PRACTICAL QUANTITATIVE INVESTMENT MANAGEMENT WITH DERIVATIVES

Transcription

1 PRACTICAL QUANTITATIVE INVESTMENT MANAGEMENT WITH DERIVATIVES

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3 Practical Quantitative Investment Management with Derivatives FRANCES COWELL

4 Frances Cowell 2002 Softcover reprint of the hardcover 1st edition All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London W1T 4LP. Any person who does any unauthorised act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The author has asserted her right to be identified as the author of this work in accordance with the Copyright, Designs and Patents Act First published 2002 by PALGRAVE Houndmills, Basingstoke, Hampshire RG21 6XS and 175 Fifth Avenue, New York, N.Y Companies and representatives throughout the world PALGRAVE is the new global academic imprint of St. Martin s Press LLC Scholarly and Reference Division and Palgrave Publishers Ltd (formerly Macmillan Press Ltd). ISBN ISBN (ebook) DOI / This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. A catalogue record for this book is available from the British Library. Editing and origination by Aardvark Editorial, Mendham, Suffolk

5 To my mother, who helped me worry about the deadline. To Cait and Ophelia, who read the book for me. To Jean-Pierre, who stoically tried to impose order on incorrigible chaos. To Dibbs, who never doubted me. To Vanderbilt and Villeneuve, who sat on the keyboard.

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7 Contents List of Tables and Examples Preface Origins of the Book Objectives Scope The Cast Overlap of Traditional and Quantitative Case Studies Spreadsheets Glossary Acknowledgements xv xxi xxi xxii xxii xxiii xxiii xxiii xxiv xxiv xxv PART I INTRODUCTION 1 Introduction 3 What has Changed? 3 Defining the Investment Fund Structure 6 The Role of the Investment Consultant 8 The Investment Strategy 11 The Investment Management Mandate 17 Manager Selection 20 Portfolio Evaluation 21 The Role of the Custodian 22 2 The Traditional Approach 25 Allocation to Asset Classes 28 Security Selection within Asset Classes 31 Limitations of Traditional Approaches 33 Trends in Traditional Investment Management 34 vii

8 viii CONTENTS 3 Investment Management Theory 36 The Efficient Markets Hypothesis (EMH) 36 The Capital Asset Pricing Model (CAPM) 38 Optimal Portfolios and Portfolio Optimization 41 Expected and Observed Return and Risk 46 Value-at-Risk (VAR) 48 Risk Budgeting 49 Reverse Optimization 50 Interest Rates 51 PART II PORTFOLIO CONSTRUCTION 4 Quantitative Asset Allocation Models 55 Applications 55 Theory 56 Long-Term Asset Allocation 57 Short-Term Asset Allocation 75 Risk Management 78 Implementation of Short-term Asset Allocation 79 Use of Derivatives 83 Ongoing Management 84 Administration 85 Valuation 85 Performance Measurement and Attribution 87 Pitfalls 90 Case Study 90 5 Portfolio Protection 94 Applications 94 Theory 97 Option Pricing 100 Black Scholes versus CPPI 105 Implementation 105 Ongoing Management 106 Currency Management 107 Administration 108 Valuation 108 Performance Measurement and Attribution 110 Pitfalls 110 The 1987 Market Crash 111 Case Study Capital Guaranteed Portfolios 118 Applications 118 Theory 118 Implementation 120

9 CONTENTS ix Currency Management 121 Ongoing Management 122 Administration 123 Valuation 124 Performance Measurement and Attribution 124 Pitfalls 124 Case Study Passive Asset Allocation 128 Applications 128 Theory 129 Implementation 130 Currency Management 130 Use of Derivatives 131 Ongoing Management 132 Administration 134 Valuation 134 Performance Measurement and Attribution 134 Pitfalls 137 Case Study Quantitative Models for Domestic Equity Portfolios 143 Applications 143 Theory 143 Defining the Benchmark 144 Return Forecasting 144 Risk Forecasting and Management 158 Currency Management 159 Implementation 160 Use of Derivatives 162 Corporate Actions 162 Ongoing Management 164 Administration 165 Valuation 165 Performance Measurement and Attribution 166 Pitfalls 167 Case Study Quantitative Models for International Equity Portfolios 173 Applications 173 Theory 174 Defining the Benchmark 175 Return Forecasting 175 Implementation 187 Ongoing Management 190 Use of Derivatives 191 Administration 192

