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Intuition of the Black-Derman-Toy interest rate model - Observed spot rates drive rate levels while implied rate volatilities drive rate spreads Understanding the intuition of imposing these two conditions helps in understanding the essence of the BDT model. The spot rates in the currently observed term structure drive the overall levels of the rates that are projected throughout the binomial tree. The implied volatilities of options trading on short‐ term rates (i.e., interest rate caplets) drives the spreads between the "up rates" and the "down rates" corresponding to the expiration dates of the caplets Mitigating Estimation Error Risk in Mean-Variance Optimization - Mitigating Estimation Error Risk in Mean-Variance Optimization returns strives to reduce estimation error and typically is executed by: (1) repeated analysis of hypothetical returns simulated from the statistical parameters estimated from the original sample of returns; or (2) repeated analysis of new samples of returns generated from the original sample using draws with replacement The three major types of credit risk modeling approaches - I. The structural approach II. The reduced-form approach
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III. The empirical approach The structural approach - In the structural approach, the framework is set around an explicit relationship between capital structure and default. The value of a firm's assets is set equal to the value of its equity plus the value of its debt. Equity of the firm is viewed as a call option on the firm's assets, with the strike price being the face value of the debt due at the time of exercise. In contrast, bondholders are viewed as having a risk-free bond and a short position in a put option on the firm's assets. If the value of assets is less than the face value of the debt, the put option will be exercised on the bondholders, resulting in their giving up the risk-free bond and receiving the firm's assets. Consider a portfolio allocation process in which the following two portfolio allocation strategies are being considered for use:
- Minimum volatility portfolio weights
- Risk parity portfolio weights In this particular portfolio allocation process, all the available investment opportunities have the same return volatilities but the return correlations between each pair of assets differ.
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However, as the time to the debt's maturity is increased, the probabilities of default (and credit spreads) increase. Therefore, for firms with low leverage the term structure of credit spreads tends to be upward sloping Altman's credit scoring model - Z < 1.81: Default group 1.81 < Z < 2.99: Gray zone Z > 2.99: Nondefault group Three challenges of empirical multifactor models - I. False identification of factors II. Potential sufficiency of the CAPM III. Factor return correlation v. causation
- p263: First, widespread searches for statistically significant factors run the risk of false identification of useful factors
- p264: A second potential difficulty is in differentiating between factors that are correlated with returns and those that cause returns
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- P264-265: A key challenge in using an empirical multi-factor model lies in justifying why it should perform better than the CAPM in describing the tradeoff between risk and return The bottom up approach - The approach places the most emphasis on the management of suitable investments The bottom-up approach is based on fund manager or security specific research, in which the emphasis is on screening all investment opportunities and picking the perceived best. The top-down approach - A top-down approach analyzes the macroeconomic environment and then determines the weights and the combination of industry sectors, countries, and so on that best meet the program objectives under the likely scenarios. Leverage Aversion Theory - The leverage aversion theory argues that large classes of investors cannot lever up low-volatility portfolios to generate attractive returns and that, as a result, low-volatility stocks and portfolios are underpriced. Those investors who are not averse to leverage can exploit the potential underpricing of
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C. De-risking procedures including procedures for modifying hedge ratios - A. Discussing broad asset categories using allocation targets and ranges Institutional investors should consider establishing targets and ranges by broad asset category or asset role, rather than the more rigid approach of detailing targets by asset classes. What is the key advantage of free ports for family office portfolio management? - The key advantage is that free ports charge no sales taxes. Taxes are charged by the country of destination when the art leaves the free port. Until then, while stored at the free port, the goods are considered "in transit" and typically not taxed. This makes free ports a convenient and often a permanent place of storage for art. What are three major explanations for the superior performance, within asset sub-classes, generated by large endowments over the last few decades? - 1. An aggressive asset allocation.
- Effective investment manager research.
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- First-mover advantage.
- Access to a network of talented alumni.
- Acceptance of liquidity risk.
- Sophisticated investment staff and board oversight From the perspective of the employee saving for retirement, the following are typical advantages of participation in an employer-sponsored defined-benefit pension fund rather than investing directly. - I. Pension plans offer economies of scale for investment management II. Pension plans can use longer time horizons and more safely make less liquid investments III. Pension plans can diversify away individual mortality risk and longevity risk
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Competitive advantages of family offices - 1. Aggressive Asset Allocation.
- Liquidity Premium Capture.
- Deal Flow.
- Speed.
- Governance and Management of Assets.
- Alignment of Interests.
- Higher Returns.
- Risk Management.
- Centralization of Services.
