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Capital Market Expectations, Part 1: Framework and Macro

Considerations

Q. Setting capital market expectations?

 Specify the set of expectations needed, including the time horizon(s) to

which they apply.
 Research the historical record.
 Specify the method(s) and/or model(s) to be used and their information
requirements.
 Determine the best sources for information needs.
 Interpret the current investment environment using the selected data
and methods, applying experience and judgment.
 Provide the set of expectations needed, documenting conclusions.
 Monitor actual outcomes and compare them with expectations,
providing feedback to improve the expectation-setting process.

Anchoring: give disproportionate weight to the first information received,

which is then adjusted. Avoid by consciously attempting to avoid premature
conclusions.

Confirmation: tendency to seek and overweight evidence or information

that confirms one’s existing or preferred beliefs and to discount evidence
that contradicts those beliefs. all evidence with equal rigor and/or debating
with a knowledgeable person capable of arguing against one’s own views.

Overconfidence: unwarranted confidence in one’s own intuitive reasoning,

judgment, knowledge, and/or ability. analyst to overestimate the accuracy of
her forecasts and/or fail to consider a sufficiently broad range of possible
outcomes or scenarios.

Prudence bias reflects the tendency to temper forecasts so that they do

not appear extreme or the tendency to be overly cautious in forecasting.

Availability bias is the tendency to be overly influenced by events that

have left a strong impression and/or for which it is easy to recall. mitigated
by attempting to base conclusions on objective evidence and analytical
procedures.

Status quo bias: most recent data weighted more heavily, can be mitigated
by a disciplined effort to avoid anchoring on the status quo.
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Data-mining: repeatedly searching a data set until a statistically significant

pattern emerges, statistical relationship cannot be expected to have
predictive value and are unreliable, should scrutinize the variables selected
and provide an economic rationale for each variable selected in the
forecasting model.

Risk of regime change: extend the data series back increases the risk of
the data representing more than one regime, is a shift in the technological,
political, legal, economic, or regulatory environments, alters the risk–return
relationship since the asset’s risk and return characteristics vary with
economic and market environments. Analysts can apply statistical
techniques that account for the regime change or simply use only part of the
whole data series.

Misinterpretation of correlation: high correlation between nominal GDP

and equity returns implies nominal GDP predicts equity returns, high
correlation does not imply causation. In this case, nominal GDP could predict
equity returns, equity returns could predict nominal GDP, a third variable
could predict both, or the relationship could merely be spurious. correlation
relationships should not be used in a predictive model without understanding
the underlying linkages between the variables.

Impact of following in late expansion:

Bond yields: In the late expansion phase of the business cycle, bond yields
are usually rising but more slowly than short-term interest rates are, so the
yield curve flattens. Private sector borrowing puts upward pressure on rates
while fiscal balances typically improve.

Equity returns: In the late expansion phase of the business cycle, stocks
typically rise but are subject to high volatility as investors become nervous
about the restrictive monetary policy and signs of a looming economic
slowdown. Cyclical assets may underperform while inflation hedges, such as
commodities, outperform.

Short-term interest rates: In the late expansion phase of the business

cycle, short-term interest rates are typically rising as monetary policy
becomes restrictive because the economy is increasingly in danger of
overheating. The central bank may aim for a soft landing.
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Economic Models:

Strengths - quite robust and can examine impact of many potential

variables, New data may be collected and consistently used within models to
quickly generate output, useful for simulating effects of changes in
exogenous variables, Imposes discipline and consistency on the forecaster
and challenges modeler to reassess prior view based on model results.

Weakness - complex and time consuming to formulate, Requires future

forecasts for the exogenous variables, which increases the estimation error
for the model. Models may be mis-specified or variable relationship may
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change over time. give false sense of precision, perform badly at forecasting
turning points.

Impact of lower inflation or disinflation:

Cash: The fund benefits from its cyclically low holdings of cash. With the
economy contracting and inflation falling, short-term rates will likely be in a
sharp decline. Cash, or short-term interest-bearing instruments, is
unattractive in such an environment. However, deflation may make cash
particularly attractive if a “zero lower bound” is binding on the nominal
interest rate. Otherwise, deflation is simply a component of the required
short-term real rate.

Bonds: The fund’s holdings of high-quality bonds will benefit from falling
inflation or deflation. Falling inflation results in capital gains as the expected
inflation component of bond yields falls. Persistent deflation benefits the
highest-quality bonds because it increases the purchasing power of their
cash flows. It will, however, impair the creditworthiness of lower-quality debt.

Equities: The fund’s holdings of asset-intensive and commodity-producing

firms will be negatively affected by falling inflation or deflation. Within the
equity market, higher inflation benefits firms with the ability to pass along
rising costs. In contrast, falling inflation or deflation is especially detrimental
for asset-intensive and commodity-producing firms unable to pass along the
price increases.

