risk-adjusted returns

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pages: 1,088 words: 228,743

Expected Returns: An Investor's Guide to Harvesting Market Rewards by Antti Ilmanen

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Andrei Shleifer, asset allocation, asset-backed security, availability heuristic, backtesting, balance sheet recession, bank run, banking crisis, barriers to entry, Bernie Madoff, Black Swan, Bretton Woods, buy low sell high, capital asset pricing model, capital controls, Carmen Reinhart, central bank independence, collateralized debt obligation, commodity trading advisor, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, debt deflation, deglobalization, delta neutral, demand response, discounted cash flows, disintermediation, diversification, diversified portfolio, dividend-yielding stocks, equity premium, Eugene Fama: efficient market hypothesis, fiat currency, financial deregulation, financial innovation, financial intermediation, fixed income, Flash crash, framing effect, frictionless, frictionless market, George Akerlof, global reserve currency, Google Earth, high net worth, hindsight bias, Hyman Minsky, implied volatility, income inequality, incomplete markets, index fund, inflation targeting, interest rate swap, invisible hand, Kenneth Rogoff, laissez-faire capitalism, law of one price, Long Term Capital Management, loss aversion, margin call, market bubble, market clearing, market friction, market fundamentalism, market microstructure, mental accounting, merger arbitrage, mittelstand, moral hazard, New Journalism, oil shock, p-value, passive investing, performance metric, Ponzi scheme, prediction markets, price anchoring, price stability, principal–agent problem, private sector deleveraging, purchasing power parity, quantitative easing, quantitative trading / quantitative finance, random walk, reserve currency, Richard Thaler, risk tolerance, risk-adjusted returns, risk/return, riskless arbitrage, Robert Shiller, Robert Shiller, savings glut, Sharpe ratio, short selling, sovereign wealth fund, statistical arbitrage, statistical model, stochastic volatility, systematic trading, The Great Moderation, The Myth of the Rational Market, too big to fail, transaction costs, tulip mania, value at risk, volatility arbitrage, volatility smile, working-age population, Y2K, yield curve, zero-coupon bond

The dollar’s downtrend lowers U.S. assets’ performance for many non-U.S. investors, while the returns of many unhedged non-U.S. assets have been augmented by currency appreciation. 4.5 RISK-ADJUSTED RETURNS Performance evaluation of any asset, strategy, or fund is increasingly done on returns that are somehow adjusted for the average risk taken. Adjustment for volatility is the most common risk adjustment, based on the logic that it would be “unfair” to compare, say, returns of 4% on two different assets with very different volatility levels. Specifically, the Sharpe ratio (SR) is the average excess return over the riskless rate of return (proxied, in practice, by a near-riskless money market asset) divided by the volatility of this excess return. The SR is a measure of volatility-adjusted or risk-adjusted return. In the CAPM context, the optimal risky asset portfolio can be levered or de-levered through borrowing or lending of cash (i.e., short or long positions in cash).

According to classic portfolio theory, systematic risk such as equity market beta is more dangerous than idiosyncratic risk that can be diversified away. More modern critics point out that volatility does not distinguish between losses that occur in good or bad times or even between upside and downside surprises. Another approach to risk-adjusted returns focuses on an asset’s—or a strategy’s or a fund’s—contribution to portfolio risk as opposed to its standalone risk (a part of which is typically diversifiable). The classic Jensen’s alpha is the intercept when regressing asset returns on equity market returns. More generally, alpha is the intercept of any risk factor model. Thus, alpha is risk-adjusted return where “risk” is some measure of the asset’s contribution to portfolio risk. In the past 10 to 15 years, the Fama–French three-factor model—which contains size and value factors besides the market beta factor—has become increasingly popular among equity managers.

Meanwhile, the way that S&P GSCI Commodity index owners synchronously roll into new futures contracts each month causes a predictable temporary supply–demand imbalance that hurts these index investors. 28.2 RISK This book does not cover the important topics of risk management and portfolio construction except for their mechanical impact on expected returns. Risk reduction through diversification is famously the one free lunch that markets offer, but it improves risk-adjusted returns rather than raw returns. However, Sections 28.2.1 and 28.2.2 show how diversification can boost portfolio returns, almost magically, through leverage or rebalancing. The more typical approach to boosting expected returns is to take more risk, but I remind the reader that not all risks are rewarded and certainly they are not all rewarded equally well. Section 28.2.3 stresses that markets do not treat all volatility as equal, a theme closely related to the shortcomings of the Sharpe ratio, the most common measure of risk-adjusted returns. Section 28.2.4 briefly reviews smart diversification or portfolio construction methods for efficient risk reduction. 28.2.1 Monetized risk reduction via leverage Many retail investor portfolios are insufficiently diversified, perhaps consisting of only a few stocks and having plenty of diversifiable, unrewarded risk.

 

Commodity Trading Advisors: Risk, Performance Analysis, and Selection by Greg N. Gregoriou, Vassilios Karavas, François-Serge Lhabitant, Fabrice Douglas Rouah

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Asian financial crisis, asset allocation, backtesting, capital asset pricing model, collateralized debt obligation, commodity trading advisor, compound rate of return, constrained optimization, corporate governance, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, discrete time, distributed generation, diversification, diversified portfolio, dividend-yielding stocks, fixed income, high net worth, implied volatility, index arbitrage, index fund, interest rate swap, iterative process, linear programming, London Interbank Offered Rate, Long Term Capital Management, market fundamentalism, merger arbitrage, Mexican peso crisis / tequila crisis, p-value, Ponzi scheme, quantitative trading / quantitative finance, random walk, risk-adjusted returns, risk/return, Sharpe ratio, short selling, stochastic process, systematic trading, technology bubble, transaction costs, value at risk

Average Monthly Gain Average Monthly Loss Standard Deviation Gain Standard Deviation Loss Standard Deviation Semideviation Skewness Kurtosis Coskewness Sharpe ratio Calmar ratio Maximum Drawdown 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23. 24. These measures can be classified into six groups: 1. Absolute return measures 2. Absolute risk measures 3. Absolute risk-adjusted return measures Gain/Loss Ratio Beta Annualized Alpha Treynor Ratio Jensen Alpha Information Ratio Up Capture Down Capture Up Number Ratio Down Number Ratio Up Percentage Ratio Down Percentage Ratio. 206 RISK AND MANAGED FUTURES INVESTING 4. Relative return measures 5. Relative risk measures 6. Relative risk-adjusted return measures DATA The data for this study came from the Center for International Securities and Derivatives Markets (CISDM) database. We selected a sample of 200 CTA managers who had complete return data for the period from January 1998 to July 2003.

In addition, CTA QU index possesses a higher Sharpe ratio than equity indices, indicating that CTAs offer superior risk-adjusted returns. These estimates may understate true risk, so monthly modified Sharpe ratios (using VaR instead of standard deviation) is also presented and confirms the advantage of the CTA QU index. Using VaR and modified VaR to measure risk, the CTAs are still less risky than equity indices. For instance, a one percent VaR of −5.3 percent for CTA QU index means that there is a 1 percent chance that the loss will be greater that 5.3 percent next month (or a 99 percent chance that it will be less than 5.3 percent). Besides very attractive risk adjusted return characteristics, one of the most important features of CTAs is their favorable correlation structure to traditional assets classes (see Table 20.2).

Ali PART FOUR Program Evaluation, Selection, and Returns 275 CHAPTER 15 How to Design a Commodity Futures Trading Program 277 Hilary Till and Joseph Eagleeye CHAPTER 16 Choosing the Right CTA: A Contingent Claim Approach 294 Zsolt Berenyi CHAPTER 17 CTAs and Portfolio Diversification: A Study through Time 307 Nicolas Laporte CHAPTER 18 Random Walk Behavior of CTA Returns 326 Greg N. Gregoriou and Fabrice Rouah CHAPTER 19 CTA Strategies for Returns-Enhancing Diversification 336 David Kuo Chuen Lee, Francis Koh, and Kok Fai Phoon CHAPTER 20 Incorporating CTAs into the Asset Allocation Process: A Mean-Modified Value at Risk Framework Maher Kooli 358 viii CONTENTS CHAPTER 21 ARMA Modeling of CTA Returns 367 Vassilios N. Karavas and L. Joe Moffitt CHAPTER 22 Risk-Adjusted Returns of CTAs: Using the Modified Sharpe Ratio 377 Robert Christopherson and Greg N. Gregoriou CHAPTER 23 Time Diversification: The Case of Managed Futures 385 François-Serge Lhabitant and Andrew Green REFERENCES 399 INDEX 417 Preface he idea for this book came about when we realized that a collection of managed futures articles dealing with quantitative and qualitative analyses of commodity trading advisors (CTAs) could be a useful and welcomed addition to existing books on the subject.

 

pages: 297 words: 91,141

Market Sense and Nonsense by Jack D. Schwager

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asset allocation, Bernie Madoff, Brownian motion, collateralized debt obligation, commodity trading advisor, conceptual framework, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, Daniel Kahneman / Amos Tversky, diversification, diversified portfolio, fixed income, high net worth, implied volatility, index arbitrage, index fund, London Interbank Offered Rate, Long Term Capital Management, margin call, market bubble, market fundamentalism, merger arbitrage, pattern recognition, performance metric, pets.com, Ponzi scheme, quantitative trading / quantitative finance, random walk, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, Sharpe ratio, short selling, statistical arbitrage, statistical model, transaction costs, two-sided market, value at risk, yield curve

Thus even though Manager C ends up ahead of Manager D, many investors will never survive the ride to see the eventual successful outcome (and even those who do may have initiated their investment on an upside excursion, reducing or even eliminating their net return). The greater the volatility, the larger the percentage of investors who will close out their investments at a loss. Clearly, there is a need to use risk-adjusted returns rather than returns alone to make valid performance comparisons. In the next section we consider some alternative risk-adjusted return measures. Risk-Adjusted Return Measures The formulas for the performance measures in this section can be found in Appendix B. Sharpe Ratio The Sharpe ratio is the most widely used risk-adjusted return measure. The Sharpe ratio is defined as the average excess return divided by the standard deviation. Excess return is the return above the risk-free return (e.g., Treasury bill rate). For example, if the average return is 8 percent per year and the T-bill rate is 3 percent, the excess return would be 5 percent.

Most of Manager B’s volatility, however, was on the upside—a characteristic most investors would consider an attribute, not a fault. Although Manager A had lower volatility overall, the downside volatility was significantly greater than Manager B’s—a characteristic that is consistent with most investors’ intuitive sense of greater risk. The Sharpe ratio does not distinguish between downside and upside volatility, while the other risk-adjusted return measures do. Table 8.4 A Comparison of Risk-Adjusted Return Measures Although all the risk-adjusted return measures besides the Sharpe ratio penalize only downside volatility, they do so in different ways that have different implications: Sortino ratio and SDR Sharpe ratio. These ratios penalize returns below a specified level (e.g., zero) with the weight assigned to downside deviations increasing more than proportionately as their magnitude increases.

The average maximum retracement is the average of all these monthly maximum retracements. The return retracement ratio is statistically far more meaningful than the MAR and Calmar ratios because it is based on multiple data points (one for each month) as opposed to a single statistic (the maximum drawdown in the entire record). Comparing the Risk-Adjusted Return Performance Measures Table 8.4 compares Managers A and B shown in Figure 8.3 in terms of each of the risk-adjusted return performance measures we discussed. Interestingly, the Sharpe ratio, which is by far the most widely used return/risk measure, leads to exactly the opposite conclusion indicated by all the other measures. Whereas the Sharpe ratio implies that Manager A is significantly superior in return/risk terms, all the other performance measures rank Manager B higher—many by wide margins.

 

pages: 363 words: 28,546

Portfolio Design: A Modern Approach to Asset Allocation by R. Marston

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asset allocation, Bretton Woods, capital asset pricing model, capital controls, carried interest, commodity trading advisor, correlation coefficient, diversification, diversified portfolio, equity premium, Eugene Fama: efficient market hypothesis, family office, financial innovation, fixed income, German hyperinflation, high net worth, hiring and firing, housing crisis, income per capita, index fund, inventory management, Long Term Capital Management, mortgage debt, passive investing, purchasing power parity, risk-adjusted returns, Robert Shiller, Robert Shiller, Ronald Reagan, Sharpe ratio, Silicon Valley, superstar cities, transaction costs, Vanguard fund

It reflects the total variability of an asset return. Beta measures only the variability that is systematically related to the market benchmark. P1: OTA/XYZ P2: ABC c01 JWBT412-Marston December 20, 2010 16:58 16 Printer: Courier Westford PORTFOLIO DESIGN Third, the advisor needs measures of risk-adjusted returns. The Sharpe ratio measures the excess return on an asset (above the risk-free return) relative to the standard deviation. So the Sharpe ratio is appropriate for measuring the risk-adjusted return if the total risk of the asset is being considered. Alpha is a risk-adjusted return based on only the systematic risk of the asset. That is, alpha is the excess return earned on an asset above that explained by the beta of that asset. Alpha is often used to measure the risk-adjusted contribution of a mutual fund manager. It can also be used to measure the marginal contribution of an individual asset to a market-based portfolio.

In Figure 1.3, the return on portfolio P, rP , is compared with a market benchmark, rM .15 Most portfolios have less risk than the market as a whole, so it’s important to compare returns at a common level of risk. Alpha∗ brings the risk level of the market down to that of the portfolio to be evaluated.16 The expression for alpha∗ (α ∗ ) shows how this is done: α ∗ = rP − [rF + (σP /σM )(rM − rF )] Thus the portfolio return is compared with the risk-adjusted return on the market where risk is adjusted downward by the ratio of σ P to σ M . Alpha∗ doesn’t give any more information about risk-adjusted returns than that which is provided by Sharpe ratios, but alpha∗ translates differences in Sharpe ratios into excess returns.17 And excess returns can be understood easily by all investors. Alpha∗ will be used repeatedly in the book to show how well one portfolio is doing relative to another. P1: OTA/XYZ P2: ABC c01 JWBT412-Marston Asset Allocation December 20, 2010 16:58 Printer: Courier Westford 19 NOTES 1.

Investment-grade bonds are highly correlated with one another. The correlation between Barclays Aggregate index and the Treasury return is 0.92. Shifting from the Treasury bond to the Barclays Aggregate raises risk-adjusted return, or alpha∗ , by only 0.3 percent. Similarly, the correlation between the S&P 500 and Russell 3000 all-cap index is very high at 0.99. The returns on these two indexes, moreover, are almost identical over the sample period since the Russell series was introduced in 1979. Diversifying beyond the S&P 500 into small- and mid-cap stocks has a negligible effect on the risk-adjusted return. What these experiments suggest is that the investor is going to have to look beyond U.S. stocks and bonds for diversification gains.3 But note how much the investor has already accomplished. By spreading out stock market investments across the entire S&P 500, the investor has already achieved substantial diversification.

 

pages: 504 words: 139,137

Efficiently Inefficient: How Smart Money Invests and Market Prices Are Determined by Lasse Heje Pedersen

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algorithmic trading, Andrei Shleifer, asset allocation, backtesting, bank run, banking crisis, barriers to entry, Black-Scholes formula, Brownian motion, buy low sell high, capital asset pricing model, commodity trading advisor, conceptual framework, corporate governance, credit crunch, Credit Default Swap, currency peg, David Ricardo: comparative advantage, declining real wages, discounted cash flows, diversification, diversified portfolio, Emanuel Derman, equity premium, Eugene Fama: efficient market hypothesis, fixed income, Flash crash, floating exchange rates, frictionless, frictionless market, Gordon Gekko, implied volatility, index arbitrage, index fund, interest rate swap, late capitalism, law of one price, Long Term Capital Management, margin call, market clearing, market design, market friction, merger arbitrage, mortgage debt, New Journalism, paper trading, passive investing, price discovery process, price stability, purchasing power parity, quantitative easing, quantitative trading / quantitative finance, random walk, Renaissance Technologies, Richard Thaler, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, shareholder value, Sharpe ratio, short selling, sovereign wealth fund, statistical arbitrage, statistical model, systematic trading, technology bubble, time value of money, total factor productivity, transaction costs, value at risk, Vanguard fund, yield curve, zero-coupon bond

., Rb = 0), so they report the IR simply as which is always higher than the SR, since it does not subtract the risk-free rate. Even if many hedge funds report this number, I view it as an unreasonable number as it gives the hedge fund credit for earning the risk-free rate (and depends on the level of interest rates). The IR is almost always reported as an annualized number, as discussed further below. Both the SR and the IR are ways of calculating risk-adjusted returns, but some traders and investors say, You can’t eat risk-adjusted returns. Suppose, for instance, that a hedge fund beats the risk-free rate by 3% at a tiny risk of 2%, realizing an excellent SR of 1.5. Some investors might say, “Well, it’s still just 3%. I was hoping for more return.” Whether this is a fair criticism or not depends on several things. First, it depends on whether the strategy’s risk really is that low on a long-term basis or this period was just lucky not to have a blowup (e.g., if the hedge fund is selling out-the-money options collecting small premiums until a big market move blows it up).

See also performance measures return drivers of investment styles, ix returns of hedge funds, 22–24. See also performance measures reversal strategies, 152–53; Asness on, 158, 159 RI (residual income), 92–93 Ricardian equivalence, 7t Ricardo, David, 208 risk: measurement of, 57–59; Soros on, 204, 206–7. See also liquidity risk; market exposure (beta risk); value-at-risk (VaR); volatility risk-adjusted alpha, 30 risk-adjusted return, 29–31. See also Sharpe ratio (SR) risk-adjusted return on capital (RAROC), 31–32 risk arbitrage, 14, 314. See also merger arbitrage risk aversion coefficient, 56, 171 risk-based asset allocation, 170–71 risk-free interest rate: bond prices and, 241; bond yields and, 248–49; return of a trading strategy and, 27–28 risk limits, 59–60 risk management, 54; drawdown control in, 54, 59, 60–62, 225; in line with trends, 212; in managed futures investing, 225; versus predatory trading, 84; prospective, 59–60; trader’s emotions and, 61 risk neutral probability, 238 risk parity investing, 16, 45, 171 risk premium: Asness on successful strategies and, 164; bond yield and, 248–49; carry trading and, ix; corporate credit and, 168, 260; inflation and, 196; leverage and, ix; liquidity-adjusted CAPM and, 43; option value and, 238; strategic asset allocation and, 168; value investing and, ix.

., if prices do not change). For instance, global macro investors are known to pursue the currency carry trade where they invest in currencies with high interest rates, bond traders often prefer high-yielding bonds, equity investors like stocks with high dividend yields, and commodity traders like commodity futures with positive “roll return.” Low-risk investing is the style of exploiting the high risk-adjusted returns of safe securities. This investment style is done in several different ways across various markets. Low-risk investing can be done as a long–short equity strategy, buying safe stocks with leverage while shorting risky ones, also called “betting against beta.” Low-risk investing can also be done as a long-only equity strategy, buying a portfolio of relatively safe stocks, also called defensive equity.

 

pages: 162 words: 50,108

The Little Book of Hedge Funds by Anthony Scaramucci

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Andrei Shleifer, asset allocation, Bernie Madoff, business process, carried interest, Credit Default Swap, diversification, diversified portfolio, Donald Trump, Eugene Fama: efficient market hypothesis, fear of failure, fixed income, follow your passion, Gordon Gekko, high net worth, index fund, Long Term Capital Management, mail merge, margin call, merger arbitrage, NetJets, Ponzi scheme, profit motive, quantitative trading / quantitative finance, random walk, Renaissance Technologies, risk-adjusted returns, risk/return, Ronald Reagan, Saturday Night Live, Sharpe ratio, short selling, Silicon Valley, too big to fail, transaction costs, Vanguard fund, Y2K, Yogi Berra

Another Theory, Another Definition Just three short years after A.W. Jones began using a metric he called velocity to measure how closely a stock’s movement tracks the broader market, a young graduate student named Harry Markowitz was busy at work developing the Modern Portfolio Theory. Discussed in a paper entitled “Portfolio Selection,” this theory postulated that it was not enough to simply maximize returns but one must maximize risk-adjusted returns, whereby returns would be based upon a given level of inherent risk. The key to his theory was that the risk of a portfolio is dependent upon the relationship among its securities. In other words, if you picked the right securities or had the right asset allocation you could get out on the efficient frontier and actually find a scenario where you earned more reward yet took less risk. Back in the 1950s, the problem with this approach was that it was not easy to implement—there simply wasn’t enough time or resources to calculate the correlations between thousands of stocks—or (at that time) just 25!

Key capital providers including Fannie Mae, Freddie Mac and Wall Street trading desks have either exited the market or are dramatically reducing their involvement. We think this will increase the size and breadth of the opportunities in the mortgage market for many years to come. We also believe that hedge fund investors will continue to commit capital to mortgage strategies to seek out uncorrelated return streams, improve portfolio diversification, and achieve high risk-adjusted returns. Chapter Six Ironing Out Inefficiencies Exploiting the Efficient Market Theory If the efficient markets hypothesis was a publicly traded security, its price would be enormously volatile. —Andrei Shleifer and Lawrence H. Summers, The Noise Trader Approach to Finance In 1990, Andrei Shleifer and Larry Summers mockingly made the comment that begins this chapter, adding that the “stock in the efficient markets hypothesis—at least as it has been traditionally formulated—crashed along with the rest of the market on October 19, 1987 . . . and its recovery has been less dramatic than that of the rest of the market.”1 Pretty fun for a pair of economists from Harvard, especially for one who would serve as President Clinton’s Secretary of the Treasury and President Obama’s Director of the White House National Economic Council.

And if you don’t have the first, the other two will kill you. —Warren Buffett Throughout this book I have been stressing the key differences between hedge funds and other asset classes. In an effort to generate absolute returns and produce alpha, a hedge fund manager must possess the uncanny ability to fundamentally select the best stocks and systematically diversify his portfolio so that he can produce risk-adjusted returns. But for every stock-picking guru like David Einhorn or Dan Loeb there are dozens of other nameless hedge fund managers who are not quite as successful. Although the purpose of this book is not to uncover the secret formula for achieving alpha-like return, nor is it to explain in painstaking detail how to invest in hedge funds, this chapter will spend a bit of time showing you how investors and fund of hedge fund managers screen the over 9,000 hedge funds that are currently in operation.

 

pages: 317 words: 106,130

The New Science of Asset Allocation: Risk Management in a Multi-Asset World by Thomas Schneeweis, Garry B. Crowder, Hossein Kazemi

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asset allocation, backtesting, Bernie Madoff, Black Swan, capital asset pricing model, collateralized debt obligation, commodity trading advisor, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, diversified portfolio, fixed income, high net worth, implied volatility, index fund, interest rate swap, invisible hand, market microstructure, merger arbitrage, moral hazard, passive investing, Richard Feynman, Richard Feynman, Richard Feynman: Challenger O-ring, risk tolerance, risk-adjusted returns, risk/return, Sharpe ratio, short selling, statistical model, systematic trading, technology bubble, the market place, Thomas Kuhn: the structure of scientific revolutions, transaction costs, value at risk, yield curve

For example, recent studies (INGARM, 2009) have shown that through the use of alternative investments one can get access to investment opportunities and factor exposures that are not available through traditional asset classes. Alternative investments such as private equity, real estate, commodities, hedge funds, and CTAs offer a variety of return and risk characteristics: ■ ■ Positive alpha: A risk-adjusted return that exceeds the risk-adjusted return of traditional asset classes. Research has suggested that alternatives often obtain an excess return as providers of liquidity to new investors. Higher rate of return relative to other asset classes: Certain alternative asset (private equity, real estate) returns are derived from less liquid 62 ■ ■ THE NEW SCIENCE OF ASSET ALLOCATION investments. These alternative strategies have a higher expected rate of return as a function of the underlying risk of the investment (e.g., late stage private equity investment has a beta of about 1.25 to 1.5).

Use of the production data has the drawback of underweighting commodities like precious metals that are storable over a longer period and overweighting commodities like agricultural products that must be used over a shorter period. Bache Commodity Index (BCI): The primary objective of the BCI is to provide broad-based exposure to global commodity markets, with low turnover and strong risk-adjusted returns resulting from multiple return factors. The BCI employs a dynamic asset allocation strategy based on the price momentum of individual commodity markets. This approach to index construction may help reduce transaction costs and turnover, and may increase the risk-adjusted return. This index also incorporates a relative roll strategy that is similar to a synthetic spread trade, which will be profitable if the price of the contract closest to expiration falls in price relative to the longer maturity contracts. With the addition of Gasoil in February 2008, the BCI comprises 19 commodities that are traded on 7 major futures exchanges located in the U.S. and the UK.

Notes CHAPTER 5 Strategic, Tactical, and Dynamic Asset Allocation Asset Allocation Optimization Models Strategic Asset Allocation Tactical Asset Allocation Dynamic Asset Allocation Notes CHAPTER 6 Core and Satellite Investment: Market/Manager Based Alternatives Determining the Appropriate Benchmarks and Groupings Sample Allocations Core Allocation Satellite Investment Algorithmic and Discretionary Aspects of Core/Satellite Exposure Replication Based Indices Peer Group Creation—Style Purity Notes 58 59 61 66 70 71 74 82 84 88 91 92 99 101 107 109 110 111 117 119 120 120 122 126 132 Contents CHAPTER 7 Sources of Risk and Return in Alternative Investments Asset Class Performance Hedge Funds Managed Futures (Commodity Trading Advisors) Private Equity Real Estate Commodities Notes CHAPTER 8 Return and Risk Differences among Similar Asset Class Benchmarks Making Sense Out of Traditional Stock and Bond Indices Private Equity Real Estate Alternative REIT Investments Indices Commodity Investment Hedge Funds Investable Manager Based Hedge Fund Indices CTA Investment Index versus Fund Investment: A Hedge Fund Example Notes CHAPTER 9 Risk Budgeting and Asset Allocation Process of Risk Management: Multi-Factor Approach Process of Risk Management: Volatility Target Risk Decomposition of Portfolio Risk Management Using Futures Risk Management Using Options Covered Call Long Collar Notes CHAPTER 10 Myths of Asset Allocation Investor Attitudes, Not Economic Information, Drive Asset Values Diversification Across Domestic or International Equity Securities Is Sufficient vii 134 135 139 143 148 153 160 166 167 168 170 173 179 179 185 185 189 189 194 195 195 200 202 203 206 206 208 210 212 213 214 viii CONTENTS Historical Security and Index Performance Provides a Simple Means to Forecast Future Excess Risk-Adjusted Returns Recent Manager Fund Return Performance Provides the Best Forecast of Future Return Superior Managers or Superior Investment Ideas Do Not Exist Performance Analytics Provide a Complete Means to Determine Better Performing Managers Traditional Assets Reflect “Actual Values” Better Than Alternative Investments Stock and Bond Investment Means Investors Have No Derivatives Exposure Stock and Bond Investment Removes Investor Concerns as to Leverage Given the Efficiency of the Stock and Bond Markets, Managers Provide No Useful Service Investors Can Rely on Academics and Investment Professionals to Provide Current Investment Models and Theories Alternative Assets Are Riskier Than Equity and Fixed Income Securities Alternative Assets Such as Hedge Funds Are Absolute Return Vehicles Alternative Investments Such as Hedge Funds Are Unique in Their Investment Strategies Hedge Funds Are Black Box Trading Systems Unintelligible to Investors Hedge Funds Are Traders, Not Investment Managers Alternative Investment Strategies Are So Unique That They Cannot Be Replicated It Makes Little Difference Which Traditional or Alternative Indices Are Used in an Asset Allocation Model Modern Portfolio Theory Is Too Simplistic to Deal with Private Equity, Real Estate, and Hedge Funds Notes CHAPTER 11 The Importance of Discretion in Asset Allocation Decisions The Why and Wherefore of Asset Allocation Models Value of Manager Discretion 215 215 216 216 217 217 218 218 218 219 220 221 222 222 223 223 223 225 226 226 230 Contents Manager Evaluation and Review: The Due Diligence Process Madoff: Due Diligence Gone Wrong or Never Conducted Notes CHAPTER 12 Asset Allocation: Where Is It Headed?

