Preface

The asset allocation problem is frequently addressed dynamically. The dynamic asset allocation shows how the optimal asset allocation depends on the investment horizon, wealth, and the investors risk preference. It is a major investment decision for individual and institutional investors alike is to choose between different asset classes, i.e., equity investments and interestbearing investments. The asset allocation decision determines the ultimate risk and return of a portfolio. Here I try to justify dynamic asset allocation leads to superior results compared to static or myopic techniques.

Managing Equity Risk

Management of equity risk refers to either eliminate or to reduce the risk associated with equity securities through the use of derivatives and dynamic asset allocation. Equity risk refers to the variation in the value of individual shares or that of an equity portfolio. So we can say that equity risk is essentially a price risk. There are four major ways of managing risk: Return Enhancement Strategy Value Protection Strategy Portfolio Insurance: Dynamic Asset Allocation Strategy Managing Equity Risk using Stock Index Futures.

Portfolio Insurance: Dynamic Asset Allocation

In real life investors change their asset allocation as time goes on and new information becomes available. Portfolio insurance is a dynamic trading strategy designed to protect a portfolio from market declines while preserving the opportunity to participate in market advances. In theory investors value wealth at the end of the planning horizon (and along the way) using a specific utility function and maximize expected utility. Fixed-mix strategies are optimal only under certain conditions. In general and in most practical cases the optimal investment strategy is dynamic and reflects real-life behavior.

Dynamic Allocation Strategy:

The best-known strategy involves trading in real and /or synthetic options. With the introduction of exchange-traded index put options, it seemed theoretically possible for an investor to use these contracts to insure well-diversified portfolios, especially index funds. For some reasons, most investors prefer not to use the option market for insuring the portfolios. Hence it calls for the dynamic trading strategy replicating the option strategy to insure the portfolio. In this strategy, the manager replicates an option through a process of continually revising, in a prescribed manner, the proportions of a portfolio consisting of the underlying the asset and the risk less asset. Besides the complex nature of the underlying option pricing theory, the dynamic strategy calls for buying more stock when the market is going up and selling off some stock as the market goes down.

Dynamic Allocation Strategy Procedure

1.

The proportions allocated to the underlying portfolio and the risk less asset change every period. The dynamic insurance strategy requires a significant amount of trading. It can be shown that how the same replication is accomplished (approximately) with either a stock portfolio and short futures positions or the risk less futures.

2. 3.

Insured Portfolio
Portfolio insurance is a dynamic trading strategy designed to protect a portfolio from market declines while preserving the opportunity to participate in market advances. An early criticism of portfolio insurance was that it reduced return as well as reducing risk. But users are discovering that portfolio insurance can be used aggressively rather than simply to reduce risks. Long run returns can actually be raised, with downside risks controlled, when insurance programs are applied to more aggressive active assets. Pension, endowment, and educational funds can actually enhance their expected returns by increasing their commitment to equities and other highreturn sectors, while fulfilling their fiduciary responsibilities by insuring this more aggressive portfolio. Compared with current static allocation techniques, annual expected returns can be raised by as much as 200 basis points per year. 2

Properties of Insured Portfolios: The return pattern of the insured portfolio has several important properties: (A) The probability of experiencing any losses is zero. (B) The return on any profitable position will be a predictable percentage of the rate of return that would have been earned by investing all funds in the S&P 500. (C) If the portfolio is restricted to investments in the S&P 500 and cash loans, if the expected rate of return on the S&P 500 exceeds the return on cash, and if the insurance is fairly priced, then among all investment strategies possessing properties (A) and (B), the insured portfolio strategy has the highest expected rate of return.

Delta Measurement
The number of units of the underlying portfolio that must be held long at any given moment will be given by the call options delta. The reciprocal of how many calls it takes to hedge a unit of the underlying portfolio. The call delta tells us the number of units of the underlying portfolio to hold. The amount of the risk less asset to hold is determined by subtracting the value of the held units of the underlying portfolio from the total value of the insured portfolio.

Industry Analysis
Industry analysis helps the investors to isolate investment opportunities that have favorable return risk characteristics. To pinpoint the benefits and limitations of an industry analysis three things are important:

Is there a difference between the returns for alternative industries during specific time periods? The stability and consistency of the performance of the industry during a time period? The potentiality of future good and sound performance.