Real Estate: The fund’s real estate holdings will be negatively affected by
falling inflation or deflation. Falling inflation or deflation will put downward
pressure on expected rental income and property values. Especially
negatively affected will be sub-prime properties that may have to cut rents
sharply to avoid rising vacancies.
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Contraction, easy monetory policy & increasing fiscal deficit

financed with bonds at different maturity – impact on yield curve:

Monetary policy: The impact of changes in monetary policy on the yield

curve are fairly clear as flattening or steepening largely determined by ST
rates. Contraction & easy policy will result into ST rates declining sharply
while bond yields declining but at a slower pace, resulting into yield curve
steepening, will continue to steepen and will be steepest just before initial
recovery.
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Fiscal: unclear due to supply of bonds at various maturity, sufficiently large

purchases/sales at different maturities will have only a temporary impact on
yields as fall in private sector borrowing during contraction to somewhat
offset increase in the supply of government securities.

Capital Market Expectations, Part 2: Forecasting Asset Class Returns

Main issues that arise when conducting historical analysis of real

estate returns?

Properties trade infrequently and valuation is based on appraisal data.

Secondly each property is different, it is said to be heterogenous. returns
calculated from appraisals represent weighted averages of unobservable
returns. Published return series is too smooth and the sample volatility
understates the true volatility of returns. It also distorts estimates of
correlations.

Key considerations in forecasting exchange rates under two

approaches - trade in goods and services & capital flows?

Trade in goods & services

focus on flows of export and imports to establish what the net trade flows are
and how large they are relative to the economy and other, potentially larger
financing and investment flows. also considers differences between domestic
and foreign inflation rates that relate to the concept of purchasing power
parity. Under PPP, the expected percentage change in the exchange rate
should equal the difference between inflation rates. The approach also
considers the sustainability of current account imbalances, reflecting the
difference between national saving and investment.

Capital flows

focuses on capital flows and the degree of capital mobility, it assumes that
capital seeks the highest risk-adjusted return. The expected changes in the
exchange rate will reflect the differences in the respective countries’ assets’
characteristics such as relative short-term interest rates, term, credit, equity
and liquidity premiums., it also considers hot money flows.
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Assessing Health of an Emerging Market

 Guidelines for bond investors to consider:

 Deficit-to-GDP ratio should be less than 4%; debt-to-GDP ratio should
be less than 70%.
 Real growth rate should be at least 4%.
 Current account deficit should be less than 4% of GDP.
 Foreign debt levels should be less than 50% of GDP; debt levels should
be less than
 200% of the current account receipts.
 Foreign exchange reserves should be at least 100% of short-term debt.

Expected real estate return:

E(Rre) = cap rate + NOI growth rate − %Δcap rate

Forecasting Volatility

Sample VCV Matrix: simplest form that uses sample historical data to
estimate constant variance & covariance; asset classes cannot be more than
historical observation (# of obs should be 10 times # of assets); method
subject to sampling error; since each element is estimated without regards to
any other element, it does not address issue of imposing cross-sectional
consistency; consistent & unbaised

VCV Matrices from Multi-Factor models: simpler than vcv; impose

structure on VCV matrix of asset returns; advantage - # of assets can exceed
no of obs as covariances are fully determined by exposure to small number
of common factors; well specified model improves cross-sectional
consistency; reduce estimation error as reduced number of parameters to be
estimated. Problems; will be mis-specified most of the time; structure
imposed may not be right & thus model may be biased; matrix is not correct
on average; inconsistent.

Shrinkage Est – combine sample VCV with alternative estimate (target VCV
Matrix) i.e assumed prior knowledge of true VCV – mitigate sampling error; it
increase (or at least not decrease) efficiency of the est; biased.
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Asset Allocation with Real-World Constraints

A change in constraints relates to material changes in constraints, such as

time horizon, liquidity needs, asset size, and regulatory or other external
constraints.

A change in an investor’s personal circumstances that may alter her risk

appetite or risk capacity is considered to be a change in goals.

A change in the investment beliefs or principles guiding an investor’s

investment activities is considered to be a change in beliefs.

Effective investment governance models do the following:

 Establish long-term and short-term investment objectives.

 Allocate rights and responsibilities within the governance structure.
 Specify processes for creating an investment policy statement (IPS).
 Specify processes for creating a strategic asset allocation.
 Apply a reporting framework to monitor the investment program’s
stated goals and
objectives.
 Periodically perform a governance audit.

Asset only Asset Allocation & MVO

MVO: most common approach to develop & set asset allocation policy; Mean–variance
optimization provides us with a framework for determining how much to allocate to each
asset in order to maximize the expected return of the portfolio for an expected level of
risk. Three sets of inputs are: expected returns, risk (SD) & correlations.
Um = E(Rm) − 0.005λσ2m
MCS: Monte Carlo simulation complements MVO by addressing the limitations of MVO
as a single-period framework. Monte Carlo simulation can help paint a realistic picture
of potential future outcomes, including the likelihood of meeting various goals, the
distribution of the portfolio’s expected value through time, and potential maximum
drawdowns. Simulation also provides a tool for investigating the effects of
trading/rebalancing costs and taxes and the interaction of evolving financial markets
with asset allocation.
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Criticism of MVO:
1. The outputs (asset allocations) are highly sensitive to small changes in the
inputs.
2. The asset allocations tend to be highly concentrated in a subset of the available
asset classes.
3. Many investors are concerned about more than the mean and variance of
returns, the focus of MVO.
4. Although the asset allocations may appear diversified across assets, the sources
of risk may not be diversified.
5. Most portfolios exist to pay for a liability or consumption series, and MVO
allocations are not directly connected to what influences the value of the liability
or the consumption series.
6. MVO is a single-period framework that does not take account of
trading/rebalancing costs and taxes.

