Back-test • P&L = change in equity • Long-run reversal factor

Return over past 60 months excluding the last 12 months

Portfolio Construction and Risk Management long short Buy losers, sell winners
Rt × $long − Rt × $short + financing,
1. Mean-variance Portfolio construction: Possible explanation: Overreaction
• Mean variance approach: f mm rebate lender PB P Bloan 5. Statistical arbitrage: based on arbitrage relations and statistical relations,
weights: w = (w1 , · · · , wn ),
P
wi = 1. financing = rt × $cash + rt × $cash − rt × $cash .
Excess Returns: Re = (R1 , · · · , Rn ). • Siamese twin stocks: based on a dual-listed company. There exists deviations
• Financing spread:
Risk aversion coefficient: γ from parity in practice
Interest rate paid on margin loan greater than the money market rate (fed
• Objective: • Trade on the “carry”, long cheap short expensive stocks; dollar neutral to
funds): rtP B > rf
0 e γ 0 t pick-up dividend yield; equal number of shares to pick-up interest from
max = w E[R ] − w σw • Interest rate earned on cash collateral supporting short positions less than additional proceeds from shorting
w 2 f rebate . • Trade on mean reversion: long the stock that is cheaper than “usual," short
money market rate: rt > rt
• By differentiating, the optimal portfolio is • Funding a long position: margin requirement, m: the other one
• Pairs trading: find stocks that tend to move in lockstep, identify a time when
∗ 1 −1 e they don’t, betting they will move back together
w = σ E[R ]. pt+1 − pt
γ P rob(− > m) = 1% • Index arbitrage: trade index agianst constituents
pt
6. Global macro investing: trade on big-ideas (China’s growth, global warming )
2. Black-Litterman model EXAMPLE G7 countries asset allocation • Currency carry trade: borrow currency with low interest (usually Japanese
• Estimate annualized volatilities and correlations • Funding a short position
Yen), then lend currency with high interest. Risk: exchange-rate; liquidity
• Obtain the equilibrium portfolio weights weq (by market cap), get equilibrium condition
pt+1 − pt
risk premium (neutral view risk-premium) P rob( > m) = 1% • Large losses in currency carry were often incurred during global sell-off of
eq eq pt risky assets (fight to quality). Accompanied with the large losses in currency
RP = γσw . carry is the sudden strengthening in Yen (or other funding currencies) as carry
• Funding the overall portfolio traders seek to unwind their trades.
• Integrate investor’s view P 7. Managed futures: use liquid exchange traded futures and futures related
View portfolio: P = (P1 , · · · , Pn ), Pi = 0 X i i instruments to take views on the direction of global markets
mi × pt × size ≤ cash posted as margin ≤ capital.
View premium: Q (how much do you expect the overweight security to • Cross-sectional momentum: long securities that outperformed their peers
outperform the underweight security) i
regardless of whether they went up, and short securities that underperformed
View confidence: Ω, the less the more confident their peers regardless of whether they went down
• Revised risk premium: • Funding liquidity risk:
Risk that a hedge fund cannot fund the position throughout the life of the • Long securities that went up & short securities that went down
trade • Trend under-reaction: due to contrarian market participants. Anchoring bias
BL −1 0 −1 −1 −1 eq 0
−1
RP = (σ +P Ω × P) (σ RP +P Ω Q) Risk of being forced to unwind positions as the fund hits/nears a margin and disposition effect
constraint or as investors pull out Large market participants not motivated by profit
• Revised portfolio weights: • Liquidity spirals: Forced liquidation can be very costly Contrarian investors who slow down price discovery
There exists a crash risk that is difficult to detect during normal trading days • Trend over-reaction: confirmation bias (adding money to winning strategies
BL 1 −1 BL and investment)
w = σ RP . Return distributions are inherently non-normal
γ Correlations across securities can suddenly change Herding behavior (perhaps due to existence of asymmetric information)
During a liquidity event, the prices of securities held by traders with funding
• * For multiple n view, view premium would be a n-vector, view confidence is problems start to co-move, even if their fundamentals are unrelated
Options
n × n matrix, with non-zero entry on diagonal. Liquidity crisis is contagious 1. Type: European Call/Put, American Call/Put
3. Risk-management 2. Diffierentiate: “Sell To Open," “Buy To Close," “Buy To Open,” and “Sell To
• Value at Risk (VaR): maximum loss with certain confidence
Strategies Close".
1. Intrinsic value 3. Black-Shcoles-Merton Model:
• Expected shortfall: ES = E[loss|loss > V aR].
