investment risk management slides

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Investment risk management Traditional and alternative products

Luis A. Seco Sigma Analysis & Management

University of Toronto RiskLab

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A hedge fund example

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A hedge fund example

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A hedge fund example

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A hedge fund example

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A hedge fund example

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The snow swap

  Track the snow precipitation in late fall and early spring;

  If the precipitation is high, the ski resort pays to the City of Montreal a prescribed amount.

  If the precipitation is low, the City pays the resort another pre-determined amount.

  The dealer keeps a percentage of the cash flows.

Slide 8

A hedge fund example

The snow fund

  Modify the snow swap so the City pays when precipitation is low in the city, and the resort pays when precipitation is high in the resort.

  The fund takes the “spread risk”, and earns a fee for the risk.   Say the “insurance claim” is $1M. The fund would charge 20%

commission, but assume to take the spread risk.   Setting aside $2M, and charging $200K, the fund could

–  Lose nothing: 75% –  Make $2M: 12.5% –  Lose $2M: 12.5%

  Expected return=10%. Std=50%

A diversified fund: a hedge fund.

  If we do the swap across 100 Canadian cities:

  Expected return:10%   Std: 5%.   Better than investing in

the stock market.

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Hedge Fund: definition

  An investment partnership; seeks return niches by taking risks, which they may hedge or diversify away (or not).

  Unregulated   Bound to an Offering Memorandum   Seeks returns independent of market

movements   Reports NAV monthly   Charges Fees: 1-20

Slide 12

The investment structure

The Management company “the hedge fund”

The Fund legal structure

The Bank Prime Broker The Administrator

Investor 1 Investor 2 Investor 3 Investor 4 Investor n

Slide 13

Risks per strategy

© Luis Seco. Not for dissemination without permission.

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Convertible arbitrage

Fig. 1: A graphical analysis of a convertible bond. The different colors indicate different exercise strategies of call and put options.

Risk management for financial institutions (S. Jaschke, O. Reiß, J. Schoenmakers, V. Spokoiny, J.-H. Zacharias-Langhans).

The Galmer Arbitrage GT

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Convertible arbitrage

  The convertible arbitrage strategy uses convertible bonds.

  Hedge: shorting the underlying common stock.   Quantitative valuations are overlaid with credit and

fundamental analysis to further reduce risk and increase potential returns.

  Growth companies with volatile stocks, paying little or no dividend, with stable to improving credits and below investment grade bond ratings.

Slide 17

An convertible arbitrage strategy example

  Consider a bond selling below par, at $80.00. It has a coupon of $4.00, a maturity date in ten years, and a conversion feature of 10 common shares prior to maturity. The current market price per share is $7.00.

  The client supplies the $80.00 to the investment manager, who purchases the bond, and immediately borrows ten common shares from a financial institution (at a yearly cost of 1% of the current market value of the shares), sells these shares for $70.00, and invests the $70.00 in T-bills, which yield 4% per year. The cost of selling these common shares and buying them back again after one year is also 1% of the current market value.

Slide 18

Scenario 1

Values of shares and bonds are unchanged:

Today 1 yr later Bonds 80 80 Stock -70 -70 T-Bill +70 +72.8 Coupon 4 Fee -3.5 Total $80 $83.3

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Scenario set 2

In the next two examples, the share price has dropped to $6.00, and the bond price has dropped to either $73.00 or $70.00, depending on the reason for the drop in share market values. The net gain to the client is 7.87% and 4.12% respectively, again after deducting costs and fees.

Today 1 yr later (a) 1 yr later (b)

Bonds 80 73 70 Stock -70 -60 -60 T-Bill +70 +72.8 72.8 Coupon 4 4 Fee -3.5 -3.5 Total $80 $86.3 $83.3

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Scenario set 3

In the following three examples, the share price increased to $8.00, and the bond price increased either to $91.00, $88.00 or $85.00, depending on the expectations of investors, keeping in mind that we have one less year to maturity. The net gain to the client is 5.37% and 1% in the first two examples, with an unlikely net loss of 2.12% in the last example.