Reverse Optimization:
Works oppositve to optimizer; Reverse optimization takes as its inputs a set of asset
allocation weights that are assumed to be optimal and, with the additional inputs of
covariances and the risk aversion coefficient, solves for expected returns. most
common set of starting weights is the observed market-capitalization value of the assets
or asset classes that form the opportunity set (World Market Portfolio).

Black-Litterman Model: Complements reverse optimization; Black–Litterman model

starts with excess returns (in excess of the risk-free rate) produced from reverse
optimization and then provides a technique for altering reverse-optimized expected
returns in such a way that they reflect an investor’s own distinctive views yet still behave
well in an optimizer; lead to well-diversified asset allocations by improving the
consistency between each asset class’s expected return and its contribution to
systematic risk.

Resampled MVO; combine MVO with MCS; more diversification; large number of
potential capital market assumption for MVO; resampling is a large-scale sensitivity
analysis in which hundreds or perhaps thousands of variations on baseline capital
market assumptions lead to an equal number of mean–variance optimization frontiers
based on the Monte Carlo–generated capital market assumptions.
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Risk Budgeting
Marginal risk – rate at which the risk changes due to small change in asset weight
MCTR – Asset beta wrt portfolio X SD of Portfolio.
Absolute risk – how much an asset class contributes to the portfolio risk
ACTR = Asset weight X MCTR

Impact of taxes is insignificant for low risk & very high risk asset allocation; taxes impact
is significant for medium risk asset allocation.

Options

Why covered call:

Yield enhancement: earn premium (cash) by writing call option on stock

that u hold & expected limited upside movement.

Reducing position at fav price: write call option at fav price & earn a
premium too for eg stock is at 16 write option of 15 & premium of 1.44; earn
16.44 if stock remains above 15.

Target Price Realisation: Write calls near target price,

Cash-Secured Put: If someone writes a put option and simultaneously

deposits an amount of money equal to the exercise price into a designated
account, it is called writing a cash-secured put. This strategy is appropriate
for someone who is bullish on a stock or who wants to acquire shares at a
particular price.

Spreads:
Two options differ by exercise price; both calls or both puts on same underlying

Bull Spread:
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Becomes valuable when price rises; buy lower price option & sell higher price option;
involves initial cash outflow (debit spread)- lower call option is expensive than higher
option
Bear Spread:
Becomes valuable when prices fall; buy higher & sell lower; involves initial cash outflow
(debit spread) – higher put option is expensive than lower put option.

Calendar spread:
Same option; buy and sell at different exercise date with same strike price. long
calendar spread—wherein the shorter-maturity option is sold and the longer-maturity
option is purchased
Volatility Smile: When the implied volatilities priced into both OTM puts and calls trade
at a premium to implied volatilities of ATM.

Volatility Skew: implied volatility increases for OTM puts and decreases for OTM calls,
as the strike price moves away from the current price; investors have generally less
interest in OTM calls whereas OTM put options have found universal demand as
portfolio insurance against a market sell-off.

Risk-reversal Strategy: when a trader thinks that the put implied volatility is too high
relative to the call implied volatility, she creates a long risk reversal, by selling the OTM
put and buying the same expiration OTM call. The options position is then delta-hedged
by selling the underlying asset.

the term structure of volatility, which is often in contango, meaning that the implied
volatilities for longer-term options are higher than for near-term ones. When markets are
in stress and de-risking sentiment prevails, however, market participants demand short-
term options, pushing up their prices and causing the term structure of volatility to invert.

Combinations:
Uses both calls & puts (Straddle); different option same underlying
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Straddle:
Zero delta strategy – buy call & buy put or sell call & sell put; If the price increases
(decreases) significantly, the delta of the call will approach +1 (0), and the put delta will
approach 0 (−1), making the delta of the position approximately +1 (−1).

Collar:
Long stock + put at lower price + write call at higher price; provides downside protection
but reduce cash outlay if price goes above call option price; helps offset full or some
premium; profit loss limited to option position.

Explain how to construct the swap that Tioga wants to use with regard to the
swap:
1. The swap tenor will be three years, consistent with the length of time for which
Tioga expects interest rates to remain low.
2. Tioga will establish an interest rate swap in which Wyalusing will make payments
based on a floating reference rate and will receive payments based on a fixed
rate. The source of the reference rate and the value of the fixed rate will be set at
the time of the swap’s inception. The net effect for Wyalusing of the combination
of making fixed payments on its coupon bond, receiving fixed payments on the
swap, and making floating payments on the swap is to convert the fixed
obligations of its bond coupon payments into floating-rate-based obligations. This
scenario will allow Wyalusing to benefit if Tioga’s expectation of low interest rates
is realized.
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3. The notional value of the swap should be set such that the fixed payments that
Wyalusing receives will equal the fixed coupon payments that Wyalusing must
make on its fixed-rate bond obligations.
4. Swap settlement dates should be set on the same days as the fixed-rate bond’s
coupon payment dates.

When u encounter choosing CTDof the two options

Decide based on bond purchase value – Settlement price

Settlement price is Future settlement price / 100 * CF * $100000.

