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1、Lecture 02Chapter 1Portfolio Management Process&IPS2Portfolio Management ProcessPLANNINGCapital Market Expectations E(r)/LT/ST risksPLANNINGInvestor Objective&ConstraintIPSFEEDBACKPerformance/MonitoringPerformance measures SpAttribution analysisRebalancePLANNINGAsset AllocationSAA/TAAweightsBased on
2、 objective/constraints max return on risk adjusted basis EXECUTIONST Tactical Asset AllocationSecurity AnalysisTransactionQUESTION:What is relationship between FRM Program&Portfolio Management Process?NOTE:Many students obtain ideas for their graduating project from concepts introduced in this cours
3、e3Portfolio Management ProcessPLANNINGCapital Market Expectations E(r)/LT/ST risksPLANNINGInvestor Objective&ConstraintIPSFEEDBACKPerformance/MonitoringPerformance measures SpAttribution analysisREBALANCEPLANNINGAsset AllocationTAA/SAAweightsBased on objective/constraints max return on risk adjusted
4、 basisEXECUTIONST Tactical Asset AllocationSecurity AnalysisTransaction Costs4Planning:Investor Objectives&ConstraintsA.(2)Objectives investors required/desired outcomes related toRisk andReturn(Cashflow)B.(5)Constraints limitations on investors ability to take advantage of particular investments(su
5、boptimal)External1.Tax2.Legal&RegulatoryInternal3.Time horizon4.Liquidity requirements5.Unique circumstances 5Sidetrip:general categories of investors2 general Categories of investorsIndividual investors(lecture 2)Institutional investors(lecture 3)IPSIndividuals(heterogeneous)Institutions(homogeneou
6、s)Risk&Return1.Time Horizon2.Liquidity3.Tax4.Legal&Regulatory5.Unique CircumstanceBehaviouralSubjective measuresClassifed as less risk adverse to more risk adverse RationalObjective measures Multi period but longManyMin 1 year expensePossibly complexSomeUsually infiniteVariesNone or lowSignificant6I
7、nvestor Objectives(Risk&Return)RISK ObjectiveRisk objectiveCANNOT be determined in isolationShould be positively correlated with return objective NOT realistic to combine low risk objective with expectations for high returns6 Questions that must be addressed to determine risk objective (can you find
8、 answers these questions in IPS?)1.How do you/should you measure risk?2.What is investors WILLINGNESS to take risk?3.What is investors ABILITY to take risk?4.How much risk is investor BOTH willing&able to bear?5.What are specific risk objectives?6.How should investor allocate risk?7Investor Objectiv
9、es(Risk&Return)QUESTION 1:How do you/should you measure risk?1.Variance(or volatility)is absolute measure2.Tracking risk(tracking error)measures variability with which portfolios return tracks benchmark index return is relative measure3.Downside riskValue at risk(VaR)probability-based measure of los
10、s that one anticipates will be exceeded only for specified small faction of time over given horizon=(1/n)RtAvg HistoricalReturnVariance=1/(n-1)Rt rAvg2=PortfoliosreturntActiveReturnt-Benchmarkindex returnt基准指数的收益率Tracking Risk=Standard Deviation of active returnStandard Deviation=Variance8Investor O
11、bjectives(Risk&Return)QUESTION 2:What is investors willingness to take risk?Individual investorsBehavioural&personality factors impact on individuals willingness to take on riskMay act in manner viewed as NOT rationalInstitutional investorsDetermined by investment committee use objective measures vi
12、ewed as rational9Investor Objectives(Risk&Return)QUESTION 3:What is investors ability to take risk?Spending needsQUESTION:How much ST$loss would inconvenience investor?High level wealth relative to potential ST$loss enable more risk takingLong-term wealth targets or obligationsQUESTION:How much ST$l
13、oss would prevent investors from reaching long term return target?High level wealth relative to targets enable more risk takingInvestor liabilities or pseudo liabilitiesQUESTION:How much ST$lossprevent institutional investor from making legally promised payments to beneficiaries orprevent individual
14、 investor from meeting expected(required not desired)retirement spending requirements?Investors financial strengthsQUESTION:What is ability to increase level of contributions(inflows)to portfolio?Greater ability to increase level of contributions,greater ability to take more risk10Investor Objective
15、s(Risk&Return)QUESTION 4:How much risk is investor BOTH willing&able to bear?orWhat is risk aversion or risk tolerance of investor?One issue:There may be mismatch betweenWillingness to take on risk andAbility to take riskInvestment professional needs to explain mismatch with clientWillingness to tak
16、e riskAbility to take riskBelow AverageAbove AverageBelow AverageAbove AverageRisk Tolerance(t):capacity to accept riskHigh Low Risk Aversion(A):inability&unwillingness to take riskHigh Low Educate that ability to take risk is limiting factor requiring revision of return expectationsEducate that wil
17、lingness is limiting factor possibly resulting in only modest return 11Investor Objectives(Risk&Return)QUESTION 5:What are specific risk objectives?Risk may be specified on relative basis or absolute basisRelative basis can be stated in objective quantitative terms “portfolio risk should be 75%marke
