Lecture 7: Portfolio management

in practice

All assets should be priced by CAPM formula

Although, there exists several reasons for why assets may not have
the correct CAPM price

The CAPM does not rely on

arbitrageurs
CAPM relies on many strong
assumptions (check lecture
6)

Thus, deviations from

equilibrium may persist
We cannot actually
observe the market
portfolio cannot test
CAPM empirically
Assumption that investors
are rational

The Stiglitz Paradox

Information is costly thus prices do not perfectly reflect available

information as those whove spent resources to acquire this would
receive no compensation/incentive
However, under CAPM conditions; if markets are efficient and prices
reflect all information whereby obtaining this info requires
resources,
Why do people commit their resources to researching securities?
And if people don't commit resources to researching securities, how
do prices become right to begin with?
Therefore, there is the belief that prices deviate enough for analysts
to acquire compensation for their work

The Single Index Model (SIM)

As the market portfolio cannot be observed, we tend to choose a

broad value-weighted market index (e.g. S&P500) in practice
o The SIM has time indexes attached to it

Jensens alpha

According to CAPM, should be zero

If not, it is mispriced indicates an error in our model rather than
with market price
o But for sake of 2624, assume that model is correct

Exploiting mispriced assets

All assets that are priced correctly should plot on the SML
To exploit mispricings,
o Combine active position in the mispriced assets
o With a passive position in the market portfolio
o Then, maximise Sharpe ratio
That is, construct a new efficient frontier with the new risky portfolio
A positive undervalued i.e. price too low thus, tilt P* away from
market portfolio such that you increase the weight of the mispriced
asset exploit mispricing
o In essence, you are just shifting weights
Why don't we put everything into the mispriced asset?
o Because it lowers CAL incurs unsystematic risk

Gains from exploiting mispriced assets

The improvement in the Sharpe ratio is reflected by the Information

Ratio (IR)
The squared Sharpe ratio is the optimal risky portfolio after
incorporating the mispriced assets

Factor models

CAPM asset returns should depend solely on asset covariance

with the market but this fails because the market return may covary with other factors higher required return
Other risk factors also co-vary with assets higher required return
HMB, SMB and MOM
Asset loadings on these factors tend to predict expected returns
o Which violets CAPM itself

Lecture 8: Behavioural finance and

market efficiency

Our current expectations on how an entity will perform in the future

is reflected in current prices
That is, the market price of the stock immediately reflects public
information
New information results in changing expectations changing prices
Thus, stock prices follow random walk
o Price changes are completely random and independent of
historic prices
The EMH states that market prices reflect all available
information

Weak form

Semi-strong form

Strong-form

Current prices reflect all

information from historical
trading data such as past
prices, trading volume, and
short interest
Current prices reflect all
public information
Current prices reflect all
publicly available information
and insider information

Profits from informational advantage are large

Although, the changes of acquiring information that is not already
reflected in prices is small

Trading strategies
Technical analysis

Use patterns from historical

stock prices to predict future
prices and returns
Violates the weak EMH
b/c weak EMH incorporates
ALL historical information into
its stock prices

Fundamental analysis

Insider trading

Analysing and interpreting

publicly available data to
make valuations
Violates the semi-strong
valuation
b/c SS EMH incorporates ALL
publicly available data into
prices already
Stiglitz paradox
Use insider information to gain
an informational advantage
Violates the strong EMH
Illegal

Testing the EMH

EMH tests have several issues:

o Volatility of stock prices ae large compared to presumed
effects of individuals/strategies beating the market difficult
to get sufficient statistical power
o Risk of reporting bias i.e. only interesting studies get
published
o To beat market, priced risk needs to be controlled
What risk is priced? Use CAPM
EMH test is a joint test of some market model

Market inefficiencies; how could markets be so

wrong?

Tulip obsession
Housing bubble
Prices in these periods were far from their intrinsic values
Why? b/c market prices may deviate from intrinsic values
o Investors may behave irrationally (behavioural biases)
o Something is hindering rational investors from exploring
irrational investors i.e. restrictions of arbitrage

Limits of arbitrage

With arbitrage trade, comes risk:

Execution (leg) risk

Model risk

Noise trader risk (not

reliant on fundamental
analysis)

Parts of the arbitrage will be

executed
Leaves them with a large
open position
Technically not an arbitrage
anymore...
Risk that model used to
represent arbitrage model is
flawed
Uninformed traders may
keep asset prices from their
fundamental values and
expose the arbitrageur to
carry cost and margin calls
Stock trader who lacks
access to inside information
and makes irrational
investment decisions
Noise trader is used to
describe an investor who
makes decisions regarding
buy and sell trades without
the use of fundamental data.
These traders generally have
poor timing, follow trends,
and over-react to good and
bad news.
Informed traders will not
enter a market without
noises, because it is
impossible to profit from
trading in a completely
efficient market. Informed

traders need the existence of

noise traders to hide their
trades and by trading on
their private information,
informed traders make
profits

Technical analysis is
considered to be noise
trading because data is
unrelated to companys
fundamentals

If uninformed trades (noise traders) traded randomly, its expected

their trades will cancel out
However, there is a systematic component that doesn't phase out
o Behavioural bias introduces mispricing and leads to
suboptimal behaviour

Anchoring

Overconfidence

Under-diversification

Home bias

Easier to depart from some

benchmark value
People tend to be
overconfidence in their
abilities
Effect is stronger when
dealing with familiar things
Explains why some investors
trade much more than
optimal
Investors tend to hold underdiversified portfolios
They hold too few stocks and
invest too much in own
country and companies
Since overconfidence is
stronger when dealing with
familiar things, investors
may be excessively sure
about their predictions
concerning their own
country/company

Are markets Darwinian?

