Types of Exchange Rate Risk

1. Transaction Exposure - I am a US investor expecting to receive 1m Euro in 2 years from a client. I don't know what the euro will be worth in 2 years.

Transaction exposure can be mitigated using derivatives. I can short a 2-year USD/EUR forward to mitigate the risk



2. Translation Exposure - this is associated with accounting when on the financial statements one currency is converted to another without necessarily any real economic gains or losses.


3. Economic Exposure - when changes in the currency rates affect the competitive standing of the business. A Russian consumer products manufacturer (with expenses and revenues in Rubles) is likely to sell more products to foreign clients if the local Russian currency devalues

Wealth Management Concepts

Goals Based Planning Financial Planning - modifies traditional MVO and accommodates for behavioral finance. The financial asset portfolio is dividend into risk buckets:

1. Personal Risk - cash, money market funds, personal residence is included

2. Market Risk - fixed income and equity market portfolio

3. Aspirational - concentrated positions etc

Primary Capital = Personal Risk Bucket + Market Risk Bucket

Surplus Capital = Aspirational Risk Bucket


Estate Planning Concepts:

Human Capital = Net Employment Capital = Present Value of Income Generated Over Lifetime

Core Capital = Amount of assets needed to meet all the individual's liabilities + reserve for unexpected needs

Excess Capital = Total Assets (financial + human capital) - Total Liabilities (financial and non-financial)

We can use mortality table or monte carlo simulation to estimate core capital

Notice that if a man with all the same characteristics as a woman but who is likely to live less, his core capital is likely to be less

Individual Risk Management Concepts

A risk with the loss characteristics of high frequency of occurrence and low severity of loss, such as dental cavities, is best managed through risk reduction—for example, through proper dental hygiene. A risk with the loss characteristics of low frequency of occurrence and high severity of loss, such as an earthquake that destroys your home, is best managed through risk transfer. A risk with the loss characteristics of low frequency of occurrence and low severity of loss is best managed through risk retention, such as not purchasing an extended warranty on an infrequently used and relatively inexpensive item.

GIPS Need to Know List

REQUIRED Disclosures

1. Definition of the Firm
2. Total assets under management (all types)
3. Composite description and creation date
4. Benchmark description
5. Currency used
6. if gross of fees returns are presented must disclose any deductions other than direct trading expenses. 
7. for net of fees returns must: a) disclose any deductions other than trading expenses and investment management fees b) if actual or model investment management fees are used and c) if returns are net of performance based fees 
8. State that composite descriptions are available upon request
9. Disclose valuation & performance measurement policies upon request
10. Disclose presence of leverage, short positions and use of derivatives. 
11. Significant events that would help interpret performance e.g. departure of key investment managers
12. For any non-compliant performance betfore 2000, must disclose period of non-compliance
13. If the firm or composite is redefined, must disclose date, description and reason
14. Must disclose minimum asset level 
15. Must disclose if the name of the composite was changed. 
16. Must disclose relevant treatment of taxes if material and provide benchmark returns net of withholding taxes if available
17. From 1st of Jan 2011, Must disclose any material differences in valuation sources and exchange rates used. (e.g. i used reuters for valuation in one portfolio and Bloomberg in another)
18. Must disclose any conflicts between GIPS and local laws/regulations
19. Must disclose carve out cash policies prior to 1 Jan 2010 (after carve outs were no longer allowed)
20. Must disclose fees included in the bundled fee
21. Disclose any sub advisors and periods they were used from jan 1 2006
22. For periods prior to 2010, must disclose if portfolios were not valued at calendar month end or last business day
23. After 2011, must disclose any material subjective unobservable inputs employed for valuation purposes and any difference in the valuation hierarchy than the one recommended
24. If no benchmark exists, must disclose why
25. If benchmark is changed must disclose date & reason
26. For custom benchmark, must disclose details of the benchmark including components, weights and rebalancing process
27. If the firm has a significant cash flow policy, must disclose how the firm defines it
28. Must disclose if a 3-year annualized ex-post standard deviation for the composite or benchmark is not presented because returns are not available
29. If the firm decides that the 3-year standard deviation is to be excluded because it is not relevant, must disclose why it is not relevant and a description of the alternative risk measure used with reason for its use
30. Must disclose if performance from past firm or affiliation is linked to the performance of the firm