 

Investment: A History by Norton Reamer, Jesse Downing

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Albert Einstein, algorithmic trading, asset allocation, backtesting, banking crisis, Berlin Wall, Bernie Madoff, Brownian motion, buttonwood tree, California gold rush, capital asset pricing model, Carmen Reinhart, carried interest, colonial rule, credit crunch, Credit Default Swap, Daniel Kahneman / Amos Tversky, debt deflation, discounted cash flows, diversified portfolio, equity premium, estate planning, Eugene Fama: efficient market hypothesis, Fall of the Berlin Wall, family office, Fellow of the Royal Society, financial innovation, fixed income, Gordon Gekko, Henri Poincaré, high net worth, index fund, interest rate swap, invention of the telegraph, James Hargreaves, James Watt: steam engine, joint-stock company, Kenneth Rogoff, labor-force participation, land tenure, London Interbank Offered Rate, Long Term Capital Management, loss aversion, Louis Bachelier, margin call, means of production, Menlo Park, merger arbitrage, moral hazard, mortgage debt, Network effects, new economy, Nick Leeson, Own Your Own Home, pension reform, Ponzi scheme, price mechanism, principal–agent problem, profit maximization, quantitative easing, RAND corporation, random walk, Renaissance Technologies, Richard Thaler, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, Sand Hill Road, Sharpe ratio, short selling, Silicon Valley, South Sea Bubble, sovereign wealth fund, spinning jenny, statistical arbitrage, technology bubble, The Wealth of Nations by Adam Smith, time value of money, too big to fail, transaction costs, underbanked, Vanguard fund, working poor, yield curve

However, the key is that the performance of passive indices is entirely a function of the market beta, or risk premium of a given asset class or other systematic strategy, rather than the active security selection of a manager, while superior performance by many alternative strategies is proving difficult to maintain over time. Reward: Vast Revenue Growth and Wealth Creation for Investment Managers Efficient market theory implies that no manager should be able to achieve outsized risk-adjusted returns consistently over time without a fundamental informational advantage, and much of the academic work regarding the performance of index funds, ETFs, mutual funds, and other investment vehicles discussed in this book seems to validate this thesis. However, this body of work seemingly fails to explain the phenomenon of a limited number of real-life, individual, independent money managers consistently beating the market or posting superior risk-adjusted returns year after year, at least for an extended period of their careers. It is worth turning our attention for a moment to the “ultrasuccessful” investment managers who have accumulated vast wealth and influence.

Put options increase in value when the index declines in price, so that serves to protect the portfolio against falling asset values. The sale of call options means that Madoff’s firm would exchange some of the upside (if stock prices increased) for a fixed amount of money. This strategy, of course, should involve reasonably low volatility (as it is buffered on both sides by the options trades). The problem? Such an approach could not possibly generate the risk-adjusted returns (that is, the return per given unit of 152 Investment: A History volatility) Bernie Madoff had claimed.15 Analyzing Madoff’s returns through one of the feeder funds that gave Madoff money to manage (Fairfield Sentry) reveals that Madoff claimed average annual returns of 10.59 percent with a volatility of just 2.45 percent (and a worst month of just—.64 percent) from December 1990 to October 2008.

In 2003, there were 170 REITs (134 of which traded on the New York Stock Exchange) valued at a combined $310 billion.46 Although liquid real estate vehicles, such as REITs, are extremely popular among investors, there are clear preferences among types of products. In one industry survey, some 68 percent of advisers responding said they had invested in such vehicles, but only 33 percent of them used nontraded REITs in their clients’ portfolios.47 This shows that liquidity preference, transparency, accountability, and ability to hold to a strict regulatory standard while still being able to achieve high risk-adjusted returns are important characteristics for investors in their alternative investment patterns. In many ways, though, REITs and their publicly traded shares are not much different than more traditional public companies—they just happen to be in the business of financing real estate and have a different wrapper and management structure around the assets. They do have some favorable tax advantages, including avoiding taxation at the trust level if more than 90 percent of the income is distributed to unitholders.

 

pages: 490 words: 117,629

Unconventional Success: A Fundamental Approach to Personal Investment by David F. Swensen

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asset allocation, asset-backed security, capital controls, cognitive dissonance, corporate governance, diversification, diversified portfolio, fixed income, index fund, law of one price, Long Term Capital Management, market bubble, market clearing, market fundamentalism, passive investing, pez dispenser, price mechanism, profit maximization, profit motive, risk tolerance, risk-adjusted returns, Robert Shiller, Robert Shiller, shareholder value, Silicon Valley, Steve Ballmer, technology bubble, the market place, transaction costs, Vanguard fund, yield curve

In aggregate, venture investors fare about as well as their marketable equity counterparts. After adjustment for risk, the overwhelming majority of venture capital fails to produce acceptable risk-adjusted returns. The new entrant to the world of private entrepreneurial finance faces an obstacle quite apart from the barriers hampering investment success in other asset classes. The top-tier venture partnerships, essentially closed to new money, enjoy superior access to deals, entrepreneurs, and capital markets. Exclusion from the venture capital elite disadvantages all but the most long-standing, most successful limited partners. Suppliers of funds to the venture capital industry generally realize poor risk-adjusted returns. Sensible individual investors look elsewhere for investment performance. CHAPTER SUMMARY Non-core asset classes provide investors with a broad range of superficially appealing but ultimately performance-damaging investment alternatives.

While default-free, noncallable, full-faith-and-credit obligations of the U.S. government play a basic, valuable, differentiable role in investor portfolios, investment-grade corporate bonds, high-yield bonds, foreign bonds, and asset-backed securities contain unattractive characteristics that argue against inclusion in well-constructed portfolios. Understanding the shortcomings of particular fixed-income investment alternatives, particularly in regard to how those alternatives relate to the objectives of the fixed-income asset class, helps investors in making well-informed portfolio decisions. Those asset classes that require superior active management results to produce acceptable risk-adjusted returns belong only in the portfolios of the handful of investors with the resources and fortitude to pursue and maintain a high-quality active investment management program. Understanding the difficulty of identifying superior hedgefund, venture-capital, and leveraged-buyout investments leads to the conclusion that hurdles for casual investors stand insurmountably high. Even many well-equipped investors fail to clear the hurdles necessary to achieve consistent success in producing market-beating active management results.

Strikingly, a comparable-maturity U.S. Treasury note produced a holding period return of 45.8 percent, as the noncallable nature of the government issue allowed investors to benefit fully from the bond market rally. The 3.4 percent holding period increment, realized by PCA bondholders over the three and one-half years, represents scant compensation for accepting a high degree of credit risk. U.S. Treasuries produced risk-adjusted returns significantly higher than those realized by holders of the PCA9.625s. Holders of PCA stock faced a tough set of circumstances. In contrast to the strong market enjoyed by bondholders, equity owners faced a dismal market environment. From the date of PCA’s IPO, which took place near the peak of one of the greatest stock market bubbles ever, to the bond-tender offer date, the S&P 500 declined a cumulative 24.3 percent.

 

pages: 337 words: 89,075

Understanding Asset Allocation: An Intuitive Approach to Maximizing Your Portfolio by Victor A. Canto

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accounting loophole / creative accounting, airline deregulation, Andrei Shleifer, asset allocation, Bretton Woods, buy low sell high, capital asset pricing model, commodity trading advisor, corporate governance, discounted cash flows, diversification, diversified portfolio, fixed income, frictionless, high net worth, index fund, inflation targeting, invisible hand, law of one price, liquidity trap, London Interbank Offered Rate, Long Term Capital Management, market bubble, merger arbitrage, new economy, passive investing, price mechanism, purchasing power parity, risk tolerance, risk-adjusted returns, risk/return, Ronald Reagan, shareholder value, Sharpe ratio, short selling, statistical arbitrage, the market place, transaction costs, Y2K, yield curve

International Allocation Chapter 7 Taking It to the Tilt 125 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 1975 1.00 1.06 1.12 1.18 1.24 1.31 1.37 1.43 1.48 1.53 1.56 1976 –0.28 –0.14 0.00 0.16 0.33 0.50 0.66 0.83 0.98 1.12 1.25 1977 1.30 1.08 0.79 0.45 0.09 –0.25 –0.56 –0.81 –1.01 –1.16 –1.28 1978 1.24 1.25 1.24 1.19 1.09 0.94 0.74 0.53 0.34 0.18 0.04 1979 –0.68 –0.54 –0.40 –0.26 –0.11 0.02 0.16 0.28 0.40 0.51 0.60 1980 0.46 0.54 0.63 0.71 0.79 0.86 0.92 0.96 1.00 1.02 1.04 1981 –0.97 –1.04 –1.12 –1.19 –1.26 –1.33 –1.39 –1.43 –1.45 –1.44 –1.42 1982 –0.74 –0.63 –0.51 –0.37 –0.22 –0.07 0.09 0.23 0.36 0.48 0.58 1983 1.34 1.40 1.45 1.48 1.49 1.47 1.44 1.40 1.35 1.29 1.23 1984 –0.15 –0.15 –0.16 –0.17 –0.17 –0.17 –0.18 –0.18 –0.18 –0.18 –0.18 1985 4.06 4.29 4.45 4.45 4.25 3.88 3.42 2.93 2.48 2.09 1.76 1986 2.28 2.29 2.29 2.26 2.17 2.03 1.82 1.56 1.27 0.98 0.71 1987 0.76 0.71 0.65 0.58 0.52 0.45 0.38 0.32 0.26 0.20 0.14 1988 1.19 1.24 1.29 1.34 1.38 1.41 1.40 1.35 1.25 1.11 0.96 1989 0.12 0.24 0.38 0.53 0.69 0.87 1.05 1.23 1.39 1.53 1.64 continues 126 Table 7.4 continued International Allocation UNDERSTANDING ASSET ALLOCATION 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 1990 –1.05 –1.05 –1.05 –1.04 –1.02 –0.99 –0.93 –0.86 –0.75 –0.63 –0.50 1991 0.32 0.43 0.54 0.66 0.79 0.91 1.04 1.15 1.26 1.35 1.43 1992 –1.19 –1.15 –1.10 –1.02 –0.92 –0.78 –0.58 –0.32 –0.02 0.29 0.56 1993 1.43 1.46 1.49 1.53 1.57 1.60 1.64 1.64 1.59 1.43 1.14 1994 0.23 0.20 0.16 0.13 0.09 0.04 0.00 –0.05 –0.10 –0.14 –0.19 1995 0.34 0.56 0.82 1.14 1.52 1.97 2.52 3.15 3.86 4.56 5.14 1996 –0.07 0.16 0.38 0.58 0.77 0.94 1.08 1.21 1.32 1.41 1.49 1997 –0.23 –0.05 0.14 0.34 0.54 0.75 0.94 1.13 1.30 1.45 1.58 1998 0.71 0.76 0.81 0.85 0.89 0.93 0.97 1.00 1.02 1.04 1.06 1999 1.50 1.52 1.52 1.51 1.50 1.47 1.42 1.37 1.31 1.25 1.18 2000 –1.56 –1.52 –1.46 –1.39 –1.31 –1.23 –1.14 –1.06 –0.97 –0.89 –0.81 2001 –1.61 –1.52 –1.43 –1.34 –1.25 –1.16 –1.07 –0.98 –0.90 –0.81 –0.73 2002 –1.01 –1.04 –1.07 –1.10 –1.12 –1.14 –1.15 –1.16 –1.17 –1.18 –1.18 2003 2.10 2.13 2.15 2.17 2.18 2.20 2.21 2.21 2.21 2.21 2.20 2004 1.63 1.61 1.59 1.57 1.55 1.52 1.49 1.45 1.40 1.36 1.30 Based on the sample period, these results suggest an all-or-nothing strategy that would have maximized risk-adjusted returns 80 percent of the time. The problem, however, with all-or-nothing is when you miss, you miss big (on a relative basis). Risk-averse investors may not be able to live with such a bipolar strategy, and might instead find it desirable to minimize their long-run volatilities relative to their long-run average returns. The SAA does just this: It allocates funds in proportion to asset-class market weights. But, if we take the long-run result seriously, a bipolar strategy should generate an average holding closer to each asset class’s market weight. This carries the promise of higher risk-adjusted returns. In simple terms, an optimal active strategy tilts around long-run values, giving us a time-consistent active strategy.

This suggests smallcap stocks, although delivering higher returns than large-caps during the sample period, were no more risky than large-caps. At the other end of the spectrum, we find growth stocks have a beta in excess of one while posting a negative alpha. The higher beta here suggests growth stocks had a higher systematic risk than the market. To make matters worse, this higher risk did not lead to superior risk-adjusted returns as measured by Jensen’s alpha. In fact, the large-cap growth portfolio for this period had a negative statistically significant coefficient; not only were growth stocks riskier, they also delivered a lower return. Given these 30-year statistics, one would be hard-pressed to make a case for the inclusion of growth stocks in a portfolio. Table 2.2 Risk measurements: 1975–2004. Risk-Adjusted Beta Annual Returns Jensen’s Alpha T-Statistics Sharpe Ratio Small-Cap 13.79% 1 5.64% 2.07 Large-Cap 8.13% 1 0.00% Growth 7.17% 1.06 –1.46% 1.87 0.43 Value 8.91% .93 0.81% 1.67 0.60 International 4.91% .62 –1.27% 0.04 0.29 0.65 0.53 Source: Research Insight, Morgan Stanley Capital Management, and Ibbotson Associates As for value stocks, they produced a somewhat lower beta than the market during the sample period, suggesting they have a lower systematic risk than the market.

Risk-Adjusted Beta Annual Returns Jensen’s Alpha T-Statistics Sharpe Ratio Small-Cap 13.79% 1 5.64% 2.07 Large-Cap 8.13% 1 0.00% Growth 7.17% 1.06 –1.46% 1.87 0.43 Value 8.91% .93 0.81% 1.67 0.60 International 4.91% .62 –1.27% 0.04 0.29 0.65 0.53 Source: Research Insight, Morgan Stanley Capital Management, and Ibbotson Associates As for value stocks, they produced a somewhat lower beta than the market during the sample period, suggesting they have a lower systematic risk than the market. Value stocks also appear to have shown a positive alpha, but only enough to be considered marginally significant at best. Once again, taken at face value, the results suggest value stocks have a lower systematic risk than the market but quite possibly offer higher risk-adjusted returns. International stocks exhibited what appears to be significantly lower beta and alpha coefficients for the period, with the alpha coming in at just about zero. This means that although international stocks offered a much lower systematic risk for the period, they did not produce additional excess return. One conclusion is this: The only possible contribution international stocks can make to a portfolio is as risk-reducing or diversification mechanisms. 20 UNDERSTANDING ASSET ALLOCATION Based on the statistics presented in Table 2.2, the CAPM investment implications are fairly straightforward: Avoid growth stocks in your portfolio, include some international stocks as a risk-reduction measure, take some value stocks also as a risk-reduction measure as well as an excess-return-producing measure, and add in small-cap stocks to generate some risk-adjusted excess returns (alpha).

 

pages: 537 words: 144,318

The Invisible Hands: Top Hedge Fund Traders on Bubbles, Crashes, and Real Money by Steven Drobny

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Albert Einstein, Asian financial crisis, asset allocation, asset-backed security, backtesting, banking crisis, Bernie Madoff, Black Swan, Bretton Woods, BRICs, British Empire, business process, capital asset pricing model, capital controls, central bank independence, collateralized debt obligation, Commodity Super-Cycle, commodity trading advisor, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency peg, debt deflation, diversification, diversified portfolio, equity premium, family office, fiat currency, fixed income, follow your passion, full employment, Hyman Minsky, implied volatility, index fund, inflation targeting, interest rate swap, inventory management, invisible hand, London Interbank Offered Rate, Long Term Capital Management, market bubble, market fundamentalism, market microstructure, moral hazard, North Sea oil, open economy, peak oil, pension reform, Ponzi scheme, prediction markets, price discovery process, price stability, private sector deleveraging, profit motive, purchasing power parity, quantitative easing, random walk, reserve currency, risk tolerance, risk-adjusted returns, risk/return, savings glut, Sharpe ratio, short selling, sovereign wealth fund, special drawing rights, statistical arbitrage, stochastic volatility, The Great Moderation, time value of money, too big to fail, transaction costs, unbiased observer, value at risk, Vanguard fund, yield curve

While that may or may not be true, illiquidity needs to be reconsidered on a risk-adjusted basis, which includes the analysis of stressed scenarios and the impact on the overall portfolio in light of annual cash liabilities. Although the Endowment Model is not dead, the flaws and shortcomings exposed in 2008 need to be considered and adjusted for when building real money portfolios. Whether the performance of endowment style portfolios snap back quickly or not doesn’t matter; we have learned that risk-adjusted returns and drawdowns are important. If large drawdowns force action beyond the portfolio level (i.e., if the underlying institutions must take action because of portfolio losses), then it makes sense to do whatever is necessary to cut off that risk. Public Pension Goes Endowment In the fall of 2006, I was invited to attend an offsite meeting for a state pension fund that had just been given clearance, through a November 2006 ballot vote, to invest outside of the United States for the first time.

Ironically, conventional wisdom in the investment world holds that global macro hedge funds are risky while real money funds are prudent and safe. It is now clear that real money managers need to reorient their thought process and approach towards improving the portfolio construction process, especially if they have annual cash needs. Specifically, a more forward looking risk-based approach should be at the foundation of real money portfolios. Real money managers should:1. Replace return targets with risk-adjusted return targets. Big drawdowns and volatility matter. Focusing on return targets misses the damage to performance caused by large drawdowns and high volatility. Portfolios should be constructed such that extreme worst-case scenarios are accounted for and dealt with in the investment process, either through the use of overlays, hedges to cut off tail risk, or less aggressive asset allocation with truly diversifying exposures. 2.

This suggests the optimization exercise should incorporate an additional constraint of avoiding losses and drawdowns so large that they imperil the existence of an economic entity (e.g., banks and insurance companies) or cause a very severe dislocation in spending for entities with fixed spending commitments (pension, endowments, foundations). That implies a solution to the optimization exercise where risk-adjusted returns and volatility play a role. It is a second-best solution, but one that helps reduce the potential for a catastrophic outcome. This was neatly illustrated in a recent discussion I had with Larry Bacow, president of my alma mater, Tufts University. He mentioned that the universities with large endowments suffered disproportionately in the crash and now face significant cutbacks in spending as a result.

 

pages: 225 words: 11,355

Financial Market Meltdown: Everything You Need to Know to Understand and Survive the Global Credit Crisis by Kevin Mellyn

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asset-backed security, bank run, banking crisis, Bernie Madoff, bonus culture, Bretton Woods, collateralized debt obligation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, cuban missile crisis, disintermediation, diversification, fiat currency, financial deregulation, financial innovation, financial intermediation, fixed income, Francis Fukuyama: the end of history, global reserve currency, Home mortgage interest deduction, Isaac Newton, joint-stock company, liquidity trap, London Interbank Offered Rate, margin call, market clearing, moral hazard, mortgage tax deduction, Northern Rock, offshore financial centre, paradox of thrift, pattern recognition, pension reform, pets.com, Plutocrats, plutocrats, Ponzi scheme, profit maximization, pushing on a string, reserve currency, risk tolerance, risk-adjusted returns, road to serfdom, Ronald Reagan, shareholder value, Silicon Valley, South Sea Bubble, statistical model, The Great Moderation, the payments system, too big to fail, value at risk, very high income, War on Poverty, Y2K, yield curve

A new ‘‘science’’ of capital management grew up, again aided and abetted by management consultants and the statistical tools we have already seen. The big idea was something called risk adjusted return on capital or RAROC. This was basically a way of measuring what every dollar of capital used by a bank to support its businesses returned to the shareholders after adjusting for risk, that is, the probable losses. Other tools and concepts like shareholder value added or SVA also got traction. In theory, if a bank took capital out of a business with low-risk adjusted returns and put it into businesses with high-risk adjusted returns, its overall return on shareholder funds should be higher. So would its position on the banking food chain. It seemed like a good idea at the time. In fact, RAROC was riddled with the same problems as VAR in terms of reliance on risk models.

Banks became seized with a superstitious belief that complex mathematical models could better manage financial risk and return than human judgment. This thinking went well beyond the FICO score or the models used by the rating agencies to ‘‘stress test’’ default probabilities. Banks came to believe that they could design and implement data-driven ‘‘scientific’’ risk systems. The key concepts were ‘‘value at risk’’ or VAR and ‘‘risk adjusted return on capital’’ or RAROC. The basic idea was simple. Every loan, trading position, or operating exposure such as fraud or computer systems failure involved risks that Financial Innovation Made Easy could be identified and quantified with some precision across the whole institution. Risks were quantified by measuring the potential gap between the expected income from a loan or investment and the income actually received if things went wrong.

Again, fancy math gives the illusion of precision when it really depends on piles of assumptions and rules of thumb. Anyone in science or engineering who tries to model complex systems knows this, though few admit it out loud. The wonder of banking since the 1980s is that a simple business was made into a very complex system in the hope that it could be managed ‘‘by the numbers.’’ THE SECURITIZATION IMPERATIVE RAROC calculations made one thing very clear to the bank managements: If you want a high-risk adjusted return on capital, don’t do stuff that needs a lot of capital. Since bank balance sheet intermediation demands big capital buffers, lending money was by definition less capital efficient than ‘‘originating’’ loans for the structured finance sausage machine. Fee income did not eat up capital, so growing feebased businesses like payments and asset management were good things. Overall, anything that transferred what are called ‘‘risk-assets’’ off the bank balance sheet was a good thing.

 

All About Asset Allocation, Second Edition by Richard Ferri

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asset allocation, asset-backed security, barriers to entry, Bernie Madoff, capital controls, commodity trading advisor, correlation coefficient, Daniel Kahneman / Amos Tversky, diversification, diversified portfolio, equity premium, estate planning, financial independence, fixed income, full employment, high net worth, Home mortgage interest deduction, implied volatility, index fund, Long Term Capital Management, Mason jar, mortgage tax deduction, passive income, pattern recognition, random walk, Richard Thaler, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, Sharpe ratio, too big to fail, transaction costs, Vanguard fund, yield curve

Accordingly, double-digit interest rates in 1980 have dropped to less than 3 percent today. Stock performance going forward will not be as high as it was in the past 30 years because inflation is a large factor in long-term market returns. High starting inflation means higher nominal returns, and low starting inflation means lower nominal returns. A realistic and conservative return for stocks over inflation is 5 percent annually. MODEL 1: RISK-ADJUSTED RETURNS The risk-adjusted return model relies on historical market volatilities to forecast the relative future performance for various asset classes. Market returns can vary considerably over different periods of time, although the volatility of those returns is more consistent. In the long term, the volatility of a market can be used to forecast its returns relative to those of other markets with different risks.

., European, and Pacific Rim Stocks S&P 500 European Index Pacific Rim Index 1985 32.2 75.1 30.3 1986 18.5 42.7 74.1 1987 5.2 13.4 23.7 1988 16.8 15.4 33.0 1989 31.5 26.9 8.9 1990 –3.2 –1.0 –23.1 1991 30.6 14.7 22.9 1992 7.7 –3.6 –7.1 1993 10.0 29.5 53.1 1994 1.3 2.4 3.8 1995 37.4 22.6 7.1 1996 23.1 23.9 2.8 1997 33.4 21.8 –27.2 1998 28.6 24.5 –0.5 1999 21.0 19.2 52.5 2000 –9.1 –10.1 –21.6 2001 –11.9 –18.8 –19.4 2002 –22.1 –17.2 –7.9 2003 28.7 39.0 41.6 2004 10.9 21.7 22.8 2005 4.9 10.4 20.2 2006 15.8 34.6 19.7 2007 5.5 12.3 13.8 2008 –37.0 –47.3 –39.6 2009 26.5 35.8 24.2 CHAPTER 4 70 U.S. dollars from the three global areas: the United States, Europe, and the Pacific Rim. The shaded cell represents the geographical region that had the highest-returning index for that year. The region of the world with the highest return varies over time. There is no pattern recognition or formula that can be used to predict the region that will outperform next. Allocating assets across these three regions has been a good strategy. It created a better risk-adjusted return than having only U.S. equities. Figure 4-2 shows a risk-and-return diagram for U.S. stocks and international stocks using 10 percent increments, starting with no international stocks on the left side and ending with only international stocks on the right side. The international index I used is split evenly between the Pacific Rim and Europe, rebalanced annually. The international composite index dates back to 1973.

Most analysts and economists agree to disagree on every element of market forecasting ranging from the methodology used to the modeling techniques to the input into those equations. Interestingly, despite differences of opinion and techniques, most long-term forecasts tend to fall within a narrow range of returns. At the end of this chapter is my own forecast of long-term market risk and return. FORECASTING MARKET RETURNS There are two basic market forecasting methodologies discussed in this chapter. The first method is a risk-adjusted return model that relies on historical price volatility in part to forecast the future performance of various asset classes relative to one another. The second method is an economic top-down model that relies on a long-term forecast of gross domestic product (GDP) to forecast various asset-class returns. Forecasting a market’s future return always involves the analysis of historical risk and return.

 

pages: 263 words: 75,455

Quantitative Value: A Practitioner's Guide to Automating Intelligent Investment and Eliminating Behavioral Errors by Wesley R. Gray, Tobias E. Carlisle

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Albert Einstein, Andrei Shleifer, asset allocation, Atul Gawande, backtesting, Black Swan, capital asset pricing model, Checklist Manifesto, cognitive bias, compound rate of return, corporate governance, correlation coefficient, credit crunch, Daniel Kahneman / Amos Tversky, discounted cash flows, Eugene Fama: efficient market hypothesis, forensic accounting, hindsight bias, Louis Bachelier, p-value, passive investing, performance metric, quantitative hedge fund, random walk, Richard Thaler, risk-adjusted returns, Robert Shiller, Robert Shiller, shareholder value, Sharpe ratio, short selling, statistical model, systematic trading, The Myth of the Rational Market, time value of money, transaction costs

“Value” represents the portfolio formed from highest ranked decile, “MF (5)” represents the portfolio formed from the middle decile, and “Glamour” is the portfolio formed from the lowest ranked decile. Figure 2.2 and Table 2.2 demonstrate that the Magic Formula does quite well ranking the stocks. The first and best decile according to the Magic Formula outperforms the worst and last decile. The better deciles also tend to outperform with lower volatility, measured by standard and downside deviation, which leads to better risk-adjusted returns, represented by higher Sharpe and Sortino ratios. TABLE 2.2 Glamour, Middle, and Value Decile Performance Statistics: Magic Formula Strategy (1964 to 2011) As the figures and tables demonstrate, Greenblatt's Magic Formula has consistently outperformed the market, and with lower relative risk than the market. The nature of compounding means that, over long periods of time, small edges can result in big differences in returns.

An edge, some patience, and the magic of compounding translate into serious profits. Our study of the Magic Formula shows that analyzing stocks according to some proxy for price (e.g., a “bargain” or a “fair” price), and some proxy for quality (e.g., a “good” business or a “wonderful” company) can help us to identify value, and provide us with an edge, that can lead to outperformance and excellent risk-adjusted returns. Naturally, we wondered if we could improve on the outstanding performance delivered by the Magic Formula. Are there other simple, logical strategies that can do better? IT's ALL ACADEMIC: IMPROVING QUALITY AND PRICE We have created a generic, academic alternative to the Magic Formula that we call “Quality and Price.” Quality and Price is the academic alternative to the Magic Formula because it draws its inspiration from academic research papers.