• Strategic risk target:( risk inteded to take) & Tactical risk target (varies from • Dividend discount model: • GBM to model stock price St :
strategic risk target depending on opp. & market conditions) ∞
• Drawdown control: X Et [Dt+s ] dSt = (µ − d)St dt + σSt dBt .
Vt = ,
Example: Given DDt , let the drawdown control policy be (MADD is s
s=1 (1 + kt+s ) Let rT = log(ST /S0 ),i.e., ST = S0 erT
maximum acceptable drawdown)
where D is dividend k is discount rate. 2 √
V aRt ≤ M ADD − DDt . rT = (µ − d − σ /2)T + σ T ,
• Gordon’s growth model: assumes Et [Dt+s ] = (1 + g)s Dt , then
or where  ∼ N (0, 1).
s × σt ≤ M ADD − DDt (1 + g)Dt • Brownian Motion Properties:
Vt = .
for some number s. k−g – B0 = 0.
• Reducing risk after losing on a position is painful. However, “first loss is your – Independent increments
least loss.” Assume market price Pt = Vt , then the implied expected return is growth plus
forward dividend yield, i.e., – Gaussian increments: BT − Bt ∼ N (0, T − t).
Transaction Costs and Liquidity Risk – Bt is continuous with probability 1.
1. Transaction costs includes commissions and other direct costs,bid-ask spread & (1 + g)Dt
k = g+ , • Risk-neutral Pricing: In risk-neutral world,
market impact costs
Pt √
• Securities with high transaction costs are said to be illiquid 2 Q
• Market liquidity risk refers to the risk of episodic spikes in transaction costs rT = (rf − q − σ /2)T + σ T  ,
• Multi-stage DMM:
• Increasing transaction costs (as a function of trade size): market impact
STRAT: split up a trade into many small orders and trade these small orders then option price is
T E [D
patiently over time X t t+s ] Pt+T
• Constant transaction costs: bid ask spreads. Vt = + Q −rT
s (1 + k)T Option price = E [e Option pay- off].
STRAT: only trade once in a while to save on trading costs, staying within a s=1 (1 + k)
band of the desired position (1 + g) (1 + g)Dt Pt+T For call option, then
• Decreasing transaction costs: commission. = (1 − ) + .
STRAT:trade in chunks that are worth the dealer’s time (1 + k)T k−g (1 + k)T
Q −rT
2. Measureing Transaction costs C0 = E [e (ST − K)1S >K ]
• Residual Income Model (RIM): Book value follows Bt = Bt−1 + NIt − Dt , T
• Dollar transaction costs versus pre-trade price: For buy orders
then −rT Q −rT Q
∞ E [RI = e E [ST 1S >K ] − e KE [1S >K ]
TC
$
= P
execution
−P
bef ore X t t+s ] T T
Vt = Bt + ,
s −qT −rT
s=1 (1 + k) = e S0 N (d1 ) − e KN (d2 )
For sell orders
$ execution bef ore where residual income RIt = N It − k · Bt−1 . where
TC = −(P −P )
• Relative Valuation: Stock price = Earnings × P/E of Comparable Companies.
Percentage: 2. Discretionary Equity Investing: log(S0 /K) + (rf − q + σ 2 /2)T
$ bef ore • Long-short equity: screen stocks by some criteria, tailored analysis built d1 =
T C = T C /P √
towards long/short investment. σ T
• Temporary price impact as captured by the subsequent price reversal. For buy:
• Value investing: buy low (stocks with high intrinsic value/market value), sell
log(S0 /K) + (rf − q − σ 2 /2)T
high (stocks with low intrinsic value/market value). d2 = √
$,realized execution later
TC = P −P • Catalysts: buy cheap stock, look for a catalyst that propels the stock price. σ T
• Studying management, analyze growth...
• Compare the execution price to the volume-weighted average price (VWAP) 3. Dedicated Short Bias: more short than long, look for companies with over-stated By put call-parity C0 − P0 = e−qT S0 − e−rT K, then
earnings, frauds, obsolete technology, etc.
$,V W AP execution V W AP • Frictions: costly when negative info nor reflected in price; speculative
TC = P −P −rT −qT
premium arise when people forecase the forecast of others. P0 = e KN (−d2 ) − e S0 N (−d1 ).
• Suppose that you have measured T Ci during each of your trade executions i, • Difficulties: lending fee, short squeeze (lack of supply drives up price), risk
• Delta Hedging: for call option
then the simple estimate of expected transaction costs is that you lose funding before the trade converges, hinderment from companies,
equity premium ∂C
I 4. Fundamental Strategies: trade on factors like value, momentum, quality, size, etc. −qT
1 X ∆0 = = e N (d1 ).
E[T C] = T Ci • Short term reversal factor: Return over past 1 month ∂S
I i=1 Buy losers, sell winners
Possible explanation: demand pressure and liquidity effects *Moreover, ∆(Call) − ∆(P ut) = 1.