Note valuation hierarchy:

1. Objective unadjusted market prices for similar investments in active markets

2.  Quoted prices for similar investments in non active markets

3. Use market based inputs other than prices

4. Subjective unobservable inputs

RECOMMENDED Disclosures

1. Disclose any material changes to valuation or calculation policies

2. Disclose material differences between the benchmark and the composite's investment mandate, objective or strategy

3. Key assumptions used to value portfolio investments

4. List of other firms contained within the parent company (if relevant)

5. Disclose any subjective unobservable inputs used to value portfolios prior to 2011 (after 2011 mandatory to disclose)

6. Disclose sub advisor used for periods prior to 2006

Investment Policy Statement Notes

Return Objective

Calculated based on wants and needs e.g. accumulation of wealth goals for retirement, financing child education etc

The return objective may be single stage or multi stage. eg. the investor may earn income upto retirement agressively investing in equities but after retirement his return objective could be lower focusing on higher income generating assets. this is a multi stage objective firstly to retirement and then post retirement.

If there are multiple goals, the investor may adopt a goals based asset allocation, targeting a certain return for each bucket - personal risk, market risk and aspyration.


Risk Tolerance

1) Willingness to take risk

2) Ability to take risk

Recommendation should not exceed willingness to take risk

Situational profiling:

Take into account:

a) Source of wealth - affects the willingness to take risk. if one inherits the wealth, he has lower willingness to take risk vs entrepreneur who actively earned his wealth and would be more willing to accept risk

b) Measure of wealth - affects both ability and willingness. if one views his wealth is high, he is likely more willing to accept risk. If objectively ones wealth is low, then his ability to tolerate risk is likely lower

c) Stage of life - ability to tolerate risk falls with age

Constraints

1) Time Horizon - if the investor is very young, he has a very long term time horizon and can accept more volatility in this portfolio

2) Liquidity - retired couples who rely on investment portfolio income would need more liquidity and therefore may not be able to invest in equities that dont pay dividends.

3) Tax - the investor may be in a high income tax bracket and therefore would benefit from investments generating returns from capital gains.

4) Unique Circumstances - e.g. special goal to make a payment or donation at a certain date 

Cross Hedging and MVHR

CROSS HEDGE Explained

It is often the case that various assets in the portfolio and exposure to different currencies with imperfect correlation between them creates a natural hedge also known as the cross hedge or proxy hedge or macro hedge. A cross hedge is an indirect hedge as opposed to using forwards to hedge which is direct.

For example historically the Brazilian Real and the Russian Ruble have been closely correlated. A short position in the Real and a long in the Ruble can reduce overall portfolio risk (as measured by volatility). In this case derivatives and forward contracts are not needed and sometimes they are not available or illiquid.

It is important to note however that whenever a cross hedge is used to minimize portfolio risk, basis risk is incorporated into the portfolio which in a sense is produced by the fact that we are assuming that these correlations between currencies will hold in the future.

For example if we were to invest in Russian Ruble Bonds and Turkish Bonds on the premise that they have lower correlation and that the Russian economy is a net exporter of oil and gas while Turkey is a net importer. We would then use cross hedging to reduce portfolio risk by including both Russian and Turkish assets in the portfolio.

Then a crisis happens due to Turkish debts skyrocketing and investors becoming frightened, pulling out of emerging markets in general. This is called contagion. In this case the correlation between the currencies of the two countries can change significantly, now the currencies both fall and correlation increases towards positive 1 as investors sell their Liras and Rubles to purchase USD which is considered safer.

The risk that the correlations between the two currencies changes is the basis risk.

Basis risk is introduced by the cross hedge which is an indirect form of hedging while a direct hedge with a forward contract for example will not produce basis risk.

Minimum Variance Hedge Ratio (MVHR)

When using forward contracts to hedge, often an ideal hedge does not exist and hedging is also often expensive. Finding an optimal hedge that is less than 100% often known as the minimum variance hedge is often the best solution.

an ordinary least squares is typically used.

return in domestic currency = alpha + beta x (FX return) + resitual 

the beta is given as correlaton of (Rfx, Rdc) x std (Rdc)/std (Rfx)

The beta is the minimum variance hedge ratio

in the case of basis risk, it is expressed in the instability of beta.

