Investment Course - 2005

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Investment Course - 2005

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Title: Investment Course - 2005


1
Investment Course - 2005
  • Day One
  • Global Asset Allocation and Portfolio Formation

2
Two Important Concepts Involving Expected
Investment Returns
  • 1. Investors perform two functions for capital
    markets
  • - Commit Financial Capital
  • - Assume Risk
  • so,
  • E(R) (Risk-Free Rate) (Risk Premium)
  • 2. The expected return (i.e., E(R)) of an
    investment has a number of alternative names
    e.g., discount rate, cost of capital, cost of
    equity, yield to maturity. It can also be
    expressed as
  • k (Nominal RF) (Risk Premium)
  • (Real RF) E(Inflation) (Risk Premium)
  • where
  • Risk Premium f(business risk, liquidity risk,
    political risk, financial risk)

3
Historical Real Returns, 1954-2003 The Global
Experience
Chile Returns 1/54 6/03 Chile Returns 1/54
12/71 1/76 6/03 Source Global Financial Data
4
Global Historical Volatility Measures, 1954-2003
5
Global Historical Risk Premia, 1954-2003
6
Historical Returns and Risk for Various U.S.
Asset Classes
7
Historical Global Stock Market Volatility
8
More on Historical Asset Class Returns U.S.
Experience
9
Historical Risk Premia vs. T-bills U.S.
Experience
10
Performance of U.S.-Oriented Investment
Strategies 1975-2004
11
Portfolio Management Strategy Broad View
  • Passive Management
  • Attempt to generate normal returns over time
    commensurate with investor risk tolerance
  • Typically achieved through diversified asset
    class selection and asset-specific portfolio
    formation
  • Active Management
  • Attempt to generate above-normal returns over
    time relative to acceptable risk level
  • Typically achieved either through periodic asset
    class or security-specific portfolio adjustments

12
Two Ways to Increase Returns (i.e., Add Alpha)
  • Tactical Allocation Decisions
  • - Global Market Timing
  • - Asset Class Timing
  • - Style/Sector Timing
  • Security Selection Decisions
  • - Stock or Bond Picking

13
Allure of Tactical Market Timing
  • Suppose that on January 1st each year from
    1975-2004, you put 100 of your money in what
    turned out to be the best asset class (stocks,
    bonds, or cash) at the end of the year.
  • This is equivalent to owning a perfect lookback
    option that entitles you to receive the return
    for the best performing asset class each year.
  • What difference would that type of tactical
    portfolio rebalancing make to your investment
    performance?

14
Allure of Tactical Market Timing (cont.)
15
Danger of Missing the Boat (i.e., Not Being
Invested)
16
The Asset Allocation Decision
  • A basic decision that every investor must make is
    how to distribute his or her investable funds
    amongst the various asset classes available in
    the marketplace
  • Stocks (e.g., Domestic, Global, Large Cap, Small
    Cap, Value, Growth)
  • Fixed-Income (e.g., Government, Investment
    Grade, High Yield)
  • Cash Equivalents (e.g., T-bills, CDs, Commercial
    Paper)
  • Alternative Assets (e.g., Private Equity, Hedge
    Funds)
  • Real Estate (e.g., Residential, Commercial)
  • Collectibles (e.g., Art, Antiques)
  • The Strategic (or Benchmark) allocation is the
    proportion of wealth the investor decides to
    place in each of these asset classes. It is
    sometimes also referred to as the investors
    long-term normal allocation because it is
    presumed to be the baseline allocation that
    will remain in place until the investors life
    circumstances change appreciably (e.g.,
    retirement)

17
The Importance of the Asset Allocation Decision
  • In an influential article published in Financial
    Analysts Journal in July/August 1986, Gary
    Brinson, Randolph Hood, and Gilbert Beebower
    examined the issue of how important the initial
    strategic allocation decision was to an investor
  • They looked at quarterly return data for 91
    pension funds over a ten-year period and
    decomposed the average returns as follows
  • Actual Overall Return (IV)
  • Return due to Strategic Allocation (I)
  • Return due to Strategic Allocation and Market
    Timing (II)
  • Return due to Strategic Allocation and Security
    Selection (III)

18
The Importance of the Asset Allocation Decision
(cont.)
  • Graphically
  • In terms of return performance, they found that

19
The Importance of the Asset Allocation Decision
(cont.)
  • In terms of return variation
  • Ibbotson and Kaplan support this conclusion, but
    argue that the importance of the strategic
    allocation decision does depend on how you look
    at return variation (i.e., 40, 90, or 100).