He wanted to find some measure that would adjust the return for the risk taken to generate it. He created the Sharpe ratio, which does this by examining the historical relationship between excess return—the return in excess of the risk-free rate—and volatility, which stands in for risk. The higher the Sharpe ratio, the more return is generated for each additional unit of volatility, and the better the price metric. The Sortino ratio, like the Sharpe ratio, measures risk-adjusted return. The difference is that the Sortino ratio only measures downside volatility, while the Sharpe ratio measures both upside and downside volatility. The Sortino ratio doesn't adjust return for upside volatility, only for downside volatility, which we wish to avoid. The Sortino ratio also measures excess returns in excess of a minimum acceptable return. We use 5 percent per year as the minimum acceptable return in our analysis.

 

pages: 389 words: 109,207

Fortune's Formula: The Untold Story of the Scientific Betting System That Beat the Casinos and Wall Street by William Poundstone

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Albert Einstein, anti-communist, asset allocation, Benoit Mandelbrot, Black-Scholes formula, Brownian motion, buy low sell high, capital asset pricing model, Claude Shannon: information theory, computer age, correlation coefficient, diversified portfolio, en.wikipedia.org, Eugene Fama: efficient market hypothesis, high net worth, index fund, interest rate swap, Isaac Newton, Johann Wolfgang von Goethe, John von Neumann, Long Term Capital Management, Louis Bachelier, margin call, market bubble, market fundamentalism, Marshall McLuhan, New Journalism, Norbert Wiener, offshore financial centre, publish or perish, quantitative trading / quantitative finance, random walk, risk tolerance, risk-adjusted returns, Robert Shiller, Robert Shiller, Ronald Reagan, short selling, speech recognition, statistical arbitrage, The Predators' Ball, The Wealth of Nations by Adam Smith, transaction costs, traveling salesman, value at risk, zero-coupon bond

The theorists were not even saying, necessarily, that all the market-beaters are simply lucky. There are ways to boost return by accepting greater risk. One is to use leverage. A very aggressive investor might borrow money to buy more stock than he could otherwise. This multiplies the expected return—and also multiplies the risk. For these reasons, the notion of a superior investor needs to be carefully qualified. The hallmark has to be a market-beating risk-adjusted return, achieved not through luck but through some logical system. It was concrete evidence of this that the economists failed to find. A name that occurs to many people today is Warren Buffett. “I’d be a bum in the street with a tin cup if the markets were efficient,” Buffett once said. Buffett had already made a name for himself with a successful hedge fund and had founded Omaha-based Berkshire Hathaway when Samuelson wrote that “a loose version of the ‘efficient market’ or ‘random walk’ hypothesis accords with the facts of life.”

Shannon’s Demon The chart’s upper line shows the value of a 50–50 stock and cash portfolio that is rebalanced each time unit. This line trends upward. The dollar scale on this chart is logarithmic, so the straight trend line actually means exponentially growing wealth. The rebalanced portfolio is also less volatile than the stock. The scale of the jitters is relatively less for the rebalanced portfolio than for the stock itself. Shannon’s rebalancer is not only achieving a superior return, but a superior risk-adjusted return. How does Shannon’s stock system work? Does it work? Shannon’s system bears a telling similarity to a great puzzle of physics. In his 1871 book Theory of Heat, British physicist James Clerk Maxwell semiseriously described a perpetual motion machine. The machine could be as simple as a container of air divided into two chambers by a partition. There is a tiny trapdoor in the partition.

It is an important idea that has been studied by such economists as Mark Rubinstein and Eugene Fama (who were apparently unaware of Shannon’s unpublished work). Rubinstein demonstrated that given certain assumptions, the optimal portfolio is always a constant-proportion rebalanced portfolio. This is one reason why it makes sense for ordinary investors to periodically rebalance their holdings in stocks, bonds, and cash. You get a slightly higher risk-adjusted return than you would otherwise. Commissions and capital gains taxes cut into this benefit, though. In recent years, Stanford information theorist Thomas Cover has built ingeniously on Shannon’s idea of the constant-proportion rebalanced portfolio. Cover believes that new algorithms can render the concept profitable, even after trading costs. Shannon’s main point in his talk, however, may have been to refute the then-common belief that the random walk of stock prices is an absolute barrier to making greater-than-market returns.

 

pages: 369 words: 128,349

Beyond the Random Walk: A Guide to Stock Market Anomalies and Low Risk Investing by Vijay Singal

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Andrei Shleifer, asset allocation, capital asset pricing model, correlation coefficient, cross-subsidies, Daniel Kahneman / Amos Tversky, diversified portfolio, endowment effect, index arbitrage, index fund, locking in a profit, Long Term Capital Management, loss aversion, margin call, market friction, market microstructure, mental accounting, merger arbitrage, new economy, prediction markets, price stability, profit motive, random walk, Richard Thaler, risk-adjusted returns, risk/return, Sharpe ratio, short selling, transaction costs, Vanguard fund

The sample includes both pure cash and pure stock bids, and bids that seek less than 100 percent of the target as long as the acquisition will result in the acquirer holding the entire 100 percent. For example, a company holding 75 percent of the target may seek to acquire the remaining 25 percent through a merger or a tender offer. For this sample of merger arbitrage deals, the risk-adjusted return is 0.7 percent per month if transaction costs and other slippages are not considered. The risk-adjusted return falls to 0.3 percent per month if all impediments and costs of transacting are considered. Further, the risk of the arbitrage portfolio is close to zero in stable or appreciating markets, but the systematic risk as measured by beta jumps to 0.50 in downtrending markets. Some other interesting information relating to the success of merger arbitrage is given in Table 9.3.4 Table 9.3 Success of Merger Arbitrage Total number of first bids Arbitrageur loses money First bid fails Target not bought out Targets taken over Hostile Deals Cash Deals Stock Deals 3,434 778 (23%) 606 (18%) 478 (14%) 86% 1,815 356 (20%) 295 (16%) 272 (15%) 85% 475 143 (30%) 173 (36%) 131 (28%) 72% It can be observed that the failure rate is high in the case of hostile deals.

Does it imply that the next stock deleted from the index is likely to appreciate? Yes. But will it appreciate? Maybe not. Similarly, the results do not imply that the next twenty stocks deleted from the index will necessarily appreciate, though they are likely to. But the results do imply that if you follow this strategy for the next two to three years and no significant changes take place in how the market reacts to these deletions, then you will earn risk-adjusted returns that are larger than the normal return. However, an unsuccessful run of any mispricing can cost the investor a significant loss of capital. POSITIVE ABNORMAL RETURNS DO NOT MEAN POSITIVE RETURNS The anomalous evidence presented generally focuses on abnormal returns. Since an abnormal return is the actual return minus the normal return, the actual return could be negative even though the abnormal return is positive.

Accordingly, all future analysis is presented based on the simple strategy of holding sectors above the mean return. Until now, the risk level of the positions was ignored. However, it is important to take risk into account because industry-momentum-based trading strategies are clearly riskier than holding a 91 92 Beyond the Random Walk broader market portfolio. The Sharpe ratio is used to compare the risk-adjusted returns.3 Sharpe ratios are reported below based on annual returns for the best-case scenarios, an average return of 4 percent for short-term Treasury bills during 1997–2001, and standard deviations (reported in parentheses) in Table 5.4. 25-week estimation period and 5-week holding period 5-week estimation period and 5-week holding period 5-week estimation period and 1-week holding period S&P 500 holding return 0.91 0.76 1.05 0.49 Since higher Sharpe ratios indicate superior investment, the best results are for the one-week holding period, with a ratio of 1.05.

 

Evidence-Based Technical Analysis: Applying the Scientific Method and Statistical Inference to Trading Signals by David Aronson

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Albert Einstein, Andrew Wiles, asset allocation, availability heuristic, backtesting, Black Swan, capital asset pricing model, cognitive dissonance, compound rate of return, Daniel Kahneman / Amos Tversky, distributed generation, Elliott wave, en.wikipedia.org, feminist movement, hindsight bias, index fund, invention of the telescope, invisible hand, Long Term Capital Management, mental accounting, meta analysis, meta-analysis, p-value, pattern recognition, Ponzi scheme, price anchoring, price stability, quantitative trading / quantitative finance, Ralph Nelson Elliott, random walk, retrograde motion, revision control, risk tolerance, risk-adjusted returns, riskless arbitrage, Robert Shiller, Robert Shiller, Sharpe ratio, short selling, statistical model, systematic trading, the scientific method, transfer pricing, unbiased observer, yield curve, Yogi Berra

Month 5 Stock 1 Stock 2 Month 4 Stock 3 Month 3 Month 2 Stock n Time Month 1 Predictor Variables FIGURE 7.7 Cross-sectional time series study. Predictability Studies Contradicting Semistrong EMH. The semistrong form of EMH is the boldest testable version of EMH.44 It asserts that no information in the public domain, fundamental or technical, can be used to generate risk-adjusted returns in excess of the market index. The bottom line of numerous well-conducted cross-sectional time series studies is this: Price movements are predictable to some degree with 352 METHODOLOGICAL, PSYCHOLOGICAL, PHILOSOPHICAL, STATISTICAL FOUNDATIONS stale public information, and excess risk-adjusted returns are possible. Here, I summarize some of these key findings: • Small capitalization effect: A stock’s total market capitalization, defined as the number of shares outstanding multiplied by its price per share, is predictive of future returns.45 Stocks in a portfolio composed of the lowest decile portfolio of market capitalization earned about 9 percent per year more than stocks in the highest decile portfolio.46 This effect is most pronounced in the month of January.

For example, geology’s dominant theory, plate tectonics, may predict that specific geologic formations that were created millions of years ago would be observed if an investigation of some specific location were to be carried out tomorrow. In finance, the efficient market’s hypothesis predicts that if a TA rule were to be back tested, its profits, after adjustment for risk, would not exceed the risk adjusted return of the market index. Once the prediction has been deduced from the hypothesis, the operations necessary to produce the new observations are carried out. They may involve a visit to the location of the predicted geologic formation or the back test of the TA rule. Then it becomes a matter of comparing prediction with observation. Measuring the degree of agreement between observation and prediction and making the decision about whether the hypothesis is left intact or falsified is what statistical analysis is all about.

Perhaps this explains the defensive, unscientific response of those who support the efficient markets hypothesis. When observations collided with their favorite theory, they tried to save it from falsification by reducing its information content. As mentioned earlier, its least informative version, EMH weak, predicts 142 METHODOLOGICAL, PSYCHOLOGICAL, PHILOSOPHICAL, STATISTICAL FOUNDATIONS that investment strategies based on TA32 will not be able to earn risk adjusted returns that beat the market index. When EMH supporters were faced with studies showing that TA-based strategies were able to earn excess returns,33 they responded by trying to immunize their theory from falsification. They did so by inventing new risk factors and claimed that the excess returns earned by TA were merely compensation for risks inherent in pursuing such a strategy. In other words, EMH defenders claimed that investors who followed the TA strategy were exposing themselves to a risk that was specific to that strategy.

 

pages: 385 words: 128,358

Inside the House of Money: Top Hedge Fund Traders on Profiting in a Global Market by Steven Drobny

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Albert Einstein, asset allocation, Berlin Wall, Bonfire of the Vanities, Bretton Woods, buy low sell high, capital controls, central bank independence, Chance favours the prepared mind, commodity trading advisor, corporate governance, correlation coefficient, Credit Default Swap, diversification, diversified portfolio, family office, fixed income, glass ceiling, high batting average, implied volatility, index fund, inflation targeting, interest rate derivative, inventory management, Long Term Capital Management, margin call, market bubble, Maui Hawaii, Mexican peso crisis / tequila crisis, moral hazard, new economy, Nick Leeson, oil shale / tar sands, oil shock, out of africa, paper trading, Peter Thiel, price anchoring, purchasing power parity, reserve currency, risk tolerance, risk-adjusted returns, risk/return, rolodex, Sharpe ratio, short selling, Silicon Valley, The Wisdom of Crowds, too big to fail, transaction costs, value at risk, yield curve, zero-coupon bond

See also Siva-Jothy, Christian Protectionism, 44 Putin,Vladimir, 237–238 Put options, 63–64, 77, 85, 236, 331, 334 Quantitative analysis, 346 Quantum Endowment, 28 Quantum Fund, 28, 30, 184, 217, 271, 273, 277–278 RAROC (risk-adjusted return on capital), 39 Raw material boom, 239 Reading recommendations, 92, 158–159 INDEX Real estate, 62–63, 242. See also Home builders; Housing bubble Real estate investment trusts (REITs), 63, 290 Real money, 53, 62, 70 Recession, 14, 115, 264 Redemptions, 58, 69 Relative value (RV), 25, 68, 126–127, 141–142, 147–148, 156, 173, 310–311, 330, 336, 337, 346 Reminiscences of a Stock Operator (Lefevre), 92, 244 Researcher. See Drobny,Andres, Dr. Return(s), 55, 99, 254, 344–346. See also Absolute returns Reverse repurchase agreements, 51 Reward/risk ratio, 174 Reward-to-volatility ratio, 342 Risk-adjusted returns, 254, 344–346 Risk arbitrage, 33, 80–81. See also Arbitrage Risk aversion, 107, 115 Risk capital, 24 Risk curve, 328 Risk-free rate, 196, 342 Risk management strategies, 7–8, 25, 32, 50, 53–54, 61–62, 131, 137–138, 172, 192, 204, 206, 213–214, 285, 293–294, 333–334 Risk premium, 55 Risk/reward analysis, 98, 110–111, 126, 296 Risk-to-return ratio, 62 Robertson, Julian, xi, 8, 10, 21, 23, 27–28, 245–247, 277 Roditi, Nick, 269, 278 Rogers, Jim, 8, 210, 217–221, 223–239, 269–271, 278 Rogers International Commodity Index, 218 Rubin, Robert, 32, 245 Rumors, 249, 268 Russia/Russian rubles, 22–23, 49–50, 64–65, 203–204, 211, 237–238, 277, 280, 283, 286, 289, 290 Russian crisis 1998, 10, 21–23, 26, 54, 64, 80, 292–294, 299–300, 310 Russian Equity Index, 65 Russian stock market index (RTSI$), 22 INDEX S&P 500 index, 27–28, 193, 212–213, 217, 273–274, 282 Safe harbor, 205 Salomon Brothers, 24 Samuelson, Paul, 9 Scholes, Myron, 24, 207 Secular trends, 234 Sell-offs, 20, 118, 175, 295, 302 SemperMacro, 71, 72 Seykota, Ed, 9 Sharpe ratio, 62, 342–343 Short-dated volatility, 55 Short positions, xii, 58.

Whereas significant assets under management can prove an issue for some more focused investing styles, it is not a particular hindrance to global macro hedge funds given their flexibility and the depth and liquidity in the markets they trade. Although macro traders are often considered risky speculators due to the large swings in gains and losses that can occur from their leveraged directional bets, when viewed as a group, global macro hedge fund managers have produced superior risk-adjusted returns over time. From January 1990 to December 2005, global macro hedge funds have posted an average annualized return of 15.62 percent, with an annualized standard deviation of 8.25 percent. Macro funds returned over HFRI Macro Index Growth of $1,000 $10,000 $9,000 $8,000 $7,000 $6,000 $5,000 $4,000 $3,000 $2,000 $1,000 $0 Initial 1990 1991 1992 1993 1994 1995 1996 HFRI Macro Index FIGURE 1.1 Source: HFR. 1997 1998 1999 2000 2001 S&P 500 w/ dividends Comparison of HFRI Macro Index with S&P 500 2002 2003 2004 2005 4 INSIDE THE HOUSE OF MONEY 500 basis points more than the return generated by the S&P 500 index for the same period with more than 600 basis points less volatility.

If you’re a pattern guy, you’re looking at the pattern and can see it developing, which is when you’re loading up. At the end, when everybody’s on it and volatility has been cranked up because it’s already been recognized, that’s when you are selling.” Tell me about your matrix. Global macro is the matrix. It’s my mental picture of how money flows around the world, the flow of funds on a global basis seeking out the highest risk-adjusted return. Money is always moving somewhere, whether it’s from oil to currencies to metals or to stocks. I follow it. The only time when global money doesn’t flow is when it’s afraid, like during 1998 or after 9/11, and then it heads to Switzerland. Markets are based on two emotions: fear and greed.The greed part is nice when you’re a part of it and are invested, but when fear takes over, it’s an unbelievable thing.

 

pages: 345 words: 87,745

The Power of Passive Investing: More Wealth With Less Work by Richard A. Ferri

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asset allocation, backtesting, Bernie Madoff, capital asset pricing model, cognitive dissonance, correlation coefficient, Daniel Kahneman / Amos Tversky, diversification, diversified portfolio, endowment effect, estate planning, Eugene Fama: efficient market hypothesis, fixed income, implied volatility, index fund, Long Term Capital Management, passive investing, Ponzi scheme, prediction markets, random walk, Richard Thaler, risk tolerance, risk-adjusted returns, risk/return, Sharpe ratio, too big to fail, transaction costs, Vanguard fund, yield curve

Here is how the Treynor Ratio works: Take any portfolio’s return and subtract a risk-free rate of return (usually the Treasury bill yield); then divide the result by the portfolio’s beta. The result is the ratio of a portfolio’s excess return to market risk as measured by the portfolio’s beta. The Treynor Ratio can be used to compare many portfolios to one another and sort the results by the best risk-adjusted returns. The funds with the highest ratios have the highest returns per unit of market risk; this is an indication of the managers who may have skill. The ratio is used to weed out bad managers from potential good ones, thus making an investment consultant’s job much easier. William Sharpe developed a similar formula for evaluating risk-adjusted returns of portfolios. Ironically, rather than using his own beta formula as the denominator in the equation, Sharpe used a portfolio’s standard deviation of return. Perhaps this was because Treynor beat him to the punch. Sharpe’s formula became known as the Sharpe Ratio.

Net of fees and risk-adjusted, 39 surviving funds beat the market while 76 funds underperformed. That’s a 1-to-2 win-loss ratio in the funds before the risk adjustment and a 1-to-2 win-loss ratio after risk adjustment. The median winning fund outperformed the market on a risk-adjusted basis by 0.6 percent while the median losing fund underperformed the market by 1.6 percent. It is interesting to note in Jensen’s study that fund managers fared no better or worse in their risk-adjusted returns than their unadjusted performance. Jensen summed up his findings in his study’s abstract: The evidence on mutual fund performance indicates not only that these 115 mutual funds were on average not able to predict security prices well enough to outperform a buy-the-market-and-hold policy, but also that there is very little evidence that any individual fund was able to do significantly better than that which we expected from mere random chance.13 Alpha is an indication of a manager’s potential skill.

These funds can experience higher share-price volatility than diversified funds because sector funds are subject to issues specific to a given sector. Securities and Exchange Commission (SEC) The federal government agency that regulates mutual funds, registered investment advisors, the stock and bond markets, and broker-dealers. The SEC was established by the Securities Exchange Act of 1934. Sharpe ratio A measure of risk-adjusted return. To calculate a Sharpe ratio, an asset’s excess return (its return in excess of the return generated by risk-free assets such as Treasury bills) is divided by the asset’s standard deviation. It can be calculated compared to a benchmark or an index. short sale The sale of a security or option contract that is not owned by the seller, usually to take advantage of an expected drop in the price of the security or option.

 

How I Became a Quant: Insights From 25 of Wall Street's Elite by Richard R. Lindsey, Barry Schachter

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Albert Einstein, algorithmic trading, Andrew Wiles, Antoine Gombaud: Chevalier de Méré, asset allocation, asset-backed security, backtesting, bank run, banking crisis, Black-Scholes formula, Bonfire of the Vanities, Bretton Woods, Brownian motion, business process, buy low sell high, capital asset pricing model, centre right, collateralized debt obligation, corporate governance, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, currency manipulation / currency intervention, discounted cash flows, disintermediation, diversification, Emanuel Derman, en.wikipedia.org, Eugene Fama: efficient market hypothesis, financial innovation, fixed income, full employment, George Akerlof, Gordon Gekko, hiring and firing, implied volatility, index fund, interest rate derivative, interest rate swap, John von Neumann, linear programming, Loma Prieta earthquake, Long Term Capital Management, margin call, market friction, market microstructure, martingale, merger arbitrage, Nick Leeson, P = NP, pattern recognition, pensions crisis, performance metric, prediction markets, profit maximization, purchasing power parity, quantitative trading / quantitative finance, QWERTY keyboard, RAND corporation, random walk, Ray Kurzweil, Richard Feynman, Richard Feynman, Richard Stallman, risk-adjusted returns, risk/return, shareholder value, Sharpe ratio, short selling, Silicon Valley, six sigma, sorting algorithm, statistical arbitrage, statistical model, stem cell, Steven Levy, stochastic process, systematic trading, technology bubble, The Great Moderation, the scientific method, too big to fail, trade route, transaction costs, transfer pricing, value at risk, volatility smile, Wiener process, yield curve, young professional

The Great Strategy Debate: From the 1990s to Today In parallel with the development of the derivatives market in the early 1990s, many traditional commercial banks were faced with a fundamental strategic issue: After watching the corporate loan market become commoditized due to intense competition and disintermediation in the capital markets, many commercial banks seriously considered changing their strategic focus. Some leaders such as Bankers Trust and JP Morgan underwent a fundamental transformation from a commercial bank to trading institutions. As with any transformation of this magnitude, the process was difficult and required strong commitment by senior management. Raroc models, used to make the risk-adjusted return from different businesses or loans directly comparable, were developed by these leading institutions in an effort to sharpen their strategies and build the commitment of senior management. In retrospect, the development of Raroc and its strategic impact have been self-reinforcing, leading the industry to look differently at the economics of credit businesses and the measurement of value creation within a financial services company.

As I developed my quantitative skills, I discovered more opportunities to apply them and came to know many others in the field who shared my appreciation of quantitative methods. 251 JWPR007-Lindsey 252 May 7, 2007 17:15 h ow i b e cam e a quant A Brief Chronology Upon graduation from college with a bachelor of science degree in economics and little exposure to quantitative methods aside from some introductory calculus and statistics, I accepted a position in the pension department at Equitable Life Assurance Society, then the third largest insurance company in the United States. My initial responsibilities involved performance calculations for pension funds—at this time, the state of the art in performance measurement was time-weighted rates of return. The notion of risk-adjusted returns had not yet gained traction at Equitable. Reasonably soon after my arrival at Equitable, I managed to land a job in the Investment Advisory Department, which managed the asset allocation of Equitable’s pension fund clients. This group determined how to allocate the funds across the various separate accounts that were invested in money market instruments, publicly traded bonds, direct placement bonds, large stocks, small stocks, and real estate.

Miller and Evan Schulman, “Money Illusion Revisited: Linking Inflation to Asset Return Correlations,” Journal of Portfolio Management (Spring 1999). 14. Ray A. LeClair and Evan Schulman, “Revenue Recognition Certificates: A New Security,” Financial Analysts Journal (July–August 2006). 15. F. Black, Exploring General Equilibrium (Cambridge, MA: MIT Press, 1995), p. 35. Chapter 6 1. Raroc is an acronym for risk-adjusted return on capital, a phrase that covers many different models for evaluating ex ante and ex post performance recognizing the risks undertaken. VaR is an acronym for value at risk, often defined as the maximum possible loss within a given confidence interval. For more information, see Wilson (98). JWPR007-Lindsey May 18, 2007 346 11:41 note s Chapter 7 1. The trick was so-called differentiating under the integral sign, here is the quote from Surely You Must be Joking: “. . . when guys at MIT or Princeton had trouble doing a certain integral, it was because they couldn’t do it with standard methods they had learned at school . . .

 

The Handbook of Personal Wealth Management by Reuvid, Jonathan.

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asset allocation, banking crisis, BRICs, collapse of Lehman Brothers, correlation coefficient, credit crunch, cross-subsidies, diversification, diversified portfolio, estate planning, financial deregulation, fixed income, high net worth, income per capita, index fund, interest rate swap, laissez-faire capitalism, land tenure, market bubble, merger arbitrage, new economy, Northern Rock, pattern recognition, Ponzi scheme, prediction markets, risk tolerance, risk-adjusted returns, risk/return, short selling, side project, sovereign wealth fund, statistical arbitrage, systematic trading, transaction costs, yield curve

A correlation of close to 0 is a sign that the two investments are actually acting independently of one another. This de-correlation should not be confused with a negative correlation; a correlation of up to –1 may arise when price movements behave almost in opposition. With this brief and fairly simplistic explanation, it is important to note that portfolios are generally directed at producing superior risk-adjusted returns when assets are de-correlated. It should therefore be the expectation of investors that their wealth managers put a high level of importance on such a characteristic.1 The utopian vision of portfolio blending does have its blips though. This decorrelated blend tends to hold in the longer term but not necessarily at shorter-term ឣ 18 PORTFOLIO INVESTMENT _________________________________________________ 1 Year Rolling Correlation Fixed Income to Equities 8 08 l-0 Ju 7 07 l-0 nJa Ju 6 06 l-0 nJa Ju 5 05 l-0 nJa Ju 4 04 l-0 nJa Ju 3 03 l-0 nJa Ju 2 02 l-0 nJa Ju 1 l-0 nJa Ju n- l-0 0 01 Average Correlation: 0.06 Ja Ja n- 00 1.00 0.90 0.80 0.70 0.60 0.50 0.40 0.30 0.20 0.10 0.00 -0.10 -0.20 -0.30 -0.40 -0.50 -0.60 -0.70 -0.80 -0.90 -1.00 Ju Correlation intervals.

Frequent review re-emphasizes the criticality of ongoing communication and information exchange, ensures that the portfolio does not steer too far off course, and checks that the investor’s goals for the portfolio have not changed. The second is the ability of the adviser to integrate portfolio solutions that can stabilize risk and return dynamics of the portfolio. ____________________________________________ PORTFOLIO RETURN BEHAVIOUR 19 ឣ Note that reviewing portfolio performance is not a substitute for the investment adviser who identifies solutions that will improve portfolio risk-adjusted returns. Despite the dynamism and inherent difficulties with identifying de-correlated strategies, a portfolio adviser should constantly be on the look out for new investment types or asset classes that may serve to improve the risk and return dynamic of the portfolio. Put simply, investors should want to ensure that they and their advisers have considered all options for improving their portfolios’ risk and return – both in the short term and over the length of the investment time horizon.

Perhaps this may create significant opportunities for some multi-strategy operations going forward. 2008 hedge fund review Hedge funds are often thought to be absolute return vehicles; however, the underlying assets in which they trade are often the same equities, bonds and commodities found in many long-only manager portfolios. Of course, the structure of the trades are often far removed from the more traditional fundamental buy-and-hold techniques found in their long-only peers’ portfolios. Given this characteristic, perhaps hedge funds should be viewed as ‘better risk adjusted returns’ rather than absolute returns; of course their stated mandate implicitly remains the production of positive returns in all market conditions. The year 2008 will go down in history as being one of the most important in the evolution of the hedge fund industry. The financial crisis has proved to be worse than many had feared and the financial and economic imbalances that have taken years to build up may take years to unwind.

