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Behavioral Finance
The Behavioral Finance Perspective

The Behavioral Finance Perspective


Subjective Expected Utility

E(U) =∑ u( xi ) p( xi )

Utility Calculation (Prospect Theory)

U = w( p1 ) v( x1 ) + w( p2 ) v( x2 ) +  w( pn ) v( xn )

where:
U = utility
x = a particular outcome
p = probability of x
v = value of x
w = probability-weighting function for outcome x; accounts for tendency to overreact to
low probability events and underreact to other events

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Private Wealth Management
Managing Individual Investor Portfolios 

Managing Individual Investor Portfolios 


Sharpe Ratio

(expected return – risk-free rate)


Sharpe ratio is:
expected standard deviation

Capital gains tax payable = Price appreciation × tCG × turnover rate

where:
tCG = capital gains tax rate

Buy tax-free bonds when Rtax-free > Rtaxable × (1 − t)

where:
R = return
 t = applicable tax rate

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Taxes and Private Wealth Management in a Global Context 

Taxes and Private Wealth Management in a Global Context 


Annual Accrual with a Single, Uniform Tax Rate

rafter-tax = rpre-tax (1 − tI )

( )
n
FVIFpre-tax = 1 + rpre-tax
FVIFafter-tax = [1 + rpre-tax (1 − tI )]n

where:
FVIF = Future value interest (i.e., accumulation) factor
r = return
t = tax rate
n = number of periods

Deferral Method with a Single, Uniform Tax Rate (Capital Gain)

FVIFCG = (1 + rCG ) (1 − tCG ) + tCG


n

Taxable Gains When the Cost Basis Differs from Current Value

Taxable gain = VT − Cost basis

where:
VT = terminal value
Cost basis = amount paid for an asset

FVIFCG = (1 + rpre‐tax)n (1 − tCG) + tCGB

where:

Cost basis
B=
V0
V0 = value of an asset when purchased

Accumulation Factor with Annual Wealth Tax

( )
n
FVIFW =  1 + rpre-tax (1 − tW ) 

Effective Annual After‐Tax Return in a Blended Tax Regime

r* = rT (1 − PI tI − PD t D − PCG tCG )

where:
P = proportion of return from income, dividends, and realized capital gains during the period

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Taxes and Private Wealth Management in a Global Context 

Effective Capital Gains Tax Rate

 1 − PI − PD − PCG 
T * = tCG 
 1 − PI t − PD t D − PCG tCG 

The after-tax future value multiplier under this blended tax regime then becomes:

FVIFafter-tax = (1 + r*)n (1 − T *) + T * − tCG (1 − B)

If the portfolio is non‐dividend paying equity securities with no turnover (i.e., PD = PI = 0


and PCG = 1) held to the end of the horizon, the formula reduces to:

FVIFafter-tax = (1 − r )n (1 − tCG ) + tCG

If the portfolio is non‐dividend paying equity securities with 100 percent turnover and
taxed annually, the formula reduces to:

FVIFafter-tax = 1 + r (1 − tCG ) 


n

Accrual Equivalent Return

Vn = V0 (1 + rAE )
n

Vn
rAE = n −1
V0

where:
Vn = value after n compounding periods

Accrual Equivalent Tax Rate

rAE = r (1 − TAE )
rAE
TAE = 1 −
r

Tax‐Deferred Accounts

FVIFTDA = (1 + r )n (1 − t ) tCG B

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Taxes and Private Wealth Management in a Global Context 

Tax‐Exempt Accounts

FVIFTEA = (1 + r )n

FVIFTDA = FVIFTEA (1 − t )

Value Formula for a Tax Exempt Account

Vn = V0 (1 − t0)(1 + r)n

Value Formula for a Tax‐Deferred Account

Vn = V0(1 + r)n (1 − tn)

The Investor’s After‐Tax Risk

σ AT = σ (1 − t )

where:
σ = standard deviation of returns

Ratio of Long-Term Capital Gains to Short-Term Capital Gains

VLTG V0 (1 + r ) (1 − t LTG )
n
=
VSTG V0 1 + r (1 − tSTG )  n
 

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Domestic Estate Planning: Some Basic Concepts

Domestic Estate Planning: Some Basic Concepts


Core Capital
kCore = PV of current lifestyle spending + emergency reserve

PV of Spending Need

n
Expected spending
Liability 0 = ∑
t =0 (1 + r )t
n
p(Survival t ) × Spendingt
=∑
t =0 (1 + r )t

where:
r = real risk-free rate

Joint Survival Probability Calculation

p(Survival t ,C1,C 2 ) = p(C1 ) + p(C2 ) − p(C1 ) p(C2 )

where:
C1 = First spouse survives
C2 = Second spouse survives

Excess Capital

Assets = House + Investments + Net employment capital


Liabilities = Mortgage + Current lifestyle + Education needs + Retirement needs
KExcess = Assets − Liabilities

Relative Value of Tax-free Gifts

n
FVGift 1 + rg (1 − tig ) 
RVTax - free Gift = =
FVBequest [1 + re (1 − tie )]n (1 − Te )

where:
FV = future value of the gift or bequest to the recipient
n = expected number of years until donor’s death, at which time bequest transfers to
recipient
r = pre-tax returns to the gift recipient g or estate making the gift e
t = tax rate on investments that applies to gift recipient g or estate making the gift e
Te = estate tax that applies to asset transfers at donor’s death

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Domestic Estate Planning: Some Basic Concepts

Relative Value of Gifts Taxable to Recipient

( )
n
FVGift 1 + rg (1 − tig )  1 − Tg
RVRecipient Taxable Gift = =
FVBequest [1 + re (1 − tie )]n (1 − Te )
where:
Tg = gift tax rate that applies to recipient

Relative Value of Gifts Taxable to Donor But Not to Recipient

FVCharitable Gift 1 + rg (1 − tig )n 1 − Tg + (TgTe × g / e)


RVTaxable Gift = = n
FVBequest [1 + re (1 − tie )] (1 − Te )

When the donor pays the gift tax and the recipient does not pay any tax, the rightmost
numerator term in parentheses indicates the equivalent of a partial gift tax credit from
reducing the estate by the amount of the gift. This formula assumes rg = re and tig = tie.