Note: If I am long USD/AUD, I am long the base currency, i.e. AUD


Example with Rubles and USD

I am a USD investor but am originally from Russia and like to have a little exposure to the local equity market in my portfolio (presumably because I think the Russian equity market is very cheap). I would like to hedge my Russian equity exposure however back to USD because I live in the US.

I note that the correlation between the returns of the Russian stock market in Rubles and the % change in USD/RUR is +0.6 i.e. when the Russian Stock Market goes up the Ruble tends to go up as well most of the time, so they to some extent move together but not perfectly.

I decide I want use forwards, so I would go short a USD/RUR forward but I need to know the nominal amount and I wish to use a minimum variance hedge ratio for this.

I regress Rdc = alpha + beta x Rfx + residual and find the beta of 1.35 fits.

If sport USD/RUR = 0.01666 and I invested $1m then I have 60m RUR invested in Russian stock market. I need to go short USD/RUR forward for the nominal amount 60m RUR x 1.35 = 81m RUR

Because the Ruble and the Ruble stock market is positively correlated, we need to hedge more than the Ruble exposure in order to account for the FX volatility.

Credit Analysis & Concepts

1. Credit Analysis:

When analyzing the fixed income opportunities use the 5 Cs of credit analyst which are

a) Character - how honest are the management and owners? Having they screwed over lenders and creditors in the past? All these sorts of questions need to be answered before contemplating becoming a creditor of the company

b) Capital - how much the borrower has put up in capital into the business. If for example an LBO firm seeks debt financing, it is worth while looking at how much equity the LBO firm is willing to put up from its side and how much capital there is in the business to date. The more equity capital the project has, the safer it is for the creditor to provide financing.

c) Capacity - ability of the business to meet its credit obligations. If there is a cushion to protect companies if the operating performance declines or if the revenues and profits are resilient due to the non-cyclical nature of the business, then the company is more credit worthy.

d) Collateral - if default occurs, the creditors should look at what assets they can use to cover whats is due to them. Banks typically pledge company assets but in the case of fixed income investors they would look at what assets can be recovered after the more senior creditors recover their money and the liquidity of those assets. For example a business with a factory and some real estate issues a bond but also has a bank loan which is guaranteed by a mortgage over the real estate. (the bank would have a senior claim over the real estate of the company in this case)

In this case if the business collapses, the bank can take over the real estate, liquidate it and recover its money but the fixed income investor may be stuck with an illiquid and abandoned brownfield site that would be sold for cents on the dollar materializing in a large loss to the fixed income investor.

e) Covenants - these could be negative (restrictive) or positive (affirmative)

Affirmative covenants are things that the issuer must do like maintain insurance or certain liquidity ratio.

Negative coventants restrict the issuer from doing something that is not in the interest of the creditor like paying large dividends or increasing leverage beyond a certain level.

2. Concepts

It is often worthwhile to understand key investing concepts. Here is a summary:

a) Credit risk has two components default risk and loss severity (also referred to loss given default)

Some fixed income investors use the formula:

credit spread = annual credit loss risk = (probability of default) x (1- recovery rate)

b) Spread Duration - a concept useful to comparing credit risk of bonds especially with a floating rate element. Spread duration measures the price change due to a change in the credit spread.

change in the bond price = change in the bond price due to a change in the risk free rate + change in the bond price due to a change in the spread.

Typically a standard fixed interest bond will have a modified duration equal to the spread duration. This is however not the case for floating rate bonds which have very little duration but could have substantial spread duration.

Spread duration is most useful for investment grade bonds.

Spread risk generally refers to the change in the bond price relative to a risk free bond due to spread widening (Credit Migration). Credit Migration refers to the decline in credit quality of the issuer leading to lower credit ratings and an increased spread.

c) Empirical Duration - is based on regression of actual bond prices and interest raEmpte changes

Effective durations are based on the present value of future expected cash flows should bond yields change either up or down.

Empirical duration tends to be lower than effective duration for investment grade bonds where as for high yield bonds the difference is negligible.

