BasicPrinciples_2

7/27/2019 BasicPrinciples_2

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Basic Principles

Ken Nyholm


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Outline

Guiding principles in finance

Strategic and tactical asset allocation

An investment framework primer

Necessary tools

Financial and econometric techniques

How to combine the two

The difference between estimation of a model andusing it to generate predictions


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Asset allocation is a central sub-element of

finance concerned with:

Allocation of capital over time

Capital is a scarce ressource

Optimal investor behaviour Equilibrium in financial market

The well-functioning of financial market Corporates investment decisions


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a) The positive relationship between return and risk


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This relationship is formalised through

The Capital Asset Pricing Model (CAPM)

The Arbitrage Pricing Theory (APT)


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b) The law of one price

Identical items (risk) should sell at the sameprices

Arbitrage

The process of generating profit without taking

risk

Simultaneously buing and selling of assets

Short selling is possible


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c) Market efficiency (information transmission)

Strong form

Semi-strong from Weak form

Prices in an efficient market reflect all available information

Information is available and is cheap to all investors

Prices react only to the flow of new information

Prices in financial markets are therefore unpredictable


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Ideas that shape financial thinking

Strong Form:

Prices contain allavailable information

Information sets

Semi-strong Form:Prices contain publicly

available information

Weak Form:

Prices contain

information about historical

prices


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Is it possible to empirically test market

efficiency?

Joint test of efficiency and an equilibrium

model for asset prices

Excess returns could reflect the costly processof gathering and processing information

Relative efficiency perhaps easier to deal withthan absolute efficiency


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Weak form tests

Can trading rules based on past price changes

generate excess returns?

Correlation tests and sign tests

Semi-strong form: Event studies of information releases

Strong-form: Tests based on insider profits


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Investor / financial agent behaviour

More wealth is desired to less

Aversion to risk

Homogenous expectations

Types of agents: Liquidity traders

Informed traders

Preferences expressed in terms of expexted risk

and return


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d) Risk measures


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Characteristics of strategic asset allocation:

Translation of the organisations long-term risk

preferences into an actual allocation

Board decision

Investment horizon: substantially longer than thehorizon for the tactical decision

The decision is typically done in terms of

currencies and asset classes...

... implementation however at asset level


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Characteristics of strategic asset allocation: Replicability is important for the tactical layers

Risk budgets are defined for each of the tacticallayers against the strategic benchmark

The strategic benchmark serves as an anchor for

the tactical levels The tactical benchmark and investment managers are

performance measured against the strategic benchmark

When the active layers have views they deviate from thestrategic benchmark

When not, they assume a neutral position against thestrategic benchmark


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E[r]

Risk

Efficient frontier all assets

Market portfolio

Efficient frontier subset

Efficient frontier ECB

Strategic benchmark portfolio

In-house benchmark construction

vs externally defined alternatives

Selection of the eligible

investment universe

Must take into account:

Investment constraints

Investment universe Subject to performance checks

Tactical benchmark

Active portfolios


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Strategic asset allocation should: Reflect the institutions long term risk-return preferences

Mathematical formulation of the long term risk-return preferences

Be forward looking i.e. take into account the current anduncertain future economic environment

Simulation based forward looking methodology for yields/returns andintegration of macro economic variables

Be based on a transparent, accountable and flexible decisionsupport framework with consistent treatment of different risksources

Quantitative, using a well documented and flexible modellingframework which can be easily adapted to handle changingrequirements i.e. additional asset classes and risk types


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Revision frequency and investment horizon

Time linet+1t t+2 T

Time interval* Monthly

* Quarterly

* Annually

New Information

flows to the market

Revision at t

Revision at t+nInvestment horizon


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Decisions regarding the Strategic asset

allocation set-up depends hugely on the

organisation in question: Investment bank

Central bank Pension fund

Design variables: Eligible investment universe

Investment horizon for SAA and TAA


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Design variables (cont):

Revision frequency

Risk budgets

Asset class constraints

Instrument constraints Issuer constraints

Investment objectives for SAA and TAA Who has the responsibility


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An example of a risk averse institution could be:

Investment universe: Government bonds, Agencies, BIS

instruments, Supranationals, Deposits

Quantification of risk appetite: No negative returns at a

given confidence level at a given horizon, e.g. 5 years

@99% VaR level

Maximum exposure to specific instrument classes based on

liquidity risk considerations

Minimum holding in highly liquid assets Risk budget allocation to active management in terms of

VaR or Modified duration limits


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Historical yield curve evolution in US


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Historical yield evolution in Japan

i f k i


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0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

1954

1958

1962

1966

1970

1974

1978

1982

1986

1990

1994

1998

2002

Dow SP500 Nasdaq

A i f k i


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0

1

2

3

4

5

6

7

8

9

Jan-99

Jul-99

Jan-00

Jul-00

Jan-01

Jul-01

Jan-02

Jul-02

Jan-03

Jul-03

Jan-04

Jul-04

Jan-05

Jul-05

Jan-06

Jul-06

Yuan/US EU/US Brazin/US

A i f k i


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Expected return distributions are at the core of Strategic AssetAllocation methodologies

Most relevant are the expected return and volatility but also other

moments can be relevant if the distributions are non-normal What are the alternatives for generating expected returns?

Forward/backward looking, ALM, Risk neutral, non parametric

techniques Strategic asset allocation decisions

Allocations for the longer time-horizon

Empirical return distributions are necessary

Forward looking methodology for yields/returns

Simulation based approach

Integration of macro economic variables

No-view and conditional optimisation

A i t t f k i


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Basic modeling building blocks: Yield curve model

Model for equity risk premia

Model for currency pairs Portfolio optimiser

Forecasting/prediction model

Definition of the investment universe Quantification of risk appetite

Maximum exposure to specific instrument classes based on

liquidity risk considerations Investment horizon

Revision frequency

A i t t f k i


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Suggestions on underlying principles:

Forward looking methodology

Scenario based

Conditional vs. unconditional predictions

Modelling Philosophy:

Not to beat the market but to reflect market expectations

Long-term view

Be objective i.e. as quantitative as possible

Provide a stable, transparent, and flexible decision supportframework

A i t t f k i


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RisksExpected returns and risksFramework

Constraints

Definition of

investment universe

Return distributions

in normal scenarios

Macroeconomic projections

Asset allocation

Portfolio optimisation

Implementation

Instrument selection

Implementation

Instrument selection

Validation

Historic properties

Stress testing

Risk decomposition

Portfolio management

Validation

Historic properties Stress testing

Return distributions

in stress scenarios

Framework

Objective

and horizon

Investment

universe

Investment

constraints

Ad-hoc analyses

A l


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An example

Intuition of the yield curve module could be:

Underlying factors drive yield curves

These factors are related to the macro economy Different future macro economic scenarios leads to different

yield curve evolutions

and, thus to different expected returns How to obtain yield curve factors?

For example, the Nelson-Siegel model / parametric model

How to create a link to the macro economy?

For example, regime switches

An example


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An example

Intuition of the portfolio optimiser Simulated return distributions are core input

The optimiser searches over different strategies to find the one

that maximises return while still fulfilling the annual lossconstraint

Illustration of a one period problem:

E[r]

Risk

Efficient frontier

VaR constraint

Feasible region

Max E[r] portfolio

An example


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An example

For long-term asset allocation it is necessary to rely on simulationmethodologies to generate necessary inputs

The process could be something like:

Estimate a relevant model e.g. a VAR(p) for the variables of interest

Look at the estimated parameters

Change them to fit with economic intuition and what is expected for the future

It could be that other drift rates are expected going forward

Or, that the board wants to see how the asset allocation performs in a given stress

scenario

Or, that the head of division wants to know what the sensitivity in the found asset

weights are to changes in the return expectations

Or, .

Perform the predictions and complete the analysis

So there is a big difference between historical estimation and forward

looking decisions based on the estimated models!

An example


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An example

A simulated recession scenario

An example


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An example

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An example

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An example

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An example

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An example

A long term scenario with inflationary and recessionary periods

An example


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An example

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An example

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An example

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An example

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