 

pages: 584 words: 187,436

More Money Than God: Hedge Funds and the Making of a New Elite by Sebastian Mallaby

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Andrei Shleifer, Asian financial crisis, asset-backed security, automated trading system, bank run, barriers to entry, Benoit Mandelbrot, Berlin Wall, Bernie Madoff, Big bang: deregulation of the City of London, Bonfire of the Vanities, Bretton Woods, capital controls, Carmen Reinhart, collapse of Lehman Brothers, collateralized debt obligation, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, currency manipulation / currency intervention, currency peg, Elliott wave, Eugene Fama: efficient market hypothesis, failed state, Fall of the Berlin Wall, financial deregulation, financial innovation, financial intermediation, fixed income, full employment, German hyperinflation, High speed trading, index fund, Kenneth Rogoff, Long Term Capital Management, margin call, market bubble, market clearing, market fundamentalism, merger arbitrage, moral hazard, natural language processing, Network effects, new economy, Nikolai Kondratiev, pattern recognition, pre–internet, quantitative hedge fund, quantitative trading / quantitative finance, random walk, Renaissance Technologies, Richard Thaler, risk-adjusted returns, risk/return, rolodex, Sharpe ratio, short selling, Silicon Valley, South Sea Bubble, sovereign wealth fund, statistical arbitrage, statistical model, technology bubble, The Great Moderation, The Myth of the Rational Market, too big to fail, transaction costs

In a rough-and-ready way, his techniques anticipated the breakthroughs in financial academia of the 1950s and 1960s. IN 1952, THREE YEARS AFTER JONES HAD LAUNCHED HIS fund, modern portfolio theory was born with the publication of a short paper titled “Portfolio Selection.” The author was a twenty-five-year-old graduate student named Harry Markowitz, and his chief insights were twofold: The art of investment is not merely to maximize return but to maximize risk-adjusted return, and the amount of risk that an investor takes depends not just on the stocks he owns but on the correlations among them. Jones’s investment method crudely anticipated these points. By paying attention to the velocity of his stocks, Jones was effectively controlling risk, just as Markowitz advocated. Moreover, by balancing the volatility of his long and short positions, Jones was anticipating Markowitz’s insight that the risk of a portfolio depends on the relationship among its components.36 Jones’s approach was more practical than that of Markowitz.

They could work wonders for a large portfolio. And so, in the aftermath of the bond-market crisis of 1994, there were two verdicts on hedge funds. Regulators were forced to confront worrisome questions about the industry; but lacking a good theory of how to tame it, they ultimately chose to look the other way. Meanwhile, institutional investors reached a critical verdict: Notwithstanding the turmoil of 1994, hedge funds promised risk-adjusted returns that were simply irresistible. In a sense, the two verdicts were one. Because markets are not perfectly efficient, hedge funds and other creatures of the markets raise difficult issues: They are part of an unstable game that can wreak havoc on the world economy. But by the same token, the inefficiency of the markets allowed hedge funds to do well. Investors would line up to get into them. 9 SOROS VERSUS SOROS To create the mining city of Noril’sk, Stalin resorted to slavery.

But even if funds make every effort to report their results honestly, they cannot help but “smooth” them. A hedge fund may estimate the value of an illiquid asset every few weeks; if it rises 5 percent and then falls back within that period, it will be recorded simply as flat—with the result that some sharp volatility along the way is not acknowledged. As a result, hedge funds with illiquid assets are not as stable as their numbers suggest. Their risk-adjusted returns look wonderful because some of the risk goes unreported. But the biggest danger for buyers of illiquid assets is that, in a crisis, these assets will collapse the hardest. In moments of panic, investors crave securities that can be easily sold, and the rest are shunned ruthlessly. Long-Term Capital’s apparently diverse portfolio concealed a single bet that the world would be stable: When this proved wrong, apparently unrelated positions collapsed simultaneously because many of them boiled down to an attempt to harvest a premium for holding illiquid assets.

 

pages: 322 words: 77,341

I.O.U.: Why Everyone Owes Everyone and No One Can Pay by John Lanchester

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asset-backed security, bank run, banking crisis, Berlin Wall, Bernie Madoff, Big bang: deregulation of the City of London, Black-Scholes formula, Celtic Tiger, collateralized debt obligation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Daniel Kahneman / Amos Tversky, diversified portfolio, double entry bookkeeping, Exxon Valdez, Fall of the Berlin Wall, financial deregulation, financial innovation, fixed income, George Akerlof, greed is good, hindsight bias, housing crisis, Hyman Minsky, interest rate swap, invisible hand, Jane Jacobs, John Maynard Keynes: Economic Possibilities for our Grandchildren, laissez-faire capitalism, liquidity trap, Long Term Capital Management, loss aversion, Martin Wolf, mortgage debt, mortgage tax deduction, mutually assured destruction, new economy, Nick Leeson, Northern Rock, Own Your Own Home, Ponzi scheme, quantitative easing, reserve currency, risk-adjusted returns, Robert Shiller, Robert Shiller, Ronald Reagan, shareholder value, South Sea Bubble, statistical model, The Great Moderation, the payments system, too big to fail, tulip mania, value at risk

In his view, “successful people understand that risk, properly conceived, is often highly productive rather than something to avoid. They appreciate that risk is an advantage to be used rather than a pitfall to be skirted. Such people understand that taking calculated risks is quite different from being rash.”6 He put this into practice by encouraging Bankers Trust to develop a precisely quantified measure of risk, a system which became known as risk-adjusted return on capital, or RAROC. RAROC offered a numerical analysis of risk and added to it a measure of the impact of that risk on a business’s profitability; just as portfolio management provided a way of assessing and optimizing the risk of a set of share holdings, RAROC did the same for a company’s or bank’s range of businesses. In time, however, the industry came to prefer a newer model of risk, called value at risk, or VAR.

., 181, 184–92, 195, 199–200, 223–24, 227 Reykjavík, 10, 12, 170 risk, risks, 49–58, 66–76, 133–36, 141–67, 211–12, 219 AIG and, 75–76 assessment of, 46, 55–56, 74, 133, 135–36, 141–43, 145–67, 187–88, 191, 202, 205, 212, 216, 226 banks and, 19, 34–37, 41, 133, 135–36, 143, 150–54, 156–57, 160, 165–66, 174, 187–88, 191–95, 202, 204–7, 216, 224, 226, 228, 230 bonds and, 61–63, 103, 118, 144, 154, 208 derivatives and, 46–47, 49–52, 54–55, 57–58, 66–75, 78–80, 114–15, 117–22, 151, 153, 158–60, 163, 166–67, 184–85, 205, 212 desirability of, 144, 146, 150, 206–7 diversification and, 146–48 Greenspan and, 142–43, 164–66, 174, 184 hedging of, 49–50, 52, 58, 115, 205 historical data and, 163, 166 housing and, 88, 94–97, 112–13, 125, 129, 145, 158–60, 163–65 investing and, 5, 68, 70, 88, 103, 144, 146–53, 158, 165, 184, 190 leverage and, 35–36 LTCM and, 55–56 overconcentration of, 72–73 regulation and, 143, 153, 164, 187–88, 191, 195, 202, 204–5, 212, 224, 226 securitization and, 69–70, 163, 165 of stairs, 134–35 VAR and, 151–57, 162–63 risk-adjusted return on capital (RAROC), 150–51 Ritholtz, Barry, 219–20 Robinson, Phillip, 128–31 Rogers, Jim, 221 Royal Bank of Scotland (RBS), 34–36, 120, 227 bailout of, 32, 40, 204 Russia, 3, 15–16, 18, 53 bond default of, 55–56, 162, 164–65 Salomon Brothers, 63 Sanford, Charles, 150 Santander, 40 savings, 28, 86, 107, 177, 179, 187 savings and loan crisis, 73, 185, 220 Scholes, Myron, 45, 47–48, 54–55, 147 Securities and Exchange Commission (SEC), 195 credit ratings and, 209–10 regulation and, 153, 186, 189–92 securitization, 20, 22, 200 derivatives and, 69–70, 74, 113–14, 117–19, 122, 212 risk and, 69–70, 125, 163, 165, 212, 224 selling, sales, 34, 42, 104, 174, 203 of bonds, 59, 61–63, 144 derivatives and, 46–50, 52, 56, 65, 67–68, 73–74, 120 of equity, 58–59 of houses, 28–29, 71, 89–90 risk and, 151–52, 165, 224 Shiller, Robert, 106, 145n, 194 Simon, David, 83–84 Singapore exchange, 54 Skilling, Jeffrey, 106 small numbers, law of, 137 Sociét Générale, 51, 77 solvency, insolvency, 28–29 of banks, 36–38, 40–43, 64, 74–75, 120 Spain, 15, 40, 177, 214 contracting economy of, 222–23 housing in, 92, 110 special purpose vehicles (SPVs), 70, 120 stairs, deaths caused by, 134–35 Standard & Poor’s (S&P), 62, 114, 151, 209 statistics, 160–62 Stefánsdóttir, Rakel, 9–10, 12 stock market, stocks, 22, 54–55, 61, 76, 80, 101–11, 115, 226 bubbles and implosions in, 3, 42, 103–9, 142, 175–76 derivatives and, 50–52, 54 investing in, 59, 73, 101–7, 111, 146–52, 158, 175, 192 new-economy, 103 1929 crash of, 152, 199, 213 October 1987 crash of, 142, 151–52, 161–62, 164–65 prices of, 102, 105–6, 109–10, 147–51, 158, 174 structured investment vehicles (SIVs), 120 Summa de Arithmetica (Pacioli), 26 Summers, Lawrence, 43, 74, 188 Taleb, Nassim, 53, 155–56 Tax Reform Act of 1986 (TRA), 100 technology, 42, 104, 149, 155, 166 terrorism, 2, 12, 18, 107 Tett, Gillian, 121, 193 Thatcher, Margaret, 199, 217, 222 free-market capitalism and, 14, 21, 24 on housing, 87, 91, 98 regulation and, 21, 195–96 torture, end of ban on, 18 tranching, 117–18, 122 Treasury, British, 181–82 Treasury, U.S., 43, 54, 64, 74, 76–78 AIG bailout and, 76, 78 regulation and, 188–90 Treasury bills (T-bills), 29–30, 62, 103, 118, 144, 208 China’s investment in, 109, 176–77 Trichet, Jean-Claude, 92 Trillion Dollar Meltdown, The (Morris), 42 Troubled Assets Relief Program (TARP), 37, 189 Turner, Adair, 181 Tversky, Amos, 136–38, 141 UBS, 36, 120 uncertainty, 96 fair value theory and, 147–48 risk and, 55–56, 153, 163 United Kingdom, 9, 11–12, 18, 28–29, 61, 122–24, 134, 139, 194–202, 216–18 banking in, 5, 11, 32–36, 38–40, 51–54, 76–77, 89, 94, 120, 146, 180, 194–96, 199, 202, 204–6, 211–12, 217, 227–28 bill of, 220–22, 224 and City of London, 21–22, 32, 195–97, 200, 217–18 credit ratings and, 123–24, 209 derivatives and, 72, 200–201 financial vs. industrial interests in, 196–99 free-market capitalism in, 14–15, 21, 230 GDP of, 32, 214, 220 Goodwin’s pension and, 76–77 housing in, 38, 87–98, 110, 122, 177–78 interest rates in, 102, 177–80 personal debt in, 221–22 prosperity of, 214, 216 regulation in, 21–22, 105n, 180–82, 194–96, 199–201, 218 United Nations, 4 United States, 17–22, 34, 62–71, 120–31, 134n, 165, 199–201 AIG bailout and, 76–78 banks of, 36–37, 39–40, 43, 63–71, 73, 75, 77–78, 84, 116, 120–21, 127, 150, 152, 163, 183, 185, 190, 195, 204, 211–12, 219–20, 225, 227–28 bill of, 219–20 China’s investment in, 109, 176–77 credit and, 109, 123–24, 195, 208–9, 211 free-market capitalism in, 14–15, 230 housing in, 37, 82–86, 95, 97–101, 109–10, 114–15, 122, 125–31, 157–58, 163 interest rates in, 102, 107–8, 173–77 regulation in, 181, 184–92, 195, 199–200, 223–24, 227 urban desolation in, 81–86 value, values, 42, 74–75, 78–80, 103–4, 179, 181, 217–18, 220, 227 bonds and, 61, 103 derivatives and, 38, 48–49, 185, 201 housing and, 28–29, 71, 90, 92–95, 111, 176 investing and, 60–61, 104, 198 LTCM and, 55–56 notional, 38, 48–49, 80 value at risk (VAR), 151–57, 162–63 Vietnam War, 18, 220 Viniar, David, 163 volatility, 20, 158 risk and, 47–48, 148–50, 161 Volcker, Paul, 20 Waldrow, Mary, 127 Wall Street, 22, 53, 64, 129, 188 Washington Post, The, 18 wealth, 4, 10, 19–21, 64, 204, 206 financial industry’s ascent and, 20–21 in free-market capitalism, 15, 19, 230 housing and, 87, 90, 121 Keynes’s predictions on, 214–15 in West, 218–19 Weatherstone, Dennis, 152 Wells Fargo, 84, 127 Wessex Water, 105n West, 14–18, 43, 213, 231 conflict between Communist bloc and, 16–18 free-market capitalism in, 14–15, 17, 21, 23 wealth in, 218–19 wheat, 49n, 52 When Genius Failed (Lowenstein), 161 Williams, John Burr, 147 Wilson, Lashawn, 130–31 Wire, The, 83–84 World Bank, 58, 65, 69 * GDP, which will be mentioned quite a few times in this story, sounds complicated but isn’t: it’s nothing more than the value of all the goods and services produced in an economy.

 

pages: 280 words: 79,029

Smart Money: How High-Stakes Financial Innovation Is Reshaping Our WorldÑFor the Better by Andrew Palmer

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Affordable Care Act / Obamacare, algorithmic trading, Andrei Shleifer, asset-backed security, availability heuristic, bank run, banking crisis, Black-Scholes formula, bonus culture, Bretton Woods, call centre, Carmen Reinhart, cloud computing, collapse of Lehman Brothers, collateralized debt obligation, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Daniel Kahneman / Amos Tversky, David Graeber, diversification, diversified portfolio, Edmond Halley, Edward Glaeser, Eugene Fama: efficient market hypothesis, eurozone crisis, family office, financial deregulation, financial innovation, fixed income, Flash crash, Google Glasses, Gordon Gekko, high net worth, housing crisis, Hyman Minsky, implied volatility, income inequality, index fund, Innovator's Dilemma, interest rate swap, Kenneth Rogoff, Kickstarter, late fees, London Interbank Offered Rate, Long Term Capital Management, loss aversion, margin call, Mark Zuckerberg, McMansion, mortgage debt, mortgage tax deduction, Network effects, Northern Rock, obamacare, payday loans, peer-to-peer lending, Peter Thiel, principal–agent problem, profit maximization, quantitative trading / quantitative finance, railway mania, randomized controlled trial, Richard Feynman, Richard Feynman, Richard Thaler, risk tolerance, risk-adjusted returns, Robert Shiller, Robert Shiller, short selling, Silicon Valley, Silicon Valley startup, Skype, South Sea Bubble, sovereign wealth fund, statistical model, transaction costs, Tunguska event, unbanked and underbanked, underbanked, Vanguard fund, web application

As we have seen in the first chapter, the advantages of diversification have long been known—to Chinese merchants thousands of years ago and to Geneva bankers in the eighteenth century. But it was first captured in formal theory in 1952, when a twenty-five-year-old graduate student at the University of Chicago named Harry Markowitz published a paper called “Portfolio Selection.” The gist of Markowitz’s theory was that the return on an investment had to be weighed against the risk of its going awry and that these “risk-­adjusted” returns could be improved by diversifying. Putting all your money into the shares of a single firm might deliver a high return, but it exposes you to disaster if that firm goes broke. Better to spread your money across different bets, be they geographies, industries, or asset classes. Securitization is another take on this idea: by pulling a lot of different loans into a single investable security, the income stream it produces should become more stable.

., 32 Keys, Benjamin, 48 Kharroubi, Enisse, 79 Kickstarter, 172 King, Stephen, 99 Klein, David, 182 Krugman, Paul, xv Lahoud, Sal, 166 Lang, Luke, 153, 161–162 Laplanche, Renaud, 179, 184, 188, 190, 193–194, 196–197 Latency, 53 Law of large numbers, 17 Layering, 57 Left-digit bias, 46 Lehman Brothers, x, 44, 65 Lending direct, 84 marketplace, 184 payday, 200 relationship-based, 11, 151, 206–208 secured, xiv, 76 unsecured, 206 See also Loans; Peer-to-peer lending Lending Club, 172, 179–180, 182–184, 187, 189, 194–195, 197 Leonardo of Pisa (Fibonacci), 19 Lerner, Josh, 59 Lethal pandemic, risk-modeling for demographic profile, 230 exceedance-probability curve, 231–232, 232 figure 3 historical data, 228–229 infectiousness and virulence, 229–230 location of outbreak, 230–231 Leverage, 51, 70–71, 80, 186, 188 Leverage ratio, 76–77 Lewis, Michael, 57 Liber Abaci or Book of Calculation (Fibonacci), 19 LIBOR (London Interbank Offered Rate), 41 Liebman, Jeffrey, 98 Life expectancy government reaction to, 128–129 projections of, 124–127, 126 figure 2 ratio of young to older people, 127–128 Life-insurance policies, 142 Life-settlements industry, 142–143 Life table, 20 Limited liability, 212 Liquidity, 12–14, 39, 185–186 List, John, 109 The Little Book of Behavioral Investing (Montier), 156 Lo, Andrew, 113–115, 117–123 Loans low-documentation, 48–49 secured, 76 small business, 181, 216 student, 164, 166–167, 169–171, 182 syndicated, 41 Victory Loans, 28 See also Lending; Peer-to-Peer lending Logistic regression, 201 London, early fire insurance in, 16–17 London, Great Fire of, 16 London Interbank Offered Rate (LIBOR), 41 Long-Term Capital Management, 123 Longevity, betting on, 143–144 Loss aversion, 136 Lotteries, 212, 213 Low-documentation loans, 48–49 Lumni, 165, 168, 175 Lustgarten, Anders, 111 Lynn, Jeff, 160–161 Mack, John, 180 Mahwah, New Jersey, 52, 53 Marginal borrowers assessment of, 216–217 behavioral finance and, 208–214 industrialization of credit, 206 microfinance and, 203 savings schemes, 209–214 small businesses, 215–219 unsecured lending to, 206 Wonga, 203, 205, 208 Marginal borrowers (continued) ZestFinance, 199, 202, 205–206 Maritime piracy, solutions to, 151–152 Maritime trade, role of in history of finance, 3, 7–8, 14, 17, 23 Market makers, 15–16, 55 MarketInvoice, 195, 207, 217–218 Marketplace lending, 184 Markowitz, Harry, 118 Massachusetts, use of inflation-protected bonds in, 26 Massachusetts, use of social-impact bonds in, 98 Matching engine, 52 Maturity transformation, 12–13, 187–188, 193 McKinsey & Company, ix, 42 Mercator Advisory Group, 203 Merrill, Charles, 28 Merrill, Douglas, 199, 201 Merrill Lynch, 28 Merton, Robert, 31, 113–114, 123–124, 129–132, 142, 145 Mian, Atif, 204 Michigan, University of, financial survey by, 134–135 Microfinance, 203 Micropayment model, 217 Microwave technology, 53 The Million Adventure, 213–214 Minsky, Hyman, 42 Minsky moment, 42 Mississippi scheme, 36 Mitchell, Justin, 166–167 Momentum Ignition, 57 Monaco, modeling risk of earthquake in, 227 Money, history of, 4–5 Money illusion, 73–74 Money laundering, 192 Money-market funds, 43, 44 Monkeys, Yale University study of loss aversion with, 136 Montier, James, 156–157 Moody, John, 24 Moody’s, 24, 235 Moore’s law, 114 Morgan Stanley, 188 Mortgage-backed securities, 49, 233 Mortgage credit by ZIP code, study of, 204 Mortgage debt, role of in 2007–2008 crisis, 69–70 Mortgage products, unsound, 36–37 Mortgage securitization, 47 Multisystemic therapy, 96 Munnell, Alicia, 129 Naked credit-default swaps, 143 Nature Biotechnology, on drug-development megafunds, 118 “Neglected Risks, Financial Innovation and Financial Fragility” (Gennaioli, Shleifer, and Vishny), 42 Network effects, 181 New York, skyscraper craze in, 74–75 New York City, prisoner-rehabilitation program in, 108 New York Stock Exchange (NYSE), 31, 52, 53, 61, 64 New York Times, Merrill Lynch ad in, 28 Noncorrelated assets, 122 Nonprofits, growth of in United States, 105–106 Northern Rock, x NYMEX, 60 NYSE Euronext, 52 NYSE (New York Stock Exchange), 31, 52, 53, 61, 64 OECD (Organization for Economic Co-operation and Development), 128, 147 Oldfield, Sean, 67–68, 80–84 OnDeck, 216–218 One Service, 94–95, 105, 112 Operating expense ratio, 188–189 Options, 15, 124 Order-to-trade ratios, 63 Oregon, interest in income-share agreements, 172, 176 Organization for Economic Co-operation and Development (OECD), 128, 147 Overtrading, 24 Packard, Norman, 60 Pandit, Vikram, 184 Park, Sun Young, 233 Partnership mortgage, 81 Pasion, 11 Pave, 166–168, 173, 175, 182 Payday lending Consumer Financial Protection Bureau, survey on, 200 information on applicants, acquisition of, 202 underwriting of, 201 PayPal, 219 Peak child, 127 Peak risk, 228 Peer-to-peer lending advantages of, 187–189 auction system, 195 big investors in, 183 borrowers, assessment of, 197 in Britain, 181 commercial mortgages, 181 CommonBond, 182, 184, 197 consumer credit, 181 diversification, 196 explained, 180 Funding Circle, 181–182, 189, 197 investors in, 195 Lending Club, 179–180, 182–184, 187, 189, 194–195, 197 network effects, 181 ordinary savers and, 184 Prosper, 181, 187, 195 RateSetter, 181, 187, 196 Relendex, 181 risk management, 195–197 securitization, 183–184, 196 Peer-to-peer lending (continued) small business loans, 181 SoFi, 184 student loans, 182 Zopa, 181, 187, 188, 195 Pensions, cost of, 125–126 Perry, Rick, 142–143 Peterborough, England, social-impact bond pilot in, 90–92, 94–95, 104–105, 112 Petri, Tom, 172 Pharmaceuticals, decline of investment in, 114–115 Piracy Reporting Centre, International Maritime Bureau, 151 Polese, Kim, 210 Poor, Henry Varnum, 24 “Portfolio Selection” (Markowitz), 118 Prediction Company, 60–61 Preferred shares, 25 Prepaid cards, 203 Present value of cash flows, 19 Prime borrowers, 197 Prince, Chuck, 50–51, 62 Principal-agent problem, 8 Prisoner rehabilitation programs, 90–91, 94–95, 98, 108, 112 Private-equity firms, 69, 85, 91, 105, 107 Projection bias, 72–73 Property banking crises and, xiv, 69 banking mistakes involving, 75–80 behavioral biases and, 72–75 dangerous characteristics of, 70–72 fresh thinking, need for, xvii, 80 investors’ systematic errors in, 74–75 perception of as safe investment, 76, 80 Prosper, 181, 187, 195 Provisioning funds, 187 Put options, 9, 82 Quants, 19, 63, 113 QuickBooks, 218 Quote stuffing, 57 Raffray, André-François, 144 Railways, affect of on finance, 23–25 Randomized control trials (RCTs), 101 Raphoen, Christoffel, 15–16 Raphoen, Jan, 15–16 RateSetter, 181, 187, 196 RCTs (randomized control trials), 101 Ready for Zero, 210–211 Rectangularization, 125, 126 figure 2 Regulation NMS, 61 Reinhart, Carmen, 35 Reinsurance, 224 Relendex, 181 Rentes viagères, 20 Repurchase “repo” transactions, 15, 185 Research-backed obligations, 119 Reserve Primary Fund, 44 Retirement, funding for anchoring effect, 137–138 annuities, 139 auto-enrollment in pension schemes, 135 auto-escalation, 135–136 conventional funding, 127–128 decumulation, 138–139 government reaction to increased longevity, 128–129 home equity, 139–140 life expectancy, projections of, 124–127, 126 figure 2 life insurance policies, cash-surrender value of, 142 personal retirement savings, 128–129, 132–133 replacement rate, 125 reverse mortgage, 140–142 savings cues, experiment with, 137 SmartNest, 129–131 Reverse mortgages, 140–142 Risk-adjusted returns, 118 Risk appetite, 116 Risk assessment, 24, 45, 77–78, 208 Risk aversion, 116, 215 Risk-based capital, 77 Risk-based pricing model, 176 Risk management, 55, 117–118, 123, 195–197 Risk Management Solutions, 222 Risk sharing, 8, 82 Risk-transfer instrument, 226 Risk weights, 77–78 Rogoff, Kenneth, 35 “The Role of Government in Education” (Friedman), 165 Roman Empire business corporation in, 7 financial crisis in, 36 forerunners of banks in, 11 maritime insurance in, 8 Rotating Savings and Credit Associations (ROSCAs), 209–210 Roulette wheel, use of in experiment on anchoring, 138 Royal Bank of Scotland, 186 Rubio, Marco, 172 Russia, mortgage market in, 67 S-curve, in diffusion of innovations, 45 Salmon, Felix, 155 Samurai bonds, 27 Satsuma Rebellion (1877), 27 Sauter, George, 58 Save to Win, 214 Savings-and-loan crisis in US (1990s), 30 Savings cues, experiment with, 137 Scared Straight social program, 101 Scholes, Myron, 31, 123–124 Science, Technology, and Industry Scoreboard of OECD, 147 Securities and Exchange Commission (SEC), 54, 56, 57, 58, 64 Securities markets, 14 Securitization, xi, 20, 37–38, 117–122, 183–184, 196, 236 Seedrs, 160–161 Sellaband, 159 Shared equity, 80–84 Shared-equity mortgage, 84 Shepard, Chris, xii–xiii Shiller, Robert, xv–xvi, 242 Shleifer, Andrei, 42, 44 Short termism, 58 SIBs.

 

pages: 244 words: 79,044

Money Mavericks: Confessions of a Hedge Fund Manager by Lars Kroijer

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Bernie Madoff, capital asset pricing model, diversification, diversified portfolio, family office, fixed income, forensic accounting, Gordon Gekko, hiring and firing, implied volatility, index fund, Jeff Bezos, Just-in-time delivery, Long Term Capital Management, merger arbitrage, new economy, Ponzi scheme, risk-adjusted returns, risk/return, shareholder value, Silicon Valley, six sigma, statistical arbitrage, Vanguard fund, zero-coupon bond

As we took the short walk down the street to the aunt’s house, I tried to explain my rediscovered revelation about the multiple-fee structure and how it probably did not make sense for Mr and Mrs Straw, or even pension funds generally, to be invested in hedge funds, but Puk was oddly casual about it. ‘Don’t you think the rest of the world knows that finance guys are not worth what they are getting paid?’ she said with a smile, before continuing, ‘And are you and Holte not a part of the problem rather than the solution?’ I gave Puk the usual song and dance about uncorrelated risk-adjusted returns at Holte Capital, but her mind was already elsewhere. PART FOUR The fast road down 20 * * * Feeling grim Burnt out ‘A stroll after the close? There’s something I want to chat with you about.’ The email from Brian was nothing unusual. We would often go down to Grosvenor Square to have a chat in the fresh air, where the team wouldn’t see us. At that point we had been running Holte Capital together for four years, with me as the portfolio manager and Brian as the CFO.

I kept hammering home the point to our investors that most larger funds that have high return profiles do so with massive market exposures even if their illiquid portfolios allow them to avoid marking down securities in a down market and thus avoid showing their market exposure. At Holte Capital I felt our market exposure was much more limited, and the low correlation to the markets only made our risk-adjusted returns look even better. But again our investors said, ‘That all sounds very good, Lars, but your talk will not fatten my bank account – returns will.’ By 2007 we felt this was our time. We had been frustrated that our low-risk profile hindered our growth to become a mega-fund, but it was not easy to increase risk so dramatically in a short period of time, as our existing investors all had to be fully informed and on board, otherwise they might have felt they had bought a very low-volatility product and feel misled at it changing into a high-volatility one.