Investment grade investors primarily experience interest rate risk while credit and spread risk is secondary. For high yield bonds investors on the other hand

d) Liquidity Risk - ability to buy or sell quickly in the market at near fair market value.

Options Strategies List

1. Covered Call: Long Stock + Short Call (income strategy)

2. Protective Put: Long Stock + Long Put (insurance strategy, the exercise of the put is near the current stock price, also known as a married put)

3. Collar: Long Stock, Out of the Money Short Call and Out of the Money Long Put

4. Bull Spread:

a) Long Call at X and Short Call at X+Y (Bull Call Spread)
b) Short Put at X and Long Put at X-Y (Bull Put Spread)

5. Bear Spread:

a) Short Call at X-Y and Long Call at X (Bear Call Spread)
b) Long Put at X and Short Put at X-Y (Bear Put Spread)

6. Seagull Spread:

a) Bullish Seagull = Bull Call Spread + Sell Put
b) Bear Seagull = Bear Put Spread + Short Call

7. Butterfly Spread:
 Long Call at X1 + 2 Short Calls at X2 and Long Call at X3 (Bull Call Spread + Bear Call Spread)

Alternatively you can construct a butterfly spread with a Bear Put and a Bull Put

The Butterfly spread is a bet on low volatility that the share price will not go up or down a lot.

A short butterfly spread is a bet on higher volatility

8. Condor Spread: Bull Call Spread and Bear Call Spread. (Volatility Bet)

9. Straddle: Long Call and Long Put Both at the Same Strike Price

10. Strangle: Long Call and Long Put wtih Different Strike Prices

11. Short Risk Reversal: Long Call + Short Put

12. Box Spread: Bear Put Spread + Bull Call Spread

13. Put Spread: Buy Put and Short Call



It is worth while to recall the put call parity relation when considering these:

p+S=c+X/(1+rf)^T
(for European options)

Portfolio Performance Evaluation Risk/Return Measures

	Type of risk measure	Advantages	Comments	Comments 2
Sharpe Ratio	Total Risk		Assumes normally distributed returns, based on the CAPM, slope of the CML	Biased upwards for hedge funds Uses portfolio total risk instead of systematic risk
Sortino Ratio	Total Risk	Good for hedge funds Good for assets with skewed distribution of returns	Improves on the Sharpe Ratio that penalizes for good performance which is incorporated in the up side deviation
Information Ratio (Appraisal Ratio)	Total Risk	Used to measure active performance of mutual funds	Higher information ratio (0.4-0.6) is considered better. The index has zero IR	IR = active return/active risk IR = IC x BR ^ (0.5)
Jensen’s alpha	Systematic	Used frequently to evaluate mutual fund performance	Based on the CAPM
Treynor	Systematic	Overcomes the Sharpe ratio limitation that it uses total risk	Slope of the SML
M squared	Total Risk	The Sharpe ratio is awkward to interpret when it is a negative value. M squared is always positive.	A skillful manager will generate an M2 greater than the return on the market	Rf + SR of asset x Market STD. M^2 measure ranks in agreement with the Sharpe ratio

Taxable vs Tax Exempt Bonds

Note that taxable bonds have a flatter yield curve and in the case of an upward sloping yield curve the investor has less incentive to extend duration as there is relatively less upside in higher duration bonds due to tax effect

Tax exempt bonds generally offer a greater incentive to extend duration compared to taxable bonds. Therefore they would have a steeper yield curve.

A US investor may decide that it is more efficient to place taxable bonds in a tax exempt investment account or a tax deferred one whereas tax exempt bonds can be placed in a taxable account.

Four Types of Liabilities

Type 1 - Known Future Amount, Known Timing

Type 2 - Known Future Amount, Unknown Timing

Type 3 - Uncertain Amount, Known Timing

Type 4 - Uncertain both Amount and Timing

Types of Tactical Asset Allocation

Discretionary - investor modifies his tactical asset allocation according to market valuations e.g. rebalancing from more expensive asset class into a cheaper one

Systematic - use of quantitative models to exploit market inefficiencies e.g. trend following/momentum based approach. If US stocks go up, overweight US stocks