Lecture 1

1. Asset Allocation - choose assets (and weights) to be included into the portfolio, by performing macro and market analysis e.g. Stocks, Bonds, Real Estate

2. Securities Selection - within a certain asset catergory we choose what particular security to buy and sell performing security analysis to find under- and overpriced securities

1) Passive Investing (Beta) means, we hold a highly diversified portfolio and track its performance to some benchmark (e.g Index Fund)

• Fee is low

• Stock pricing is minimal

• Transaction costs are low

• Expected return is the market return, risk is market risk

2) Active investing (alpha) means we try hard to outperform the market by systematically selecting securies.

• Fee is high

• Stock picking is crucial

• Expected return is above market return, risk is active

3) Smart Beta or Beta + Alpha means we use a combination of Active and Passive. We construct using active but we hold it passively.

If an investors borrows money to invest in a stock and then the stock price drops to a certain level (below maintenance margin), a margin call is issued. The Investor then has to add new cash or securities, otherwise broker will sell existing securities to pay off the loan.

Risk

Both are measures of asymmetry (risk measures)

Skewness: a measure of asymmetry around the mean. It is zero for a normal distribution. Negative (positive) skew means a long left (right) tail.

Kurtosis: a measure of the degree of fat tails or peakedness. It is 3 for Normal distributions

1) Security Selection: produce input list (given in this example) by performing security analysis

2) Asset Allocatioon: selecting the composition of risky portfolios across broad asset classes. > Find the optimal risky portfolios (P), calculate its expected return and variance

3) Capital Allocation: allocate funds between risky portfolio and risk-free asset based on the degree of risk aversion. Find the optimal complete portfolio C, calculate its expected return and variance

The correlation p measures, how much 2 assets in a portfolio move in the same direction. We want a diversified portfolio to decrease our risk (variance), so best would be if the two assets are perfectly negative correlated.

P = 1 means they are perfectly positive correlated, risk is highest in that case

-1 > P < 1 means portfolios risk is reduced

It is the Capital allocation line, showing all risk-return combinations for various portfolio weights

It’s also called the Reward-to-Volatility ratio (the increase in return per unit of extra risk) - so it's the slope of CAL

When there are N assets, Portfolio opportunity set becomes the minimum-variance-frontier (MVF)

All portfolio risk-return combinations that are above global minimum-variance portfolio lie on the efficient frontier of risky assets

Given CAPM, we can split portfolio construction in two independent tasks

1) The optimal risky portfolio P is the same for all clients, regardless of their risk aversion, since all investors will have exactly the same efficient frontiers and CAL.

2) Capital Allocation between risky and risk-free assets will depend on personal preference (risk aversion)

Investing in a market-index fund and a risk-free asset (a passive strategy) is efficient (max sharpe)

3 assumptions for that

1) Investors are rational & want to optimise mean variance and have homogenous expectations

2) All stocks are publicly available, short positions are allowed, borrowing and lending are allowed

3) All information is publicly available, there are no taxes and transaction costs

The security market line is the linear expected return-beta relationship

Beta: measures the contribution of a stock to the variance of the market portfolio

It’s incredibly difficult since consistent success requires the skill of finding what thousands of other miss

• Economics is a strong antagonist of active investing (and pro of passive) as prices reflect all available information (only fools actively analyse securities)

Find a portfolio with the lowest possible risk for a given level of expected return

Hold many assets in the portfolio so that the exposure to any particular asset is limited

The correlation among assets

1. Money Market - short term debt securities, highly liquid and marketable (e.g. Treasury Bills)

2. Bond Market - long term debt instruments offering a fixed stream of income until maturity (e.g. Treasury Bonds)

3. Equity Market - stock represents ownership shares, giving the right to vote at annual meeting (e.g. common stock)

4. Derivatives Market - Options and futures

• Market Order - buy and sell orders to be executed immediately at current ask and bid prices. The bid-ask spread is what dealers earn

• Limit Order - buy and sell some number of shares only when stock price is below and above a specified level.

• Stop Order - buy and sell the stock if its price rises above and falls below a specified level (protect from losses)

• Open-End : most common type of investment fund (e.g mutual funds or ETFs), the fund can create new shares when investors buy in and redeem shares when they sell out. Always to NAV

• Closed-End: operate like publicly traded companies. Fund raises a fixed amount of capital and does not issue or redeem shares afterwards

• Hedge Funds Are private Investment partnerships that use flexible and often aggressive strategies to generate returns

• Mutual Funds Pool Money from many investors to invest in stocks, bonds or other securities

Differences:

1. Goal for MF is to outperform benchmark, for HF to generate absolute return

2. Regulation is strict for MF, light for HF

3. Liquidity is daily for MF, limited for HF

4. HF takes higher management fees

1. Taking a longer sample from the same distribution.

2. Increasing the frequency of observations

The reward per unit of risk (reward-to-volatility ratio)

• The Market Portfolio M contains all securities, all investors hold a fraction

• CAL becomes CML

• All investors have the same input list

• In Equilibrium, the prices of all assets must adjust until all are held by investors