20
Examples of Strategic Asset Allocations
  • Public Endowments

21
Examples of Strategic Asset Allocations (cont.)
  • Public Retirement Fund

22
Examples of Strategic Asset Allocations (cont.)
23
Asset Allocation and Building an Investment
Portfolio
  • I. Global Market Analysis
  • - Asset Class Allocation
  • - Country Allocation Within Asset Classes
  • II. Industry/Sector Analysis
  • - Sector Analysis Within Asset Classes
  • III. Security Analysis
  • - Security Analysis Within Asset Classes
  • and Sectors

24
Asset Allocation Strategies
  • Strategic Asset Allocation The investors
    baseline asset allocation, taking into account
    his or her return requirements, risk tolerance,
    and investment constraints.
  • Tactical Asset Allocation Adjustments to the
    investors strategic allocation caused by
    perceived relative mis-valuations amongst the
    available asset classes. Ordinarily, tactical
    strategies overweight the undervalued asset
    class. Also known as market timing strategies.
  • Insured Asset Allocation Adjustments to the
    investors strategic allocation caused by
    perceived changes in the investors risk
    tolerance. Usually, the asset class that
    experiences the largest relative decline is
    underweighted. Portfolio insurance is a
    well-known application of this approach.

25
Sharpes Integrated Asset Allocation Model
26
Sharpes Integrated Asset Allocation Model (cont.)
  • Notice that the feedback loops after the
    performance assessment box (M3) make the
    portfolio management process dynamic in nature.
  • The strategic asset allocation process can be
    viewed as going through the model once and then
    removing boxes (C2) and (I2), thus removing any
    temporary adjustments to the baseline allocation.
  • Tactical asset allocation effectively removes box
    (I2), but allows for allocation adjustments due
    to perceived changes in capital market conditions
    (C2).
  • Insured asset allocation effectively removes box
    (C2), but allows for allocation adjustments due
    to perceived changes in investor risk tolerance
    conditions (I2).

27
Measuring Gains from Tactical Asset Allocation
  • Example Consider the following return and
    allocation characteristics for a portfolio
    consisting of stocks and bonds only.
  • Stock Bond
  • Allocation Strategic 60 40
  • Actual 50 50
  • Returns Benchmark 10 7
  • Actual 9 8
  • The returns to active management (i.e., tactical
    and security selection) are
  • Policy Performance (.6)(.10) (.4)(.07)
    8.80
  • Actual Performance (.5)(.09)
    (.5)(.08) 8.50
  • Active Return - 30 bp

28
Measuring Gains from Tactical Asset Allocation
(cont.)
  • Also
  • (Policy Timing) (.5)(.10)
    (.5)(.07) 8.50
  • (Policy Selection) (.6)(.09)
    (.4)(.08) 8.60
  • so
  • Timing Effect 8.50 8.80
    -0.30
  • Selection Effect 8.60 8.80
    -0.20
  • Other 8.50 8.60 8.50 8.80
    0.20
  • Total Active
    -0.30

29
Example of Tactical Asset Allocation Fidelity
Investments
30
Example of Tactical Asset Allocation Texas TRS
31
Example of Tactical Asset Allocation Texas TRS
32
Overview of Equity Style Investing
  • The top-down approach to portfolio formation
    involves prudent decision-making at three
    different levels
  • Asset class allocation decisions
  • Sector allocation decisions within asset classes
  • Security selection decisions within asset class
    sectors
  • The equity style decision (e.g., large cap vs.
    small cap, value vs. growth) is essentially a
    sector allocation decision
  • There is tremendous variation in the returns
    produced by the myriad style class-specific
    portfolios, so investors must pay attention to
    this aspect of the portfolio management process

33
Defining Equity Investment Style
  • The investment style of an equity portfolio is
    typically defined by two dimensions or
    characteristics
  • - Market Capitalization (i.e., Shares
    Outstanding x Price)
  • - Relative Market Valuation (i.e., Value
    versus Growth)

