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85 Cards in this Set
- Front
- Back
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Invesment Risk |
We compute using standard deviation, with total risk = systemic risk + unsystematic risk |
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Diversification |
Even after undertaking diversification, an investor is still exposed to systemic risk - Diversification effectiveness depends on correlation of returns b/n investments/asset classes involved |
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Risk/return |
Generally accepted that higher risk = higher EXPECTED return - models such as CAPM illustrate this |
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Causes of risk |
Income risk - poss that income from a fund fluctuates due to i/rate changes - Inflation risk - inc prices erodes purchasing power of capital/income, thus investing risks a loss of purchasing power - Shortfall risk - risk that an amount invested will not reach a target financial goal at point in future |
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Causes of risk(2) |
Interest rate risk - inc in i/rates is risk for borrowers who borrow at a variable rate. dec in i/rates is risk for savers. A borrower could hedge by fixing i/rate on mortgage - Capital risk - poss of loss of some/all of original capital invested. General market falls reduce capital values, therefore risk is referred to as market risk |
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Causes of risk(3) |
Business risk - co. specific risk that a particular investment with unique characteristics will fail Credit risk - risk of default of a fixed income investment Fraud - a financial loss incurred due to financial crime |
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Causes of risk(4) |
Currency risk - arises from fluctuations in currency values against each other. eg. UK investor => buys euro stocks/bonds Liquidity risk - risk an investor will be unable to sell their investment when they need to( at a reasonable price) - eg. property markets can be illiquid |
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Causes of risk(5) |
regulatory risk - risk associated with potential for laws related to a given industry, country or type of security to change and impact relevant investments Systemic risk - failure or collapse of entire fin. system, due to extraneous events or failures in areas of system that cascade |
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Causes of risk(6) |
Political risk - describes the risk that unexpected action by Gov in country of investment where investment is located may devalue it Institutional risk - It may be difficult for 'outsiders' to become full aware of institutional structure in overseas markets(incl. regulation, liquidity, and availability of info) |
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Risk measurement |
Ex-ante risk: risk anticipated by investor when originally undertaken Ex-post risk: risk actually experienced by investor during investment period. This may be diff from ex-ante Fundamental assumption: Investors are rational & risk-averse i.e. demand higher return for higher risk |
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Exp return measurement |
Arithmetic return is normally used to calc the expected return of an investment under consideration |
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Normal Distribution |
Symmetric dist, with poss security returns defined by mean and st.dev. Bell-shaped curve: 1SD = 68% 1.96SD = 95% 3SD = 99% |
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Diversification Effect |
Depends on corr. coefficient b/n movements of returns corr. coef = -1 => Neg perfect corr +1 => pos perfect corr 0 => uncorrelated |
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Diversification - total risk, sigma i ^2 |
total risk of inv (sigma i)^2 = systemic risk (sigma s)^2 + unsystemic/idiosyncratic risk(sigma u)^2 |
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Systemic risk, sigma s ^2 |
variability in returns of a security caused by general market influences: - i/r changes - inflation rate changes - tax rate changes - state of economy => CANNOT be eliminated by diversification |
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Unsystemic risk, u ^2 |
Factors: - Quality of management - Susceptibility to demands of suppliers and customers - profitability margins and levels => CAN be eliminated by diversification |
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Value at Risk(VaR) |
defined as amount by which the value of an investment or portfolio may fall over a given period of time at a given level of probability e.g. if VaR is £1m at prob level of 5% for one week => there is a 95% chance that the value will not fall by >£1m over any one week |
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VaR advantages |
Useful summary of risk in one no - easy to understand - used by regulators for risk control and capital adequacy - can be used by co's to measure capital at risk |
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VaR disadvantages |
use of poor assumptions possible e.g. non-normal distributions may skew metric - only focuses on downside, not upside - difficult to calc VaR for large, complex portfolios - can give a false sense of security, as managers believe risk is well controlled when this is not the case |
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VaR preparation |
parametric - returns follow a normal dist historic - assumes return follow historic pattern Monte-Carlo - uses pricing models to calc potential dist of returns based on potential distribution of economic inputs. |
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Terms |
Dispersion - standard deviation measures the average dispersion of variables around their mean. Assumes that underlying data is normally distributed Tracking error - a relative risk measurement that is most relevant to funds tracking a benchmark: standard deviation of diff b/n index and tracking fund |
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Terms(2) |
Active share - a measure of %age of stock holdings which differ from the benchmark index target semi variance - based on the squared deviation below the specified target return. When the target return is the mean of the distribution, the target semi-variance = semi-variance |
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Terms(3) |