Today 1 yr later(a) 1 yr later(b) 1 yr later(c)

Bonds 80 91 88 85 Stock -70 -80 -80 -80 T-Bill +70 +72.8 +72.8 +72.8 Coupon 4 4 4 Fee -3.5 -3.5 -3.5 Total $80 $84.3 $81.3 $78.3

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A Risk Calculation: normal returns

If returns are normal, assume the following:

Bond mean return: 10% Equity mean return: 5% Libor: 4% Bond/equity covariance matrix

(50% correlation):

  Mean return (gross): 10-5+4=9%

  Standard deviation:

Slide 22

Long-short equity

William Holbrook Beard (1824-1900)

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A long-short pair trade

  The fund has $1000. The manager is going to purchase stock 9 units of stock A, and sell-short 9 units of stock B. Both are valued at $100 each. After a year, A is worth $110, B is $105.

Assets at Prime Broker

(Before trade)

• $1000

Assets at Prime Broker

(After trade)

•  $1000

•  -$900 + 9 A

•  +$900 – 9 B

Assets at Prime Broker

(After one year)

•  $1000

•  990

•  -945

•  -9

$ 1036

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A long-short pair trade (v2)

  The fund has $500. The manager is going to purchase stock 9 units of stock A, and sell-short 9 units of stock B. Both are valued at $100 each. After a year, A is worth $110, B is $105.

Assets at Prime Broker

(Before trade)

• $500

Assets at Prime Broker

(After trade)

•  $500

•  -$900 + 9 A

•  +$900 – 9 B

Assets at Prime Broker

(After one year)

•  $500

•  990

•  -945

•  -9

$ 536

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A long-short pair trade (v3)

  Assumptions: 50% collateral for long trades, 80% collateral for short trades.

Securities at Prime Broker

•  9 A ($900):

•  – 9 B (-$900):

Collateral required:

$450+$720=$1170

Cash from short sale: $900

Cash required: $270

Securities at Prime Broker

•  9 A ($990):

•  – 9 B (-$945):

Profit: $36

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Hedge Fund Correlation histogram

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Risk and Performance Measurement

Slide 28

Measurement

  Return: –  from track records

  Risks: – Volatility – Operational risk: due diligence – Business risk – Exposures to market factors

Slide 29

Sample Hedge Fund report

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Data Issues (discussion)

  www.hedgefundresearch.com   www.hedgefund.net   www.hedgefund-index.com   www.barclaygrp.com   www.eurekahedge.com   sigma2.fields.utoronto.ca

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The portfolio distribution function (CDF)

90% probability that annual returns are less than 3%

7% probability that annual losses exceed 5%

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Probability density: histogram

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Return

  Return is usually measured on a monthly basis, and quoted on an annualized basis.

  If the series of monthly returns (in percentages) is given by numbers ri, where the subindex i denotes every consecutive month, the average monthly return is given by

  Because returns are expressed in percentages, one has to be careful, as the following example shows.

Slide 34

Returns: careful.

Imagine a hedge fund with a monthly NAV given by

$1, $2, $1, $2, $1, $2, etc. The monthly return series is given by 100%, -50%, 100%, -50%, 100%, -50%, etc. Its average return (say, after one year) is 25%

monthly, or an annualized return in excess of 300%.

Slide 35

Returns: from monthly to annual

There is no standard method of quoting annualized returns:

One possibility is multiplying returns by 12 (annual return with monthly compounding)

Another, is to annualize using the formula

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Portfolio returns

The big advantage of “return”, is that the return of a portfolio is the average of the returns of its constituents.

More precisely, if a portfolio has investments with returns given by

with percentage allocations given by

then, the return of the portfolio is given by

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Volatility

  Like returns, volatility is usually measured on a monthly basis, and quoted on an annual basis.

