Cost and problems of switching large funds
- The main problems when making large changes to the asset allocation are:
- The possibility of shifting market prices (both on sale of existing portfolio and purchase of new assets)
- The time needed to effect the change and the difficulty of making sure that the timing of deals is advantageous
- The dealing costs involved
- The possibility of the crystallisation of capital gains leading to a tax liability. These problems are particularly acute when unmarketable securities are involved, or where the normal market size for deals in the securities is small.
Advantages of using swaps instead of switching using the cash market
- Swaps should be cheaper to arrange.
- Swaps should be arranged much more quickly, whereas a physical sale and purchase could take days or weeks
- Swaps can be reversed or terminated much more quickly and cheaply, whereas the market conditions at the time of reversing the deal are unknown and could be very volatile Swaps can be arranged in large size, avoiding marketability issues.
- Swaps are unlikely to move market prices of the underlying assets.
- Swap costs will be set out clearly in terms of the size of the spread against LIBOR, whereas the costs of a physical switch will be much harder to determine and not known in advance
- No assets are bought or sold and so no tax gains are crystallised
- No assets are bought or sold and so market prices should not be affected
- Counterparty risks can be mitigated to a large extent through collateral and margin accounts
Disadvantages of using swaps to switch assets
Swaps have counterparty risk.
The profits and losses at the termination of the swap can be very large, and if the counterparty defaults then this results in a large loss.
lf the switch needs to be reverse sooner than expected, the swaps will need to be either terminated (which may be very costly) or neutralised through an equal and opposite swap portfolio.
lf the switch is maintained for longer than expected, the swaps would need to be rolled forward by undertaking new swaps with a longer maturity date.
Again this has costs and risks attached.
Swaps normally involve a collateral account which needs to be financed. lf swaps are ‘cash settled’, the counterparty may have to deal in the physical markets to hedge risk.
This could mean costs, which would be built into the swap margin and could increase the overall costs substantially.
Swaps would be based on an index, and not the actual UK and US index-linked bond portfolios. This introduces basis (cross-hedging) risk: the risk that the swap leg hedging the UK bond portfolio does not move in line with the portfolio itself. Likewise the US index may not represent the US bond portfolio that would have been bought with a physical switch.
What is the risk budgeting process
- Define a feasible set of assets
- Choose an initial asset allocation using a risk optimiser and a value at risk assessment to determine risk tolerance
- Monitor risk exposure
- Rebalance the portfolio once necessary
What are the type of portfolio risk
- Strategic risk - risk that the benchmark does not perform relative to the liabilities
- Active risk
- Structural risk - where the aggregate of the individual manager benchmark does not equal to the total benchmark for the fund
What is the primary purpose of an investment agreement
- The primary purpose of an investment management agreementis to act as a business contact between investment management manager and the investor
- It would need to describe the services to be carried out by the manager on behalf of the investor and fees associated with this
- Ideally the agreement should be structured so that the investment manager is incentivised appropriately to act in the best interest of the investors. The needs of the investor and manager should be aligned so as to avoid agency problem
Why an agreement for the active will adopt a prescriptive approach rather than giving them complete descretion
- Giving a fund manager too much control may lead to
- total portfolio bearing no resembalance to the strategic benchmark
- scheme being exposed to unwanted risk
- The prescriptive approach ensures that individual investment manager does not deviate too much from their benchmark
- So that asset allocation can be controlled on a global level
- A prescriptive approach gives the client a framework to
- measure the perfomance of a manager
- challenge asset allocaiton decisions
How can investment manager contrain the risk
- Prohibit investing in certain bonds/equities
- Ethical reasons
- limitions on the riskier assets
- Limitations on investing in highly geared assets
- Limitations on derivative
- Max range for holding a position to a single business
What are the uses of swaps
Investors
- An investor could use swaps to transform its assets to match its liabilities.
- A pension fund with mostly fixed interest investments and salary -related liabilities could enter in a RPI or LPI swap, under which it recieves payment links to RPI or LPI and makes fixed payments
- Equity swaps could be used for hedging.
- Investors with equity investments could reduce the market risk of a fall in equity values by entering into an equity swap, paying equity index returns and recieving fixed/floating.
- Likewise an investor with corporate bonds investments could reduce the credit risk by enterinng into a credit defaul swap
- Swaps could be used for speculation
- Could be used for transition management
- This is cheaper than using underlying cash markets
Risk BudgetÍng
The term risk budgeting refers to the process of establishing:
- how much investment risk should be taken
- where it is most efficient to take the risk (in order to maximise return)
What is the risk budgeting process
A feasible set
- A ‘feasible’ set of asset classes that could be included in the portfolio are first analysed.
