August 8, 2008 MS&E247s International Investments Handout #20 Page 1 of 72

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1 August 8, 2008 MS&E247s International Investments Handout #20 Page 1 of 72 Reading Assignments for this Week MWF 3:15-4:30 Gates B01 Final Exam MS&E 247S Fri Aug :15PM-3:15PM Gates B03 (Alternate Time) Or Saturday Aug PM-10PM Terman Auditorium (Official Time) Remote SCPD participants will also take the exam on Friday, 8/15 Please Submit Exam Proctor s Name, Contact info as SCPD requires. C.c. the info to yeetienfu@yahoo.com, preferably a week before the exam. Local SCPD students please come to Stanford to take the exam. Light refreshments will be served. Handout #20 as of 0808, 2008 International Asset Portfolios Equity Portfolios + Foreign Exchange Market Intervention Scan Read Levich Chap 15 Pages Equity Portfolios + Chap 17 Foreign Exchange Market Intervention (pp ) Luenberger Solnik Eun Chap 8, 9, 12, 13 Pages , , Alternate Investments, Int l Diversification, Performance Measurement, Global Asset Allocation: Structuring and Quantifying the Process Wooldridge Chap Chap Pages Pages International Financial Management 4E:Chapter 13 International Equity Markets Pages 15-2 International Asset Portfolios Equity Portfolios Introduction to Equities While they share a long history, equities and bonds are very different financial instruments. The owner of a bond is entitled to a set amount of at periodic intervals. All bonds (excluding those with equity-like features) are claims on some nominal amount of. In comparison, the owner of an equity share in a British firm may receive dividends denominated in. But what the shareholder truly owns is a claim on the real assets of the firm and all the cash flows that accrue once the firm has paid all of its creditors. MS&E 247S International Investments Yee-Tien Fu 15-4 Introduction to Equities Both bonds and shares may be exposed to similar market forces. If a bond was issued in London and trades in London, it will be subject to British exchange control risk, expropriation risks, and withholding taxes when viewed by non-british investors. The fundamental difference is this: The valuation of a bond is based on a stream of nominal cash flows that we can enumerate. The valuation of a British equity is linked to the firm s real assets (regardless of location) and the cash flows (in all currencies) associated with Introduction to Equities The performance of equity investments is usually evaluated in 2 dimensions - expected return and risk. These dimensions describe the 2 basic incentives for international investment: to enhance portfolio returns for the same level of risk, or to reduce the riskiness of a portfolio without sacrificing expected return. the firm s operations

2 August 8, 2008 MS&E247s International Investments Handout #20 Page 2 of 72 Introduction to Equities Expected value gains could occur if foreign equity markets are inefficient, such that foreign equity prices do not reflect all available information, or if foreign equity markets may be segmented from other capital markets, such that investors in the foreign market receive a different compensation for bearing equity risk than in other markets. Diversification gains could occur if the correlation of returns across countries is low Introduction to Equities Diversification gains are available even when domestic and foreign capital markets are integrated, so that risk bearing in different markets is rewarded in a similar fashion. When investors are risk averse, international equity investment offers an opportunity for welfare gains through superior sharing of international equity risks Introduction to Equities A pioneering study by Herbert Grubel (1968) showed that investors from 11 developed economies could have enjoyed substantially more favorable risk-return opportunities had they diversified their portfolios internationally in the 1960s. However... The analysis overstated the gains. Capital restrictions would have made some markets off-limits to foreign investors.. The efficient frontier could not have been Return and Risk in World Equity Markets and Efficient Frontiers, Efficient frontier labeled AA includes all 11 industrial countries, while BB includes only 8 European and North American countries Japan A Australia + x x 8 xx x x U.K. A B S. Africa Italy B USA Germany 6 Canada x Netherlands 4 France 2 Belgium obtained by all investors Risk: Standard Deviation of Returns Figure 15.1 Pg 524 % Rate of Return (% per annum) Introduction to Equities The portfolios in segment AA of the efficient frontier call for roughly a 40% weight on Australia. Since Australia represents less than 1% of the world equity market, these portfolios were inconsistent with the overall valuation of equity markets. Despite the shortcomings, Grubel s insight has been verified by many subsequent studies. Yet, despite promotion by investment advisors as a prudent strategy, most investor portfolios reflect a home country bias in equities as well Residence of investor Canada Germany Japan Netherlands U.K. U.S. Holdings of Foreign Securities by Residence of Investor US$ Value of Holdings (in billions) as bonds, as shown in Table Table 14.1 $ $ $ Equities % of Equity Portfolio Bonds % of Bond Portfolio

3 August 8, 2008 MS&E247s International Investments Handout #20 Page 3 of 72 Introduction to Equities This investment pattern is a puzzle that has rekindled research into international equity markets. Have home country investors been inexcusably slow to diversify their portfolios internationally? Or have important aspects of the international investment process been left out of the theoretical and empirical analysis thus far? Size and Institutional Features of Global Equity Markets Market Capitalization Measures From Figure 15.2, we see that U.S. market capitalization, while growing in absolute terms, has fallen in relative size from 54.1% of the world market in 1984 to 38.6% in Higher economic growth rates in smaller economies is the primary contributor to this long-term trend which is most likely to continue. Also note the substantial growth of emerging markets World Market Capitalization US$ Trillions Figure $ % 15.2% 19.4% 7.1% 54.1% $ % 18.2% 40.2% 7.9% 28.7% $ % 21.9% 21.3% 8.2% 37.0% $36.0 U.S. U.K. Japan Other Developed Emerging 8.4% 24.6% 12.6% 8.1% 46.2% Market Capitalization of Equity Markets in Developed Countries (in Billions of U.S. Dollars) Size and Institutional Features of Global Equity Markets The pattern for Japan is unusual on 2 accounts: 1 Japan s share of world stock market capitalization more than doubled between 1984 and 1988, and then dropped by half in This reflects the surge in Japanese equity prices in the late 1980s, which many label a speculative bubble, and the collapse of those prices in The value of Japanese equities surpassed the U.S. in 1987 to become (for 3 years) the world s largest equity market. Note that the GNP of U.S. exceeds that of Japan by about 75% Market Capitalization of Equity Markets in Selected Developing Countries (in Billions of U.S. Dollars)

4 August 8, 2008 MS&E247s International Investments Handout #20 Page 4 of 72 How Large is the Japanese Stock Market? Cross-holding of securities (the practice of firm A owning equity shares in firm B) complicates the calculation of market capitalization values. Cross-holding is common in Japan, Germany, etc. where banks are permitted to hold substantial and sometimes controlling interests in non-banking firms. Cross-holding is fairly rare in the United States. Suppose firm A has $100 of net productive assets and 100 shares outstanding, each valued at $1. Firm B is similar. The market value of these 200 shares of firms A and B is $200. To introduce a cross-holding effect, let A issue 50 new shares at $1 each and use the proceeds to purchase How Large is the Japanese Stock Market? As conventionally measured (taking the number of shares outstanding and multiplying by the price per share) the market value of firms A and B is now $250. Yet the value of productive physical assets is unchanged at $200, and $200 is sufficient to purchase all of A s and B s stock. It takes $150 to buy all of A s stock, and only $50 to buy the remaining shares of B not already acquired by purchasing A. Hence, to measure market value properly, we must adjust for the cross-holding effect by netting out the value of the cross-held shares. This adjustment reduced the 1988 market capitalization weight for Japan from 44% to 29.5%, a figure very close shares in B to Japan s GDP weight in the world portfolio Size and Institutional Features of Global Equity Markets Institutional Aspects of Global Equity Markets Investors are unlikely to invest abroad if restrictions and limitations affect the repatriation of their capital. Number of Firms Listed In 1994, less than 7% of the firms listed on U.S. exchanges are foreign firms. In comparison, foreign firms make up about 18% of the total firms listed in United Kingdom, the center for trading in foreign stocks. The requirements for listing shares are more stringent in the U.S. Size and Institutional Features of Global Equity Markets Market Concentration Market concentration, measured by the percentage of market capitalization within the 10 largest firms, is another statistic with wide variation across countries. In the U.S., Japan, and India, the top 10 firms account for 15-20% of the overall market capitalization. In all other countries, market concentration is higher, averaging close to 30%. In the Netherlands, New Zealand, and some smaller emerging markets, market concentration exceeds 60%. than elsewhere Percentage of Market Capitalization Represented by the 10 Largest Stocks: Emerging Equity Markets in Selected Developing Countries Size and Institutional Features of Global Equity Markets Trading Volume Market turnover, measured as the annual volume of trading as a percentage of market capitalization, also varies substantially across countries. Statistics suggest that liquidity varies considerably across markets, as high trading volume tends to reduce liquidity risks and trading costs. But liquidity could vary as well within a market, with greater liquidity for a small number of high capitalization stocks, and much lower liquidity otherwise

5 August 8, 2008 MS&E247s International Investments Handout #20 Page 5 of 72 Turnover Ratio of Equity Markets in Developed Countries (Transactions in US $ / Year-End Market Capitalization in US $) Turnover Ratio of Emerging Equity Markets in Selected Developing Countries (Transactions in US $ / Year-End Market Capitalization in US $) Size and Institutional Features of Global Equity Markets Transaction Taxes, Transaction Costs, Clearing and Settlement A long settlement period for making payment and obtaining delivery of securities (on the buy side) and delivering securities and obtaining cash settlement (on the sell side) is a deterrent to investment Trading Practices and Costs of Major Equity Markets Trading Practices and Costs of Major Equity Markets International Investment Vehicles Direct Purchase of Foreign Shares American Depositary Receipts (ADRs) In order to issue an ADR, a U.S. bank takes custody of foreign shares in its foreign office. Then an ADR can be issued as a claim against these foreign shares. This can be especially valuable when there are doubts about the authenticity of foreign shares. Owners of the ADR have the right to redeem their ADR and obtain the true underlying foreign shares. Arbitrage of this sort ensures that the price of the ADR and the underlying shares will be nearly identical

6 August 8, 2008 MS&E247s International Investments Handout #20 Page 6 of 72 Mechanics of Issuance and Cancellation of ADRs International Investment Vehicles The issuing bank services the ADR by collecting all dividends, rights offerings, and so forth in foreign currency, and distributing the proceeds in US$ to the ADR owner. Rights offering - When a corporation is about to issue additional stock, it is customary to offer the stock first to its existing shareholders at special rate. U.S. investors can trade ADRs with each other without recourse to the foreign equity market, without using the foreign exchange market, and without relying on foreign clearing and settlement International Investment Vehicles In a sponsored ADR, the foreign firm pays a fee to the depositary bank to cover the cost of the ADR program. In an unsponsored ADR, the issuance of the ADR is demand driven in response to a security firm s desire to facilitate trading in a popular foreign issue. Closed-End and Open-End Mutual Funds Mutual funds that invest in foreign stocks can be grouped into several categories - global, international, regional, country, specialty. In addition, foreign stock funds are classified as either open-end or closed-end. Types of ADRs International Investment Vehicles An open-end fund stands ready to issue and redeem shares at prices reflecting the net-assetvalue of the underlying foreign shares. A closed-end fund issues a fixed number of shares against an initial capital offering. The shares of the fund then trade in a secondary market (usually listed on an exchange) at prices reflecting a premium or discount relative to the net-asset-value of the underlying foreign shares. Closed-end country funds were the fastest growing segment of the public investment funds during the late 1980s. At the end of 1992, there were 42 closed-end country funds listed in the Global Depository Receipt Tombstone U.S., representing $4.3 billion in equity

7 August 8, 2008 MS&E247s International Investments Handout #20 Page 7 of 72 Example of Dow Jones Country Stock Market Indexes Major National Stock Market Indexes Major National Stock Market Indexes International Investment Vehicles A 1994 paper by Gikas Hardouvelis, et al. analyzed the behavior of closed-end country fund discounts and premiums. They concluded that: Such discounts varied widely and are a significant factor in the variability of country fund returns. On average, the variance of country fund returns is 3 times larger than the variance on the underlying foreign assets. Discounts tend to be mean reverting, implying that unusually large discounts and premiums tend back toward their average value. Thus, by selecting a closed-end country fund, the investor also takes a position on an additional unobserved factor - the local sentiment about Risk and Return in International Equity Markets Calculating the Unhedged Returns on Foreign Equity in US$ Terms Let E t represent the initial purchase price of the equity in foreign currency terms. Let S t represent the spot exchange rate, in $/FC terms, on the purchase date. The product E t S t is the US$ purchase price of the foreign equity. ~ After one period, the value of the equity is E t+1, representing the initial equity price plus the price change over the period (Δ ~ t+1 ) plus dividends D t+1 : world events and country-specific events. Et + 1 Et + Δt Dt ~ ~ Risk and Return in International Equity Markets The value of the equity after one period in US$ terms is ~ ~ E t+1 S t+1. The continuous rate of return on the foreign equity measured in US$ and on an unhedged basis is: E S E S R ~ ~ ~ ~ ~ t + 1 t + 1 t + 1 t + ~ ~ $, U = ln = ln + ln 1 = EFC + SUS$,FC EtSt Et St (15.1) The equation shows that the unhedged US$ return has 2 components: the return on the equity shares in foreign currency terms plus the return on the foreign currency used to buy the shares. Both terms may be greater than or less than zero Risk and Return in International Equity Markets The variance of the returns reflects the variance of each term and the covariance between the returns on the foreign equity and the returns on spot foreign exchange: 2 ~ 2 ~ 2 ~ ~ ~ σ R$, U = σ EFC + σ SUS$,FC + 2Cov EFC; SUS$,FC ( ) ( ) ( ) ( ) (15.2) The covariance term represents the sensitivity of share returns to exchange rate changes, and can be either positive or negative. A positive covariance implies that the value of foreign equity tends to fall or rise along with the value of foreign currency as shown in cells A and B in Table