Cost of 100% hedging:

 Trading requires dealing on the bid/offer spread offered by dealers. Maintaining a
100% hedge will require frequent rebalancing & could prove to be expensive &
reduce the hedge benefits.
 A long position in currency options involves an upfront payment. If the options
expire out-of-the-money, this is an unrecoverable cost.
 Forward contracts have maturity & need to be rolled forward with an FX swap
transaction to maintain the hedge. Rolling hedges typically generate cash inflows
and outflows, based on movements in the spot rate as well as roll yield.
 Hedging requires maintaining the necessary administrative infrastructure for
trading (personnel and technology systems). These overhead costs can become
a significant portion of the overall costs of currency trading.

Technical analysis: Market technicians believe that in a liquid, freely-traded market the
historical price data already incorporates all relevant information on future price
movements. Technicians believe that it is not necessary to look outside the market at
data like the current account deficit, inflation and interest rates because current
exchange rates already reflect the market consensus view on how these factors will
affect future exchange rates.

Fundamental analysis: This approach assumes that, in free markets, exchange rates
are determined by logical economic relationships that can be modeled. A fundamentals-
based approach estimates the “fair value” of the currency, with the expectation that
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observed spot rates will converge to long-run equilibrium values described by parity
conditions.

When can you include currency overlay in SAA?

By introducing foreign currencies as a separate asset class, the more currency overlay
is expected to generate alpha that is uncorrelated with the other programs in the
portfolio, the more likely it is to be allowed in terms of strategic portfolio positioning.

Developed vs Emerging Return Distribution:

Emerging market currency trades are subject to relatively frequent extreme events and
market stresses. Thus, return probability distributions for emerging market investments
exhibit fatter tails than the normal distributions that are customarily used to evaluate
developed market investment performance. Additionally, emerging market return
probability distributions also have a pronounced negative skew when compared with
developed market (normal) distributions.
Given these differences, risk management and control tools (such as VAR) that depend
on normal distributions can be misleading under extreme market conditions and greatly
understate the risks to which the portfolio is exposed. Likewise, many investment
performance measures used to evaluate performance are also based on the normal
distribution. As a result, historical performance evaluated by such measures as the
Sharpe ratio can look very attractive when market conditions are stable, but this
apparent outperformance can disappear into deep losses faster than most investors can
react.
Short-term stability in emerging markets can give investors a false sense of
overconfidence and thereby encourage over-positioning based on the illusion of
normally distributed returns. Thus, CCM should not assume a normal distribution for its
“model” emerging market portfolio. CCM should assume a fatter-tailed, negatively
skewed return probability distribution better reflecting the risk exposure to extreme
events.

Over-hedging / under-hedging: When you have a long position in base currency &
you want to hedge by selling base currency - Over hedge when you expect base
currency to depreciate & vice versa
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Minimum Variance Hedge Ratio

Fixed Income

Effective duration: price sensitivity to parallel changes in the benchmark yield curve;
Essential for complex bonds (uncertain cash flow) interest rate risk.
Key rate duration: price sensitivity to changes in the benchmark yield curve at specific
maturity; Identifying shaping risk (steepening / flattening)
Empirical duration: interest rate sensitivity that is determined from market data using
regression.
Money duration: A measure of the price change in units of the currency in which the
bond is denominated. Money duration can be stated per 100 of par value
PVBP: An estimate of the change in a bond’s price given a 1 bp change in yield to
maturity.
Convexity: second order effect of large changes in the yield curve; extent to which the
yield/price relationship deviates from a linear relationship. Higher convexity = higher
return when interest rate changes; higher convexity means YTM is low.
Effective convexity: second order effect of large changes in the benchmark yield curve.

Immunize single liab:

1. Market value of asset => PV of liab
2. Macualay dur = horizon of investment
3. Convexity should be lower.
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Immunize multiple liab:

1. MV of assets >= PV of liab
2. Match money duration in particular BPV of asset & liab should closely match
3. Convexity of the asset should lower among the options but be greater than
convexity of liab

Yield Curve Strategies:

When view is of static upward sloping curve:

Dynamic yield curve:

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Divergent Yield Curve Strategy

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Equities

Pitfalls in Quantitative Investing

Quantitative investing involves the following pitfalls:
Survivorship bias. If backtests are only applied to existing companies, then they will
overlook companies that have failed in the past, and this will make the strategy look
better than it actually is.
Look-ahead bias. Results from using information in the model to give trading signals
at a time when the information was not available, e.g., using December financial
accounting data to generate trading signals for the following January.
Data-mining/overfitting. Excessive search analysis of past financial data to find data
that shows a strategy working.
Turnover. Constraints on turnover may constrain the manager’s ability to follow a
strategy.
Lack of availability of stock to borrow. For short selling, this may also constrain a
manager’s ability to follow a strategy.
Transaction costs. This can quickly erode the returns of a strategy that looked good
in backtesting.
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Pearson IC: simple correlation coefficient between the factor scores (essentially
standardized exposures) for the current period’s and the next period’s stock returns. As
it is a correlation coefficient, its value is always between –1 and +1 (or, expressed in
percentage terms, between –100% and +100%). any factor with an average monthly IC
of 5%–6% is considered very strong. Problem: Sensitive to outliers.

