where/ how much risk to take specify how risk is distributed regardless of expected returns how much additional risk the investor is willing to take relative to benchmark

when to rebalances to benchmark; calendar or percentage-range based drift corridor width based on transaction costs (+) risk tolerance (+) correlation w/ porfolio (+) volatility of portfolio (-)

1. GIGO 2. concentrated AA 3. diversification 4. ignores liabilities 5. single period 6. ignores skewness/ kurtosis of returns

1. reverse opt - derive weights from expected return of global market port 2. Black-Litterman model - reverse opt adjusted for investor exp 3. add more constraints 4. resample MVO - Monte Carlo Sim; less extreme weights, includes all asset classes 5. include skewness/ kurtosis in utility function; use an asymmetric definition of risk (conditional VAR)

multi-factor regression to derive return w/ MVO use risk factors instead of asset classes corr btwn factors typically lower than corr btwn asset classes

asset liability management 1. surplus optimization (pension funds) 2. hedging/ return-seeking approach (insurance companies, overfunded pensions) \> mimics the liabilities it's funding (fully hedge = conservative) 3. integrated asset-liability approach (banks)

Asset Allocation Flashcards by Laura Wolfe

Asset Allocation Approaches

Asset-Only: manage risk/ return of assets
Liability-Relative: manage assets in relation to liabilities
Goals-Based: manage subportfolios to meet goals

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Factor Portfolio

isolate systematic risk exposure

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Risk Budgeting

where/ how much risk to take

specify how risk is distributed regardless of expected returns
how much additional risk the investor is willing to take relative to benchmark

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Rebalancing

when to rebalances to benchmark; calendar or percentage-range based

drift corridor width based on

transaction costs (+)
risk tolerance (+)
correlation w/ porfolio (+)
volatility of portfolio (-)

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Mean Variance Optimization

approach to determining AA
lowest standard deviation for a given level of expected return
constraints: budget, no non-neg weights, client constraints
find optimal weights: max utility, efficient frontier, min return, max SD

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MVO Criticisms

GIGO
concentrated AA
diversification
ignores liabilities
single period
ignores skewness/ kurtosis of returns

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MVO Improvements

reverse opt - derive weights from expected return of global market port
Black-Litterman model - reverse opt adjusted for investor exp
add more constraints
resample MVO - Monte Carlo Sim; less extreme weights, includes all asset classes
include skewness/ kurtosis in utility function; use an asymmetric definition of risk (conditional VAR)

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Utility Maximization Equation

U_m = E(r) - 0.5 * λ * Var

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Roy’s Safety First Criterion

probability of portfolio exceeing min threshold return (want highest)

SF ratio = [E(RP) - R_L]/ σ_P

R_L = min level of portfolio return

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Sharpe Ratio

excess return per unit of risk (want highest)

( R_m- R_f )/ σ_m

ERP_m / σ_m

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Illiquid Assets and MVO

calc MVO w/o illiquid assets classes, include in portfolio w/ set specific allocations for illiquid assets
calc MVO w/ illiquid assets
calc MVO w/ illiquid asset classes, include in portfolio w/ alt inv indexes

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Incorporating Client Risk Pref in AA

specifying additional constraints
specifying a risk aversion factor for the investor
monte carlo simulation

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Factor-Based AA

multi-factor regression to derive return w/ MVO

use risk factors instead of asset classes
corr btwn factors typically lower than corr btwn asset classes

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Contribution to Total Risk

MCTR (marginal): β_ac*σ_p

ACTR (abs): w*MCTR

opt allocation: excess return/ MCTR for each asset class = portfolio Sharpe Ratio

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ALM

asset liability management

surplus optimization (pension funds)
hedging/ return-seeking approach (insurance companies, overfunded pensions) > mimics the liabilities it’s funding (fully hedge = conservative)
integrated asset-liability approach (banks)

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Strategic AA

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reflects desired systematic risk exp
set target weights for portfolio
longer-term capital market expectations to inc portfolio value

Tactical AA

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use perceived short-term opportunities in the market to inc portfolio value; inc risk

discretionary vs systematic (value or momentum)

TAA Performance Evaluation

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compare Sharpe Ratio to SAA
compare realized risk/ return to SAA efficient frontier
calc info ratio/ t-stat of excess returns relative to SAA
attribution analysis to determine excess return

Mark to Market

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PV of any g/l that would be realized if the forward contract was closed early w/ an offsetting contract position

Value = (g or l)/ ( 1 + LIBOR^n-t)

Put Option

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right to sell the underlying sec if P < X

gains value delta closer to -1, loses value delta closer to 0

Call Option

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right to buy the underlying sec if X < P

gains value delta closer to 1, loses value delta closer to 0

Domestic Currency Return

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R_DC = R_FC + R_FX + R_FC*R_FX

R_DC = ( EV - BV )/ BV

Domestic Currency Risk

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σ²_RC = σ²_RC + σ²_RF + 2σ_RCσ_RFρ_(RFC,RFX)

corr = pos = inc volatility of returns

coor = neg = dec volatility of returns

Currency Management Strategies

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passive hedging: benchmark
discretionary hedging: benchmark w/ slight deviation
active curr management: greater deviation from benchmark
currency overlay: seperate manager for currency

Influences on Whether to Fully Hedge Currency Position

1. time horizon 2. risk aversion 3. liquidity needs 4. FX bond exposure 5. hedging costs 6. opportunity costs

Economic Fundamentals

assumes LT currency value will converge w/ fair value inc value of currency 1. undervalued relative to FV 2. inc in FV 3. higher real or nom int rates 4. lower inflation 5. dec risk premium

Technical Analysis

1. past price data can predict future 2. patterns repeat: overbought/ sold reverse, support/ resistance levels, moving avg 3. don't need to know value of currency, just where it will trade

Carry Trade

borrow lower int rate currency (developed), invest proceeds in higher int rate currency (developing) RISK: higher int rate durrency depreciates by more than the diff in spot rates

Covered Interest Rate Parity

F = S ( 1 + i_p)/ ( 1 + i_b)

Volatility Trading

profit from changes in volatility expect inc volatility: long straddle (call, put in the money), long strangle (call, put out of the money)

Vega

change in value of option b/c change in volatility of underlying inc volatility = inc value of options = inc price

Roll Yield

roll yield = hedged curr return = F/S - 1 hedge = locks in forward price * S \> F; i_B \< i_P: long B = pos roll yield \> yes hedge * S \< F; i_B \> i_P: long B = neg roll yield \> no hedge

Hedging

* dynamic - change hege to cover additional exp * depens on trans costs, risk aversion * discretionary - imperfect hedge uj * hedge long curr exp = sell forward

Hedging Types

1. cross hedge: hedge w/ proxy deriv (not perfectly corr) 2. macro hedge: hedge portfolio w/ deriv based on basket of curr 3. MVHR: min var hedge ratio: reg to find % to hedge, min volatility of R_DC

Asset Allocation Flashcards

(34 cards)