2
FIN 402 Exam 3 with verified detailed solutions
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Mandate sets the parameters for the permissible investments
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- Fixed Income, Equity, etc.
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- Defines sub-asset classes (Investment Grade, High Yield, etc.) - Risk levels
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- Return Expectation - usually measured relative to a benchmark
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Properties of a valid benchmark || || || ||
- Investable
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- Known (specified in advance)
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- Measurable
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- Representative of Mandate
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Active Return ||
= Return - Benchmark Return
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• Tracking Risk
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Active Risk ||
= Standard deviation of active return
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- Tracking Error
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,2
Benchmark selection ||
• Indexes are often used as a benchmark
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• Fixed income indexes are dynamic
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- Changing duration, composition
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- Many more components
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- Advantages:
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• Already specified and not easily manipulated
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• Custom Benchmarks
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- Used to represent a specific investment mandate
|| || || || || || ||
- May be used in conjunction with an index
|| || || || || || || ||
Strategic Asset Allocation (Policy Portfolio) - Long-term
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- If matched perfectly, active return and active risk will be zero
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- Index investing
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Tactical Asset Allocation - Short-term
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- Intentional deviations away from strategic asset allocation
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- Enhancements, ways to add additional return
|| || || || || ||
- Smart beta (factor analysis)
|| || || ||
- More active management strategy
|| || || ||
Why Index? ||
- Greater diversification
|| ||
, 2
- Lower cost/fees
|| ||
- Easy to understand / assess performance
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Full Replication
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- Problems with full replication:
|| || || ||
• Breadth of fixed income market
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• Liquidity challenges
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• Changing security characteristics
|| || ||
- Techniques
||
• Indexing risk characteristics, not securities
|| || || || ||
• Stratified sampling
|| ||
• Choosing an appropriate index
|| || || ||
Methods for Index Investing || || ||
1. Full replication
|| ||
2. Enhanced Index Strategies
|| || ||
Stratified Sampling ||
• Determine benchmark index
|| || ||
• Divide index into the risk characteristics important for the portfolio to match
|| || || || || || || || || || || ||
- Primary risk characteristic / Secondary characteristics
|| || || || || ||
• Select securities to represent or match each of these characteristics
|| || || || || || || || || ||
FIN 402 Exam 3 with verified detailed solutions
|| || || || || || ||
Mandate sets the parameters for the permissible investments
|| || || || || || ||
- Fixed Income, Equity, etc.
|| || || ||
- Defines sub-asset classes (Investment Grade, High Yield, etc.) - Risk levels
|| || || || || || || || || || ||
- Return Expectation - usually measured relative to a benchmark
|| || || || || || || || ||
Properties of a valid benchmark || || || ||
- Investable
||
- Known (specified in advance)
|| || || ||
- Measurable
||
- Representative of Mandate
|| || ||
Active Return ||
= Return - Benchmark Return
|| || || ||
• Tracking Risk
|| ||
Active Risk ||
= Standard deviation of active return
|| || || || ||
- Tracking Error
|| ||
,2
Benchmark selection ||
• Indexes are often used as a benchmark
|| || || || || || ||
• Fixed income indexes are dynamic
|| || || || ||
- Changing duration, composition
|| || ||
- Many more components
|| || ||
- Advantages:
||
• Already specified and not easily manipulated
|| || || || || ||
• Custom Benchmarks
|| ||
- Used to represent a specific investment mandate
|| || || || || || ||
- May be used in conjunction with an index
|| || || || || || || ||
Strategic Asset Allocation (Policy Portfolio) - Long-term
|| || || || || ||
- If matched perfectly, active return and active risk will be zero
|| || || || || || || || || || ||
- Index investing
|| ||
Tactical Asset Allocation - Short-term
|| || || ||
- Intentional deviations away from strategic asset allocation
|| || || || || || ||
- Enhancements, ways to add additional return
|| || || || || ||
- Smart beta (factor analysis)
|| || || ||
- More active management strategy
|| || || ||
Why Index? ||
- Greater diversification
|| ||
, 2
- Lower cost/fees
|| ||
- Easy to understand / assess performance
|| || || || || ||
Full Replication
||
- Problems with full replication:
|| || || ||
• Breadth of fixed income market
|| || || || ||
• Liquidity challenges
|| ||
• Changing security characteristics
|| || ||
- Techniques
||
• Indexing risk characteristics, not securities
|| || || || ||
• Stratified sampling
|| ||
• Choosing an appropriate index
|| || || ||
Methods for Index Investing || || ||
1. Full replication
|| ||
2. Enhanced Index Strategies
|| || ||
Stratified Sampling ||
• Determine benchmark index
|| || ||
• Divide index into the risk characteristics important for the portfolio to match
|| || || || || || || || || || || ||
- Primary risk characteristic / Secondary characteristics
|| || || || || ||
• Select securities to represent or match each of these characteristics
|| || || || || || || || || ||