Spearman IC Rank: A similar but more robust measure; Spearman rank IC is essentially
the Pearson correlation coefficient between the ranked factor scores and ranked
forward returns.

Active Share vs Active Risk

 High net exposure to a risk factor leads to high level of active risk.
 A portfolio with no net factor exposure will have active risk attributed entirely to
active share.
 Active risk attributable to active share is inversely proportional to the number of
securities in the portfolio.
 Active risk increases as factor and idiosyncratic risk levels increase.
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Hedge Funds

Long/Short:
Add little alpha through factor bet but sec selection; accounts for 30% of all hedge
funds; manager skill; typicaly hold net long position; 40%–60% net long (70%–90%
long, vs. 20%–50% short); returns similar to long only but lower SD; Liquid; short reduce
beta; potential alpha with reduced risk; Leverage – variable (more market neutral more
leverage).

Dedicated Short:
60-120% short; may moderate short beta by holding cash or long position in value
stocks or index; 30-60% net short; more volatile than L/S; liquid, negatively corelated
alpha to other strategies; returns have been limpy & generally disappointing; Leverage
is low;

Equity Neutral:
Net zero exposure to market; long and short position in similar or related sec; ex. Pair
trading; stub trading – buying undervalued subs & selling over valued holding;
Multiclass; sec selection main skill; significant leverage; relatively modest return; high
diversification, liquidity & lower SD; mean reversion & short duration;
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Event Driven:
Soft Catalyst – anticipation of an event; Hard catalyst – investment made in reaction to
already announced event.
Merger Arbitrage: selling insurance on acq; if acq succeed manager collect the spread
or else significant losses occur; pay off – riskless bond & short position; rel liquid
strategy; high sharpe ratio; low double digit return & single digit SD; left tail risk;
moderate to high leverage; 3 to 5 times; 5
Distressed Sec: special skill & monitoring needed; illiquid; high return high vol; returns
lumpy & cyclical; leverage – moderate to low; 1.2 to 1.7x

Rel value
FI Arbitrage: buy rel undervalued and sell overvalued bond; high leverage;

Convertible arbitrage:
Straight debt + Long Eq Option
Exercise Price = Strike price x Conversion Ratio
Conversion ratio = no of shares bonds can be exchanged
Bond Conversion value = current share price x conversion ratio
Conversion price = current bond price divided by conversion ratio
Straight bond if conversion value below bond price or share price below conversion
price.
Buy undervalued convertible & short stock;
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Opportunistic
Global Macro: exploit market trend opportunity; focus on certain theme; invest early
before the trend reversal; use a wide variety of instruments and markets; use
fundamental & technical; use leverage via derivatives; mean reverting low vol is a bane
to the strategy;
Managed Futures: use Eq & bonds futures; return profile is cyclical; highly liquid;
crowding and slippage due to increase in AUM; more systematic vs more dis of global
macro; right tail skweness during market stress; more vol; high leverage;

Specialist
Vol trading: Vix liquidity is high;
Reinsurance:

Multi-Manager:
FoF: aggregate investors’ capital and allocate it to a portfolio of separate, individual
hedge funds following different, less correlated strategies; provides diversification;
provides liquidity; double layer of fees; lack of transparency into individual hedge fund
processes & return; inability to net performance fees on individual managers; additional
principal agent relationship; less extreme risk exposure; lower vol; less single manager
tail risk;
Multi-strategy: combine multiple hedge fund strategies under the same hedge fund
structure; reallocate capital into different strategy areas more quickly and efficiently than
would be possible by the FoF manager; full transparency into individual strategy; lower
mgmt. fees vs FoF; ability to net performance fees; general partner absorbs netting risk;
quite levered; operational risk not well diversified; require pool of in-house manager
talent 7 skills; has outperformed FoF but with more variance 7 occasional large losses
(high leverage);

Dedicated short bias: Equity hedge fund strategies focus primarily on the equity
markets, and the majority of their risk profiles contain equity-oriented risk. Dedicated
short bias managers look for possible short selling targets among companies that are
overvalued, that are experiencing declining revenues and/or earnings, or that have
internal management conflicts, weak corporate governance, or even potential
accounting frauds.
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Equity Market Neutral: EMN managers are more useful for portfolio allocation during
periods of non-trending or declining markets. EMN hedge fund strategies take opposite
(long and short) positions in similar or related equities having divergent valuations while
attempting to maintain a near net zero portfolio exposure to the market. EMN managers
neutralize market risk by constructing their portfolios such that the expected portfolio
beta is approximately equal to zero. Moreover, EMN managers often choose to set the
betas for sectors or industries as well as for common risk factors (e.g., market size,
price-to-earnings ratio, and book-to-market ratio) equal to zero. Since these portfolios
do not take beta risk and attempt to neutralize many other factor risks, they typically
must apply leverage to the long and short positions to achieve a meaningful return
profile from their individual stock selections.
EMN strategies typically deliver return profiles that are steadier and less volatile than
those of many other hedge strategy areas. Over time, their conservative and
constrained approach typically results in a less dynamic overall return profile than those
of managers who accept beta exposure. Despite the use of substantial leverage and
because of their more standard and overall steady risk/return profiles, equity market-
neutral managers are often a preferred replacement for fixed-income managers during
periods when fixed-income returns are unattractively low.
Merger arbitrage: Event-driven hedge fund strategies focus on corporate events, such
as governance events, mergers and acquisitions, bankruptcy, and other key events for
corporations. Merger arbitrage involves simultaneously purchasing and selling the
stocks of two merging companies to create “riskless” profits.
Convertible bond arbitrage: Relative value hedge fund strategies focus on the relative
valuation between two or more securities. Relative value strategies are often exposed to
credit and liquidity risks because the valuation differences from which these strategies
seek to benefit are often due to differences in credit quality and/or liquidity across
different securities. A classic convertible bond arbitrage strategy is to buy the relatively
undervalued convertible bond and take a short position in the relatively overvalued
underlying stock. In a convertible bond arbitrage strategy, the manager strives to extract
“cheap” implied volatility by buying the relatively undervalued convertible bond and
taking a short position in the relatively overvalued common stock.
Global macro: Opportunistic hedge fund strategies take a top-down approach, focus
on a multi-asset opportunity set, and include global macro strategies. Global macro
managers use both fundamental and technical analysis to value markets, and they use
discretionary and systematic modes of implementation. The key source of returns in
global macro strategies revolves around correctly discerning and capitalizing on trends
in global markets.
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Conditional Linear factor model

