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Flashcards in S8 Deck (27):

when to use compounding or addition in target return calculation

use additive by default, excluding situation s when:
- compounding is requested
- multi-period calculation is mentioned
- path dependency is mentioned


utility adjusted return calculation. Utility =

Expected return - 0.005*A*StandDev^2
A = investors risk aversion score (1-10)


roy safety first =

(R.expected - Rminacceptable) / StandDevPorffolio


assets need to be specified so that

- assets in the class should be both descriptively and statistically SIMILAR
- NOT highly CORRELATED (in order to provide diversification)
- individual assets to be included JUST in 1 class
- cover the MAJORITY of all possible investable assets
- contain sufficiently large % of liquid assets


sharpe of portfolio will increase if

Sharpe of proposed investment
= Sharpe of existing portfolio
correlation between proposed investment and portfolio returns


asset allocation approaches

Mean Variance Optimisation MVO
Resampled efficient fronttier
Black Litterman
Monte Carlo simulation
Asset Liability Management
Experience based 60/40, 100 less age


mean variance optimization - advantages

- software available
- optimization programs used to generate the efficient frontier
- identifies pf with the highest expected return at each level of risk and associated asset allocation
- it is typically sign constraint to prevent negative weights
- cash equivalents are modeled as if risky asset class is included
- widely understood and accepted
- easily adopted to model risk as a downside risk or tracking error, return as excess return over some minimum threshold return, constrain the deviations of asset weights vs. some relevant benchmark, model the correlation to change over time and converge during periods of stress
- the modeling of the EF can be simplified with the use of corner portfolios


mean variance optimization - limitations

- number and nature of estimates required can be overwhelming
- expected returns are subject to estimation bias
- static one period approach
- can yield underdiversified pf unless constrained
- output can be very sensitive to the inputs, so the result is unstable


resampled efficient frontier - advantages

- EF is more stable than traditional MV
- small changes in inputs produce only minor changes in SAA (strategic asset allocation)
- portfolios tend to be better diversified than traditional MVO
- commercially available software


resampled efficienc frontier - limitations

- no theoretical basis for the approach
- inputs often based on historical data


Black Litterman - advantages

- theoretically justified way to address the sensitivity of inputs problem and incorporate manager views
- typically generated more stable asset asslocation and better diversification
- can be constrained or unconstrained, though constrained is the more useful and rigurous approach
- BL (constrained) quantifies and begins with market consensus expected returns and allows the manager to systematically diverge from this starting point
- commercially available software


Black Litterman - liimitations

often the inputs are based on historical data



monte carlo simulation - advantages

- statistical analysis tool to further analyze the asset allocation output of the other approahces
- models path dependency issues
- generates statistical probabilities of meeting or not meeting return objectives
- can also model liabilities and surplus
- used to complement the other approaches
- commercially available software


monte carlo simulation - limitations

- can be complex to implement
- can generate false confidence. output is only as accurate as the inputs


asset liability management - strengths

- considers the allocation of the assets with the respect to liabilities
- can generate a surplus frontier that shows the combinations of risk and return
- otherwise similar to MVO
- commercially available software


asset liability management - limitations

same as MVO

- number and nature of estimates required can be overwhelming
- expected returns are subject to estimation bias
- static one period approach
- can yield underdiversified pf unless constrained
- output can be very sensitive to the inputs, so the result is unstable


experience based - strengths

- incorporated decades of asset allocation experience
- easy to understand and consistent with the more complex approaches
- inexpensive to implement
- useful on the exam


experience based - limitations

allocation rules may be too simple for some investors

experience based rules can be contradictory in some applied settings


sharpe function of market risk premium =

sharpe = MRP/stand dev


capital allocation line, definition

capital allocation line is the straight line drawn from the risk free rate to the tangency portfolio on the efficient frontier ...

... WHERE the tangency portfolio is the corner portfolio with the HIGHEST sharpe ratio


primary goals of security portfolio of the banks

provide liquidity

manage the credit risk

manager the duration (gap management)

generate income


tactical asset allocation

short term deviations from strategical asset allocation in attempt to capitalize on capital market mispricing


strategic asset allocation combines

capital market expectations and the investors risk/return/contraints


% of return explained by tactic asset allocation

0-10% according to different studies


utility adjusted return. MUST REMEMBER

0.005 USED when using 20 for 20%
0.5 USED when using 0.20 for 20%


if individual's planned expenses are after tax, you must

convert then into BEFORE tax by division to (1-tax rate)

add inflation rate to pretax return NOT to after tax return


Black Litterman model

1. Equilibrium assumption that the asset allocation should be proportional to the market values of the available assets.
2. Modifies that to take into account the 'views' of the investor in question to arrive at a bespoke asset allocation.