Archive for the 'Risk Management' Category

Bid-Ask Spreads: Effective versus Quoted

The quoted bid/ask spread is the difference between the lowest ask price for a security and the highest bid price. For small orders, the quoted spread is a good indication of the execution cost for a trade. For large orders, however, it may not fully represent the cost.

The effective spread better captures the cost of a round-trip order by including both price movement (dealers coming in to execute orders at a better price than previously quoted) and market impact (spread widening due to the size of the order itself.)

Effective spread is defined as twice the difference between the actual execution price and the market quote at the time of order entry. For example, an order is entered when the quote is $10.00/$10.20. The order is executed at $10.15. The effective spread is 2(10.15 – 10.10) = $0.10.

Posted on 3rd June 2008
Under: Active Management, Institutional Investing, Investing in Stocks, Investment Returns, Portfolio Management, Risk Management, Trading Execution | No Comments »

Unweighted Securities Indexes

An unweighted securities index assigns equal value to each index component regardless of its relative price or market capitalization. It is equivalent to investing the same dollar amount in each index component.

Smaller cap stocks will receive a higher weighting in an unweighted index than they would in a value-weighted index. This can lead to a bias toward small cap stocks over time.

Posted on 2nd June 2008
Under: Investing in Stocks, Investment Returns, Passive Management, Performance Measurement, Risk Management | No Comments »

The Analytical (Variance-Covariance) Method for Estimating Value at Risk (VaR)

One way to estimate VaR is the analytical method, also called the variance-covariance method.

This method assumes a normal distribution of portfolio returns, which requires estimating the expected return and standard deviation of returns for each asset. As the number of securities in a portfolio increases, these calculations can become unwieldy. As a result, a simplifying assumption of zero expected return is sometimes made. This assumption has little effect on the outcome for short-term (daily) VaR calculations but is inappropriate for longer-term measures of VaR.

The advantage of this method is its simplicity. The disadvantage is that the assumption of a normal return distribution can be unrealistic.

Posted on 29th May 2008
Under: Governance, Portfolio Management, Risk Management | No Comments »

Hedge Fund Benchmarks

There are a number of benchmarks available for hedge funds, distinguished primarily by the frequency of data reporting (monthly or daily), whether they are investable or not, and whether they list the actual funds from which they are comprised.

Principle differences among the indices include:

  • Selection criteria – what kind of track record or level of assets must a fund attain in order to qualify for inclusion?
  • Style classification
  • Weighting scheme – usually either equal weights or based on assets under management
  • How frequently the weights of the constituent funds are rebalanced
  • Investability

Since hedge funds often promote themselves as absolute return vehicles (and thus do not have a direct benchmark) that absolute return nonetheless must be measured in terms of some benchmark. Important questions to consider are whether any alpha reported is sensitive to the benchmark in use and whether the alpha takes into account the true systematic risks faced by the portfolio.

There are also a number of limitations to most of the available hedge fund indices, including:

  • Results are self-reported by the managers and may not be completely neutral or accurate
  • Databases reflect survivorship bias as poorly performing managers exit leaving only the best included. This results in an upward bias to reported returns.
  • The frequency of data reporting may lead to stale prices and distort correlation measures.
  • Missing data can be filled at the manager’s convenience, leading to a backfill bias.

Studies to determine whether hedge fund returns can be mimicked using passive strategies have shown mixed results but do show that returns are influenced largely by the trading strategy employed. Market neutral strategies may offer better diversification to traditional asset classes.

Hedge fund returns have been shown to exhibit low skewness and high kurtosis, which are undesirable features. Mean-variance optimizations are sensitive to errors in the return estimates, and historical data (as discussed above) can be unreliable.

Posted on 28th May 2008
Under: Active Management, Alternative Assets, Asset Allocation, Hedge Funds, Investment Returns, Portfolio Management, Risk Management | No Comments »

Longevity Annuities

Longevity annuities exchange an up-front payment for a stream of payments that will begin some years after retirement. For example, the annuity may be purchased when the investor is 65, but only begin to pay benefits when the investor turns 80. Benefits will continue for the remainder of the investor’s life.

Investment annuity payouts per dollar invested are much higher than immediate annuity payments for several reasons:

  • The lack of payouts in early years allows for greater compounding benefits on investment returns
  • The shorter remaining expected life span after payouts begin allows for each payment to be larger
  • Potential annuitants who die before reaching the target age subsidize returns for those who live longer

In the January/February 2008 Financial Analysts Journal, Scott argues that many investors will benefit from an allocation to longevity annuities, and that the optimal bundle depends upon the percentage of total assets the annuitant is willing to allocate to annuities. The greater the proportion annuitized, the earlier payments should start.

Posted on 4th May 2008
Under: Alternative Assets, Asset Allocation, Investment Returns, Personal Finance, Risk Management | No Comments »

“Best Execution”

Part of the responsibility of any investment manager is to seek the best possible execution for clients. Best execution is the trading strategy that maximizes the value of the client’s portfolio, subject to the investor’s objectives and constraints.

Some characteristics of best execution include:

  • A tie to the investment decision (obtaining the right price or capitalizing on the information)
  • Inability to know what the best execution will be prior to the actual execution, but an ability to measure and analyze the execution afterward
  • A component of complex practices and relationships that are undergoing continuous refinement

To help achieve best execution, firms should establish processes around maximizing the asset value of client portfolios, and establish guidelines for measuring and managing execution. The compliance with these procedures should be documented and disclosed to clients.

