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16 Cards in this Set
- Front
- Back
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Explain what is meant by strategic and tacticalasset allocations. What are the key drivers for each strategy? |
Strategic allocation refers to the long term assetmix, whereas tactical allocation refers to the short term asset mix. Strategicallocations are driven by the long term risk-reward expectations and hence theasset mix changes very infrequently. Tactical allocations focus on currentmarket trends and the asset mix will therefore change more frequently. |
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Outline the main categories of commodities anddiscuss important features for each group. E-P-I-S |
Energy – oilreceives a lot of attention in financial markets. Key driver of prices iseconomic growth, but can also be affected by political events. Middle East isthe main exporter, and China and the US are the main importers. Therefore,economic and political developments in these regions will have a large impactupon the oil price. -Precious metals– dependent on supply and demand conditions, although a distinction is oftenmade between physical demand (e.g. to make jewellery) and investment demand(i.e. to hold as part of a portfolio). Gold in particular is an interestingcase, as demand for gold is also dependent on wider economic developments suchas confidence in the US dollar as a currency. -Industrial metals – dependent on supply and demand conditions and are mainly involved in cyclical economic sectors (i.e. sectors whose activity runs in cycle with the economy as a whole. Construction is a good example). China is the main consumer of industrial metals, so economic developments in China are important forfurthering understanding of the industrial metals market. -Soft commodities– refers to agricultural commodities. While economic conditions are important the effect is less than for other commodities because demand is more inelastic.This is why supply is important, so weather conditions which reduce supply can have an adverse effect on price. |
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Explain how an investor can gain exposure tocommodities. What are the advantages and disadvantages of each? B-S-F-L-E |
Can gain exposure to commodities through:-
Buying theactual asset – this comes with obvious problems (e.g. storage). -Invest in stocks whose fortunes depend largely on the underlying commodity (e.g. buy BP forexposure to oil) – advantage is that you can gain exposure while not taking on the full risk of direct investment in the commodity; however, the disadvantageis that the fortunes of BP depend on other factors besides oil, meaning theshare price could suffer even if the oil market is looking favourable. -Commodity futures – an advantage is the transparent pricing and standardised contracts that comes from being traded on an exchange; however, the disadvantage is thatthe rolling over of futures contracts can become very expensive, andperformance monitoring is also required. -Commodity-linked notes – advantage is that you do not have to worry about the rolling over or performance monitoring of futures; however, the disadvantage is that you must accept lower coupon payments relative to conventional bonds in return forsharing in the upside potential of higher commodity prices. -Commodity ETFs –funds that invest in commodities, which you can buy shares in because they are traded on a stock exchange. The main advantage is their simplicity, but adisadvantage is that the fortunes of the ETF may exhibit some correlation withthe overall stock market. |
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Discuss the rationale behind commodity investing. E- |
The main rationale for commodity investing is asfollows:
-Economicrationale – relationship with inflation means negative correlation to traditionalasset classes, and prices also act differently across the business cycle. -Event risk –investing in commodities can provide positive exposure to event risk, since market events which negatively impact stocks can positively impact commodities.For example, oil price shocks are good for investors in oil, and a lack of confidence in major currencies is good for investors in gold. |
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Doyou believe commodities should form a large proportion of a portfolio, for atypical investor? |
Typically, commodities will not form a large part ofan investor’s portfolio (5% - 10%). Interestingly, the ‘optimal’ allocation hasfallen over time, probably because we are in what some say is a ‘new normal’for the economy. What this means is that the period of high and sustainedeconomic growth is over. As a result, commodities are unlikely to be priced atthe high levels they were before the crisis. |
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Why / why not? |
Furthermore, commodities are assets whosefundamentals can change rapidly, and are hence risky investments. Additionally,commodities provide no regular income, whereas shares and bonds do. However,clearly the exact allocation will depend on the risk-tolerance of the investorand their specific investment requirements. |
