Helpful Notes

Mneunomic Phrases
1. Seriously did I make adjustments? - Steps in Risk Mgmt
Set Policies and Procedure
Define Risk Tolerance
Identify Risk
Measure Risk
Adjust Risk based upon advantage
2. MULCH - Specify Asset Class
Mutually Exclusive
Uncorrelated
Liquid
Comprehensive in totality
Homogenous
3. FACE - ID (Committee)
Feedback mechanism - prompt and acurate
Agenda - Stick to it
Clear choice after Debate
Encourage Debate
Independent Opinion
Diverse Group
4. SAMURAI
Specificed in advance
Accountable
Measurable
Unambiguous
Reflective of Mgr opinion
Appropriate
Investable
5. Expect Real Models In Every Place Man (Capital Mkt Expectations)
Expect - Expectations are set which include time horizon
Research - The historical Records
Models - are specified as well as method
In - Info is appropriate frequency, used best sources to get it
Every - Environment interpreted and make sure forecasts make sense when put together
Place - Provide finish expectations
Man - Monitor actual and compare to forecast to improve process
6. E-TEA Phone Home (How ERM system is judged)
Effective
Transparent
Efficient
Accountable
7. Emotional - LOSERS
Loss Aversion
Overconfidence
Self Control
Endowment
Regret Aversion
Status Quo
8. RICH Cognitive belief persistance
Representative
Illusion of control
Conservatism
Hindsight
Confirmation
 
131. Exotic options are european style
Binary option will pay off fixed amount when they touched immediately and represents highly leveraged position.
132. Call on Price Currency is a Put on base currency. Options are always in reference to base unless otherwise stated.
133. Macro Hedge = Hedge entire portfolio with an index
134. If long in currency A and short in currency B and A&B are highly correlated you will have a natural hedge.
135. 2 Beliefs you must have to choose active:
A. Successful active mgmt is possible
B. You have the skill to select the successful manager
136. Tail Risk = Risk in emerging markets that gov directly intervenes via market intervention or capital controls. Can use nondeliverable forwards to get around this risk which always net in a developed country. So if asked the gain on a nondeliverable forward make sure you convert the gain to the developed currency
137. Excess kurtosis and neg skewness in emerging markets due to contagion, panicked unwiding of carry trade when currency pegs break
138. Certainty overconfidence - belief of success is too high and belief of failure is too low this leads to excessive turnover
Prediction Overconfidence - Set too narrow of a confidence interval or don’t provide a range of outcomes at all which results in a poorly diversified portfolio due to underestimating risks.
139. Myopic Loss Aversion - combines loss aversion, time horizon framing and mental accounting
Occurs due to people evaluating portfolio annually and focusing too heavily on annual gains or losses (framing reference rate as previous years statements to determine gain/loss) which results in focusing on short term and ignoring long term. This causes a higher equity risk premium for the whole market.
140. Consequence of Self Control problems - Insufficient saving, accept too much risk to make up for poor savings, have asset allocation imbalance problems as they focus on income producing securities to provide income to spend more.
 
141. A con of BB&K is it measures how investors approach life which may be completely different from how they approach investing. Investors will change as they age and may not fit the mold. Biases have both cognitive and emotional aspects. Risk tolerance questionaires usually do not consider behavioral biases and are better suited towards institutional investors who are less likely to be emotional.
142. Technical analysis can provide value by taking advantage of short-term over and underreactions to new data
143. If required return is inconsistent with risk will need to state that you have to counsel investors to either moderate required return (by reducing costs of living, working longer) or by increasing willingness to tolerate risk (if they have the ability)
144. If port has dominant equity portion, does not use options and is long term you can use shortfall risk
145. Make sure when calulating a port after-tax return you consider that muni returns are not taxed
146. 2 Drawbacks of monte-carlo when used by practitioners and 2 improvements
A. Relies on historical data —> Use forecasted data
B. Looks at only asset class returns —>Model specific assets
147. Cap Weight Pro - macro consistent, CAPM consistent, does not require rebalance if div/split, gold standard for indexing (float weighted) Con - Less diversification, possible concentrations that mgr may find unnaceptable, exposed to bubbles
Price Weight Pro - simple and long history. Con - not macro consistent, does not match typical port construction, splits change weights
Equal Weight Pro - small cap bias and more diversification Con - less liquidity, higher turnover, periodic rebalancing required, sell winners buy losers
Fundamental Weight Pro - small cap bias, more representative of economic importance CON - less diversified and reflect creators view of valuation
148. Classical immunization causes price and reinvestment risk to offset
Port YTM = Immunization Target return if yield curve is flat
Port YTM > Immunization Target Return if yield curve is upward slowing
Port YTM < Immunization Target return if yield curve is downward sloping
149. 3 Options that the SHORT in an interest rate futures contract possesses
A. Quality Option - can choose which bond to deliver
B. Timing Option - Can determine when in month to deliver
C. Wild Card Option - Can give notice of intent to deliver up to 8pm night before
150. Interest rate options are more liquid, more cost effective, and easier to short vs. cash market
 
