Professional Documents
Culture Documents
Final Examination
Portfolio Management
Table of Contents
3. Portfolio Management 25
3.1 Modern Portfolio Theory...........................................................................25
3.1.1 The Risk/Return Framework .......................................................................... 25
3.1.2 Measures of Risk .............................................................................................. 27
3.1.3 Portfolio Theory ................................................................................................ 29
3.1.4 Capital Asset Pricing Model (CAPM) ........................................................... 30
3.1.5 Arbitrage Pricing Theory (APT) .................................................................... 31
3.2 Practical Portfolio Management .............................................................34
3.2.1 Managing an Equity Portfolio........................................................................ 34
3.2.2 Derivatives in Portfolio Management .......................................................... 37
3.3 Asset/Liability-Analysis and Management...........................................42
3.3.1 Valuation of Pension Liabilities .................................................................... 42
3.3.2 Surplus And Funding Ratio ........................................................................... 43
3.3.3 Surplus Risk Management ............................................................................. 43
3.4 Performance Measurement ......................................................................45
3.4.1 Performance Measurement and Evaluation .............................................. 45
Copyright © ACIIA®
Fixed Income Valuation and Analysis
Future value
Present value =
( 1 + Interest rate p.a.) number of years
1.1.1.2 Annuities
The present value of an annuity is given by
N CF CF 1
Pr esent value = ∑ = ⋅ 1 −
t =1 ( 1 + R )t R (1 + R )N
where
CF constant cash flow
R discount rate, assumed to be constant over time
N number of cash flows
(1 + R ) N − 1
Future value = CF ⋅
R
where
CF constant cash flow
R discount rate, assumed to be constant over time
N number of cash flows
Future value
Present value = number of years ⋅ continuous interest rate p.a.
e
Future value = (Present value) ⋅ e number of years ⋅ continuous interest rate p.a.
Between two coupon dates, for a bond paying coupons annually, the bond price
is given by
CF1 CFN
Pcum, f = Pex, f + f ⋅ C = (1 + Y ) f
CF2
+ +...+
(1 + Y ) (1 + Y )2 (1 + Y ) N
1
where
Pcum , f current paid bond price (including accrued interest)
Pex, f quoted price of the bond
Y yield to maturity
f time since last coupon date in years
CFi cash flow (coupon) received at time t i
CFN final cash flow (coupon plus principal)
N number of cash flows
(1 + R0,t ) t ⋅ (1 + Ft ,t ( )t (
1 + R 0 ,t )t 2 t2 −t1
t2 −t1
= 1 + R 0 ,t 2 ⇔ Ft1 ,t2 = 2 −1
( )t
1 ) 2
1 1 2 1+ R 1
0,t1
where
R0 ,t1 spot rate p.a. from 0 to t1
R0 ,t 2 spot rate p.a. from 0 to t 2
Ft1 ,t 2 forward rate p.a. from t 1 to t 2
Expectations hypothesis
~
Ft1 ,t2 = E( Rt1 ,t2 )
where
Ft1 ,t2 forward rate from t 1 to t 2
~
Rt1 ,t2 random spot rate from t1 to t 2
E(.) expectation operator
where
Ft1 ,t2 forward rate from t1 to t 2
~
Rt1 ,t2 random spot rate from t1 to t 2
Π t ,t
1 2
risk premium for the time from t1 to t 2
E(.) expectation operator
Yield Ratio
Yield bond B
Yield ratio =
Yield bond A
CFt
P0 =
(1 + Rt ) t
where
P0 bond price at time 0
CFt cash flow (principal) received at repayment date t
Rt spot rate from 0 to t
where
Pcum, f price of the bond including accrued interest
Pex, f quoted price of the bond
f time since the last coupon date in fractions of a year
CFi cash flow at time ti
Rti spot rate from f to ti
C coupon
CF
P0 =
R
where
P0 current price of the perpetual bond
CF perpetual cash flow (coupon)
R discount rate, assumed to be constant over time
Macaulay’s Duration
N t i ⋅ CFi t1 ⋅ CF1 t 2 ⋅ CF2 t N ⋅ CFN
∑ + + ... +
N t i ⋅ PV( CFi ) i =1 (1 + Y )ti
(1 + Y )t1
(1 + Y )t2
(1 + Y )t N
D= ∑ P
= N CFi
=
CF1 CF2 CFN
i =1 + + ... +
∑
i =1 (1 + Y )ti
(1 + Y ) t1
(1 + Y ) t2
(1 + Y )t N
where
D Macaulay’s duration
P current paid bond price (including accrued interest)
Y bond’s yield to maturity
CFi cash flow (coupon) received at time ti
PV(CFi) present value of cash flow CFi
CFN cash flow (coupon plus principal) received at repayment date t N
N number of cash flows
1 ∂P D
D mod = − =
P ∂Y 1 + Y
∂P D
DP = − = D mod ⋅ P = P
∂Y 1+ Y
where
D mod modified duration