10 x CONTENTS Valuation 192 Performance Measurement and Attribution 192 Pitfalls 195 Case Study Optimized Stock Selection Models 200 Applications 200 Theory 201 Optimizers for Asset Allocation and Stock Selection 203 Estimating the Risk Factor Model 203 The Relationship Between Stock Selection and Asset Allocation 208 Applying Global Factors 211 Portfolio Risk Analysis 213 Portfolio Construction 216 Currency Management 219 Use of Derivatives 219 Ongoing Management and Administration 220 Performance Measurement and Attribution 220 Reverse Optimization 220 Pitfalls Indexation 225 Applications 225 Theory 226 Defining the Benchmark 228 Currency Management 235 Use of Derivatives 235 Index Enhancements 236 Customized Indexed Portfolios 240 Indexation of Domestic Fixed Interest Portfolios 241 Indexation of International Fixed Interest Portfolios 243 Indexation of Property Portfolios 243 Ongoing Management 243 Administration 245 Valuation 245 Performance Measurement and Attribution 246 Pitfalls 248 Case Study Fixed Interest Portfolios 252 Applications 252 Theory 253 Calculating the Price of Fixed Interest Securities 255 Credit Risk 259 Portfolio Construction 262

11 CONTENTS xi Interest Rate Risk Management 263 Yield Curve Modelling 267 Implementation 269 Use of Derivatives 270 Currency Management 271 Ongoing Management 272 Administration 273 Valuation 273 Performance Measurement and Attribution 274 Pitfalls 274 Case Study Property Portfolios 277 Applications 277 Theory 277 Implementation 278 Use of Derivatives 280 Ongoing Management 281 Administration 282 Valuation 282 Performance Measurement and Attribution 283 Pitfalls 285 Case Study Market Neutral (Hedge) Portfolios and Other Alternative Investment Classes 288 Characteristics of Alternative Investment Funds 288 Applications 290 Theory 291 Alternative Investment Strategies 291 Implementation 300 Currency Management 301 Ongoing Management 302 Administration 303 Valuation 303 Performance Measurement and Attribution 304 Pitfalls 305 Case Study Portfolio Transition and Transition Portfolios 310 Portfolio Transition 310 Transition Management 312 Transition Portfolios 314 Objectives 314 Implementation 315 Currency Management 316

12 xii CONTENTS Ongoing Management 317 Administration 317 Valuation 317 Performance Measurement and Attribution 318 Pitfalls 318 Case Study Currency Management 322 Applications 322 Theory 324 Approaches to Active Currency Management 327 Defining the Currency Management Mandate 329 Implementation 330 Use of Derivatives 331 Ongoing Management 331 Administration 332 Valuation 333 Performance Measurement and Attribution 334 Pitfalls 335 PART III PERIPHERALS 17 Implementation of Equity Portfolios 339 The Traditional Approach 339 Basket Trading 342 Stock Borrowing and Lending 344 Soft Dollars 346 Directed Commissions Performance Measurement and Attribution 350 Single Period Return Measurement 350 Multiple Period Return Measurement 354 The Limitations of Returns 355 Single Period Attribution Analysis 358 Analysis of Deadweight and Active Holdings 361 Multiple Period Attribution Analysis The Use of Software in Investment Management 366 Market Information 367 Return Forecasting for Asset Classes and Individual Securities 368 Risk Modelling, Portfolio Analysis and Construction 368 Analysis of Derivatives 371 Recording and Reconciling Transactions 372 Maintaining Portfolio Records 374 Tax 374 Portfolio Valuation 375

