The standard normal density function N(t) is


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

(b1z + b2z2 + b3z3 + b4z4 + b5z5)

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

Chapter 10: Important concepts

0 t < . This is however no problem since the normal distribution


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

to work out the distribution function across the entire range.


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) =

so the transformed variable x is now standard normal.


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

and apply the relationship:

Pr [y t] = N

and use one of the algorithms NSimple or NComplicated above.

American vs European options


The Black-Scholes option pricing formula for calls and puts, respectively:
c = SN (d1) Xe r (Tt) N (d2)

p = Xer (Tt) N (d2) SN (d1)

hold for European options. Is it ever optimal to exercise these early? To


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

Chapter 11: Sample examination paper

Chapter 11: Sample examination paper


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

Yr1 cash flow

Yr2 cash flow

Yr3 cash flow

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

Try to work out whether there are arbitrage opportunities


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.
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Chapter 11: Sample examination paper

c. What is the historical evidence regarding investment returns in


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

Appendix 1: Technical terms

Appendix 1: Technical terms


This appendix aims to explain a number of technical terms that we
encounter at various stages in this study guide.

Averages: geometric vs arithmetic


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

and the arithmetic average return is defined by the familiar formula:


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

Dividends + Sales price


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
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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

Value end of first year

Value end of second year

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%

Log return asset A

9.5%

4.7%

Return asset B

10%

5.6%

Log return asset B

10.5%

5.4%

If we take a weighted average of the return of the two assets we can


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

= 4.9 % = 9.5% 4.7%

and the log return of asset B over the entire two-year period is similarly
given by:

95
100

ln

= 5.1 % = 10.5% + 5.4%

We can, however, remedy the problems with time-aggregation of returns


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

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Appendix 1: Technical terms

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.

A review of regressions 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, 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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Appendix 1: Technical terms

Risk aversion coefficient


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:

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.

Expected utility maximisation


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.

CARA utility functions


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

normally distributed portfolios. For each portfolio p, the expected return is


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.

124