 

The Intelligent Asset Allocator: How to Build Your Portfolio to Maximize Returns and Minimize Risk by William J. Bernstein

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asset allocation, backtesting, capital asset pricing model, computer age, correlation coefficient, diversification, diversified portfolio, Eugene Fama: efficient market hypothesis, fixed income, index arbitrage, index fund, Long Term Capital Management, p-value, passive investing, prediction markets, random walk, Richard Thaler, risk tolerance, risk-adjusted returns, risk/return, South Sea Bubble, the scientific method, time value of money, transaction costs, Vanguard fund, Yogi Berra, zero-coupon bond

It takes years to become comfortable with this strategy; many lose their nerve and never see the thing through. You cannot pilot a modern jet fighter before mastering the trainer; likewise, you should not attempt dynamic asset allocation before mastering fixed asset allocation. In the 1995 version of this book, I provided an example of how changing the stock and bond allocation in the opposite direction of P/B produced a slight improvement in risk-adjusted return. Alas, this is no longer true, as a P/B sensitive investor would have completely exited the stock market by last year. However, for what it’s worth, Figure 7-10 is a graph of P/B versus five-year forward average return. Although there is some scatter, there is obviously a strong tendency for returns to be high with low starting P/Bs, and low with high P/Bs. The most remarkable aspect of this plot is that the lower boundary of the data points forms quite a straight line; this represents the minimum return which can be expected for a given P/B.

Cyclical stock: A security that is particularly sensitive to economic conditions, such as an aircraft or paper company (as opposed to a food or drug manufacturer, whose profits and sales are not sensitive to economic conditions). Discounted dividend model (DDM): A method of estimating the intrinsic value of a company or market by calculating the discounted value of its expected future dividends. The amount by which future 190 The Intelligent Asset Allocator dividends are reduced is called the discount rate ; it typically approximates the risk-adjusted return of the asset. Diversification: Allocating assets among investments with different risks, returns, and correlations in order to minimize nonsystematic risk. Efficient frontier: All of the possible portfolio combinations which maximize return for every possible level of expected risk or which minimize expected risk for every possible level of expected return. The mathematical technique for calculating these portfolios, called mean-variance analysis, was invented by Harry Markowitz.

 

pages: 264 words: 115,489

Take the money and run: sovereign wealth funds and the demise of American prosperity by Eric Curt Anderson

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asset allocation, banking crisis, Bretton Woods, business continuity plan, business intelligence, business process, collective bargaining, corporate governance, credit crunch, currency manipulation / currency intervention, currency peg, diversified portfolio, floating exchange rates, housing crisis, index fund, Kenneth Rogoff, open economy, passive investing, profit maximization, profit motive, random walk, reserve currency, risk tolerance, risk-adjusted returns, risk/return, Ronald Reagan, sovereign wealth fund, the market place, The Wealth of Nations by Adam Smith, too big to fail, Vanguard fund

As with domestic equity markets, Yale seeks to make the most of the situation by hiring managers with “bottom-up fundamental research capabilities” but also by allocating funds to these managers based on confidence in the individual and “the appropriate size for a particular strategy.”32 This is tailored investing at its best. Yale’s “private equity” asset class is marketed as “extremely attractive longterm risk-adjusted return.” This asset class is said to include participation with venture capitalists and “leveraged buy-out partnerships.” Given this build-up, it’s not surprising to find that the Endowment believes this asset class can be expected to generate real returns of 11.2%, but with a high risk of 27.7%. Nonetheless, Yale is clearly proud of its track record in private equity, reporting Investing Like a Sovereign Wealth Fund 73 that since inception this area of the portfolio has provided a 31.4% annualized return.33 The last asset class, “real assets,” is described as providing “attractive return prospects, excellent portfolio diversification, and a hedge against unanticipated inflation.”

On 12 March 2008, the government of Abu Dhabi—operator of the world’s largest sovereign wealth fund—sent a letter to Western financial officials spelling out the United Arab Emirates’ investment guidelines. According to the letter, “the Abu Dhabi Government has never and will never use its investments as a foreign policy tool.” Rather, Abu Dhabi’s “investment organizations have always sought solely to maximize risk-adjusted returns.”11 As evidence supporting this claim, Abu Dhabi declared 80% of the Abu Dhabi Investment Authority’s (ADIA) funds are managed by “outside firms” who provide access to “international financial expertise.” In addition to these broad statements clearly intended to assuage Western skeptics, the letter outlined nine principles said to guide Abu Dhabi’s capital investment organizations. As listed in the letter, these principles are: • To operate for the public good, generating long-term, attractive returns for the prosperity of the people of Abu Dhabi • To operate as strictly individual entities, making independent, commercially driven investment decisions • To follow meticulously all of the laws, regulations, and rules of the countries and exchanges in which investments are made • To meet all disclosure requirements of relevant government and regulatory bodies in countries in which they invest • To maximize risk-adjusted returns, relative to well-established market indices • To recruit and retain world-class financial professionals either as in-house or external managers • To invest with a long-term perspective • To invest in a well-diversified portfolio across asset classes, geographies, and sectors • To maintain appropriate standards of governance and accountability12 The letter closed by noting Abu Dhabi realized its investments “are good for the global economy—providing increased liquidity, injecting capital for growth, expanding market access, creating jobs, and encouraging a common interest and commitment to mutual prosperity.”13 Quite clearly, the authors had been reading through U.S.

As listed in the letter, these principles are: • To operate for the public good, generating long-term, attractive returns for the prosperity of the people of Abu Dhabi • To operate as strictly individual entities, making independent, commercially driven investment decisions • To follow meticulously all of the laws, regulations, and rules of the countries and exchanges in which investments are made • To meet all disclosure requirements of relevant government and regulatory bodies in countries in which they invest • To maximize risk-adjusted returns, relative to well-established market indices • To recruit and retain world-class financial professionals either as in-house or external managers • To invest with a long-term perspective • To invest in a well-diversified portfolio across asset classes, geographies, and sectors • To maintain appropriate standards of governance and accountability12 The letter closed by noting Abu Dhabi realized its investments “are good for the global economy—providing increased liquidity, injecting capital for growth, expanding market access, creating jobs, and encouraging a common interest and commitment to mutual prosperity.”13 Quite clearly, the authors had been reading through U.S.

 

pages: 467 words: 154,960

Trend Following: How Great Traders Make Millions in Up or Down Markets by Michael W. Covel

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Albert Einstein, asset allocation, Atul Gawande, backtesting, Bernie Madoff, Black Swan, buy low sell high, capital asset pricing model, Clayton Christensen, commodity trading advisor, correlation coefficient, Daniel Kahneman / Amos Tversky, delayed gratification, deliberate practice, diversification, diversified portfolio, Elliott wave, Emanuel Derman, Eugene Fama: efficient market hypothesis, fiat currency, fixed income, game design, hindsight bias, housing crisis, index fund, Isaac Newton, John Nash: game theory, linear programming, Long Term Capital Management, mandelbrot fractal, margin call, market bubble, market fundamentalism, market microstructure, mental accounting, Nash equilibrium, new economy, Nick Leeson, Ponzi scheme, prediction markets, random walk, Renaissance Technologies, Richard Feynman, Richard Feynman, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, shareholder value, Sharpe ratio, short selling, South Sea Bubble, Stephen Hawking, systematic trading, the scientific method, Thomas L Friedman, too big to fail, transaction costs, upwardly mobile, value at risk, Vanguard fund, volatility arbitrage, William of Occam

Campbell remained with his fund, which today is the oldest commodity fund still trading.67 However, it is unfair to refer to Campbell and Co. as a “commodity fund” because Campbell trades more than just commodities. Jim Little of Campbell and Co. makes this clear when he describes the widely diverse markets they trade, which include stocks: “We always are looking for non-correlated absolute return strategies that can produce higher quality risk adjusted returns; whether that is more managed futures strategy models or long/short equities or whatever. We have 30 years of experience doing long/short stock indexes, bond futures, and currencies; to do it in individual equities (stocks) isn’t that much different.” But, like John W. Henry, trading diverse markets doesn’t translate into complicated trading strategies. Campbell also believes in keeping it simple: “I’m very uncomfortable with black box trading where I’m dealing with algorithms I don’t understand.

That’s why 80 percent of mutual funds don’t beat the averages. Fear of Volatility and Confusion with Risk There are organizations that rank and track monthly performance numbers. One organization gives a “star ranking” (like Morningstar): “The quantitative rating system employed ranks and rates the performance of all commodity trading advisors (CTA)…Ratings are given in four categories: a) equity, b) performance, c) risk exposure, and d) risk-adjusted returns. In each category, the highest possible rating is five stars and the lowest possible rating is one star. The actual statistics on which the percentiles are based as follows: 1. Performance: Rate of Return 2. Risk: Standard Deviation 3. Risk Adjusted: Sharpe Ratio 4. Equity: Assets”5 The class of those who have the ability to think their own thoughts is separated by an unbridgeable gulf from the class of those who cannot.

The following illustrations highlight the significance of failure to adjust for dividends in high yielding stocks: 329 330 Trend Following (Updated Edition): Learn to Make Millions in Up or Down Markets The same error impacts exits (stops) in a similar manner. A casual glance at the first chart of Cousins Properties clearly shows significant volatility that is a function only of a corporate action, not of monetary losses. This “phantom” volatility can result in your exit price being breached when it otherwise would not have been, as well as negatively impacting risk-adjusted return metrics. A price chart supplied by the typical database or charting service often does not tell the whole story. Failure to adjust for cash dividends will result in an understatement of the profitability of owning dividend paying stocks. This error is a direct function of the dividend yield of the security in question; the higher the yield, the greater the error. Failure to adjust for cash dividends will also overstate the profitability of any short-selling strategies because the short seller (who must borrow shares to short) is responsible for compensating the actual owner of the shares for any dividends paid.

 

pages: 349 words: 134,041

Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives by Satyajit Das

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accounting loophole / creative accounting, Albert Einstein, Asian financial crisis, asset-backed security, Black Swan, Black-Scholes formula, Bretton Woods, BRICs, Brownian motion, business process, buy low sell high, call centre, capital asset pricing model, collateralized debt obligation, complexity theory, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, cuban missile crisis, currency peg, disintermediation, diversification, diversified portfolio, Eugene Fama: efficient market hypothesis, financial innovation, fixed income, Haight Ashbury, high net worth, implied volatility, index arbitrage, index card, index fund, interest rate derivative, interest rate swap, Isaac Newton, job satisfaction, locking in a profit, Long Term Capital Management, mandelbrot fractal, margin call, market bubble, Marshall McLuhan, mass affluent, merger arbitrage, Mexican peso crisis / tequila crisis, moral hazard, mutually assured destruction, new economy, New Journalism, Nick Leeson, offshore financial centre, oil shock, Parkinson's law, placebo effect, Ponzi scheme, purchasing power parity, quantitative trading / quantitative finance, random walk, regulatory arbitrage, risk-adjusted returns, risk/return, shareholder value, short selling, South Sea Bubble, statistical model, technology bubble, the medium is the message, time value of money, too big to fail, transaction costs, value at risk, Vanguard fund, volatility smile, yield curve, Yogi Berra, zero-coupon bond

Is it in credit risk, market risk, wherever? What return are we getting on each unit of capital? He thought this would be a sensible way to run the bank. It was, but the answers weren’t easy to get; the basic tools and information required were not readily available. The work took time, it spawned revolutionary risk management tools like RiskMetrics and CreditMetrics. BT was also creating similar tools such as RAROC (Risk Adjusted Return On Capital). DAS_C10.QXD 5/3/07 7:59 PM Page 269 9 C re d i t w h e re c re d i t i s d u e – f u n w i t h C D S a n d C D O 269 The answer, when it came back, was disturbing – the vast bulk of Morgan’s capital was tied up in credit risk. It was returning something in single figures. Given its target return was around 20%, there was a big problem. Morgan’s knew it couldn’t stop lending; the loans were the basis of its relationship with clients, the thin end of the wedge used to get more lucrative deals.

L Position title DAS_Z01.QXP 8/11/06 2:10 PM Page 314 Tr a d e r s , G u n s & M o n e y 314 Table E.1 Continued • You will be supported by a world-class risk management team (readily identifiable by their guide dogs) and operational staff and systems (specially chosen for their total ignorance). • There are excellent career prospects for advancement in this progressive organization. (We have sinecures for everybody who has failed to perform.) • Trading with the bank’s capital to achieve targeted risk adjusted returns on capital under the bank’s unique Economic Capital Allocation system. (If you are half as smart as you think you are then you will be able to game the system from day one. Everybody else has.) • Developing innovative trading strategies. (You need to be able to come up with hare-brained trading schemes based on the relationship between the El Nino cycle and market prices.) • Closely managing trading positions.

However, the text is different. 6 ‘What Worries Warren’ (3 March 2003) Fortune. 13_INDEX.QXD 17/2/06 4:44 pm Page 325 Index accounting rules 139, 221, 228, 257 Accounting Standards Board 33 accrual accounting 139 active fund management 111 actuaries 107–10, 205, 289 Advance Corporation Tax 242 agency business 123–4, 129 agency theory 117 airline profits 140–1 Alaska 319 Allen, Woody 20 Allied Irish Bank 143 Allied Lyons 98 alternative investment strategies 112, 308 American Express 291 analysts, role of 62–4 anchor effect 136 Anderson, Rolf 92–4 annuities 204–5 ANZ Bank 277 Aquinas, Thomas 137 arbitrage 33, 38–40, 99, 114, 137–8, 171–2, 245–8, 253–5, 290, 293–6 arbitration 307 Argentina 45 arithmophobia 177 ‘armpit theory’ 303 Armstrong World Industries 274 arrears assets 225 Ashanti Goldfields 97–8, 114 Asian financial crisis (1997) 4, 9, 44–5, 115, 144, 166, 172, 207, 235, 245, 252, 310, 319 asset consultants 115–17, 281 ‘asset growth’ strategy 255 asset swaps 230–2 assets under management (AUM) 113–4, 117 assignment of loans 267–8 AT&T 275 attribution of earnings 148 auditors 144 Australia 222–4, 254–5, 261–2 back office functions 65–6 back-to-back loans 35, 40 backwardation 96 Banca Popolare di Intra 298 Bank of America 298, 303 Bank of International Settlements 50–1, 281 Bank of Japan 220 Bankers’ Trust (BT) 59, 72, 101–2, 149, 217–18, 232, 268–71, 298, 301, 319 banking regulations 155, 159, 162, 164, 281, 286, 288 banking services 34; see also commercial banks; investment banks bankruptcy 276–7 Banque Paribas 37–8, 232 Barclays Bank 121–2, 297–8 13_INDEX.QXD 17/2/06 326 4:44 pm Page 326 Index Baring, Peter 151 Baring Brothers 51, 143, 151–2, 155 ‘Basel 2’ proposal 159 basis risk 28, 42, 274 Bear Stearns 173 bearer eurodollar collateralized securities (BECS) 231–3 ‘behavioural finance’ 136 Berkshire Hathaway 19 Bermudan options 205, 227 Bernstein, Peter 167 binomial option pricing model 196 Bismarck, Otto von 108 Black, Fischer 22, 42, 160, 185, 189–90, 193, 195, 197, 209, 215 Black–Scholes formula for option pricing 22, 185, 194–5 Black–Scholes–Merton model 160, 189–93, 196–7 ‘black swan’ hypothesis 130 Blair, Tony 223 Bogle, John 116 Bohr, Niels 122 Bond, Sir John 148 ‘bond floor’ concept 251–4 bonding 75–6, 168, 181 bonuses 146–51, 244, 262, 284–5 Brady Commission 203 brand awareness and brand equity 124, 236 Brazil 302 Bretton Woods system 33 bribery 80, 303 British Sky Broadcasting (BSB) 247–8 Brittain, Alfred 72 broad index secured trust offerings (BISTROs) 284–5 brokers 69, 309 Brown, Robert 161 bubbles 210, 310, 319 Buconero 299 Buffet, Warren 12, 19–20, 50, 110–11, 136, 173, 246, 316 business process reorganization 72 business risk 159 Business Week 130 buy-backs 249 ‘call’ options 25, 90, 99, 101, 131, 190, 196 callable bonds 227–9, 256 capital asset pricing model (CAPM) 111 capital flow 30 capital guarantees 257–8 capital structure arbitrage 296 Capote, Truman 87 carbon trading 320 ‘carry cost’ model 188 ‘carry’ trades 131–3, 171 cash accounting 139 catastrophe bonds 212, 320 caveat emptor principle 27, 272 Cayman Islands 233–4 Cazenove (company) 152 CDO2 292 Cemex 249–50 chaos theory 209, 312 Chase Manhattan Bank 143, 299 Chicago Board Options Exchange 195 Chicago Board of Trade (CBOT) 25–6, 34 chief risk officers 177 China 23–5, 276, 302–4 China Club, Hong Kong 318 Chinese walls 249, 261, 280 chrematophobia 177 Citibank and Citigroup 37–8, 43, 71, 79, 94, 134–5, 149, 174, 238–9 Citron, Robert 124–5, 212–17 client relationships 58–9 Clinton, Bill 223 Coats, Craig 168–9 collateral requirements 215–16 collateralized bond obligations (CBOs) 282 collateralized debt obligations (CDOs) 45, 282–99 13_INDEX.QXD 17/2/06 4:44 pm Page 327 Index collateralized fund obligations (CFOs) 292 collateralized loan obligations (CLOs) 283–5, 288 commercial banks 265–7 commoditization 236 commodity collateralized obligations (CCOs) 292 commodity prices 304 Commonwealth Bank of Australia 255 compliance officers 65 computer systems 54, 155, 197–8 concentration risk 271, 287 conferences with clients 59 confidence levels 164 confidentiality 226 Conseco 279–80 contagion crises 291 contango 96 contingent conversion convertibles (co-cos) 257 contingent payment convertibles (co-pays) 257 Continental Illinois 34 ‘convergence’ trading 170 convertible bonds 250–60 correlations 163–6, 294–5; see also default correlations corruption 303 CORVUS 297 Cox, John 196–7 credit cycle 291 credit default swaps (CDSs) 271–84, 293, 299 credit derivatives 129, 150, 265–72, 282, 295, 299–300 Credit Derivatives Market Practices Committee 273, 275, 280–1 credit models 294, 296 credit ratings 256–7, 270, 287–8, 297–8, 304 credit reserves 140 credit risk 158, 265–74, 281–95, 299 327 credit spreads 114, 172–5, 296 Credit Suisse 70, 106, 167 credit trading 293–5 CRH Capital 309 critical events 164–6 Croesus 137 cross-ruffing 142 cubic splines 189 currency options 98, 218, 319 custom repackaged asset vehicles (CRAVEs) 233 daily earning at risk (DEAR) concept 160 Daiwa Bank 142 Daiwa Europe 277 Danish Oil and Natural Gas 296 data scrubbing 142 dealers, work of 87–8, 124–8, 133, 167, 206, 229–37, 262, 295–6; see also traders ‘death swap’ strategy 110 decentralization 72 decision-making, scientific 182 default correlations 270–1 defaults 277–9, 287, 291, 293, 296, 299 DEFCON scale 156–7 ‘Delta 1’ options 243 delta hedging 42, 200 Deming, W.E. 98, 101 Denmark 38 deregulation, financial 34 derivatives trading 5–6, 12–14, 18–72, 79, 88–9, 99–115, 123–31, 139–41, 150, 153, 155, 175, 184–9, 206–8, 211–14, 217–19, 230, 233, 257, 262–3, 307, 316, 319–20; see also equity derivatives Derman, Emmanuel 185, 198–9 Deutsche Bank 70, 104, 150, 247–8, 274, 277 devaluations 80–1, 89, 203–4, 319 13_INDEX.QXD 17/2/06 4:44 pm Page 328 328 Index dilution of share capital 241 DINKs 313 Disney Corporation 91–8 diversification 72, 110–11, 166, 299 dividend yield 243 ‘Dr Evil’ trade 135 dollar premium 35 downsizing 73 Drexel Burnham Lambert (DBL) 282 dual currency bonds 220–3; see also reverse dual currency bonds earthquakes, bonds linked to 212 efficient markets hypothesis 22, 31, 111, 203 electronic trading 126–30, 134 ‘embeddos’ 218 emerging markets 3–4, 44, 115, 132–3, 142, 212, 226, 297 Enron 54, 142, 250, 298 enterprise risk management (ERM) 176 equity capital management 249 equity collateralized obligations (ECOs) 292 equity derivatives 241–2, 246–9, 257–62 equity index 137–8 equity investment, retail market in 258–9 equity investors’ risk 286–8 equity options 253–4 equity swaps 247–8 euro currency 171, 206, 237 European Bank for Reconstruction and Development 297 European currency units 93 European Union 247–8 Exchange Rate Mechanism, European 204 exchangeable bonds 260 expatriate postings 81–2 expert witnesses 310–12 extrapolation 189, 205 extreme value theory 166 fads of management science 72–4 ‘fairway bonds’ 225 Fama, Eugene 22, 111, 194 ‘fat tail’ events 163–4 Federal Accounting Standards Board 266 Federal Home Loans Bank 213 Federal National Mortgage Association 213 Federal Reserve Bank 20, 173 Federal Reserve Board 132 ‘Ferraris’ 232 financial engineering 228, 230, 233, 249–50, 262, 269 Financial Services Authority (FSA), Japan 106, 238 Financial Services Authority (FSA), UK 15, 135 firewalls 235–6 firing of staff 84–5 First Interstate Ltd 34–5 ‘flat’ organizations 72 ‘flat’ positions 159 floaters 231–2; see also inverse floaters ‘flow’ trading 60–1, 129 Ford Motors 282, 296 forecasting 135–6, 190 forward contracts 24–33, 90, 97, 124, 131, 188 fugu fish 239 fund management 109–17, 286, 300 futures see forward contracts Galbraith, John Kenneth 121 gamma risk 200–2, 294 Gauss, Carl Friedrich 160–2 General Motors 279, 296 General Reinsurance 20 geometric Brownian motion (GBM) 161 Ghana 98 Gibson Greeting Cards 44 Glass-Steagall Act 34 gold borrowings 132 13_INDEX.QXD 17/2/06 4:44 pm Page 329 Index gold sales 97, 137 Goldman Sachs 34, 71, 93, 150, 173, 185 ‘golfing holiday bonds’ 224 Greenspan, Alan 6, 9, 19–21, 29, 43, 47, 50, 53, 62, 132, 159, 170, 215, 223, 308 Greenwich NatWest 298 Gross, Bill 19 Guangdong International Trust and Investment Corporation (GITIC) 276–7 guaranteed annuity option (GAO) contracts 204–5 Gutenfreund, John 168–9 gyosei shido 106 Haghani, Victor 168 Hamanaka, Yasuo 142 Hamburgische Landesbank 297 Hammersmith and Fulham, London Borough of 66–7 ‘hara-kiri’ swaps 39 Hartley, L.P. 163 Hawkins, Greg 168 ‘heaven and hell’ bonds 218 hedge funds 44, 88–9, 113–14, 167, 170–5, 200–2, 206, 253–4, 262–3, 282, 292, 296, 300, 308–9 hedge ratio 264 hedging 24–8, 31, 38–42, 60, 87–100, 184, 195–200, 205–7, 214, 221, 229, 252, 269, 281, 293–4, 310 Heisenberg, Werner 122 ‘hell bonds’ 218 Herman, Clement (‘Crem’) 45–9, 77, 84, 309 Herodotus 137, 178 high net worth individuals (HNWIs) 237–8, 286 Hilibrand, Lawrence 168 Hill Samuel 231–2 329 The Hitchhiker’s Guide to the Galaxy 189 Homer, Sidney 184 Hong Kong 9, 303–4 ‘hot tubbing’ 311–12 HSBC Bank 148 HSH Nordbank 297–8 Hudson, Kevin 102 Hufschmid, Hans 77–8 IBM 36, 218, 260 ICI 34 Iguchi, Toshihude 142 incubators 309 independent valuation 142 indexed currency option notes (ICONs) 218 India 302 Indonesia 5, 9, 19, 26, 55, 80–2, 105, 146, 219–20, 252, 305 initial public offerings 33, 64, 261 inside information and insider trading 133, 241, 248–9 insurance companies 107–10, 117, 119, 150, 192–3, 204–5, 221, 223, 282, 286, 300; see also reinsurance companies insurance law 272 Intel 260 intellectual property in financial products 226 Intercontinental Hotels Group (IHG) 285–6 International Accounting Standards 33 International Securities Market Association 106 International Swap Dealers Association (ISDA) 273, 275, 279, 281 Internet stock and the Internet boom 64, 112, 259, 261, 310, 319 interpolation of interest rates 141–2, 189 inverse floaters 46–51, 213–16, 225, 232–3 13_INDEX.QXD 17/2/06 4:44 pm Page 330 330 Index investment banks 34–8, 62, 64, 67, 71, 127–8, 172, 198, 206, 216–17, 234, 265–7, 298, 309 investment managers 43–4 investment styles 111–14 irrational decisions 136 Italy 106–7 Ito’s Lemma 194 Japan 39, 43, 82–3, 92, 94, 98–9, 101, 106, 132, 142, 145–6, 157, 212, 217–25, 228, 269–70 Jensen, Michael 117 Jett, Joseph 143 JP Morgan (company) 72, 150, 152, 160, 162, 249–50, 268–9, 284–5, 299; see also Morgan Guaranty junk bonds 231, 279, 282, 291, 296–7 JWM Associates 175 Kahneman, Daniel 136 Kaplanis, Costas 174 Kassouf, Sheen 253 Kaufman, Henry 62 Kerkorian, Kirk 296 Keynes, J.M. 167, 175, 198 Keynesianism 5 Kidder Peabody 143 Kleinwort Benson 40 Korea 9, 226, 278 Kozeny, Viktor 121 Krasker, William 168 Kreiger, Andy 319 Kyoto Protocol 320 Lavin, Jack 102 law of large numbers 192 Leeson, Nick 51, 131, 143, 151 legal opinions 47, 219–20, 235, 273–4 Leibowitz, Martin 184 Leland, Hayne 42, 202 Lend Lease Corporation 261–2 leptokurtic conditions 163 leverage 31–2, 48–50, 54, 99, 102–3, 114, 131–2, 171–5, 213–14, 247, 270–3, 291, 295, 305, 308 Lewis, Kenneth 303 Lewis, Michael 77–8 life insurance 204–5 Lintner, John 111 liquidity options 175 liquidity risk 158, 173 litigation 297–8 Ljunggren, Bernt 38–40 London Inter-Bank Offered Rate (LIBOR) 6, 37 ‘long first coupon’ strategy 39 Long Term Capital Management (LTCM) 44, 51, 62, 77–8, 84, 114, 166–75, 187, 206, 210, 215–18, 263–4, 309–10 Long Term Credit Bank of Japan 94 LOR (company) 202 Louisiana Purchase 319 low exercise price options (LEPOs) 261 Maastricht Treaty and criteria 106–7 McLuhan, Marshall 134 McNamara, Robert 182 macro-economic indicators, derivatives linked to 319 Mahathir Mohammed 31 Malaysia 9 management consultants 72–3 Manchester United 152 mandatory convertibles 255 Marakanond, Rerngchai 302 margin calls 97–8, 175 ‘market neutral’ investment strategy 114 market risk 158, 173, 265 marketable eurodollar collateralized securities (MECS) 232 Markowitz, Harry 110 mark-to-market accounting 10, 100, 139–41, 145, 150, 174, 215–16, 228, 244, 266, 292, 295, 298 Marx, Groucho 24, 57, 67, 117, 308 13_INDEX.QXD 17/2/06 4:44 pm Page 331 Index mathematics applied to financial instruments 209–10; see also ‘quants’ matrix structures 72 Meckling, Herbert 117 Melamed, Leo 34, 211 merchant banks 38 Meriwether, John 167–9, 172–5 Merrill Lynch 124, 150, 217, 232 Merton, Robert 22, 42, 168–70, 175, 185, 189–90, 193–7, 210 Messier, Marie 247 Metallgesellschaft 95–7 Mexico 44 mezzanine finance 285–8, 291–7 MG Refining and Marketing 95–8, 114 Microsoft 53 Mill, Stuart 130 Miller, Merton 22, 101, 194 Milliken, Michael 282 Ministry of Finance, Japan 222 misogyny 75–7 mis-selling 238, 297–8 Mitchell, Edison 70 Mitchell & Butler 275–6 models financial 42–3, 141–2, 163–4, 173–5, 181–4, 189, 198–9, 205–10 of business processes 73–5 see also credit models Modest, David 168 momentum investment 111 monetization 260–1 monopolies in financial trading 124 moral hazard 151, 280, 291 Morgan Guaranty 37–8, 221, 232 Morgan Stanley 76, 150 mortgage-backed securities (MBSs) 282–3 Moscow, City of 277 moves of staff between firms 150, 244 Mozer, Paul 169 Mullins, David 168–70 multi-skilling 73 331 Mumbai 3 Murdoch, Rupert 247 Nabisco 220 Napoleon 113 NASDAQ index 64, 112 Nash, Ogden 306 National Australia Bank 144, 178 National Rifle Association 29 NatWest Bank 144–5, 198 Niederhoffer, Victor 130 ‘Nero’ 7, 31, 45–9, 60, 77, 82–3, 88–9, 110, 118–19, 125, 128, 292 NERVA 297 New Zealand 319 Newman, Frank 104 news, financial 133–4 News Corporation 247 Newton, Isaac 162, 210 Nippon Credit Bank 106, 271 Nixon, Richard 33 Nomura Securities 218 normal distribution 160–3, 193, 199 Northern Electric 248 O’Brien, John 202 Occam, William 188 off-balance sheet transactions 32–3, 99, 234, 273, 282 ‘offsites’ 74–5 oil prices 30, 33, 89–90, 95–7 ‘omitted variable’ bias 209–10 operational risk 158, 176 opinion shopping 47 options 9, 21–2, 25–6, 32, 42, 90, 98, 124, 197, 229 pricing 185, 189–98, 202 Orange County 16, 44, 50, 124–57, 212–17, 232–3 orphan subsidiaries 234 over-the-counter (OTC) market 26, 34, 53, 95, 124, 126 overvaluation 64 13_INDEX.QXD 17/2/06 4:44 pm Page 332 332 Index ‘overwhelming force’ strategy 134–5 Owen, Martin 145 ownership, ‘legal’ and ‘economic’ 247 parallel loans 35 pari-mutuel auction system 319 Parkinson’s Law 136 Parmalat 250, 298–9 Partnoy, Frank 87 pension funds 43, 108–10, 115, 204–5, 255 People’s Bank of China (PBOC) 276–7 Peters’ Principle 71 petrodollars 71 Pétrus (restaurant) 121 Philippines, the 9 phobophobia 177 Piga, Gustavo 106 PIMCO 19 Plaza Accord 38, 94, 99, 220 plutophobia 177 pollution quotas 320 ‘portable alpha’ strategy 115 portfolio insurance 112, 202–3, 294 power reverse dual currency (PRDC) bonds 226–30 PowerPoint 75 preferred exchangeable resettable listed shares (PERLS) 255 presentations of business models 75 to clients 57, 185 prime brokerage 309 Prince, Charles 238 privatization 205 privity of contract 273 Proctor & Gamble (P&G) 44, 101–4, 155, 298, 301 product disclosure statements (PDSs) 48–9 profit smoothing 140 ‘programme’ issuers 234–5 proprietary (‘prop’) trading 60, 62, 64, 130, 174, 254 publicly available information (PAI) 277 ‘puff’ effect 148 purchasing power parity theory 92 ‘put’ options 90, 131, 256 ‘quants’ 183–9, 198, 208, 294 Raabe, Matthew 217 Ramsay, Gordon 121 range notes 225 real estate 91, 219 regulatory arbitrage 33 reinsurance companies 288–9 ‘relative value’ trading 131, 170–1, 310 Reliance Insurance 91–2 repackaging (‘repack’) business 230–6, 282, 290 replication in option pricing 195–9, 202 dynamic 200 research provided to clients 58, 62–4, 184 reserves, use of 140 reset preference shares 254–7 restructuring of loans 279–81 retail equity products 258–9 reverse convertibles 258–9 reverse dual currency bonds 223–30 ‘revolver’ loans 284–5 risk, financial, types of 158 risk adjusted return on capital (RAROC) 268, 290 risk conservation principle 229–30 risk management 65, 153–79, 184, 187, 201, 267 risk models 163–4, 173–5 riskless portfolios 196–7 RJ Reynolds (company) 220–1 rogue traders 176, 313–16 Rosenfield, Eric 168 Ross, Stephen 196–7, 202 Roth, Don 38 Rothschild, Mayer Amshel 267 Royal Bank of Scotland 298 Rubinstein, Mark 42, 196–7 13_INDEX.QXD 17/2/06 4:44 pm Page 333 Index Rumsfeld, Donald 12, 134, 306 Rusnak, John 143 Russia 45, 80, 166, 172–3, 274, 302 sales staff 55–60, 64–5, 125, 129, 217 Salomon Brothers 20, 36, 54, 62, 167–9, 174, 184 Sandor, Richard 34 Sanford, Charles 72, 269 Sanford, Eugene 269 Schieffelin, Allison 76 Scholes, Myron 22, 42, 168–71, 175, 185, 189–90, 193–7, 263–4 Seagram Group 247 Securities and Exchange Commission, US 64, 304 Securities and Futures Authority, UK 249 securitization 282–90 ‘security design’ 254–7 self-regulation 155 sex discrimination 76 share options 250–1 Sharpe, William 111 short selling 30–1, 114 Singapore 9 single-tranche CDOs 293–4, 299 ‘Sisters of Perpetual Ecstasy’ 234 SITCOMs 313 Six Continents (6C) 275–6 ‘smile’ effect 145 ‘snake’ currency system 203 ‘softing’ arrangements 117 Solon 137 Soros, George 44, 130, 253, 318–19 South Sea Bubble 210 special purpose asset repackaging companies (SPARCs) 233 special purpose vehicles (SPVs) 231–4, 282–6, 290, 293 speculation 29–31, 42, 67, 87, 108, 130 ‘spinning’ 64 333 Spitzer, Eliot 64 spread 41, 103; see also credit spreads stack hedges 96 Stamenson, Michael 124–5 standard deviation 161, 193, 195, 199 Steinberg, Sol 91 stock market booms 258, 260 stock market crashes 42–3, 168, 203, 257, 259, 319 straddles or strangles 131 strategy in banking 70 stress testing 164–6 stripping of convertible bonds 253–4 structured investment products 44, 112, 115, 118, 128, 211–39, 298 structured note asset packages (SNAPs) 233 Stuart SC 18, 307, 316–18 Styblo Bleder, Tanya 153 Suharto, Thojib 81–2 Sumitomo Corporation 100, 142 Sun Tzu 61 Svensk Exportkredit (SEK) 38–9 swaps 5–10, 26, 35–40, 107, 188, 211; see also equity swaps ‘swaptions’ 205–6 Swiss Bank Corporation (SBC) 248–9 Swiss banks 108, 305 ‘Swiss cheese theory’ 176 synthetic securitization 284–5, 288–90 systemic risk 151 Takeover Panel 248–9 Taleb, Nassim 130, 136, 167 target redemption notes 225–6 tax and tax credits 171, 242–7, 260–3 Taylor, Frederick 98, 101 team-building exercises 76 team moves 149 technical analysis 60–1, 135 television programmes about money 53, 62–3 Thailand 9, 80, 302–5 13_INDEX.QXD 17/2/06 4:44 pm Page 334 334 Index Thatcher, Margaret 205 Thorp, Edward 253 tobashi trades 105–7 Tokyo Disneyland 92, 212 top managers 72–3 total return swaps 246–8, 269 tracking error 138 traders in financial products 59–65, 129–31, 135–6, 140, 148, 151, 168, 185–6, 198; see also dealers trading limits 42, 157, 201 trading rooms 53–4, 64, 68, 75–7, 184–7, 208 Trafalgar House 248 tranching 286–9, 292, 296 transparency 26, 117, 126, 129–30, 310 Treynor, Jack 111 trust investment enhanced return securities (TIERS) 216, 233 trust obligation participating securities (TOPS) 232 TXU Europe 279 UBS Global Asset Management 110, 150, 263–4, 274 uncertainty principle 122–3 unique selling propositions 118 unit trusts 109 university education 187 unspecified fund obligations (UFOs) 292 ‘upfronting’ of income 139, 151 Valéry, Paul 163 valuation 64, 142–6 value at risk (VAR) concept 160–7, 173 value investing 111 Vanguard 116 vanity bonds 230 variance 161 Vietnam War 182, 195 Virgin Islands 233–4 Vivendi 247–8 volatility of bond prices 197 of interest rates 144–5 of share prices 161–8, 172–5, 192–3, 199 Volcker, Paul 20, 33 ‘warehouses’ 40–2, 139 warrants arbitrage 99–101 weather, bonds linked to 212, 320 Weatherstone, Dennis 72, 268 Weil, Gotscal & Manges 298 Weill, Sandy 174 Westdeutsche Genosenschafts Zentralbank 143 Westminster Group 34–5 Westpac 261–2 Wheat, Allen 70, 72, 106, 167 Wojniflower, Albert 62 World Bank 4, 36, 38 World Food Programme 320 Worldcom 250, 298 Wriston, Walter 71 WTI (West Texas Intermediate) contracts 28–30 yield curves 103, 188–9, 213, 215 yield enhancement 112, 213, 269 ‘yield hogs’ 43 zaiteku 98–101, 104–5 zero coupon bonds 221–2, 257–8

