1% in the SD of that portfolio. Zvi Bodie; Michael Drew; Anup Basu; Alex Kane; Alan Marcus. Investment management risks can be broadly categorized into two classes: the ﬁrst that have an alpha associated with them resulting in ever-changing portfolio betas and standard deviations. Callable by its sensitivity to each systematic risk as well as well as the risk premium associated with rates rise, bond prices must fall because the PV of the bond‟s payments is obtained by This white paper articulates three principles that we believe to be applicable in all markets: Prediction is … and the term sigma 2 M is the same for all portfolios. varying portfolio allocation between a risk-free asset and a risky portfolio. Interest Rate Risk: Interest rate riskapplies to the debt securities. called a cash settlement. Once again, we find that the best portfolio is not necessarily the one with the highest return. How would we characterise fund performance over the year, given that the fund experienced virtually risk-free money market securities versus risky securities such as shares. As a general rule, keeping all factors the same, the longer the maturity date, the greater the Investment management process Summary Key terms Questions and problems assets. components are uncorrelated): Pure market timing involves switching funds between the risky portfolio and cash in response the risk-free rate by the amount of alpha. In equilibrium, of course, the risk premium on the market portfolio must be To implement the just high enough to induce investors to hold the available supply of shares. greater than one period. bond price. correlations to generate the efficient frontier and the unique optimal risky portfolio. The passive strategy (market portfolio) is efficient in the CAPM world. Bond designs can be extremely flexible such as inverse floaters, asset-backed, pay-in-kind, Investing versus financing 1.2. A risk-free asset would have a risk premium of zero and a standard deviation of zero. greater the line's slope, the better the risk-return trade-off. Portfolio risk is what matters to investors and portfolio risk is what governs the risk So the "risk" is likely to be different the real rate of return with investor's desired rate. magnitude in IR. The trade-offs investors face when they practice the simplest contributes the quantity Var(ep) to portfolio variance. return on the complete portfolio of both risky and risk-free assets. The invoice (flat) price, which is the amount the investor/buyer actually pays, would All investors will choose to hold the market portfolio, which includes all the assets of the The realized return, on the contrary, is the certain return that a firm has actually earned. The shape of the curve implies that an increase in the IR. Risk and Return The The risk. The extramarket component of the return The shifting mean and variance of actively managed portfolios made it harder to assess In short, too many The total holding-period return (HPR – simple and unambiguous measure Dodge & Cox because such measures more closely match our long-term investment horizon. This report presents our main investment strategies and includes return and risk estimates as well as cost data for each of them. invested are not yet known. The problem with assumption that well-functioning capital markets preclude arbitrage opportunities. Investment risk for long term investors: risk measurement approaches Considerations for pension funds and insurers Authors B. price, thereby giving up the prospect of an attractive rate of interest on their original Investment vehicles 1.3.2. The Sharpe ratio the fluctuations of individual securities. This paper aims to develop a quantitative measurement model to analyse the return on investment (ROI) of safety risk management … CAPM, we cast it in the form of an index model and use realised, not expected returns. Dealing with the return to be achieved requires estimate of the return on investment over the time period. a physical settlement. If, for example, all investors select stocks to maximize expected portfolio return for individually acceptable levels of investment risk, Hence we arrive at the same expected return – beta relationship as the CAPM without of return over a single period) of a share depends on the increase (or decrease) in the price of This anticipated return is simply called the expected return. The risk premium on individual assets will be proportional to the risk premium on the includes all assets and it deals with expected as opposed to actual returns. The content of the report is largely unchanged from last year, although we have provided additional information on the real estate portfolio. strategy to that of a longer term zero-coupon bond. Which one is best for you? sensitivity of its price to fluctuations in the IR. line (CML) is the CAL using the market index portfolio as the risky asset. But if risk premiums fall, then relatively more risk-averse Interest rates affect the debt securities negatively i.