DP price or dollar duration
D Macaulay’s duration
P current paid bond price (including accrued interest)
Y bond’s yield to maturity
Portfolio Duration
N
D P = ∑ xi ⋅ Di
i =1
where
DP portfolio duration
xi proportion of wealth invested in bond i
Di duration of bond i
N number of bonds in the portfolio
1.1.5.2 Convexity
1 ∂ 2P 1 1 N
t i (t i + 1) ⋅ CFi
2 ∑
C= ⋅ = ⋅ ⋅
P ∂Y 2 N
CFi (1 + Y ) i =1 (1 + Y )ti
∑ (1 + Y )
i =1
ti
CP = C ⋅ P
where
C convexity
P
C price convexity
P current paid bond price (including accrued interest)
Y bond’s yield to maturity
CFi cash flow (coupon) received at time ti
CFN cash flow (coupon plus principal) received at repayment date t N
1 P
∆P ≅ − D P ⋅ ∆Y + C ⋅ ∆Y 2
2
∆P −D 1 1
≅ ⋅ ∆Y + C⋅ ∆Y 2 = − D mod ⋅ ∆Y + C ⋅ ∆Y 2
P (1 + Y ) 2 2
where
∆P price change of the bond
D mod modified duration
DP price or dollar duration
D Macaulay’s duration
C convexity
CP price convexity
P current paid bond price (including accrued interest)
Y bond’s yield to maturity
∆Y Small change in the bond yield
Portfolio Convexity
N
Portfolio convexity = ∑ wi ⋅ C i
i =1
where
wi weight (in market value terms) of bond i in the portfolio
Ci convexity of bond i
N number of bonds in the portfolio
where
PP payback period in years
MP market price of the convertible
CV conversion value of the convertible
CY current yield of the convertible = (coupon/MP)
DY dividend yield on the common stock = dividend amount / stock price
CV − FV FV ⋅ ( Ync − Yc )
NPV = −∑
( 1+Ync ) n ( 1+Ync )t
where
NPV net present value
CV conversion value
FV face value
Ync yield on non-convertible security of identical characteristics
Yc yield on the convertible security
n years before the convertible is called
Callable bond price = Call-free equivalent bond price – Call option price
where
δ Delta of the call option embedded in the bond
γ Gamma of the call option embedded in the bond
1.4.1.1 Immunisation
A=L
DA = DL
A ⋅ DA = L ⋅ DL
where
A present value of the portfolio
L present value of the debt
DA duration of the portfolio
DL duration of the debt
σ ∆S S ⋅ D Smod
HR = ρ ∆S ,∆F ⋅ = t
σ ∆F Ft ,T ⋅ D Fmod
N S ⋅ S t ⋅ DSmod N S ⋅ S t ⋅ DSmod
NF = − =− ⋅ CFCTD ,t
k ⋅ Ft ,T ⋅ D Fmod k ⋅ S CTD ,t ⋅ D Fmod
where
HR hedge ratio
St spot price at time t
Ft,T futures price at time t with maturity T
ρ ∆S ,∆F correlation coefficient between ∆S and ∆F
σ ∆S standard deviation of ∆S
σ ∆F standard deviation of ∆F
CTD cheapest-to-deliver
DSmod modified duration of the asset being hedged
D Fmod modified duration of the futures (i.e. of the CTD)
NF number of futures contracts
NS number of the spot asset to be hedged
k contract size
SCTD,t spot price of the CTD
CFCTD,t conversion factor of the CTD
2.1.1.1 Swaps
n K Q
B1 = ∑ +
i =1 (1 + R0,ti ) ti (1 + R0,tn ) tn
where
B1 value of the fixed rate bond underlying the swap
K fixed payment corresponding to the fixed interest to be paid at time t i
Q notional principal in the swap agreement
R0, t i spot interest rate corresponding to maturity t i
When entering in the swap and immediately after a coupon rate reset date, the
value of bond B2 is equal to the notional amount Q . Between reset dates, the
value is
K* Q
B2 = +
(1 + R0,t1 ) t1
(1 + R0,t1 ) t1
where
B2 value of the floating rate bond underlying the swap
K * floating amount (initially known) used for the payment at date t1 , the next
reset date.
Q notional principal in the swap agreement
R0 ,t1 spot interest rate corresponding to maturity t1
V = S ⋅ BF − BD
where
V value of the swap
S spot rate in domestic per foreign currency units
B F value of the foreign currency bond in the swap, denoted in the foreign
currency
B D value of the domestic bond in the swap, denoted in the domestic currency
The payment in case of default to the buyer of the CDS may be expressed as
N ⋅ (1 − R )
where
N Notional amount of the CDS
R Recovery rate of the reference bond
Default probabilities
(p1 ⋅ p2 ⋅ ... ⋅ pi −1 ) ⋅ (1 − pi )
where
p i Probability of surviving over the interval t i −1 to t i without a default payment
1 − p i Probability of a default being triggered
CDS Evaluation
where
Present Value of expected payment =
T
and
2.2.1 Futures
where
Ft ,T futures price at date t of a contract for delivery at date T
St spot price of the underlying at date t
Rt ,T risk-free interest rate for the period t to T
where
Ft ,T forward or futures price at date t of a contract for delivery at date
T
St spot price of the underlying at date t
Rt ,T risk-free interest rate for the period t to T
k (t , S ) carrying costs, such as insurance costs, storage costs, etc.