34
Equity Style Classification Specific Terminology
  • Market Capitalization
  • - Large (gt 10 billion)
  • - Mid (1 - 10 billion)
  • - Small (lt 1 billion)
  • Relative Valuation
  • - Value (Low P/E, Low P/B, High Dividend
    Yield, Low
  • EPS Growth)
  • - Blend
  • - Growth (High P/E, High P/B, Low Dividend
    Yield, High
  • EPS Growth)

35
Equity Style Grid
Value
Growth
Large
Small
36
Style Indexes Representative Stock Positions
January 2005
Value
Growth
Large
Small
37
Comparative Classification Ratios January
2005(Source Morningstar)
Value
Growth
Large
Small
38
Historical Equity Style Performance 1991-2004
(Source Frank Russell)
39
Equity Style Rotation 1991-2004
40
Relative Return PerformanceValue vs. Growth
LV Outperforms
LG Outperforms
41
Relative Risk Performance Value vs. Growth
LV Riskier
LG Riskier
42
Relative Return Performance Large Cap vs.
Small Cap
LB Outperforms
SB Outperforms
43
Relative Risk PerformanceLarge Cap vs. Small Cap
LB Riskier
SB Riskier
44
Value vs. Growth Global Evidence (Source Chan
and Lakonishok, Financial Analysts Journal, 2004)
45
Equity Style Investing Instruments and Strategies
  • Passive Style Alternatives
  • - Index Mutual Funds
  • - Exchange-Traded Funds (ETFs)
  • Active Style Alternatives
  • - Investor Portfolio Formation
  • - Open-Ended Mutual Funds

46
Methods of Indexed Investing
  • Open-End Index Mutual Funds There is a
    long-standing and active market for mutual funds
    that hold broad collections of securities that
    mimic various sectors of the stock market.
    Examples include the Vanguard 500 Index Fund,
    which recreates the holdings and weightings of
    the Standard Poors 500, and the various
    Fidelity Select Funds, which reproduce the
    profiles of different industry sectors.
  • Exchange-Traded Funds (ETF) A more recent
    development in the world of indexed investment
    products has been the development of
    exchange-tradable index funds. Essentially, ETFs
    are depository receipts that give investors a
    pro-rata claim on the capital gains and cash
    flows of the securities held in deposit.

47
Index Fund Example VFINX
48
Index Fund Example (cont.)
49
Top ETFs in the Large Blend Style Category
50
ETF Example SPY
51
ETF Example (cont.)
52
Growth of U.S. Equity Mutual Funds
53
Mutual Fund Performance Characteristics1991-2003
54
Mutual Fund Performance Characteristics1991-2003
(cont.)
55
Notion of Tracking Error
56
Notion of Tracking Error (cont.)
57
Notion of Tracking Error (cont.)
  • Generally speaking, portfolios can be separated
    into the following categories by the level of
    their annualized tracking errors
  • Passive (i.e., Indexed) TE lt 1.0 (Note TE lt
    0.5 is normal)
  • Structured 1.0 lt TE lt 3
  • Active TE gt 3 (Note TE gt 5 is normal for
    active managers)

58
Large Blend Active Manager DGAGX
59
Tracking Errors for VFINX, SPY, DGAGX
60
Risk and Expected Return Within a Portfolio
  • Portfolio Theory begins with the recognition that
    the total risk and expected return of a portfolio
    are simple extensions of a few basic statistical
    concepts.
  • The important insight that emerges is that the
    risk characteristics of a portfolio become
    distinct from those of the portfolios underlying
    assets because of diversification. Consequently,
    investors can only expect compensation for risk
    that they cannot diversify away by holding a
    broad-based portfolio of securities (i.e., the
    systematic risk)
  • Expected Return of a Portfolio
  • where wi is the percentage investment in the i-th
    asset
  • Risk of a Portfolio
  • Total Risk (Unsystematic Risk) (Systematic
    Risk)

61
Example of Portfolio Diversification Two-Asset
Portfolio
  • Consider the risk and return characteristics of
    two stock positions
  • Risk and Return of a 50-50 Portfolio
  • E(Rp) (0.5)(5) (0.5)(6) 5.50
  • and
  • sp (.25)(64) (.25)(100) 2(.5)(.5)(8)(10)(.4
    )1/2 7.55
  • Note that the risk of the portfolio is lower than
    that of either of the individual securities