An investor who is convinced that the economy and market are attractive for investing should proceed to consider those industries that promise the most opportunities in the coming years. The significance of industry analysis can be established by considering the performance of various industries. After considering the above requirements and the relative industry risk I took 5

different industries to make dynamic asset allocation. I have decided to invest in Banking and Financial Sector, Fuel and Power Sector, Pharmaceuticals Sector, and Cement Sector. These industries are selected as Banking industry is the growing sector and the capital adequacy, profitability and most importantly the price trends are increasing. In perspective of the chosen investment horizon of the year 2010 Engineering industry was experiencing profitability and price hike. Pharmaceuticals industry is also a growing segment Finally according to market capitalization and the increasing demand of construction sector the cement industry is chosen.

Company Analysis
To select the companies I have taken account the following conditions: Banking, Power & Fuel, Pharmaceuticals, Insurance and Engineering are the 5 sectors from which companies will be selected. Company must belong to A Category Company. It has declared dividend for the year of 2010 whether it is Cash or Stock dividend. From each selected industry 2 companies will be selected according to the Standard deviation of daily closing price from 2001 to 2010 (September). That means both higher and lower risky companies should be taken for perfect hedge. Assumptions By portfolio insurance we mean all the policies which aim to protect portfolio, usually share portfolios, against losses. Based upon the assumption the portfolio is constructed to insure the initial investment value against price falling risk. The assumptions are: Total amount of investment is BDT 50 00,000. T bill rate is considered as
July 91 days T-bill Rate Monthly adjusted T-bill Rate August 4.67% 1.59% 3.18% September 4.67%

Price data is collected mainly for 3 months: July, August and September of 2010, as I have considered investment horizon to be in the year 2011. 4

 Continuous compounded risk free rate is assumed. The amount of Tk. 10,00,000 will be distributed among the 10 securities equally. Initial distribution of total fund is considered to be 50: 50 in securities and T-bills.

100% Equity
Selected Companies AB Bank Bankasea SUMMIT POWER Jamuna oil Renata Square Heidelburg Cement Confifidence cement bextex APEX SPINNING July 85,841.79 91,635.41 10,197.98 107,579.16 109,516.51 89,907.38 114,197.48 112,798.39 112,050.08 114,599.34 August 92,666.97 90,146.24 100,668.19 92,678.57 93,912.06 92,507.87 76,762.79 94,191.59 117,878.20 101,130.29 September 96,290.89 109,434.87 94,202.47 96,903.21 94,088.00 106,666.75 108,200.10 139,916.56 89,795.89 129,962.20

It gives a positive return to the portfolio. In the appendix the lower and higher value of each quarter is calculated using the higher and lower prices of the respective shares for that quarter. Though the portfolio is giving us a sound profit but it is risky to invest the entire amount in the risky portfolio. Higher risk aversion investor will want to be secured even after sacrificing some portion of return.

50% Equity & 50% Risk free Asset

It is a common practice to invest in the risk free government security which is default free. In case of 50% equity investment strategy I have invested 50% of the total available investment amount in equity securities in a similar manner followed in 100% equity securities. The remaining 50% of the initial investment amount is invested in 91days T-Bill. In each month the amount available from the previous month is reinvested in that respective months 91 days T Bill rate adjusted monthly.

Dynamic Asset Allocation

This strategy requires buying more stock when the market is going up and selling off some stock as the market is goes down. The proportions allocated to the underlying risky asset and the risk less asset change every period, so this strategy requires a significant amount of trading. The number of units of the underlying risky asset that must be held long at any given moment will be given by the call options Delta, the reciprocal of how many calls it takes to hedge a unit of the underlying portfolio. The call delta tells us the number of units of the underlying portfolio to hold. In case of constructing my dynamic portfolio the amount of risk less asset to hold is determined by subtracting the value of the units held in the underlying asset from the total value of the insured portfolio. The delta tells us the number of stocks required to make a portfolio insured. It is the optimal number of risky assets that ensure the highest amount of return with the given insurance. In case of the Dynamic Portfolio Construction I have calculated Delta by following the above procedure. Delta = Insured Equity Value (High- low) /100% Equity High Value- 100% Equity Low Value Delta is the ratio of the variation of the insured value to the variation of the equity portfolio value available to invest in stock. The delta tells us the number of units of the underlying portfolio to hold. The amount of the risk less asset to hold is determined by subtracting the value of the held units of the underlying portfolio from the total value of the insured portfolio. In case of the Dynamic Portfolio Construction I have calculated Delta by following the above procedure The initial delta was .50 which requires that the total Tk. 10,00,000 will be invested equally in equity and risk free security. Initially the insured value of the portfolio was Tk. 10,00,000.
Initial Delta Buy (sell) Share Buy (Sell) T-Bill 0.5 July 0.31 (92254.99) 92254.99 August 0.43 (30473.72) 30473.72 September 0.19 (74956.25) 74956.25

