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 investor’s 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 investor’s 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.

1

An early criticism of portfolio insurance was that it reduced return as well as reducing risk. With the introduction of exchange-traded index put options. For some reasons. The dynamic insurance strategy requires a significant amount of trading. while fulfilling their fiduciary responsibilities by insuring this more aggressive portfolio. and educational funds can actually enhance their expected returns by increasing their commitment to equities and other high‐return sectors. the manager replicates an option through a process of continually revising. The proportions allocated to the underlying portfolio and the risk less asset change every period. 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. 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. Dynamic Allocation Strategy Procedure 1. endowment. 2 . with downside risks controlled. most investors prefer not to use the option market for insuring the portfolios. 3. Besides the complex nature of the underlying option pricing theory. Compared with current static allocation techniques. annual expected returns can be raised by as much as 200 basis points per year. when insurance programs are applied to more aggressive active assets. especially index funds. the proportions of a portfolio consisting of the underlying the asset and the risk less asset. But users are discovering that portfolio insurance can be used aggressively rather than simply to reduce risks. in a prescribed manner. Long run returns can actually be raised. In this strategy. the dynamic strategy calls for buying more stock when the market is going up and selling off some stock as the market goes down. Pension. Hence it calls for the dynamic trading strategy replicating the option strategy to insure the portfolio. it seemed theoretically possible for an investor to use these contracts to insure well-diversified portfolios. 2.Dynamic Allocation Strategy: The best-known strategy involves trading in “real” and /or “synthetic” options.

The significance of industry analysis can be established by considering the performance of various industries.Properties of Insured Portfolios: The return pattern of the insured portfolio has several important properties: (A) The probability of experiencing any losses is zero. if the expected rate of return on the S&P 500 exceeds the return on cash. 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. and if the insurance is fairly priced.  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. 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 option’s “delta”.  The reciprocal of how many calls it takes to hedge a unit of the underlying portfolio. (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. After considering the above requirements and the relative industry risk I took 5 3 . (C) If the portfolio is restricted to investments in the S&P 500 and cash loans.   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. then among all investment strategies possessing properties (A) and (B). the insured portfolio strategy has the highest expected rate of return.  The call delta tells us the number of units of the underlying portfolio to hold.

4 . Pharmaceuticals Sector. These industries are selected as  Banking industry is the growing sector and the capital adequacy.18% September 4. as I have considered investment horizon to be in the year 2011. Based upon the assumption the portfolio is constructed to insure the initial investment value against price falling risk.000. Assumptions By portfolio insurance we mean all the policies which aim to protect portfolio.different industries to make dynamic asset allocation.67% 1.  In perspective of the chosen investment horizon of the year 2010 Engineering industry was experiencing profitability and price hike. Company must belong to A Category Company. Power & Fuel. profitability and most importantly the price trends are increasing. Insurance and Engineering are the 5 sectors from which companies will be selected. against losses.  Pharmaceuticals industry is also a growing segment  Finally according to market capitalization and the increasing demand of construction sector the cement industry is chosen.67%  Price data is collected mainly for 3 months: July. The assumptions are:  Total amount of investment is BDT 50 00. Fuel and Power Sector. I have decided to invest in Banking and Financial Sector. and Cement Sector. Pharmaceuticals. Company Analysis To select the companies I have taken account the following conditions: • • • • Banking. usually share portfolios. That means both higher and lower risky companies should be taken for perfect hedge. It has declared dividend for the year of 2010 whether it is Cash or Stock dividend. August and September of 2010.  T bill rate is considered as July 91 days T-bill Rate Monthly adjusted T-bill Rate August 4. From each selected industry 2 companies will be selected according to the Standard deviation of daily closing price from 2001 to 2010 (September).59% 3.

21 94. In each month the amount available from the previous month is reinvested in that respective month’s 91 days T ‐Bill rate adjusted monthly.98 107.24 100.79 94. Higher risk aversion investor will want to be secured even after sacrificing some portion of return.38 114.57 93.16 109.89 129.191.146.050.48 112.878.75 108.912.903.29 September 96.47 96.00.197.  Initial distribution of total fund is considered to be 50: 50 in securities and T-bills.088.507.197.916.00 106.599.434.579.87 94.666.19 92.20 101. Though the portfolio is giving us a sound profit but it is risky to invest the entire amount in the risky portfolio.635. 5 .907.962. 50% Equity & 50% Risk free Asset It is a common practice to invest in the risk free government security which is default free.000 will be distributed among the 10 securities equally. 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.59 117.666.841. 10.20 It gives a positive return to the portfolio.762.97 90.668.34 August 92.  The amount of Tk.41 10. 100% Equity Selected Companies AB Bank Bankasea SUMMIT POWER Jamuna oil Renata Square Heidelburg Cement Confifidence cement bextex APEX SPINNING July 85.200. In the appendix the lower and higher value of each quarter is calculated using the higher and lower prices of the respective share’s for that quarter.798.06 92.87 76.39 112.89 109. The remaining 50% of the initial investment amount is invested in 91days T-Bill.795.202.10 139.290.56 89.51 89.516.79 91.130.678.08 114. Continuous compounded risk free rate is assumed.

