Derivative agreements are contracts between two parties, under which at least one of the parties faces a financial obligation to the other. Each counterparty to a contract can be subjected to credit risk, or the possibility that the other party fails to meet its obigation.
In a forward contract, commitments are made at the contract outset but settlement is due at expiration. Consider an agreement under which party A agrees to buy the S&P 500 index from party B for 1,500 in one year. IfÂ the S&P 500 is at 1,400, party A owes party B 100, and party B faces potential credit risk (prior to settlement) and actual credit risk (at the time of settlement.) When the S&P 500 is higher than 1,500 it is party A that is subject to credit risk.
Swap contracts are similar to a series of forward contracts, with interim payments occurring along the way. Each payment exposes one party to credit risk. As each payment is made, the total potential credit risk is reduced.
Option contracts have unilateral credit risk – only the seller is obligated to make a payment, so only the buyer is exposed to credit risk once the initial premium has been paid.
Posted on 29th November 2008
Under: Derivatives, Futures, Investing in Commodities, Options, Portfolio Management, Risk Management, Swaps | No Comments »
Market risks related to the economy, interest rates, and the state of the market are relatively unimportant when considering investments in distressed securities. There are, however, several types of risks that particularly apply to investments in distressed securities.
Event risk relates to unexpected company-specific or situation-specific events that affect valuation.
Market liquidity risk arises because distressed securities are less liquid, and demand runs in cycles.
J-factor risk relates to the judge presiding over bankruptcy proceedings. The track record in adjudication and restructuring can play a significant role in both the overall outcome and determining the optimum securities in which to invest.
Posted on 28th November 2008
Under: Active Management, Alternative Assets, Investing in Distressed Securities, Portfolio Management, Risk Management | No Comments »
Portfolio stress testing is a means of identifying unusual circumstances that could lead to larger than expected losses. It frequently takes the form of scenario analysis or a simulation of historical or hypothetical events.
In a scenario analysis, stylized scenarios ranging from modest to extreme outcomes are modeled individually. For example, scenarios could include a 10-basis point interest rate move in either direction, a 100-basis point move in either direction, and a steepening or flattening of the yield curve. By using standard measures such as these, scenario analysis can facilitate risk comparisons across assets. However, it does not account for correlations between risk exposures – for example, the effect of both a 100-basis point move in interest rates and a steepening yield curve would not be known.
Simulation of hypothetical or actual historical events is used to see how the entire portfolio would perform when subjected to a given set of extreme conditions. It is particularly useful when extreme breaks (price gaps) are considered more likely that the model being used assumes.
Posted on 29th October 2008
Under: Governance, Portfolio Management, Risk Management | No Comments »
Investors seeking exposure to securities issued by companies in distress are typically seeking higher returns in exchange for the added risks. Success in distressed security investment requires unique skills, and typically investors participate via vehicles such as hedge funds or private equity funds. Hedge funds offer greater liquidity for the investor (and greater access to capital for the manager.) However, the illiquid nature of many distressed securities may confer advantages to the fixed term and closed-end structure of private equity funds.
There are a number of security types that relate to distressed companies:
- The publicly traded debt and equity
- Newly issued (orphan) equity of companies recently emerged from reorganization
- Bank debt and trade claims that the original creditor may wish to monetize
- “Lender of last resort” notes
Frequently investors use these securities in conjunction with a range of derivative products to hedge related risks.
The reasons distressed securities can offer high risk-adjusted returns relates to the market opportunity that arises because other investors are either unwilling or unable to participate in the market. Some funds are prohibited from owning speculative grade debt, and are forced to sell holdings that lose an investment grade rating regardless of price. Others do not wish to participate in drawn-out bankruptcy proceedings and will accept a fraction of the value of their claims in exchange for immediate cash. In other cases, failed leveraged buyouts or unduly shunned companies that recently emerged from bankruptcy may create a temporary imbalance of supply and demand for their securities.
Posted on 28th October 2008
Under: Active Management, Alternative Assets, Investing in Distressed Securities, Investment Returns, Portfolio Management, Risk Management | No Comments »
Bonds may either be issued as speculative grade bonds (original issue)or become so following a rating downgrade (fallen angels). In either case, their risk-adjusted returns should be similar. However, in an article published in the Fall 2007Journal of Portfolio Management Fridson and Sterling point out that fallen angels have historically delivered far higher risk-adjusted returns, and discuss several explanations for an apparent market inefficiency.
The authors find the correlation between fallen angels and original-issue speculative grade debt to be lower than that between Treasuries and investment-grade corporate bonds, suggesting dissimilar attributes and below the threshold normally used to classify securities as part of the same asset class.