Relative Value of Charitable Gratuitous Transfers

(1 + rg )n + Toi [1 + re (1 − tie ) ] (1 − te )
n
FVCharitable Gift
RVCharitable Gift = =
FVBequest [1 + re (1 − tie )]n (1 − Te )

where:
Toi = tax on ordinary income (donor can increase the charitable gift amount)

Tax Code Relief

Credit Method

tCM =Max (tRC, tSC)

where:
tRC = applicable tax rate in the residence country
tSC = applicable tax rate in the source country

Exemption Method

tEM = tSC

Deduction Method

t DM = t RC + tSC − t RC tSC

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Risk Management for Individuals

Risk Management for Individuals


Human Capital
Human capital is calculated as follows:

N
p(st ) wt −1 (1 + gt )
HC0 = ∑
t =1 (1 + r f + y)t

where:
p(st) = probability of survival during a period, t
 wt-1 = income from employment in the previous year, t – 1
  N = length of worklife in years
  rf = the risk-free rate
  y = an adjustment to rf for earnings volatility

A Framework for Individual Risk Management


The formula for calculating the mortality-weighted net present value of the pension:

N
p(st )bt
mNPV0 = ∑ t
t =1 (1 + r )

where:
bt = the future expected vested benefit
p(st) = the probability of surviving until year t
r = a discount rate reflecting higher required return for riskier benefit payments as well
as whether nominal or real terms

Gross and Net Life Insurance Premium

Gross premium = Net Premium + Load representing insurance company overhead


E (VDB )
Net premium =
1 + rp
E (VDB ) = DB × [1 − P( St ) ]

where:
E(VDB) = Expected value of the death benefit
rP = return on the insurance company’s portfolio
DB = death benefit
P(St) = Probability of survival in period t

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Risk Management for Individuals

Income Yield for an Immediate Fixed Annuity

CFAnnual
YIncome =
P0

where:
CFAnnual = guaranteed annual payment
P0 = price of the immediate fixed annuity

Policy Reserve

Policy reserve = PV of future benefits – PV future net premium

Net Payment Cost Index

Interest-adjusted annual payment cost


Net payment cost index =
100
Interest-adjustment annual payment cost = Annuity due (20-year insurance cost, 5%, 20 years)
20-year insurance cost = FV annuity due (Premium, 5%, 20 years)
–FV ordinary annuity (projected annual dividend,
5%, 20 years)

Note: Assumes policy owner will die at the end of the 20-year period.

Surrender Cost Index

Interest-adjusted annual surrender cost


Surrender cost index =
Policy face value/1000
Interest-adjustment annual surrender cost = Annuity due (20-year insurance cost, 5%, 20 years)
20-year insurance cost = FV annuity due (Premium, 5%, 20 years)
–FV ordinary annuity (projected annual dividend,
5%, 20 years)
–20-year projected cash value

Note: Assumes policy owner will receive projected cash value by surrendering the policy
at the end of the period.

Hint: The only differences in surrender cost index and net payment cost index are
highlighted in the surrender cost formulas.

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Risk Management for Individuals

Human Life Value: Growing Income Replacement (Life Insurance Need)

VHL = PV annuity due (Y0,pretax , i , 20 years)


1+ r
i= −1
1+ g

where:
VHL = human life value; i.e., amount of insurance required to replace insured’s income
tax contribution
Y0,pretax = The pretax income at time 0 required to replace the insured’s posttax contribution
i = required return adjusted for a growing income
r = return on investments
g = growth rate of income

Note: Taxation of life insurance proceeds and annual annuities formed from life insurance
proceeds differs by jurisdiction and should be considered in calculating pre-tax income
replacement.

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Portfolio Management for
Institutional Investors
Managing Institutional Investor Portfolios

Managing Institutional Investor Portfolios


Simple Spending Rule

Spendingt = Spending rate × Ending market valuet−1

Rolling Three-year Average Spending Rule

Spendingt = Spending rate × 1⁄3 [Ending market valuet−3


+ Ending market valuet−2 + Ending market valuet−1]

Geometric Smoothing Rule

Spendingt = Smoothing rate × [Spendingt−1 × (1 + Inflationt−1)]


+ [(1 − Smoothing rate) × (Spending rate × Beginning market valuet−1)]

Leverage-Adjusted Duration Gap

Leverage-adjusted duration gap = D A − kDL


L
k=
A

where:
k = ratio of liabilities to assets, both at market value

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Applications of Economic Analysis to
Portfolio Management
Capital Market Expectations

Capital Market Expectations


Volatility Clustering

σ t2 = βσ t2−1 + (1 − β)εt2

where:
σ2 = volatility
β = decay factor (i.e., effect of prior volatility on future volatility)
ε = error term

Multifactor Regression Models

Ri = α i + b1F1 + b2 F2 +…+ bk Fk + εi

where:
Fk = return to factor k
 bk = asset i’s return sensitivity to factor k

Quantitative Methods: Discounted Cash Flow Models


CFt
V0 = ∑ t
t =1 (1 + r )

where:
CFt = cash flow in period t
r = required return on investment

Dividend Discount Model (DDM)

Gordon (Constant) Growth Model

D1 D (1 + g)
P0 = = 0
re − g re − g

where:
P0 = current justified price
D = dividend (in period specified by subscript t)
  g = long-run average growth rate
re = required return on equity investments

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Capital Market Expectations

Expected Return, E(R)

D0 (1 + g) D
E ( R) = +g= 1 +g
P0 P0

Grinold‐Kroner Model

D
E ( R) ≈ − %∆S + INFL + gr + %∆PE
P

where:
D/P = expected dividend yield
S = number of shares outstanding (Note: % change in S is the opposite of the
repurchase yield)
INFL = inflation rate
gr = real earnings growth
PE = price-earnings ratio

Build‐Up Approach

E ( Ri ) = RF + RP1 + RP2 + ... + RPk

where:
RF = nominal risk-free rate interest rate
RPk = risk premium k

Fixed‐Income Premiums

E ( Rb ) = rrF + RPINFL + RPDefault + RPLiquidity + RPMaturity + RPTax

where:
rrF = real risk-free rate
INFL = inflation

Equity Risk Premium

E ( Re ) = RF + ERP = YTM 10 − year Treasury + ERP

where:
ERP = equity risk premium
YTM = yield-to-maturity

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Capital Market Expectations

International Capital Asset Pricing Model

E ( Ri ) = RF + βi [ E ( RM ) − RF ]

where:
βi = return sensitivity of asset i
RM = global investable market (GIM)

Asset Class Risk Premium Singer-Terhaar in a 100% fully integrated market

COVi , M σ i σ M ρi , M  σ 
βi = = =  i  ρi , M
σ 2M σ 2M  σM 
σi
RPi = (ρi , M )( RPM )
σM

where:
COVi,M = covariance of asset i and GIM returns
ρi,M = correlation of asset i and GIM returns

 RP 
RPi =  M  σ i ρi , M
 σM 

where:
RPM/σM = Sharpe ratio for the market
ρi,M = correlation, indicates degree of integration (Note that the correlation coefficient
in a fully segmented market is equal to 1.0.)