- Lifestyle Assets. The three steps of unsmoothing a return series that contains a first-order autocorrelation - Step 1: Specify the form of the autocorrelation (in this case, first order) Step 2: Estimate the parameter(s) of the assumed autocorrelation process
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Step 3: Use the estimated autocorrelation coefficient to generate an unsmoothed return series In the context of alternative investment risk management, what are the three methods of approximating short-term valuations for illiquid securities? - I. Capital statement valuations II. Discounted cash flow model-based calculations III. Customized index-based calculations While not perfect, three methods for approximating short-term valuations for illiquid securities are capital balance statements, discounted cash flow models, and customized indices Assets for which diversification return is highest - Diversification returns are highest when the individual assets in a portfolio are highly volatile and the correlation among those assets is low PME method - The PME method is a cash-weighted metric (like IRR) that considers multiple negative and/or multiple positive cash flows. The intuition of the PME method is that it indicates the attractiveness of a private investment by comparing the cash-weighted returns of two identical cash flow streams: one invested in a
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the human brain with various "nodes" and "layers" forming connections and associations that are modified within the model Three risks of currency carry trades - (1) the funding currency interest rate rises, thereby increasing borrowing costs; (2) the funding currency appreciates against the target currency; and (3) the target currency investment does not yield as much as initially expected Discretionary directional managers - Discretionary directional managers take fewer bets and larger position sizes because their approach is more labor intensive, and each investment opportunity needs to be analyzed carefully and separately The strategy of bottom-up fundamental analysis is to estimate the value of a company's stock based on firm-level forecasted sales, expenses, earnings, and other data linked economically to the eventual cash distributions of a firm in an attempt to enhance portfolio returns.
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Why are hedonic price indices used in real estate? - To adjust for heterogeneity in property characteristics when using transactions to infer price changes The hedonic-pricing method (HPM) - The hedonic-pricing method (HPM) assumes that each of these attributes has its own market price. Examples of these attributes include the number of rooms, the size of the lot, the number of bathrooms, and so on. In other words, properties can be viewed as bundles of attributes and characteristics. We can observe the market price and the attributes or characteristics of the properties. It is thus required to unbundle and determine the implicit price or contribution of each of these attributes (i.e., the hedonic price) within the observed market price, including precise location, that renders them virtually unrepeatable and unique. An infrastructure analyst is estimating a multiple regression model. Assuming that there is no multicollinearity, what is the effect of adding additional true factors? - The r-square value increases, indicating that more of the variation in the dependent variable has been explained A typical result of adding more true factors to a model is that the r-squared increases and the estimated intercept (ai) declines. The r-squared increases as the additional factors are explaining a greater portion of the variance in the dependent variable.
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- No instant history bias
- Less survivorship bias Which of the following hedge fund replication products would be most likely to have returns that are poorly correlated with the hedge fund strategy being replicated? A. An algorithmic replication product B. A bottom-up replication product C. A factor-based replication product D. A payoff-distribution replication product - D. A payoff-distribution replication product On the other hand, the payoff-distribution replicator almost exactly matches the higher moments of the distribution of the Factor-Based Approach to Replication 463 hedge fund's return, but does a poor job of tracking the monthly returns on
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the hedge fund. It can be seen that monthly return from the payoff replicator has very low correlation to the monthly return on the hedge fund Some hedge fund replication products are designed to achieve portfolio weights that mimic the returns of a hedge fund index, even though the funds' managers are actively trading the funds' portfolios. What are the conditions under which these replication products can best mimic a hedge fund index? - High view commonality with substantial exposure inertia View commonality - View commonality refers to the fact that when the views of individual hedge fund managers (measured by their exposures) are aggregated in a hedge fund index, they tend to cluster into common themes that drive the overall performance of the index. For instance, if most equity long/short hedge fund managers have positive views on energy stocks, they may attempt to exploit this view by allocating assets to various companies that have exposure to the energy sector. In the index, these views are aggregated and are represented by increased exposure of the index to the energy sector, which could be captured by the replication product through increased allocations to an energy ETF. Exposure Inertia - Exposure Inertia: How can the appropriate weights of the mimicking portfolio be estimated if the weights of the actively managed product change over time? If managers are dynamically changing the weights of their
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What is the effect of rising interest rates on the market price of storable commodities? - Reducing the market price by decreasing the desire to carry inventories Commodities and interest rates: High real interest rates increase the opportunity costs of investors who hold commodities in storage, which leads to a temporary reduction in the potential demand for storable commodities. First, high interest rates reduce the potential demand for storable commodities (or increase the potential supply) through three channels: (1) by increasing the incentive for extraction today rather than tomorrow; (2) by decreasing firms' desire to carry inventories; and (3) by encouraging investors to shift out of commodity contracts into fixed-income instruments. Consider a family office evaluating which type of structure to use in order to gain exposure to real estate. What is an advantage for the family office of using a privately organized structure compared to a listed structure? - Tax benefits: For taxable investors, private structures may better flow through tax advantages such as depreciation and depletion. For the general partners, carried interest may be taxed at highly preferred long-term capital gains rates in some jurisdictions.
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Trade blotter - The running list of all trades desired and completed during each trading day is commonly referred to as a trade blotter. Trade allocation - Trade allocation refers to the process by which trades are divided among the firm's various funds and/or accounts with best practice for a fund to maintain a predetermined trade allocation policy that does not favor one of the firm's funds or accounts at the expense of another. Meta Risks - Meta risks, which are defined as "the qualitative risks beyond explicit measurable financial risks. They include human and organizational behavior, moral hazard, excessive reliance on and misuse of quantitative tools, complexity and lack of understanding of market interactions, and the very nature of capital markets in which extreme events happen with far greater regularity than standard models suggest. An example would be expenditures on elaborate office space, rather than hiring operational staff Entry and Establish phase of private equity fund manager-investor relationship - During the entry and establish phase, substantial entry barriers into the PE market exist for both GPs and LPs and, lacking a verifiable track record, new teams find it