 

pages: 524 words: 143,993

The Shifts and the Shocks: What We've Learned--And Have Still to Learn--From the Financial Crisis by Martin Wolf

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air freight, anti-communist, Asian financial crisis, asset allocation, asset-backed security, balance sheet recession, bank run, banking crisis, banks create money, Basel III, Ben Bernanke: helicopter money, Berlin Wall, Black Swan, bonus culture, Bretton Woods, call centre, capital asset pricing model, capital controls, Capital in the Twenty-First Century by Thomas Piketty, Carmen Reinhart, central bank independence, collateralized debt obligation, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency manipulation / currency intervention, currency peg, debt deflation, deglobalization, Deng Xiaoping, diversification, double entry bookkeeping, en.wikipedia.org, Erik Brynjolfsson, Eugene Fama: efficient market hypothesis, eurozone crisis, Fall of the Berlin Wall, fiat currency, financial deregulation, financial innovation, financial repression, floating exchange rates, forward guidance, Fractional reserve banking, full employment, global rebalancing, global reserve currency, Growth in a Time of Debt, Hyman Minsky, income inequality, inflation targeting, invisible hand, Joseph Schumpeter, Kenneth Rogoff, labour market flexibility, labour mobility, liquidationism / Banker’s doctrine / the Treasury view, liquidity trap, Long Term Capital Management, margin call, market bubble, market clearing, market fragmentation, Martin Wolf, Mexican peso crisis / tequila crisis, moral hazard, mortgage debt, new economy, North Sea oil, Northern Rock, open economy, paradox of thrift, price stability, private sector deleveraging, purchasing power parity, pushing on a string, quantitative easing, Real Time Gross Settlement, regulatory arbitrage, reserve currency, Richard Feynman, Richard Feynman, risk-adjusted returns, risk/return, road to serfdom, Robert Gordon, Robert Shiller, Robert Shiller, Ronald Reagan, savings glut, Second Machine Age, secular stagnation, shareholder value, short selling, sovereign wealth fund, special drawing rights, The Chicago School, The Great Moderation, The Market for Lemons, the market place, The Myth of the Rational Market, the payments system, The Wealth of Nations by Adam Smith, too big to fail, Tyler Cowen: Great Stagnation, very high income, winner-take-all economy

A seventh objection is that relying solely on leverage relative to total assets, rather than relative to risk-weighted assets, again risks arbitrage, with banks choosing riskier assets since they would not be penalized for doing so and might, in this way, hope to meet their return on equity targets. Peter Sands of Standard Chartered has made this argument.45 But shareholders should only be interested in their risk-adjusted returns. If taking on more risk does not raise risk-adjusted returns, shareholders should flee. If it does raise risk-adjusted returns, it should have happened anyway. Moreover, with substantially higher equity, banks could take on more risk safely. Finally, the disaster came from what banks wrongly thought to be safe. Risk-weighting is extremely unreliable, because the samples from which the weights are derived are always too small or irrelevant. A similar objection arises over regulatory arbitrage: with high levels of equity imposed on banks, risk would migrate elsewhere, as happened prior to the crisis of 2007–08.

 

pages: 302 words: 86,614

The Alpha Masters: Unlocking the Genius of the World's Top Hedge Funds by Maneet Ahuja, Myron Scholes, Mohamed El-Erian

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Asian financial crisis, asset allocation, asset-backed security, backtesting, Bernie Madoff, Bretton Woods, business process, call centre, collapse of Lehman Brothers, collateralized debt obligation, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, Donald Trump, en.wikipedia.org, family office, fixed income, high net worth, interest rate derivative, Isaac Newton, Long Term Capital Management, Mark Zuckerberg, merger arbitrage, NetJets, oil shock, pattern recognition, Ponzi scheme, quantitative easing, quantitative trading / quantitative finance, Renaissance Technologies, risk-adjusted returns, risk/return, rolodex, short selling, Silicon Valley, South Sea Bubble, statistical model, Steve Jobs, systematic trading

The Avenue team prides itself on its comprehensive approach and broad experience across a large number of distressed opportunities as well as cycles over the past 20-plus years. Understanding the fundamental value of companies in distress as well as the unique risks and opportunities of bankruptcy is a particular strength of Lasry’s investment team. As a result, the firm has captured outsized risk-adjusted returns in the distressed investing space. “You need to understand how a company’s going to operate in the bankruptcy process and how that’s going to affect its ongoing operations,” says Lasry. “You’ve got to mesh many different disciplines into one. That’s our edge. We have the expertise to understand those different disciplines better than others.” “What has made Buffett successful, what has made other people very, very good, is their ability to see things in the available data that others don’t see,” Lasry continues.

Although this is the ultimate goal of all hedge funds, most don’t control risk and take significant factor exposures. Bridgewater realized that by concentrating on alpha strategies, unconstrained management (i.e., no benchmark other than LIBOR), it could enhance investor returns and provide them with lower risk than by combining both alpha and beta strategies. Or, to put it differently, it is always possible to port an alpha-producing strategy to any factor exposure and provide superior risk-adjusted returns. The unconstrained alpha strategy produces abnormal returns; the beta strategies produce systematic returns. Ahuja is an energetic lady. That energy flows throughout the book. She has a great group of Masters who explain their craft, who they are, and how they think, through informative and stimulating interviews. I don’t know how she was able to assemble this amazing group (or even how she got me to write this afterword), but we are fortunate to have so many wonderful insights in one place. 1The classic example of efficiency gain is the farmer transferring the risk of his wheat crop to the miller who stores the crop until the bakers ask for the flour to make the bread and cakes that we consume.

 

pages: 354 words: 26,550

High-Frequency Trading: A Practical Guide to Algorithmic Strategies and Trading Systems by Irene Aldridge

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algorithmic trading, asset allocation, asset-backed security, automated trading system, backtesting, Black Swan, Brownian motion, business process, capital asset pricing model, centralized clearinghouse, collapse of Lehman Brothers, collateralized debt obligation, collective bargaining, diversification, equity premium, fault tolerance, financial intermediation, fixed income, high net worth, implied volatility, index arbitrage, interest rate swap, inventory management, law of one price, Long Term Capital Management, Louis Bachelier, margin call, market friction, market microstructure, martingale, New Journalism, p-value, paper trading, performance metric, profit motive, purchasing power parity, quantitative trading / quantitative finance, random walk, Renaissance Technologies, risk tolerance, risk-adjusted returns, risk/return, Sharpe ratio, short selling, Small Order Execution System, statistical arbitrage, statistical model, stochastic process, stochastic volatility, systematic trading, trade route, transaction costs, value at risk, yield curve

The maximum gain potential at every frequency is determined by the sum of all per-period ranges at that frequency. The gain potential in the high-frequency space is nothing short of remarkable, as is the maximum potential loss, which is equal to the negative maximum gain. Careful strategy design, extensive back testing, risk management, and implementation are needed to realize the high-frequency gain potential. The profitability of a trading strategy is often measured by Sharpe ratios, a risk-adjusted return metric first proposed by Sharpe (1966). As Table 7.2 shows, maximum Sharpe ratios increase with increases in trading frequencies. From March 11, 2009, through March 22, 2009, the maximum possible annualized Sharpe ratio for EUR/USD trading strategies with daily position rebalancing was 37.3, while EUR/USD trading strategies that held positions for 10 seconds could potentially score Sharpe ratios well over the 5,000 mark.

Journal of Financial Economics 39, 321–351. 318 REFERENCES Lyons, Richard K., 1996. “Optimal Transparency in a Dealer Market with an Application to Foreign Exchange.” Journal of Financial Intermediation 5, 225–254. Lyons, Richard K., 2001. The Microstructure Approach to Exchange Rates. MIT Press. MacKinlay, A.C., 1997. “Event Studies in Economics and Finance.” Journal of Economic Literature XXXV, 13–39. Mahdavi, M., 2004. “Risk-Adjusted Return When Returns Are Not Normally Distributed: Adjusted Sharpe Ratio.” Journal of Alternative Investments 6 (Spring), 47–57. Maki, A. and T. Sonoda, 2002. “A Solution to the Equity Premium and Riskfree Rate Puzzles: An Empirical Investigation Using Japanese Data.” Applied Financial Economics 12, 601–612. Markowitz, Harry M., 1952. “Portfolio Selection,” Journal of Finance 7 (1), 77–91. Markowitz, Harry, 1959.

 

The Smartest Investment Book You'll Ever Read: The Simple, Stress-Free Way to Reach Your Investment Goals by Daniel R. Solin

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asset allocation, corporate governance, diversification, diversified portfolio, index fund, market fundamentalism, passive investing, prediction markets, random walk, risk tolerance, risk-adjusted returns, risk/return, transaction costs, Vanguard fund

It is available at: http://ssrn .com/abstract::61698 1. T he weU-credentiailcd and highly respected authors of this study performed an analysis of the cost and performance of more than 4000 mutual funds sold by finan cial advisors and selected by investors from 1996 to 2002. Here is what they found: • Funds selected by fi nancial adviso rs significantly IIndtrptrfonntd those selected by investors on their own. The risk-adjusted returns were lowtr. • Funds selected by advisors were hightr cost than those selected by investors on their own. • Advisors did not provide superior asset allocation to their clients. 150 The Real Way Smart Investors Beat 95% of the ~Pros" • Advisors did not preveR[ their diems from pursumg illadvised investor behaviou r, like chasing performance. You have to ask yourself, given these fi ndings, why you would rely on these "investmenr professionals" for financial advice.

 

pages: 272 words: 19,172

Hedge Fund Market Wizards by Jack D. Schwager

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asset-backed security, backtesting, banking crisis, barriers to entry, Bernie Madoff, Black-Scholes formula, British Empire, Claude Shannon: information theory, cloud computing, collateralized debt obligation, commodity trading advisor, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, delta neutral, diversification, diversified portfolio, family office, financial independence, fixed income, Flash crash, hindsight bias, implied volatility, index fund, James Dyson, Long Term Capital Management, margin call, market bubble, market fundamentalism, merger arbitrage, oil shock, pattern recognition, pets.com, Ponzi scheme, private sector deleveraging, quantitative easing, quantitative trading / quantitative finance, risk tolerance, risk-adjusted returns, risk/return, riskless arbitrage, Sharpe ratio, short selling, statistical arbitrage, Steve Jobs, systematic trading, technology bubble, transaction costs, value at risk, yield curve

Do you feel the hedge fund industry is following the path of the mutual fund industry, which became equivalent to the market, or actually worse than the market once you take into account transaction costs? I believe the overall returns make hedge funds a less compelling investment than they once were. Where do you see the steady-state equilibrium for the hedge fund industry? It seems to me that the steady state would be when there is no excess risk-adjusted return in the hedge funds. Wouldn’t you expect there to be some excess return simply because hedge fund investors have to be compensated for accepting greater illiquidity? I agree with that. Where do you think we are now? Do hedge funds still have some premium in risk-adjusted returns versus other investments? My instincts are that they still have an edge, but not by very much. Do you still invest in hedge funds? I haven’t found new good ones to invest in for a while. If I did, though, I would happily invest. So you are still invested in ones from earlier days?

but rather the appropriate questions were “How inefficient is the market?” and “How can we exploit the inefficiencies?” The claim of market efficiency, which implies that no market edge is possible, is a hollow statement because you can’t prove a negative. But you can disprove market efficiency if there are people who have a demonstrable edge. There is a market inefficiency if there is a participant who can generate excess risk-adjusted returns that can be logically explained in a way that is difficult to rebut. Convertible arbitrage is a good example. You can lay out exactly how it works, why it works, and approximately how much return you expect to get. How would you summarize your philosophy of the markets after all these years? I think inefficiencies are there for the finding, but they are fairly hard to find. Do you think it has gotten harder to find inefficiencies, given the increased competition?

 

pages: 701 words: 199,010

The Crisis of Crowding: Quant Copycats, Ugly Models, and the New Crash Normal by Ludwig B. Chincarini

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affirmative action, asset-backed security, automated trading system, bank run, banking crisis, Basel III, Bernie Madoff, Black-Scholes formula, buttonwood tree, Carmen Reinhart, central bank independence, collapse of Lehman Brothers, collateralized debt obligation, collective bargaining, corporate governance, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, delta neutral, discounted cash flows, diversification, diversified portfolio, family office, financial innovation, financial intermediation, fixed income, Flash crash, full employment, Gini coefficient, high net worth, hindsight bias, housing crisis, implied volatility, income inequality, interest rate derivative, interest rate swap, labour mobility, liquidity trap, London Interbank Offered Rate, Long Term Capital Management, low skilled workers, margin call, market design, market fundamentalism, merger arbitrage, Mexican peso crisis / tequila crisis, moral hazard, mortgage debt, Northern Rock, Occupy movement, oil shock, price stability, quantitative easing, quantitative hedge fund, quantitative trading / quantitative finance, Ralph Waldo Emerson, regulatory arbitrage, Renaissance Technologies, risk tolerance, risk-adjusted returns, Robert Shiller, Robert Shiller, Ronald Reagan, Sharpe ratio, short selling, sovereign wealth fund, speech recognition, statistical arbitrage, statistical model, systematic trading, The Great Moderation, too big to fail, transaction costs, value at risk, yield curve, zero-coupon bond

TABLE 2.1 LTCM Returns versus Standard Asset Classes The Sharpe ratio is an important, risk-adjusted tool for comparing the performances of different investments or portfolio managers. The higher the ratio, the better the portfolio manager. (See Box 2.1.) Table 2.1 shows that, before 1998, the LTCM fund had a Sharpe ratio five times that of the standard returns of U.S. Treasury bills and bonds. Box 2.1 The Sharpe Ratio The Sharpe ratio measures the return of a portfolio minus the risk-free rate divided by the portfolio’s standard deviation. It is a risk-adjusted return measure that assists in comparing different portfolios or investments, even in the presence of leverage. If portfolio A has a higher Sharpe ratio than portfolio B, then there is no amount of leverage that can make portfolio B as good as A. Sometimes hedge fund returns are distributed non-normally. In these cases, a better measure is the Sortino ratio, which is similar to the Sharpe ratio but divides excess return by the semistandard deviation rather than the standard deviation.

Return distributions are assumed to be normal.2 Using these techniques, we could postulate how LTCM’s risk might have looked at any time before their 1998 collapse. Suppose LTCM had 50 trading strategies in its portfolio, with an average annual return of 6.70% and an average annual volatility of 2.33%. LTCM measured trade correlations at 0.1. This implies that the entire portfolio, without leverage, would have an expected return of 6.70% with an annual volatility of 0.33%. This hypothetical portfolio looked very attractive from a risk-adjusted return perspective, but LTCM altered the return-risk profile with leverage. Their leverage ratio at the beginning of 1998 was 28, which created a portfolio with an expected annual return of 35% and an annual volatility of 22%.3 A simple VaR calculation shows that, with a leverage ratio of 28, the portfolio’s maximum one-month loss would be $58 million. In 99 out of 100 months, the portfolio’s loss would not exceed $58 million.

securitization The act of taking several individual securities or loans and bunching them together and selling the whole pool as a security. shadow banking system The banking system that is performed by investment banks, insurance companies, and other types of companies that are in the business of some form of short-term borrowing and long-term lending. Sharpe ratio Measures the return of a portfolio minus the risk-free rate divided by the portfolio's standard deviation. It is a risk-adjusted return measure that assists in comparing different portfolios or investments, even in the presence of leverage. short the spread A short spread trade is positioned to profit if the spread narrows. For example, if swap yields are 10% and bond yields are 5%. A short spread trade profits when swap yields decrease relative to bond yields. slap hands The game, within the larger game of spoofing, where a trader places a limit order and removes it before the market can hit it.

 

pages: 416 words: 118,592

A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing by Burton G. Malkiel

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accounting loophole / creative accounting, Albert Einstein, asset allocation, asset-backed security, backtesting, Bernie Madoff, BRICs, capital asset pricing model, compound rate of return, correlation coefficient, Credit Default Swap, Daniel Kahneman / Amos Tversky, diversification, diversified portfolio, Elliott wave, Eugene Fama: efficient market hypothesis, experimental subject, feminist movement, financial innovation, fixed income, framing effect, hindsight bias, Home mortgage interest deduction, index fund, invisible hand, Isaac Newton, Long Term Capital Management, loss aversion, margin call, market bubble, mortgage tax deduction, new economy, Own Your Own Home, passive investing, pets.com, Ponzi scheme, price stability, profit maximization, publish or perish, purchasing power parity, RAND corporation, random walk, Richard Thaler, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, short selling, Silicon Valley, South Sea Bubble, The Myth of the Rational Market, The Wisdom of Crowds, transaction costs, Vanguard fund, zero-coupon bond

As a result, pricing irregularities and predictable patterns in stock returns can appear over time and even persist for short periods. But I suspect that the end result will not be an abandonment of the belief of many in the profession that the stock market is remarkably efficient in its utilization of information. The EMH’s basic underlying notion that there are obvious opportunities to earn excess risk-adjusted returns and that people will flock to exploit them until they disappear is as reasonable and commonsense as anything put forward by the EMH’s critics. Systematically beating the market remains really hard, and the EMH remains an extremely useful working hypothesis. If any $100 bills are lying around, they will not be there for long. Part Four A PRACTICAL GUIDE FOR RANDOM WALKERS AND OTHER INVESTORS 12 A FITNESS MANUAL FOR RANDOM WALKERS In investing money, the amount of interest you want should depend on whether you want to eat well or sleep well.

If the spread of news is unimpeded, prices will react quickly so that they reflect all that is known. This led me to predict in the 1981 edition that favorable discounts would not always be available. I wrote, “I would be very surprised to see the early-1980s levels of discounts perpetuate themselves indefinitely.” For the same reason, I am skeptical that simple popular rules such as “Buy low P/E stocks” or “Buy small company stocks” will perpetually produce unusually high risk-adjusted returns. And I am also skeptical that large discounts on some emerging-market funds will persist indefinitely. I have recounted the story of the finance professor and his students who spotted a $100 bill lying on the street. “If it was really a $100 bill,” the professor reasoned out loud, “someone would have already picked it up.” Fortunately, the students were skeptical, not only of Wall Street professionals but also of learned professors, and so they picked up the money.