FV(revenues) future value of the revenues paid by the spot
( rt ,T − y )⋅(T −t )
Ft ,T = St e
where
Ft ,T futures price at date t of a contract for delivery at date T
St spot price of the underlying at date t
y continuous net yield (revenues minus carrying costs) of the underlying asset
or commodity
rt ,T continuously compounded risk-free interest rate
where
Ft ,T futures price at date t of a contract that expires at date T
It current spot price of the index
Di,t j dividend paid by stock i at date tj
wi weight of stock i in the index
Rt ,T risk-free interest rate for the period t to T
Rt j ,T interest rate for the time period tj until T
N the number of securities in the index
( St + At ) ⋅ ( 1 + Rt ,T )T − t − Ct ,T − AT
Ft ,T =
Conversion Factor
where
Ft ,T quoted futures “fair” price at date t of a contract for delivery at date T
C t ,T future value of all coupons paid and reinvested between t and T
St spot value of the underlying bond
At accrued interest of the underlying at time t
Rt ,T risk-free interest rate for the period t to T
AT accrued interest of the delivered bond at time T
Commodity Futures
Ft ,T = S t ⋅ (1 + Rt ,T ) + k (t , T ) − Yt ,T
where
Ft,T futures price at date t of a contract for delivery at date T
St spot price of the underlying at date t
Rt,T risk-free interest rate for the period (T – t)
k(t,T) carrying costs, such as insurance costs, storage costs, etc.
Yt,T convenience yield
∆S N ⋅k NS
HR = =− F N F = − HR ⋅
∆F NS k
where
HR hedge ratio
∆S change in spot price per unit
∆F change in futures price per unit
NF number of futures
NS number of spot assets
k contract size
where
HR hedge ratio
NF number of futures
NS number of spot assets
k contract size
- Hedged Profit
For a long position in the underlying asset
Hedged profit = (ST − S t ) − (FT ,T − Ft ,T )
where
ST spot price at the maturity of the futures contract
St spot price at time t
FT ,T futures price at its maturity
Ft ,T futures price at time t with maturity T
where
HR hedge ratio
Cov(∆S,∆F) covariance between the changes in spot price (∆S) and the changes
in futures price (∆F)
Var(∆F) variance of changes in futures price (∆F)
ρ∆S,∆F coefficient of correlation between ∆S and ∆F
σ∆S standard deviation of ∆S
σ∆F standard deviation of ∆F
2.2.2 Options
C E = S ⋅ N (d1 ) − Ke − rτ ⋅ N (d 2 )
PE = Ke − rτ ⋅ N (− d 2 ) − S ⋅ N (− d1 )
ln(S / K ) + (r + σ 2 / 2)τ
d1 = , d 2 = d1 − σ τ
σ τ
where
CE value of European call
PE value of European put
S current stock price
τ time in years until expiry of the option
K strike price
σ volatility p.a. of the underlying stock
r continuously compounded risk-free rate p.a.
N( ⋅ ) cumulative distribution function for a standardised normal random
variable
(see table in 2.2.3), and
s2
x 1 −
N ( x) = ∫ e 2 ds
− ∞ 2π
C E = S * ⋅ N (d1* ) − Ke − rτ ⋅ N (d 2* )
PE = Ke − rτ ⋅ N (− d 2* ) − S * ⋅ N (−d1* )
d1* =
( )
ln S * / K + (r + σ 2 / 2)τ I
, d 2* = d1* − σ τ , S * = S − ∑ Di ⋅ e − rτ i
σ τ i =1
where
CE value of European call
PE value of European put
τi time in years until i th dividend payment
Di dividend i
S current stock price
τ time in years until expiry of the option
K strike price
σ volatility p.a. of the underlying stock
r continuously compounded risk-free rate p.a.
I number of dividend payments
N( ⋅ ) cumulative normal distribution function (see table in 2.2.3)
J I − r ⋅τ
C E = S − ∑ ∑ D j ,i ⋅ e j ,i N ( d1 ) − K ⋅ e − r ⋅τ ⋅ N ( d 2 )
j =1i =1
J I − r ⋅τ
PE = K ⋅ e − r ⋅τ ⋅ N ( −d 2 ) − S − ∑ ∑ D j ,i ⋅ e j ,i ⋅ N ( − d1 )
j =1i =1
J I − r ⋅τ
S t − ∑ ∑ D j ,i ⋅ e j ,i
j =1i =1
ln
K ⋅ e −r ⋅τ
1
d1 = + ⋅ σ ⋅ τ and d = d − σ ⋅ τ
2 1
σ⋅ τ 2
where
CE price of the European call at date t
PE price of the European put at date t
S price of the index at date t
K strike price
r continuously compounded risk-free rate p.a.
σ standard deviation of the stock index instantaneous return
Dj,i dividend paid at time ti by company j weighted as the company in the
index
τ time in years until expiry of the option
τj,i time remaining until the dividend payment at time ti by company j
N( ⋅ ) cumulative normal distribution function (see table in 2.2.3)
Options on Futures
C E = e − rτ [F ⋅ N (d1 ) − K ⋅ N (d 2 )]
PE = e − rτ [K ⋅ N (−d 2 ) − F ⋅ N (−d1 )]
ln (F / K ) 1
d1 = + σ τ , d 2 = d1 − σ τ
σ τ 2
where
CE value of European call
PE value of European put
F current futures price
τ time in years until expiry of the option
K strike price
σ volatility p.a. of the futures returns
r continuously compounded risk-free rate p.a.
N( ⋅ ) cumulative normal distribution function (see table in 2.2.3)
Options on Currencies
− r for τ
CE = S ⋅ e ⋅ N (d1 ) − Ke − rτ ⋅ N (d 2 )
− r for τ
PE = Ke − rτ ⋅ N (−d 2 ) − S ⋅ e ⋅ N (−d1 )
ln(S / K ) + (r − r for + σ 2 / 2)τ
d1 = , d 2 = d1 − σ τ
σ τ
where
CE value of European call
PE value of European put
S current exchange rate (domestic per foreign currency units)
τ time in years until expiry of the option
K strike price (domestic per foreign currency units)
σ volatility p.a. of the underlying foreign currency
r continuously compounded risk-free rate p.a.
r for continuously compounded risk-free rate p.a. of the foreign currency
N( ⋅ ) cumulative normal distribution function (see table in 2.2.3)
ln(S / K ) + ( r − σ 2 / 2 )τ
d2 =
σ τ
where
C value of call option
P value of put option
S current price of the underlying
K strike price
σ volatility p.a. of the underlying returns
τ time in years until expiry of the option
r continuously compounded risk-free rate p.a.
