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CISI - Portfolio Construction Theory in Wealth Management > Chapter 4 > Flashcards

Chapter 4 Flashcards

1
Q

What is Asset Liability Management (ALM)

A

Strategy to meet future contingent liability

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2
Q

What is the MVO model?

A

The Mean-Variance Optimisation model

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3
Q

What are the limitations of the MVO model? (3)

A
  • allocations are extremely sensitive to model inputs
  • small change in input can alter the allocations drastically
  • Very sensitive to expected returns
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4
Q

How does expected returns sometimes limit the MVO?

A

Can generate unreasonable allocations

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5
Q

How can difficulties on MVO be countered?

A
  • Re-run the MVO procedure many times over around target allocations and permitted ranges
  • assess sensitivities of performance outcomes
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6
Q

What did Black and Litterman propose to help with sensitivity of MVO to estimates of expected returns? (3)

A

Use expected returns from observed market prices

This assumes asset pricing models such as CAPM holds

current market prices are converted into expected return estimates

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7
Q

What is portfolio insurance?

A

Technique for limiting potential loss on a portfolio

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8
Q

What is the idea behind portfolio insurance strategies? (2)

A

maintain certain level of wealth

while allowing investor to participate in rising equity market

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9
Q

What theory is portfolio insurance strategy based on?

A

Options theory

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10
Q

What is the risk/reward profile of call options?

A

unlimited exposure to any potential profits but limited exposure to losses

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11
Q

What is a put options and how does it become more valuable? (2)

A
  • right to sell stock at a specified price in the future
  • if asset falls in value, then can get more for selling
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12
Q

What condition are put options bad? (4)

A
  • falling/bearish market
  • put options very expensive
  • large premium
  • costs passed to investors
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13
Q

What do Leland and Rubenstein propose for an option-based portfolio? (2)

A
  • Buying a portfolio of risky assets
  • a put option written on it
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14
Q

How does Leland and Rubensteins’ option-based portfolio help investors?

A
  • Put option hedges downside risk of equity investment
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15
Q

What is CPPI?

A

Constant proportion portfolio insurance

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16
Q

What is the CPPI strategy?

A

a trading strategy that dynamically allocates assets between a risk-free asset and a portfolio of risky assets

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17
Q

How does CPPI help investor? (2)

A
  • can get gain in favourable market conditions
  • limits loss
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18
Q

What are the advantages of selling futures contracts for portfolio insurance? (3)

A
  • lower cost
  • greater efficiency
  • less portfolio disruption
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19
Q

What are the shortcoming of using futures for portfolio insurance? (3)

A
  • Hard to get same risk characteristics
  • Hard to know when to enter and exit the futures contract
  • Calculating the number of futures contract to sell
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20
Q

What is it hard to get the same risk characteristic of a portfolio for futures contract?

A

might not have a suitable index with the same risk characteristic

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21
Q

How does synthesising a portfolio with call options work?

A
  • hold cash / shor-dated government bonds
  • buy call options for requisite instruments
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22
Q

What is the upside of a synthesised portfolio with call options? (2)

A
  • price of instrument rise, exercise call option
  • the price of the instrument falls, only the price of call options is lost
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23
Q

What are the drawbacks of a synthesised portfolio using call options? (4)

A
  • call option premiums expensive
  • needs rolling over
  • often not available on many investments
  • call option doesn’t allow to participate in total returns of actual investment
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24
Q

How is net worth of an ALM portfolio calculated?

A

Net worth = PV of assets in portfolio - PV of liabilities

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25
Q

What is risk parity?

A

different assets have the same level of risk contribution

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26
Q

What is the problem with risk parity? (3)

A

low returns as high bond allocation

heavy quantitative approach

leverage might be expensive to boost returns

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27
Q

What are the critiques on risk parity?

A
  • assumes risk is represented by volatility
  • proved flaws in VaR methodologies
  • no views on future returns
  • can include asset classes with 0 or -ve risk premiums
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28
Q

What is risk budgeting for portfolio construction? 🗓️

A

setting long-term plan about risks they plan to take on investments place in portfolio

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29
Q

What are the three basic steps in risk budgeting?

A
  • set a tolerable risk target
  • construct portfolio that matches risk profile
  • implement and monitor to maintain risk within target level
30
Q

What is market timing

A

taking advantage of short-term opportunities to enhance returns

31
Q

What is implication of market timing regarding EMH? (2)

A
  • rejects strong form EMH
  • accepts that assets can be mispriced at least in the short term
32
Q

How can you adjust beta for a fixed income portfolio?

A
  • if bullish, increase duration
  • if bearish, decrease duration
33
Q

How can you use beta of equities for market timing?

A
  • if bullish, include higher beta stocks
  • if bearish, include lower beta stocks
34
Q

what is the disadvantage of adjusting beta for market timing? (2)

A

transactions costs expensive

better way might be using derivative instruments

35
Q

For pensions, What are the other reasons and strategies for market timing? (3)

A
  • pension funds timing inflows and when to invest
  • could do pound cost averaging (PCA)
  • or delay and wait until right time to invest
36
Q

What are the four market timing spread measures?