151. Max Drawdown = LARGEST (High point - subsequent low)
152. Act of God/terrorism/input errors = Operational Risk
Use wrong model / model not predictive = model risk
153. Any OTC vehicle has largest potential credit risk in the middle with the exception of Currency Swaps, Forwards or zero coupon bonds which have largest potential credit risk between middle and end
At beginning credit risk analysis has been done which mutes potential credit risk
At end most payments have been made reducing potential credit risk
154. Factor Push - Worst possible combo of variables
Worst-Case Scenario - Worst possible combo analyst thinks is likely
Max Loss Opt - Variable that produces max loss
155. Stressing models (above) can highlight weaknesses in risk mgmt process and are useful in addition to VAR
156. caps and floors are OTC and pay 1 month in arrears just like Libor Calls/Puts on interest rates
157. Delta hedging - port return will equal rf if done perfectly (rare as delta changes with passage of time and change in underlying)
158. If Volatility is expected to increase use options instead of forwards/futures as vega (volatility) is the only unobservable input in calculating option price and as volatility increases options become more valuable. Cannot separate vega from gamma/delta
159. Theta = time decay, gamma measures delta sensitivity and is greatest near expiry and when option ATM. Delta moves away from 0 as option becomes more in the money. This is why a put option has a greater change in value when the underlying decreases and a call has a greater change in value when the underlying increases because the option is becoming more in the money and the delta is moving away from 0 and thus becoming more sensitive to changes in the underlying
160. Costs for Swaps/Forwards/Zero cost Collar
Opportunity costs and administrative costs
 
161. Generally the first period of a loan is unhedged as the rate is known at initiation however the first period could be hedged if the hedge were made in anticipation of a future loan.
162. Generally futures are on the price return not the total return
163. Managed Futures (A subset of maco hedge funds) have positive skew as they earn alpha due to behavioral underreaction to new info. They also have lower transaction costs. They EXCLUSIVELY trade in derivative markets which is what distinguishes them. The GP who runs the fund is called a commodity pool operator. Categorized by style (Trend / Contrarian), market (financial/currency), or Strategy (rules based, discretionary). Cannot have a passive approach as derivatives are zero sum in nature. More regulated than hedge funds. Less STDDEV than stocks but more STDDEV than bonds. Better Sharpe than equity worse sharpe than bonds.
164. Bad Economy = More opportunities for distressed debt. But a recession will also cause distressed debt to take a beating as credit spreads widen.
165. Prepackaged banktruptcy = PE Firm (Vulture Investor) acquires debt of failing company in banktruptcy, gets representation on board, makes concessions to stay in business and keep most valuable assets. Receives equity in new company in return and becomes majority shareholder of new company. Previous shareholders lose everything this is an active approach.
166. True rf asset has known return and std dev of 0 which a TBill doesn’t have over multiple periods as rf changes over time. Should treat rf as any other risky asset unless told otherwise. All ports will be on the efficient frontier use corner ports.
167. Historical volatility of hedge funds persists but not historical returns
168. Commodities do well in crises and exhibit positive event risk
169. Annual Sharpe / (SQRT(12)) = monthly sharpe
170. Survivorship most relevant for hedge funds and not relevant for fund of funds.
 