  If the series of monthly returns (in percentages) is given by numbers ri, where the subindex i denotes every consecutive month, the monthly volatility is given by

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Covariances and correlations

  They measure the joint dependence of uncertain returns. They are applied to pairs of investments.

  If two investments have monthly return series given by numbers ri and si respectively, where the subindex i denotes every consecutive month, and their average returns are given by r and s, their covariance is given by

  If they have volatilities given respectively by

  Then, their correlation is given by

Slide 41

Covariance and correlation matrices

Because correlations and covariances are expressed in terms of pairs of investments, they are usually arranged in matrix form.

If we are given a collection of investments, indexed by i, then the matrix will have the form

Slide 42

Portfolio Optimization: Markowitz

Markowitz optimization allows investors to construct portfolios with optimal risk/return characteristics.

  Risk is represented by the portfolio expected return

  Risk is represented by the standard deviation of returns.

The optimization problem thus created is LQ, it is solved using standard techniques.

Slide 43

Risk/return space

A portfolio is represented by a vector θ which represents the number of units it holds in a vector of securities given by S.

Each security Si is assumed a gaussian return profile, with mean µi, and standard deviation given by σi. Correlations are given by a variance/covariance matrix V.

The portfolio return is represented by its return mean

and its risk is given by its standard deviation

Slide 44

The efficient frontier

Risk

Return

Feasible

Region

EfficientPortfolios

Slide 45

Sharpe’s ratio

A way to bring return and risk into one number is by the information ratio, and by the Sharpe’s ratio.

If a certain investment has a return given by r, and a volatility given by σ, then the information ratio is given by r/ σ.

If interest rates are given by i, then Sharpe’s ratio is given by (r-i)/ σ.

It measures the average excess return per unit of risk. Portfolios with higher Sharpe’s ratios are usually better.

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Sharpe’s ratio: basic fact

  Imagine one is looking for the portfolio that has the best chance of optimizing its performance against a benchmark given by LIBOR. That portfolio is the one with the highest Sharpe ratio, as defined in the previous paragraph.

Slide 47

Sharpe Ratio

The objective function to maximize is

Since φ is increasing, our optimization problem becomes that of maximizing

Probabilityofmeetingthebenchmark

Cummulativedistributionfunctionofthegaussian

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Sharpe vs. Markowitz

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Benchmarks

They are reference portfolios against which performance of other portfolios are measured:

  Bonuses are paid on benchmark-based performance.

  They can be constant or random

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Tracking error

  It is the standard deviation of the difference between the portfolio returns and the benchmark returns.

  A performance indicator often times used in traditional investments is

Slide 51

Alpha and beta

Consider a portfolio with returns given by

and a benchmark with returns given by.

Find the linear regression coefficients α, β, such that,

with ε with mean 0 and lowest standard deviation.

Slide 52

VaR and risk budgeting

Assume a portfolio represented by a vector θ which represents the percentage allocated to specific managers or investment instruments.

Each manager or security Si is assumed a gaussian return profile, with mean µi, and standard deviation given by σi. Correlations are given by a variance/covariance matrix V.

VaR and portfolio standard deviation are related to the fundamental expression

Slide 53

Risk budgeting

The previous expression allows us to do a risk allocation to each manager

in such a way that the overall risk of the portfolio is given by

This expression is useful when allocating risk or risk limits to each of the investments in a certain universe.

Slide 54

The normality assumption

Under the normal assumption, a portfolio with a 1% standard deviation will have annual returns which will vary no more than 1%, up or down, from its expected return, with a 65% probability.

If a higher degree of certainty about portfolio performance is desired, then one can say that the portfolio return will vary more than 2% from its expected return only 1% of the times.

These probabilities are linear in the standard deviation; in other words, if the portfolio volatility is 3% (instead of 1% as in the example above), one will expect the returns to oscillate within a 6% band of its average return 99% of the time.