A
  • Earnings yield
  • Dividend yield
  • GRY
  • Flat yield
37
Q

What is the formula for earnings yield spread?

A

Earnings yield spread (bps) = GRY - earnings yield

38
Q

What can you tell when looking at the earnings yield spread? (5)

A
  • GRY should be less than earnings yield
  • equities tend to be higher risk than bonds
  • if earnings yield spread becomes more negative
  • could add more equities
  • vice versa
39
Q

What is the formula for the dividend yield spread?

A

Dividend yield spread = GRY - dividend yield

40
Q

What can you tell when looking at the dividend yield spread? (3)

A
  • GRY should be greater than dividend yield
  • equity issuers tend to not pay our large sums of dividend
  • prefer to reinvest into growth opportunities
41
Q

What would a portfolio manager think if dividend spread is small and expanding? (3)

A
  • equity growth rates will increase
  • equity risks will fall
  • increase equity holding
42
Q

What are the benefits of using pooled TAA funds?

A
  • access to futures contracts
  • TAA managed funds can be riskier than benchmark
  • Pooled funds have a limited liability status
  • TAA funds can be used as a smaller sub-portfolio
43
Q

What are the three main reasons for using derivatives?

A
  • Hedging
  • Speculation
  • Arbitrage
44
Q

How does derivates help with hedging?

A

reduce impact of adverse price movements

45
Q

How does derivatives help with speculation? (2)

A

only margin is paid by counterparties to open positions

can speculate on both rising and falling asset prices

46
Q

How does deritvatives help with arbitrage?

A

if price of derivative and underlying asset mismatched

  • profit from pricing anomaly
47
Q

What is a futures contract?

A

an agreement between a buyer and seller

48
Q

What is the agreement in a futures contract?

A
  • pre-specified price
  • quantity of an asset
  • future date
49
Q

What are the two distinct features of futures contract?

A

Exchange traded

deal on standardised terms

50
Q

Most futures that are opened are not delivered but are either…

A

closed out

settled physically

51
Q

What does it mean by closing out a futures contract?

A

opening buyer avoid delivery by making a closing sale before delivery date

52
Q

What does it mean settling physically a futures contract? (2)

A

settles by cash the monetary gain or loss to date on the underlying asset

know as CFDs

53
Q

When would a buyer avoid settling physically a futures contract?

A

if the buyer is a financial institution that is simply speculating

54
Q

What does it mean when a derivative is written covered? (2)

A

holding the underlying assets

typically done for hedging

55
Q

What does it mean when a derivative is written naked?

A

doesnt hold the underlying asset

only speculating

56
Q

How might a portfolio manager construct investments in multiple funds to achieve the projected asset allocation to best meet the return and risk objective? (3)

A
  • investing directly in equities
  • determine portfolio’s exposure from analysis of securities
  • asset class factor model
57
Q

What are the difficulties of investing directly in equities? (3)

A
  • need asset allocation and securities analysis skills
  • Need high AUM to achieve desired diversification
  • hard to justify time and effort to mange such accounts
58
Q

How does a detailed analysis of the securities held by each of the prospective or actual funds within a portfolio work?

A
  • breaking down funds into individual securities
  • consolidate them into one fund
59
Q

What are the disadvantages of fund of funds? (2)

A

time consuming

costly on ex-ante basis

60
Q

What is asset class factor model?

A
  • examine funds based on their type of exposure
61
Q

What are the advantages of using asset clas factor model?

A

can use informatino from easily obtainable external sources

62
Q

How does asset class factor model differ from fund of funds?

A

fund of funds usings information available from sources internal to the fund

i.e. all constituents and their weights

63
Q

Give four examples of factors used in asset class factor model

A

European/Asian

Growth/Value

Large cap/Small cap

High quality/Low quality

64
Q

In asset class factor model, the asset classes should be

EEDCIL

A
  • mutually exclusive
  • separable or exhaustive
  • have different patterns of returns and standard deviations
  • low correlations with one another
  • not contain identical securities
  • consist of a large number of securities
65
Q

What are the pros of returns based style analysis? (2)

A
  • quick to calculate
  • doesn’t need special info from fund manager
66
Q

What are the cons of returns based analysis? (3)

A
  • ‘behaves like’ only, no guarantee
  • Historical data is used
  • style is historical avg of returns from period analysed
67
Q

What are the pros of holdings based style analysis? (3)

A
  • detailed info
  • can determine which style factors
  • style analysis more timely and up-to-date
68
Q

Issues relating to use of funds in asset allocation (4)

A
  • a mismatch between SAA and available funds
  • blending funds increases chance of beta of 1
  • cash levels, risk and beta outside of control
  • beta of funds fluctuate as money flows
69
Q

Benefits of mutual funds (5)

A
  • large AUM better opportunity for diversification
  • top-quality management pool
  • access to high-quality research and information sources
  • cost efficient due to scale
  • liquidity
70
Q

Benefits of SMAs (5)

A
  • portfolio customisation and approachability with managers
  • voting rights for shares purchased on the account
  • transparency of portfolio holdings and transactions
  • portability of the underlying investment pool in the account, and
  • charitable gifting of equities purchased on the account on a low-cost basis

CISI - Portfolio Construction Theory in Wealth Management (15 decks)

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