Singer‐Terhaar Approach for Expected Return including a Liquidity Risk Premium

E ( Ri ) = RF + RPi* + RPLiquidity

where:
RPi* = weighted average of completely segmented and perfectly integrated asset class
risk premiums
RPLiquidity = liquidity risk premium (primarily alternative investments including real estate)

Gross Domestic Product (GDP)

GDP = C + I + G + ( X − M )

where:
C = consumption
I = investment spending
G = government spending
(X − M) = exports less imports (i.e., net exports)

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Capital Market Expectations

Taylor Rule

ROptimal = RNeutral + [0.5 × (GDPgForecast − GDPgTrend ) + 0.5 × ( I Forecast − I Target )]

where:
ROptimal = short-term interest rate target
RNeutral = interest rate under target growth and inflation
GDPg = growth rates for GDP forecast and long-term trend
I = inflation rate forecast and target

Econometric Models

%∆GDP = %∆C + %∆I + %∆G + %∆( X − M )

%∆C = f (Disposable income and Interest rates)


%∆I = f (Earnings and Interest rates)
%∆( X − M ) = f (Foreign exchange rates)

Government Debt

YTM Treas = rrF + INFL

Corporate Debt

Credit spread = YTMCorp − YTM Treas

Inflation‐Linked Debt

E ( INFL ) = YTM Treas − YTM TIPS

where:
YTMTIPS = yield on treasury inflation protected securities

Capitalization Rate

(VRE = NOI/r)

where:
VRE = value of real estate
NOI = net operating income

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Capital Market Expectations

Purchasing Power Parity Approach

%∆FX f / d ≈ INFL f − INFLd

where:
%FXf/d = foreign for domestic currency exchange rate
INFL = foreign f and domestic d inflation

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Asset Allocation and Related Decision in
Portfolio Management (1)
Introduction to Asset Allocation

Introduction to Asset Allocation


Cobb-Douglas

∆Y ∆A ∆K ∆L
≈ +α + (1 − α)
Y A K L

where:
Y = total real economic output.
A = level of technology.
K = level of capital.
L = level of labor.
α = output elasticity of capital.
(1 – α) = output elasticity of labor.

H-Model

D0  N
V0 =  (1 + gL ) + ( gS − gL ) 
r − gL  2 

where:
N = period of years from higher to lower linear growth rate.
gS = short-term high growth rate.
gL = long-term steady growth rate.

Earnings-Based Models

Fed Model

E1 r − ROE (1 − P ) yT − yT (1 − p)
= = = yT
P0 p p

where:
E1/P0 = Earnings yield
p = dividend payout ratio
  yT = 10-year T-note yield
ROE(1 – P) = sustainable growth rate
Fed Model implicitly assumes that r = ROE = yT, which ignores the equity risk premium.

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Introduction to Asset Allocation

Yardeni Model to Value an Equity Market

E1
= yB − d × LTEG
P0

where:
yB = Moody’s A-rated corporate bond yield
d = earnings projection weighting factor
LTEG = Consensus S&P 500 5-year annual earning growth

Cyclically-Adjusted P/E Ratio

Real S&P500 Price Index


CAPE =
10-year MA Real S&P500 Reported Earning

where:
MA = moving average

Portfolio Asset Class Optimization

max E [U (WT ) ] = f (W0 , wi , ri , A)


n
Subject to : ∑ wi = 1
i −1

where:
E[U(WT)] = Expected utility of wealth at time t
W0 = Current wealth
wi = weights of each asset class in the allocation
ri = returns of each asset class in the allocation
A = investor’s risk aversion

For the case of a risky asset and a risk-free asset, the optimization becomes:

* 1  µ − rf 
w =  
λ  σ2 

Where:
w* = weight of the risk asset in the two-asset portfolio
λ = investor’s risk aversion
μ = risk asset return
rf = risk-free asset return
σ2 = risk asset variance

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Principles of Asset Allocation

Principles of Asset Allocation


Risk Objectives

U p = E ( R p ) − 0.005 × A × σ 2p

where:
U is the investor’s utility.
E(Rp) is the portfolio expected return.
A is the investor’s risk aversion.
σ 2p is the variance of the portfolio.

Roy’s Safety First Ratio (SF Ratio)

E ( R p ) − RL
SF Ratio =
σp

where:
RL is the lowest acceptable return over a period of time.
E(Rp) is the portfolio’s expected return.
σp is the portfolio’s standard deviation.

Including International Assets


• The Sharpe ratio of the proposed new asset class: SR[New]
• The Sharpe ratio of the existing portfolio: SR[p]
• The correlation between asset class return and portfolio return:
Corr (R[New], R[p])

SR[ New] > SR[ p] × Corr ( R[ New], R[ p])

Portfolio Risk Budgeting

Marginal contribution to total risk identifies the rate at which risk changes as asset i is
added to the portfolio:

MCTR i = βi ,P σ P

where:
βi,P = beta of asset i returns with respect to portfolio returns
 σP = portfolio return volatility measure as standard deviation of asset i returns

Absolute contribution to total risk identifies the contribution to total risk for asset i

ACTRi = wi × MCTRi
ACTRi
% ACTRi to total risk =
σP

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Principles of Asset Allocation

The optimal portfolio occurs when:

ri − r f rj − r f rTP − r f
= ==
MCTRi MCTR j σ TP

where:
σTP = standard deviation of the tangency portfolio

Risk Parity

1
wi × covi ,P = × σ 2P
n

where:
wi = weight of asset i in the portfolio
n = number of assets in the portfolio
covi,P = covariance of asset i returns with portfolio returns
σ2P = variance of portfolio returns

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Asset Allocation and Related Decisions in
Portfolio Management (2)
Asset Allocation with Real-World Constraints

Asset Allocation with Real-World Constraints


After-tax Portfolio Optimization

Optimizing a portfolio subject to taxes requires using the after-tax returns and risks on an
ex-ante basis.

rat = rpt (1 − t )

where:
rat = expected after-tax return
rpt = expected pre-tax return
  t = expected tax rate

Extending this to a portfolio with both income and capital gains:

rat = pd rpt (1 − td ) + pa rpt (1 − tcg )

where:
 pd = proportion of return from dividend income
 pa = proportion of return from price appreciation (i.e., capital gain)
td = tax rate on dividend income
tcg = tax rate on capital gain

This formula ignores the multi-period benefit from compounding capital gains rather than
recognizing the annual capital gain.