 

pages: 483 words: 141,836

Red-Blooded Risk: The Secret History of Wall Street by Aaron Brown, Eric Kim

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Albert Einstein, algorithmic trading, Asian financial crisis, Atul Gawande, backtesting, Basel III, Benoit Mandelbrot, Bernie Madoff, Black Swan, capital asset pricing model, central bank independence, Checklist Manifesto, corporate governance, credit crunch, Credit Default Swap, disintermediation, distributed generation, diversification, diversified portfolio, Emanuel Derman, Eugene Fama: efficient market hypothesis, experimental subject, financial innovation, illegal immigration, implied volatility, index fund, Long Term Capital Management, loss aversion, margin call, market clearing, market fundamentalism, market microstructure, money: store of value / unit of account / medium of exchange, moral hazard, natural language processing, open economy, pre–internet, quantitative trading / quantitative finance, random walk, Richard Thaler, risk tolerance, risk-adjusted returns, risk/return, road to serfdom, Robert Shiller, Robert Shiller, shareholder value, Sharpe ratio, special drawing rights, statistical arbitrage, stochastic volatility, The Myth of the Rational Market, too big to fail, transaction costs, value at risk, yield curve

Next, academics turned to studying trading strategies that hadn’t been published. What if you bought every company after a good earnings announcement, or after a dividend increase, or after a new CEO came on board? What if you bought only small companies, or big companies, or companies in growing industries? Time after time it turned out that the market had priced things very precisely, so the average risk-adjusted return on these strategies was the same. However, it’s very important to understand that all of this evidence—by necessity—dealt with averaging large numbers of transactions over long periods of time. The market could look efficient in these tests and still have lots of individual transactions that were attractive—that a smart investor could discover and use to beat the market. No statistical test could prove that attractive opportunities don’t exist, a point that was well understood by efficient markets workers.

Sharpe Ratios and Wealth Returning to the old school, the two main branches found different kinds of market opportunities, distinguished by Sharpe ratio. We’re going to get a bit mathematical again, but you don’t need the numbers to follow the argument. The Sharpe ratio of a strategy is defined as the return of the strategy minus what you could make investing the same capital in risk-free instruments, divided by the standard deviation of the return. It is a measure of risk-adjusted return. A strategy with an annualized Sharpe ratio of 1 will make more than the risk-free rate about five years out of six. A strategy with an annualized Sharpe ratio of 2 will make more than the risk-free rate about 39 years out of 40. However, it’s hard to find Sharpe ratios near or above 1 in high-capacity, liquid strategies that are inexpensive to run. You don’t need a Sharpe ratio near or at 1 to get rich.

 

pages: 320 words: 33,385

Market Risk Analysis, Quantitative Methods in Finance by Carol Alexander

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asset allocation, backtesting, barriers to entry, Brownian motion, capital asset pricing model, constrained optimization, credit crunch, Credit Default Swap, discounted cash flows, discrete time, diversification, diversified portfolio, en.wikipedia.org, implied volatility, interest rate swap, market friction, market microstructure, p-value, performance metric, quantitative trading / quantitative finance, random walk, risk tolerance, risk-adjusted returns, risk/return, Sharpe ratio, statistical arbitrage, statistical model, stochastic process, stochastic volatility, transaction costs, value at risk, volatility smile, Wiener process, yield curve

Finally, the head of the desk will allocate limits to traders designed to maximize the (risk adjusted) return on capital. These allocations (e.g. the trading limits at the very end of the process) cannot be negative, which is the same in mathematical terms as the constraint that no short sales are allowed. And, just as a portfolio manager’s attitude to risk will influence his choice of optimal portfolio, the degree of risk aversion of the head of desk will determine the trading limits that are optimal and the board’s attitude to risk will determine their choice of allocation to global product lines. Even the performance of a trader, just like the performance of a portfolio or of a product line, can be compared in terms of risk-adjusted returns. In mathematical terms these problems are all equivalent. In this chapter we consider the allocation problem from the perspective of an asset manager, but the same principles apply to capital allocation in an investment bank or in any other large financial institution.

 

pages: 466 words: 127,728

The Death of Money: The Coming Collapse of the International Monetary System by James Rickards

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Affordable Care Act / Obamacare, Asian financial crisis, asset allocation, Ayatollah Khomeini, bank run, banking crisis, Ben Bernanke: helicopter money, bitcoin, Black Swan, Bretton Woods, BRICs, business climate, capital controls, Carmen Reinhart, central bank independence, centre right, collateralized debt obligation, collective bargaining, complexity theory, computer age, credit crunch, currency peg, David Graeber, debt deflation, Deng Xiaoping, diversification, Edward Snowden, eurozone crisis, fiat currency, financial innovation, financial intermediation, financial repression, Flash crash, floating exchange rates, forward guidance, George Akerlof, global reserve currency, global supply chain, Growth in a Time of Debt, income inequality, inflation targeting, invisible hand, jitney, Kenneth Rogoff, labor-force participation, labour mobility, Lao Tzu, liquidationism / Banker’s doctrine / the Treasury view, liquidity trap, Long Term Capital Management, mandelbrot fractal, margin call, market bubble, market clearing, market design, money: store of value / unit of account / medium of exchange, mutually assured destruction, obamacare, offshore financial centre, oil shale / tar sands, open economy, Plutocrats, plutocrats, Ponzi scheme, price stability, quantitative easing, RAND corporation, reserve currency, risk-adjusted returns, Rod Stewart played at Stephen Schwarzman birthday party, Ronald Reagan, Satoshi Nakamoto, Silicon Valley, Silicon Valley startup, Skype, sovereign wealth fund, special drawing rights, Stuxnet, The Market for Lemons, Thomas Kuhn: the structure of scientific revolutions, Thomas L Friedman, too big to fail, trade route, uranium enrichment, Washington Consensus, working-age population, yield curve

The centerpiece of the complex is the White House, a sprawling, multitiered, bleach-white International Style home with a large outdoor pool trimmed with the obligatory steel-post-and-Kevlar tenting reminiscent of the Denver Airport. I was there in the winter of 2003 for a private gathering of top financiers from the institutional, hedge fund, and private equity worlds to discuss the next big thing in alternative investing—a project to blend hedge fund and private equity strategies to optimize risk-adjusted returns. As typically happens at such gatherings, there was downtime for drinks and getting to know the other guests. During one such break, I chatted with the head of one of the largest institutional portfolios in the world. He asked me about my career, and I recounted my early days at Citibank on assignment in Karachi. That had been in the 1980s, not long after the shah of Iran had been deposed in the Iranian Revolution.

The challenge, of course, is being attentive to the indications and warnings and making a timely transition to one of the alternatives already mentioned. On the whole, a portfolio of 20 percent gold, 20 percent land, 10 percent fine art, 20 percent alternative funds, and 30 percent cash should offer an optimal combination of wealth preservation under conditions of inflation, deflation, and social unrest, while providing high risk-adjusted returns and reasonable liquidity. But no portfolio intended to achieve these goals works for the “buy-and-hold” investor. This portfolio must be actively managed. As indications and warnings become more pronounced, and as greater visibility is offered on certain outcomes, the portfolio must be modified in sensible ways. If gold reaches $9,000 per ounce, there may then come a time to sell gold and acquire more land.

 

Quantitative Trading: How to Build Your Own Algorithmic Trading Business by Ernie Chan

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algorithmic trading, asset allocation, automated trading system, backtesting, Black Swan, Brownian motion, business continuity plan, compound rate of return, Elliott wave, endowment effect, fixed income, general-purpose programming language, index fund, Long Term Capital Management, loss aversion, p-value, paper trading, price discovery process, quantitative hedge fund, quantitative trading / quantitative finance, random walk, Ray Kurzweil, Renaissance Technologies, risk-adjusted returns, Sharpe ratio, short selling, statistical arbitrage, statistical model, systematic trading, transaction costs

To profit from a quantitative trading business, it is essential to manage your risks in a way that limits your drawdowns to a tolerable level and yet be positioned to use optimal leverage of your equity to achieve maximum possible growth of your wealth. Furthermore, if you have more than one strategy, you will also need to find a way to optimally allocate capital among them so as to maximize overall risk-adjusted return. The optimal allocation of capital and the optimal leverage to use so as to strike the right balance between risk management and maximum growth is the focus of this chapter, and the central tool we use is called the Kelly formula. A OPTIMAL CAPITAL ALLOCATION AND LEVERAGE Suppose you plan to trade several strategies, each with their own expected returns and standard deviations. How should you allocate capital among them in an optimal way?

 

pages: 236 words: 77,735

Rigged Money: Beating Wall Street at Its Own Game by Lee Munson

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affirmative action, asset allocation, backtesting, barriers to entry, Bernie Madoff, Bretton Woods, buy low sell high, California gold rush, call centre, Credit Default Swap, diversification, diversified portfolio, estate planning, fiat currency, financial innovation, fixed income, Flash crash, follow your passion, German hyperinflation, High speed trading, housing crisis, index fund, joint-stock company, moral hazard, passive investing, Ponzi scheme, price discovery process, random walk, risk tolerance, risk-adjusted returns, risk/return, too big to fail, trade route, Vanguard fund, walking around money

The best opportunities involve the worst of the worst junk bonds, are illiquid, and end up as the hunting ground of the best hedge fund managers in the world. Not exactly the place for Main Street investors. Plus, the real trash is not available via your online broker. From a practical level, the cost of trading, minimum size, and research to do it right is highly specialized. Adding to the problem of incorporating junk bonds into a portfolio is the high correlation to equity markets with lower risk-adjusted returns. Over the past five years we can see a correlation to the S&P 500 of 0.63. This is not bad, and some would say if this was for an equity basket, it is better than the 0.9 correlation with the MSCI Emerging Markets Index. However, when you match that with raw annual volatility of 21 percent versus 25 percent for the S&P 500, you just don’t get a big enough bang for your buck to compensate for the risk.

 

pages: 192 words: 75,440

Getting a Job in Hedge Funds: An Inside Look at How Funds Hire by Adam Zoia, Aaron Finkel

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backtesting, barriers to entry, collateralized debt obligation, commodity trading advisor, Credit Default Swap, credit default swaps / collateralized debt obligations, discounted cash flows, family office, fixed income, high net worth, interest rate derivative, interest rate swap, Long Term Capital Management, merger arbitrage, offshore financial centre, random walk, Renaissance Technologies, risk-adjusted returns, rolodex, short selling, side project, statistical arbitrage, systematic trading, unpaid internship, value at risk, yield curve, yield management

We, of course, want you to be excited and will encourage you to pursue your dream job, yet we would be remiss if we didn’t caution that getting a job with a hedge fund is extremely difficult. There are simply many more people who want to work at hedge funds than there are openings. In that scenario, the hiring firms can afford to be very selective and bring on only those people who they believe have precisely what it takes to succeed. Although hedge funds differ significantly depending on their investment style, the goal of all of them is to produce superior risk-adjusted returns for their investors. To work at one, you should ideally be passionate about investing. At some funds, you may be able to get away with just being interested in investing, but it will not set you apart as much from other candidates. You need to be able to thrive in a pressure-packed environment and work as part of a close-knit group of highly skilled professionals in which the performance of each investment can be measured on a daily basis.

 

pages: 272 words: 64,626

Eat People: And Other Unapologetic Rules for Game-Changing Entrepreneurs by Andy Kessler

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23andMe, Andy Kessler, bank run, barriers to entry, Berlin Wall, British Empire, business process, California gold rush, carbon footprint, Cass Sunstein, cloud computing, collateralized debt obligation, collective bargaining, computer age, disintermediation, Eugene Fama: efficient market hypothesis, fiat currency, Firefox, Fractional reserve banking, George Gilder, Gordon Gekko, greed is good, income inequality, invisible hand, James Watt: steam engine, Jeff Bezos, job automation, Joseph Schumpeter, knowledge economy, knowledge worker, libertarian paternalism, low skilled workers, Mark Zuckerberg, McMansion, Netflix Prize, packet switching, personalized medicine, pets.com, prediction markets, pre–internet, profit motive, race to the bottom, Richard Thaler, risk tolerance, risk-adjusted returns, Silicon Valley, six sigma, Skype, social graph, Steve Jobs, The Wealth of Nations by Adam Smith, transcontinental railway, transfer pricing, Yogi Berra

Money for people, money for offices, money for computers, for labs, for bandwidth, for heat, for coffee and on and on. If you don’t have enough, you need to attract it, like my Net Net example raising capital and going public. But how? Fortunately, money sloshes around the globe seeking its highest return. To be a true Free Radical, be the highest return. Money goes wherever it damn pleases. Moving around the globe, pulsing through electronic networks and bank databases, seeking to maximize its risk-adjusted return. Maybe someone’s risk tolerance is low so they invest their money in U.S. Treasury Bills. So be it. Others (like me) think that teams of smart people inventing the future are actually less risky than big corporations that are or will soon be under attack from these entrepreneurs, so I invest in small companies and start-ups. That’s me and my money’s prerogative. Others are even more daring and invest in Estonia or the Congo or even Venezuela, places with potentially high returns but huge political or physical risks.

 

pages: 224 words: 13,238

Electronic and Algorithmic Trading Technology: The Complete Guide by Kendall Kim

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algorithmic trading, automated trading system, backtesting, corporate governance, Credit Default Swap, diversification, en.wikipedia.org, family office, financial innovation, fixed income, index arbitrage, index fund, interest rate swap, linked data, market fragmentation, natural language processing, quantitative trading / quantitative finance, random walk, risk tolerance, risk-adjusted returns, short selling, statistical arbitrage, Steven Levy, transaction costs, yield curve

Trade and portfolio analytics to model price and evaluate transactions and strategies . Access to securities lending markets to provide direct connectivity to lenders through securities lending networks . Risk management to run and monitor portfolio and aggregate risks . Performance reporting and risk attribution to compute performance records of each strategy, fund, and fund family and provide risk-adjusted return reports to investors independently from the fund administrator.3 14.4 The Impact of Increased Trading Automation Automation has led to an increase in both trades and market data, challenging the infrastructure at hedge funds and prime brokers. The TABB Group estimates that during peak cycles, top-tier prime brokers could be hit with close to 150 trades per second and more than 10 times as 3 Sungard, ‘‘The Emergence of Hedge Funds,’’ SungardWorld 3 no. 1, http://www.sungard.com/ company_info/v311623.pdf.

 

Everydata: The Misinformation Hidden in the Little Data You Consume Every Day by John H. Johnson

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Affordable Care Act / Obamacare, Black Swan, business intelligence, Carmen Reinhart, cognitive bias, correlation does not imply causation, Daniel Kahneman / Amos Tversky, Donald Trump, en.wikipedia.org, Kenneth Rogoff, labor-force participation, lake wobegon effect, Long Term Capital Management, Mercator projection, Mercator projection distort size, especially Greenland and Africa, meta analysis, meta-analysis, Nate Silver, obamacare, p-value, PageRank, pattern recognition, randomized controlled trial, risk-adjusted returns, Ronald Reagan, statistical model, The Signal and the Noise by Nate Silver, Tim Cook: Apple, wikimedia commons, Yogi Berra

As a Bloomberg Business headline noted, 221158 i-xiv 1-210 r4ga.indd  134 2/8/16  5:58:50 PM Predicting Disaster 135 “Hedge Funds Trail Stocks for Fifth Year with 7.4% Return.”32 This may be a classic case of cherry picking, however, as looking at other time periods produces very different ­results—​­including a Wall Street Journal article that noted, “Over the past 15 years, [hedge funds’] returns have beaten the overall stock market.”33 And, to be fair, outperforming the S&P 500 (a constantly changing list of approximately 500 stocks) in terms of nominal returns may not be the goal of all hedge funds, as Berger and others have noted. Rather, the ultimate objective is often to provide the best ­risk-​­adjusted ­returns—​­a measure that factors in the risk that was taken in order to achieve the returns. Although sometimes, the predictions are off. In one classic example, hedge fund ­Long-​­Term Capital Management (LTCM) “lost $4.4 billion of its $4.7 billion in capital” in less than one year, in part due to spreads that didn’t converge as predicted.34 Regardless of their performance, hedge funds sometimes get a bad rap because of the salaries that some hedge fund managers earn.

 

pages: 318 words: 77,223

The Only Game in Town: Central Banks, Instability, and Avoiding the Next Collapse by Mohamed A. El-Erian

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Airbnb, balance sheet recession, bank run, barriers to entry, Bretton Woods, British Empire, capital controls, Capital in the Twenty-First Century by Thomas Piketty, Carmen Reinhart, carried interest, collapse of Lehman Brothers, corporate governance, currency peg, Erik Brynjolfsson, eurozone crisis, financial innovation, Financial Instability Hypothesis, financial intermediation, financial repression, Flash crash, forward guidance, friendly fire, full employment, future of work, Hyman Minsky, If something cannot go on forever, it will stop, income inequality, inflation targeting, Jeff Bezos, Kenneth Rogoff, Khan Academy, liquidity trap, Martin Wolf, megacity, Mexican peso crisis / tequila crisis, moral hazard, mortgage debt, oil shale / tar sands, price stability, principal–agent problem, quantitative easing, risk tolerance, risk-adjusted returns, risk/return, Second Machine Age, secular stagnation, sharing economy, sovereign wealth fund, The Great Moderation, The Wisdom of Crowds, too big to fail, University of East Anglia, yield curve

Instead, take some of this positioning and barbell it into lower- and higher-risk exposures—namely, accumulating more cash and short-dated high-quality government bonds while investing a smaller part of it in less-trafficked areas that involve new opportunities (including new tech startups), directly sourced infrastructure, and the completion of markets in the emerging word. • When it comes to portfolio positioning in the more highly trodden segments of the markets, recognize that sector- and security-specific portfolio differentiation (or what is known as “alpha” in the marketplace) will likely be a better potential generator of risk-adjusted returns than market-wide positioning (“beta”); and if you are going to opt for beta anyway, have a look at the work done on getting smarter passive exposures by such thinkers as Rob Arnott, the CEO of Research Affiliates. Concurrently, investors will need to be more sensitive to specific events, including M&A opportunities and emerging firms using disruptive technologies. In turn, these considerations speak to four potentially more controversial views.

 

pages: 339 words: 109,331

The Clash of the Cultures by John C. Bogle

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asset allocation, collateralized debt obligation, corporate governance, corporate social responsibility, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, diversified portfolio, estate planning, Eugene Fama: efficient market hypothesis, financial innovation, financial intermediation, fixed income, Flash crash, Hyman Minsky, income inequality, index fund, interest rate swap, invention of the wheel, market bubble, market clearing, mortgage debt, new economy, Occupy movement, passive investing, Ponzi scheme, principal–agent problem, profit motive, random walk, rent-seeking, risk tolerance, risk-adjusted returns, Robert Shiller, Robert Shiller, shareholder value, short selling, South Sea Bubble, statistical arbitrage, The Wealth of Nations by Adam Smith, transaction costs, Vanguard fund, William of Occam

The combined expense/turnover cost ratio for the lowest-cost quartile is 0.96 percent, and for the highest-cost quartile 2.86 percent, a cost advantage of fully 1.90 percentage points per year. This cost gap helped drive an even larger 1.5 percentage-point advantage in annual performance—9.0 percent versus 7.5 percent (see Exhibit 5.2). Since the high-cost funds (annual standard deviation of 19.8 percent) have assumed about 30 percent more risk than the low-cost funds (standard deviation of 17.5 percent), the gap in risk-adjusted returns is even larger. Please do not underestimate the impact of what might seem moderate differences between returns and costs. Based on an actual investment of $10,000 20 years ago, a fund earning 9.0 percent over the past 20 years would have produced a profit of $46,000; at a 7.5 percent rate, the profit would be just $32,500—a 40 percent increase in capital appreciation. Whether we like it or not, the jury is in.

 

pages: 363 words: 107,817

Modernising Money: Why Our Monetary System Is Broken and How It Can Be Fixed by Andrew Jackson (economist), Ben Dyson (economist)

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bank run, banking crisis, banks create money, Basel III, Bretton Woods, call centre, capital controls, cashless society, central bank independence, credit crunch, David Graeber, debt deflation, double entry bookkeeping, eurozone crisis, financial innovation, Financial Instability Hypothesis, financial intermediation, floating exchange rates, Fractional reserve banking, full employment, Hyman Minsky, inflation targeting, informal economy, land reform, London Interbank Offered Rate, market bubble, market clearing, Martin Wolf, means of production, money: store of value / unit of account / medium of exchange, moral hazard, mortgage debt, Northern Rock, price stability, profit motive, quantitative easing, Real Time Gross Settlement, regulatory arbitrage, risk-adjusted returns, seigniorage, shareholder value, short selling, South Sea Bubble, The Great Moderation, the payments system, The Wealth of Nations by Adam Smith, too big to fail, total factor productivity, unorthodox policies

For example, in a situation where a bank had a profitable lending opportunity but no money in its Investment Pool it could seek to attract more funds by changing the interest rate it offers on its Investment Accounts.4 An increase in the offered rate would attract money into its Investment Accounts. Conversely interest rates could be lowered if the supply of funds outweighed demand from eligible and creditworthy borrowers. Banks could also seek to alter the funds in Investment Accounts through non-interest rate measures, such as altering any guarantees provided on the accounts. By doing so (e.g. by guaranteeing 90% of the value of an account rather than 80%) the bank alters the risk-adjusted return which – other things equal – will affect the attractiveness of the investment and the amount of funds put into such an Investment Account. If a bank did wish to attract money into Investment Accounts by raising interest rates, it would need to either increase the interest rates it charged on loans in order to maintain profits (the ‘spread’) or accept a lower margin. However, it is important to note that any increase in the interest rate banks charge on loans is limited in scope.

 

pages: 355 words: 92,571

Capitalism: Money, Morals and Markets by John Plender

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Andrei Shleifer, asset-backed security, bank run, Berlin Wall, Big bang: deregulation of the City of London, Black Swan, bonus culture, Bretton Woods, business climate, Capital in the Twenty-First Century by Thomas Piketty, central bank independence, collapse of Lehman Brothers, collective bargaining, computer age, Corn Laws, corporate governance, credit crunch, Credit Default Swap, David Ricardo: comparative advantage, deindustrialization, Deng Xiaoping, discovery of the americas, diversification, Eugene Fama: efficient market hypothesis, eurozone crisis, failed state, Fall of the Berlin Wall, fiat currency, financial innovation, financial intermediation, Fractional reserve banking, full employment, Gordon Gekko, greed is good, Hyman Minsky, income inequality, inflation targeting, invention of the wheel, invisible hand, Isaac Newton, James Watt: steam engine, Johann Wolfgang von Goethe, John Maynard Keynes: Economic Possibilities for our Grandchildren, joint-stock company, Joseph Schumpeter, labour market flexibility, London Interbank Offered Rate, London Whale, Long Term Capital Management, manufacturing employment, Mark Zuckerberg, market bubble, market fundamentalism, means of production, Menlo Park, moral hazard, moveable type in China, Nick Leeson, Northern Rock, Occupy movement, offshore financial centre, paradox of thrift, Plutocrats, plutocrats, price stability, principal–agent problem, profit motive, quantitative easing, railway mania, regulatory arbitrage, Richard Thaler, rising living standards, risk-adjusted returns, Robert Gordon, Robert Shiller, Robert Shiller, Ronald Reagan, savings glut, shareholder value, short selling, Silicon Valley, South Sea Bubble, spice trade, Steve Jobs, technology bubble, The Chicago School, The Great Moderation, the map is not the territory, The Wealth of Nations by Adam Smith, Thorstein Veblen, time value of money, too big to fail, tulip mania, Upton Sinclair, We are the 99%, Wolfgang Streeck

In periods when the return on capital is higher than the rate of economic growth, the resulting premium is the amount investors require to compensate for the risk of deviations from the norm that could destroy income and wealth. There can be no scientific guarantee that the return on capital will outstrip economic growth and at the time of writing there is widespread concern in capital markets that the risk-adjusted return on capital is below current rates of growth in the developed world. But should Piketty’s assertion turn out to be right, the already extreme levels of inequality in pre-tax income and wealth in much of the developed world would indeed become even more extreme. Hence his case for far higher marginal tax rates on high incomes and a progressive global wealth tax.199 If policymakers found his arguments persuasive, that would imply a return to the level of taxation reached in Western democracies in the 1970s – the high water mark in terms of redistribution.

 

pages: 353 words: 88,376

The Investopedia Guide to Wall Speak: The Terms You Need to Know to Talk Like Cramer, Think Like Soros, and Buy Like Buffett by Jack (edited By) Guinan

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Albert Einstein, asset allocation, asset-backed security, Brownian motion, business process, capital asset pricing model, clean water, collateralized debt obligation, correlation coefficient, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, discounted cash flows, diversification, diversified portfolio, dividend-yielding stocks, equity premium, fixed income, implied volatility, index fund, interest rate swap, inventory management, London Interbank Offered Rate, margin call, market fundamentalism, mortgage debt, passive investing, performance metric, risk tolerance, risk-adjusted returns, risk/return, shareholder value, Sharpe ratio, short selling, statistical model, time value of money, transaction costs, yield curve, zero-coupon bond

An R-squared of 100 means that all the movements of a security are explained completely by movements in the index. A high R-squared (between 85 and 100) indicates that the fund’s performance patterns have been in line with the index. A fund with a low R-squared (70 or less) does not move in lockstep with an index. A higher R-squared value indicates a more useful beta figure. For example, if a fund has an R-squared value close to 100 but has a beta below 1, it most likely is offering higher risk-adjusted returns. A low R-squared means that an investor should ignore the beta. Related Terms: • Alpha • Mutual Fund • Treasury Bill—T-Bill • Benchmark • Risk Run Rate What Does Run Rate Mean? (1) How the financial performance of a company would look if one extrapolated current results out over a certain period. (2) The average annual dilution from company stock option grants over the most recent three-year period recorded in the annual report.

 

pages: 338 words: 106,936

The Physics of Wall Street: A Brief History of Predicting the Unpredictable by James Owen Weatherall

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Albert Einstein, algorithmic trading, Antoine Gombaud: Chevalier de Méré, Asian financial crisis, bank run, Benoit Mandelbrot, Black Swan, Black-Scholes formula, Bonfire of the Vanities, Bretton Woods, Brownian motion, butterfly effect, capital asset pricing model, Carmen Reinhart, Claude Shannon: information theory, collateralized debt obligation, collective bargaining, dark matter, Edward Lorenz: Chaos theory, Emanuel Derman, Eugene Fama: efficient market hypothesis, financial innovation, George Akerlof, Gerolamo Cardano, Henri Poincaré, invisible hand, Isaac Newton, iterative process, John Nash: game theory, Kenneth Rogoff, Long Term Capital Management, Louis Bachelier, mandelbrot fractal, martingale, new economy, Paul Lévy, prediction markets, probability theory / Blaise Pascal / Pierre de Fermat, quantitative trading / quantitative finance, random walk, Renaissance Technologies, risk-adjusted returns, Robert Gordon, Robert Shiller, Robert Shiller, Ronald Coase, Sharpe ratio, short selling, Silicon Valley, South Sea Bubble, statistical arbitrage, statistical model, stochastic process, The Chicago School, The Myth of the Rational Market, tulip mania, V2 rocket, volatility smile

Here, though, the opposite is the case: on Wall Street, success breeds imitation, and the more firms there are implementing a strategy, the less profitable it is for anyone. There are some indications, however, that the Prediction Company has been wildly successful. As one former board member I spoke with pointed out, it is still an active subsidiary of UBS, after more than a decade. Another knowledgeable source told me that, over the firm’s first fifteen years, its risk-adjusted return was almost one hundred times larger than the S&P 500 return over the same period. Farmer stayed with the firm for about a decade before his passion for research lured him back to academia. He took a position at the Santa Fe Institute as a full-time researcher in 1999. Packard stayed with the company for a few more years, serving as CEO until 2003, when he left to start a new company, called ProtoLife.

