Asset Allocation. Cash Flow Matching and Immunization CF matching involves bonds to match future liabilities Immunization involves duration matching

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1 Asset Allocation Strategic Asset Allocation Combines investor s objectives, risk tolerance and constraints with long run capital market expectations to establish asset allocations Create the policy portfolio Strategic asset allocation specifies the investor s desired exposures to systematic risk Strategic asset allocation is an effective way to exercise control over systematic risk exposures Tactical Allocation (TAA) Involves making short term adjustments to asset class weights based on short term predictions of relative performance among asset classes TAA creates active risk Asset Classes Overlapping asset classes will reduce the effectiveness of strategic asset allocation in controlling risk and will lead to problems in developing expectations for asset class returns Each class should contain homogeneous investments and asset classes should be mutually exclusive For purposes of risk control asset classes should have low correlation Asset Liability vs. Asset Only Approaches ALM approach involves modeling liabilities and adopting the optimal asset allocation in relationship to funding the liabilities ALM approach used by DB pension plans AO approach does not involve modeling liabilities, return objective dictates allocation Dynamic vs. Static Approaches The dynamic approach recognizes returns generated affect optimal investment decision in future periods Static approach does not account for links between optimal decisions at different time periods Dynamic approach is more costly to implement, but in an ALM approach the cost may be justified Cash Flow Matching and Immunization CF matching involves bonds to match future liabilities Immunization involves duration matching Calculation of Return Objective Return objective for a foundation is equal to the spending rate plus inflation Preserve the real purchasing power of the portfolio after making distributions Exam Preparation & Investment Sales Training 1 info@examsuccess.ca

2 Example: Assume the spending rate is 5% and expected inflation is 4%. (i) Calculate the return requirement using an additive return objective (ii) Calculate the return requirement that accounts for the effect of compounding Further assume that the cost of earning investment returns is 30 bps. (iii) Calculate the return requirement that accounts for the effect of compounding Solutions: (i)5+4=9% (ii)(1.05)(1.04)=9.2% (iii)(1.05)(1.04)(1.003)-1=9.53% Exam Preparation & Investment Sales Training 2 info@examsuccess.ca

3 Mean-Variance Approach Often applied to AO strategic asset allocation Inputs include expected return, standard deviation and asset correlation Need to quantify an investor s risk aversion Expected utility for an asset mix is adjusted by a risk penalty (the more risk averse the investor, the greater the penalty) U m = ER m 0.005R A σ 2 m Investor should choose among the portfolios that are consistent with their tolerance for risk Structure of the Minimum Variance Frontier Each portfolio on the MVF has the smallest variance of return for its level of expected return Assumption that asset weightings equal 1 and no negative weightings permitted (ie. Short sales), leads to the concept of corner portfolios Knowing the composition of the corner portfolios allows us to compute the weights of any portfolio on the MVF Exam Preparation & Investment Sales Training 3 info@examsuccess.ca

4 Calculation of Approximate Standard Deviation Example: Based on the information below, (i) calculate the composition of the efficient portfolio with an 8% expected return and (ii) calculate the approximate standard deviation of the efficient portfolio with an 8% expected return. Corner Portfolio Expected Return Expected SD Sharpe Ratio Asset Classes (Portfolio Weights %) The remainder of this question can be found on our Level 3 Test Bank. The Level 3 Test Bank contains hundreds of minutes of Essay style questions and 30 full Item Sets. The cost of the Test Bank is only $99 (+tax) To gain access, simply click on the Buy Now below and you will be taken to our ecommerce/paypal site where you can complete the transaction. Thank you. Best of luck with your studies! Exam Success Buy Now Exam Preparation & Investment Sales Training 4 info@examsuccess.ca

