Lecture 1 of investment management, Lecture notes of Investment Theory

Download Lecture 1 of investment management and more Lecture notes Investment Theory in PDF only on Docsity! Lecture 1: Course Overview and Review of Institutions and Markets 1. Understand important financial institutions and markets 2. Provide a toolkit for creating portfolios of financial assets 3. Use asset pricing models to understand the trade-off between risk and return 4. Apply these models to: 1. identify investment opportunities 2. evaluate portfolio performance The goals of this class What we’ll learn How do we interpret observed returns? Build to a model of returns Three ingredients necessary for our models: 1. Defining risk appetite/aversion 2. Understanding mean variance trade-off 3. Allocating between risky and safe investments Use models to construct a portfolio of risky investments Capital Asset Pricing Model Arbitrage Pricing Theory / Factor Models Questions to consider: What is the goal of an investment portfolio? What is risk? How do I quantify it (vs. return)? What simplifications am I willing to assume? Timeline for our course Part 2: Portfolio tools What we’ll learn How consistent is CAPM with the data? How consistent is the data with APT? Markets are efficient? Or is it behavioral? How should we use the models when there are market anomalies? Active portfolio management Treynor-Black / Black-Litterman Robust Portfolio Management Questions to consider: Are my portfolio decisions intuitive? What am I missing? Timeline for our course Part 3: Critical evaluation of the tools What we’ll learn CAPM / APT describe returns from a passive strategy (no skill required) How should we evaluate active managers? Portfolio evaluation techniques answers: “Did you beat your benchmark?” Performance attribution answers the question, “How did you beat your benchmark?” Timeline for our course Part 4: Evaluate and attribute portfolio returns 1. Who are the participants in the equity market? Overall estimated level AuM (globally) as of 2022: 115+ Understand the marketplace Know thy enemy and know yourself; in a hundred battles, you will never be defeated. When you are ignorant of the enemy but know yourself, your chances of winning or losing are equal. If ignorant both of your enemy and of yourself, you are sure to be defeated in every battle. — Sun Tzu Institutions Global assets under management Mutual Funds Pension Funds Insurance Funds Sovereign Wealth Funds Private Equity Hedge Funds 0 10 20 30 40 5. oF Trillions of USD (as of 2016q4) GEMENT Institutions U.S. Institutional Holdings Bonds Equities Gov't Retirement Funds Property-Casualty Insurance Private Pension Funds Mutual Funds Life Insurance Companies Closed End Funds 10 15 0 5 10. «615 OOL OF Trillions of USD IAGEMENT  Compare the A, B and C shares What are the trade-offs between initial and deferred loads? Level of annual fees and expenses Institutions Example of fees for various classes of mutual funds Mutual Funds - fees and incentives People don’t avoid high-fee index funds (Choi et al. 2010) Experimenters overfocused on returns since fund inception Mutual Funds - fees and incentives Fund flow response distorts risk-taking incentives (Chevalier and Ellison (1997)) | have no idea what I'm doing Matt Levine Reading “Active investment funds should be illegal for fiduciaries.” Do you agree or disagree? Institutions Mutual Funds - do fund managers earn their fees? Are all mutual fund managers like Andy Dwyer, or just the average? Malkiel (1995) evaluates 239 mutual funds with at least ten-year records Compare each fund’s performance to holding the S&P 500 Institutions Mutual Funds – luck or skill? Fama French “Luck vs Skill in Mutual Fund Returns” 2010 Value weighted portfolio of active funds earns the market return, minus fees Distribution of “alpha” looks more consistent with luck than skill Net Returns Institutions Mutual Funds – luck or skill? Fama French “Luck vs Skill in Mutual Fund Returns” 2010 Value weighted portfolio of active funds earns the market return, minus fees Distribution of “alpha” looks more consistent with luck than skill Gross Returns Institutions Closed-End Funds Unlike mutual funds (open-end), no change in shares outstanding Old investors cash out by selling to new investors Managers unburdened with managing flows Traded continuously on exchanges Priced at premium or discount to NAV No easy arbitrage to close price gaps Hedge funds may ride discounts Alternatively, may attempt to “open” funds Market Structure What types of orders are there? Market order – Buy or sell order to be executed immediately at prevailing bid/ask price Limit order – Buy or sell order with a pre specified limit for the price Stop order Buy or sell order at the market price if specified threshold is crossed Limit orders make up a limit order book REAL-TIME ORDER BOOK FROM INET Bid Orders Ask Orders Price Order Size Price Order Size 89.06 400 89.12 70 89.05 100 89.13 100 89.04 300 89.15 300 89.03 400 89.16 600 89.01 100 89.17 300 89.00 100 89.18 400 88.95 200 89.24 200 88.92 300 89.26 300 88.56 30 89.29 300 88.43 100 89.34 300 Yale sCHOOL OF MANAGEMENT Limit orders make up a limit order book BANK AMER CORPCOM 248,575 3,215,870 13:19:56 17,437 13:19:56 13:19:56 13:19:56 AOOL OF NAGEMENT 13:19:56 13:19:56 13:19:56 g/s|8 88 s|8 8 a/3|8 8/8 8\8)2 Market Structure Types of Markets: OTC