171. Hedge fund Risk Adj Return Metrics (have to use because sharpe is useless if nonnormal returns)
Calmar Ratio = Port Return / (Max Drawdown)
Sterling Ratio = Port Return / (Avg Annual Monthly Drawdown - 10%)
Gain Loss Ratio = (# Up months / # Down months) * (Avg Up Return / Avg Down Return)
172. Ways sharpe can be gamed
Compound returns on top and have std. dev be noncompound
Lengthening Sharpe measurement period
Smoothing returns by buying illiquid assets or by using special total return swaps to smooth volatility (receiving negative skew in return for less STDDEV)
173. Using options to hedge against an increase in interest rates before taking out a loan you will want to use a call option so you gain if rates rise to offset the loss you will experience due to paying higher interest rates
174. Look through leverage on hedge funds. If borrow 100 and have 100 in equity monthly return will be (220 - 200) / 200
175. Translation exposure is if you have a foreign subsidiary and you want to hedge balance sheet volatility
176. FS (1, 3) Swaption = 1 year swap option, 2 year underlying swap
177. A total return swap can be used to diversify a concentration but you can have a cash flow risk as well as basis risk if the concentration does way better than the index the total return swap is based on as you will have to pay the net performance between the two in cash which you might not have if you just have one huge concentration
178. CAN ONLY COMPARE VAR IF SAME TIME ELEMENT DO NOT IGNORE TIME ELEMENT
179. % of Port Rebalance = Interval Rebalance = % Range Rebalance
Set same tolerance band for all asset classes ignores differences in liquidity and transaction costs between asset classes
Requires frequent monitoring and rebalances WHOLE PORT if just ONE asset class is out of range
Exercises tighter control
180. If a hedge did not work out perfectly despite following the formula it could be because
Futures contract was mispriced
Beta/Duration was an incorrect estimate
Beta exhibited mean reversion to 1 (can calc effective beta and compare to previous beta to see if this the case)
 
181. Dynamically hedge - change hedge ratio to over or under hedge to add convexity (Think CPPI)
182. Flat or unknown volume and you want to use a VWAP based? Use TWAP which evenly spaces it out based upon time
183. Roll’s Critique of the CAPM/Treynor/Alpha:
Can have majorly different estimates depending upon what index is used for mkt port
Using indexes overstates the performance of a passive alternative as they don’t consider the transaction costs
CAPM underlying assumptions and single index nature are questionable
Stability of managers beta can change over time and is merely an estimate of historical risk taken.
184. If Quoted Spread > Effective Spread then dealers are providing price improvement otherwise market impact.
185. Opportunistic participation seeks to take advantage of liquidity by providing it to those who needs it. Pegging/discretion not a true participation strategy.
186. One of the ways to assess a persons willingness to take risk is to look at how their portfolio is currently allocated
187. If time horizon is perpetual do not forget to state “Single Stage”
188. Legal Liability (bank, defined benefit, life insurance, casualty) decreases ability to take risk
189. Geometric smoothing rule places greater emphasis on recent market values. A dramatic return 3 years ago can still have a big impact on 3 year avg rule while not so on geometric
190. An increase in interest rate lowers the roll yield. A increase in convenience yield increases the roll yield
 
191. The credit risk on currency swaps is bilateral. The default risk on an OTC is not isolated between the two parties on the contract because if either party defaults on an obligation to a 3rd party and declares banktruptcy the swap may then go into default
192. Grinold Kroner = (Div Yield + Repurcase Yield) + Inflation + Real Earn Growth + Repricing Return (beneficial change in P/E)
Grinold Kroner = Income Return + Nominal Earnings Growth + Repricing Return
If a company buys back (decreases) shares this is a positive for shareholders (obviously) thus it will add to return
193. Daily/Weekly Data = Short Term forecast Quarterly/Annual Data = Long term forecast
194. If Market A is highly correlated with Market B and Market B is highly correlated with Market C. Market C cannot be negatively correlated with Market A
195. Possible problems with econ data: IMF Reports econ data for emerging countries with huge time lags. Methods and definitions can change and indexes can be rebased.
196. High frequency data (weekly/daily) produce lower correlation estimates
197. Time Series data is useful for short term forecasts and can capture VOLATILITY CLUSTERING which is low volatility followed by low volatilty and high volatility followed by high volatility.
198. Major advantage of multi-factor model is ability to establish consistency efficiently. If first layer is consistent the layers that feed into it will be consistent
199. YTM on a zero coupon bond is a superior estimate of the total returns in fixed income
200. Inflation premium is one of the most volatile elements of interest rates that is based upon EXPECTED FUTURE INFLATION
 