A linear factor model can provide insights into the intrinsic characteristics and risks in a
hedge fund investment. Since hedge fund strategies are dynamic, a conditional model
allows for the analysis in a specific market environment to determine whether hedge
fund strategies are exposed to certain risks under abnormal market conditions. A
conditional model can show whether hedge fund risk exposures to equities that are
insignificant during calm periods become significant during turbulent market periods.
During normal periods when equities are rising, the desired exposure to equities (S&P
500 Index) should be long (positive) to benefit from higher expected returns. However,
during crisis periods when equities are falling sharply, the desired exposure to equities
should be short (negative).

Circumstances affecting Convertible Arbitrage Strategy?

Short selling: Since Hedge Fund 1 employs a convertible arbitrage strategy, the fund
buys the convertible bond and takes a short position in the underlying security. When
short selling, shares must be located and borrowed; as a result, the stock owner may
want his/her shares returned at a potentially inopportune time, such as during stock
price run-ups or when supply for the stock is low or demand for the stock is high. This
situation, particularly a short squeeze, can lead to substantial losses and a suddenly
unbalanced exposure if borrowing the underlying equity shares becomes too difficult or
too costly for the arbitrageur.
Credit issues: Credit issues may complicate valuation since bonds have exposure to
credit risk. When credit spreads widen or narrow, there would be a mismatch in the
values of the stock and convertible bond positions that the convertible manager may or
may not have attempted to hedge away.
Time decay of call option: The convertible bond arbitrage strategy can lose money
due to time decay of the convertible bond’s embedded call option during periods of
reduced realized equity volatility and/or due to a general compression of market implied
volatility levels.
Extreme market volatility: Convertible arbitrage strategies have performed best when
convertible issuance is high (implying a wider choice among convertible securities as
well as downward price pressure and cheaper prices), general market volatility levels
are moderate, and the liquidity to trade and adjust positions is sufficient. Extreme
market volatility typically implies heightened credit risks. Convertibles are naturally less-
liquid securities, so convertible managers generally do not fare well during such periods.
Because hedge funds have become the natural market makers for convertibles and
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typically face significant redemption pressures from investors during crises, the strategy
may have further unattractive left-tail risk attributes during periods of market stress.

Path for implementing relative value volatility arbitrage?

One path is through simple exchange-traded options. The maturity of such options
typically extends to no more than two years. In terms of expiry, the longer-dated options
will have more absolute exposure to volatility levels than shorter-dated options, but the
shorter-dated options will exhibit more delta sensitivity to price changes.
A second, similar path is to implement the volatility trading strategy using OTC options.
In this case, the tenor and strike prices of the options can be customized. The tenor of
expiry dates can then be extended beyond what is available with exchange-traded
options.
A third path is to use VIX futures or options on VIX futures as a way to more explicitly
express a pure volatility view without the need for constant delta hedging of an equity
put or call for isolating the volatility exposure.
A fourth path for implementing a volatility trading strategy would be to purchase an OTC
volatility swap or a variance swap from a creditworthy counterparty. A volatility swap is a
forward contract on future realized price volatility. Similarly, a variance swap is a forward
contract on future realized price variance, where variance is the square of volatility. Both
volatility and variance swaps provide “pure” exposure to volatility alone, unlike
standardized options in which the volatility exposure depends on the price of the
underlying asset and must be isolated and extracted via delta hedging.

Multi vs FOF
Multi-strategy manager reallocate capital into different strategy areas more quickly and
efficiently than would be possible by a fund-of-funds (FoF) manager. The multi-strategy
manager has full transparency and a better picture of the interactions of the different
teams’ portfolio risks than would ever be possible for FoF managers to achieve.
Consequently, the multi-strategy manager can react faster to different real-time market
impacts—for example, by rapidly increasing or decreasing leverage within different
strategies depending upon the perceived riskiness of available opportunities.
The fees paid by investors in a multi-strategy fund can be structured in a number of
ways, some of which can be very attractive when compared to the FoFs’ added fee
layering and netting risk attributes. Conceptually, FoF investors always face netting risk,
whereby they are responsible for paying performance fees due to winning underlying
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funds while suffering return drag from the performance of losing underlying funds. Even
if the FoF’s overall performance is flat or down, FoF investors must still pay incentive
fees due to the managers of winning funds.