5 Strategic Asset Allocation, IPS, Expectations and MVO Use return objective and risk tolerance to identify appropriate portfolio Statistical Equivalence Region Simulated efficient portfolios generated based on the same set of underlying parameters are considered statistically equivalent efficient portfolios The scatter forms a statistical equivalence region Resampled Efficient Frontier A portfolio defined by the average weights on each asset class among the simulated efficient portfolios for a given return rank (eg, lowest to highest) Use resampled efficient frontier to select the portfolio that is most appropriate given the investor s return and risk objectives Addresses the issue of estimation error 90% Sample Acceptance Region Includes 90% of the simulated efficient portfolios A portfolio that plots within the region is consistent with mean-variance efficiency with a 10% chance of identifying the portfolio as inefficient when in fact it is efficient (a Type 1 error) Efficiency of Portfolios Portfolios on the resampled efficient frontier are more diversified, more stable through time and more likely to produce superior performance than portfolios chosen on the basis of a conventional mean-variance efficient frontier Exam Preparation & Investment Sales Training 5 info@examsuccess.ca

6 The Case for International Diversification Why add Global Securities Foreign investments allow investors to reduce the total risk of the portfolio, while offering additional return potential Expanded investment opportunity set helps to improve the risk-adjusted performance of the portfolio Traditional case: Low correlation with domestic securities Changes in Risk Total risk is reduced as long as the correlation of the foreign asset with the domestic market is not large COV d,f = ρ d,f x σ d x σ f Er p = w d x Er d + w f x Er f σ 2 p = w 2 d x σ 2 d + w 2 f x σ 2 f + 2w d w f COV d,f σ p = [w 2 d x σ 2 d + w 2 f x σ 2 f + 2w d w f x ρ d,f x σ d x σ f ] 1/2 Standard Deviation Example 1: Assume that the domestic and foreign assets have standard deviations of 15% and 17% respectively, with a correlation of 0.4. A. Calculate the standard deviation of a portfolio equally invested in domestic and foreign assets. B. Calculate the standard deviation of a portfolio with a 40% investment in the foreign asset. C. Calculate the standard deviation of a portfolio equally invested in domestic and foreign assets if the correlation is 0.5. Exam Preparation & Investment Sales Training 6 info@examsuccess.ca

7 Effects of Currency The dollar value of a foreign asset is equal to its local currency value multiplied by the exchange rate: r$ = r + s + (r x s) where, r$ = return in dollars r = return in local currency s = percentage exchange rate movement Currency Exchange rates and Risk Variance of the dollar return is equal to the variance of the sum of the local currency return and of the exchange rate movement Var(r$) = Var(r + s) = Var(r) + Var(s) + 2 COV(r,s) Or σ 2 f = σ 2 + σ 2 s + 2 x ρ x σ x σ s (variance of the foreign asset measured in dollars) Currency Effect Example 2: If the return on a Swiss asset is 5% in Euros and the Euro appreciates by 1%, calculate the return in dollars. Currency Risk Contribution Example 3: Suppose that a foreign investment has the following characteristics: SD in local currency, σ 15.5% SD of the exchange rate, σ s = 7% Correlation between the asset return, in local currency, and the exchange rate movement, ρ = 0 Calculate the risk in domestic currency and the contribution of currency risk Exam Preparation & Investment Sales Training 7 info@examsuccess.ca

8 Solutions: Standard Deviation Example 1: A. σ p = [0.5 2 x x x 0.5 x 0.5 x 0.4 x 15 x 17] 1/2 = 13.4% B. σ p = [0.6 2 x x x 0.5 x 0.5 x 0.4 x 15 x 17] 1/2 = 13.27% C. σ p = [0.5 2 x x x 0.5 x 0.5 x 0.5 x 15 x 17] 1/2 = 13.87% Currency Effect Example 2: r$ = 5% + 1% = 6% incorrect! r$ = 5% + 1% + (5% x 1%) = 6.05% correct! Currency appreciation applies to the original capital and to the capital gain Currency Risk contribution Example 3: σ 2 f = = , hence SD = = 17% Contribution of currency risk = 17% % = 1.5% Exam Preparation & Investment Sales Training 8 info@examsuccess.ca