62
Another Two-Asset Class Example
63
Example of a Three-Asset Portfolio
64
Diversification and Portfolio Size Graphical
Interpretation
Total Risk
0.40
0.20
Systematic Risk
Portfolio Size
40
1
20
65
Advanced Portfolio Risk Calculations
66
Advanced Portfolio Risk Calculations (cont.)
67
Advanced Portfolio Risk Calculations (cont.)
68
Advanced Portfolio Risk Calculations (cont.)
69
Example of Marginal Risk Contribution Calculations
70
Fidelity Investments PRISM Risk-Tracking System
Chilean Pension System March 2004
71
Chilean Sistema Risk Tracking Example (cont.)
72
Chilean Sistema Risk Tracking Example (cont.)
73
Notion of Downside Risk Measures
  • As we have seen, the variance statistic is a
    symmetric measure of risk in that it treats a
    given deviation from the expected outcome the
    same regardless of whether that deviation is
    positive of negative.
  • We know, however, that risk-averse investors have
    asymmetric profiles they consider only the
    possibility of achieving outcomes that deliver
    less than was originally expected as being truly
    risky. Thus, using variance (or, equivalently,
    standard deviation) to portray investor risk
    attitudes may lead to incorrect portfolio
    analysis whenever the underlying return
    distribution is not symmetric.
  • Asymmetric return distributions commonly occur
    when portfolios contain either explicit or
    implicit derivative positions (e.g., using a put
    option to provide portfolio insurance).
  • Consequently, a more appropriate way of capturing
    statistically the subtleties of this dimension
    must look beyond the variance measure.

74
Notion of Downside Risk Measures (cont.)
  • We will consider two alternative risk measures
    (i) Semi-Variance, and (ii) Lower Partial Moments
  • Semi-Variance The semi-variance is calculated
    in the same manner as the variance statistic, but
    only the potential returns falling below the
    expected return are used
  • Lower Partial Moment The lower partial moment
    is the sum of the weighted deviations of each
    potential outcome from a pre-specified threshold
    level (t), where each deviation is then raised to
    some exponential power (n). Like the
    semi-variance, lower partial moments are
    asymmetric risk measures in that they consider
    information for only a portion of the return
    distribution. The formula for this calculation
    is given by

75
Example of Downside Risk Measures
76
Example of Downside Risk Measures (cont.)
77
Example of Downside Risk Measures (cont.)
78
Example of Downside Risk Measures (cont.)
79
Overview of the Portfolio Optimization Process
  • The preceding analysis demonstrates that it is
    possible for investors to reduce their risk
    exposure simply by holding in their portfolios a
    sufficiently large number of assets (or asset
    classes). This is the notion of naïve
    diversification, but as we have seen there is a
    limit to how much risk this process can remove.
  • Efficient diversification is the process of
    selecting portfolio holdings so as to (i)
    minimize portfolio risk while (ii) achieving
    expected return objectives and, possibly,
    satisfying other constraints (e.g., no short
    sales allowed). Thus, efficient diversification
    is ultimately a constrained optimization problem.
    We will return to this topic in the next
    session.
  • Notice that simply minimizing portfolio risk
    without a specific return objective in mind
    (i.e., an unconstrained optimization problem) is
    seldom interesting to an investor. After all, in
    an efficient market, any riskless portfolio
    should just earn the risk-free rate, which the
    investor could obtain more cost-effectively with
    a T-bill purchase.

80
The Portfolio Optimization Process
  • As established by Nobel laureate Harry Markowitz
    in the 1950s, the efficient diversification
    approach to establishing an optimal set of
    portfolio investment weights (i.e., wi) can be
    seen as the solution to the following non-linear,
    constrained optimization problem
  • Select wi so as to minimize
  • subject to (i) E(Rp) R
  • (ii) S wi 1
  • The first constraint is the investors return
    goal (i.e., R). The second constraint simply
    states that the total investment across all 'n'
    asset classes must equal 100. (Notice that this
    constraint allows any of the wi to be negative
    that is, short selling is permissible.)
  • Other constraints that are often added to this
    problem include (i) All wi gt 0 (i.e., no short
    selling), or (ii) All wi lt P, where P is a fixed
    percentage