Distinguishing Features Between Hedge Funds and Traditional Investments

 Lower regulatory and legal constraints.
 Flexibility to use short selling and derivatives.
 A larger investment universe.
 Aggressive investment exposures.
 Comparatively free use of leverage.
 Liquidity constraints for investors.
 Lack of transparency.
 Higher cost structures.

Alternatives

Real Assets like timber: low correlation with public equities and can fulfill the
functional role of risk diversification. provides high long-term returns and can
fulfill the functional role of capital growth since growth is provided by the
underlying biological growth of the tree (Timber) as well as through
appreciation in the underlying land value.

Qualitative Risk

 Pua’s investment has been affected by key person risk as shown by the
effect of the management change.
 Style drift has occurred as shown by the change from a local to a
regional investment strategy and the expansion of the investment
strategy to include commercial properties.
 The risk of the investment has changed owing to the added complexity
of the property renovations.
 The longer holding periods and the change in interim profit distribution
targets will affect this investment.
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 Client/asset turnover following the management change may now

affect the performance of the investment.
 The management change may alter the client profile, which could have
a negative effect on investment performance.

Traditional better than Risk based

 The traditional approach is more appropriate since describing the roles

of various asset classes is intuitive.

 This approach will be easier for Ng to explain to the IC, whose

members have only a basic understanding of the investment process.

 This approach will make it easier to identify relevant mandates for the
portfolio’s alternative investments.

 Since Ælfheah seeks to maintain low overhead costs, the risk-based

approach would not be appropriate. easier to implement, and the IC
does not want to add costly in-house resources, which would likely be
necessary with the risk-based approach.

CVAR vs MVO

 Mean–CVaR will better address the IC’s concern about left-tail risk (the
risk of a permanent capital loss).

 If the portfolio contains asset classes and investment strategies with

negative skewness and long tails, CVaR optimization could materially
alter the asset allocation decision.

asset allocation decision will be enhanced by the more detailed

understanding of left-tail risk offered by mean–CVaR optimization relative to
MVO. MVO cannot easily accommodate the characteristics of most
alternative investments. MVO characterizes an asset’s risk using standard
deviation. Standard deviation, a one-dimensional view of risk, is a poor
representation of the risk characteristics of alternative investments for which
asset returns may be not normally distributed. MVO typically over-allocates
to alternative asset classes, partly because risk is underestimated because of
stale or infrequent pricing and the underlying assumption that returns are
normally distributed.
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An investor particularly concerned with the downside risk of a proposed asset

allocation may choose to minimize the portfolio’s CVaR rather than its
volatility relative to a return target. If the portfolio contains asset classes and
investment strategies with negative skewness and long tails, CVaR
optimization could materially alter the asset allocation decision.

Norway: 60/40 Eq / FI; passively managed; little to no alt allocation; tight tracking error;
low cost; transparent; little governance; limited potential for value addition;
Endowment; high allocation to alts; significant active mgmt.; externally managed assets;
cost is high
Canada: like endowment with internally manged assets; in-house team and capabilities
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Additional personal information for a new client:

 Family situation: Marital status, children and grandchildren, ages of

family members

 Identification: Copy of driver’s license or passport

 Additional career information: Future aspirations for career, business,

and retirement

 Investment background

 More details on financial goals and risk tolerance

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Client segmentation / Adviser type

Robo-advisers support advanced asset allocation techniques, implement

typically with exchange-traded funds or mutual funds, and are lower-cost
alternatives for relatively small portfolios.

The mass affluent segment covers asset levels between $250,000 and $1
million and serves clients who are focused on building their portfolios and
want help with financial planning needs.

The private client range in the high-net-worth segment covers asset levels
between $1 million and $10 million and can provide a team of specialized
advisers that supports more customized strategies for more sophisticated
investments with longer time horizons, greater risk, and less liquidity.

The ultra-high-net-worth segment covers asset levels over $50 million for
clients with multi-generational time horizons and provides a wider range of
services for complex tax situations, estate planning, bill payment, concierge
services, travel planning, and advice on acquiring high-end assets.

Mortality table:

A mortality table allows for estimating the present value of retirement

spending needs by associating each outflow with a probability based on life
expectancy.

Annuity Method:

The calculated price of an annuity equals the present value of a series of

future fixed outflows during retirement.

Monte Carlo Simulation:

Monte Carlo simulation yields an overall probability of meeting retirement

needs by aggregating the results of many trials of probability-based
estimates of key variables, and it is a flexible approach for exploring different
retirement scenarios.
A Monte Carlo simulation uses assumptions of probability distributions for the
key variables and then runs many independent trials that generate many
random outcomes. These outcomes are then aggregated to determine the
probability of Sili reaching his investment objectives.
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An advantage of Monte Carlo simulation for retirement planning is its

flexibility in modeling and exploring different scenarios. Typically, retirement
goals are more complex than a fixed, annual cash flow need. For instance, if
Sili wishes to determine the effect of a significant purchase/gift or large
unforeseen expenses, he can model these scenarios with a Monte Carlo
simulation.