Wouldn't irrational traders die out? behavioural biases

Irrational traders tend to take more risk than rational traders
Higher risk yields higher returns!

Summary:

Stock prices seem to follow random walk there are no predictable

patterns to exploit
Support concept that market prices reflect currently available
information (semi-strong EMH)
Only new information will affect stock prices
Weak EMH market stock prices reflect all historical trading data
Invalidates technical analysis
Semi-strong EMH & strong EMH
Technical analysis focuses on price patterns and buy/sell pressure
proxies
Fundamental analysis focuses on determinants of underlying value
of firm
Since both tech and fund analysis focus on all public
information, it is invalidated by the EMH
Neither should generate profits if markets are efficient
EMH advocates passive investment strategies
That is, to buy and hold a market index (e.g. S&P500) and do not
use resources on researching the market nor simultaneously buying
and selling stocks frequently.
Technical analysts do not support notion that it generates large
profits; exception is the success of momentum-based strategies
Performance record of funds are not credible in claiming that
managers are able to consistently beat the market

Lecture 9: Portfolio Performance

Evaluation

Returns should be adjusted for risk before they can be compared

Whilst each of the following measures are appealing, they do not
provide consistent assessments of performance as the risk
measures (which adjust returns) differ significantly i.e. alpha, beta,
standard deviation, and unsystematic risk

Sharpe Ratio portfolio

represents the entire
investment fund

Treynor measure portfolio

represents one of many

Jensens alpha portfolio

represents one of many

Information ratio portfolio
represents an active portfolio to
be optimally mixed with the
passive (market) portfolio

Expected portfolio return

divided by standard deviation
of returns
Measures reward-to-risk tradeoff
Excess return per unit of
systematic risk
Return on portfolio over and
above that which is predicted
by CAPM
Portfolio alpha divided by
unsystematic risk tracking
error

Measures abnormal return per

unit of risk that could
otherwise be diversified away
by holding an indexed market
portfolio

Choose the asset with the

highest absolute value

Performance Attribution Procedures

Allows investors to discern which decisions resulted in superior or

inferior performance
Attribution method explains the difference in returns between a
managed portfolio, P, and a benchmark-bogey portfolio, B.
For each asset class, a benchmark index is formed e.g. the S&P 500
may have been chosen as a benchmark for equities
First term measures impact of asset allocation demonstrates how
weight deviations from the benchmark weight for the asset
multiplied by the return
Second term measures sum of security selection demonstrates
managers excess return within the asset class compared to the
benchmark return multiplied by the portfolio weight
Bogey is designed to measure returns from a passive strategy
Superior performance relative to the bogey is achieved by overweighting investments in markets that perform well and
underweighting those in poorer market
Deviations of the managers return from the bogey-benchmark must
be due to either asset allocation or security selection

Sector and Security Selection Decisions

Hedge funds and other active positions mixed with the passive
indexed portfolio should be evaluated based on their information
ratio
Attribution procedures discern performance improvement to asset
allocation, sector selection, and security selection
Performance is assessed by calculated deviation of portfolio from a
bogey-benchmark portfolio

Lecture 10: Option Strategies

In the money positive intrinsic value

When X=S at the money
Deep in/out of the money
Although your option might be out of the money, there is still a
possibility for the option to be in the money before expiry time
value
Option value = time value + intrinsic value
Time value moneyness may increase

o The probability of this increases with time to maturity and

volatility

American

European

Exercised any time before

maturity
Written on individual stocks

Exercised only at maturity

BS model
Index options are generally
European

Creating (and selling) the option is known as writing/issuing the

option
Physical settlement vs. cash settlement
o For cash; writer must pay out intrinsic value of option
Hedging vs. speculation

Option strategies
Protective put

One stock
One long put

Butterfly spread

2 long calls
2 short calls

Straddle

1 long X
1 long Y

Covered call

One stock
One short call

Hedging;
guarantees
lowest possible
value of the
position
Neg: Must pay
option even if we
don't exercise
right
Low volatility
Neg: net
premiums
positive
High volatility
Neg: net
premiums are
low
Hedge against
risk
Gain call
premium
Neg: Loss of
upside from the
stock

Lecture 11: option valuation

By choosing delta stocks and one short derivative ensured that

P is risk neutral probability of a stock price increase
o Lower than actual probability

Black-Scholes

N(d2), or p, is the risk neutral probability t

Implied volatility is only B-S variable that we cannot observe directly