Shortfall risk - risk is the prob that the observation will have a lower value than the specified risk e.g. 40% => chance you will earn a return less than specified return Drawdown - measure of the amount by which the value of an investment has fallen from its all-time historical peak => scale of historical losses Relative drawdown - relative to a benchmark |
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Diversification Methods |
Two types - BY Asset class: hold a combination of diff types ofassets in portfolio - cash, FI, equities, property etc. WITHIN asset class: hold a variety of investments within particular asset types. i.e. various industry sectors, geographical markets |
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CAPM |
Exp return, r= rf + beta( rm - rf) rm - returns expected from investing in the market portfolio rf - returns from risk free investments beta - proportion of funds invested in market portfolios |
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CAPM Appraisal |
We compare security returns with the Securities Market Line Beta - a relative measure of systemic risk of the investment , with the sign indicating (+/-) whether returns move with or against the market. The scale of Beta indicates relative volatility |
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Beta |
Beta>1, on average investment's returns will move in the same direction but to a greater extent Beta = 1, on average, investment's return will move in the same direction to the same extent 0 same direction but to a lesser extent Beta = 0, investments uncorrelated with the market Beta <1, investments returns will move inversely to the market |
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Calculating Beta |
beta = sigma s / sigma m = sigma i * Corr i, m / sigma m
= covariance i , m / variance market |
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CAPM Assumptions/Limitations |
Single period model: rate of return derived from the model is only valid as long as the inputs( rm, rf, beta) are valid. One or more factors will change over the years due to annual budgets, impacting tax rates and i/rates(via PSNCR) - Assumes overall portfolio is diversified and equal to the market as a whole. Thus, approach not suitable for small, undiversified portfolio |
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CAPM Assumptions/Limitations |
- Difficult to estimate the beta factor for an investment, as need to estimate future returns under diff economic conditions; not practical. is solution to look at a similar investment accepted in the past and calc beta? |
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Arbitrage Pricing Theory |
r= rf + b1F1+b2F2+b3F3+...... rf = risk free rate F1, F2, F3 - APT factors where there is sensitivity, or premium return on those factors - ideally uncorrelated beta - measures the individual sensitivity of these factors |
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Equity APT Factors |
- Market returns - Sector returns - Inflation rates - GDP growth - Tax rates - economic growth - dividend yields |
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FI APT Factors |
- Market returns - Duration - Default risk - liquidity risk - conversion options - issuer options |
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Using APT |
- to construct portfolios with selected sensitivities to certain factors - manage fund to its strengths, optimise sensitivities to factors that are predictable - immunise the portfolio against uncontrollable/unpredictable factors |
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APT Assumptions |
Investors: rational & risk-averse - efficient markets; free of transaction costs to permit arbitrage - factors that are sensitive are uncorrelated |
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APT Limitations |
- APT doesn't specify factors to use - The problem of determining relevent Beta factors for a security, and stability of these factors - possibility that pure factor portfolios, or risk-free substitute, may in fact be impossible to construct from securities available |
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Behavioural Finance |
Argues many facts about asset prices, investor behaviour, and managerial behaviour are best understood in models where some elements are irrational => Cognitive illusions 2 classifications: Heuristics & Mental Frames/Propect Theory |
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Heuristics Decision Process |
rules of thumb used to make decisions in complex, uncertain environments |
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Heuristics |
memory bias - value scale is fixed/anchored by recent observations, leads to under reaction to trend changes overconfidence - investors overestimate their predictive skills and believe they can "time" market confirmation bias - investors are quick to accept info that confirms their opinions, but disregard info that contradicts them |
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Heuristics(2) |
Conservation bias - investors are slow to update their investment view in face of new ec./financial evidence sample size neglect/Representativeness - investors see patterns where none exist Endownment effect - where investor places a higher value on an asset than they would the same asset were it not held |
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Heuristics(3) |
Anchoring - a value scale is fixed/anchored by recent observations Self-attribution - when an investor believes that any investment success is due to their careful skill & judgement but any failure is due to factors outside their control Gamblers' fallacy - people inappropriately predict that a trend will reverse due to mean reversion |
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Mental Frames/Prospect Theory |
States of mind which affect decision making Loss aversion: based on idea that the mental penalty associated with a given loss is greater than mental reward from a gain of same size Regret Aversion: arises from desire to avoid feeling pain of regret resulting from a poor investment decision |
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Mental Frames/Prospect Theory(2) |
Mental Accounting - name given to propensity of individuals to compartmentalise their worl into separate 'mental accounts' => can lead to inefficient decision making Faulty Framing - when investors fail to mark their portfolios to the market each day but reference performance vs. historical cost |
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Efficient Market Hypothesis(EHM) |
Market can be termed informationally efficient when market price of a security 'instantaneously and fully reflects all relevent available information EHM suggests three forms: |