81
Example of Mean-Variance Optimization (Three
Asset Classes, Short Sales Allowed)
82
Example of Mean-Variance Optimization (Three
Asset Classes, No Short Sales)
83
Mean-Variance Efficient Frontier With and Without
Short-Selling
84
Efficient Frontier Example Five Asset Classes
85
Example of Mean-Variance Optimization (Five
Asset Classes, No Short Sales)
86
Efficient Frontier Example 2003 Texas Teachers
Retirement System
87
Efficient Frontier Example Texas Teachers
Retirement System (cont.)
88
Efficient Frontier Example Texas Teachers
Retirement System (cont.)
89
Efficient Frontier Example Chilean Pension
System (Source Fidelity Investments)
  • Base Case Assumptions
  • Expected real returns based on 1954 2003 risk
    premiums
  • Real returns for developed market stocks and
    bonds areGDP-weighted excluding US
    (equally-weighted returns for stocks and bonds
    are 5.73 and 1.39, respectively)
  • Chilean risk-premium volatility estimates
    exclude the period 1/72 12/75

90
Efficient Frontier Example Chilean Pension
System (cont.)
- Correlation matrix is based on real returns
from the period 1/93 6/03 using Chilean
inflation and based in Chilean pesos - Real
returns for developed market stocks and bonds
areGDP-weighted excluding US
91
Efficient Frontier Example Chilean Pension
System (cont.)
Unconstrained Frontier
92
Efficient Frontier Example Chilean Pension
System (cont.)
Constraint Set
93
Efficient Frontier Example Chilean Pension
System (cont.)
Constrained Frontier for Fund A
94
Efficient Frontier Example Chilean Pension
System (cont.)
Asset Allocations of Various Funds Using Point 20
on Unconstrained Frontier
95
Example of Mean-Lower Partial Moment Portfolio
Optimization(Five Asset Classes, No Short Sales)
96
Estimating the Expected Returns and Measuring
Superior Investment Performance
  • We can use the concept of alpha to measure
    superior investment performance
  • a (Actual Return) (Expected Return) Alpha
  • In an efficient market, alpha should be zero for
    all investments. That is, securities should, on
    average, be priced so that the actual returns
    they produce equal what you expect them to given
    their risk levels.
  • Superior managers are defined as those investors
    who can deliver consistently positive alphas
    after accounting for investment costs
  • The challenge in measuring alpha is that we have
    to have a model describing the expected return to
    an investment.
  • Researchers typically use one of two models for
    estimating expected returns
  • Capital Asset Pricing Model
  • Multi-Factor Models (e.g., Fama-French
    Three-Factor Model)

97
Developing the Capital Asset Pricing Model
98
Developing the Capital Asset Pricing Model (cont.)
99
Using the SML in Performance Measurement An
Example
  • Two investment advisors are comparing
    performance. Over the last year, one averaged a
    19 percent rate of return and the other a 16
    percent rate of return. However, the beta of the
    first investor was 1.5, whereas that of the
    second was 1.0.
  • a. Can you tell which investor was a better
    predictor of individual stocks (aside from the
    issue of general movements in the market)?
  • b. If the T-bill rate were 6 percent and the
    market return during the period were 14 percent,
    which investor should be viewed as the superior
    stock selector?
  • c. If the T-bill rate had been 3 percent and the
    market return were 15 percent, would this change
    your conclusion about the investors?

100
Using the SML in Performance Measurement (cont.)
101
Using CAPM to Estimate Expected Return Empresa
Nacional de Telecom
102
Estimating Mutual Fund Betas FMAGX vs. GABAX
103
Estimating Mutual Fund Betas FMAGX vs. GABAX
(cont.)
104
Estimating Mutual Fund Betas FMAGX vs. GABAX
(cont.)
105
The Fama-French Three-Factor Model
  • The most popular multi-factor model currently
    used in practice was suggested by economists
    Eugene Fama and Ken French. Their model starts
    with the single market portfolio-based risk
    factor of the CAPM and supplements it with two
    additional risk influences known to affect
    security prices
  • A firm size factor
  • A book-to-market factor
  • Specifically, the Fama-French three-factor model
    for estimating expected excess returns takes the
    following form

106
Estimating the Fama-French Three-Factor Return
Model FMAGX vs. GABAX
107
Fama-French Three-Factor Return Model FMAGX vs.
GABAX (cont.)
108
Fama-French Three-Factor Return Model FMAGX vs.
GABAX (cont.)
109
Style Classification Implied by the Factor Model
Value
Growth
Large
Small
110
Fund Style Classification by Morningstar
  • FMAGX
  • GABAX