N ( ⋅ ) cumulative distribution function (see table in 2.2.3)
ln(S / K ) + ( r + σ 2 / 2 )τ
d1 =
σ τ
where
C value of call option
P value of put option
S current price of the underlying
τ time in years until expiry of the option
σ volatility p.a. of the underlying returns
r continuously compounded risk-free rate p.a.
N ( ⋅ ) cumulative distribution function (see table in 2.2.3)
n(x) probability density function:
x2
1 −
n( x ) = N ' ( x ) = e 2
2π
∂C S ∂P S
ΩC = ⋅ ΩP = ⋅
∂S C ∂S P
where
ΩC elasticity of a call
Ω P elasticity of a put
C current value of call option
P current value of put option
S current price of the underlying
∂C
νC = = S ⋅ τ ⋅ n( d1 ) ( ν C ≥ 0 )
∂σ
∂P
νP = = S ⋅ τ ⋅ n( d1 ) = ν C (ν P ≥ 0 )
∂σ
ln(S / K ) + ( r + σ 2 / 2 )τ
d1 =
σ τ
where
C value of call option
P value of put option
S current price of the underlying
K strike price
τ time in years until expiry of the option
σ volatility p.a. of the underlying returns
r continuously compounded risk-free rate p.a.
n(x) probability density function (see formula 0 for definition)
3. Portfolio Management
3.1.1.1 Return
Pt − Pt −1 +
J
∑ Dt j (
⋅ 1 + Rt*j ,t ) t −t j
j =1
Rt =
Pt −1
where
Rt simple (or discrete) return of the asset over period t − 1 to t
Pt price of the asset at date t
Dt j dividend or coupon paid at date t j between t − 1 and t
where
rA arithmetic average return over N sequential periods
Ri holding period returns
N number of compounding periods in the holding period
R A = N (1 + R1 ) ⋅ (1 + R 2 ) ⋅...⋅ (1 + R N ) − 1
where
RA geometric average return over N sequential periods
Ri discrete return for the period i
N number of compounding periods in the holding period
= ln(1 + Rt )
Pt
rt = ln
Pt −1
Rt = e rt − 1
where
Pt price of the asset at date t
rt continuously compounded return between time t − 1 and t
Rt simple (discrete) return between time t − 1 and t
Annualisation of Returns
Annualising holding period returns (assuming 360 days per year)
Assuming reinvestment of interests at rate Rτ
Rann = (1 + Rτ )360 / τ − 1
where
Rann annualised simple rate of return
Rτ simple return for a time period of τ days
Note: convention 360 days versus 365 or the effective number of days varies
from one country to another.
360
ran = × rτ
τ
where
ran annualised rate of return
rτ continuously compounded rate of return earned over a period of τ
days
rtreal = rtnominal − it
where
Rtreal real rate of return on an asset over period t (simple)
Probability Concepts
Expectation value E(.), variance Var(.), covariance Cov(.) and correlation
Corr(.) of two random variables X and Y if the variables take values x k , y k in
state k with probability p k
K K
E( X ) = ∑ p k ⋅ x k , E(Y ) = ∑ p k ⋅ y k
k =1 k =1
[ ] K
Var ( X ) = σ X2 = E ( X − E( X )) 2 = E( X 2 ) − E( X ) 2 = ∑ p k ( x k − E( X )) 2
k =1
K
Cov( X , Y ) = σ XY = E[( X − E( X )) ⋅ (Y − E(Y ))] = ∑ p k ( x k − E( X )) ⋅ ( y k − E(Y ))
k =1
σ XY
Corr ( X , Y ) =
σ X ⋅σ Y
K
where ∑ p k = 1 , and
k =1
pk probability of state k
xk value of X in state k
yk value of Y in state k
K number of possible states
The mean E(.), variance Var(.), covariance Cov(.) of two random variables X
and Y, in a sample of N observations of xi and yi , are given by
1 N 1 N
E( X ) = x = ∑ xi , Var( X ) = σ X2 = ∑ ( xi − x ) 2
N i =1 N − 1 i =1
1 N
Cov( X , Y ) = σ XY = ∑ ( xi − x ) ⋅ ( y i − y )
N − 1 i =1
where
xi , yi observation i
x, y mean of X and Y
σ X ,σ Y standard deviations
σ XY covariance of X and Y
N number of observations
Normal Distribution
Its probability density is given by the following function:
−
( x − µ )2
1 2⋅σ 2
f ( x) = ⋅e
2 ⋅π ⋅σ
where
x the value of the variable,
µ the mean of the distribution,
σ standard deviation.