Taxes also affect expected standard deviation.

σ at = σ pt (1 − t )

Taxes result in lower highs and higher lows, effectively reducing the mean return and
muting dispersion.

Equivalent After-Tax Rebalancing Range

Rat = R pt (1 − t )

where:
Rat = After-tax rebalancing range
Rpt = Pre-tax rebalancing range

Portfolio Value After Taxable Distributions

Vat = Vpt (1 − ti )

where:
vat = after-tax portfolio value
vpt = pre-tax portfolio value
 ti = tax rate on distributions as income

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Currency Management: An Introduction

Currency Management: An Introduction


Forward Exchange Rates

1 + (i FC × Actual 360)
FFC/DC = SFC/DC ×
1 + (i DC × Actual 360)
1 + (i PC × Actual 360)
FPC/BC = SPC/BC ×
1 + (i BC × Actual 360)

where:
FFC/DC = forward rate for domestic currency in terms of foreign currency; same as “base
currency in terms of price currency”
SFC/DC = spot rate for domestic currency in terms of foreign currency
iFC = interest rates in foreign currency country
iDC = interest rates in domestic currency country

Forward Premium/Discount

 (i − i ) × Actual 360 
FFC/DC − SFC/DC = SFC/DC  FC DC Actual 
 1 + (i DC × 360 ) 

 (i − i ) × Actual 360 
FPC/BC − SPC/BC = SPC/BC  PC BC Actual 
 1 + (i BC × 360 ) 

Domestic Return on Global Assets

RDC = (1 + RFC )(1 + RFX ) − 1


= RFC + RFX + RFC RFX
≈ RFC + RFX

where:
RDC = return in domestic currency terms
RFC = return in foreign currency terms
RFX = percentage change in SDC/FC (i.e., foreign currency in terms of domestic currency)

Portfolio Return in Domestic Currency Terms

RDC = [ w1 × (1 + RFC1 )(1 + RFX 1 ) + w2 × (1 + RFC 2 )(1 + RFX 2 )] − 1

where:
wn = weight of asset in the portfolio

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Currency Management: An Introduction

Risk on Global Assets in Domestic Currency Terms

σ 2 ( RDC ) ≈ σ 2 ( RFC ) + σ 2 ( RFX ) + [2 × σ ( RFC ) × σ ( RFX ) × ρ( RFC , RFX )]

Roll Yield

( FP / B − SP / B )
YRoll =
SP / B

where || indicates absolute value. Positive roll yield occurs when a trader buys base
currency at a forward discount or sells it at a forward premium.

Minimum Variance Hedge

yt = α + βxt + εt

where:
yt = percentage change in asset to be hedged
xt = percentage change in hedging instrument
β = hedge ratio for minimum variance hedge
ε = error term to be minimized

Minimum Hedge Ratio

 σ ( RDC ) 
h = β = ρ ( RDC ; RFX ) ×  
 σ ( RFX ) 

where:
h = hedge ratio
ρ = correlation of return in domestic currency terms and return on conversion to domestic
currency.

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Market Indexes and Benchmarks

Market Indexes and Benchmarks


Factor-Model-Based

Rportfolio = ap + b1f1 + b2f2 … bkfk + εp

where:
aP = expected portfolio return if all sensitivities equal 0
 bk = sensitivity to systematic factors
 fk = systematic factors
 εp = residual return from non-systematic factors

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Fixed-Income Portfolio Management (1)
Introduction to Fixed-Income Portfolio Management

Introduction to Fixed-Income Portfolio Management


Expected Return Decomposition

E ( R) ≈ Yield income
+Rolldown return
+E(∆P based on investor’s yield and spread view)
–E(Credit losses)
+E(Currency gains or losses)

where:
Yield income = Annual coupon payment/Current bond price = Current yield
Rolldown return = (B1 − B0) / B1 = % change in bond price due to changing time to maturity
E(ΔP based on investor’s yield and spread view) = (− DM × ΔY%) + (0.5 × C × ΔY%)

Note: Credit losses and currency gains or losses are discussed elsewhere.

Effect of Leverage on the Portfolio

Portfolio return [ r1 × (VE − VB ) − (VB × rB ) ]


rP = =
Portfolio equity VE
V
= r1 + B (r1 − rB )
VE

where:
  r1 = Return on the unlevered portfolio
  rB = Borrowing costs
VE = Equity
VB = Borrowed amount

The remainder of the equation indicates the return effect of leverage such that r1 > rB
results in a positive contribution from leverage.

Leverage Using Futures

Notional value – Margin


Leverage Futures =
Margin

Securities Lending

Rebate rate = Collateral earnings rate − Security lending rate

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Introduction to Fixed-Income Portfolio Management

Total Return Analysis

1
 Total future dollars  n
Semiannual total return =  −1
 Full price of the bond 

Dollar Duration

Dollar duration = Duration × Bond value1 × 0.01

1
Note: Bond value is market value not par value

Spread Duration

Three major types of spreads:

• Nominal spread is the difference between the portfolio yield and the treasury yield
for the same maturities.
• Zero-volatility spread (Z-spread) is the constant spread over all the Treasury spot
rates at all maturities that forces equality between the bond’s price and the present
value of the bond’s cash flows.
• Option-adjusted spread (OAS) is the spread over the treasury or the benchmark
after incorporating the effects of any embedded options in the bond.