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EHM - Weak form |
weak EHM - all historical share price info & patterns are fully reflected in current share price - Implication - investors will be unable to earn excess returns by using tech analysis |
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EHM - Semi-strong form |
Semi-strong EHM Believes prices reflect all historical and publicly available info - implication: as soon as any info is released, it will be immediately incorporated into the share price => therefore, investors will be unable to consistently excess returns by buying/selling on announcement of new info |
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EHM - Strong |
Strong EHM - all historical, publicly and privately accessible info is fully reflected in the price - implication; even with insider info, an investor will not be able to profit from it because the market would already have reacted to it. |
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Anomalies contradicting EHM |
Seasonal effect - january returns consistently higher than other months - Monday effect - consistently lower returns than other days Small co's effect - consistently higher returns than from larger companies index effect - stocks taken into index have been observed to rise, EHM provides justification |
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Anomalies contradicting EHM |
stock market crashes - crashes normally follow a bubble weather effect - corr b/n weather & market returns => better weather = higher returns |
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Fair values/secondary markets |
Liquidity = fairer price of any trades - A market with higher liquidity has lower dealing costs and a narrow dealing spread. Assets likely to trade at/close to FV - main market listed equities - gilts/listed bonds - money market instruments - collective investments Assets that may trade away from FVs - Property - Private company shares - AIM shares in extreme markets |
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Secondary Markets Dealing |
- UK Equities, negotiable c. 0.2% - POTAM levy on UK equity deals over £10k - £1 for both buyer and seller - SDRT charged on share purchases at 0.5% on the consideration -> rounded to the nearest penny - SDRT exempt: AIM and high growth, gilts, corp loan stock, foreign securities, bearer securities, traded options on ICE Futures Europe |
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MiFiD |
- allows Inv banks to trade shars bilaterally, off-exchange, with a requirement to publish prices - Also introduced the concept of a multilateral trading facilitity(MTF) that allows off-exchange trades b/n multiple counterparties |
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GEMMs |
Gilt Edged Market Makers are obliged to make a market in all conventional gilts at a size deemed appropriate by the DMO Settlement: T+1 |
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Inter-dealer Brokers |
IDBs provide an anonymous dealing service allowing GEMMs to unwind positions - only accessible to market makers in gilt market |
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Stock Borrowing & Lending Intermediaries |
SBLIs borrow stock on behalf of market makers from institutional investors holding large blocks of stock and charge a commission for it - The stock is passed to GEMMs who use it to settle trades, and go short |
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Exchange Traded Market Characteristics |
- Highly liquid - Low dealing - Central counterparty, low counterparty risk |
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Exchange Traded Derivs/alternatives |
- futures - exchange-traded options - warrants and convertibles - commodities - commodity derivs |
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OTC market characteristics |
- poor liquidity - high dealing costs/spreads - high counterparty risk |
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OTC Derivs |
- Forwards - OTC options - swaps - property - collectibles |
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Fund Objectives |
1 - return maximisation for individuals as per risk/return preferences - risk tolerance important 2 - liability matching; eg. a pension fund looking to match assets and liabilities or minimise any mismatch - only was is to invest in gov bonds where income & capital flows exactly match the liabilities |
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Fund Constraints |
- Liquidity needs: need to be able to respond to changing circumstances - Liabilities: many funds have liabilities they are obliged to meet, the inv manager must take these into account. eg. pension fund/life assurance cos have statistical projections of liabilities into future - risk aversion: diff clients have diff risk tolerances in needs for diff return levels |
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Fund Constraints |
Tax status: investment portfolio and strategy adopted must be consistent with the fund tax position - pension funds don't incur taxation Time horizon: governs the types of investment possible and the type of risk that may be taken |
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Return Maximisation |
OEICs: UTs, OEICs, ETFs Private client Funds: for particular priv clients Life assurance funds: annuities and investment bonds Closed-ended collective Investments: investment trusts, hedge funds, structured products, VTCs, EISs and SEISs |
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Liability matching funds |
Charities - General Insurance Companies - Life assurance companies |
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Life Assurance Cos |
A no. of policies exist: - Term assurance: a person's life is insured for a specific period - Whole of life: a capital sum paid on a person's death, when this occurs - endownment policies: combines life assurance and savings and are often associated with mortgages (LT time horizon as a pension fund) |
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Pension Funds |
- Defined Benefit: offers a specific return based on the employees salary and no. of years of service(liability matched to specific return) - Defined Contribution: the fund aims to achieve a general increase in the value of the contributions made by the employer(liability match and return max) LT term time horizons so funds may take high risk |
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Banks/Building Soc's |
derive much of their assets from deposit taknig without being repayable on demand - ST liability |
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Risk/Investments |