111
Does Investment Style Consistency Matter?
Consider the style classification of two funds (A
B) over time
112
Does Investment Style Consistency Matter? (cont.)
  • Study conducted using several thousand mutual
    funds from all nine style classes over the period
    1991-2003
  • (see K. Brown and V. Harlow, Staying the
    Course Performance Persistence and the Role of
    Investment Style Consistency in Professional
    Asset Management)
  • Calculates style consistency measure for each
    fund using two different methods (i.e., R-squared
    from three-factor model, tracking error from
    style benchmark) and correlated these statistics
    with several portfolio characteristics, including
    returns
  • Estimated regressions of future fund returns on
    past performance, style consistency, and other
    controls (e.g., fund expenses, turnover, assets
    under management)

113
Correlation of Style Consistency (i.e.,
R-Squared) With Other Fund Characteristics
114
Regression of Future Predicted Returns on (i)
Past Performance (i.e., Alpha), (ii) Style
Consistency (i.e., RSQ), and (iii) Portfolio
Control Variables in both Up and Down Markets
115
Investment Style Consistency Conclusions
  • In general, the findings strongly suggest that
    fund style consistency does matter in evaluating
    future fund performance
  • Overall, there is a positive relationship between
    fund style consistency and subsequent investment
    performance
  • However, the nature of how style consistency
    matters is somewhat complicated
  • In up markets, style-consistent funds
    outperform style- inconsistent funds, everything
    else held equal
  • The reverse is true in down markets
    style-inconsistent funds outperform
    style-consistent funds, everything else held
    equal
  • Up and down markets are predictable in
    advance
  • Being able to maintain a style-consistent
    portfolio is a valuable skill for a manager to
    have

116
Using Derivatives in Portfolio Management
  • Most long only portfolio managers (i.e.,
    non-hedge fund managers) do not use derivative
    securities as direct investments.
  • Instead, derivative positions are typically used
    in conjunction with the underlying stock or bond
    holdings to accomplish two main tasks
  • Repackage the cash flows of the original
    portfolio to create a more desirable risk-return
    tradeoff given the managers view of future
    market activity.
  • Transfer some or all of the unwanted risk in the
    underlying portfolio, either permanently or
    temporarily.
  • In this context, it is appropriate to think of
    the derivatives market as an insurance market in
    which portfolio managers can transfer certain
    risks (e.g., yield curve exposure, downside
    equity exposure) to a counterparty in a
    cost-effective way.

117
The Cost of Synthetic Restructuring With
Derivatives
118
The Hedging Principle
119
The Hedging Principle (cont.)
  • Consider three alternative methods for hedging
    the downside risk of holding a long position in a
    100 million stock portfolio over the next three
    months
  • 1) Short a stock index futures contract expiring
    in three months. Assume the current contract
    delivery price (i.e., F0,T) is 101 and that
    there is no front-expense to enter into the
    futures agreement. This combination creates a
    synthetic T-bill position.
  • 2) Buy a stock index put option contract expiring
    in three months with an exercise price (i.e., X)
    of 100. Assume the current market price of the
    put option is 1.324. This is known as a
    protective put position.
  • 3) (i) Buy a stock index put option with an
    exercise price of 97 and (ii) sell a stock index
    call option with an exercise price of 108.
    Assume that both options expire in three months
    and have a current price of 0.560. This is
    known as an equity collar position.

120
1. Hedging Downside Risk With Futures
121
1. Hedging Downside Risk With Futures (cont.)
122
2. Hedging Downside Risk With Put Options
123
2. Hedging Downside Risk With Put Options (cont.)
124
3. Hedging Downside Risk With An Equity Collar
125
3. Hedging Downside Risk With An Equity Collar
(cont.)
Terminal Position Value
Collar-Protected Stock Portfolio
108
97
97
108
Terminal Stock Price
126
Zero-Cost Collar Example IPSA Index Options
127
Zero-Cost Collar Example IPSA Index Options
(cont.)
128
Another Portfolio Restructuring
  • Suppose now that upon further consideration, the
    portfolio manager holding 100 million in U.S.
    stocks is no longer concerned about her equity
    holdings declining appreciably over the next
    three months. However, her revised view is that
    they also will not increase in value much, if at
    all.
  • As a means of increasing her return given this
    view, suppose she does the following
  • Sell a stock index call option contract expiring
    in three months with an exercise price (i.e., X)
    of 100. Assume the current market price of the
    at-the-money call option is 2.813.
  • The combination of a long stock holding and a
    short call option position is known as a covered
    call position. It is also often referred to as a
    yield enhancement strategy because the premium
    received on the sale of the call option can be
    interpreted as an enhancement to the cash
    dividends paid by the stocks in the portfolio.