Economic Surplus

Economic Surplus = MVAssets − PVLiabilities

where:
MVAssets = market value of assets
PVLiabilities = present value of liabilities

Derivatives Overlay

Liability portfolio BPV – Asset portfolio BPV


Nf =
Futures BPV
BPVCTD
Futures BPV ≈
CFCTD

where:
  Nf = number of futures contract to immunize portfolio
 BPV = Basis point value
CTD = Cheapest to deliver
   CF = Conversion factor

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Introduction to Fixed-Income Portfolio Management

Liability portfolio BPV – Asset portfolio BPV


NP = × 100
Swap BPV

where:
NP = Notional principal of the swap

Index Matching to a Fixed-Income Portfolio

Active return = Portfolio return – Benchmark index return

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Fixed‐Income Portfolio Management (2)
Yield Curve Strategies

Yield Curve Strategies


Yield Curve Measurement

Butterfly spread = –(Short-term yield) + ( × 2 Medium-term yield) – (Long-term yield)

Higher spread values indicate greater curvature.

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Fixed-Income Active Management: Credit Strategies

Fixed-Income Active Management: Credit Strategies


Excess Return on Credit Securities

XR ≈ (s × t ) − ( ∆s × SD)

where:
s = spread at the beginning of the measurement period
t = holding period (i.e., fractional portion of the year)
SD = spread duration of the bond

Expected Excess Return on Credit Securities

EXR ≈ (s × t ) – ( ∆s × SD) − (t × p × L )

where:
 p = annual probability of default
L = expected severity of loss

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Equity Portfolio Management
Equity Portfolio Management

Equity Portfolio Management

Manager Active Return

Active return
Information ratio =
Active risk

where:
Active return = Portfolio return – Portfolio’s benchmark return
Active risk = Tracking risk (i.e., annualized standard deviation of
active returns)

Manager’s “true” active return = M anager’s return − Manager’s normal benchmark return
Manager’s “misfit” active return = Manager’s normal benchmark − Investor’s benchmark
Total active risk = true active risk 2 − misfit active risk 2

Portfolio Information Ratio (Fundamental Law of Active Management)

IRP ≈ IC × BR

where:
IR = information ratio for the portfolio
IC = information coefficient (i.e., correlation between forecast return and active return;
investment insight)
BR = breadth (i.e., number of independent active management decisions made each year

Portfolio Active Return

n
ARP = ∑ hAi rAi
i =1

n
Aσ P = ∑ h2Ai σ 2Ai
i =1

where:
ARP = Active return for a portfolio of managers
rAi = each manager’s active return
hAi = weight assigned for each manager’s active return
AσP = Standard deviation of active returns for a portfolio of managers (assumes zero
correlation of their returns)

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Alternative Investments
for Portfolio Management
Alternative Investments for Portfolio Management

Alternative Investments for Portfolio Management

Spot Return

E ( ∆F ) = E ( ∆S )

where:
F = forward price
S = spot price

Roll Return (or Roll Yield)

Ft −1 − Ft − ( St − St −1 ) ∆F − ∆S
rRoll = =
Ft −1 Ft −1

Total return on commodity index = Spot return + Roll return + Collateral return

where:
Collateral return = risk-free rate times the cash held as collateral over holding period

Fund Returns

NAVt − NAVt −1 NAVt


r= = −1
NAVt −1 NAVt−1

Rolling Return

RRn ,t = ri + rt −1 +  + ri −( n −1)  / n

Downside Deviation (Semideviation)

∑ i=1[ min(ri − r*,0)]


n 2

Downside deviation =
n −1

where:
ri = return on asset i
r* = specified return

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Alternative Investments for Portfolio Management

Drawdown

Drawdown is a period where portfolio value is less than at some previous high water mark.

Maximum drawdown = max( HWM t − Lt + n )

where:
HWMt = high-water mark at time t
Lt+n = low after the same high-water mark

Performance Appraisal

Sharpe Ratio

(rj − rF )
Sharpe ratio j =
σj

where:
rj = return on asset j
rF = annualized risk-free rate
σj = standard deviation of asset j returns

Sortino Ratio

rj − rF
Sortino ratio =
DD

where:
DD = Downside deviation

Gain‐to‐Loss Ratio

#monthly gains Average gain


G/L ratio = ×
#monthly losses Average loss

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Risk Management
Risk Management

Risk Management 

Portfolio Theory

rP = w1r1 + w2r2

σ 2P = w12 σ12 + w22 σ 22 + 2 w1w2ρσ1σ 2

where:
rP = portfolio return
σ 2P = portfolio variance
w = portfolio weights for assets 1 and 2
r = returns for assets 1 and 2
σ = standard deviation for assets 1 and 2
ρ = correlation between assets 1 and 2

Value at Risk (VAR)

Miniumum $ VaR = VP × [ E ( RP ) − Zα σ P ]

where:
VP = portfolio value
E(RP) = expected portfolio return
zα = the number of standard deviations at the selected confidence level
σP = standard deviation of portfolio returns (e.g., 1.65 for 5% and 2.33 for 1%)

Note: To convert to daily values, divide annual expected return by 250 trading days and
annual expected standard deviation by (250)0.5, the square root of 250.

(Hint: we expect that the number of standard deviations for a given probability well be
provided on the exam.)

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Risk Management Applications of Derivatives
RISK MANAGEMENT APPLICATIONS OF FORWARD AND FUTURES STRATEGIES

Risk Management Applications of Forward and Futures


Strategies
Managing Equity Risk by Beta Adjustment

βT S = β S S + N f β f f
 β − βS   S 
Nf =  T  
 βf  f 

β S is the current beta of an equity portfolio.


βT is the target beta of an equity portfolio: the desired level of beta after hedging.
S is the market value of a current equity portfolio.
β f is the beta of the index futures. It is often close to one, but may not be exactly equal to
one.
f is the futures price of market index futures.
Nf is the number of futures contracts needed to hedge the equity portfolio in order to
achieve the target beta after hedging is established.

Creating Synthetic Equity or Cash Positions

Long stock+Short futures=Long risk‐free bond


Long stock=Long risk‐free bond+Long futures

Creating a Synthetic Index Fund

V is the amount of money to be invested.


f is the futures price of market index futures.
q is the price multiplier of the futures contract (e.g., the S&P Index futures is $250).
T is the time to maturity of the futures contract.
r is the risk‐free interest rate.
δ is the dividend yield of the market index.
St is the level of stock index at time t.
Nf is the number of futures contracts.
N *f is the rounded (whole number) number of futures contracts.