18、t index risk”Absolute basis are often stated in subjective qualitative terms “investor has below average risk tolerance”QUESTION 6:How should investor allocate risk?After investor has determinedSpecific risk measure to utilize,andDesired level of risk that will be acceptedRisk budget is allocated to
19、 various assets classes(or assets)with goal of maximizing overall risk-adjusted return(return/risk)QUESTION:Does IPS utilized formal risk budget?QUESTION:Should IPS develop formal risk budget?12Investor Objectives(Risk&Return)RETURN ObjectiveReturn objective cannot be determined in isolation because
20、 it should be positively correlated with its risk objective.4 Questions that must be addressed to formulate return objective (Can you find answers to these questions in IPS?)1.How do you/should you measure return?2.How much return does investor say they WANT(desire)?Secondary objective3.How much ret
21、urn does investor NEED(must)to achieve on average?Primary objective4.What are specific return objectives?13Investor Objectives(Risk&Return)QUESTION 1:How do you/should you measure return?Normal measure is total return investment income plus price appreciationNominal return vs real return what real r
22、eturn is required by IPS?Pretax vs post tax returnReturn objective may be stated in termsAbsolute return Relative(to benchmark)return QUESTION2:How much return does investor say they want(stated return desired)?secondary objective14QUESTION 3:How much return does investor need to achieve on average(
23、required return or return requirement)?primary objectiveRequired return is more stringent than stated return desired Illustration(discounting of cashflows on financial calculator):Current financial assets(outflowa/t)=1,200,000Investment horizon=18 yearsRequired income each year(inflowa/t)=25,000Weal
24、th target(inflowa/t)=2,000,000Tax rate=35%QUESTION:Calculate before tax required returnQUESTION:Assuming there NO requirement for income of 25000/year calculate after tax required return to achieve wealth target Investor Objectives(Risk&Return)Ia/t=?=4.55n=18PV=-1200000 PMT=+25000FV=+2000000=Ia/t-2,
25、000,000 1,200,0001()(1/18)=2.88=ib/4 4.55/(1 0.35)=7.0015Investor Objectives(Risk&Return)QUESTION 4:What are specific return objectives?Specific return objective should be measurable annual total return(income&capital appreciation)Return objective mustconsistent with risk objectivesufficient to sati
26、sfy wealth objectives or liabilitiessufficient to satisfycurrent income needs with capital appreciation to satisfy future income needs after inflation(which will preserve purchasing power)16Investor ConstraintsIn addition to Objectives(Return/Risk),investor may have constraints that impact on portfo
27、lio choiceThere are five constraints1.Liquidity requirements2.Time horizon3.Tax4.Legal&Regulatory5.Unique circumstances 17Investor Constraints1.Liquidity(at time T)Liquidity requirements(for nonrecuring event or emergency)requirement for cash in excess of new contributions at specific point in time
28、impact investors ability to take riskLiquidity risk of asset incurring loss as result of selling less liquid asset to satisfy liquidity requirementAsset selection used to control liquidity risk of asset entire liquidity requirement should be invested in assets with little or no liquidity risk(which
29、may earn lower total return)18Investor Constraints2.Time horizon time period associated with investment objectiveIn general,longer time horizon greater investors risk toleranceHow does length of time horizon modify investorsability to take risk?asset allocation?How does multistage time horizon const
30、rain investors asset allocation?19Investor Constraints3 Tax tax policy affects investment decision because reduce total returns(b/t a/t,we live in after tax world)IssuesDifferent tax rates apply investment income vs capital gainsEstates taxesTaxable vs non taxable investors4 Legal&Regulatory externa
31、l factors imposed by government,regulatory or oversight authorities impact decision makingLimits on concentration of holdings in debt&equityLimits on foreign investment5 Unique circumstances specific to investorEthical or social responsibility(SRI)Specifics of individual(health,dependants)Inclusion/
32、exclusion of specific asset classes(ie currency or commodities)Investors financial knowledge 20Summary Constraints(lecture 2&3)Return RequirementsRisk ToleranceIndividualDepends on stage of life,circumstance&obligationsVariesPension Plans(Defined Benefits)Return must fund liability on inflation-adju
33、sted basisDepends on characteristics of plan&characteristics of sponsorPension Plans(Defined Contribution)Depends on stage of life on individual beneficiaryVaries with risk tolerance of individualsFoundations&EndowmentsReturn covers spending,capital expenditures&expected inflationAverage or above av