13 CONTENTS xiii Return Measurement, Attribution and Reporting 377 Buy versus Build 378 Integrated versus Cherry-picking with Middleware Trends in Investment Management 380 Ownership and Structure of Investment Management Firms 380 Boutiques versus Full Service Managers 381 Fee Structures 382 The Custodian as Investment Manager 384 The Role of the Consultant 385 Corporate Governance 386 The Role of the Compliance Officer 388 People versus Processes: Atomization of Investment Management Functions Conclusions: Traditional versus Quantitative 393 Models for Investment Management 394 Traditional versus Quantitative Investment Management 396 The Grey Areas 398 PART IV APPENDICES Appendix 1: Pricing Interest Rate Securities 403 The Settlement Value of a Discount Security 403 The Point Value of a Discount Security 404 The Settlement Value of a Bond 405 The Point Value of a Bond 406 Appendix 2: Forward Contracts 407 Theory 407 Pricing 408 Foreign Exchange Forwards 410 Interest Rate Forwards 411 Implementation 413 Ongoing Management 415 Administration 416 Appendix 3: Futures Contracts 418 Theory 418 Pricing 418 Applications 419 Futures on Discount Interest-bearing Securities 420 Futures on Bonds 421 Pricing a Bond Future 422 Implementation 422

14 xiv CONTENTS Ongoing Management 425 Administration 426 Performance Measurement and Attribution 428 Appendix 4: Swaps 431 Theory 431 Pricing 433 Implementation 434 Administration 435 Performance Attribution 436 Synthetic Swaps 436 Advantages and Disadvantages of Swaps Over Futures and Forwards 439 Appendix 5: Options 440 Pricing 441 Options on Futures 442 Assumptions 445 Put call Parity 445 Option Volatility Gamma 450 Implied Volatility 452 Implementation 452 Options on Physical Securities 453 Over-the-counter 453 Ongoing Management 454 Administration 455 Performance Measurement and Attribution 455 Appendix 6: Convertible and Converting Notes 457 Theory 457 Pricing 458 Convertible Notes 458 Converting Notes 461 Applications 462 Implementation 463 Ongoing Management 463 Administration 464 Performance Measurement and Attribution 464 Glossary of Terms 467 Bibliography 490 Index 492

15 List of Tables and Examples Tables 1.1 A typical investment management process How many investment managers? Example credit ratings 260 Examples 1.1 Assessing the value of short-term asset allocation Scenario analysis The efficient frontier Value of dividend tax credits for domestic and international investors Active portfolio and market returns Quantifying diversification: a 2-stock portfolio Quantifying diversification: a 3-stock portfolio Quantifying diversification: asset correlations Correlation matrix changes over time Observed tracking error Value-at-risk The yield curve Extrapolating from past returns Calculating the present value of dividends 63 xv

16 xvi LIST OF TABLES AND EXAMPLES 4.3 Interest rate parity Purchasing power parity Currency fluctuations A simple hedge to base currency Comparing correlation matrices Linear and exponentially weighted correlations Optimization of long-term allocation: constrained and unconstrained Reverse optimization Contribution to portfolio variance Short-term allocation shift using futures and forwards Transaction summary start of period Transaction summary end of period Valuation of short-term asset allocation overlay Return contribution for short-term asset allocation Return calculation Observed tracking error Hold shares and buy put options versus sell portfolio and buy call options Cost of option versus equity participation Actual versus replicating options Constant proportions portfolio insurance (CPPI) CPPI: asset allocation CPPI: asset allocation adjustment Valuation of bought put option Valuation of replicated put option Valuation of CPPI An option on a basket of assets versus a basket of options Comparison of protection methods Comparison between unprotected portfolio and three protection methods The cost and price of a guarantee Estimated capital requirement for various asset allocations Portfolio liquidation values Market conditions Rebalancing passive asset allocation Return to the portfolio and asset classes Attribution analysis for passive asset allocation with active and passive sector management Long-term asset allocation Portfolio structure Portfolio returns Attribution analysis 142