- This should be subject to any constraints specified in the investment mandate or the investment agreement, for example whether to include hedge funds and private equity.
- This process will consider the expected returns on each asset class, and the volatilities and covariances between asset class returns. This information will generally come from past data.
Risk return optimisation
- Some risk / return optimisation process is then used to select an initial asset allocation between the asset classes. An asset liability model (ALM) would be used in this process.
- A Value at Risk (VaR) assessment will be used to determine the total risk budget - the risk tolerance in respect of the exposure to potential loss on the portfolio.
Allocating risk
The total risk budget is then allocated between:
- strategic risk
- active risk
- structural risk (if there is any).
Finally the total active risk is allocated between the various asset managers, for example active equity managers may be given more of the risk budget than active bond managers if it is considered that active returns are easier to generate in these market
Monitroing over time
It is important that the developing position of the chosen portfolio is monitored to assess the risk exposures (increases and decreases in the value of the positions) and changes in volatilities and correlations.
The portfolio will need to be rebalanced in the light of such changes, in order to keep the overall portfolio risk at the level defined as tolerable.
Three techniques to identify bond policy switches
Volatility
- Calculations of volatility or duration…
- …together with forecasts for changes in yield at different points along the yield curve can be used to estimate percentage changes in value,..
- …and so to determine the area of the market which will give the best returns.
Reinvestment rates
- ldentify the yields on two bonds of different terms to maturity.
- Compute the rate at which the proceeds of one bond would have to be reinvested…
- ..,up to maturity of the longer term bond, to match its yield.
Spot rotes ønd lorward rdtes
- Derive forward and/or spot rates from the yield curve.
- This may reveal oddities in the term structure of interest rates which give rise to a policy switch opportunity.
Approaches to minimise multinational corporatîon tax charges
- A multinational company will have earnings in different countries, which may be subject to different tax rates. The company will reduce its tax charge if it is able to move earnings to the countries with the lower tax rates.
- It might achieve this by: .
- borrowing heavily in the country with lower tax rates …
- lending this money on to its operations in the country with the higher tax rates
- … often at very high rates of interest these interest payments reduce pre-tax earnings in the country with higher tax rates increasing pre-tax earnings instead in the lower-tax environment.
- Alternatively, a company can based certain services (such as lT or administration) or assets (such as intellectual property or brand names) in a low-tax country.
- The company then provides these services / leases the assets to subsidiaries in high-tax countries. This also has the effect of reducing pre-tax profits in the high-tax country, transferring the earnings to the low-tax country.
- This process is called ‘transfer pricing’. Often the transfer price is set at artificially high rates to maximise the transfer of earnings between tax jurisdictions.
Main uses of futures
- Hedging - using futures to reduce risk on an investment portfolio.
- Speculotion - taking high-risk positions with futures with the aim of making large profits.
- Arbitrage - making profits by exploiting anomalous pricing between the financial future and the underlying investments.
- Portfolio manogement - using futures to alter the characteristics of a portfolio without disturbing the underlying assets.
Technical analysis - Factors to consider
In techinical analysis you could consider the following:
Chartisim - how the current share price cmpares to its moving average
- If the current share price is above/below its moving average, this might indicate that the share is currently over-priced/under-priced
- This can lead to a contrarian approach to investing in shares
- alternatively the charts can be used to look for momentun in the share price
- If the share price currently appears to be following a strong short term upward trrend, then it might be a good time to buy the share, in te expectation that the trend will continue
The recent streength of the share price cmpared to other similar shares i.e. relative strength analysis
- If it has a strong record fo relative out performance, which is expected to continue/falter, then it might be a good time to buy/sell the shares
- In addition, it would be worth comparing the performance of industry in general relative to the market as a whole, as the future performance of the sector is likely to influence that of each of the individual companies within the market
Setting mechicnal trading rules so that if the share price rise or falls by a certain aount they would be automatically brought or sold.
How fundamental analysis is used to decide to invest in share
The following factors to investigate are
- The future role and influence of the CEO. In particular, how dependt is the success of the compmany on the CEO, whether he will be able to “turn-around” the under performing business, and whether he is likely to remin as the CEO
- The existing management may have little or no experience of managing a this type of company
- The recent financial results of the company, and what thes suggest about the future financial perfromance of the company over the proposed period of investment
- The future revenues of the merged company
- Which will depend on the contunied demand
- Prospect Future economic prospects for their market
- Trends in competition
- Impact of future concerns e.g. climate controls
- Future costs of the business