Firms should also disclose general information about their trading techniques, venues and agents and also any potential conflicts of interest that may result.

Posted on 4th May 2008
Under: Active Management, Governance, Institutional Investing, Investing in Stocks, Passive Management, Portfolio Management, Risk Management, Trading Execution | No Comments »

Value at Risk (VaR)

Value at Risk (VaR) has come to be regarded as the premier risk management technique for the financial industry. It measures the probability-based measure of potential loss that can be measured for specific transactions, business units or the total enterprise.

VaR estimates the loss in money terms that could be exceeded (i.e. it represents the minimum loss) at a given level of probability. For example, a $5 million one-day VaR at 5% indicates a 5% chance that losses could exceed $5 million on a given day.

All else equal, a higher loss has a lower probability of occurrence. Likewise, reducing the probability level from 5% to 1% (the two most common levels in use) would result in a higher VaR at the lower probability level.

Posted on 29th April 2008
Under: Asset Allocation, Governance, Portfolio Management, Risk Management | No Comments »

Risk and Return in Fixed Income Arbitrage

In the May 2007 Review of Financial Studies, Duarte, Longstaff and Yu examine the risk/return characteristics of commonly used fixed-income arbitrage strategies. They find that the strategies that require high levels of modeling produce significant positive excess returns even after adjusting for risk, transaction costs and management fees.

Fixed income arbitrage strategies tend to exploit small differences between intrinsic value and market prices for securities. There has been some debate as to whether they are truly low risk arbitrage or whether the small positive returns most frequently earned are offset by infrequent but dramatic losses.

Of five strategies tested, the ones requiring the greatest intellectual capital – yield curve, mortgage and capital structure arbitrage – produced the highest excess returns after controlling for risk and costs. Swap spread arbitrage also produced positive risk adjusted returns.

Volatility arbitrage, or selling options on fixed income instruments and hedging the underlying asset exposure, produced positive excess returns but also had periods of significant losses.

Posted on 10th April 2008
Under: Active Management, Alternative Assets, Fixed income investments, Hedge Funds, Investing in bonds, Investment Returns, Performance Measurement, Risk Management | No Comments »

Algorithmic Trading Methods

Algorithmic trading systems use electronic trading methods driven by quantitative rules and user-specified benchmarks and constraints. The objective of an algorithmic trading system is to exploit patterns of market trading volume to control execution costs and risks by breaking large trades into smaller, more manageable pieces.

The main types of trading algorithms are logical participation strategies and implementation shortfall strategies.

In a logical participation strategy, one of a number of simple rules is used to determine the proper size of each trade.

  • VWAP strategy – uses an estimated VWAP  to break up the order based on a predicted volume profile to match or improve upon the daily VWAP.
  • Time weighted VWAP assumes a flat volume profile throughout the day and trades in proportion to time passed. This strategy is useful for illiquid securities.
  • Percentage of volume – trades are placed in proportion to the total volume throughout the day until completed.

Implementation shortfall strategies solve for an “optimal” trading strategy, which should minimize the trading costs when measured as implementation shortfall. Such strategies are often front-loaded to take advantage of the higher volume that usually occurs early in the trading day. It can be a useful strategy for portfolio trades or for managing transitions between managers.

Posted on 4th April 2008
Under: Active Management, Institutional Investing, Investing in Stocks, Portfolio Management, Risk Management, Trading Execution | No Comments »

Market and Limit Orders in Trading

The two most common types of orders that can be placed when buying a security are market orders and limit orders.

Market orders are executed promptly at the best available price, which in the case of a buy order is the lowest price a prospective seller is willing to accept. If the buyer wants more shares than the lowest asking party is offering, the remaining shares would be sold to the next-lowest ask price and so on until all shares requested were purchased.

For example, a buyer places a market order for 10,000 shares of stock X. The lowest ask price is offering 5,000 shares at $100 and these are filled. The next lowest ask price is for 3,000 shares at $100.25 and these are filled. The third-lowest ask price is for 5,000 shares at $100.50 and 2,000 of these are filled to complete the order. The effective purchase price is ((5,000 X 100) + (3,000 X 100.25) + (2,000 X 100.50))/10,000 = $100.175

Market orders emphasize prompt execution, and in return result in accepting some uncertainty as to the actual execution price.

Limit orders are instructions to accept only those prices that are better than a designated limit, including a time (end of day, good-til-canceled, etc) at which the order will expire.

For example, the buyer above may specify that the order has a $100.25 limit price. In that case, 5,000 shares would be executed at $100 and 3,000 at $100.25. The others would remain on order until a prospective seller was willing to accept $100.25 or less. The average price at execution would be ((5,000 X 100) + (3,000 X 100.25))/8,000 = $100.09375. If the remaining 2000 shares were executed at $100.25 the effective price would be ((5,000 X 100) + (5,000 X 100.25))/10,000 = 100.125.

Limit orders emphasize price at the expense of uncertainty as to whether the order will be filled in entirety.

Posted on 3rd April 2008
Under: Active Management, Investing in Stocks, Portfolio Management, Risk Management, Security Selection, Trading Execution | No Comments »