Possible reasons for the disparity include:
- Lack of investor awareness, given that the primary high-yield index only recently began breaking out the performance of the two categories
- Emphasis on security selection and possible overconfidence among managers that they can pick the superior original-issue bonds
- Investability – fallen angels account for just 30% of available speculative-grade debt and trade infrequently
- Lottery-like returns for specific original issue bonds
- Yield appeal due to higher yields typically found with original issue bonds
Posted on 6th October 2008
Under: Active Management, Investing in Distressed Securities, Investing in bonds, Investment Returns, Performance Measurement, Research, Risk Management | No Comments »
One way to balance the costs and risks associated with portfolio rebalancing is to set target corridors for asset class weights rather than specific weights. At least five factors should be considered when setting the tolerance ranges:
- Transaction costs – higher transaction costs should result in a wider corridor so that rebalancing occurs less frequently
- Risk tolerance – higher risk tolerance also justifies wider corridors
- Correlation with the rest of the portfolio – when assets move in the same direction as the rest of the portfolio they are unlikely to drift further from target weight. This, in turn, allows for a wider target corridor.
- Asset class volatility – the more volatile the asset class, the more likely a wider divergence from the optimal weight. This requires a tighter corridor.
- Volatility of the rest of the portfolio can also lead to large divergences from optimal weights and the need for tighter corridors.
Once a target corridor is breached, the portfolio may be rebalanced to the target weight or to some level within the target corridor. The latter methods allow for more control, particularly with regard to illiquid assets. The alignment to strategic asset allocations would be less, but transaction costs would be lower.
Posted on 4th October 2008
Under: Active Management, Asset Allocation, FInancial Planning, Investment Returns, Portfolio Management, Risk Management | No Comments »
The risk management concept of Value at Risk (VaR) has met with wide acceptance and has spawned a number of extensions and supplements to the original concept. These include cash flow at risk, earnings at risk and tail value at risk.
Cash flow at risk and earnings at risk measure the risk to either cash flow or earnings (rather than market value) for a given risk factor. It can be useful when assessing assets that generate cash flow or earnings but are difficult to value. It can also be used as a sensitivity test for valuation models.
Tail value at risk adjusts VaR to not only express the minimum loss but also the expected loss when extreme outcomes occur. It is expressed as VaR plus the expected loss in excess of VaR. For example, the tail value at risk for a 5% VaR would be the average of the worst 5% of outcomes.
Posted on 29th September 2008
Under: Governance, Portfolio Management, Risk Management | No Comments »
Because the investment returns of all managers, on average, will be average paying higher fees for active management is justified only if the superior managers can be identified in advance.
In the March/April 2008 Financial Analysts Journal Waring and Ramkumar write that the expected alpha from active fund managers can be forecasted, as long as investors pay heed to the rules of zero-sum-game investing.
The forecasts are based on two equations derived from the fundamental law of active management. Variables for the equation are estimates of the manager’s skill, estimates of the sponsor’s assessment of its own skill in identifying skilled managers, the cross-sectional standard deviation of manager skill, portfolio breadth, implementation efficiency, expected active risk, and fees.
Posted on 5th September 2008
Under: Active Management, Institutional Investing, Investment Returns, Performance Measurement, Portfolio Management, Risk Management | No Comments »
Portfolio rebalancing requires a trade-off between the cost of rebalancing and the cost of not rebalancing. Costs of rebalancing include trading costs and taxes, which must be weighed against:
- the reduction in expected portfolio value resulting from suboptimal asset allocation
- exposure to greater risk as the riskier assets typically earn more and become a larger percentage of the portfolio
- shifting risk factors as asset weights change
- using rebalancing to reduce exposure to the assets that have risen most and may be overvalued
To reflect this trade-off, rebalancing is typically performed in a disciplined fashion, based either on the calendar or on tolerance corridors.
Calendar rebalancing takes place at specific times, and as such does not require constant monitoring. However, it is insensitive to market conditions and may allow weights to drift substantially between rebalancings.
Tolerance corridors call for rebalancing whenever an asset class drifts out of proportion to a pre-specified range around the target weight. It allows tighter control as it is directly related to market performance, but also requires continuous monitoring.
Posted on 4th September 2008
Under: Active Management, Asset Allocation, FInancial Planning, Investment Returns, Passive Management, Portfolio Management, Risk Management | No Comments »
Various studies have documented that the four-day period starting with the last trading day of a month and ending on the third trading day of the subsequent month accounts for the bulk of stock market returns. In the March/April 2008 Financial Analysts Journal McConnell and Xu show that this effect has persisted, and is not confined to small capitalization or low priced stocks. It occurs in 31 of the 35 countries they examined and does not appear to be caused by month-end buying pressure as measured by trading volume or equity fund money flows.
Posted on 5th August 2008
Under: Active Management, Investing in Stocks, Investment Returns, Research, Risk Management, Technical Analysis | No Comments »