9 Solutions: Solutions to these questions can be found on our Level 3 Test Bank. The Level 3 Test Bank contains hundreds of minutes of Essay style questions and 30 full Item Sets. The cost of the Test Bank is only $99 (+tax) To gain access, simply click on the Buy Now below and you will be taken to our ecommerce/paypal site where you can complete the transaction. Buy Now Thank you. Best of luck with your studies! Exam Success Exam Preparation & Investment Sales Training 9 info@examsuccess.ca

10 International diversification pushes out the efficient frontier E(r) International & US Securities Domestic Securities Only Total Risk Equity Market Correlations Correlation is a direct function of how closely the two countries economies are linked Factors causing equity market correlations across countries to be low are the independence of a nation s economy and government policies, technological specialization, social and cultural factors R 2 provides an indication of the percentage of common variance between two markets R 2 = 34% may be interpreted as, 34% of stock market A s price movements are the result of influences shared with stock market B, or 66% of the price movements are independent of stock market B s influences Bond Market Correlations Factors causing bond market correlations across countries to be relatively low are the differences in national monetary / budget policies Foreign bonds allow investors to diversify the risks associated with domestic monetary / budget policies Lagged Correlation Simply caused by differences in time zones, not by international market inefficiency that can be exploited Sharpe Ratio Investing in foreign assets allows a reduction in portfolio risk (the denominator), without necessarily sacrificing expected return (the numerator), thus domestic and foreign investors can see their Sharpe ratio increase if they diversify away from purely local assets Exam Preparation & Investment Sales Training 10 info@examsuccess.ca

11 Risk Return Framework Adding Bonds E (r) Stocks & Bonds Stocks only Total Risk Adding bonds elongates the efficient frontier Different Market Environments The world index theoretically should provide an average return of all national markets US investors benefited by achieving lower risk and higher returns Japanese investors only benefited by achieving lower risk, as their market outperformed the world index Passive global diversification is wise in terms of risk, but does not provide a free lunch in terms of return. Contribution of Currency Risk The lower the correlation between the exchange rate and asset price, the smaller the contribution of currency risk to total risk Currency risk may easily be eliminated by hedging Holding some foreign currency assets can actually reduce risk through diversification benefits The contribution of currency risk decreases with the length of the investment horizon (exchange rates tend to exhibit mean reversion) Exam Preparation & Investment Sales Training 11 info@examsuccess.ca

12 Increasing Correlation Argument International correlations have trended upward over the past decade 1. Economies and financial markets are becoming increasingly integrated, leading to higher correlations 2. Corporation have become more global in their operations International correlation increases in periods of high market volatility 1. Normal market assumption 2. Distributions of returns tend to have fat tails, thus the occurrence of large positive or negative returns is more frequent than expected under normal distributions Implication is that you lose the diversification benefits, correlation breakdown, when you need it the most! Country Specific Argument Against International diversification Based on the belief that if the domestic market has outperformed most other markets, there is no need for international investments in the future Barriers to International Investing 1. Lack of familiarity with foreign markets - Cultural differences 2. Political risk 3. Market efficiency a question of liquidity 4. Regulations 5. High transaction costs 6. Taxes withholding taxes 7. Currency risk Global Investing vs. International Diversification Link to: country factor vs. industry factor argument Investors must research the global product market and international competition for domestic companies Emerging Markets Offer potential for higher returns and lower portfolio risk Exhibit low correlations with developed markets Return volatility is higher Investability Refers to the degree of restrictions faced by foreign investors when investing in emerging markets Restrictions include: foreign ownership, repatriation of capital, discriminatory taxes, foreign currency restrictions, authorized investors, small free float of shares (lack of liquidity) Segmentation Emerging markets are segmented from the international markets Exam Preparation & Investment Sales Training 12 info@examsuccess.ca