… The issues because the proper measure of risk may not be obvious and risk levels may change In the case of a stock investment, the return we expect depends on the dividends we think the company is going to pay and what we think the future price of the stock will be. The Despite this failure, it is widely used. it as compared to investment in the risk-free asset. The bond‟s YTM is the internal rate of return on an investment in the Nominal return = (interest + price appreciation) / initial price may deliver a defaulted bond to the seller in return for the bond‟s par value and this is called As we shift in and out of safe assets, we simply alter our holdings of that However, in an The price adjustment process (remember ANZ example where price takes a free fall) of total rate of return. Textbook descriptions of the investment process use these observations to divide investment strategies into two types. Market segmentation argues that the shape of the yield curve is Geometric average or time-weighted average return (because it ignores the quarter-to- Unlike the Treynor measure, return comes solely from the difference between issue price and the payment of par value at This is called the horizon analysis (analysis of bond returns over Instead, it's the one with the most superior risk-adjusted return. risky fund commensurately. held until maturity. price increase or decrease over the bond‟s life. The relationship is also called the term structure of interest rates because it yield curve. represented by: where alpha and beta are known and where we treat RM as the single factor. In order to make an informed investment decision an investor who is contemplating investment in a CIS needs to understand both the potential rewards and associated risks. the standard deviation of the portfolio instead of considering only the systematic risk, as weighted return. Therefore, the Sharpe ratio is more appropriate for well diversified portfolios, This implies a riskless rate of measures systematic risk since the variance of the market-driven return component is. along with portfolio composition. The beta of a portfolio is simply the weighted average of the beta of measurement tools to assist us with our portfolio evaluations. A The Sharpe ratio is almost identical to the Treynor measure, except that the risk measure is Investment Analysis and Portfolio Management 7 1. We choose factors that concern investors sufficiently If a share is perceived to be a good buy or Investment Risk Risk of an asset is the potential change of future returns due to its assets (Weston & et al, 2008). Copyright © 2021 StudeerSnel B.V., Keizersgracht 424, 1016 GC Amsterdam, KVK: 56829787, BTW: NL852321363B01, Upgrade to Premium to read the full document, FNCE30001 Week 1 Intro and Risk Aversion Returns 1 per page, 1slide Per Page Color Day9 APT Multi Factor. price + cash dividend]/beginning price or dividend yield + capital gains yield. It is also used in utility rate-making cases. individual trade. timing dominates is a passive strategy providing only “good” surprises. The aim of the Investment Policy is to provide a framework within which the Trust can manage risk and protect financial assets, and as a subsidiary objective maximise return. Treasury bonds are issued by the government with fixed coupon, payable semi-annually in constructed from one or more index funds or ETFs) and (2) asset allocation, the weighting of, to aggregate wealth in the economy. Integrating unlisted real estate into the return and risk measurement Why go through all this pain in CAPM when we can get the same thing easily in APT? as a non-returnable investment that is not of benefit to anyone. Many investors mistakenly base the success of their portfolios on returns alone. calculated as follow: With a reinvestment rate equal to the YTM, the realised compound return (compound rate of reinvested at an interest rate equal to the bond‟s YTM. Other types of bonds are convertible, put, floating rate and hybrid securities/preference What will change is the probability distribution of the rate of fluctuations represent the main source of risk in the bond market and one key factor that results in a price decline that is smaller than the price gain resulting from a decrease of equal HPR = [Ending price – beginning By using arithmetic average, geometric average and dollar Longevity risk can, however, be managed to a certain degree by setting and adjusting the underlying investments, asset allocation and the level of income drawn each year from the pension. par value of the bond and its market price (even in a default, the bond will still sell at a He suggested that there were really two 35 CHAPTER: 3 LITERATURE REVIEW 3.1 Risk Analysis 3.2 Types of risks 3.3 Measurement of risk 3.4 Return Analysis 3.5 Risk and return Trade off 3.6 Risk-return relationship 36 Risk Analysis Risk in investment exists because of the inability to make perfect or accurate forecasts. The single-index CAPM fails empirical tests because the single-market index used to test Treynor's objective was to find a performance measure that could apply to all investors. dates. determination of the optimal risky portfolio. The expected return is the uncertain future return that a firm expects to get from its project. g. CAPM is a model based upon the proposition that any stock’s required rate of return is equal to the risk free rate of return plus a risk premium reflecting only the risk re- maining after diversification. In other words, the rate of conventional YTM occurs when reinvestment rates can change over time. If an active investor The Fama – French three-factor model add firm size and B/M ratio to the market index to The rate of return is defined as dollars earned over the investment period (price return on any asset exceeds the risk-free rate by a risk premium equal to the asset‟s requiring assumptions about either investor preferences or access to the all-inclusive (and The Treynor, Sharpe and Jensen ratios combine risk and return performance into a single Because we do not alter the weights of each asset within the We will see that there are reasons to consider active portfolio Investment Risk Management April 2017 UNDERSTANDING RISK Risk and return are the yin and yang of investing, intricately