Computing volatility
1 N 1 N
σ = ∑ (rt − r ) 2 , r= ∑ rt
N − 1 t =1 N t =1
where
σ standard deviation of the returns (the volatility)
N number of observed returns
Pt
rt = ln continuously compounded return of asset P over period t
Pt −1
Annualising Volatility
Assuming that monthly returns are independent, then
σ
σ ann = 12 ⋅ σ m = τ
τ
where
σ ann annualised volatility
where ∑ xi = 1 , and
R P,t return on the portfolio in period t
Ri, t return on asset i in period t
xi initial (at beginning of period) proportion of the portfolio invested in asset
i
N number of assets in portfolio P
N N N N
Var( R P ) = σ P2 = ∑ ∑ xi x j σ ij = ∑ ∑ xi x j ρ ij σ i σ j
i =1 j =1 i =1 j =1
where
σ P2 variance of the portfolio return
σ ij covariance between the returns on assets i and j
ρ ij correlation coefficient between the returns on assets i and j
σi , σ j standard deviations of the returns on assets i and j
xi initial proportion of the portfolio invested in asset i
xj initial proportion of the portfolio invested in asset j
N number of assets in portfolio P
E( R M ) − r f
E( R P ) = r f + σP
σM
where
E( R P ) expected return of portfolio P
rf risk free rate
E( RM ) expected return of the market portfolio
σM standard deviation of the return on the market portfolio
σp standard deviation of the portfolio return
[
E( Ri ) = r f + E( R M ) − r f ⋅ β i ]
Cov( Ri , R M )
βi =
Var( R M )
where
E( Ri ) expected return of asset i
E( RM ) expected return on the market portfolio
rf risk free rate
βi beta of asset i
Cov( Ri , R M ) covariance between the returns on assets i and market portfolio
Var( R M ) variance of returns on the market portfolio
Beta of a Portfolio
N
β p = ∑ xi β i
i =1
where
βP beta of the portfolio
βi beta of asset i
xi proportion of the portfolio invested in asset i
N number of assets in the portfolio
( )
K −1
( )
E [ri ] − r f = β i ⋅ E [rM ] − r f + ∑ γ i ,k ⋅ E [s k ] + r fk − r f
k =1
where
E( ri ) expected return of asset i
E( rM ) expected return on the market portfolio
βi beta of asset i
rf continuous compounded risk-free rate in the domestic country
sk return on the exchange rate of country k
r fk continuous compounded risk-free rate in country k
K number of countries considered
and
Cov[ri , s k ]
γ i,k =
Var [s k ]
N
E(Ri ) ≈ R f + ∑ λ j β ij
j =1
where
E(Ri ) expected return on asset i
Rf risk free rate
λj expected return premium per unit of sensitivity to the risk factor j
β ij sensitivity of asset i to factor j
N number of risk factors
Single-Index Model
Rit = α i + β i ⋅ Rindex , t + ε it
where
Rit return on asset or portfolio i over period t
αi intercept for asset or portfolio i
βi sensitivity of asset or portfolio i to the index return
Rindex ,t return on the index over period t
ε it random error term ( E(ε it ) = 0 )
Market Model
Rit = α i + β i ⋅ RMt + ε it
Covariance between two Assets in the Market Model or the CAPM Context
σ ij = β i ⋅ β j ⋅ σ M
2
where
σ ij covariance between the returns of assets i and j
βi beta of portfolio i
βj beta of portfolio j
σM
2
variance of the return on the market portfolio
σ i2 = β i2σ M
2
+ σ ε2
123 {i
market residual
risk risk
where
σ i2 : total variance of the return on asset or portfolio i
β i2σ M
2
: market or systematic risk (explained variance)
β i2 ⋅ σ I2 β i2 ⋅ σ I2 σ ε2
2
R = = =1− i
= ρ iI2
σ i2 β i2 ⋅ σ I2 + σ ε2 σ i2
i
where
R2 coefficient of determination in a regression of Ri on R I
Multi-Index Models
ri = α i + β i1I1 + β i 2 I 2 + ... + β in I n + ε i
where
Ri return on asset or portfolio i
β ij beta or sensitivity of the return of asset i to changes in index j
Ij index j
εi random error term
n number of indices
Active Return
R AP,,tB = RtP − RtB
where
R AP,,tB active return in period t
RtP return of the portfolio in period t
RtB return of the benchmark in period t
Tracking Error
TE P , B = V ( R AP , B )
where
TE P , B tracking error
(
V R AP , B ) variance of the active return
where:
Ri excess return of an asset i (i = 1, …, N)
xi, j exposure (factor-beta respectively factor-loading) of asset i to factor j
Fj excess return of factor j (j = 1, … , NF)
εi specific return of asset i (residual return)
NF number of factors
R P = x P' ⋅ F + ε P
where:
N
x'P = ( x P ,1 ,K , x P ,NF ), x P , j = ∑ wiP ⋅ xi , j (j=1,…,NF)
i =1
and
xi, j exposure (factor-beta respectively factor-loading) of asset i to factor j
xP, j exposure of the portfolio to factor j
F = ( F1 ,..., FNF ) is the NF x 1 vector of factor returns,
wiP is the weight of asset i in the portfolio
N
ε P = ∑ wiP ⋅ ε i specific return of the portfolio, where ε i is the specific
i =1
return
of asset i
NF number of factors
N number of assets in the portfolio
where:
x'P 1 x NF vector of portfolio exposures to factor returns
W covariance matrix of vector F, i.e. of the factor returns
s i2 variance of asset i specific return
s P2 variance of the portfolio’s specific return
