when to use compounding or addition in target return calculation
use additive by default, excluding situation s when:
- compounding is requested
- multi-period calculation is mentioned
- path dependency is mentioned
utility adjusted return calculation. Utility =
Expected return - 0.005AStandDev^2
A = investors risk aversion score (1-10)
roy safety first =
(R.expected - Rminacceptable) / StandDevPorffolio
assets need to be specified so that
- assets in the class should be both descriptively and statistically SIMILAR
- NOT highly CORRELATED (in order to provide diversification)
- individual assets to be included JUST in 1 class
- cover the MAJORITY of all possible investable assets
- contain sufficiently large % of liquid assets
sharpe of portfolio will increase if
Sharpe of proposed investment
= Sharpe of existing portfolio
X
correlation between proposed investment and portfolio returns
asset allocation approaches
MR. B.E.A.M Mean Variance Optimisation MVO Resampled efficient fronttier Black Litterman Monte Carlo simulation Asset Liability Management Experience based 60/40, 100 less age
mean variance optimization - advantages
- software available
- optimization programs used to generate the efficient frontier
- identifies pf with the highest expected return at each level of risk and associated asset allocation
- it is typically sign constraint to prevent negative weights
- cash equivalents are modeled as if risky asset class is included
- widely understood and accepted
- easily adopted to model risk as a downside risk or tracking error, return as excess return over some minimum threshold return, constrain the deviations of asset weights vs. some relevant benchmark, model the correlation to change over time and converge during periods of stress
- the modeling of the EF can be simplified with the use of corner portfolios
mean variance optimization - limitations
- number and nature of estimates required can be overwhelming
- expected returns are subject to estimation bias
- static one period approach
- can yield underdiversified pf unless constrained
- output can be very sensitive to the inputs, so the result is unstable
resampled efficient frontier - advantages
- EF is more stable than traditional MV
- small changes in inputs produce only minor changes in SAA (strategic asset allocation)
- portfolios tend to be better diversified than traditional MVO
- commercially available software
resampled efficienc frontier - limitations
- no theoretical basis for the approach
- inputs often based on historical data
Black Litterman - advantages
- theoretically justified way to address the sensitivity of inputs problem and incorporate manager views
- typically generated more stable asset asslocation and better diversification
- can be constrained or unconstrained, though constrained is the more useful and rigurous approach
- BL (constrained) quantifies and begins with market consensus expected returns and allows the manager to systematically diverge from this starting point
- commercially available software
Black Litterman - liimitations
often the inputs are based on historical data
complicated
monte carlo simulation - advantages
- statistical analysis tool to further analyze the asset allocation output of the other approahces
- models path dependency issues
- generates statistical probabilities of meeting or not meeting return objectives
- can also model liabilities and surplus
- used to complement the other approaches
- commercially available software
monte carlo simulation - limitations
- can be complex to implement
- can generate false confidence. output is only as accurate as the inputs
asset liability management - strengths
- considers the allocation of the assets with the respect to liabilities
- can generate a surplus frontier that shows the combinations of risk and return
- otherwise similar to MVO
- commercially available software
asset liability management - limitations
same as MVO
- number and nature of estimates required can be overwhelming
- expected returns are subject to estimation bias
- static one period approach
- can yield underdiversified pf unless constrained
- output can be very sensitive to the inputs, so the result is unstable
experience based - strengths
- incorporated decades of asset allocation experience
- easy to understand and consistent with the more complex approaches
- inexpensive to implement
- useful on the exam
experience based - limitations
allocation rules may be too simple for some investors
experience based rules can be contradictory in some applied settings
sharpe function of market risk premium =
sharpe = MRP/stand dev
capital allocation line, definition
capital allocation line is the straight line drawn from the risk free rate to the tangency portfolio on the efficient frontier …
… WHERE the tangency portfolio is the corner portfolio with the HIGHEST sharpe ratio
primary goals of security portfolio of the banks
provide liquidity
manage the credit risk
manager the duration (gap management)
generate income
tactical asset allocation
short term deviations from strategical asset allocation in attempt to capitalize on capital market mispricing
strategic asset allocation combines
capital market expectations and the investors risk/return/contraints
% of return explained by tactic asset allocation
0-10% according to different studies