© Luis Seco. Not to be reproduced without permission

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Non-normal returns

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Gain/loss deviation

It measures the deviation of portfolio returns from its expected return, taking into account only gains. In other words, portfolio losses are not taken into account with calculating the deviation.

Loss deviation is the corresponding thing when losses only are taken into account in calculating portfolio deviations.

Both of these are used when one is trying to get a feeling as to the asymmetry of the gain/loss distribution. They are not statistically conclusive amounts per se, like standard deviation is.

Slide 57

Semi-standard deviation formula

Target return / benchmark

Gains give a value ot 0

Slide 58

Sortino ratio

It is the substitute of the Sharpe ratio when one looks only at the loss deviation, instead of looking at the combined standard deviation.

Many people believe that by not punishing unusual gains, like the Sharpe ratio does indirectly, one maximizes the upside while maintaining the downside.

There is however no evidence that the Sortino ratio, as such, actually achieves this but it still remains to be a curious quantity to look at.

Slide 59

Moments

One of the criticisms of the use of volatilities and correlations as risk measures is the presence of extreme events in portfolio returns, which will go un-noticed in those calculations.

From a certain viewpoint, volatilities and correlations are magnitudes inherited from normal distributions, according to which events such as the ones in 1987, 1995, 1998, etc. should have never occurred.

One attempt to capture “tail events” is by introducing higher moments to measure large deviations: higher moments are defined as follows:

Slide 60

Skew and kurtosis

  Skew is a measure of asymmetry. It is the normalized third moment.

  Kurtosis is a measure of spread. It is the fourth moment, minus 3.

Platykurtotic: k<0 Leptokurtotic: k>0 Mesokurtotic: k=0.

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Biased estimators

  The estimator for the skewness and kurtosis introduced earlier is biased: –  Its expected value can even have the opposite sign from the true

skewness (or kurtosis).

  Intuitively speaking, the third and fourth powers are so large, that one or two events will dominate the value of the formula, making all other observations irrelevant.

  Skew and kurtosis should not be used in critical situations

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Skewness is useless

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Uselessness of skewness

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L-moments

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The Omega

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Omega

  Shadwick introduced the concept of “Omega” a few years ago, as the replacement of the Sharpe ratio when returns are not normally distributed.

  His aim was to capture the “fat tail” behavior of fund returns.

  Once the “fat tail” behavior has been captured, one then needs to optimize investment portfolios to maximize the upside, while controlling the downside.

Omega: Shadwick, Keating (2002)

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Wins vs. losses: the Omega

Omega tries to capture tail behavior avoiding moments, using the relative proportion of wins over losses:

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Wins vs. losses: the Omega

Omega tries to capture tail behavior avoiding moments, using the relative proportion of wins over losses:

TruncatedFirstMoments

Slide 72

The Omega of a heavy tailed distribution

Correlation risk

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Hedge fund diversification

Hedge funds are uncorrelated to traditional markets, and internally uncorrelated also.

CorrelationhistogramforDowstocks

Correlationhistogramforhedgefunds

Slide 75

Fact.

Hedge funds are uncorrelated to traditional markets, so they constitute excellent diversification strategies.

Yes, ... and no! Many hedge funds are indeed

uncorrelated to markets, but others are very correlated to simple portfolios of traditional markets, so they add little diversification.

Even those funds which exhibit low correlation to markets and macroeconomic factors, when combined into portfolios, they can be highly correlated to the market.

Slide 76

Normal correlations

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Distressed correlations

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Correlation switching

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Distress analysis

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Correlation switching

Slide 81

Correlation risk

We will deal with correlation sensitivity from a mixtures of multivariate gaussian approach

Its density is given by:

Slide 82

GM in pictures

Slide 83

Non-gaussian portfolio theory

Each portfolio is described by four performance numbers: mean and standard deviation, each under normal and distressed market assumptions. They are given by

and

Slide 84

Benchmark satisfaction

The objective function to maximize was

It is possible to have portfolios which are efficient from this point of view, which however are not efficient under either normal or distressed conditions.