8 August 8, 2008 MS&E247s International Investments Handout #20 Page 8 of 72 Currency Market Return and Stock Market Return Combinations Stock Market Returns Negative Positive Currency Market Return Negative Stock Market Prices Spot FX (A) Stock Market Prices Spot FX (D) Positive Stock Market Prices Spot FX (C) Stock Market Prices Spot FX (B) Risk and Return in International Equity Markets The Mexican peso devaluation in late 1994 and early 1995 is an example of cell A, where capital flight and a loss in confidence in the Mexican economy brought the Mexican stock market down as well. With the peso overvalued and the country running a large current account deficit, Mexican policy makers allowed the peso to depreciate. Interest rates rose dramatically, as did import prices; the Mexican stock market dropped sharply in anticipation of a fall in Mexican GDP and corporate profits. Table $$ Pricing Determinants $$ Pricing Determinants The analysis of international equity prices requires us to confront several challenging problems: 1 Are national equity markets integrated or segmented? 2 Are national equity markets efficient or inefficient? 3 Does purchasing power parity hold or not? 4 Do the assumptions of the capital asset pricing model (CAPM) apply or is arbitrage pricing theory (APT) more appropriate? The traditional CAPM hypothesizes that returns for an individual equity (R i ) in excess of the risk-free rate (R F ) are proportional to the systematic risk of the equity (β im ) times the expected market risk premium : R R i F = β [ E( R ) R ] where E(R M ) is the expected return on the market portfolio. im M F $$ Pricing Determinants $$ Pricing Determinants The assumptions of the traditional CAPM are: Investors maximize their utility which depends only on expected return (+) and risk (-). Investors have homogeneous expectations, agreeing about expected return and risk for all assets. Returns are expressed in nominal terms. A risk-free interest rate exists and unlimited borrowing and investing is possible at this rate. No transaction costs or taxes exist A security s β is related to its covariance with the return on the market portfolio. σ iw regression coefficient β 2 σw β tells us how much the security s rate of return tends to change when the return on the market portfolio changes. Thus, for a security with a β of 2, if the market goes up by 10% more than what was expected, the return on the security will tend to go up by 20% more than what was expected

9 August 8, 2008 MS&E247s International Investments Handout #20 Page 9 of 72 $$ Pricing Determinants The CAPM leads to a separation, or mutual fund theorem, which claims that all investors will hold some combination of two assets: The risk-free asset and the market portfolio of all risky assets Is Investment in MNCs a Close Substitute for International Investment? If portfolios exhibit a home country bias, can investors argue that the shares of multinational corporations (MNCs) offer a close substitute for international diversification? The shares of an MNC could reflect real assets and/or cash flows from, say, 20 countries. So, the MNC could offer ready-made diversification and an inexpensive proxy for the purchase of 20 firms, each one based in a different country Is Investment in MNCs a Close Substitute for International Investment? While this strategy sounds reasonable, the data reject the hypothesis that MNCs are a proxy for foreign markets or international diversification. A study by Jacquillat and Solnik (1978) examined the returns of MNCs from 9 countries by regressing their returns against all 9 market indexes. In each case, the returns on MNCs were most closely connected with the domestic market index. In the case of U.S. and U.K. MNCs, the addition of foreign markets offered virtually no Policy Matters - Private Enterprises After 15 years, Let s ask the same question: Can investors create homemade international diversification? Using data from 1973 to 1993 for seven developed and nine emerging markets, a study found that a set of domestically traded assets, including market indices, industry portfolios, 30 MNCs, closed-end country funds and ADRs, was successful at mimicking the gains from international portfolio diversification. improved explanation of MNC share returns Total, Domestic, and Foreign Company Listings on Major National Stock Exchanges for Assignments from Chapter 15 Exercises 3, 4, 5. (no need to hand in) 15-54

10 August 8, 2008 MS&E247s International Investments Handout #20 Page 10 of 72 Chap 17 Foreign Exchange Market Intervention (pp ) Overview Foreign Exchange Market Intervention Intervention as a Policy Instrument The Objectives of Central Bank Intervention The Mechanics of Intervention Empirical Evidence on Intervention The Effectiveness of Central Bank Intervention Security Transaction Taxes: Should We Throw Sand in the Gears of Financial Markets? Foreign Exchange Market Intervention Many government actions (such as monetary policy, interest rate policy, fiscal spending, and taxation policies) can have an impact on the foreign exchange rate. The central bank may also intervene officially by directly purchasing or selling currency. Intervention is an essential part of a pegged exchange rate system Foreign Exchange Market Intervention The modern experience of floating exchange rates is better described as a period of managed floating exchange rates. Note that acknowledging the importance of exchange rates and the potentially adverse effects of exchange rate misalignments or volatility does not automatically establish a valid case for central bank intervention Foreign Exchange Market Intervention Under floating exchange rates, an active intervention policy presumes that: markets are at times inefficient, thus permitting misaligned or excessively volatile rates, policymakers can identify such market inefficiencies, intervention techniques can correct the misalignments and excess volatility, and the benefits from the correction exceed the costs of conducting the intervention The Objectives of Central Bank Intervention Shortly after the breakdown of the Bretton Woods Agreement in 1973, the International Monetary Fund (IMF) enacted a set of guidelines designed to limit the use of intervention and the potential for conflicts among nations The Objectives of Central Bank Intervention The guidelines, which are still in effect, specify that member nations of the IMF: Have an obligation to intervene to prevent disorderly conditions in the foreign exchange market. Should avoid manipulating exchange rates to prevent balance of payments adjustment or gain an unfair competitive advantage in trade. Should take into account the interests and policies of other members when setting their own intervention policies

11 August 8, 2008 MS&E247s International Investments Handout #20 Page 11 of 72 Eun: International Financial Management Chapter 4: The Market for Foreign Exchange Eun: International Financial Management Chapter 4: The Market for Foreign Exchange Stephen G. Cecchetti on Central Banks, Monetary Policy, and Financial Stability Stephen G. Cecchetti on Central Banks, Monetary Policy, and Financial Stability (great optional reading) Chapter 15 Central Banks in the World Today 2_ch15.pdf (great optional reading) Chapter 16 The Structure of Central Banks: The Federal Reserve and the European Central Bank 2_ch16.pdf The Mechanics of Intervention Central bank interventions typically occur in the spot foreign exchange market. If the domestic currency is stronger than desired, the central bank sells domestic currency, and vice versa. Central bank interventions may generate direct effects associated with the changed quantities of money and/or bonds. The magnitude of the effects depends on whether the intervention was sterilized or unsterilized The Mechanics of Intervention An unsterilized intervention is simply a foreign exchange market sale or purchase. The money supplies in both countries are affected. A sterilized intervention includes an offsetting transaction in the domestic money market (such as the purchase or sale of government securities) that reverses, or sterilizes, the impact of the initial intervention transaction. The money supplies remain unchanged, but the bond supplies are affected

12 August 8, 2008 MS&E247s International Investments Handout #20 Page 12 of 72 The Mechanics of Intervention According to the monetary approach, sterilized interventions have no direct impact on the exchange rate. However, according to the portfolio balance approach, the relative supply of government bonds helps to determine the exchange rate. The Mechanics of Intervention Central bank interventions may also generate indirect effects: They may signal the market about future monetary and fiscal policies. They may interrupt short-term patterns in rates and reduce the profitability and incidence of noise trading Empirical Evidence on Intervention From 1982 to 1991, the U.S. Federal Reserve sold $35.8 billions and purchased $15.8 billions. Note that the interventions were small compared with the daily foreign exchange trading volume. There was also evidence of coordinated interventions with other central banks, such as the German Bundesbank and the Swiss National Bank The Effectiveness of Central Bank Intervention Does intervention have any effect - beneficial or detrimental - on the course of exchange rates and the ability of policymakers to achieve their larger macroeconomic goals? The debate hinges on whether a market failure has occurred and whether official intervention can correct this failure The Effectiveness of Central Bank Intervention Private Speculation Official Intervention A C Stabilizing Efficient markets view Official intervention smoothes the market Credible signals of future policy remove uncertainty Encourages stabilizing private speculators B D Destabilizing Inefficient markets: Stabilization policy gamed bandwagons, bubbles, by market and becomes noise traders destabilizing Intervention is inconsistent with underlying economic policies The Effectiveness of Central Bank Intervention Evidence suggests that intervention may stabilize exchange rates by lowering the daily volatility, as well as cause the rates to move in the intended direction. It seems that interventions send the strongest signals and have the highest chance of success when the conditions of surprise, publicity, and coordination with other central banks, are met

13 August 8, 2008 MS&E247s International Investments Handout #20 Page 13 of 72 Excel Finance Gallery Available at Companion Website for Oxford Handbook of Financial Modeling by Ho and Lee Oup.org (Oxford University Press Website) 94 downloadable Excel Templates for Finance Modelers. Ross / Corporate Finance 7E / CAPM Capital Asset Pricing Model 10.3 The Return and Risk for Portfolios Stock fund Bond Fund Rate of Squared Rate of Squared Scenario Return Deviation Return Deviation Recession -7% 3.24% 17% 1.00% Normal 12% 0.01% 7% 0.00% Boom 28% 2.89% -3% 1.00% Expected return 11.00% 7.00% Variance Standard Deviation 14.3% 8.2% Note that stocks have a higher expected return than bonds and higher risk. Let us turn now to the risk-return tradeoff of a portfolio that is 50% invested in bonds and 50% invested in stocks The Return and Risk for Portfolios Rate of Return Scenario Stock fund Bond fund Portfolio squared deviation Recession -7% 17% 5.0% 0.160% Normal 12% 7% 9.5% 0.003% Boom 28% -3% 12.5% 0.123% 10.3 The Return and Risk for Portfolios Rate of Return Scenario Stock fund Bond fund Portfolio squared deviation Recession -7% 17% 5.0% 0.160% Normal 12% 7% 9.5% 0.003% Boom 28% -3% 12.5% 0.123% Expected return 11.00% 7.00% 9.0% Variance Standard Deviation 14.31% 8.16% 3.08% The rate of return on the portfolio is a weighted average of the returns on the stocks and bonds in the portfolio: r = w r + w r P B B S S 5 % = 50% ( 7%) + 50% (17%) Expected return 11.00% 7.00% 9.0% Variance Standard Deviation 14.31% 8.16% 3.08% The rate of return on the portfolio is a weighted average of the returns on the stocks and bonds in the portfolio: r = w r + w r P B B S S 12.5% = 50% (28%) + 50% ( 3%) The Return and Risk for Portfolios Rate of Return Scenario Stock fund Bond fund Portfolio squared deviation Recession -7% 17% 5.0% 0.160% Normal 12% 7% 9.5% 0.003% Boom 28% -3% 12.5% 0.123% Expected return 11.00% 7.00% 9.0% Variance Standard Deviation 14.31% 8.16% 3.08% The expected rate of return on the portfolio is a weighted average of the expected returns on the securities in the portfolio. E r ) = w E( r ) + w E( r ) ( P B B S S 9 % = 50% (11%) + 50% (7%) The Return and Risk for Portfolios Rate of Return Scenario Stock fund Bond fund Portfolio squared deviation Recession -7% 17% 5.0% 0.160% Normal 12% 7% 9.5% 0.003% Boom 28% -3% 12.5% 0.123% Expected return 11.00% 7.00% 9.0% Variance Standard Deviation 14.31% 8.16% 3.08% The variance of the rate of return on the two risky assets portfolio is σ = P (wbσ B ) (wsσ S ) 2(wBσ B )(wsσ S )ρ BS where ρ BS is the correlation coefficient between the returns on the stock and bond funds

14 August 8, 2008 MS&E247s International Investments Handout #20 Page 14 of The Return and Risk for Portfolios Rate of Return Scenario Stock fund Bond fund Portfolio squared deviation Recession -7% 17% 5.0% 0.160% Normal 12% 7% 9.5% 0.003% Boom 28% -3% 12.5% 0.123% Expected return 11.00% 7.00% 9.0% Variance Standard Deviation 14.31% 8.16% 3.08% Observe the decrease in risk that diversification offers. An equally weighted portfolio (50% in stocks and 50% in bonds) has less risk than stocks or bonds held in isolation The Efficient Set for Two Assets % in stocks Risk Return 0% 8.2% 7.0% 5% 7.0% 7.2% 10% 5.9% 7.4% 15% 4.8% 7.6% 20% 3.7% 7.8% 25% 2.6% 8.0% 30% 1.4% 8.2% 35% 0.4% 8.4% 40% 0.9% 8.6% 45% 2.0% 8.8% 50.00% 3.08% 9.00% 55% 4.2% 9.2% 60% 5.3% 9.4% 65% 6.4% 9.6% 70% 7.6% 9.8% 75% 8.7% 10.0% 80% 9.8% 10.2% 85% 10.9% 10.4% 90% 12.1% 10.6% 95% 13.2% 10.8% 100% 14.3% 11.0% Portfolio Return 12.0% 11.0% 10.0% 9.0% 8.0% 7.0% 6.0% 5.0% Portfolo Risk and Return Combinations 100% bonds 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0% Portfolio Risk (standard deviation) We can consider other portfolio weights besides 50% in stocks and 50% in bonds 100% stocks The Efficient Set for Two Assets 10.4 The Efficient Set for Two Assets % in stocks Risk Return 0% 8.2% 7.0% 5% 7.0% 7.2% 10% 5.9% 7.4% 15% 4.8% 7.6% 20% 3.7% 7.8% 25% 2.6% 8.0% 30% 1.4% 8.2% 35% 0.4% 8.4% 40% 0.9% 8.6% 45% 2.0% 8.8% 50% 3.1% 9.0% 55% 4.2% 9.2% 60% 5.3% 9.4% 65% 6.4% 9.6% 70% 7.6% 9.8% 75% 8.7% 10.0% 80% 9.8% 10.2% 85% 10.9% 10.4% 90% 12.1% 10.6% 95% 13.2% 10.8% 100% 14.3% 11.0% P ortfolio R eturn 12.0% 11.0% 10.0% 9.0% 8.0% 7.0% 6.0% 5.0% Portfolo Risk and Return Combinations 100% bonds 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0% Portfolio Risk (standard deviation) 100% stocks We can consider other portfolio weights besides 50% in stocks and 50% in bonds % in stocks Risk Return 0% 8.2% 7.0% 5% 7.0% 7.2% 10% 5.9% 7.4% 15% 4.8% 7.6% 20% 3.7% 7.8% 25% 2.6% 8.0% 30% 1.4% 8.2% 35% 0.4% 8.4% 40% 0.9% 8.6% 45% 2.0% 8.8% 50% 3.1% 9.0% 55% 4.2% 9.2% 60% 5.3% 9.4% 65% 6.4% 9.6% 70% 7.6% 9.8% 75% 8.7% 10.0% 80% 9.8% 10.2% 85% 10.9% 10.4% 90% 12.1% 10.6% 95% 13.2% 10.8% 100% 14.3% 11.0% P ortfolio R eturn Portfolo Risk and Return Combinations 12.0% 11.0% 10.0% 9.0% 100% 8.0% stocks 7.0% 6.0% 100% 5.0% bonds 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0% Portfolio Risk (standard deviation) Note that some portfolios are better than others. They have higher returns for the same level of risk or less. These compromise the efficient frontier Definition of Risk When Investors Hold the Market Portfolio Researchers have shown that the best measure of the risk of a security in a large portfolio is the beta (β)of the security. Beta measures the responsiveness of a security to movements in the market portfolio. Cov( Ri, RM ) β = i 2 σ ( R ) M Estimating β with regression Security Returns Slope = β i Characteristic Line Return on market % R i = α i + β i R m + e i