17 LIST OF TABLES AND EXAMPLES xvii 8.1 Technical analysis Analysis of momentum Dividend discounting A simplified single stock model Arbitrage pricing theory Portfolio exposures to currencies Risk and return Forecast tracking error: sectors, industry groups and currencies as factors Foreign currency exposures within domestic portfolios Return measurement Comparison of return and volatility for Australian All Ordinaries, All Industrials and All Resources indices Comparison of return and volatility for Australian All Ordinaries, All Industrials and All Resources indices: 1993 and Results for Australian All Ordinaries, All Industrials and All Resources indices and 90/10 portfolio from 1996 to Risk-return trade-off for Australian All Ordinaries, All Industrials and All Resources indices and 90/10 portfolio from 1980 to Actual portfolio performance 1996 to Risk and return for domestic and international portfolios Categorization of international portfolio by country Categorization of international portfolio by industry Categorization of emerging markets portfolio by country Foreign currency exposure of a portfolio with a nominal currency hedge Portfolio valuation Single period performance attribution Composition of the international indexed portfolio and benchmark Performance of the international indexed portfolio and benchmark: Summary attribution analysis of the international indexed portfolio A typical portfolio asset allocation Foreign currency exposure in two domestic portfolios Currency sensitivities of Rolls-Royce from a UK pound base Factor beta versus contribution to portfolio risk Constrained and unconstrained optimization Effect of changed forecast returns on optimization Optimization with forecast returns # Optimization with forecast returns # Reverse optimization Stratified samples Expected beta and tracking error stratified and optimized sample 233

18 xviii LIST OF TABLES AND EXAMPLES Exploiting mispriced derivatives and initial prices Exploiting mispriced derivatives and outcome Sample indexed portfolio for domestic fixed interest Summary of exposure and duration Monthly performance of domestic equities indexed portfolio Return summary, domestic equities indexed portfolio to 30 June Performance summary, domestic equities indexed portfolio to 31 May Tracking error versus number of stocks The yield curve Discounting Compounding within one year Compounding over more than one year Continuous compounding Calculating the bond price The bond price over the coupon cycle (cum-interest) Portfolio value per basis point for two bonds Modified duration for two bonds Convexity of two bonds Pull to par Effect on the bond price of a change in credit risk A simple fitted curve Put call parity in terms of yield / and settlement value Frequency of valuation Leverage from borrowing and bought futures positions Discounted cash flow Short call and put at the same exercise price Short call and put at the same exercise price Short call and put at the same exercise price with short stock position Payoff to option strategy Portfolio transition Performance of a transition portfolio Single period return in local and base currency: unhedged Single period return in local and base currency: hedged Purchasing power parity Interest rate parity: calculating the forward exchange rate Long-term exchange rate trends Single period return in local and base currency: hedged 334

19 LIST OF TABLES AND EXAMPLES xix 18.1 Single period portfolio return with cash flow Arithmetic and geometric linking Monthly portfolio returns Return summary to 30 June Return summary to 31 May Expected and observed beta and tracking error Summary attribution analysis by industry group Attribution analysis by industry group Portfolio equals benchmark plus long short Attribution analysis: three assets, three periods, arithmetic and geometric linking Futures exposure 376 A1.1.1 The settlement value of a discount security 404 A1.1.2 The point value of a discount security 405 A1.2.1 The settlement value of a bond 405 A1.2.2 The point value of a bond 406 A2.1.1 The settlement value of a forward contract 409 A2.1.2 The settlement value of a forward contract 409 A2.2 The value of a foreign exchange forward contract 411 A2.3 Interest rate forward: physical 2-month investment plus 3-month forward versus 5-month physical investment 412 A3.1 Futures on share price indices 419 A3.2 Interest rate future: physical 2-month investment plus 3-month forward versus 5-month physical investment 421 A3.3 Pricing a bond future 422 A3.4 Pricing a futures roll 424 A3.5 Calculation of simple variation margins 426 A3.6 Valuation and attribution analysis for a bought futures contract 429 A4.1 Asset swap 432 A4.2 Pricing an asset swap 434 A4.3 Revaluation and reset of an asset swap 435 A4.4.1 Synthetic swap structure 437 A4.4.2 Synthetic swap outcome 438 A5.1.1 The call option 443 A5.1.2 The option premium 444 A5.2.1 Put call parity 446 A5.2.2 Sell stock and buy call versus hold stock and buy put 447 A5.3 Replicating options 448 A5.4 Replicated call options 449 A5.5 Delta and gamma of an option portfolio 451