 

pages: 502 words: 107,657

Predictive Analytics: The Power to Predict Who Will Click, Buy, Lie, or Die by Eric Siegel

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Albert Einstein, algorithmic trading, Amazon Mechanical Turk, Apple's 1984 Super Bowl advert, backtesting, Black Swan, book scanning, bounce rate, business intelligence, business process, call centre, computer age, conceptual framework, correlation does not imply causation, crowdsourcing, dark matter, data is the new oil, en.wikipedia.org, Erik Brynjolfsson, experimental subject, Google Glasses, happiness index / gross national happiness, job satisfaction, Johann Wolfgang von Goethe, Machine translation of "The spirit is willing, but the flesh is weak." to Russian and back, Moneyball by Michael Lewis explains big data, Nate Silver, natural language processing, Netflix Prize, Network effects, Norbert Wiener, personalized medicine, placebo effect, prediction markets, Ray Kurzweil, recommendation engine, risk-adjusted returns, Ronald Coase, Search for Extraterrestrial Intelligence, self-driving car, sentiment analysis, software as a service, speech recognition, statistical model, Steven Levy, text mining, the scientific method, The Signal and the Noise by Nate Silver, The Wisdom of Crowds, Turing test, Watson beat the top human players on Jeopardy!, X Prize, Yogi Berra

No question about it: All involved relished this fiesta, and the party raged on and on, continuing almost nine years, consistently outperforming the overall market all along. The system chugged, autonomously trading among a dozen market sectors such as technology, transportation, and healthcare. John says the system “beat the market each year and exhibited only two-thirds its standard deviation—a home run as measured by risk-adjusted return.” But all good things must come to an end, and, just as John had talked his client up, he later had to talk him down. After nearly a decade, the key measure of system integrity began to decline. John was adamant that they were running on fumes, so with little ceremony the entire fund was wound down. The system was halted in time, before catastrophe could strike. In the end, all the investors came out ahead.

 

pages: 1,042 words: 266,547

Security Analysis by Benjamin Graham, David Dodd

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asset-backed security, backtesting, barriers to entry, capital asset pricing model, carried interest, collateralized debt obligation, collective bargaining, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, diversified portfolio, fear of failure, financial innovation, fixed income, full employment, index fund, invisible hand, Joseph Schumpeter, locking in a profit, Long Term Capital Management, low cost carrier, moral hazard, mortgage debt, p-value, risk-adjusted returns, risk/return, secular stagnation, shareholder value, The Chicago School, the market place, the scientific method, The Wealth of Nations by Adam Smith, transaction costs, zero-coupon bond

Fueled by performance pressures and a growing expectation of low (and inadequate) returns from traditional equity and debt investments, institutional investors have sought high returns and diversification by allocating a growing portion of their endowments and pension funds to alternatives. Pioneering Portfolio Management, written in 2000 by David Swensen, the groundbreaking head of Yale’s Investment Office, makes a strong case for alternative investments. In it, Swensen points to the historically inefficient pricing of many asset classes,10 the historically high risk-adjusted returns of many alternative managers, and the limited performance correlation between alternatives and other asset classes. He highlights the importance of alternative manager selection by noting the large dispersion of returns achieved between top-quartile and third-quartile performers. A great many endowment managers have emulated Swensen, following him into a large commitment to alternative investments, almost certainly on worse terms and amidst a more competitive environment than when he entered the area.

If you don’t agree with that statement, try looking for the bonds that were rated AAA a few decades ago or mortgage-backed securities that went from AAA to junk status in 2007. In Security Analysis, the principle is developed and reiterated that “a high coupon rate is not adequate compensation for the assumption of substantial risk of principal.” (p. 125 on accompanying CD) This statement would seem to rule out investing in high yield bonds, which has been successfully pursued over the last 30 years with absolute and risk-adjusted returns well above those on investment-grade bonds. A more thorough reading, however, shows that securities that the authors say should not be purchased “on an investment basis” can still be considered “for speculation.” Nevertheless, today Graham and Dodd’s blanket statement certainly seems doctrinaire—especially in that it implements a distinction that has almost entirely ceased to exist. The statement that certain assets either are or aren’t appropriate for purchase on an investment basis is probably one of the dicta to which I reacted negatively 43 years ago.

 

pages: 374 words: 114,600

The Quants by Scott Patterson

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Albert Einstein, asset allocation, automated trading system, Benoit Mandelbrot, Bernie Madoff, Bernie Sanders, Black Swan, Black-Scholes formula, Bonfire of the Vanities, Brownian motion, buttonwood tree, buy low sell high, capital asset pricing model, centralized clearinghouse, Claude Shannon: information theory, cloud computing, collapse of Lehman Brothers, collateralized debt obligation, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, Donald Trump, Doomsday Clock, Emanuel Derman, Eugene Fama: efficient market hypothesis, fixed income, Gordon Gekko, greed is good, Haight Ashbury, index fund, invention of the telegraph, invisible hand, Isaac Newton, job automation, John Nash: game theory, law of one price, Long Term Capital Management, Louis Bachelier, mandelbrot fractal, margin call, merger arbitrage, NetJets, new economy, offshore financial centre, Paul Lévy, Ponzi scheme, quantitative hedge fund, quantitative trading / quantitative finance, race to the bottom, random walk, Renaissance Technologies, risk-adjusted returns, Rod Stewart played at Stephen Schwarzman birthday party, Ronald Reagan, Sergey Aleynikov, short selling, South Sea Bubble, speech recognition, statistical arbitrage, The Chicago School, The Great Moderation, The Predators' Ball, too big to fail, transaction costs, value at risk, volatility smile, yield curve, éminence grise

The Absolute Return Fund had lost more than half of its assets from its peak, dropping to about $1.5 billion from about $4 billion in mid-2007. AQR in total had about $7 billion in so-called alternative funds and about $13 billion in long-only funds, down sharply from the $40 billion it sat on heading into August 2007, when it was planning an IPO. In a little more than a year, AQR had lost nearly half its war chest. AQR’s poor performance shocked its investors. So-called absolute return funds were supposed to provide positive risk-adjusted returns in any kind of market—they were expected to zig when the market zagged. But Absolute Return seemed to follow the S&P 500 like a magnet. One reason behind the parallel tracks: in early 2008, AQR had made a big wager that U.S. stocks would rise. According to its value-centric models, large U.S. stocks were a bargain relative to a number of other assets, such as Treasury bonds and markets in other countries.

 

pages: 402 words: 110,972

Nerds on Wall Street: Math, Machines and Wired Markets by David J. Leinweber

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AI winter, algorithmic trading, asset allocation, banking crisis, barriers to entry, Big bang: deregulation of the City of London, butterfly effect, buttonwood tree, buy low sell high, capital asset pricing model, citizen journalism, collateralized debt obligation, corporate governance, Craig Reynolds: boids flock, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Danny Hillis, demand response, disintermediation, distributed generation, diversification, diversified portfolio, Emanuel Derman, en.wikipedia.org, experimental economics, financial innovation, Gordon Gekko, implied volatility, index arbitrage, index fund, information retrieval, Internet Archive, John Nash: game theory, Khan Academy, load shedding, Long Term Capital Management, Machine translation of "The spirit is willing, but the flesh is weak." to Russian and back, market fragmentation, market microstructure, Mars Rover, moral hazard, mutually assured destruction, natural language processing, Network effects, optical character recognition, paper trading, passive investing, pez dispenser, phenotype, prediction markets, quantitative hedge fund, quantitative trading / quantitative finance, QWERTY keyboard, RAND corporation, random walk, Ray Kurzweil, Renaissance Technologies, Richard Stallman, risk tolerance, risk-adjusted returns, risk/return, Ronald Reagan, semantic web, Sharpe ratio, short selling, Silicon Valley, Small Order Execution System, smart grid, smart meter, social web, South Sea Bubble, statistical arbitrage, statistical model, Steve Jobs, Steven Levy, Tacoma Narrows Bridge, the scientific method, The Wisdom of Crowds, time value of money, too big to fail, transaction costs, Turing machine, Upton Sinclair, value at risk, Vernor Vinge, yield curve, Yogi Berra

We use a variety of holdback samples, statistical and financial measures, and heuristics to identify what we consider promising models. The ability of the GA to incorporate these diverse elements (in contrast to simpler statistical tools) is part of its appeal in this context. • Risk and return. The obvious candidate for fitness in this context is financial return. This is used in most simple GA trading strategies, and certainly makes sense. In more complex strategies, there are other aspects to consider. Measures of risk-adjusted returns, such as the Sharpe ratio, are more appropriate. • Statistical fitness. In many contexts, the performance of an investment strategy will depend on multiple models working together; there may not even be a sensible measure of the return to a single model in a complex strategy using combined forecasts and portfolio optimization. In these situations, a statistical measure of the fitness of the model is appropriate.

 

pages: 431 words: 132,416

No One Would Listen: A True Financial Thriller by Harry Markopolos

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backtesting, barriers to entry, Bernie Madoff, call centre, centralized clearinghouse, correlation coefficient, diversified portfolio, Emanuel Derman, Eugene Fama: efficient market hypothesis, family office, fixed income, forensic accounting, high net worth, index card, Long Term Capital Management, Louis Bachelier, offshore financial centre, Ponzi scheme, price mechanism, quantitative trading / quantitative finance, regulatory arbitrage, Renaissance Technologies, risk-adjusted returns, risk/return, rolodex, Sharpe ratio, statistical arbitrage, too big to fail, transaction costs

It has reported losses of no more than 55 basis points in just four of the past 139 consecutive months, while generating highly consistent gross returns of slightly more than 1.5 percent a month and net annual returns roughly in the range of 15.0 percent. Among all the funds on the database in that same period, the Madoff/ Fairfield Sentry fund would place at number 16 if ranked by its absolute cumulative returns. Among 423 funds reporting returns over the last five years, most with less money and shorter track records, Fairfield Sentry would be ranked at 240 on an absolute return basis and come in number 10 if measured by risk-adjusted return as defined by its Sharpe ratio. What is striking to most observers is not so much the annual returns—which, though considered somewhat high for the strategy, could be attributed to the firm’s market making and trade execution capabilities—but the ability to provide such smooth returns with so little volatility. The best known entity using a similar strategy, a publicly traded mutual fund dating from 1978 called Gateway, has experienced far greater volatility and lower returns during the same period.

 

pages: 320 words: 87,853

The Black Box Society: The Secret Algorithms That Control Money and Information by Frank Pasquale

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Affordable Care Act / Obamacare, algorithmic trading, Amazon Mechanical Turk, asset-backed security, Atul Gawande, bank run, barriers to entry, Berlin Wall, Bernie Madoff, Black Swan, bonus culture, Brian Krebs, call centre, Capital in the Twenty-First Century by Thomas Piketty, Chelsea Manning, cloud computing, collateralized debt obligation, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, crowdsourcing, cryptocurrency, Debian, don't be evil, Edward Snowden, en.wikipedia.org, Fall of the Berlin Wall, Filter Bubble, financial innovation, Flash crash, full employment, Goldman Sachs: Vampire Squid, Google Earth, Hernando de Soto, High speed trading, hiring and firing, housing crisis, informal economy, information retrieval, interest rate swap, Internet of things, invisible hand, Jaron Lanier, Jeff Bezos, job automation, Julian Assange, Kevin Kelly, knowledge worker, Kodak vs Instagram, kremlinology, late fees, London Interbank Offered Rate, London Whale, Mark Zuckerberg, mobile money, moral hazard, new economy, Nicholas Carr, offshore financial centre, PageRank, pattern recognition, precariat, profit maximization, profit motive, quantitative easing, race to the bottom, recommendation engine, regulatory arbitrage, risk-adjusted returns, search engine result page, shareholder value, Silicon Valley, Snapchat, Spread Networks laid a new fibre optics cable between New York and Chicago, statistical arbitrage, statistical model, Steven Levy, the scientific method, too big to fail, transaction costs, two-sided market, universal basic income, Upton Sinclair, value at risk, WikiLeaks

The Citizens United decision is an open invitation to tech firms to escalate the prices they charge for audiences, as billionaire donors are eager to foot the bill. Recall again Vaidhyanathan’s title, The Googlization of Everything. For Big Data buffs, “Googlization” is ultimately a hopeful process: systematic use of analytics to squeeze maximum effectiveness out of any decision; maximum relevance from any search; THE HIDDEN LOGICS OF SEARCH 97 maximum risk-adjusted return from any investment. To paraphrase Jeff Jarvis, today’s businesses should ask themselves, “What would Google do?” But the answer to that question is all too clear: use their data to outflank competitors and extract maximum profits from their customers.210 “Googlization” has an even darker meaning, too: that whole industries stand to be taken over by Google itself.211 Walmart (Walmart!) has said that it considers Google one of its most formidable competitors.

 

pages: 497 words: 150,205

European Spring: Why Our Economies and Politics Are in a Mess - and How to Put Them Right by Philippe Legrain

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3D printing, Airbnb, Asian financial crisis, bank run, banking crisis, barriers to entry, Basel III, battle of ideas, Berlin Wall, Big bang: deregulation of the City of London, Bretton Woods, BRICs, British Empire, business process, capital controls, Capital in the Twenty-First Century by Thomas Piketty, Carmen Reinhart, Celtic Tiger, central bank independence, centre right, cleantech, collaborative consumption, collapse of Lehman Brothers, collective bargaining, corporate governance, credit crunch, Credit Default Swap, crony capitalism, currency manipulation / currency intervention, currency peg, debt deflation, Diane Coyle, Downton Abbey, Edward Glaeser, Elon Musk, en.wikipedia.org, energy transition, eurozone crisis, fear of failure, financial deregulation, first-past-the-post, forward guidance, full employment, Gini coefficient, global supply chain, Growth in a Time of Debt, hiring and firing, hydraulic fracturing, Hyman Minsky, Hyperloop, immigration reform, income inequality, interest rate derivative, Irish property bubble, James Dyson, Jane Jacobs, job satisfaction, Joseph Schumpeter, Kenneth Rogoff, labour market flexibility, labour mobility, liquidity trap, margin call, Martin Wolf, mittelstand, moral hazard, mortgage debt, mortgage tax deduction, North Sea oil, Northern Rock, offshore financial centre, oil shale / tar sands, oil shock, open economy, price stability, private sector deleveraging, pushing on a string, quantitative easing, Richard Florida, rising living standards, risk-adjusted returns, Robert Gordon, savings glut, school vouchers, self-driving car, sharing economy, Silicon Valley, Silicon Valley startup, Skype, smart grid, smart meter, software patent, sovereign wealth fund, Steve Jobs, The Death and Life of Great American Cities, The Wealth of Nations by Adam Smith, too big to fail, total factor productivity, Tyler Cowen: Great Stagnation, working-age population, Zipcar

Estimates of the boost to trade vary; perhaps the most authoritative study, by Richard Baldwin and others, reckons the euro increased it by 5 per cent between 1999 and 2006.112 The euro has also stimulated cross-border business investment, notably in manufacturing, enabling firms to merge and restructure their activities across national lines, while also attracting increased investment from outside the eurozone. Studies agree that the euro has boosted foreign direct investment (but differ as to how much).113 No doubt the euro has also generated some other positive financial flows across the eurozone, allowing investors to diversify their portfolios and earn higher risk-adjusted returns, particularly on equity investments. But because the euro’s launch coincided with the biggest financial bubble in history across the Western financial system, those positive flows were swamped by misdirected cross-border bank lending. And when European banks came unstuck, it turned out that they were still national after all. Sharing the euro has also protected its members against damaging exchange-rate instability, notably in 2008 and 2009, as the chapter will explain.

 

pages: 545 words: 137,789

How Markets Fail: The Logic of Economic Calamities by John Cassidy

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Albert Einstein, Andrei Shleifer, anti-communist, asset allocation, asset-backed security, availability heuristic, bank run, banking crisis, Benoit Mandelbrot, Berlin Wall, Bernie Madoff, Black-Scholes formula, Bretton Woods, British Empire, capital asset pricing model, centralized clearinghouse, collateralized debt obligation, Columbine, conceptual framework, Corn Laws, correlation coefficient, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, Daniel Kahneman / Amos Tversky, debt deflation, diversification, Elliott wave, Eugene Fama: efficient market hypothesis, financial deregulation, financial innovation, Financial Instability Hypothesis, financial intermediation, full employment, George Akerlof, global supply chain, Haight Ashbury, hiring and firing, Hyman Minsky, income per capita, incomplete markets, index fund, invisible hand, John Nash: game theory, John von Neumann, Joseph Schumpeter, laissez-faire capitalism, liquidity trap, London Interbank Offered Rate, Long Term Capital Management, Louis Bachelier, mandelbrot fractal, margin call, market bubble, market clearing, mental accounting, Mikhail Gorbachev, Mont Pelerin Society, moral hazard, mortgage debt, Naomi Klein, Network effects, Nick Leeson, Northern Rock, paradox of thrift, Ponzi scheme, price discrimination, price stability, principal–agent problem, profit maximization, quantitative trading / quantitative finance, race to the bottom, Ralph Nader, RAND corporation, random walk, Renaissance Technologies, rent control, Richard Thaler, risk tolerance, risk-adjusted returns, road to serfdom, Robert Shiller, Robert Shiller, Ronald Coase, Ronald Reagan, shareholder value, short selling, Silicon Valley, South Sea Bubble, sovereign wealth fund, statistical model, technology bubble, The Chicago School, The Great Moderation, The Market for Lemons, The Wealth of Nations by Adam Smith, too big to fail, transaction costs, unorthodox policies, value at risk, Vanguard fund

Another way to characterize such arrangements is as a “trader’s option,” because they give the employee a free option on the upside to his trades. Some banks try to mitigate this problem by charging their trading desks a rental fee on the firm’s money they trade with. If the desk invests in risky areas, such as commodities, the rental fee is higher than if it invests in Treasury bonds, say. When these schemes work, traders get rewarded only if they create positive risk-adjusted returns, commonly known as “alpha.” This type of reward structure can mitigate incentive problems, but it doesn’t eliminate them. Clever traders will try to game the system by taking risks that aren’t reflected in the benchmark they are judged against. Take the practice of writing credit default swaps. In exchange for receiving a positive return most of the time, the providers of credit protection bear the hidden “tail risk” of a low probability of a very bad outcome.

 

pages: 515 words: 142,354

The Euro: How a Common Currency Threatens the Future of Europe by Joseph E. Stiglitz, Alex Hyde-White

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bank run, banking crisis, barriers to entry, battle of ideas, Berlin Wall, Bretton Woods, capital controls, Carmen Reinhart, cashless society, central bank independence, centre right, cognitive dissonance, collapse of Lehman Brothers, collective bargaining, corporate governance, correlation does not imply causation, credit crunch, Credit Default Swap, currency peg, dark matter, David Ricardo: comparative advantage, disintermediation, diversified portfolio, eurozone crisis, Fall of the Berlin Wall, fiat currency, financial innovation, full employment, George Akerlof, Gini coefficient, global supply chain, Growth in a Time of Debt, housing crisis, income inequality, incomplete markets, inflation targeting, investor state dispute settlement, invisible hand, Kenneth Rogoff, knowledge economy, labour market flexibility, labour mobility, manufacturing employment, market bubble, market friction, market fundamentalism, Martin Wolf, Mexican peso crisis / tequila crisis, moral hazard, mortgage debt, neoliberal agenda, new economy, open economy, paradox of thrift, pension reform, pensions crisis, price stability, profit maximization, purchasing power parity, quantitative easing, race to the bottom, risk-adjusted returns, Robert Gordon, Robert Shiller, Robert Shiller, Ronald Reagan, savings glut, secular stagnation, Silicon Valley, sovereign wealth fund, the payments system, The Wealth of Nations by Adam Smith, too big to fail, transaction costs, transfer pricing, trickle-down economics, Washington Consensus, working-age population

Europe had created a divergent system even as it thought it was putting together a convergent one. Several features of the eurozone that were thought of as essential to its success were actually central to its divergence. Standard economics is based on the gravity principle: money moves from capital-rich countries with low returns to countries with capital shortage. The presumption was that the risk-adjusted returns in such countries would be high. But in Europe under the euro, movements of not just capital but also labor seem to defy the principles of gravity. Money flowed upward.1 In this chapter, I explain how Europe created this gravity-defying system. Understanding the sources of the divergence is essential to creating a eurozone that works. DIVERGENCE IN CAPITAL AND FINANCIAL MARKETS AND THE SINGLE-MARKET PRINCIPLE One of the strengths of the eurozone was that capital and labor could move freely throughout the region.

 

Stock Market Wizards: Interviews With America's Top Stock Traders by Jack D. Schwager

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Asian financial crisis, banking crisis, barriers to entry, Black-Scholes formula, commodity trading advisor, computer vision, East Village, financial independence, fixed income, implied volatility, index fund, Jeff Bezos, John von Neumann, locking in a profit, Long Term Capital Management, margin call, paper trading, passive investing, pattern recognition, random walk, risk tolerance, risk-adjusted returns, short selling, Silicon Valley, statistical arbitrage, the scientific method, transaction costs, Y2K

My typical target is a double within twelve months. Unless I believe the stock has that potential, I probably will not be interested. In the case of Tektronix, the stock hit the double less than six months after we bought it, and we significantly reduced our position. Usually, when I get out of a stock, I still believe there is at least 20 or 30 percent left on the upside, but the key question is whether I can get a better risk-adjusted return somewhere else. So once a stock you buy approximately doubles, the question is no longer, "Will it move higher?" but rather, "Can I buy something else that will give me a higher return with less risk?" Yes, it comes back to the notion that we restrict ourselves to fifteen stocks. If we have a position in the portfolio, it means that it still has to be more attractive on a risk-reward basis than any other opportunity we could find as a replacement.

 

pages: 741 words: 179,454

Extreme Money: Masters of the Universe and the Cult of Risk by Satyajit Das

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affirmative action, Albert Einstein, algorithmic trading, Andy Kessler, Asian financial crisis, asset allocation, asset-backed security, bank run, banking crisis, banks create money, Basel III, Benoit Mandelbrot, Berlin Wall, Bernie Madoff, Big bang: deregulation of the City of London, Black Swan, Bonfire of the Vanities, bonus culture, Bretton Woods, BRICs, British Empire, capital asset pricing model, Carmen Reinhart, carried interest, Celtic Tiger, clean water, cognitive dissonance, collapse of Lehman Brothers, collateralized debt obligation, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Daniel Kahneman / Amos Tversky, debt deflation, Deng Xiaoping, deskilling, discrete time, diversification, diversified portfolio, Doomsday Clock, Emanuel Derman, en.wikipedia.org, Eugene Fama: efficient market hypothesis, eurozone crisis, Fall of the Berlin Wall, financial independence, financial innovation, fixed income, full employment, global reserve currency, Goldman Sachs: Vampire Squid, Gordon Gekko, greed is good, happiness index / gross national happiness, haute cuisine, high net worth, Hyman Minsky, index fund, interest rate swap, invention of the wheel, invisible hand, Isaac Newton, job automation, Johann Wolfgang von Goethe, joint-stock company, Joseph Schumpeter, Kenneth Rogoff, Kevin Kelly, labour market flexibility, laissez-faire capitalism, load shedding, locking in a profit, Long Term Capital Management, Louis Bachelier, margin call, market bubble, market fundamentalism, Marshall McLuhan, Martin Wolf, merger arbitrage, Mikhail Gorbachev, Milgram experiment, Mont Pelerin Society, moral hazard, mortgage debt, mortgage tax deduction, mutually assured destruction, Naomi Klein, Network effects, new economy, Nick Leeson, Nixon shock, Northern Rock, nuclear winter, oil shock, Own Your Own Home, pets.com, Plutocrats, plutocrats, Ponzi scheme, price anchoring, price stability, profit maximization, quantitative easing, quantitative trading / quantitative finance, Ralph Nader, RAND corporation, random walk, Ray Kurzweil, regulatory arbitrage, rent control, rent-seeking, reserve currency, Richard Feynman, Richard Feynman, Richard Thaler, risk-adjusted returns, risk/return, road to serfdom, Robert Shiller, Robert Shiller, Rod Stewart played at Stephen Schwarzman birthday party, rolodex, Ronald Reagan, Ronald Reagan: Tear down this wall, savings glut, shareholder value, Sharpe ratio, short selling, Silicon Valley, six sigma, Slavoj Žižek, South Sea Bubble, special economic zone, statistical model, Stephen Hawking, Steve Jobs, The Chicago School, The Great Moderation, the market place, the medium is the message, The Myth of the Rational Market, The Nature of the Firm, The Predators' Ball, The Wealth of Nations by Adam Smith, Thorstein Veblen, too big to fail, trickle-down economics, Turing test, Upton Sinclair, value at risk, Yogi Berra, zero-coupon bond

Sharpe ratios are ex post (based on actual risk) rather than ex ante (expected risk). Actual returns should be compared to expected risk at the time the position was taken. Insufficient attention is paid to the asymmetry of hedge fund returns, which do not follow the familiar bell-shaped normal distribution. Risk models grossly underestimate tail risk, exposure to large price moves. Traders arb internal risk metrics to inflate risk-adjusted returns to increase bonuses. Real hedge fund risks—correlation, liquidity, complexity, and model risk—are not measured properly. If the portfolio of long and short positions is perfectly balanced and prices move identically, then the gains and losses should cancel out, reducing risk but earning zero return. To make money, the correlation, the relationship between the long and short securities, must change.

 

pages: 726 words: 172,988

The Bankers' New Clothes: What's Wrong With Banking and What to Do About It by Anat Admati, Martin Hellwig

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Andrei Shleifer, asset-backed security, bank run, banking crisis, Basel III, Bernie Madoff, Big bang: deregulation of the City of London, Black Swan, bonus culture, Carmen Reinhart, central bank independence, centralized clearinghouse, collapse of Lehman Brothers, collateralized debt obligation, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, diversified portfolio, en.wikipedia.org, Exxon Valdez, financial deregulation, financial innovation, financial intermediation, George Akerlof, Growth in a Time of Debt, income inequality, invisible hand, Jean Tirole, joint-stock company, joint-stock limited liability company, Kenneth Rogoff, London Interbank Offered Rate, Long Term Capital Management, margin call, Martin Wolf, moral hazard, mortgage debt, mortgage tax deduction, Nick Leeson, Northern Rock, open economy, peer-to-peer lending, regulatory arbitrage, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, shareholder value, sovereign wealth fund, technology bubble, The Market for Lemons, the payments system, too big to fail, Upton Sinclair, Yogi Berra

The bank’s new CEO, Antony Jenkins, announced in August 2012 that his ROE target would be above the bank’s stated “cost of capital” of 11.5 percent (see “New Barclays CEO Sets Sights on ‘Credible’ RoE Plan,” Reuters, August 30, 2012). He did not explain how this cost of equity was estimated and whether it could be reduced if the bank had more equity. In fact, Allison (2011, loc. 409) states that megabanks generally fail to generate the risk-adjusted returns that shareholders should expect. Mayo (2011) describes how, as an analyst, he has often been critical of banks’ investment decisions. 18. On the flaws of ROE targets, see, for example, Anat Admati, “Beware of Bankers’ Flawed ROE Measure,” New York Times, July 25, 2011, and “Change Bank Pay Now—BoE’s Robert Jenkins,” Reuters, October 31, 2011, and note 33 of this chapter. 19. Andrew Haldane, the executive director for financial stability at the Bank of England, has argued that the high ROEs banks achieved for a period of time prior to the crisis can be fully explained by increased leverage and risk and cannot be interpreted as an indication of bankers’ performance; see Haldane (2010). 20.