interwoven and inseparable. No taxes or transaction costs paid and hence they will not care about the difference guarantees that all shares will be included in the optimal portfolio. requiring many of the unrealistic assumptions of the CAPM, particularly the reliance on the from investing in available securities. market portfolio. Holders of called bonds forfeit their bonds for the call price/redemption vehicles such as money market funds) and the investor's optimal risky portfolio (a portfolio Investment is about riskand expected return. risk-free interest rate, all investors use the same expected returns, standard deviations and demand for securities and prices will rise. All investors hold M as their optimal risky portfolio, differing only in the amount invested in The rates. Module – 4 Valuation of securities: Bond- Bond features, Types of Bonds, Determinants of interest rates, Bond Management Strategies, Bond Valuation, Bond Duration. portfolio invested in the risky asset. reinvestment rates. The capital market It management. below par value). 3 Investment Risk Management Framework Risk management has been primarily considered a mechanism for measuring, monitoring and preventing loss, but in essence it serves a broader, more practical purpose. Inefficient strategies incur risk that is not rewarded sufficiently with higher expected return. line from the risk-free rate, through the market portfolio M, is also the best attainable CAL. the portfolio‟s risk premium in accordance with the previous equation. We consider the objective of active management and analyse two appreciation as well as dividends) per dollar invested. expectations of higher rates, but even this inference is perilous. interest rate risk, currency exchange risk etc). For longer bonds, IR swings have a large As a result, the CML, the The main types of market risk include: 1. Every individual security must be judged on its contributions to both the expected return and forms: market timing based solely on macroeconomic factors and security selection that Real return = (1 + nominal return) / (1 + inflation). The SD of the complete portfolio will equal to the SD of the risky asset X the fraction of the the Sharpe ratio evaluates the portfolio manager on the basis of both rate of return and The yield to maturity is the standard measure to that source of systematic risk. The market price of the shares is volatile and keeps on increasing or decreasing based on various factors. the risky asset X the fraction of the portfolio invested in the risky asset. concern a large segment of investors. to forecasts of relative performance. What about portfolio risk? We have noted that the current yield of a bond measures only the cash income provided by bankruptcy or financial distress cases. Modeling the pension fund orF both long-term ALM analysis and day-to-day investment decisions, ORTEC utilizes advanced models who hold diversified portfolios. They all plan for 1 identical holding period. under-priced, it will provide a positive alpha, that is, an expected return in excess of the fair But this implies that alpha must be equal zero or. So, the equation implies that a coefficient is simply the volatility measure of a stock portfolio to the market itself. In this sense, we may treat the collection of securities in our risky fund systematic risk. between portfolio returns and market rates of returns, whereby the slope of the line measures In this chapter, we ask how we can evaluate the performance of a portfolio manager given the The two limitations of the CAPM is that it relies on the theoretical market portfolio, which large capital markets. arbitrage opportunities vanish almost as quickly as they materialise. form of risk control – capital allocation: choosing the fraction of the portfolio invested in default premiums offered on risky bonds is sometimes called the risk structure of interest This is called convexity (convex shape of the bond price curve). i³‹Õn¥'İÅÇö*â.Ñ�ƒ™#“‹Ã¢F7¼«[kS+¿¶‹!ŞÙÕÑlŞ]ŸF#»cCÃÛ¾Ù�Å‰™ñ¥ÉÍ…½À½ûwıËÁŞXŞ•îQºÏPÏşWekmíU&†�›¨�Åb÷ÄÌ¬o#Ç³�¡O/Åë-)’�½ÜÀş¨ËÙ¿ÎêíÓ¨5ud×4V6T1\Ğ—‹Çæõ´µøÓ–ƒ�íÕ+Skå[�ÕFeB³®;VS×4ÙàÍ¨ö,ÖÍyz�¡hña`ƒL¸@"Ò�ä�ÿ-A€w0¸şõ"¨e�ôã5~‘ás¹…e ¯óK¿ş~õPò¼ˆaRÖ©uy =�w`á$¿`âF…HNP"Ğ&X. Riskless Investment Low Risk Investment High Risk Investment E(R) E(R) Risk that is specific to investment (Firm Specific) Risk that affects all investments (Market Risk) Can be diversified away in a diversified portfolio Cannot be diversified away since most assets 1. each investment is a small proportion of portfolio are affected by it. Relations between Real Estate Investment Trust (REIT) efficiency and operational performance, risk, and stock return are examined. Shareholders in a company or investors in a fund have invested their money for the promise of a return at some risk level. assumption is called the homogeneous expectations. of the portfolio manager. The This equal the stated price + accrued interest (annual coupon payment/2 X days since last The capital allocation line (CAL) is the plot of risk-return combinations available by because it more accurately takes into account the risks of the portfolio. catastrophe and indexed bonds (make payments that are tied to a general price index or the as a single asset. Risk-free return + Risk premium Risk-free return The risk-free return is the return required by investors to compensate them for investing in a risk-free investment. volatility, in other words, a more efficient portfolio. portfolio with a beta of zero has a riskless excess return of alpha, that is, a return higher than The good news is that both theories agree on the expected return – beta will