15 August 8, 2008 MS&E247s International Investments Handout #20 Page 15 of 72 Estimates of β for Selected Stocks The Formula for Beta Stock Bank of America Borland International Travelers, Inc. Du Pont Kimberly-Clark Corp. Microsoft Green Mountain Power Homestake Mining Oracle, Inc. Beta Cov( Ri, RM ) β = i 2 σ ( R ) Clearly, your estimate of beta will depend upon your choice of a proxy for the market portfolio. M Relationship between Risk and Expected Return (CAPM) Expected Return on the Market: R M = R F + Market Risk Premium Expected return on an individual security: Ri = R F + β ( R i M R F ) Expected Return on an Individual Security This formula is called the Capital Asset Pricing Model (CAPM) Ri = R + β ( RM R ) Expected return on a security F = Riskfree rate Beta of the + security i F Market risk premium Market Risk Premium This applies to individual securities held within welldiversified portfolios Assume β i = 0, then the expected return is R F. Assume β i = 1, then R i = RM Relationship Between Risk & Expected Return Relationship Between Risk & Expected Return Expected return R M Ri = R F + β ( R i M R F ) Expected return 13.5% 3% R F 1.0 β β i R F =3% RM =10% β =1.5 Ri = 3 % (10% 3%) = 13.5% 15-90

16 August 8, 2008 MS&E247s International Investments Handout #20 Page 16 of Summary and Conclusions This chapter sets forth the principles of modern portfolio theory. The expected return and variance on a portfolio of two securities A and B are given by E r ) = w E( r ) + w E( r ) ( P A A B B Summary and Conclusions The efficient set of risky assets can be combined with riskless borrowing and lending. In this case, a rational investor will always choose to hold the portfolio of risky securities represented by the market portfolio σ P = (waσ A ) + (wbσ B ) + 2(wBσ B )(wσ A A )ρ AB By varying w A, one can trace out the efficient set of portfolios. We graphed the efficient set for the two-asset case as a curve, pointing out that the degree of curvature reflects the diversification effect: the lower the correlation between the two securities, the greater the diversification. The same general shape holds in a world of many assets. Then with borrowing or lending, the investor selects a point along the CML. return r f M CML efficient frontier σ P Summary and Conclusions The contribution of a security to the risk of a well-diversified portfolio is proportional to the covariance of the security's return with the market s return. This contribution is called the beta. Cov( Ri, RM ) β = i 2 σ ( R ) The CAPM states that the expected return on a security is positively related to the security s beta: Ri = R F M + β ( R i M R F ) Ross / Corporate Finance 7E / CAPM 12.1 The Cost of Equity Capital Firm with excess cash Invest in project Pay cash dividend A firm with excess cash can either pay a dividend or make a capital investment Shareholder s Terminal Value Shareholder invests in financial asset Because stockholders can reinvest the dividend in risky financial assets, the expected return on a capital-budgeting project should be at least as great as the expected return on a financial asset of comparable risk The Cost of Equity From the firm s perspective, the expected return is the Cost of Equity Capital: Ri = R F + β R i ( M RF To estimate a firm s cost of equity capital, we need to know three things: 1. The risk-free rate, R F 2. The market risk premium, RM R F 3. The company beta, Cov( Ri, RM ) σi, M β = = i 2 Var( R ) σ M ) M Example Suppose the stock of Stansfield Enterprises, a publisher of PowerPoint presentations, has a beta of 2.5. The firm is 100-percent equity financed. Assume a risk-free rate of 5-percent and a market risk premium of 10-percent. What is the appropriate discount rate for an expansion of this firm? R = R + β ( R M RF ) F i R = 5 % % R =30% 15-96

17 August 8, 2008 MS&E247s International Investments Handout #20 Page 17 of 72 Example (continued) Suppose Stansfield Enterprises is evaluating the following nonmutually exclusive projects. Each costs $100 and lasts one year. Project Project β Project s Estimated Cash Flows Next Year IRR NPV at 30% A 2.5 $150 50% $15.38 B 2.5 $130 30% $0 C 2.5 $110 10% -$ Using the SML to Estimate the Risk-Adjusted Discount Rate for Projects Project IRR 30% Good project B A SML C Bad project 5% Firm s risk (beta) 2.5 An all-equity firm should accept a project whose IRR exceeds the cost of equity capital and reject projects whose IRRs fall short of the cost of capital Estimation of Beta: Measuring Market Risk Market Portfolio - Portfolio of all assets in the economy. In practice a broad stock market index, such as the S&P Composite, is used to represent the market. Beta - Sensitivity of a stock s return to the return on the market portfolio Estimation of Beta Theoretically, the calculation of beta is straightforward: Cov( Ri, R ) σ M i, M β = = 2 Var( RM ) σ M Problems 1. Betas may vary over time. 2. The sample size may be inadequate. 3. Betas are influenced by changing financial leverage and business risk. Solutions Problems 1 and 2 (above) can be moderated by more sophisticated statistical techniques. Problem 3 can be lessened by adjusting for changes in business and financial risk. Look at average beta estimates of comparable firms in the industry Stability of Beta Most analysts argue that betas are generally stable for firms remaining in the same industry. That s not to say that a firm s beta can t change. Changes in product line Changes in technology Deregulation Changes in financial leverage Using an Industry Beta It is frequently argued that one can better estimate a firm s beta by involving the whole industry. If you believe that the operations of the firm are similar to the operations of the rest of the industry, you should use the industry beta. If you believe that the operations of the firm are fundamentally different from the operations of the rest of the industry, you should use the firm s beta. Don t forget about adjustments for financial leverage

18 August 8, 2008 MS&E247s International Investments Handout #20 Page 18 of 72 Learning Objectives Modern Financial Markets: Prices, Yields, and Risk Analysis Blackwell, Griffiths and Winters Chapter Portfolio formation and correlation 2. Measuring portfolio risk 3. Incremental value-at-risk 4. Portfolio risk management strategies using derivative securities Stock Portfolio Formation and Risk Management The Basics of Portfolio Formation A portfolio is a group of assets. The relative importance (weight) of an asset in a portfolio is based on the asset s contribution to the value of the portfolio. We will focus on forming a stock portfolio. The Basics of Portfolio Formation (cont.) Example Let s assume we have 15,000 invested in our portfolio and the investment is divided among three stocks: FLYBY 5,000 33% UO 6,000 40% GDAY 4,000 27% The Basics of Portfolio Formation (cont.) Example (cont.) The Basics of Portfolio Formation (cont.) Example (cont.) Investment Expected Return (Annual) Standard Deviation (Monthly) Beta FLYBY 11% 10% 1.05 UO 9% 5% 0.95 GDAY 12% 7% 1.11 Correlation Coefficients FLYBY UO GDAY FLYBY UO GDAY So, what is the likely return on the portfolio? The answer is the weighted average of the individual returns. E[R] = w1*r1 + w2 * r2 + w3*r3 = 0.33(11%) (9%) (12%) = 10.47% Also, what is the Beta (β) of the portfolio? The answer is the weighted average of the individual Betas. E[β] = w1*β1 + w2 *β2 + w3*β3 = 0.33(1.05) (0.95) (1.11) =

19 Return Return Return Return Return August 8, 2008 MS&E247s International Investments Handout #20 Page 19 of 72 The Basics of Portfolio Formation (cont.) Example (cont.) The third calculation we would like to do for our portfolio is its standard deviation. However, the standard deviation of the portfolio is not the weighted average of the individual standard deviations because of the difference between diversifiable and non-diversifiable risk. The Basics of Portfolio Formation (cont.) Correlation The degree of correlation is a measure of the extent to which returns on two assets move together. If both move up and down together, they are positively correlated and ρ ij > The Basics of Portfolio Formation (cont.) Correlation (cont.) The Basics of Portfolio Formation (cont.) Correlation (cont.) If one moves up when the other moves down, they are negatively correlated and ρ ij < 0. Perfect Positive Correlation Stock A Stock B Less Than Perfect Positive Correlation Stock A Perfect Negative Correlation Stock B Less Than Perfect Negative Correlation Stock B Time Time Stock B Stock A Stock A Time Time The Basics of Portfolio Formation (cont.) Correlation (cont.) If the two assets are completely independent, then they are uncorrelated and ρ ij = 0. Zero Correlation Measuring Portfolio Risk We now want to measure portfolio risk and since a portfolio has more than one asset we have to consider the correlation of the assets in the portfolio. Stock B Stock A The standard deviation of a portfolio includes the correlation between the assets in the portfolio and thus provides a measure of portfolio risk. Time

20 August 8, 2008 MS&E247s International Investments Handout #20 Page 20 of 72 Measuring Portfolio Risk (cont.) The formula for portfolio standard deviation is: Measuring Portfolio Risk (cont.) Now, let s return to our portfolio and calculate its standard deviation. σ p 2 2 [ w + 2( )] 0. 5 i σ i wi w j ρ ijσ iσ = j INVESTMENT FLYBY UO FLYBY UO GDAY GDAY The shaded area (on the diagonal) represent the weighted total risk of the of the individual securities in the portfolio, which in the formula is Σw i2 σ 2 i Measuring Portfolio Risk (cont.) The off-diagonal items represent the correlations between the different assets in the portfolio and the formula is: 2(ΣΣw i w j ρ ij σ i σ j ) Measuring Portfolio Risk (cont.) Using our portfolio, the cells of the figure are as follows: INVESTMENT FLYBY UO GDAY The formula starts by multiplying by 2 because the items above the diagonal are the same as the items below the diagonal. FLYBY UO (0.33) 2 (.1) 2 (.33)(.4)(.8)(.1)(.05) (0.4) 2 (0.05) 2 (.33)(.27)(.5)(.1)(.07) (.4)(.27)(.2)(.05)(.07) GDAY (0.27) 2 (.07) Measuring Portfolio Risk (cont.) Measuring Portfolio Risk (cont.) σ Now, the calculation for the portfolio standard deviation is: p 2 2 = [ wi σ i + 2( wi w jρijσ iσ j )] σ = [(.33) (.1) + (.4) (.05) + (.27) (.07) + p 2((.33)(.4)(.8)(.1)(.05) + (.33)(.27)(.5)(.1)(.07) + (.4)(.27)(.2)(.05)(.07))] = [ ( )] The financial definition of risk is uncertainty and standard deviation provides a measure of uncertainty. However, individuals often think of risk in terms of losses and focus on the absolute dollar value of their losses. = [ ] 0.5 =.0606 or 6.06% The focus on dollar losses as a concept of risk has led to the development of an alternative measure of risk called Value-at- Risk

21 August 8, 2008 MS&E247s International Investments Handout #20 Page 21 of 72 Value-at-Risk Value-at-Risk (cont.) To measure value-at-risk, we change our focus from portfolio percentages to dollar value invested. With this change we can measure portfolio standard deviation in terms of dollar value invested. That is, we replace the portfolio percentage weights with the dollar values invested. The calculation for our portfolio is as follows: σ p Continuing with our portfolio, the portfolio standard deviation based on value invested is = [ wi σ i + 2( wi w jρijσ iσ j )] σ = [(5000) (.1) + (6000) (.05) + (4000) (.07) + p 2((5000)(6000)(.8)(.1)(.05) + (5000)(4000)(.5)(.1)(.07) + (6000)(4000)(.2)(.05)(.07))] = [250, , , (120, , ,800)] = [832,000] = Value-at-Risk (cont.) Having calculated the portfolio standard deviation in terms of value invested, we have completed the first step in determining Valueat-Risk. Value-at-Risk provides the expected maximum loss over a target horizon with a given level of confidence. Value-at-Risk (cont.) To calculate Value-at-Risk, we need two more pieces of information: 1. Length of holding period, which is chosen to match the amount of time required to liquidate the portfolio in an orderly manner. 2. Confidence interval, which is a function of the amount of risk aversion of the investor. Higher confidence intervals imply higher value-at-risk figures Value-at-Risk (cont.) Both measures are somewhat arbitrary and are chosen to fit the situation and the investors. For a stock portfolio, a common horizon is one month and we will choose a confidence level of 5% for our calculation of value-at-risk. Value-at-Risk (cont.) Recall from statistics that the point estimate from a confidence level is as follows: Point estimate = +/- (confidence level critical value) * (standard deviation) Since we are looking at value losses, we focus only on the left tail of the distribution

22 August 8, 2008 MS&E247s International Investments Handout #20 Page 22 of 72 Value-at-Risk (cont.) Assuming that the changes in the value of our portfolio are normally distributed then the critical value for the confidence interval can been seen from Figure N(d) c = 5% confidence level 1.65 σ d = Standard Normal Variable Value-at-Risk (cont.) Value-at-Risk calculation: Portfolio standard deviation in value is and critical value for 5% lower tail confidence interval is So, the value-at-risk is 1, = ( *1.65). This means that we are 95% confident that our maximum monthly loss is 1, Incremental Value-at-Risk Value-at-Risk provides a calculation of portfolio risk. However, we may want to know which security provides the most risk (or threat to maintaining value) in our portfolio. We can address this question by calculating incremental value-at-risk. Incremental Value-at-Risk (cont.) Incremental value-at-risk is a two step calculation with the steps as follows: 1. Calculate the individual stock value variance in the portfolio followed by 2. Calculating the individual stock contribution to the value-at-risk for the portfolio Incremental Value-at-Risk (cont.) Incremental Value-at-Risk (cont.) Step 1 of incremental value-at-risk Step 2 of incremental value-at-risk Stock Positio n Variance + Position Covariance + Position Covariance Stock Stock (Variance/ Covariance) Portfolio Variance * Portfolio Value-at- Risk * Stock Wealth Position FLYBY 5, , , = FLYBY * * 5,000 = UO 6, , , = UO * * 6,000 = GDAY 4, , , = GDAY * * 4,000 Total (rounded) = Recall that covariance = ρ ij σ i σ j so the covariance between GDAY and FLYBY is (0.5)(.1)(.07) =