20 xx LIST OF TABLES AND EXAMPLES A5.6 Valuation and attribution analysis for a bought call option on a futures contract 456 A6.1.1 A simple convertible note 460 A6.1.2 A simple convertible note 461 A6.2 A simple converting note 462 A6.3 Valuation and attribution analysis for a simple convertible note 465

21 Preface ORIGINS OF THE BOOK With the increasing importance of individual savings accounts and the growth of defined contributions pension schemes, people are required to make decisions about long-term investments that previously could be left to governments or actuaries. Concurrently, advances in information processing capabilities enable the application of breakthroughs in investment theory to be applied in day-to-day investment management. This has in turn spurred the use of ever-more sophisticated investment instruments, such as derivatives and customized benchmarks. The result is an explosion of information that challenges the powers of assimilation of most ordinary folk, and even many investment professionals; and jargon that can make any real comprehension of the issues all but unachievable. Most users of investment management services work in professions that are at least as complex as investment management, yet find understanding the investment management process and the techniques applied difficult and the jargon hard to interpret. This gives rise to the need for a comprehensive plainlanguage description of the basic processes of investment management, an explanation of the underlying principles and a translation of the jargon. xxi

22 xxii PREFACE OBJECTIVES This book seeks to help the reader by translating the jargon and explaining, in plain words, the investment instruments and techniques used in investment management, and putting them in the context in which they frequently occur, together with a discussion of the benefits and potential pitfalls of each. In doing so, it explains the practical aspects of some of the more sophisticated investment management techniques currently in use by investment managers, so that readers can pose specific questions to investment professionals about investment strategies, portfolio construction and expected outcomes. By explaining the principles underlying investments technology and the jargon frequently used by investment managers, it is hoped that this book will enable the reader to understand and evaluate the responses given. SCOPE The purpose is not to offer advice on investments, products or even investment strategies, but to equip the reader with sufficient understanding to evaluate them him- or herself. To this end, the book begins with a discussion of the investment management process, from fund structure, through investment strategy definition to investment manager selection and evaluation of investment results. This is followed by a discussion of the traditional approach and a primer on the basic theory underpinning quantitative investment techniques. Part II addresses, in turn, each stage of the investment process, beginning with asset allocation and followed by portfolio construction for each asset class. In each case the process is placed in its context and the basic underlying theory is described. This leads to a discussion of the peculiarities, including important strengths and weaknesses, of the technique and its applications, and concludes with a description of the implementation process and administrative, valuation and return evaluation issues as well as addressing what can go wrong. Case studies further illustrate some of the important issues. Part III discusses some of the issues common to most parts of the investment management process and those that pertain to the industry overall, concluding with a discussion of how traditional and quantitative techniques can fit together. Spreadsheets are included in the accompanying compact disc. They are designed to enhance the reader s understanding by giving him or her the opportunity to conduct live experiments on the examples: to change inputs to see what the effect is on the relevant computations.

23 PREFACE xxiii THE CAST The titles and roles applied to the various participants in investment management sound very similar to anyone not engaged full time in the investments industry. Often roles and titles overlap. In an attempt to avoid the confusion this can cause, the various participants are referred to in this book by the following titles: Consultant Fund Manager Investment Manager Investor Portfolio Manager Person or company providing independent advice to investors on investment type, structure and management. A person or company charged with overseeing the investments of a pension fund, mutual fund or other jointly owned investment. The company engaged by the fund manager to conduct day-to-day management of the investments. The owner of the money invested. The person employed by the investment manager to manage specific components or aspects of the investment portfolio. OVERLAP OF TRADITIONAL AND QUANTITATIVE The use of the term quantitative in the context of investment management can be misleading, implying as it does, that traditional investment management involves little or no sums. In fact, a traditional non-quantitative investment manager will find much of the contents of this book familiar, since many techniques for investment analysis are claimed by both groups as their own. In fact, many quantitative techniques, particularly for return forecasting, merely formalize and apply precision, in effect quantifying the intuitive analytic processes that have for a long time been used by traditional investment managers. Surprisingly few quantitative investment techniques are genuinely new. CASE STUDIES Most chapters devoted to a particular investment process are accompanied by a case study. The purpose of the case studies is to illustrate the principles discussed in that chapter. While based on actual events, some details have been altered to simplify the illustration and enhance the scope of the illustrations. Therefore, they are not faithful sequences of events.