Prepare the Investment Objectives section of Patel’s IPS.

 Purpose: Support Patel’s lifestyle in retirement (higher priority), provide

for family’s needs (higher priority), fund philanthropic activities (lower
priority), provide inheritance for children (lower priority)

 Anticipated annual need: €200,000, with annual increases for inflation

 Annual need met with: Income from small business (approx. €120,000),
pension (€50,000 with annual inflation increases), portfolio
distributions

 Intent to purchase of €1.4 million vacation home in three years

 Zik should assist in quantifying philanthropic and bequest goals and

determining how to fund the vacation home purchase.

Performance report should include:

 Performance summary and market commentary for the current period

as a means of comparison.
 Portfolio asset allocation at the end of the current period.
 Detailed performance of asset classes and individual securities.
 Benchmark report comparing asset class and overall performance.
 Historical performance of portfolio since inception.
 Transaction details, purchases, and sales for the current period.

Most appropriate strategy that can generate liquidity and

accomplish liquidating concentrated position:

A personal loan secured by Omo’s company’s shares (Strategy 1) can

generate liquidity and still satisfy all of Omo’s goals. The loan would allow
Omo to maintain his ownership and control of the company, and it has the
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advantage that it should not cause an immediate taxable event for the
company or Omo if structured properly (without a put arrangement).
Specifically, these loan transactions usually contain a “put” arrangement
back to the company to make the lender comfortable—although such an
arrangement would likely be considered a taxable event (Strategy 1 does not
contain the put arrangement). Although at some point the debt will need to
be repaid, Omo will have access to cash to diversify his concentration risk
and will avoid triggering a taxable event. In most jurisdictions, the interest
expense paid on the loan proceeds should be deductible for tax purposes.
A leveraged recapitalization (Strategy 2) will not allow Omo to maintain his
ownership and control of the company or avoid a taxable event. Typically,
under a leveraged recapitalization, a private equity firm will invest equity
and take partial ownership of the business. The private equity firm will then
provide or arrange debt with senior and mezzanine (subordinated) lenders.
Omo would receive cash for a portion of his stock and would retain a minority
ownership interest in the freshly capitalized entity. Omo would likely be taxed
currently on the cash received. If structured properly, a tax deferral will be
achieved on the stock rolled over into the newly capitalized company. The
after-tax cash proceeds that Omo receives could be deployed into other
asset classes to help build a diversified portfolio, reducing Omo’s risk of
wealth concentration.
A leveraged employee stock ownership plan (ESOP, Strategy 3) will not
satisfy Omo’s goal to maintain his ownership and control of the company but
may allow him to avoid a taxable event. To implement an ESOP for his
company, Omo would have to sell some or all of his shares to a pension plan
that is created by the company. An ESOP that is leveraged would borrow
funds (typically from a bank) to finance the purchase of Omo’s shares.
Depending on the legal form of company structure, it may be possible to
defer any capital gains tax on the shares sold to the ESOP. Using an ESOP,
Omo can partially diversify his holdings and diversify his overall portfolio
while retaining control of the company and maintaining upside potential in
the retained shares.

Identify the conditions under which the adviser would find style
analysis most useful.

The adviser would find style analysis most useful, whether it be returns-
based (RBSA) or holdings-based (HBSA), when applied to strategies that hold
publicly-traded securities where pricing is frequent. It can be applied to other
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strategies (hedge funds and private equity, for example), but the insights
drawn from a style analysis of such strategies are more likely to be used for
designing additional lines of inquiry in the course of due diligence rather
than for confirmation of the investment process.

In addition, style analysis, whether returns-based or holdings-based, must be

meaningful, accurate, consistent, and timely in order to be useful.
Accordingly, style analysis would be most useful to Connell in understanding
most of the asset classes in the funds he is considering, including the
equities and bonds. However, it would be less meaningful for evaluating the
venture capital assets since they are not traded and are thus illiquid.

Describetwo considerations for each type of component recommended to

Grimmett for her manager selection process.

Qualitative:

Process and People: Evaluating the manager’s investment process, including

the manager’s philosophy, process, people, and portfolio. This consideration
is broadly described as part of “investment due diligence.”
Operational due diligence: Evaluating the manager’s infrastructure and firm,
including the accuracy of the manager’s track record and whether the record
fully reflects risks; the back office processes and procedures; the terms and if
they are acceptable and appropriate for the strategy and vehicle; and the
firm’s profitability, its culture, and if it’s likely to remain in business. This and
the following bulleted considerations as a whole are broadly described as
part of “operational due diligence”:
• Investment vehicle: Is the investment vehicle suitable for the portfolio
need?
• Terms: Are the terms acceptable and appropriate for the strategy and
vehicle?
• Monitoring: Does the manager continue to be the “best” fit for the portfolio
need?

Quantitative:

Attribution and appraisal: To assess if the manager has displayed skill in

investing.
The capture ratio: How has the manager performed in “up” versus “down”
markets?
Drawdown: Does the return distribution exhibit large drawdowns?
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