From lowest to highest national savings certificates Bank/BS accounts incl. money market deposits gilts held to redemption local authority issues corp bonds - dependent on cred rating life assurance policies unit/inv trusts shares & property commodities and collectibles warrants, futures and options |
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Returns |
nominal: returns which are fixed in value irrespective of future inflation e.g. money market instruments, bonds real: adjusted in line/for inflation e.g. index linked bonds, shares, commodities, property, collectibles |
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Asset characteristics and performance |
- variable interest cash deposit - provide capital protection and a small return, but perform poorly during inflationary periods - Gov FI securities: provide a safe nominal return, thus good to satisfy nominal liabilities. perform well when i/rates fall but poorly in rising rate scenarios. low vol, but increases with longer dated issues |
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Asset characteristics and performance(2) |
index-linked securities: provide a safe, real return. Hence protect income and capital against inflationary effects. Low coupon reflects safety of issues |
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Asset characteristics and performance(2) |
Equities: LT real return, little security. Good in booming economy and vice versa thus HIGH risk Property: LT real return, but not with risk. Offers diversification benefits relative to equities given little correlation. Low liquidity and management are drawbacks Commodities: LT real return, little security. Pays no income, but gains grow over time. Exhibit little correlation to eq. markets=> diversification benefits |
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Fund Management Approach |
1. Fund Objectives & constraints 2. inv. strategy and allocation 3. stock selection 4. fund performance ==> a recursive process - compare to initial objectives & constraints |
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Management Styles |
Active: managers interact with portfolio on reg basis => do not believe securities markets are continuously efficient Passive: a strategy is established which should require little active intervention to achieve strategy goals => has substantial theoretical support in form of EHM Hybrids: indexed core fund with a peripheral or satellite fund which is more actively managed => can 'tilt' |
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SRI |
1. Screening - either +ve or -ve - inclusion/exclusion on social/ethical determinants 2. Positive engagement - identification of investments which could improve ethical, social or environmental behavior. ie. fund managers with substantial state lobbies management for change 3. Thematic investment - key themes are used to identify investment opps e.g. pollution, education which improve social wellbeing of the world. |
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Market Timing |
ST variation/tactical asset allocation: take advantage of market changes/fluctuations - implies ST mis-pricing of asset classes |
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Asset allocation in falling market |
- switch from sensitive( high beta/duration) stocks to less sensitive( high beta/duration)stocks - a derivative overlay ie,. selling futures or buying put options |
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Asset allocation in rising market |
- switch from insensitive (low beta/ duration) stocks to more sensitive stocks (high beta/ duration) stocks - deriv overlay: ie buying futures or call options |
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Active Equity Selection Strategies |
Compare to SML to ascertain if security under/overpriced - Management style: growth, value, - market orientation: portfolio close to market? - Small cap investor |
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Passive Equity Selection Strategies |
Buy & hold for extended pd of time, with infrequent changes Indexation; buy portfolio to mirror chosen index Full replication Stratified Sampling Factor matching No-mingling Synthetic fund - Results: underperformance due to cost? Tracking error, unless perfect match to index |
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Active Bond Strategies |
riding yield curve: when yield curve upwards sloping then bond investor can buy bonds in excess of the required investment horizon => bond can then be sold at the end of the investment pd. =>if YC hasnt shifted during the pd. the inv. manager will have generated higher returns than if they'd bought bonds with same maturity as the investment |
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Passive bond strategies |
Immunisation: create a portfolio with assured return over specific time horizon, irrespective of any changes in i/rate. Match a liability with a bond portfolio of same duration. Risks: i/r changing before cash flow dates, reinvest at diff rates - non-parallel shifts in YC - callable bonds => non-certain maturity or duration |
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Passive bond strategies(2) |
cash flow matching[dedication]: approach to purchase bonds whose redemption proceeds will meet a liability of a fund as they fall due. This is done by purchasing bonds to exactly match fund liabilities. combination matching[horizon matching]: a mix of the above two approaches to Inv. mgmt. e.g. cash flow matches liabilities for the next four quarters but is immunised for remaining investment horizon. At the end of 4th Q, portfolio is rebalanced to match cash flow ovre subsequent 4 Qs, and again immunised for remaining period. |
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Liability Driven Investment |
Used by pension schemes to build a portfolio that meets future liabilities of the scheme; 1. analyse fund liabilities: particulary i/r risk(discount rates applied to future liabilities), and inflation risk(funds must satisfy a real return), therefore liability will grow at least with inflation in LR 2. Quantify re'ship b/n assets/liabilities to determine if over/underfunded and return/risk required to achieve asset/liability match |
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Liability Driven Investment(2) |
3. Develop & implement appropriate investment strategies through consideration of passive & active strategies, including: - immunisation to counter i/r risk (poss using i/r swaps) - inflation swaps to counter inflation risk 4. Monitor and where necessary re-balance assets and liabilities mix and investment strategy |