Futures payoff= N *f q (ST – f)

( N *f qf )
V=
(1 + r )T

V (1 + r )T
N *f =
fq

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RISK MANAGEMENT APPLICATIONS OF FORWARD AND FUTURES STRATEGIES

Creating Cash Out of Equity

1
Unit of stock = N f q
(1 + δ)T

V (1 + r )T
N *f = −
qf

Due to rounding, the amount converted to cash is:

− N f qf
V* =
(1 + r )T

Adjusting Duration Using Futures

 MDURT − MDURB   B 
N bf =   
 MDUR f   fB 

 β − βS  S
Nsf =  T 
 β f  fs

The same concepts can be used to adjust the allocation to different types of equities or
bonds, or preinvesting in an asset class using equity or bond futures.

Currency Forward Contracts (Foreign Exchange)

If desiring to hedge an amount of money to be received in a foreign currency, the hedger


can sell the value received in foreign currency (FC) forward for the desired currency (DC)
to lock in the value received in DC:

VDC = VFC × FDC FC

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Risk Management Applications of Swap Strategies

Risk Management Applications of Option Strategies 


Notation for Options

S = The value of the underlying stock


X = The exercise price of an option
c = A call option premium
p = A put option premium
V = Value of a position
π = Profit of a transaction
r = Risk‐free rate of interest
T = Option expiration
S*T = Breakeven (profit equals 0)
Put and call subscripts go from 1 being the lowest exercise price to 3 being the highest
exercise price, with 2 between 1 and 3 in exercise price.

Covered Calls

Value at initiation = V0 = S0 + c0
Value at option expiration = VT = ST − cT = ST − max(ST − X, 0)
Profit at option expiration = VT − V0 = [ST − max(ST − X, 0)] − [S0 − c0]
Max profit = X – [S0 – c0 ] when ST ≥ X
Max loss = S0 – c0 when ST = 0
Breakeven point = S*T = S0 − c0

Protective Put

Value at initiation = V0 = S0 − p0
Value at option expiration = VT = ST + pT = ST + max[X − ST, 0)
Profit at option expiration = VT − V0 = [ST + max[X − ST, 0)] − [S0 + p0]
Max profit = ∞ when ST approaches ∞
Max loss = [S0 + p0 ] − X when ST ≤ X
Breakeven point = S*T = S0 + p0

Bull Spreads

Value at initiation = V0 = c1 − c2
Value at option expiration = VT = max(ST − X1, 0) − max(ST − X2, 0)
Profit at option expiration = VT − V0 = [max(ST – X1, 0) − max(ST − X2, 0)] − [c1 − c2]
Max profit = [X2 – X1] − [c1 − c2] when ST ≥ X2
Max loss = c1 − c2 when ST ≤ X1
Breakeven point = S*T = X1 + [c1 − c2]

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Risk Management Applications of Option Strategies

Bear Spreads

Value at initiation = V0 = p2 – p1
Value at option expiration = max[X2 –ST, 0) – max(X1 – ST, 0)
Profit at option expiration = VT − V0 = [max(X2 − ST, 0) – max(X1 – ST , 0)]
– [p2 – p1]
Max profit = [X2 − X1] – [p2 − p1] when ST ≥ X1
Max loss = p2 – p1 when ST ≥ X2
Breakeven point = S*T = X2 – [p2 – p1]

Butterfly Spreads

Value at initiation = V0 = c1 – 2c2 + c3


Value at option expiration = VT = max(sT – X1, 0) – 2max(ST − X2, 0)
+ max(ST − X3, 0)
Profit at option expiration = VT − V0 = [max[ST – X1, 0) – 2max[ST − X2, 0)
+ max(ST − X3, 0)] – [c1 – 2c2 + c3]
Max profit = [X2 – X1] – [c1 – 2c2 + c3] when ST = X2
Max loss = c1 – 2c2 + c3 when ST ≥ X3 or ST ≤ X1,
Breakeven points = S*T = X1, + [c1 – 2c2 + c3] and 2X2 – X1, – [c1 – 2c2 + c3]

Collars

Value at initiation = V0 = S0 + [p1 − c2] = S0 + 0 = S0


Value at option expiration = VT = ST + max(X1 − ST, 0) – max(ST – X2, 0)
Profit at option expiration = VT − V0 = [ST + max(X1 − ST, 0)]
− max(ST − X2, 0) − [S0]
Max profit = X2 − S0 when ST ≥ X2
Max loss = S0 − X1 when ST ≤ X1
Breakeven point = S*T = S0

Straddles

Value at initiation = V0 = c0 + p0
Value at option expiration = VT = max(ST − X, 0) + max(X − ST, 0)
Profit at option expiration = VT − V0 = [max(ST − X, 0)] + max(X − ST, 0) − [c0 + p0]
Max profit = ∞ when ST → ∞
Max loss = c0 + p0 when ST = X
Breakeven point = S*T = X +[c0 + p0] and X − [c0 + p0 ]

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Risk Management Applications of Swap Strategies

Option Strap
Strip = c + 2p

Strap = 2c + p

Box Spread

Value at initiation = V0 = [c1 – c2 ] + [p2 – p1]


Value at option expiration = VT = X2 – X1
Profit at option expiration = VT – V0 = [X2 – X1] – [[c1 – c2 ] + [p2 – p1]]
Max profit = Profit = [X2 – X1] – [[c1 – c2] + [p2 – p1]]
regardless of terminal stock price
Max loss = None
Breakeven point = None

Interest Rate Option Strategies

Call option payoff = Notional principal × max(Realized spot rate − Exercise rate,0)
Days in underlying rate
×
360

Put option payoff = Notional principal × max(Exercise rate − Realized spot rate,0)
Days in underlying rate
×
360

Combining Caplets with a Floating Rate Loan

Because the first rate is usually already set, there are usually (n – 1) caplets to protect a
floating rate loan. There may be another caplet if taken out prior to borrowing the money.

m 
iFRN = VL ( Libort −1 + S L ) 
 360 

where:
iFRN = loan interest on the floating rate note
VL = loan value; the amount of the loan
Libort-1 = Libor on the previous reset date
SL = spread over Libor
m = actual days in the settlement period

m
PayoffCaplet = VL × max(0, Lt −1 − rx )
360

where:
rX = exercise rate for the cap

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Risk Management Applications of Option Strategies

Combining Floorlets with a Floating Rate Loan

Loan interest is calculated as with caplets.

m
PayoffFloorlet = VL × max(0, rx − Lt −1 ) =
360

Collar on a Floating Rate Loan

A borrower’s collar consists of long cap and short floor positions with the intent of zero
cost from the strategy (i.e., exercise rates are selected such that floor premium equals cap
premium). A lender’s collar consists of long floor and short cap positions.