129
Restructuring With A Covered Call Position
130
Restructuring With A Covered Call Position (cont.)
131
Some Thoughts on Currency Hedging and Portfolio
Management
Question How much FX exposure should a portfolio
manager hedge?
Weakening CLP
Strengthening CLP
132
Conceptual Thinking on Currency Hedging in
Portfolio Management
  • There are at least three diverse schools of
    thought on the optimal amount of currency
    exposure that a portfolio manager should hedge
    (see A. Golowenko, How Much to Hedge in a
    Volatile World, State Street Global Advisors,
    2003)
  • Completely Unhedged Froot (1993) argues that
    over the long term, real exchange rates will
    revert to their means according to the Purchasing
    Power Parity Theorem, suggesting currency
    exposure is a zero-sum game. Further, over
    shorter time frameswhen exchange rates can
    deviate from long-term equilibrium
    levelstransaction costs make involved with
    hedging greatly outweigh the potential benefits.
    Thus, the manager should maintain an unhedged
    foreign currency position.
  • Fully Hedged Perold and Schulman (1988) believe
    that currency exposure does not produce a
    commensurate level of return for the size of the
    risk in fact, they argue that it has a long-term
    expected return of zero. Thus, since the
    investor cannot, on average, expect to be
    adequately rewarded for bearing currency risk, it
    should be fully hedged out of the portfolio.
  • Partially Hedged An optimal hedge ratio
    exists, subject to the usual caveats regarding
    parameter estimation. Black (1989) demonstrates
    that this ratio can vary between 30 and 77
    depending on various factors. Gardner and
    Wuilloud (1995) use the concept of investor
    regret to argue that a position which is 50
    currency hedged is an appropriate benchmark.

133
Hedging the FX Risk in a Global Portfolio Some
Evidence
  • Consider a managed portfolio consisting of five
    different asset classes
  • Chilean Stocks (IPSA), Bonds (LVAC Govt), Cash
    (LVAC MMkt)
  • US Stocks (SPX), Bonds (SBBIG)
  • Monthly returns over two different time periods
  • February 2000 February 2005
  • February 2002 February 2005
  • Five different FX hedging strategies (assuming
    zero hedging transaction costs)
  • 1 Hedge US positions with selected hedge ratio,
    monthly rebalancing
  • 2 Leave US positions completely unhedged
  • 3 Fully hedge US positions, monthly rebalancing
  • 4 Make monthly hedging decision (i.e., either
    fully hedged or completely unhedged) on a monthly
    basis assuming perfect foresight about future FX
    movements
  • 5 Make monthly hedging decision (i.e., either
    fully hedged or completely unhedged) on a monthly
    basis assuming always wrong about future FX
    movements

134
Investment Performance for Various Portfolio
Strategies February 2000-February 2005
135
Investment Performance for Various Portfolio
Strategies February 2002-February 2005
136
Sharpe Ratio Sensitivities for Various Managed
Portfolio Hedge Ratios
137
Currency Hedging and Global Portfolio Management
Final Thoughts
  • Foreign currency fluctuations are a major source
    of risk that the global portfolio manager must
    consider.
  • The decision of how much of the portfolios FX
    exposure to hedge is not clear-cut and much has
    been written on all sides of the issue. It can
    depend of many factors, including the period over
    which the investment is held.
  • It is also clear that tactical FX hedging
    decisions have potential to be a major source of
    alpha generation for the portfolio manager.
  • Recent evidence (Jorion, 1994) suggests that the
    FX hedging decision should be optimized jointly
    with the managers basic asset allocation
    decision. However, this is not always possible
    or practical.
  • Currency overlay (i.e., the decision of how much
    to hedge made outside of the portfolio allocation
    process) is rapidly developing specialty area in
    global portfolio management.
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