34、erageLife InsuranceDetermined by rates used to calculate policy reservesBelow average due to regulatory constraintsNon Life InsuranceSufficient to fund liabilities with competitive pricingBelow average due to regulatory constraintsBanksReturn cost of fundsVaries21Portfolio Management ProcessPLANNING
35、Capital Market Expectations E(r)/LT/ST risksPLANNINGInvestor Objective&ConstraintIPSFEEDBACKPerformance/MonitoringPerformance measures SpAttribution analysisREBALANCEPLANNINGAsset AllocationSAA/TAAweightsBased on objective/constraints max return on risk adjusted basisEXECUTIONST Tactical Asset Alloc
36、ationSecurity AnalysisTransaction Costs22Planning:Capital Market ExpectationsCapital Market ExpectationsForecast(educated guess or possibly determined by risk models)Risks&Returnsfor various asset classes(sectors)Length of forecastsLong term(market cycle)strategic asset allocation(SAA)Short term(2 y
37、ears)tactical asset allocation(TAA)23Portfolio Management ProcessPLANNINGCapital Market Expectations E(r)/LT/ST riskPLANNINGInvestor Objective&ConstraintIPSFEEDBACKPerformance/MonitoringPerformance measures SpAttribution analysisREBALANCEPLANNINGAsset AllocationSAA/TAAweightBased on objective/constr
38、aints max return on risk adjusted basisEXECUTIONTactical Asset AllocationSecurity AnalysisTransaction Costs24Execution:Portfolio OptimizationPortfolio optimization(asset allocation)Using Capital Market Expectation(E(return)&risk)of various asset classes)determine efficient frontierUsing Investors ob
39、jectives&constraintsSUBJECTIVE:determine minimum required return&riskOBJECTIVE(quantitatively):determine investors indifference curve(derived from coefficient risk aversion&utility function)Determine weights of individual asset classes thatSUBJECTIVE:Identify portfolio that satisfys investors minimu
40、m required return&riskOBJECTIVE:Maximize portfolio return on risk adjusted basisE(r)riskE(r)riskE(r)risk25Portfolio Management ProcessPLANNINGCapital Market Expectations E(r)/LT/ST riskPLANNINGInvestor Objective&ConstraintIPSFEEDBACKPerformance/MonitoringPerformance measures SpAttribution analysisRE
41、BALANCEPLANNINGAsset AllocationSAA/TAAweightsBased on objective/constraints max return on risk adjusted basisEXECUTIONST Tactical Asset Allocation Security AnalysisTransaction Costs26ExecutionExecution is initiation of portfolio decisions by selecting specific assets for portfolioIndividual securiti
42、es evaluated based on number of factors competitive advantagequality of managementanalysis of risk factorsexpected cashflows on expected risk adjusted basisFactors associated with execution that must be considered traderExplicit transaction costsCommissions paid to brokersFees paid to exchangesTaxes
43、Implicit transaction costsBid/ask spreadSize of transactionMissed trade opportunity costs price change that prevent trades from being filledDelay costs order size or liquidity prevent trades from being filled27Portfolio Management ProcessPLANNINGCapital Market Expectations E(r)/ST/LT risksPLANNINGIn
44、vestor Objective&ConstraintIPSFEEDBACKPerformance/MonitoringPerformance measures SpAttribution analysisREBALANCEPLANNINGAsset AllocationSAA/TAAweightsBased on objective/constraints max return on risk adjusted basisEXECUTIONST Tactical Asset Allocation Security AnalysisTransaction CostsMonitorMonitor
45、Rebalance28Feedback:Performance&MonitoringPerformance Evaluation investment performance is periodically evaluated to:compliance1.Investors progress towards achieving their investment objectives2.Assess portfolio management skillPerformance measurement calculate portfolios actual rate of return(over
46、different time horizons)Performance attribution determine source of portfolios relative performance returnsAttribution variance from strategic asset allocation(portfolio manager)Selection selection of individual securities within asset class(sector managers)Portfolio appraisal evaluation of managers
47、 performance relative to benchmark29Feedback:RebalanceRebalancing(change in composition of asset classes in portfolio)may be required due toChange of Prices(of asset classes)orMonitoring(requiring change to IPS)Circumstances which require revision to investors objectives(return&risk)&constraints orC
48、hange in economic factors&capital market expectations(both returns&risk)of various asset classesActual timing of rebalancingQuarterly review (at beginning not end of next quarter)Deviation beyond specified rangeDiscretion of managementOther factors impacting on rebalancingTransaction costsTaxes30Inv
49、estment Policy Statement(IPS)Investment Policy Statement document which formalizesrisk&return objectives of client5 investment criteria used by investment professional to meet objectives of clientTypical IPS includes:Description of clientClients objectives(risk&return)&5 constraintsStrategic asset a
50、llocation(range weights by asset classes)Performance measures&benchmarksGuidelines for rebalancingSchedule for review(quarterly,annual)Investment style/investment strategy clarify basis for selection of individual securitiesPASSIVEDo not have capitalExpectationsIndexingBuy&HoldACTIVEHave capitalExpe