From the table we can observe that the delta value has been changed with the course of time. The value decreased in July and then increased in August drastically and again decreased in September. To adjust the delta value the buy/sell decisions of equity and T-Bill have been taken in every month. There were sell decisions of equity in all 3 months. In case of T-Bill, there were buy decisions in every 3 months. 6

Interpretation
Static allocation of asset requires the rigid proportion of assets; dynamic asset allocation strategy requires the adjustment of the proportion of asset with the change of equity price. If price increases, dynamic asset allocation strategy requires increasing the equity proportion and vice versa. The portfolio value is different in static and dynamic asset allocation in every quarter. The graph comparing the static and dynamic asset allocation strategy is given below: Static Vs. Dynamic

1,200,000 1,000,000 800,000 600,000 400,000 200,000 July August September Static Dynamic

From the above graph we can observe that, Static asset allocation strategy provides better results than dynamic asset allocation strategy. The insured portfolio values are lower in the all 3 months.

Findings
The dynamic insurance strategy requires a significant amount of trading. By dynamic asset allocation it can be shown that how the same replication is accomplished (approximately) with either a stock portfolio and short futures positions or the risk less futures. If price increases, dynamic asset allocation strategy requires increasing the equity proportion and vice versa. Where static allocation of asset requires the rigid proportion of assets, dynamic asset allocation strategy requires the adjustment of the proportion of asset with the change of equity price. The portfolio value is different in static and dynamic asset allocation in every quarter. Findings: Security selection is the most vital part of the portfolio investment.

 Where static allocation of asset requires the rigid proportion of assets, dynamic asset allocation strategy requires the adjustment of the proportion of asset with the change of equity price. If price increases, dynamic asset allocation strategy requires increasing the equity proportion and vice versa. The result may differ in static allocation and dynamic allocation. Dynamic asset allocation provides insured portfolio unlike static asset allocation. As a final point, it can be said that, dynamic asset allocation strategy is the superior form of portfolio investment in comparison with the static asset allocation strategy. This method provides the basis for adjustment in asset proportion in the portfolio in terms of the changes in prices of the underlying securities. This is a continuous process of changing the portfolio combination. ***************

Appendix
Static Portfolio Initial 91 days T-bill Rate Monthly adjusted T-bill Rate Continuous Compounding rate Amount to be invested in T-bill 500,000 Amount to be invested in Equity 500,000 Total 1,000,000 Reallocation of Fund Amount to be invested in T-bill Amount to be invested in Equity 2,500,000 Total 5,000,000 Portfolio Return -2.31% 976,879 975,415 -0.15% 7.01% 1,043,754 Initial 2,500,000 488439.429 487707.3812 521876.9914 July 488439.429 August 487707.3812 September 521876.9914 474,161.76 976878.86 476,271.39 975414.76 532,730.47 1043753.98 July 1.59% 1.0054 502717.10 August 4.67% 3.18% 1.0219 499143.38 September 4.67% 1.0478 511023.51

Dynamic Asset Allocation

Insured Portfolio Equity T-Bill Delta New Portfolio Equity T-Bill Total 1,000,000 500,000 500,000 0.50 500,000 500,000 1,000,000

July Delta Calculation Insured Portfolio Initial Equity T-Bill New Equity Closing Value Delta Sell Share Buy T-Bill New Portfolio Equity T-Bill 725,520.31 500,000 251,358.55 474,161.76 0.31 92254.99003 92254.99003 381906.7729 252,724.48

Total

634631.2506

August Delta Calculation Insured Portfolio Initial Equity T-Bill New Equity Closing Value Delta Sell Share Buy T-Bill New Portfolio Equity T-Bill Total 512,111.72 381,907 258,262.83 253,848.89 0.43 30473.71821 30473.71821 284322.6081 227,789.11 512,111.72

September Delta Calculation Insured Portfolio Initial Equity T-Bill New Equity Closing Value Delta Sell Share Buy T-Bill New Portfolio Equity T-Bill 556,706.50 284,323 238,679.17 318,027.33 0.19 74956.2488 74956.2488 243071.0819 313,635.42

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