3. Funding and leverage • Momentum factor • Implied Volatility: use market-observed price for the call to solve for implied
• leverage = long positions/NAV Return over past 12 months, excluding the last month volatility σ imp by using B-S formula.
• gross leverage = (long positions + short positions)/NAV Buy winners, sell losers • B-S Assumptions: log-normal distribution (fat-tailed in reality), constant
• net leverage = (long positions - short positions)/NAV Possible explanation: Under-reaction and delayed overreaction volatility (random in reality), continuous price change (jumps in reality).
4. More on Implied Volatility: Fix Income 5. Duration:
• Typically FX options produce implied volatility smile. 1. Features: T
∂P 1 + y C i · ti T ·F
• After the fall of 2008, currency options prices exhibit a sharp increase in tail
X
• Price vs. par value (at par, discount or premium) D = − = + .
t (1 + y)T P
risk.
• Option provisions: callable (bond issuer can pay back before maturity),
∂y P i=1 (1 + y) i
• Before the Fall of 2008, G10 option prices were only mildly asymmetric across
putable (bondholder has right demand payment before maturity), covertible
strikes. Instantaneous return of bond is
(bondholder has the right to exchange for stocks)
• During the Fall of 2008, however, high interest rate currencies sharply
depreciated while low interest rate currencies appreciated. 2. Benchmark Role of Treasury Bond:
∆P D
• Carry traders borrowing in Japanese yen and lending in New Zealand dollars • Treasury Curve as indicator for cost of funds at different borrowing horizons = − ∆y = −D̄∆y,
lost close to 30% of their investment in October 2008. • Price discovery about inflation prospects / macroeconomic fundamentals P 1+y
• Since the Fall of 2008, out-of-the money puts on high interest rate currencies • The most credit-worthy, essentially free of default risk
have become more expensive than out-of-the-money calls, indicating a high • Large amount outstanding, highly liquid
risk of large depreciations in those currencies. • A wide range of maturities, facilitating the construction of yield curves where D̄ = D/(1 + y) is modified duration (MD) that captures the percentage
5. Crash Premium: in the presence of tail risk, options are no longer redundant and • Well developed repo and derivatives markets change in bond price per unit change in yield.
cannot be dynamically replicated, and their pricing has two components: the • Increasing competition from private sector debt instruments 6. Convexity:
likelihood and magnitude of the tail risk, aversion or preference toward such tail
3. YTM & Bond price: Let P be price of bond with maturity T , Ci be coupon
events; investor are more senstive to left-tail, so protective puts tends to be more
over-priced than calls.
payment at time ti and F be face value of the bond, then ∂2 P 1 1 T C (t2 + t )2
X i i i F (T 2 + T )
= = +
6. VIX: a real-time market index that represents the market’s expectation of 30-day ∂y 2 P P (1 + y)2 i=1 (1 + y)t (1 + y)T
forward-looking volatility derived from the price inputs of the S&P 500 index T
X Ci F
options, it provides a measure of market risk and investors’ sentiments. P = +
t (1 + y)T
7. *Generalized Models: i=1 (1 + y) i
2-nd order approximation:
• Stochastic Volatility:
4. Yield Curve (term structure of interest rate) depends on Investor’s expectations
dSt = (r − q)St dt + σt St dWt , of future interest rates; premiums required by investors to hold long-term bonds: ∆P 1 2
2 follows an mean-reverting sqrt process: risk premium or liquidity preference; Monetary policy;economic growth and = −D̄∆y + Convexity(∆y) .
with σt P 2
inflation; Market segmentation.
2 2
d(σt ) = κ(θ − σt )dt + ησt dBt , • Normal: anticipate that economy will continue to grow at a normal rate
where κ, θ, η are postive and W, B are correlated BM. • Flat: indicates that the market is sending mixed signals to investors, generally Facts: The higher the coupon rate, the lower a bondâĂŹs convexity. Zero-coupon
• Jump-difussion Model****: happens when the market is making a transition between normal and inverted bonds have the highest convexity.
curves 7. *Principal Component Analysis (PCA): regression of returns of fixed income
St • Inverted: thought as indication that the economy will experience a slowdown security against three attributes of the yield curve: level, steepness, and
= (r − q − λk̄)dt + σdWt + kdNt . by some investors. curvature.
St