Increasingfunctions

Slide 85

Other risks

  Backfill bias   Survivorship bias   Liquidity risk   Style risk   Legal risk   Non-linear effects: option writing.

Slide 86

Hedge Fund Products

  Fund-of-funds: Indices   Options on fund-of-funds   Warrants   Non-recourse loans with fund collaterals   CPPI (Constant proportion portfolio

insurance)   CFO’s

Slide 87

Hedge Fund indices

  They offer fund-of-fund investments that try to track the performance of the hedge fund sector (global and style specific) investing in liquid funds with high capacity.

  The result is a fund that tracks nothing and lags performance.

  In contrast with equity indices, investors in a fund don’t like it when their fund is included in an index.

Slide 88

Hedge Fund Indices

  Investable   Non-investable

Slide 89

Historical comparative analysis

Pro-Forma

Slide 90

Correlation analysis

Slide 91

Guaranteed notes

  There are two main reasons for a guarantee: – Regulatory environments – Risk perceptions (not to confuse with risk appetite)

  Some guarantees are provided by well-rated banks. Others are not (Portus).

  Guarantees are obtainable by setting aside an interest-earning portion of the assets, and investing the remainder at higher levels of leverage, through a variety of different instruments.

Slide 92

Anatomy of a guarantee Guaranteesprincipalin

thefuture:Howmuchisneededisdeterminedby

• Interestrates

• Maturitydateofthenote

ObtainsexposuretotheHedgeFunds

Slide 93

The cost of the guarantee

About2%peryearcost

An underlying hedge fund portfolio that produces 6bps/month

Interest rates at 25bps per month A 5 year note that guarantees principal No management or performance fees

Leveraged structures

Loans Options

CPPI

Slide 94

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Non-recourse loans

  The bank lends to the investor and takes the investment in the hedge fund portfolio as collateral.

  In a low interest rate environment, it allows investors to amplify good hedge fund performance. In high interest rate environments, if hedge fund performance is poor, they can lead to sustained losses.

  It allows small investors to increase the asset base and diversify the portfolio better; it makes it easier to satisfy the minimum investment requirements of individual hedge funds.

  The structurer may demand liquidation if performance drops below a certain floor.

Slide 96

Options

  Options are delta-hedged; the liquidity of the underlying hedge fund portfolio contributes to a volatility spread.

  They are hard to delta-hedge due to the low liquidity of the underlying portfolio. Implied volatilities will be much higher than historical volatilities.

  They are path-independent. They are also insensitive to changes in interest rates.

Slide 97

CPPI

  Investor provide equity to a fund;   the structurer provides leverage   Proceeds are invested in a reference portfolio   If the performance of the reference portfolio is

below a reference curve, the strike price is increased.

  If performance of the reference portfolio is above another reference curve, the strike price is decreased

Slide 98

CPPI options

Slide 99

Bank

Bond Investor (1)

Bond Investor (2)

Bond Investor (3)

Equity Investor

Fund Pool

Collateralized Fund Obligation (CFO)

Slide 100

A $500M CFO

Slide 101

CFO’s

Advantages   Equity investors find a way

to obtain leverage.   Debt holders find an

uncorrelated asset class to invest in.

  Tranches can be packaged by volume and credit rating.

Disadvantages   Hard to value   Very dependent on

correlations amongst the funds constituents

  Expensive structuring fees makes it difficult to find the equity investor sometimes.

Slide 102

S&P CTA CFO. A case study.

© Luis Seco. Not to be reproduced without permission

Slide 103

Blow-up risk

© Luis Seco. Not to be reproduced without permission

Slide 104

The Merton model of default

Slide 105

A double-layer rating system

A B C

A Infrequent, small losses

Frequent, small losses

B

C Infrequent, large losses

Large, probably losses

Slide 106

Rating and Due Diligence