24 xxiv PREFACE SPREADSHEETS Each of the examples presented in the book is represented as a spreadsheet on the accompanying compact disc, with the examples for each chapter collected in a workbook, the name of which corresponds to the chapter. The objective of the spreadsheets is to enhance the reader s understanding of the examples presented in the book by allowing experimentation with the inputs to each analysis to show their impact on the outcome. They are designed to work in Excel 95 and subsequent versions. To use the spreadsheets, insert the compact disc into the CD drive. It will launch automatically, presenting a menu showing the name of each chapter and appendix for which there are examples. The workbook will open at the first example in that chapter or appendix. To view other examples, click on the appropriate tab at the bottom of the spreadsheet. The names of the tabs correspond to the names of the examples in the book. Not all examples are editable. Those that are display the editable cells in blue text. The cells with black text are either fixed values or formulae, and so are not editable. Change the blue values to see how a change in interest rates affects the price of a bond; or how a change in share price affects the value of an option. Spreadsheet cells containing formulae have a comment explaining the calculations. When the curser is moved near a cell with a comment, the comment becomes readable. Alternatively, select the required cell, then View Comments to read the contents of the comment box. GLOSSARY Glossary entries are indicated by a different bold font in the text the first time they appear. This is to help readers become familiar with the more specialised terms used in investment management. Bold is used in the text font for emphasis.

25 Acknowledgements This book could not have been completed without the practical help and encouragement of my employer, Vestek-Quantec, a subsidiary of Thomson Financial. They helped me in every respect, from pure encouragement to allowing the use of their investment analysis software and data, ensuring that I was provided with the best resources possible and of course being patient with me when demands on my time conflicted. In particular, I am thankful to my colleagues Tim Matthews and Claire Robinson for a thousand small favours that made such a difference at every stage of the book, including helping me manage the demands of my day job while preparing the manuscript for delivery. Thank you also to Toks Osokoya for getting hold of data that would have taken ages without him, and to Scott Douglas, for enthusiasm and encouragement, and who, with Alex Senicki, re-equipped me at full speed when my laptop was stolen five days before the promised delivery date of the manuscript. My colleague, David Vernest, applied his programming talent to transform the compact disc into something intelligible, thereby contributing an invaluable enhancement to the overall result. I would also like to thank Jason MacQueen, founder of QUANTEC Limited, for his oft-repeated phrase, which provided the opening sentence to the book James Bevan, at Inscape, provided invaluable help and support, especially in providing everyday language explanations of some of the more esoteric ideas in investment management. I want also to thank old friends and former colleagues. I am indebted to Satyajit Das, whose idea it was to write the book, and who helped get it started and contributed welcome suggestions for both content and format. Paul Seager helped by sending data at short notice. I am thankful also to the dozens of xxv

26 xxvi ACKNOWLEDGEMENTS colleagues and friends, past and present, who provided the inspiration and material for the case studies. I am also grateful to those at Aardvark Editorial, who were patient beyond the call, when normal people would have thrown their hands up in dismay, and for the encouraging words and helpful comments that made such a difference to the readability of the book. Also, Andrea Hartill at Palgrave, who was full of encouragement and reassurance. Data came from Thomson Financial Datastream, FTSE, MSCI, Salomon Smith Barney and STOXX, with analysis using QUANTEC risk management and portfolio analysis systems. All the errors came from me. It would have been more difficult and less enjoyable without Jean-Pierre to keep in order all the non-book-related aspects of life, including settling in to a new apartment in a new city. Every effort has been made to trace all the copyright holders but if any have been inadvertently overlooked the publishers will be pleased to make the necessary arrangements at the first opportunity.