201. The Fed Bank prefer some inflation for monetary flexibility during low periods
202. Growth Policies of a good Gov
Sound Fiscal Policy - Long term deficit close to 0
Minimal Private Sector intrusion by gov
Competition is encouraged (Bad for profits, good for GDP) (openness to foreign investment, no tarriffs)
Infrastructure and Human Capital Development Encouraged (Build roads, encourage education)
Tax Policies are Broad based and not redistributive they are simple
203. 8 Emerging Market Warning Signs
Monetary Fiscal Policy - Greater than 4% fiscal deficit to GDP ——Greater than 80% Debt/GDP
Economic & Currency - Lower than 4% GDP Growth —— Current account financed with Debt
External Debt - Greater than 50% foreign Debt / GDP ——-Greater than 200% Debt / Current Acct Receipts
Liquidity - Less than 100% Reserves / Short Term Debt
Political - If any of the above warning signs flash red then governments willingness or lack therof to make necessary reforms are what will matter
204. Econometric model (Think Top Down Approach) Pro - Challenges prior views, maintains degree of consistency, good at forecasting upswing
Con - Complex, time consuming, relies on personal judgement and historical info that may change, not good at forecasting downswing
205. TIPS - Real Yields rises and falls with real economic growth. If inflation becomes volatile and is expected to increase demand for tips will increase and (due to supply and demand) yields will fall. They are a distinct asset class because they do not have inflation premium volatility which is the largest part of nominal bonds volatility
206. Molodovsky Effect - P/E for cyclical companies low at peak and high at bottom
Low inflation increases P/E because earnings are more real
Slow growth lowers P/E
207. PPP - Long term parity relationship which asserts that changes in inflation will be offset by currency movements. It gains more importance when investors don’t believe a deficit can be financed without printing money.
208. Relative Econ Strength (CARRY TRADE EXPLAIN)
Shorter term relationship
Better Economic growth increases inflation and thus increases rates which causes investors to borrow their currency and buy higher yielding debt causing the currency to increase.
209. Capital Flows (Cut Interest Rates, Boosts Stocks, Boosts Currency) (AKA WHAT HAPPENED IN 2009 with US QE)
Inflow to gain attactive stock returns boosts currency
Shorter term Relationship
210. Savings-Invest Imbalance
Medium Term Relationship that explains longer term divergences with PPP but not easy to use
Economic expansion will need to be financed by money. If investors aren’t saving enough to finance the current expansion they will need foreign dollars which will cause the currency to strengthen. Eventually it will strengthen to a point where the stronger currency impacts their export/import mix and causes the economy to slow which will then decrease the currency as the Demand for investment will be less than domestic saving.
 
211. Government can only control exchange rates with capital controls or interest rate policy changes
212. Best Expecution
A. Tied to strategy cannot be viewed independent from strategy
B. Must measure after the trade
C. Cannot evaluate just one trade over a short period of time. Must be over a longer period
213. Trading is a process
A Establish policy on best execution evaluation
B Disclose to clients and prospects the policies as well as conflicts of interest
C Maintain proper records
214. Market Adjusted Implementation Shortfall = Implementation Shortfall - (Change in Market * Stock Beta)
215. Delay costs are the largest part of trade costs and are the least visible
216. Bid - Ask, Price impact of large trades, delay/slippage are implicit trading costs
217. Costs of trading correlated to:
A. Stock Liquidity
B. Risk
C. Order Size / Avg. Daily Trade Vol
D. Momentum - (More costly to buy in uptrending mkt)
E. Order Type - (Limit less expensive than mkt)
218. Pretrade analysis is an econometric approach to estimate cost in order to guage right trade size and assess execution quality.
219. Electronic Limited Order =Automated Auction = Electronic Communication Network (ECN)
This is the same as a crossing network but it OPERATES CONTINOUSLY and provides PRICE DISCOVERY wheras a Crossing network does NOT provide price discovery which leads to PARTIAL FILLS
Benefits of both: Low Cost, Good for Illiquid Stocks, Provides anonominty
220. Broker = Agent = Provides secrecy and finds willing parties = best used for large block trades. Can cause info leak.
 
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