Loan interest is calculated as before. Payoffs from the cap and floor positions are
calculated as before.

Effective interest = interest due – caplet payoff – floorlet payoff

Note: Effective interest applies to both borrower and lender, but whether a receipt or
payment depends on whether the cap/floor has been bought/sold.

Risk Management of an Option Portfolio

Change in option price ∆c


Option delta = =
Change in the underlying stock price ∆S

Change in option delta


Option gamma =
Change in the underlying stock price

Change in option price


Option vega =
Change in annualized stock return volatility

Delta Hedge

Nc  1 
Delta Hedge Ratio = = − 
NS  ∆c / ∆S 

where:
N = number of call options c; number of shares S
Δc = change in call option price
ΔS = change in share price
Δc/ΔS = option delta

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Risk Management Applications of Swap Strategies

Risk Management Applications of Swap Strategies


Convert a Floating Rate to a Fixed Rate

[Pay fixed and receive floating interest rate swap] = Floating-rate bond – Fixed-rate bond

Floating-rate bond = Fixed-rate bond + [Pay fixed and receive floating interest rate swap]

− Floating-rate bond = − Fixed-rate bond − [Pay fixed and receive floating interest rate swap]

Fixed-rate bond = Floating-rate bond − [Pay fixed and receive floating interest rate swap]

− Fixed-rate bond = − Floating-rate bond + [Pay fixed and receive floating interest rate swap]

Change the Duration of a Fixed‐Income Portfolio

[Pay fixed and receive floating interest rate swap] = Floating-rate bond − Fixed-rate bond

Decrease Portfolio Duration

Duration of [Pay fixed and receive Duration of Duration of


= −
floating interest rate swap] (floating‐rate bond) (fixed‐rate bond)

Increase Portfolio Duration

Duration of [Pay floating and receive Duration of Duration of


= −
fixed interest rate swap] (fixed‐rate bond) (floating‐rate bond)

Duration Management

MDURT − MDURP
NP = VP ×
MDURS
VP ( MDURP ) = VP ( MDURT ) − NP ( MDURS )
$ DURP + S = $ DURT

where:
NP = notional principal of the swap
VP = value of the portfolio
MDUR = target, portfolio, and swap modified durations
$DUR = dollar duration

*Note: To decrease duration (MDURT < MDURP) the denominator needs to be negative so
the investor must be the fixed rate payer.

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Risk Management Applications of Swap Strategies

Floating Rate Notes

Leveraged Floating-rate Notes

CFLeveraged floater = − kL ( FP )
CFBond = ( ci ) k ( FP )
CFFloating side of swap = Lk ( FP )
CFFixed side of swap = − ( FS ) k ( FP )
CFNet = kFP ( ci − FS )

where:
CF = net cash flow from the perspective of leveraged floater issuer
k = leverage ratio
L = receive floating rate on the swap
FP = face value/principal amount of the floating-rate note
FS = pay fixed rate on the swap
ci = coupon interest rate (i.e., fixed interest rate on a coupon-paying bond)

Inverse Floating-rate Notes

CFNet = FP (FS + ci − b)

where:
b = base interest rate against which Libor is drawn

Swapping Foreign Currency Cash Flows for Domestic Currency Cash Flows

t 
CFF = NPF (iF ) 
 360 
CFF
NPF =
t 
(iF ) 
 360 
NPD = NPF × S D / F or NPF SF / D
t 
CFD = NPD (iD ) 
 360 

where:
CFF = Foreign cash flow receipt to be swapped
NPF = Notional principal of foreign currency to be swapped at iF to achieve periodic CFF
iF = interest rate applicable to notional principal of foreign currency to be swapped
t = number of days between cash flows to be received
NPD = Notional principal of domestic currency swapped for foreign currency
SD/F = spot rate for foreign currency priced in domestic currency
SF/D = spot rate for domestic currency priced in foreign currency
CFD = Domestic cash flow received in exchange for swapped foreign cash flow

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Risk Management Applications of Swap Strategies

Creating Dual‐Currency Bonds

Dual currency bond = Conventional bond + Currency swap (without exchanging NP)

Swaptions

Receiver swaption = Call option on a bond


Payer swaption = Put option on a bond

Add or Remove Embedded Options in a Bond

Receiver swaption = Call option on bond

Payer swaption = Put option on bond

Callable bond = Straight bond − Call option on bond

Putable bond = Straight bond + Put option on bond

Callable bond = Straight bond − Receiver swaption


Putable bond = Straight bond + Payer swaption

Monetizing an Embedded Call

(2a) −Callable bond = −Straight bond + Receiver swaption


(2b) −Straight bond = −Callable bond − Receiver swaption

NCF = NP × {−[ F (t , T ) + s] + LIBOR − X + F (t , T ) − LIBOR}


= NP × [− X − s] = NP × [−(r0 − s) − s] = NP(r0 )

where:
NCF = Non-callable bond cash flows
NP = notional principal
F(t,T) = prevailing swap rate
s = credit spread over Libor
X = strike rate
r0 = interest rate on the non-callable bond with credit spread s over Libor

Creating a Synthetic Embedded Call

(2a) −Callable bond = −Straight bond + Receiver swaption

NCF = NP × [− Noncallable bond fixed rate − ( LIBOR + Strike rate − Prevailing swap rate + LIBOR )
= NP × [−r0 − LIBOR + X − F (t , T ) + LIBOR] = −r0 + (r0 − s) − F (t , T )
= NP × −[ F (t , T ) + s]

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Trading, Monitoring, and Rebalancing
Execution of Portfolio Decisions

Execution of Portfolio Decisions

(Bid price + Ask price) 


Effective spread = 2 ×  Execution price − 
 2

Implementation Shortfall Costs for purchases

Explicit Costs

Commissions, taxes, and fees


Expicit costs =
S H × PH

Realized Profit/Loss

S × ( PE − PR )
RPL =
S H × PH

Slippage (Delay Costs)

S × ( PR − PH )
Delay =
S H × PH

Unrealized Profit/Loss (Missed Trade Opportunity Cost)