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What is the outlook for commodities for theyear ahead? Does this have any investment implications? Explain. |
-Coffee – keep aneye on Brazil, which is the world’s largest coffee producer. Prices fallenapprox. 25% over the last year, largely due to the depreciation in theBrazilian real against USD (commodities are priced in USD). This means thatexporters can sell at lower USD prices without suffering loss in domesticcurrency. Brazil’s economy continues to show signs of weakness (see chartbelow). If this continues to weaken the currency, then coffee prices might falleven further (I hope this is eventually reflected in the prices at the shopsxD). -Copper – pricesalso fallen approx. 25% over the last year, largely due to slowing economicactivity in China. Weak Chinese demand will continue to put downward pressureon copper prices. Additionally, USD strength may also dictate market sentimentfor the year ahead. This is because a strong USD makes it more profitable forexporters to produce copper, which may lead to an oversupply. |
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Explain carefully the meaning of the termsconvenience yield and cost of carry. What is the relationship between futuresprices, spot prices, convenience yield, and cost of carry? |
Convenienceyield measures the extent towhich there are benefits obtained from ownership of the physical asset that arenot obtained by owners of long futures contracts. The cost of carry is the interest plus storage costs less the incomeearned. The futures price, , and the spot price,, are related by:Where c isthe cost of carry, y is theconvenience yield, and T is the timeto maturity of the futures contract, in years. |
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(a) Consider a6-month futures contract on brent crude oil. Assume that it costs 3% of theprice of brent crude oil to store a barrel of oil, and the payment is made atthe end of the 6 months. If the spot price is $20 and the risk-free rate is 2%,then what is the value of a 6-month crude oil futures contract? |
Formula F0= S.e^(F+C).T(years) |
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(b) The spot priceof an ounce of silver is $350, and the risk-free rate is 1.5%. If the cost ofstorage is 2.5% of the purchase price, and the lease rate of silver is 0.5%,what is the value of a 3-month futures contract? |
Formula F0= S.e^(F+C-Y).T(years) |
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What is meant by: (a) An ABS? (b) An ABS CDO? (c) A mezzaninetranche? |
(a) An ABS is a set of tranches created from a portfolio of mortgages orother assets. (b) AnABS CDO is an ABS created from particular tranches, normally the mezzanine tranche of a number of different ABS. (c) Amezzanine tranche is a tranche that is in the middle as far as the senioritygoes. It ranks below the senior tranche and therefore absorbs losses beforethey do. It ranks above the equity tranche, so receives income before they do. |
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How is an ABS CDO created? What was the motivationto create ABS CDOs? Explain why the AAA-rated tranche of an ABS CDO is riskierthan the AAA-rated tranche of an ABS. |
-Typically, an ABS CDO is created from the BBB-rated tranches of an ABS.This is because it is difficult to find investors in a direct way for theBBB-rated tranches of an ABS. -An AAA-rated ABS CDOis riskier than an AAA-rated ABS because a moderately high default rate willwipe out the tranches underlying the ABS CDO, so that even the AAA-ratedtranche of the ABS CDO is also wiped out. -However, a moderately high defaultrate will probably only at worse wipe out part of the AAA-rated tranche of anABS |
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EWMA Model |
σn^2=λσ(n-1)^2+(1-λ) μ(n-1)^2 |
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GARCH (1,1) Model |
σn^2=ω+αu(n-1)^2+βσ(n-1)^2 |
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What are the main ways of estimating volatility? Arethere any advantages and disadvantages to these models? |
-GARCH model – a very popular model which accounts for volatilityclustering and mean reversion. Additionally, parameters are obtained usingmaximum log-likelihood estimation. The main drawback is its assumption thatonly the magnitude of returns matter, whereas the direction is also likely tomatter. The GARCH (1,1) model is given by: σn^2=ω+αu(n-1)^2+βσ(n-1)^2 -Moving averagemodels – these are very simplistic and provide a reasonable proxy forvolatility. However, they do not give more weight to more recent observations. -EWMA model –this aims to solve the above problem, and places more weight on recentobservations. However, it assumes an i.i.d. process. It is given by: σn^2=λσ(n-1)^2+(1-λ) μ(n-1)^2 |
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As an investor, underwhat circumstances might you invest in volatility? Why might you avoid it?Explain. |
Investors may want to invest in volatility ifthey want to increase positive exposure to tail risk. However, investors maywant to avoid volatility so as to not open up their portfolio to unnecessaryrisk. Additionally, exposure to volatility often requires an abnormal marketevent to pay-off and make the risk-return trade-off worthwhile |