N number of assets in the portfolio
Tracking error
N
TE P,B = (x'P − x'B ) ⋅ W ⋅ (x P − x B ) + ∑ (wiP − wiB ) 2 ⋅ si2
i =1
where:
TE P ,B tracking error of the portfolio with respect to the benchmark
x'P 1 x NF vector of portfolio exposures to factor returns
x'B 1 x NF vector of benchmark exposures to factor returns
W covariance matrix of vector F, i.e. of the factor returns
wiP weight of asset i in the portfolio
wiB weight of asset i in the benchmark
s i2 variance of asset i specific return
N number of assets in the portfolio
Information Ratio
~
~ P,B R AP,B
IR A = ~ P,B
TE A
where
~
IR AP ,B information ratio for portfolio P with respect to benchmark B
~
R AP ,B the expected active return of the portfolio
~
T E AP ,B the expected tracking error
Portfolio Return
rPC + rPD = r f + β ( rMC + rMD − r f )
where
rPC capital gain of the portfolio
rPD dividend yield of the portfolio
rMC price index return
rMD dividend yield of the index
rf risk-free rate
β portfolio beta with respect to the index
Portfoliovalue S
NP = β ⋅ =β⋅ 0
Index level ⋅ Option contract size I0 ⋅ k
where
NP number of protective put options
S0 initial value of the portfolio to be insured
I0 initial level of the index
β portfolio beta with respect to the index
k option contract size
Floor
Φ
f =
V0
where
f insured fraction of the initial total portfolio value
Φ floor [= minimum final portfolio value, capital + dividend income]
V0 initial total value of the insured portfolio
K S
VT = (1 − β)(1 + rf ) + β ⋅ rMD + β ⋅ ⋅ S0 = f ⋅ S0 + β ⋅ P( I 0 , T, K ) 0
I0 I0
Strike price
I0 P( I 0 , T , K )
K= f ⋅ 1 + β ⋅ − (1 − β)(1 + rf ) − β ⋅ rMD
β I0
where
VT total final value of the insured portfolio
S0 initial value of the portfolio to be insured
I0 initial level of the index
β portfolio beta with respect to the index
f insured fraction of the initial total portfolio value
rMD dividend yield of the index
rf risk-free rate
P(I0,T,K) put premium for a spot I0, a strike K and maturity T
K
VT = ( 1 − β )( 1 + r f ) + β ⋅ rMD + β ⋅ ⋅ S 0 = f ⋅ S 0
I0
Strike price
K=
I0
β
[ f − ( 1 − β )( 1 + r f ) − β ⋅ rMD ]
where
VT total final value of the insured portfolio
S0 initial value of the portfolio to be insured
I0 initial level of the index
β portfolio beta with respect to the index
f insured fraction of the initial total portfolio value
rMD dividend yield of the index
rf risk-free rate
Black&Scholes Model
P(S t , T , K ) = K ⋅ e
− r f ⋅(T −t )
(
⋅ N (− d 2 ) − S t ⋅ e − y⋅(T −t ) ⋅ N ( − d1 ) )
S
ln t + (r f − y )⋅ (T − t )
d1 =
K 1
+ ⋅σ ⋅ T − t d 2 = d1 − σ ⋅ T − t
σ ⋅ T −t 2
where
P ( S t , T , K ) put premium for a spot St, a strike K and maturity T
St index spot price at time t
K strike price
rf risk-free rate (continuously compounded, p.a.)
y dividend yield (continuously compounded, p.a.)
σ volatility of index returns (p.a.)
T−t time to maturity (in years)
N(.) cumulative normal distribution function
∆ P = e − y⋅(T −t ) ⋅ [N (d1 ) − 1]
where
∆P delta of a put
y dividend yield (continuously compounded, p.a.)
T−t time to maturity (in years)
where
N F number of futures
T* maturity of the futures contract
T maturity of the replicated put
β risky asset beta with respect to the index
NS number of units of the risky assets
k futures contract size
Cushion
ct = Vt – Φt
where
ct cushion
Vt value of the portfolio
Φt floor
where
At total amount invested in the risky assets at time t
NS,t number of units of the risky assets
St unit price of the risky assets
m multiplier
ct cushion
where
Bt value of the risk-free portfolio at time t
Vt value of the total portfolio at time t
At value of the risky portfolio at time t
where
∆St changes in spot price at time t
St spot price at time t
α intercept of the regression line
β slope of the regression line
∆F t changes in the futures price at time t
Ft,T futures price at time t with maturity T
εt residual term
HR hedge ratio
S 0 ⋅ (D St arg et − D Sactual )
HR =
F0,T ⋅ D F
where
HR hedge ratio
S0 is the value of the spot price at time 0
D St arg et is the target duration
D Sactual is actual duration
F0,T is the futures price at time 0
DF is the duration of the futures (i.e. of the CTD)
Lt = α t ⋅ Wt ⋅ RFt ,T ⋅ Π t ,T ⋅ a x ⋅ d t ,T
where
Lt value of liabilities at time t
T time of retirement
αt pension benefit accrual factor at time t
Wt salary of the future retiree at time t
RFt ,T revaluation factor at time t
Π t ,T retention factor at time t
ax annuity factor for a (future) retiree retiring at age x
dt ,T discount factor between time t and retirement age T
Annuity factor
w −x px,t
ax = ∑
t
t =0 (1 + r)
where
ax annuity factor for a (future) retiree retiring at age x
w ending age of the mortality table
px ,t probability of a person aged x to survive until age x+t
r (deterministic) interest rate
3.3.2.1 Surplus
SPt = At − Lt
where
SPt surplus at time t
At value of assets at time t
Lt value of liabilities at time t