( S H − S ) × ( PL − PH )
UPL =
S H × PH

Implementation Shortfall

Commissions + S ( PE − PL ) + S H ( PL − PH )
Implementation shortfall =
S H × PH

where:
S = shares executed
SH = hypothetical shares executed
PH = hypothetical price; benchmark price
PE = execution price
PR = relevant price when shares are not purchased at the hypothetical price
PL = last available valuation price

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Monitoring and Rebalancing 
The Perold‐Sharpe Analysis of Rebalancing Strategies

VPortfolio = VRisk-free + VStocks

Buy‐and‐Hold Strategies

VStocks VStocks
m= =
(
(VPortfolio − Floor ) VPortfolio − VRisk-free 0
)
Constant Mix Strategies

VStocks
m=
VPortfolio

Constant Proportion Portfolio Insurance (CPPI)

Investment in Stock = M(Vportfolio − Floor)

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Performance Evaluation
Evaluating Portfolio Performance

Evaluating Portfolio Performance 


The Holding Period Return

MVt − MV0 MVt


rt = = −1
MV0 MV0

where:
MVt is the market value of the account at time t; and rt is the holding period return over the
investment period.

Cash Inflow Occurs at the Beginning of the Reporting Period

MVt − ( MV0 + CF0 )


rt =
MV0 + CF0

Cash Inflow Occurs at the End of the Reporting Period

( MVt − CFt ) − MV0


rt =
MV0

Total return = Income yield + Capital gains yield

The Time‐Weighted Rate of Return

rtwr = (1 + rt1 )(1 + rt 2 ) … (1 + rtn ) − 1

where:
rti is the holding period return of sub‐period i, and there are a total of n sub‐periods.

Annualizing Returns

1/ n
rannual = n (1 + ryr .1 )(1 + ryr .2 )…(1 + ryr .n ) − 1 = (1 + ryr .1 )(1 + ryr .2 )…(1 + ryr .n )  −1

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Evaluating Portfolio Performance

Benchmarks

P=P

P = B + (P − B)

P = M + (B − M) + (P − B) = M + S + A

P is the return performance of a portfolio under management.


B is the return on a benchmark that matches the portfolio’s investment style.
M is the return on the market portfolio.
A is the portfolio manager’s active return: A = P − B.
S is the return contribution due to style selection: S = B − M.

Systematic Bias

P = M + (B − M) + (P − B) = M + S + A

Correlation(A, S) = 0

Correlation(E, S) = Correlation(P − M, B − M) > 0

Tracking Error

Tracking error = Volatility(A) < Volatility(E)

= Volatility(P − B) < Volatility(P − M)

where:
Volatility(E) = E
 xcess volatility of returns from the managed portfolio over returns from
the market portfolio

Hedge Fund Benchmarks

MVt − MV0
rt =
MV0

rv = rP − rB

where:
rv is the value‐added return.
rP is the portfolio return.
rB is the benchmark return.

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Evaluating Portfolio Performance

Sector Weighting Micro Attribution

S
Selection effect = ∑ [ wBi × (rPi − rBi )]
i =1

S
Sector allocation effect = ∑ [( wPi − wBi ) × (rBi − rB )]
i =1

S
Interaction effect = ∑ [( wPi − wBi ) × (rPi − rBi )]
i =1

Ex Post Alpha

Also known as Jensen’s alpha

Rt − r ft = α + β( RMt − r ft ) + εt

where for period t:


Rt = the portfolio return
rft = the risk-free return
RMt = the return on the market index
α = the intercept of the regression
β = the beta of the portfolio return relative to the market index return
ε = the random error term

Treynor Measure

RA − rf
TA =
β A

Sharpe Ratio

RA − rf
Sharpe ratio A =
σA

M‐Squared (M2)

 RA − rf 
M 2 = rf +  
A  σM
 σ 

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Evaluating Portfolio Performance

Information Ratio

RA − RB
IRA =

σ A− B

where:
σA–B = standard deviation of the differential returns of the asset over the benchmark

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Global Investment Performance Standards
Overview of the Global Investment Performance Standards

Overview of the Global Investment


Performance Standards
Return Calculation Methodologies

Total Return

V1 − V0
rt =
V0

Time‐Weighted Return

rtw = (1 + r1 )(1 + r2 )(1 + rn ) − 1

Modified Dietz Method

V1 − V0 − CF
rmodDietz =
V0 + ∑ t =1 (CFi × wi )
n

Weighting Formula

CD − Di
wi =
CD

where:
wi = weight of cash flow i
CD = calendar days in the period
Di = calendar days since the beginning of the period to receipt of cash flow i

Modified Internal Rate of Return Approach

n
V1 = ∑ CFi (1 + r ) w  + V0 (1 + r )
i

t =1

Original Dietz Method

V1 − V0 − CF
rDietz =
V0 + 0.5CF

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Overview of the Global Investment Performance Standards

Composite Returns

Beginning Assets Method

 V 
rc = ∑ rpi  
0, pi
 ∑ n V0, pi 
 pi =1 

where:
rc = composite return
rpi = individual portfolio returns
V0,pi = individual portfolio beginning value

Beginning Assets Plus Weighted Cash Flows Method

 Vpi 
rc = ∑ rpi  
 ∑ Vpi 

Presentation and Reporting

∑ i=1(ri − rC )
n 2

SC =
n −1

where:
Sc = standard deviation of returns in the composite
ri = individual portfolio returns
rc = composite returns

n
∑ (ri − rC ,aw )
2
SC ,aw = wi
i =1
V0,i
= wi −
∑ i=1V0,i
n

n
= rC ,aw = ∑ wi × ri
i =1

where:
SC,aw = asset-weighted standard deviation
wi = beginning-of-period weight for portfolio i in the composite
V0,i = beginning-of-period value of portfolio i

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Overview of the Global Investment Performance Standards

y
Ly = (n + 1)
100

( )
rY = rA −  L y − n A, Ly ( rA − rB ) 

where:
Ly = location of the portfolio in the yth percentile
n = number of observations
r = linear interpolation of return between observations around the yth percentile

Portfolio returns
Less: Trading costs
Equals: Gross-of-fee returns
Less: Management fees
Equals: Net-of-fee returns

n
∏ (1 + rt ) − 1 = (1 + r1 )(1 + r2 )(1 + r3 )…(1 + rn )
1/ n
rann = n −1
t =1

where:
n = number of compounding periods during the annual period

Internal Rates of Return Since Inception (Si‐Irr) Using Quarterly or More Frequent
Cash Flows

( )
4
rann = 1 + rQuarterly −1

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