To adjust the delta value the buy/sell decisions of equity and T-Bill have been taken in every month. 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 option’s ‘Delta’. The proportions allocated to the underlying risky asset and the risk less asset change every period. the reciprocal of how many calls it takes to hedge a unit of the underlying portfolio. 10.00. There were sell decisions of equity in all 3 months.31 (92254.50 which requires that the total Tk.000.25 From the table we can observe that the delta value has been changed with the course of time. 10. In case of T-Bill.72 September 0. The delta tells us the number of stocks required to make a portfolio insured.99) 92254.00. 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. 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.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 call delta tells us the number of units of the underlying portfolio to hold. Initially the insured value of the portfolio was Tk. 6 .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.5 July 0.25) 74956. The value decreased in July and then increased in August drastically and again decreased in September. Initial Delta Buy (sell) Share Buy (Sell) T-Bill 0. there were buy decisions in every 3 months.19 (74956.000 will be invested equally in equity and risk free security. Delta = Insured Equity Value (High.low) /100% Equity High Value. 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.72) 30473. In case of the Dynamic Portfolio Construction I have calculated Delta by following the above procedure The initial delta was .99 August 0.43 (30473. The delta tells us the number of units of the underlying portfolio to hold.

000 400. The graph comparing the static and dynamic asset allocation strategy is given below: Static Vs.Interpretation Static allocation of asset requires the rigid proportion of assets. Where static allocation of asset requires the rigid proportion of assets. Findings The dynamic insurance strategy requires a significant amount of trading. dynamic asset allocation strategy requires increasing the equity proportion and vice versa.000 600. The insured portfolio values are lower in the all 3 months.000.000 July August September Static Dynamic From the above graph we can observe that. Findings:  Security selection is the most vital part of the portfolio investment.000 1. 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. dynamic asset allocation strategy requires the adjustment of the proportion of asset with the change of equity price. Static asset allocation strategy provides better results than dynamic asset allocation strategy. If price increases.000 200.000 800. If price increases. 7 .200. 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. 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. Dynamic 1.

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

000.99003 381906.31 92254.000.9914 474.86 476.500.879 975.99003 92254.161.429 487707.7729 252.67% 1.3812 September 521876.000 July Delta Calculation Insured Portfolio Initial Equity T-Bill New Equity Closing Value Delta Sell Share Buy T-Bill New Portfolio Equity T-Bill 725.9914 July 488439.161.000 Total 1.76 532.000 Reallocation of Fund Amount to be invested in T-bill Amount to be invested in Equity 2.000 488439.0054 502717.000 1.724.98 July 1.67% 3.47 1043753.18% 1.76 0.000 251.0219 499143.415 -0.01% 1.000 Total 5.271.000 Amount to be invested in Equity 500.55 474.000.76 976878.500.520.043.429 August 487707.51 Dynamic Asset Allocation Insured Portfolio Equity T-Bill Delta New Portfolio Equity T-Bill Total 1.Appendix Static Portfolio Initial 91 days T-bill Rate Monthly adjusted T-bill Rate Continuous Compounding rate Amount to be invested in T-bill 500.38 September 4.000 500.000 0.3812 521876.50 500.31% 976.48 9 .31 500.000 500.358.15% 7.000 Portfolio Return -2.59% 1.000.0478 511023.000 500.39 975414.754 Initial 2.730.10 August 4.

111.Total 634631.2488 74956.71821 284322.42 ************* 10 .19 74956.635.89 0.50 284.83 253.679.907 258.6081 227.262.0819 313.72 September Delta Calculation Insured Portfolio Initial Equity T-Bill New Equity Closing Value Delta Sell Share Buy T-Bill New Portfolio Equity T-Bill 556.706.17 318.71821 30473.72 381.789.848.111.43 30473.2506 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 512.11 512.2488 243071.33 0.323 238.027.

Sign up to vote on this title
UsefulNot useful