Markets Trades negotiated dealer to dealer Nasdaq (National Association of Securities Dealers Automated Quotation system) Originally, a price quotation system Large orders may still be negotiated through brokers and dealers Today, NASDAQ provides electronic trading (less OTC) Private computer networks that directly link buyers with sellers for automated order execution To attract liquidity, networks may pay rebates to liquidity providers (market makers) Electronic clearing facilitates high frequency trading Market Structure Types of Markets: Electronic Communication Networks Risks of high speed algorithmic trading include market disruption Flash Crash (2010) On May 6, 2010, US indices fell by more than 5% in a matter of minutes, before rebounding almost as quickly Knight Capital (2012) Flawed deployment of new trading program bankrupts major market maker Lost 440 million dollars from one programming mistake Market Structure Electronic Communication Networks and high-frequency trading Market Structure Short-selling Mechanics Suppose we have one dollar and believe stock A will underperform stock B. Buy $1 of asset B Borrow $1 worth of stock A ( shares) and promptly sell the stock Now, you owe the owner of A his shares back and will have to repurchase them in the market at tomorrow’s price Proceeds from the sale serve as collateral to stock lender (e.g. $1) Reg T requires 50% additional collateral (above and beyond proceeds) be kept in account (shares of B will suffice) 1/PA Final Payoff = 1 + ( ) + … +rB rA short rebate to be defined Market Structure Short-selling Mechanics Assume that , and you want to short the stock. What will your return be if the stock drops to ? First, calculate your initial position: 1. You will borrow a share of stock A and sell it immediately. You now have $100 dollars, but owe 1 share of Stock A. 2. You addditionally post the required 50% collateral (e.g. $50 of a treasury bill) Assets Liabilities Cash 100 Short position 100 T-Bill Collateral 50 Equity 50 Now imagine the stock drops to = 25 and you close your position: 1. You buy the stock at $25, and return it to the original owner 2. The collateral and cash are returned to you, net of your purchase As a result, you have 75 dollars profit. Your return is Note that the maximum upside is a return of 100%. Why? Because the initial sale at 100$ creates a liability of $100 dollars – at best, this liability goes to zero, netting 100 dollars in profit and a return of 100%. Note that the downside is unlimited. = 100PA = 25PA PA = = 0.75rshort 75 100 Market Structure Short-selling Mechanics Now assume we do this in pairs. There are two stocks, and , each worth 100 dollars.We buy stock and short stock . What will your return be if next period, and ? First, calculate your initial position: 1. You will borrow a share of stock A and sell it immediately. You now have $100 dollars, but owe 1 share of Stock A. 2. You addditionally post the required 50% collateral (you can post stock shares) Assets Liabilities Cash 100 Short position 100 Stock B Collateral 50 Equity 100 Stock B 50 Now imagine the stocks change to and and you close your position: 1. You buy the stock at $90, and return it to the original owner 2. The collateral and cash are returned to you, net of your purchase 3. You sell Stock B at $105 As a result, you have 10 dollars profit from stock A and 5 dollars profit from stock B. Your returns are and = 0.05 Our total profit is 15 dollars. Our net return is ((100 - 90) + (105 - 100))/100 =0.15. A B B A = 90PA = 105PB B = 90PA = 105PB = − = 0.1rshort rA =rlong rB The peculiar case of GameStop and r/WallStreetBets GameStop is a videogame retail company with poor outlook pre-pandemic, and little strategy for the pandemic potential for a “turnaround” with new board members, etc. but unlikely Shorting this stock is a natural strategy However, coordinated stock purchasing (a short squeeze) can make this untenable Why? Short covering creates a feedback loop Citron Research se @CitronResearch Tomorrow am at 11:30 EST Citron will livestream the 5 reasons GameStop $GME buyers at these levels are the suckers at this poker game. Stock back to $20 fast. We understand short interest better than you and will explain. Thank you to viewers for pos feedback on last live tweet 23:58 - 19 Jan 21 - Twitter Web App 2 Retweets 4 Likes rs Oy Yale sCHOOL OF MANAGEMENT $21.98 & 51.1% Price as of January 22, 2021, 9:00 p.m. EST View Interactive GME Charts GameStop $65.01 Tre Con INTERACTIVE CHART $70 $60 $50 $40 $30 $20 $10 $0 Feb 4 Mar 4 Apri May 4 Jun 4 Jul 4 Aug 1 Sep 1 Oct 1 Nov 4 Dec 1 dan 4 Yale SCHOOL OF MANAGEMENT  It?s not about money.: HOME > GME - NYSE GameStop Corp. $21.63 407.75% 417.37 SY Jan 24, 9:45:10 AM UTC-5 - USD - NYSE Disclaimer iD 5D iM 6M YTD i¥ 5Y¥ MAX @ Key events 100 80 iy 60 A Oy : Yale sCHOOL OF . MANAGEMENT — ee Market Structure Alternative ways to short stocks: synthetic shorts Consider the following replicating strategy: Buy a put and sell a call at the current strike price Have the option to sell stock at current price (put option) Give someone else the option to buy the stock at today’s price (call option) What happens if real stock goes down 10x? up 10x? However, options traded on less than half of publicly traded firms Moreover, options market behaves badly for “hot shares” Put-call parity is violated by large amounts of short interest