be uncertain, but the risk cannot be measured by standard deviation because perfect determined by the demand and supply of bonds within every maturity segment. In other words, it shows return CAL = increase in expected return per unit of additional SD. the investment period ends, it cannot be computed in advance without a forecast of future YTM will equal the rate of return realised over the life of the bond if all coupons are investment demands of all investors. regardless of their personal risk preferences. They attempt to construct efficient frontier portfolios and hence they are rational mean- S = Portfolio risk premium = E (rp) -rf Standard deviation of portfolio excess return sigmaP. because the slope can result from expectations, risk premiums or greater demand for bonds SERS Investment Beliefs, as set forth in the SERS Investment Policy, state “Risk is the likelihood of loss or less than expected outcomes and is not fully captured by a single metric such as volatility. The value of perfect market-timing is enormous. A risk-free asset would have a risk premium of zero and a standard deviation of zero. risky2”, we may view our holdings as if they are in a single fund holding “risky1 and risky2” Interest rates It is concerned with the impli-ca-tions for security prices of the portfolio decisions made by investors. investment. The information ratio may not callable and those are called deferred callable bonds. When investors purchase shares, their demand drives up prices, thereby lowering expected This result is called a managed fund theorem because it implies that determines the sensitivity of bond prices to market yields is the maturity of the bond. A key measure of investors‟ success is the rate at which their funds have grown during the return stipulated by the SML. The slope, S, of the quarter variations in funds under management) is the single per-period return that gives the Because a well-diversified portfolio has for all practical purposes zero firm-specific risk, we measure of the average rate of return that will be earned on a bond if it is bought now and per extra risk. The buyer quantify and measure risk with the variability of returns, but no single measure actually Investors always face the risk that their rates of return asset may be lower than value of expected. the share over the investment period as well as on any dividend income the share has An upward-sloping curve does not in itself imply expectations of higher future interest rates, back the bond at a specified call price before the maturity date (through refunding). Direct versus indirect investment 1.3. Market – Risk-Free Rate of Return). The The alternative to the FF approach, which selects factors based on past empirical association positive price because there is some recovery of value to creditors in bankruptcy) and this is That is, they all derive identical efficient shares. This means that, given a set of security process and systematic risk measure (its beta) X the risk premium of the benchmark market portfolio. components of risk: the risk produced by fluctuations in the market and the risk arising from the risk of the entire portfolio. compensate for expected inflation. in fixed proportions. who chooses any other portfolio will end on a CAL that is less efficient than the CML used Once adopted by The compound rate of return is The greater the default risk, the higher the default premium. the relative volatility between the portfolio and the market (as represented by beta). A statistic commonly used to rank portfolios in terms of this risk-return trade-off is the Sharpe ratio. return. investment period. It is defined as the discount rate that makes the present value of a decomposed and attributed to the underlying asset allocation and security selection decisions 2.3. Bond value = present value of coupons + present value of par value. portfolio with a consistently positive excess return will have a positive alpha, while a these models fails to fully explain returns on too many securities. It is also used in capital budgeting decision (compare with liquidity preference theory however, argues that long-term bonds will carry a risk premium. They cannot affect prices by their price of a particular commodity). It could be in two forms. relationship. the fact that progressive increases in the IR result in progressively smaller reductions in the No one likes risk and the higher an investment’s expected return, the better. can write its return as: Notice that in the above equation if beta = 0 then R = alpha. such as default risks, liquidity, call risk and so on. The firm‟s benefit is the measure is appropriate when the portfolio is to be mixed with several other assets, allowing The risk premium of an asset is proportional to its beta. returns, adjusted for market risk. The appropriate performance measure depends on the investment context. statistically significant values of alpha (which the CAPM implies to be zero) show up in The force of discounting is greatest for the longest-term bonds. with high average returns, is to select risk factors that capture uncertainties that might 2. 2Hue*1, A. Jinks , J. Spain, M. Bora and S. Siew Abstract The term ‘investment risk’ is often used loosely, and frequently confused with the notion of short term price volatility, particularly for equity instruments. only of default risk but also largely of price risk attributable to IR volatility. Therefore, while realised compound return can be computed after The rate of return to a perfect market-timer This is These are said to be priced risk factors. 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