A
FRt = t
Lt
where
FRt funding ratio at time t
At value of assets at time t
Lt value of liabilities at time t
SP1 − SP0
RSP = = FR0 ⋅ R A − R L
L0
where
RSP one period surplus return
SPt surplus at time t
L0 value of liabilities at time 0
FR0 funding ratio at time 0
R A return on assets
RL return on liabilities
µ SP = FR0 ⋅ µ A − µ L
where
µSP mean surplus return
FR0 funding ratio at time 0
µ A mean return on assets
µL mean return on liabilities
Surplus risk
σ SP = (FR0 ⋅ σ A ) 2 − 2 ⋅ (FR0 ⋅ σ A ) ⋅ σ L ⋅ ρ AL + σ L2
where
σ SP surplus risk
FR0 funding ratio at time 0
σ A risk (volatility) on assets
σ L risk (volatility) on liabilities
ρAL correlation coefficient of assets and liabilities
P[RSP ≤ SPmin ] ≤ α
α shortfall risk
RSP one period surplus return
SPmin minimal (threshold) surplus
µSP ≥ SPmin + zα σ SP
Simple Return
MVend ,t − MVbegin,t MVend ,t
TWRt / t −1 = = −1
MVbegin,t MVbegin,t
where
TWRt/t−1 simple time weighted return for sub-period t
MVbegin,t market value at the beginning of sub-period t
MVend,t market value at the end of sub-period t
Dietz Formula
1
AIC = MVbegin + ⋅ NCF
2
where
AIC average invested capital
MVbegin market value at the beginning of the period
NCF net cash flow
Dietz formula
( MVend − MVbegin ) − NCF
MWR =
1
MVbegin + ⋅ NCF
2
where
MWR money weighted return
MVbegin market value at the beginning of the period
MVend market value at the end of the period
NCF net cash flow
where
VWDj value weighted day of the total cash flow of type j (contributions, purchases,
sales, ...)
CFj,i i-th cash flow of type j (contributions, purchases, sales, ...)
ti day when the i-th cash flow takes place
= MVbegin + ( pC ⋅ ∑ Ci + p P ⋅ ∑ Pi + p E ⋅ ∑ Ei ) − ( pW ⋅ ∑ Wi + p S ⋅ ∑ S i + p D ⋅ ∑ Di + p R ⋅ ∑ Ri )
14444444444444444 4244444444444444444 3
=WCF
where
AIC average invested capital
MVbegin market value at the beginning of the period
ti time of cash flow I
tbegin time corresponding to the beginning of the period
tend time corresponding to the end of the period
CFi cash flow
Ci effective contributions
Pi purchases
Ei immaterial contributions measured by the expenses they generate
Wi effective withdrawals
Si sales
Di net dividend and other net income
Ri reclaimable taxes
WCF weighted cash flow
pC, pP, pE, pW, pS, pD and pR are the weights calculated as follows:
where
j various cash flow types (contributions, purchases, expenses etc.)
CFj,i i-th cash flow of type j
VWDj value weighted day
where
MVend market value at the end of the period
Sharpe Ratio or rP − r f
Reward-to-Variability Ratio RVAR P =
σP
Treynor Ratio or rP − r f
Reward-to-Volatility Ratio RVOLP =
βP
Jensen’s α α P = (rP − r f ) − β P ⋅ (rM − r f )
Information Ratio α
ARP =
(Appraisal Ratio) σε
where
rP average portfolio return
rM average market return
rf average risk-free rate
αP Jensen’s alpha
α Active Return (Excess return)
βP portfolio beta
σP portfolio volatility
σε Active Risk (standard deviation of the tracking error)
Price-Weighted Indices
n
∑ pt
j
where
Pt / 0 arithmetic average of the elementary price indices
n number of elementary price indices
pj
Pt j/ 0 = j t j elementary index for security j where:
ct / 0 ⋅ p 0
ptj , p0j price of security j at time t, respectively at time 0
ctj/ 0 adjustment coefficient for a corporate action on security j (=1 at time 0)
n
∑ pt ⋅ q 0
j j
j =1 n n p0j ⋅ q0j
PILt / 0 = n
= ∑ w0
j
⋅ Pt /j 0 =∑ n
⋅ Pt /j 0
j =1 j =1
∑ p0 ⋅ q0 ∑ p0 ⋅ q0
j j i i
j =1 i =1
j
pt
Pt j/ 0 = = 1 + Rt j/ 0
p 0j
where
PILt/0 Laspeyres capital-weighted index
j
pt actual price of security j
w0j weight of security j in the index at the basis i.e. relative market capitalization
of security j at the basis
Rt j/ 0 return in security j between the basis and time t
Index Scaling
Itoriginal Btk
scaled
It / 0 = / 0 ⋅ Bt k = Itoriginal
/ 0 ⋅
Itoriginal Itoriginal
k /0 k /0
where
I tscaled
/0 scaled index at time t with base 0 and level Btk at scaling time tk
I toriginal
/0 unscaled original index at time t with basis 0
I toriginal
/0
unscaled original index at scaling time tk with basis 0
k
Btk scaling level (typically 100 or 1000)
Index Chain-Linking
I tnew
I tchained
/0 = /0
⋅ I told
k /0
= f t / tk ⋅ I told
k /0
I tnew
k /0
where
I tchained
/0 chained index level at time t, with original basis in 0
I tnew
/0 new index computed at time t
new
I tk / 0 new index computed at chain-linking time tk
I told
k /0
old index level at chain-linking time tk
f t / tk chaining factor at time t, with chain-linking time tk = 1 + Rt / tk
I tchained
/0 = f t / t −1 ⋅ f t −1 / t −2 ⋅ ... ⋅ f 2 / 1 ⋅ f1 / 0 ⋅ B0
= ( 1 + Rt / t −1 ) ⋅ ( 1 + Rt −1 / t −2 ) ⋅ ... ⋅ ( 1 + R2 / 1 ) ⋅ ( 1 + R1 / 0 ) ⋅ B0
where
Rt/t-1 elementary index return for period t
B0 index level at reference time 0
Sub-Indices
General Index
Ki Ki
I tgeneral
/0 = ∑ wt/ 0t ⋅ I t/ 0t
segments K ti
where
I tgeneral