23 August 8, 2008 MS&E247s International Investments Handout #20 Page 23 of 72 Incremental Value-at-Risk (cont.) Points from incremental value-at-risk. 1. FLYBY puts the most value-at-risk even though at is not the largest investment in the portfolio. 2. UO has the lowest value variance (from Step 1) but is not the least risky portion of our portfolio because of the large value investment in UO. Three Important Points about Value-at-Risk 1. The value-at-risk calculation is only an estimate. It is not a guarantee. 2. The value-at-risk calculation assumes that stock returns follow a certain distribution (e.g., normal). 3. To this point we have not borrowed to buy stock. Borrowing to buy stocks is referred to as trading on margin Value-at-Risk with Margin Value-at-Risk with Margin (cont.) Our calculations assumed that we owned the stocks in our portfolio. If an investors uses margin to buy stock, then the investor does not own the entire investment because a portion of the cash flows are obligated to the lender. Buying on margin is a classic example of leverage; we know that leverage increases risk Let s assume that we borrow 15,000 at a rate of 7% to increase the positions in each of the three stock in our portfolio by 5,000. Security FLYBY UO GDAY Margin Loan Total Equity Value Net Equity Value Original position 5,000 6,000 4, ,000 15,000 Margin Position 10,000 11,000 9,000 15,000 30,000 15,000 Market Falls 20% 8,000 8,800 7,200 15,000 24,000 9,000 Market Rises 20% 12,000 13,200 10,800 15,000 36,000 21, Market Rises by 20% Value-at-Risk with Margin (cont.) The impact of margin on portfolio return is the following Ending Portfolio Value 36,000 Repayment of Principal and Interest 16,050 Net Gain (Loss) 19,950 Investor Return (19,950-15,000)/15,000 = 33% Value-at-Risk with Margin (cont.) Points about investor returns with margin. 1. When there is no change in the market, the investor loses because of the interest owed on the borrowing. 2. Leverage magnifies both gains and losses. Market Unchanged 30,000 16,050 13,950 (13,950-15,000)/15,000 = -7% Market falls by 20% 24,000 16,050 7,950 (7,950-15,000)/15,000 = -47%

24 August 8, 2008 MS&E247s International Investments Handout #20 Page 24 of 72 Value-at-Risk with Margin (cont.) Now, let s take the leverage effect of margin and apply it to our value-at-risk calculation for the portfolio. Re-calculating the money standard deviation with margin, the standard deviation becomes 3,351, which means at a confidence interval of 95% the value-at-risk of our portfolio with 15,000 of margin borrowing is 5,529.15, which is a 3.67 time increase over the original value-at-risk amount. Global Portfolios and Value-at-Risk Let s use market indices from 13 stock markets around the world and look at value-at-risk for an equal weighted portfolio invested in the 13 market indices. Returns, standard deviations and correlations for the indices using data from January 1998 through December 1999 are: Global Portfolios and Value-at-Risk (cont.) Global Portfolios and Value-at-Risk (cont.) Country E[R] standard deviation USA Egypt France Germany Hong Kong Israel Japan Korea Mexico So Africa Taiwan Canada UK Correlations S&P Egpt Fr Ger HK Isr Jap Kor Mex So Af Tai Cda UK S&P Egypt France Germany Hong Israel Japan Korea Mexico So Africa Taiwan Canada UK Global Portfolios and Value-at-Risk (cont.) Global Portfolios and Value-at-Risk (cont.) If a $1,000,000 investment is divided equally among the 13 indices, the incremental value-at-risk of each index is: inc risk USA Egypt France Germany Hong Kong Israel Japan Korea Mexico So Africa Taiwan Canada UK So, the data suggest that the high risk indices in our equal weighted portfolio are: Korea, Mexico, and Hong Kong

25 August 8, 2008 MS&E247s International Investments Handout #20 Page 25 of 72 Global Portfolios and Value-at-Risk (cont.) Global Portfolios and Value-at-Risk (cont.) Repeating the portfolio calculations for the first 15 weeks of Country E[R] standard deviation USA Egypt France Germany Hong Kong Israel Japan Korea Mexico So Africa Taiwan Canada UK Country inc risk USA Egypt France Germany Hong Kong Israel Japan Korea Mexico So Africa Taiwan Canada UK Global Portfolios and Value-at-Risk (cont.) Global Portfolios and Value-at-Risk (cont.) The new data suggest that high risk indices in our equally weighted portfolio are: Mexico, Hong Kong, and Canada. What do we learn from these calculations about incremental value-at-risk? Our estimates of VaR are only as good as the data. That is, we assume that historic data is the best predictor of the future, so our calculations are only as good as data is as a predictor Portfolio Risk Management Strategies Now that we can quantify portfolio risk, both in percentages and dollars, we need to turn our attention to how to manage this risk exposure. We discuss two techniques: 1. Protective puts and 2. Protective collars. Portfolio Risk Management Strategies (cont.) Protective Puts Protective puts are often referred to as portfolio insurance. That is, you pay for the put option to protect against bad events and if good events occur the insurance (put) expires unused

26 August 8, 2008 MS&E247s International Investments Handout #20 Page 26 of 72 Portfolio Risk Management Strategies (cont.) Protective Puts (cont.) The idea behind a protective put is the investor has a portfolio (or an asset) that is valuable, that the investor does not want to sell, and that the investor is concerned about a near-term decrease in value. So, the investor buys put options on the portfolio to protect the current value. Portfolio Risk Management Strategies (cont.) Protective Puts (cont.) Recalling the vector notation for options in Chapter 10, applying a protective put to a portfolio is: Long Portfolio + Buy a Put = Protected Position = Portfolio Risk Management Strategies (cont.) Protective Puts (cont.) So, what we see from the vector notation is that the portfolio with a protective put (buy the put so we have the right to sell the portfolio at the strike price) gains when the portfolio gains, but has no losses when the portfolio declines in value. Portfolio Risk Management Strategies (cont.) Protective Puts (cont.) Profit Unprotected Portfolio Portfolio with Protective Put Index Level Loss Portfolio Risk Management Strategies (cont.) Protective Puts (cont.) Example Example inputs Portfolio = $4,000,000 and is roughly similar to the NASDAQ Composite Index (NMCI), NMCI = 1580, Put option = $37 at a strike index level of 1580 and the size of one contract is index level * 100. Portfolio Risk Management Strategies (cont.) Protective Puts (cont.) Example cont. Position and cost of protective put 1.$4,000,000/(1580*100) = 25.3 contracts. We cannot buy a fractional contract so we buy 25 put options. 2.The cost of the position is $37 * 100 * 25 = $92,

27 August 8, 2008 MS&E247s International Investments Handout #20 Page 27 of 72 Portfolio Risk Management Strategies (cont.) Protective Puts (cont.) Example cont. What happens on the put expiration date? If the index increases in value, we let the put expire; the cost of our portfolio insurance, $92,500, is lost. If the index declines, we exercise the put to recover the losses on the portfolio. Of course, we still pay the $92,500 for the insurance but this time we use the insurance to cover losses. Portfolio Risk Management Strategies (cont.) Protective Puts (cont.) The protective put limits any losses on our portfolio. However, the cost of the insurance (protective put) is high. A method to limit the cost of the portfolio insurance is to apply a protective collar to the portfolio instead of a protective put Portfolio Risk Management Strategies (cont.) Protective Collar A protective collar is designed to limit the downside losses on a portfolio at reduced premium costs. A protective collar is the combination of a buying a put with selling a call on the portfolio with the put and call at different strike prices. Portfolio Risk Management Strategies (cont.) Protective Collar (cont.) The put and call options in the collar are chosen so that they have similar premiums. The idea behind a collar is that you buy loss protection for the portfolio (buy the put) by selling some portion of the potential gains of the portfolio (sell the call) Portfolio Risk Management Strategies (cont.) Protective Collar (cont.) Portfolio Risk Management Strategies (cont.) Protective Collar (cont.) Profit Loss Unprotected Portfolio Protective put from the collar to limit losses on the portfolio Call limits gains on the portfolio but was sold to pay for the protective put Index Level Points about the protective collar 1. The collar, as drawn, is designed to limit risk on the portfolio around the current index level. 2. The put strike index level is different (lower) than the call strike index level. 3. Between the two strike levels the portfolio value is NOT hedged and therefore changes

28 Chapter 8 Alternative Investments Introduction In this chapter we discuss: Common features of alternative investments. Different types of alternative investments. Risk and return features of alternative investments. Explain how net asset value is calculated. Nature of various mutual fund fees. Distinguish between open-end and closed-end funds. Copyright 2009 Pearson Prentice Hall. All rights reserved. Copyright 2009 Pearson Prentice Hall. All rights reserved. 8-2 Introduction In this chapter we discuss: Discuss exchange traded funds (ETFs) Venture capital investing Hedge fund investments. Alternative Investments Features Alternative investments are often equity investments in some non-publicly traded asset. Alternative investments beckon investors to areas of the market where alpha is more likely to be found than in more liquid and efficient markets. Alternative assets are assets not traded on exchanges. Copyright 2009 Pearson Prentice Hall. All rights reserved. 8-3 Copyright 2009 Pearson Prentice Hall. All rights reserved. 8-4 Alternative Investments Features The common features of alternative investments include: Illiquidity Difficulty in determining current market values. Limited historical risk and return data. Extensive investment analysis required. A liquidity risk premium Segmentation risk premium Alternative Investments Additional Features Alternative investments can be characterized as raising unique legal and tax considerations. Many forms of alternative investments involve special legal structures that avoid some taxes (exchange traded funds) or avoid some regulations (hedge funds). In some cases, alternative investments may look more like an investment strategy than an asset class. Copyright 2009 Pearson Prentice Hall. All rights reserved. 8-5 Copyright 2009 Pearson Prentice Hall. All rights reserved

29 Investment Companies Investment Companies These are financial intermediaries that earn fees to pool and invest investors funds, giving the investors rights to a proportional share of the pooled fund performance. An open-end fund stands ready to redeem investor shares at net asset value, but closed-end funds do not. Closed-end funds issue shares that are then traded in the secondary markets. Copyright 2009 Pearson Prentice Hall. All rights reserved. 8-7 Copyright 2009 Pearson Prentice Hall. All rights reserved. 8-8 Valuing Investment Company Shares The basis for valuing investment company shares is net asset value (NAV). NAV is the per-share value of the investment company s assets minus its liabilities. Assets Liabilities NAV = Number of shares Liabilities may come from fees owed to investment managers. Fund Management Fees Investment companies charge fees, some as one-time charges and some as annual charges. Front-end fee a sales commission charged at the time of purchase. A redemption (back-end) fee a charge to exit the fund. Annual fees include distribution and operating fees. Copyright 2009 Pearson Prentice Hall. All rights reserved. 8-9 Copyright 2009 Pearson Prentice Hall. All rights reserved Fund Management Fees Only management fees can be considered a portfolio management incentive fee. Operating Expenses Expense ratio = Average assets Exchange Traded Funds (ETFs) Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved

30 Exchange Traded Funds (ETFs) ETFs are not truly alternative investments. They are included here because of their particular legal structure. But they are liquid investments. They are shares of a portfolio, not of an individual company. ETFs are index-based investment products that allow investors to buy or sell exposure to an index through a single financial instrument. Exchange Traded Funds (ETFs) ETF is a special case of a fund that tracks some market index but that is traded on a stock market as any common share. In the US, ETFs have adopted three different legal structures: managed investment companies unit investment trusts grantor trusts. Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved Exhibit 8.1: Creation/Redemption Process of Exchange Traded Funds Copyright 2009 Pearson Prentice Hall. All rights reserved ETFs Advantages ETFs have the following advantages: Diversification Trading similarly to a stock Can be sold short or bought on margin. Transparency Cost effectiveness (no load fees) Management of their risk augmented by futures and options contracts on them. Avoidance of significant premiums or discounts to NAV Tax savings from payment of in-kind redemption Immediate dividend reinvestment for open-end ETFs. Copyright 2009 Pearson Prentice Hall. All rights reserved ETFs Disadvantages ETFs have the following disadvantages: Only a narrow-based market index tracked in some countries Intraday trading opportunity is not important for long-horizon investors. Large bid-ask spreads on some ETFs. Possibly better cost structures and tax advantages to direct index investing for large institutions. ETFs Types ETFs can be grouped under the following categories: Broad domestic market index Style (such as value and growth) Sector or industry (can be found in the United States, Europe and Japan) Country or region (multiple countries. ishares are indexed to several developed and emerging markets). Fixed Income Commodity Actively managed funds Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved

31 ETFs Risks Listed are the major risks faced by ETFs: Market Risk Asset class/sector risk Trading Risk Tracking error risk Derivatives risk Currency risk Country risk ETFs Risks Market risk, trading risk and tracking error risk affect all ETFs. Sector risk, currency risk and country risk may affect some sector and country ETFs. Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved ETFs Applications Following are some popular applications of a variety of investment strategies: Implementing asset allocation Diversifying sector/industry exposure Gaining exposure to international markets Equitizing cash Managing cash flows Completing overall investment strategy Bridging transitions in fund management Managing portfolio risk Applying relative value, long/short strategies Copyright 2009 Pearson Prentice Hall. All rights reserved Real Estate Copyright 2009 Pearson Prentice Hall. All rights reserved Real Estate The most common form of investment in tangible assets. In many countries, real estate is a common investment vehicle for pension funds and life insurance companies. Difficulties in investing in foreign real estate: Difficult to monitor properties located abroad. Taxes, paperwork and unforeseen risks may make foreign real estate investment impractical. Mortgage-backed Eurobonds are growing in popularity. Real Estate- Characteristics Characteristics include: Each property is immovable Basically indivisible and unique Not directly comparable to other properties Illiquid Bought and sold intermittently in a generally local marketplace. High transaction costs and market inefficiencies. Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved

32 Forms of Real Estate Investment There are several forms of real estate investment: Free and clear equity (sometimes called fee simple ) Leveraged equity Mortgages Aggregation vehicles (RELPs, commingled funds, REITs) Copyright 2009 Pearson Prentice Hall. All rights reserved Real Estate - Valuation Approaches The following four approaches are used worldwide: The Cost Approach The Sales Comparison Approach The Income Approach The Discounted After-Tax Cash flow Approach The net operating income from a real estate investment is gross potential income minus expenses, which include estimated vacancy and collection costs, insurance, taxes, utilities, and repairs and maintenance. Copyright 2009 Pearson Prentice Hall. All rights reserved Real Estate -Valuation Approaches Cost Approach: What is the cost of replacing the building in its present form? Sales Comparison Approach (similar to price multiple comparables approach): An adjusted value from a benchmark of comparable sales. Hedonic price estimate from a regression model Real Estate -Valuation Approaches Income Approach: Capitalized net operating income. NOI = gross potential income expenses (which incl. estimated vacancy and collection costs, insurance, taxes, utilities and repairs and maintenance) NOI Appraisal price = Market cap rate Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved Real Estate -Valuation Approaches The NPV of a property to an equity investor is obtained as the present value of the after tax cash flows, discounted at the investor s required rate of return on equity, minus the amount of equity required to make the investment. Real Estate - Example Question: Refer to the statistical analysis in example 8.2. You wish to value a house that has 8 rooms, a garden of 15,000 square feet, a swimming pool and a distance of three miles to the nearest shopping centre. What is the appraisal value based on this sales comparison approach of hedonic price estimation? Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved

33 Real Estate - Example Answer: The appraisal value is given by the equation: Private Equity Value = 20,000 x (#Rooms) + 5 x (Garden surface) + 20,000 x (pool) 10,000 x (Distance to shopping centre) Value = (20,000 x 8) + (5 x 15,000) + (20,000 x 1) (10,000 x 3) Value = 225,000 Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved Private Equity Private equity investing has grown rapidly in the 2000s. Private equity investments are equity investments that are not traded on exchanges. The limited partnership is called the Fund. General partners are sometimes designated as the Management Company. Private Equity There are three main categories of private equity: Venture capital Leverage buyout Distressed investing Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved Private equity Leveraged buyout investing The largest category of private equity Investors put up a equity stake (20-40%) and borrow the rest. Company is then taken private. Private equity firm then gets involved in the management of the acquired company and takes steps to increase its value. The objective is to resell the company a few years later at a higher price. Copyright 2009 Pearson Prentice Hall. All rights reserved Venture Capital Stages Venture capital financing is done in many stages: Seed-stage financing Early stage financing Start-up First-stage Formative stage financing Later stage financing Second-stage Third-stage Mezzanine Copyright 2009 Pearson Prentice Hall. All rights reserved

34 Venture Capital Stages Expansion-stage financing includes second and third stage. Balanced stage financing is a term used to refer to all stages, seed through mezzanine. Exit strategies are crucial for venture capital investing. Venture Capital Characteristics Some of the characteristics are common to alternative investing, but many are unique: Illiquidity Long-term commitment required Difficulty in determining current market values Limited historical risk and return data Limited information Entrepreneurial/management mismatches Fund manager incentive mismatches Lack of knowledge of how many competitors exist Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved Venture Capital Characteristics Some of the characteristics are common to alternative investing, but some are unique: Vintage cycles Extensive operations analysis and advice may be required. The challenges to venture capital performance measurement are: The difficulty in determining precise valuations The lack of meaningful benchmarks The long-term nature of any performance feedback. Venture Capital Valuation The expected NPV of a venture capital project with a single, terminal payoff and a single, initial investment can be calculated, given its possible payoff and its conditional failure probabilities, as the present value of the expected payoff minus the required initial investment. Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved Venture Capital Example Venture Capital Example Year Failure (Prob) Determine the probability that the project survives to the end of the sixth year. Prob = (1-0.4)(1-0.35)(1-0.30)(1-0.25)(1-0.15) 2 Prob =14.79% Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved

35 Vulture investing Distressed investing, or vulture investing, or special situations. The concept is to invest in operationally sound, financially distressed companies and to reorganize them. Hedge Funds Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved Hedge Funds: Definition Today, funds using the hedge fund appellation follow all kinds of strategies and cannot be considered a homogeneous asset class. Hedge funds can be defined as: Funds that seek absolute returns Having a legal structure that avoids some government regulations Have option-like fees, including a base management fee and an incentive fee proportional to realized profits. Hedge Funds The 1990s witnessed rapid growth in hedge funds. In 2007, assets under management surpassed $2 trillion. In 2007, the number of hedge funds exceeded 13,000. Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved Hedge funds Hedge fund managers can create leverage in trading by: 1) Borrowing external funds to invest more or sell short more than the equity capital that they put in. 2) Borrowing through a brokerage margin account 3) Use of financial instruments and derivatives. Copyright 2009 Pearson Prentice Hall. All rights reserved Legal Structure for US hedge funds The legal structure of a hedge fund largely depends who its investors will be. For example, a private investment vehicle formed for the benefit of persons who reside outside of the United States will be organized differently than an investment vehicle formed for the benefit of United States residents. Domestic US: A Limited partnership (LP) where investors are limited partners and the manager is General partner. Under Investment Act, no more than 100 investors, and no public solicitation Copyright 2009 Pearson Prentice Hall. All rights reserved

36 Legal Structure for US hedge funds International: For the purpose of managing the assets of persons residing outside of the US, and also tax-exempt US investors, an offshore fund is ordinarily structured as a corporation and organized in a tax haven jurisdiction (e.g. Bermuda, British Virgin Islands, Cayman Islands, Ireland). Often, the manager of an offshore fund forms a corporate entity to provide advisory services to the fund. This entity serves as the investment manager of the fund. If the hedge fund manager already manages the assets of a domestic partnership through a single corporate entity, the general partner of the partnership may also serve as the investment manager of the offshore fund. Copyright 2009 Pearson Prentice Hall. All rights reserved Master Feeder Structure ( hub and spoke ) - Feeder refers to the legal structure used. - The master fund is generally an offshore fund Copyright 2009 Pearson Prentice Hall. All rights reserved Registration & Information In the USA, the question was raised whether hedge funds needed to register with SEC. At the end of 2007, the answer is NO, but that does not mean that they escape any form of regulation. In other countries, there is a strong drive to regulate hedge funds and impose some information requirements. The industry is lobbying hard and tries to selfregulate and educate (e.g. CAIA, Chartered Alternative Investment Analyst Association ). Copyright 2009 Pearson Prentice Hall. All rights reserved Types of investment strategies Classifications are arbitrary and vary across data providers. Hedge funds can be classified as: Long/short Market neutral Fixed income Global macro Emerging market funds Managed futures funds Event driven Distressed securities funds Risk arbitrage in M&A Copyright 2009 Pearson Prentice Hall. All rights reserved Long/short hedge funds Long/short funds are the traditional type of hedge funds, taking short and long bets in common stocks. They vary their short and long exposure according to forecasts, use leverage, and now play on numerous markets throughout the world. These funds often maintain net positive or negative market exposures; so they are not necessarily market-neutral. In fact, a subgroup within this category is funds that have a systematic short bias, known as dedicated-short funds, or short-seller funds. The distinction with traditional funds is getting blurred, as some mutual funds offer a 130/30 strategy (or 120/20 etc..). A 130/30 strategy means that the funds goes short 30% and long 130%. Some hedge funds started to compete with similar products. Copyright 2009 Pearson Prentice Hall. All rights reserved Long/short Example A hedge fund has a capital of $10 million and invests in a market neutral long/short strategy on the British equity market. Shares can be borrowed from a primary broker with a cash margin deposit equal to 18% of the value of the shares. Given the high level of cash margin, no additional costs are charged to borrow the shares. The hedge fund has drawn up a list of shares regarded as undervalued (list A) and a list of shares regarded as overvalued (list B). The hedge fund expects that shares in list A will outperform the British index by 5% over the year, while shares in list B will underperform the British index by 5% over the year. The hedge fund wishes to retain a cash cushion of $1 million for unforeseen events. What strategy would you suggest? Copyright 2009 Pearson Prentice Hall. All rights reserved

37 Answer The hedge fund would sell short shares from list B and use the proceed to buy shares from list A for an equal amount. Some capital needs to be invested in the margin deposit. The hedge funds could take long/short positions for $50 millions: Keep $1 million in cash Borrow $50 million of shares B from a broker, Deposit $9 million in margin (18% $50 million), Sell shares B for $50 million in cash, Use the sale proceeds to buy $50 million worth of shares A The positions in shares A & B are established so that the portfolio s beta is close to zero. The ratio of invested assets to equity capital is roughly 5:1. Copyright 2009 Pearson Prentice Hall. All rights reserved Answer (2) If expectations materialize, the long/short portfolio of shares should have a gain over the year of 10% on $50 million whatever the movement in the general market index. To be market neutral, the fund would aim for a beta of zero. This $5 million gain will translate into an annual return before fees of 50% over the invested capital of $10 million. This calculation does not take into account the return on invested cash ($1 million) and assumes that the dividends on longs will offset dividends on shorts. Copyright 2009 Pearson Prentice Hall. All rights reserved Market Neutral hedge funds Merger Risk Arbitrage Example Market-neutral funds are a form of long/short funds that attempt to be hedged against a general market movement. They take bets on valuation differences of individual securities within some market segment. Long/short equity funds are a form of market neutral funds. But there are all kinds of market neutral strategies, mostly based on some form of arbitrage: equity long/short fixed-income hedging, pairs trading, warrant arbitrage, mortgage arbitrage, convertible bond arbitrage, closed-end fund arbitrage, and statistical arbitrage. Copyright 2009 Pearson Prentice Hall. All rights reserved A merger has been announced between a French company A and a German company B. A will acquire B by offering one share of A for two shares of B. Shares of B were trading in a 15 to 20 range prior to any merger discussion. Shares of B currently trade at 24, while shares of A trade at 50. The merger has been approved by both boards of directors but is awaiting ratification by all shareholders (that is extremely likely) and approval by the EU commission (there is a slight risk because the combined company has a large European market share in some products). How could a hedge fund take advantage of the situation? What are the risks? Copyright 2009 Pearson Prentice Hall. All rights reserved Answer The hedge fund should construct a hedged position where it buy two shares of B for every share of A that it sells short. As the proceeds of the short sale of one share of A ( 50) can be used to buy two shares of B ( 48), the position can be highly leveraged. Of course the cost of securities lending and margin deposit should also be taken into account. When the merger is completed, the hedge fund will make a profit of approximately 2 euros for each share of A. The risk is that the merger will be cancelled. It is hard to tell what will be the stock price reaction to this announcement, but it is clear that the stock price of B will drop more, because it was to be acquired at a price well above its pre-merger market value. That would mean a sizable loss for the hedge fund. Copyright 2009 Pearson Prentice Hall. All rights reserved Fee Structure Total fee = base (fixed) fee + Incentive (performance) fee Typically 1% (fixed) plus 20% (performance), but varies across funds. The calculation of performance fee varies and is somewhat complicated because of high watermark feature. Copyright 2009 Pearson Prentice Hall. All rights reserved

38 Funds of Funds Definition: Funds of funds (FOF ) have been created to allow easier access to small investors, but also to institutional investors. A FOF is open to investors and, in turn, invests in a selection of hedge funds. Additional fee: typically 1% and 10%, on top of the hedge funds fees (typically 1% and 20%). Fund of Funds Advantages Retailing Diversification Managerial expertise Due diligence process Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved Fund of Funds Disadvantages Potentially high fees Little evidence of persistence performance Absolute return loss through diversification Hedge Funds Risks The unique risks of hedge funds include: Liquidity risk Pricing risk Counterparty credit risk Settlement risk Short squeeze risk Financing squeeze risk. Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved Hedge Fund Index/database There are a number of indexes that track the hedge fund industry. The list of hedge fund index providers is long: Specialized hedge fund firms (such as HFR, Van Hedge, Hennessee, Greenwich) Banks such as ABN-AMRO/Eurekahedge or Crédit Suisse/Tremont (As of 2007, the Crédit Suisse/Tremont indexes are based on the TASS database that is managed by Tremont but owned and distributed by Lipper) Index providers (such as MSCI, S&P, FTSE), and even universities (CISDM, EDHEC) offering dedicated hedge fund indexes. Hedge Fund Index/database (2) These indexes are also broken down in sub-indexes for various classifications of hedge funds according to the investment strategy they follow. But the classifications vary across providers. The launching date of these indexes differs markedly. Some were launched in the 1990s, others in the 2000s. In some cases, the historical value of the index was back-calculated to an earlier date, with the risk of only including surviving hedge funds and biasing the performance upward. Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved

39 Hedge Funds Biases in performance Investors should exercise caution when using historical track record of hedge funds in reaching asset allocation decisions. The biases present in performance reporting: Self selection bias Instant backfilling bias Survivorship bias on return and risk Smoothed pricing on infrequently traded assets Option-like investment strategies Fee structure-induced gaming Exhibit 8.2: Performance and Risk Characteristics of Various Market Indexes January 1994-December 2006, in U.S. dollars Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved Closely Held Companies and Inactively Traded Securities Other Alternative Investments A closely held company is one that is not publicly traded. Require analysis of legal, financial and ownership considerations with account taken of the effect of illiquidity. An inactively traded security is not generally traded on a major exchange. A discount is used for lack of liquidity, lack of marketability, and for a minority interest, but a control premium is added for controlling ownership. Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved Closely Held Companies and Inactively Traded Securities Valuation Approaches: Cost approach (what it would cost to replace the company s assets in their present form). Comparables approach Income Approach Distressed Securities/Bankruptcies Are securities of companies that have filed or are close to filing for bankruptcy court protection, or that are seeking out-of-court debt restructuring to avoid bankruptcy. In the U.S. there are two types of bankruptcy protection: Chapter 7 (liquidation) Chapter 11 (reorganization) Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved

40 Distressed Securities/Bankruptcies Investment characteristics: Illiquid Require a long investment horizon Require intense investor participation/consulting Offer the possibility of alpha because of mispricing. Commodity Markets and Commodity Derivatives These investments complement investment opportunities offered by shares of corporations that extensively use these as raw materials in their production processes. Several indirect ways of commodity investing: Futures contracts Bonds indexed on some commodity price Stocks of companies producing the commodities. Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved Commodity Markets and Commodity Derivatives (2) These are attractive to investors because 1) commodities may have negative correlation with stock and bond returns 2) A desirable positive correlation with inflation. In the case of commodity-linked securities, the investor can receive some income rather than depending solely on commodity price changes. Managed Futures Commodity trading advisers (CTAs) offer managed futures funds that take positions in exchange traded derivatives on commodities and financials. A passive investor would typically invest through a collateralized position in a futures contract. A collateralized position in futures is a portfolio in which an investor takes a long position in futures for a given amount of underlying value and simultaneously invests the same amount in government securities, such as Treasury bills. Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved Collateralized Futures Example Assume that the futures price is currently $100. If $100 million is added to the fund, the manager will take a long position in the futures contract for $100 million of underlying value and simultaneously buy $100 million worth of Treasury bills (part of this will be deposited as margin). If the futures price drops to $95 the next day, the futures position will be marked to market, and the manager will have to sell $5 million of the Treasury bills to cover the loss. Conversely, if the futures price rises to $105, the manager will receive a marked-to-market profit of $5 million, which will be invested in additional Treasury bills. Discuss the sources of total return from such an investment. Answer The total return on the collateralized futures position comes from the change in futures price and the interest income on the Treasury bills. Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved

41 Commodity Markets and Commodity Derivatives - Risks The risks of managed futures can be managed as follows: Liquidity monitoring Through diversification Volatility dependent allocation VaR Risk budgeting on various levels Limits on leverage Use of derivatives Care in model selection The Example of Gold Former international monetary asset Offers protection in case of a major disruption Gold often allows investors to diversify against the kinds of risks that affect all stock markets simultaneously (depression, ) There are many gold-linked investments, such as gold mining stocks, gold-linked bonds. Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved

42 Chapter 9 The Case for International Diversification Copyright 2009 Pearson Prentice Hall. All rights reserved. Introduction In this chapter we cover: The advantages and disadvantages of international investing. Present the traditional case for international diversification. Calculate the expected return and standard deviation for a two-asset portfolio containing a domestic asset and a foreign asset. Demonstrate how changes in currency exchange rates can affect return and risk that investors earn on foreign security investments. Copyright 2009 Pearson Prentice Hall. All rights reserved. 9-2 Introduction Exhibit 9.1: Stock Market Capitalization Developed Markets to 2000, all Markets from 2002 In this chapter we also cover: Discuss global equity market correlations and global bond market correlations. Benefits of a global approach in light of the recent changes in the global economic landscape. The case for investing in emerging markets. Copyright 2009 Pearson Prentice Hall. All rights reserved. 9-3 Copyright 2009 Pearson Prentice Hall. All rights reserved. 9-4 International Investing Foreign investment allows investors to reduce the total risk of the portfolio while offering additional return potential. By expanding the investment opportunity set, international diversification helps to improve the risk-adjusted performance of a portfolio. Traditional Case for International Diversification A low international correlation allows for reduction of volatility of a global portfolio. A low international correlation provides profit opportunities for an active investor. Otherwise, the lower the correlation, the bigger the risk reduction. Cov d,f = ρ d,f σ d σ f Copyright 2009 Pearson Prentice Hall. All rights reserved. 9-5 Copyright 2009 Pearson Prentice Hall. All rights reserved

43 Traditional Case for International Diversification The expected return on the portfolio is simply equal to the average expected return on the two asset classes: E(R p ) = w d E(R d ) + w f E(R f ) The standard deviation of the portfolio is equal to: σ p = (w d2 σ d2 + w f2 σ f2 + 2w d w f ρ df σ d σ f ) 1/2 The portfolio s total risk (σ p ) will always be less than the average of the two standard deviations (w d σ d + w f σ f ). The only case in which it will be equal is when ρ d,f = +1. Copyright 2009 Pearson Prentice Hall. All rights reserved. 9-7 Example Assume that the domestic and foreign assets have standard deviations of σ d = 12% and σ f = 20% respectively, with a correlation of ρ d,f = What is the standard deviation of a portfolio equally invested in domestic and foreign assets? 2. Repeat the previous calculation only this time assume ρ d,f = +0.8 and that 60% of the portfolio is invested in foreign assets. Copyright 2009 Pearson Prentice Hall. All rights reserved. 9-8 Example - Answer 1. σ p = (w d2 σ d2 + w f2 σ f2 + 2w d w f ρ df σ d σ f ) 1/2 σ p = ((0.5) 2 (0.12) 2 + (0.5) 2 (0.20) 2 + 2(0.5)(0.5)(- 0.2)(0.12)(0.20)) 1/2 σ p = 10.58% 2. σ p = (w d2 σ d2 + w f2 σ f2 + 2w d w f ρ df σ d σ f ) 1/2 σ p = ((0.4) 2 (0.12) 2 + (0.6) 2 (0.20) 2 + 2(0.4)(0.6)(+0.8)(0.12)(0.20)) 1/2 σ p = 16.10% Currency Considerations The dollar value of an asset is equal to its local currency value (V) multiplied by the exchange rate (S) (number of dollars/local currency): V $ = V S The rate of return over the period is: r $ = r + s + (r s) where r = return in local currency s = percentage exchange rate movement Copyright 2009 Pearson Prentice Hall. All rights reserved. 9-9 Copyright 2009 Pearson Prentice Hall. All rights reserved Example Currency Risk Suppose we have a foreign investment with the following characteristics: σ = 16.5%, σ s = 8% and ρ = +0.1 What is the risk in domestic currency and the contribution of currency risk? Example Currency Risk Answer: σ f2 = (0.165) 2 +(0.08) 2 +2(0.1)(0.165)(0.08) = σ f = 19.04% Contribution of currency risk: σ f σ = 19.04% % = 2.54% Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved

44 Exhibit 9.2: Risk-Return Trade-off of Internationally Diversified Portfolios Exhibit 9.3 Risk-Return Trade-Off of Internationally Diversified versus Domestic-Only Portfolios Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved Exhibit 9.4: Correlation of Stock Markets, Monthly returns in U.S. dollars (bottom left) and currency hedged (top right) Market Correlations (Stock Markets) The degree of independence of a stock market is directly linked to the independence of a nation s economy and governmental policies. Purely national or regional factors seem to play an important role in asset prices, leading to sizeable differences in the degree of independence between markets. Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved Market Correlations (Stock Markets) Correlations between various stock and bond markets are systematically monitored by major international money managers. Low correlation across countries offers riskdiversification and return enhancement opportunities. Technological specialization Cultural and sociological differences. Exhibit 9.5: Correlation of Bond Markets, January Monthly Returns in U.S. Dollar (bottom right) and Currency Hedged (top right) Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved

45 Market Correlations (Bond Markets) In general, long-term bond return variations are not highly correlated across countries. Regional blocs do appear. Eurozone bond markets now exhibit a correlation close to 1.0 for government bonds. Foreign bonds offer excellent diversification benefits to a U.S. stock portfolio manager. Market Correlations (Bond Markets) Factors causing bond market correlations across countries to be low are the differences in national monetary and budgetary policies. National monetary/budgeting policies are not fully synchronized. There exists a correlation between currency movements and bond yield movements. Some countries practice a leaning against the wind policy, whereby they raise their interest rates to defend their currencies. Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved Exhibit 9.6: Stock Exchange Trade Hours in Greenwich Mean Time (GMT) and Eastern Time (EST) Clocks Portfolio Return Performance A common way to evaluate a portfolio s riskadjusted performance is to evaluate its Sharpe Ratio. The Sharpe Ratio is the ratio of return on a portfolio, in excess of the risk-free rate, divided by its standard deviation. Sharpe ratio = E ( R p r f ) σ p Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved Sharpe Ratio In other words, the Sharpe ratio measures the excess return per unit of risk. Money managers attempt to maximize the Sharpe ratio. Investing in foreign assets allows a reduction in portfolio risk and possibly an increased return. Example Sharpe Ratio You are given the following information: σ f = 15%, σ d = 12%, ρ df = 0.55, E(R f ) = 12%, E(R d ) =10%, r fd = r ff = 4% Calculate the Sharpe ratio for the domestic asset, the foreign asset and an internationally diversified portfolio equally invested in the domestic and foreign assets. Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved

46 Example Sharpe Ratio Domestic: E( R p r Sharpe ratio = σ 10 4 Sharpe ratio = 12 Sharpe ratio = 0.5 p f ) Example Sharpe Ratio Foreign: E( Rp rf ) Sharperatio = σ p 12 4 Sharperatio = 15 Sharperatio = Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved Example Sharpe Ratio Exhibit 9.7: Efficient Frontier for Stocks (U.S. dollar, ) Portfolio E(R p ) = 0.5(10) + 0.5(12) = 11% The standard deviation of the portfolio is equal to: σ p = (w d2 σ d2 + w f2 σ f2 + 2w d w f ρ df σ d σ f ) 1/2 σ p = ((0.5) 2 (12) 2 + (0.5) 2 (15) 2 + 2(0.5)(0.5)(0.55)(12)(15)) 1/2 σ p = 11.91% E( Rp rf ) Sharpe ratio = σ p 11 4 Sharpe ratio = Sharpe ratio = Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved Currency Risk In a global portfolio, the depreciation of one currency is often offset by the appreciation of another. market and currency risk are not additive (only true if the two are perfectly correlated). The exchange rate risk of an investment may be hedged for major currencies by selling futures or forward currency contracts, buying put currency options, or even borrowing foreign currency. The contribution of currency risk should be measured for the total portfolio. Contribution of currency risk decreases with the length of the investment horizon. Copyright 2009 Pearson Prentice Hall. All rights reserved Exhibit 9.8: Global Efficient Frontier for Stocks and Bonds (U.S. dollar, ) Copyright 2009 Pearson Prentice Hall. All rights reserved

47 Case Against International Diversification International correlations have trended upward over the past decade. It has also been observed that international correlation increases in periods of high market volatility. Markets that used to be segmented are moving towards global integration. Increases in Correlations The increases in correlations have been due to such factors as deregulation, capital mobility, free trade, and the globalization of corporations. Capital mobility has increased especially among developed countries. The country-specific argument against international diversification arises during periods when the domestic market does better than most other markets. Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved Exhibit 9.9a: Global Efficient Frontiers for Non-U.S. Investors Japanese yen ( ) Exhibit 9.9b: Global Efficient Frontiers for Non-U.S. Investors British Pound ( ) Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved Exhibit 9.9c: Global Efficient Frontiers for Non-U.S. Investors Deutsche Mark ( ) Increases in Correlations Correlation seems to increase dramatically in periods of crises. So the benefits of international risk diversification disappears when they are most needed. A phenomenon referred to as correlation breakdown. Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved

48 Exhibit 9.10: Mean Return and Correlation of Selected Markets with the U.S. Equity Market Five Year Period from 1971 to 2000, in U.S. Dollars Exhibit 9.11: Real Growth Rate (GDP Growth) of Selected Regions Ten-Year Periods from 1971 to 2000 Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved Exhibit 9.12: Value of Cross-Border M&As, Exhibit 9.13: 1987 U.S. Stock Market Crash One-Day Movement in Units of Normal Daily Standard Deviations Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved Barriers to International Investment Familiarity with Foreign Markets: this could include cultural differences, trading procedures, the way reports are presented, different languages, different time zones. Political Risk: some countries run the risk of being politically unstable in the form of political, economic or monetary crises. Barriers to International Investment Market Efficiency one issue is liquidity. Some markets are very small; others have many assets traded in large volumes. Capital controls is another form of liquidity risk on foreign investments. Price Manipulation and Insider Trading Currency Risk can be hedged with derivative Hedging leads to additional administrative and trading costs. Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved

49 Barriers to International Investment Regulations In some countries, regulations constrain the amount of foreign investment that can be undertaken by local investors. The European Union prohibits any ownership discrimination amongst its members. Taxes Withholding taxes: The country where a corporation is headquartered generally withholds an income tax on the dividends paid by the corporations. Copyright 2009 Pearson Prentice Hall. All rights reserved Barriers to International Investment Transaction Costs: Brokerage commissions (fixed, negotiable, variable schedule, part of bid-ask spread) In foreign countries, brokerage commissions vary between 0.1-1% A large component is the price impact of a trade. Copyright 2009 Pearson Prentice Hall. All rights reserved Barriers to International Investment Transaction Costs: Custodial costs add to transaction costs. International money management fees tend to be higher because of: data collection and research international database subscriptions international accounting systems and communication costs Exhibit 9.14: Average Correlation of Countries and of Industries Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved The Case for Emerging Markets Expected profit is potentially large. As are local risks (volatility, liquidity and political risks). Emerging markets also present a positive but moderate correlation with developed markets. The correlation with the world index of developed markets from 1987 to 2007 was The Case for Emerging Markets The volatility of emerging markets is much larger than that of developed markets. Investment risk in emerging economies often comes from the possibility of a financial crisis. e.g. Mexican peso crisis (1994) Asian financial crisis (1997) Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved

50 Exhibit 9.15 Performance of World Developed Markets and Emerging Markets Volatility, Correlations and Risk Distribution of emerging market returns is not symmetric. The development of many emerging markets stems from political reform and liberalization. Existing infrastructure can limit growth (for example, Thailand and China). Corruption is a rampant problem everywhere but may be more so in some emerging markets. Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved Volatility, Correlations and Risk The banking sector is sometimes poorly regulated, unsupervised, undercapitalized for the lending risks assumed. International correlation tends to increase in periods of crisis, and emerging markets are subject to large periodic crises. In emerging markets, both the stock market and the currency are affected by the state of the economy. Contagion spread depends on whether the factors creating the boom or crisis are primarily global or local. Copyright 2009 Pearson Prentice Hall. All rights reserved Emerging Market Portfolio Return Performance Most analysts expect economies to grow at a higher rate than developed nations, given the liberalization of international trade. Emerging markets have shown signs of becoming more efficient, providing more rigorous research on companies and progressively applying stricter standards of market supervision. Many have adopted international accounting standards, automated trading and settlement procedures. Copyright 2009 Pearson Prentice Hall. All rights reserved Investing in Emerging Markets The investability in emerging markets is constrained by various regulations and liquidity problems. Emerging markets tend to be segmented and mispricing is evident. Investable or free indexes have been introduced to reflect investability of emerging markets. Investing in Emerging Markets Restrictions can take the form of: Foreign ownership Free float Repatriation of income or capital Discriminatory taxes Foreign currency restrictions Authorized investors Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved

51 Chapter 12 Global Performance Evaluation Introduction In this chapter we look at: The three steps of global performance evaluation. Calculate money-weighted and time-weighted rates of return. Decomposition of portfolio return into yield, capital gains (in local currency) and currency contribution. Performance attribution in multi-currency, multi-asset portfolios. Copyright 2009 Pearson Prentice Hall. All rights reserved. Copyright 2009 Pearson Prentice Hall. All rights reserved Introduction In this chapter we look at: Calculate and interpret Sharpe ratio. Performance appraisal to determine whether the manager has a true ability to add value. Discuss different international benchmarks used in performance evaluation. Discuss various biases that may affect performance appraisal. Global Performance Evaluation (GPE) There are three components: Performance measurement: Should not be confused with accounting valuation. The GPE component by which returns are calculated over a measurement period for the overall portfolio and various segments. Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved GPE (continued) Performance attribution: The GPE component by which the total portfolio performance is attributed to major investment decisions taken by the manager. Performance appraisal: The GPE component by which some judgment is formulated on the investment manager s skill. Risk-adjusted measures are used. Performance Measurement Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved

52 Calculating a Rate of Return One approach to calculating a rate of return if there are no cash flows in or out of the portfolio: V 1 V r = V 0 V r = V 0 There are two approaches to calculating a rate of return in the presence of an interim cash flow. The money-weighted return (MWR) The time-weighted return (TWR) Copyright 2009 Pearson Prentice Hall. All rights reserved or Example Simple Portfolio Consider a Simple Portfolio with a single cash flow during the measurement period. For simplicity, the measurement period is supposed to be one year. Using the formula on the previous slide, what would be the rate of return? The details on the portfolio are as follows: Value at start of the year is V 0 = 10,000 Cash withdrawal on day t is C t = -650 The cash outflow takes place 40 days after the start of the period, or at t = 40/365 = year Value on day t, before the cash flow is V t = 9450 Final value at end of the year is V 1 = 9550 Copyright 2009 Pearson Prentice Hall. All rights reserved Example Simple Portfolio If the formula were applied directly, we would find: V1 V r = 0 V0 9,550 10,000 r = 10,000 r = 4.5%, which is clearly incorrect Money Weighted Return (MWR) Captures the return on average invested capital. It measures net enrichment of the client. Sometimes called the dollar-weighted rate of return (in the U.S). Sometimes called an internal rate of return. Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved MWR (formula) The MWR is defined as: Ct V1 V0 = + t 1 (1 + r) (1 + r) r = MWR, V 1 = final value, C t = cash flow at time t V 0 = initial value. The cash flow convention is a + if it represents a contribution by the client, and a - if it is a cash flow withdrawal by a client. Copyright 2009 Pearson Prentice Hall. All rights reserved MWR - Example Consider the Simple Portfolio example on slide 7. Calculate the money weighted return. Answer: ,000 = + (40/365) ( 1+ r) (1 + r) r 2. 12% Copyright 2009 Pearson Prentice Hall. All rights reserved

53 MWR - Example Another approach (Dietz Method) Profit MWR1 = Average invested capital 9,550 10, MWR1 = , MWR1 2.12% Time Weighted Return (TWR) Is the performance per dollar invested (or per unit of base currency). It measures the performance of the manager independently of the cash flows to or from the portfolio. Obtained by calculating the rate of return between each cash flow date and chain linking these rates over the total measurement period. Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved Time Weighted Return (TWR) This method is necessary for comparing performance among managers or with a passive benchmark. The TWR must be used for performance evaluation under GIPS guidelines. TWR (formula) The formula over the measurement period is: V (1 ) (1 )(1 1 1) t V + r = + rt + rt+ = V0 ( Vt + Ct) When there is only one cash flow C t at time t. Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved TWR - Example Consider the example on slide 7. Calculate the TWR based on the given information. Answer: 9, rt = 10,000 9, rt + 1 = 8, r = rt = 5.5% rt + 1 = 8.523% TWR = r = 2.554% Copyright 2009 Pearson Prentice Hall. All rights reserved MWR versus TWR MWR is useful for measuring the return of invested capital. MWR gives an assessment of the client s net enrichment over the measurement period. TWR is the preferred method for measuring and comparing the performance of money managers. TWR should be used for performance evaluation. Copyright 2009 Pearson Prentice Hall. All rights reserved

54 Example Valuing Stock Selection Ability on a Japanese Equity Portfolio Consider a 10 million fund that is restricted to a 10% investment limitation in Japan. 100 million ( 1 million) are invested in the Japanese stock market and managed by a local money manager. The British fund s trustee wants to evaluate the manager s security selection skill in this market. Assuming a fixed exchange rate (i.e., 100 per rate), we will consider the following scenario. The Japanese manager invests 100 million in the Japanese stock index, via an index fund, thereby exactly tracking the index. After two weeks, the index rises from 100 to 130, and the fund s trustee ask the manager to transfer 30 million to a falling market (such as the U.K. market) to keep within the 10% limitation on Japanese investment and rebalance the asset allocation to its desired target. Over the next two weeks, the Japanese index loses 30% of its value (falling to 91), so that by the end of the month, the Japanese portfolio is down to 70 million. The calculations for the MWR, using the Dietz method, and the TWR are indicated below. The fund uses a consultant that performs a GPE with monthly MWR to estimate performance. What would be the conclusions regarding the security selection ability of the manager in Japan? Copyright 2009 Pearson Prentice Hall. All rights reserved Exhibit 12.1: TWR and Dietz Approximation to MWR for a Hypothetical Japanese Portfolio Copyright 2009 Pearson Prentice Hall. All rights reserved Solution The TWR on the Japanese portfolio is -9%; that is the performance of the Japanese index, which was perfectly tracked and fell from 100 to 91. The MWR computed by the consultant will be 0% (a net profit equal to 0, divided by some average capital), wrongly implying that the manager outperformed the Japanese market and has great skills in Japanese stock selection. In fact, the manager precisely tracked the Japanese market and no more. Performance Attribution in Global Performance Evaluation To conduct a detailed GPE, one should calculate the return for various segments of the portfolio. Return in local currency: r j = p j + d j where p j = capital gain d j = yield in percent Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved Exhibit 12.2: International Portfolio: Composition and Market Data Currency Contribution The currency contribution for a portfolio is the difference between the portfolio return measured in base currency and the portfolio return measured in local currency (i.e. assuming no change in exchange rates over the measurement period). Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved

55 Exhibit 12.3: Market and Currency Gains Example: British market goes up 10% and goes up 5% Total Return Decomposition The portfolio s total return, measured in base currency, can be decomposed as: Capital gain (in local currency) Yield Currency To perform the calculation it is useful to break down the portfolio into homogenous segments by asset type and currency (e.g., one segment is foreign stocks). Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved Total Return Decomposition (formula) Let s denote: p j the percentage capital gain on segment j d j the percentage yield on segment j c j the percentage currency contribution on segment j w j the percentage of segment j in the total portfolio at the start of the period Exhibit 12.4: International Portfolio: Total Return Decomposition r = j w p j + j j w d j + j j w c j j Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved Exhibit 12.5: International Benchmark: Total-Return Decomposition Performance Attribution Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved

56 Performance Attribution Superior performance can result from any of the following major investment decisions: Asset allocation Currency allocation Market timing (time variation in the weights) Security selection on each market. Security Selection Ability is determined by isolating the local market return of the various segments. Part of the return measures the performance that would have been achieved had the manager invested in a local market index instead of individual securities. Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved Example of Security Selection The return attributed to security selection can be determined by comparing to market index returns Let s denote I j The local-currency return on the market index of segment j. Then: r = w I + w p I + w d + w c j j j j j j j j j Asset Allocation The word contribution in this context indicates performance relative to a selected benchmark. A manager s relative performance, r I *, can be attributed to: A market allocation different from that of the index. A currency allocation different from that of the index Superior security selection Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved Exhibit 12.6: Summary of Previous Results Market Timing Market timing makes a contribution due to time variation in weights, w j. Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved

57 More on Currency Management In general, there are two major ways to take active currency exposure relative to a benchmark. Deviations from benchmark currency weights Using derivatives The overall currency component of the portfolio return can be viewed as the sum of: 1) The currency component of the passive benchmark 2) The currency allocation contribution 3) Return on currency hedges. Exhibit 12.7: Data on Portfolio and Benchmark Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved Exhibit 12.8: Multiperiod Performance Attribution Exhibit 12.9: Analysis of Performance: Non-North American Equity Return in U.S. Dollars: One year (in percent) Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved Risk Performance Appraisal The most common approach to global investment involves two steps: The investor decides on an asset allocation across various asset classes based on expected returns and risks for the various asset classes. An actively managed portfolio is constructed for each asset class, and a benchmark is assigned. Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved

58 Risk Measures - Total, or Absolute Risk (Standard Deviation) Usually annualized and expressed in percent per year. If a global benchmark is assigned to the total portfolio, the standard deviation of the total portfolio and the global benchmark can be compared. The formula is: 1 T 2 σ TOT = ( rt r) T 1 t1 = Where T is the number of observations (e.g., 12 months) Risk Measures (Continued) Relative Risk (Tracking Error): Usually annualized, expressed in percent per year. Tracking error is sometimes called active risk. Measures how closely the portfolio, or segment of a portfolio, tracks a benchmark. 1 T 2 σer = ( er t er ) where er t r t I T 1 t=1 = t Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved Exhibit 12.10: Tracking Error and Total Risk of International Portfolio Risk-Adjusted Performance The Sharpe ratio measures reward to variability. The Sharpe ratio should be used only for the investor s global portfolio. The Sharpe ratio is defined as: Sharpe ratio = r R0 s - tot Where R 0 is the risk-free rate. Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved Risk-Adjusted Performance Other measures include Treynor ratio which uses market risk (beta) and Jensen s measure. The pertinent measure of risk of a portfolio of foreign assets should be its contribution to the risk of the global portfolio of the client. Information Ratio Defined as the ratio of the excess return from the benchmark divided by the tracking error relative to the benchmark. Measures whether the excess return generated is large relative to the tracking error incurred. Grinold and Kahn (1995) assert that an IR of 0.50 is good and that an IR of 1.0 is exceptional. The formula is: er IR = σer Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved

59 Examples - Question You are provided with annual return, standard deviation of returns, and tracking error to the relevant benchmark for three portfolios. Calculate the Sharpe ratio and information ratio for the three portfolios and rank them according to each measure. Portfolio Return Standard Deviation Tracking error % 19.50% 7.50% % 25.00% 8.00% % 24.00% 7.50% Benchmark 14.00% 21.00% Risk-free rate 6.00% Examples Sharpe Ratio calculations Portfolio 1 = = 43.59% Rank Portfolio 2 = = 45.0% 0.25 Rank Portfolio 3 = = 50.0% 0.24 Rank1 Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved Example Information ratio calculations: Exhibit 12.11: Risk-Return Performance Comparisons: World Equity Portfolios (U.S. dollars) Four years Portfolio1 = = Rank Portfolio 2 = = Rank Portfolio3 = = Rank Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved Risk Allocation and Budgeting Performance appraisal requires that both return and risk measures be unbiased. The total risk (standard deviation) of a portfolio is the result of decisions at two levels: The absolute risk allocation to each asset class. The active risk allocation of managers in each asset class. Implementation Important issues in constructing customized international benchmarks are: Individual country/market weights Countries, industries, and styles Currency hedging Standard international equity indexes are weighted by market capitalization. Some prefer weights based on relative national GDP. Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved

60 Some Potential Biases in Return and Risk Biases in Performance Evaluation Infrequently traded assets Option-like investment strategies Survivorship bias: return Survivorship bias: risk Tricks sometimes used Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved Infrequently Traded Assets Smoothed pricing: Infrequently traded assets: Some assets trade infrequently. This is the case for many alternative assets that are not exchange-traded, such as real estate or private equity. This is also the case for illiquid exchange-traded securities or OTC instruments often used by hedge funds. Infrequently Traded Assets (cont d) Because prices used are often not up-todate market prices, but estimates of fair value, their volatility is reduced (smoothing effect). It introduces serial correlation of returns and a downward bias to the measured risk of the assets. In addition, it reduces the apparent correlation with conventional (liquid) equity and fixed income assets. Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved Infrequently Traded Assets (2) The bias can be large, so the true risk is much larger than the reported estimates. As suggested by Asness, Krail, and Liew (2001), Lo (2002) and Getmansky, Lo, and Makarov (2004), the correction requires taking serial correlation of return into account. This will lead to an increase in the estimated standard deviation and a decrease in the Sharpe ratio commonly used to measure risk-adjusted performance. After adjusting for serial correlation, Lo (2002) finds estimates that differ from the naive Sharpe ratio estimator by as much as 70 percent. Infrequently Traded Assets (2) Some hedge funds purport to be market neutral (i.e., funds with relatively small market betas), but Asness, Krail, and Liew (2001) show that including both contemporaneous and lagged market returns as regressors and summing the coefficients yields significantly higher market exposure. Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved

61 Option-like investment strategies Risk measures used in performance appraisal assume that portfolio returns are normally distributed. Many investment strategies followed by hedge funds have some option-like features that violate the normality assumption. For example, hedge funds following so-called arbitrage strategies will generally make a small profit when asset prices converge to their arbitrage value, but they run the risk of a huge loss if their arbitrage model fails. Standard deviation or traditional VaR measures understate the true risk of losses. Biases in Returns Self-selection bias: Hedge fund managers decide themselves whether they want to be included in a database. Managers that have funds with an unimpressive track record will not wish to have that information exposed. Some managers only include the bestperforming funds. Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved Biases in Returns (cont d) Backfilling bias: When a hedge fund enters a database, it brings with it its track record. Because only hedge funds with good track records enter the database, this creates a positive bias in past performance in the database. Ibbotson and Chen (2006) studied the TASS database from 1995 to 2006 and estimate that excluding backfilled data reduces the average annual return by some 350 basis points. Reliable index providers have recently taken steps to minimize backfill bias. Biases in Return (2) Survivorship bias: In the investment industry, unsuccessful funds and managers tend to disappear over time. Only successful ones search for new clients and present their track records. This creates a survivor bias. Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved Biases in Return (2) (cont d) This problem is acute with hedge funds because they often do not have to comply with performance presentation standards. It is not uncommon to see hedge fund managers present the track records of only their successful funds, omitting those that have been closed. If a fund begins to perform poorly, perhaps even starting to go out of business, it may stop reporting its performance entirely, thus inflating the reported average performance of hedge funds. Hedge fund indexes and databases may only include funds that have survived. Funds with bad performance disappear and are removed from the database that is used by investors to select among existing funds. Survivorship Bias Most academic studies suggest that survivorship bias overstates return by basis points per year. Malkiel and Saha (2005) studied the TASS database from 1996 to 2003 and estimated the average annual bias in performance to be 442 basis points. A similar survivorship bias exists for equity mutual funds, but it is smaller because the attrition rate of mutual funds is much smaller that the hedge fund attrition rate (of the order of 8 to 15 percent per year on average). Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved

62 Survivorship Bias (cont d) Reliable hedge fund indexes are now be much less susceptible to survivorship bias as defunct hedge funds are kept in the database; however, funds that simply stop reporting still pose a problem. Tricks sometimes played A manager without any expertise has decided to launch five long/short hedge funds with some seed money. The investment strategies of the five funds are quite different. Actually, the investment strategy of fund A is just the opposite of that of fund E. After a couple of years, some have performed well and some badly, as could be expected by pure chance. The manager decides to close funds A, B, and C and to enter funds D and E in a well-known hedge fund database. The marketing pitch of the manager is that the funds have superior performance (Sharpe ratio of 1.7 and 2.7). What do you think? Fund Name Mean Annual Return Standard Deviation Sharpe Ratio Fund A 30% 10% 3.3 Fund B 20% 10% 2.3 Fund C 0% 10% 0.3 Fund D +20% 10% 1.7 Fund E +30% 10% 2.7 Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved Answer The performance on the funds is purely random. But only the good-performing funds are included in the hedge fund database. The performance reported for a selection of funds is misleading. There is obvious survivorship and self-selection bias. Similarly, the performance of the hedge fund index is biased upward and misleading. Tricks sometimes played (2) An investment company decides to merge two of its international equity mutual funds: Fund A has 100 million of AUM, with a mediocre track record. The manager is fired. Fund B has 1 million of AUM, with a great track record. The manager will takeover the merged funds. What will be the name and published track record of the new Fund? Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved Answer (2) The temptation for the investment company is to give the name of Fund B and use solely its track record, as the same manager takes over the merged fund. Ethical performance standards should not allow this track-record game. Tricks sometimes played (3) A manager leaves investment company X and joins investment company Y. He has a bad track record. Should the accounts he/she managed be removed from the universe (composite) of his/her former investment company X when it reports its track record? Should it be added to the universe (composite) of investment company Y newly-joined by the manager? Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved

63 Answer (3) The temptation for Investment company X is to remove the past record of the accounts managed by the former manager from the reported track record of its composites, because the bad performance was due to a guy who is no longer with the firm. Hence including his/her bad performance would not be representative of the current firm. Investment company Y does not include the bad performance of the new manager. Anyway, they never had the accounts under management and the bad performance was caused by the old firm, not by the manager. Ethical performance standards should not allow Investment company X to adjust its reported past performance. A similar question arises when a client leaves the investment company because of the bad performance of her account. Copyright 2009 Pearson Prentice Hall. All rights reserved Global Investment Performance Standards (GIPS ) Designed by the CFA Institute Allow investors to compare investment firms on a global level and allows investment managers to compete globally. Also ensure uniformity in reporting so that results are directly comparable among investment managers. TWR is required. The concept of composites is central to AIMR presentation standards. A composite is an aggregation of a number of portfolios into a single group that is representative of a particular objective or strategy. Copyright 2009 Pearson Prentice Hall. All rights reserved Global Investment Performance Standards (GIPS ) Exhibit 12.A: Account Valuation Reports (explanation) In 2005, a new version of GIPS was published to be used worldwide. As of 2006, GIPS replaced the AIMR-PPS standards and are being adopted by many countries. Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved Exhibit 12.A: Account Valuation Reports (explanation) (cont d) Copyright 2009 Pearson Prentice Hall. All rights reserved

64 Chapter 13 Structuring the Global Investment Process Introduction In this chapter we discuss: The functions and relationships among the major participants in the global investment industry. The components of a formal investment policy statement. The various steps of the global portfolio management process. Copyright 2009 Pearson Prentice Hall. All rights reserved. Copyright 2009 Pearson Prentice Hall. All rights reserved Introduction Compare and contrast the major choices active/passive, top-down/bottom-up, global/specialized, currency, quantitative/subjective available in structuring the global investment decision making process. Discuss the important issues particularly scope, weights and currency allocation in choosing a global benchmark for strategic asset allocation. Evaluate the implications of a portfolio performance analysis for a global investor. A Tour of the Global Investment Industry - Investors Private Investors: Usually belong to two broad categories: private and institutional. Usually refers to an individual or small group of individuals. Can buy foreign shares, mutual funds or have their money managed by investment professionals. Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved A Tour of the Global Investment Industry - Investors Institutional Investors: Refers to an organization that invests on behalf of others, such as a mutual fund, pension fund, insurance companies or charitable organization. Endowments and foundations accumulate the contributions made to charitable and educational institutions. Participants in the Global Investment Industry Investment managers Range from asset management departments of banks to independent asset management boutiques. Brokers Play an important role in terms of implementing security trades and in research of companies and markets. Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved

65 Participants in the Global Investment Industry Consultants and Advisers Better known for their work with with pension funds, but they also work with private clients and other types of investors. Custodians Information technology is an important component of custodial services. Investment Managers Range from the asset management department of banks to independent asset management boutiques specializing in offering specific investment products. Some asset managers cater to retail clients as well as institutional clients, while others serve the needs of one client. Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved Brokers Sell-side analysts: work for brokerage firms and make recommendations to clients. Buy-side analysts: work for investment managers and institutional investors. All CFA charter holders and CFA candidates must follow the CFA Institute Code of Ethics and Standards of Professional Conduct, wherever they work and invest. Consultants and Advisers Play a major role in the asset management industry. Independent consulting firms have traditionally advised U.S. pension funds, while actuaries played a similar role in the U.K. Consultants also focus on services such as recommending asset allocation, selecting investment managers and monitoring performance, and giving tax and legal advice. Their most sensitive role is the process of selecting, hiring and firing external managers. Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved Custodians Securities owned by investors are deposited with a custodian, which often uses a global network of sub-custodians. With the high development costs of software, many banks have sold their custodial activities, and further consolidation is expected in the future, because economies of scale can be significant in this business. Institutional Investors - Pension Funds There are two different systems: The system found in France, Italy and most of Continental Europe, where active workers pay for the pensions of retired workers ( pay as you go or PYG). The Anglo-American system, where workers and their employers contribute to a pension fund, which capitalizes all contributions and pays them back at the time of retirement. In this case, pension funds are considered to be longterm investors. Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved

66 Pension Funds The investment approach of pension funds is greatly affected by the way future benefits are planned. There are basically two plan types and a combination thereof (following slide) Pension Funds Types A defined benefit pension plan (DB) which promises to pay beneficiaries a defined income after retirement. The benefit depends on factors such as the workers salary and years of service. A defined contribution plan (DC) where the amount of contributions paid is set, usually as a percentage of wages, but future benefits are not fixed. Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved Pension Funds Types In a traditional pension fund, all contributions are pooled and the total money is managed collectively. A board sets the investment policy of the fund. A recent trend is to give more investment decision power to each employee. (E.g., 401(k) plans in the U.S.) Copyright 2009 Pearson Prentice Hall. All rights reserved Institutional Investors: Endowments and Foundations Concerned about total return in the long run. Capital gains and income on the assets can be used to meet budgetary needs. Tend to have great investment freedom, because they operate under few regulatory constraints. Often the most aggressive institutional investors, with many having extensive global and alternative investments. Copyright 2009 Pearson Prentice Hall. All rights reserved Institutional Investors: Insurance Companies Collect premiums on life insurance and on property and casualty insurance, which are invested until claims are paid. Heavily regulated in each country and state in which they operate. Tend to adopt conservative investment policies. Tend to focus on fixed income assets, in order to assure their claim-paying ability. Copyright 2009 Pearson Prentice Hall. All rights reserved Global Investment Philosophies An investment management organization must make certain major choices in structuring its global decision process, based on: Its view of the world regarding security price behavior Its strengths, in terms of research and management Cost aspects Its location and prospective domestic/global marketing strategy Copyright 2009 Pearson Prentice Hall. All rights reserved

67 Global Investment Philosophies The Passive Approach The Active Approach Balanced and Specialized Industry or Country Approach Top-Down or Bottom-Up Style Management Currency Quantitative or Subjective Global Investment Philosophies: Passive Approach This approach simply attempts to reproduce a market index of securities (index fund approach). It is an extension of modern portfolio theory, which claims that the market portfolio should be efficient. The trend toward global indexing is strongly felt among institutional investors. Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved Global Investment Philosophies: Passive Approach Various indexing methods can be used: Full replication Stratified sampling Optimization sampling Synthetic replication Copyright 2009 Pearson Prentice Hall. All rights reserved Global Investment Philosophies: Active Approach A benchmark is often imposed in the mandate set by the client, and it will clearly guide the structure of the portfolio. Active decisions show up at various levels: Regional/country allocation Sector/industry selection Style selection Security selection Market timing Currency hedging Copyright 2009 Pearson Prentice Hall. All rights reserved Global Investment Philosophies: Active Approach A new dimension: Sector selection/credit selection Duration/yield curve management Yield enhancement techniques Global Investment Philosophies: Balanced or Specialized A balanced asset manager decides on all aspects of the global portfolio, from asset allocation to security selection and currency management. A specialized asset manager focuses on a particular investment area, such as Japanese equity or European value stocks or currency overlay. The asset allocation decision remains with the client (possibly helped by advisers), who uses many specialized managers for the various asset classes. Industry or Country approach Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved

68 Global Investment Philosophies: Top-Down or Bottom-Up Top-down approach The manager first allocates his assets across asset classes and then selects individual securities to satisfy that allocation. The most important decision in this approach is the choice of markets and currencies. Bottom-up approach The manager studies the fundamentals of many individual stocks, from which she selects the best securities (regardless of their national origin or currency denomination) to build a portfolio. Example - Risk Premium Suppose all investors in the world have similar risk aversion and require a Sharpe ratio of 0.45 on their diversified portfolios. The world market portfolio has a volatility of 25 percent. The emerging market asset has a volatility of 45 percent and a correlation of 0.45 with the world market portfolio. The beta of the emerging market asset class is 0.81 Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved Example - Risk Premium 1) What is the equilibrium for the market portfolio? 2) Assuming full integration, what is the equilibrium risk premium for the emerging market? 3) Assuming full segmentation, what is the equilibrium risk premium for the emerging market? Example - Answer RPM 1)0.45 = RPM = 11.25% 25 RPM ) ρim = 0.45 = or 20.25% σ 25 Hence RP = σ = = % RPi 3) = 0.45 σ RP = = or 20.25% i i M i i Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved Style Management Common style decisions: Value versus growth stocks Small versus large firms Currency Some managers treat currencies only as residual variables. Others fully hedge or decide on a permanent hedge ratio Currency overlay managers actively manage the currency exposure of a portfolio and often resort to currency options and forward or futures contracts for selective hedging or speculation. Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved

69 The Investment Policy Statement The investment policy statement (IPS) is the cornerstone of the portfolio management process. Prepared by the adviser and the client. A well constructed policy statement typically includes a summary of the various elements: Client description and purpose. Return and risk objectives Constraints Asset allocation considerations. Schedule for review and monitoring. Constraints Fall into one of five categories: 1) Liquidity requirements 2) Time horizon 3) Tax concerns 4) Legal and regulatory factors 5) Unique circumstances constrain asset allocation. Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved Schedule for Review and Monitoring Performance evaluation is a critical step Performance measurement Performance appraisal Performance attribution allows us to understand the sources of performance. Capital Market Expectations Expectations about future distributions of returns to asset classes. The formulation process is usually decomposed into three steps: Defining asset classes. Formulating long-term expectations used in strategic asset allocation. Formulating shorter-term expectations used in tactical asset allocation. Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved Defining Asset Classes The segmentation of asset classes is usually based on various criteria: Asset type (e.g., debt, equity real estate) Geography (domestic vs. international, or regional) Sector (e.g., technology stocks, high yield bonds, energy stocks) Style (e.g., growth vs. value stocks) Long-Term Capital Market Expectations: Historical Returns Long-term typically refers to five to ten years or more. Two basic approaches are used to formulate long-term expectations: historical returns forward-looking returns. Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved

70 Long-Term Capital Market Expectations: Forward-Looking Returns The approach can be summarized in three steps: 1) Calculate an updated covariance matrix (volatility and correlation of asset classes). 2) Infer expected returns for each asset class, using the CAPM. 3) Adjust expected returns for possible market segmentation and liquidity. Short-Term Capital Market Expectations: Historical Returns Short-term typically refers to a year or less than a year. Short-term capital market expectations will suggest (temporary) tactical deviations from the strategic asset allocation. Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved Strategic Asset Allocation (SAA) SAA is derived by conducting an asset allocation optimization using long-term capital market expectations. The choice of the proper global benchmark is important. Three important issues are: Scope of the benchmark Set of weights chosen Attitude toward currency risk. Strategic Asset Allocation (SAA) Individual clients use investment policy statement. Institutional clients use investable benchmark. Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved Tactical Asset Allocation (TAA) Also called dynamic allocation. Some managers use a disciplined risk-return optimization process. TAA is the process of deciding: 1) which asset classes are currently attractively or unattractively priced 2) making short-term departures from the long-term policy by buying more of the attractive markets and reducing the holding of unattractive markets. Exhibit 13.1: An Integrated Investment Process Copyright 2009 Pearson Prentice Hall. All rights reserved Copyright 2009 Pearson Prentice Hall. All rights reserved

71 Limitations of Mean-Variance Optimization Mean-variance optimization assumes that return distributions are normal. Rather than minimizing variance, another approach is to set a specific loss level (shortfall) and to build a portfolio that minimizes the probability of losing more than this set value. This is often known as minimizing shortfall or downside risk. Copyright 2009 Pearson Prentice Hall. All rights reserved Performance and Risk Control Performance control should be driven by an organization s daily accounting system. The following questions should be examined: What is the total return on the fund over a specific period? What is the breakdown of the return in terms of capital gains, currency fluctuations and income? To what extent is the performance explained by asset allocation, market timing, currency selection or individual security selection? How does the overall return compare with that of certain benchmarks? Is there evidence of particular expertise in various asset classes and markets? Has the risk diversification objective been achieved? How aggressive is the manager s strategy? How does this compare wit the goals of the client? Copyright 2009 Pearson Prentice Hall. All rights reserved

72 Exhibit 13.1: An Integrated Investment Process Copyright 2009 Pearson Prentice Hall. All rights reserved