/0 index level for the general index at time t with reference time 0
Ki
I t/ 0t index level for the segment Ki at time t with reference time 0
Ki
wt/ 0t the relative market capitalization of the segment Ki at time t
Sub-Index Weight
p0j ⋅ q0j
w0K = ∑ w0j = ∑ n
j∈K j∈K
∑ p0i ⋅ q0i
i =1
where
w0K the relative market capitalisation of the segment K
Performance Indices
∑ ( pt + d sj+1 ) ⋅ q sj
j
j∈K si
f ti/ s =
∑ p sj ⋅ q sj
j∈K si
where
j security identifier in segment i
f ti/ s compounding factor for segment i
j
qs number of outstanding shares of security j at previous closing/chaining time
s
psj cum-dividend price of security j at previous closing time s
where
f ti/ s compounding factor for segment i
j
qs number of outstanding shares of security j at previous closing/chaining time s
rsj+1 price quoted for the right detached from security j on day s+1
where
CBC/LC simple currency return
SBC/LC,t spot exchange rate at the end of the period
SBC/LC,t-1 spot exchange rate at the beginning of the period
where
CF,BC/LC simple currency forward return
SBC/LC,t spot exchange rate at time t
FBC/LC,T frward exchange rate at time t with expiration in T
Rf,BC risk-free rate on the base currency
Rf,LC risk-free rate on the local currency
where
CBC/LC simple currency return
EBC/LC unexpected currency return
CF,BC/LC simple currency forward return
St spot price at the end of the period
Ft-1,1 forward rate at the beginning of the period for one period
Rf,BC risk-free rate on the base currency
Rf,LC risk-free rate on the local currency
Jensen’s α
α P = RP − RE = ( RP − RB ) + ( RB − RE )
14243 14243
Net selectivity Diversification
where
σP
RB = R f + ⋅ ( RM − R f )
σM .
RE = R f + β P ⋅ ( RM − R f )
and
αP Jensen’s alpha
RP actual portfolio return
RM actual market return
Rf risk-free rate
RE portfolio return at equilibrium with beta equal to βP
RB portfolio return at equilibrium with volatility equal to σP
σP portfolio volatility
σM market volatility
where
RP actual portfolio return
Rf risk-free rate
RB portfolio return at equilibrium with volatility equal to σP
RE portfolio return at equilibrium with beta equal to βP
RM actual market return
Simple Return
1 + R Dt = (1 + R Ft ) ⋅ (1 + st )
where
RDt simple rate of return denominated in domestic currency
RFt simple rate of return denominated in foreign currency
st relative change (depreciation or appreciation) in the value of the domestic
currency
where
rDt continuously compounded rate of return denominated in domestic
currency
rFt continuously compounded rate of return denominated in foreign
currency
stcc continuously compounded relative change (depreciation or
appreciation) in the value of the domestic currency
[ ]
Var [rDt ] = Var [rFt ] + Var s cc
t
[
+ 2 ⋅ Cov rFt , s cc
t
]
where
Var []
⋅ the covariance operator.
Cov[]⋅ the covariance operator.
rDt continuously compounded rate of return denominated in domestic
currency
rFt continuously compounded rate of return denominated in foreign currency
s tcc continuously compounded relative change (depreciation or appreciation)
in the value of the domestic currency
= ∑ ((wP,j − wI,j) ⋅RI,j + wI,j ⋅ (RP,j −RI,j) + (wP,j − wI,j) ⋅ (RP,j − RI,j))
where
VA value added
R portfolio return
I benchmark return
∑ sum over every market in the portfolio and in the benchmark
RP,j portfolio return in each market
RI,j index return in each market
wP,j portfolio weight in each market at the beginning of the period
wI,j index weight in each market at the beginning of the period
where
VA value added
R portfolio return
I benchmark return
∑ sum over every market in the portfolio and in the benchmark
RP,j portfolio return in each market
RI,j index return in each market
wP,j portfolio weight in each market at the beginning of the period
wI,j index weight in each market at the beginning of the period
where
vaBC value added in base currency
rBC portfolio return in base currency(continuously compounded)
iBC benchmark return in base currency(continuously compounded)
where
rBC,adj adjusted local market return in base currency
rLC local market return in local currency
rf,BC risk-free rate in base currency at the beginning of the period
rf,LC risk-free rate in local currency at the beginning of the period
where
eBC/LC unexpected currency return
cBC/LC actual currency return
rf,BC risk-free rate in base currency at the beginning of the period
rf,LC risk-free rate in local currency at the beginning of the period
where
vaBC value added in base currency
∑ sum over every market in the portfolio and in the benchmark
rBC,P,adj adjusted portfolio return of the local market in base currency
rBC,I,adj adjusted index return of the local market in base currency
eP unexpected portfolio currency return
eI unexpected passive currency return
wP portfolio weight in each market at the beginning of the period
wI index weight in each market at the beginning of the period