risk/return

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pages: 300 words: 77,787

Investing Demystified: How to Invest Without Speculation and Sleepless Nights by Lars Kroijer

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Andrei Shleifer, asset allocation, asset-backed security, Bernie Madoff, bitcoin, Black Swan, BRICs, Carmen Reinhart, cleantech, compound rate of return, credit crunch, diversification, diversified portfolio, equity premium, estate planning, fixed income, high net worth, implied volatility, index fund, intangible asset, invisible hand, Kenneth Rogoff, market bubble, money market fund, passive investing, pattern recognition, prediction markets, risk tolerance, risk/return, Robert Shiller, Robert Shiller, selection bias, sovereign wealth fund, too big to fail, transaction costs, Vanguard fund, yield curve, zero-coupon bond

By combining the minimal risk asset and A (world equities) in various proportions we choose various risk/return levels in the most efficient way, from minimal risk to the risk of the world equity markets, or greater than that if we borrow money. Point T is already the tangency point, or optimal portfolio, and we don’t think we can reallocate money between the many securities in such a way that we end up with better risk/return characteristics (see Figure 3.7). Figure 3.7 Combining the minimal risk asset and world equities Later, when we add other government and corporate bonds, we will see that this is akin to when we added the possibility of investment B earlier. While adding a bit of complexity to the portfolio, the other government and corporate bonds enhance the risk/return profile of the whole portfolio. The best theoretical and actual portfolio The rational portfolio is a compromise: a compromise between what we would like to create in a theoretical world and what is available practically.

We can accept the premise that market forces have set a price on individual securities and the aggregate market at a level that is consistent with the risk/return characteristics of that asset class. Because equities are riskier, we get higher expected returns, etc. For other investments left out of the rational portfolio there is typically not a liquid and efficient market to set prices for the individual investments, so someone without an edge is unable to simply buy into the whole asset class and expect to get its overall risk/return. So there is no theoretical inconsistency in being a rational investor – on the contrary. We don’t think we know any better than the market about the risk/return profiles of individual securities or how they move relative to one another. By pricing securities, the market effectively incorporates the views of thousands of investors and presents us with the results of the market as it currently stands.

Now ask the same people to do the same thing for all listed stocks and they will tell you that you are crazy – it’s not realistic to have this kind of expectation for more than a small portfolio of shares, and besides, risk and return expectations, and correlations, change all the time. It simply can’t be done. The beautiful shortcut – follow the crowd But here is the beautiful thing. If you generally believe in efficient markets, you don’t need to worry about the portfolio theory above or collecting millions of correlations and thousands of risk-return profiles. The market’s ‘invisible hand’ has already done all that for you. We don’t think we are able to reallocate between securities in such a way that we have a higher risk/return profile than what the aggregate knowledge of the market provides. Buying the entire market is essentially like buying the tangency point T. To some people it will seem like too bold an assumption that capital has seamlessly flowed between countries and industries in such a way that world markets are efficiently allocated.


pages: 317 words: 106,130

The New Science of Asset Allocation: Risk Management in a Multi-Asset World by Thomas Schneeweis, Garry B. Crowder, Hossein Kazemi

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asset allocation, backtesting, Bernie Madoff, Black Swan, capital asset pricing model, collateralized debt obligation, commodity trading advisor, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, diversified portfolio, fixed income, high net worth, implied volatility, index fund, interest rate swap, invisible hand, market microstructure, merger arbitrage, moral hazard, Myron Scholes, passive investing, Richard Feynman, Richard Feynman, Richard Feynman: Challenger O-ring, risk tolerance, risk-adjusted returns, risk/return, selection bias, Sharpe ratio, short selling, statistical model, survivorship bias, systematic trading, technology bubble, the market place, Thomas Kuhn: the structure of scientific revolutions, transaction costs, value at risk, yield curve, zero-sum game

The main foundation of the CAPM is that regardless of their risk-return preference, all investors can create desirable mean-variance efficient portfolios by combining two portfolios/assets: One is a unique, highly diversified, mean-variance efficient portfolio (market portfolio) and the other is the riskless asset. By combining these two investments, investors should be able to create mean-variance efficient portfolios that match their risk preferences. The combination of the riskless asset and 5 A Brief History of Asset Allocation the market portfolio (the Capital Market Line [CML] as shown in Exhibit 1.2) provides a solution to the asset allocation problem in a very simple and intuitive manner: Just combine the market portfolio with riskless asset and you will create a portfolio that has optimal risk-return properties. In such a world, the risk of an individual security is then measured by its marginal contribution to the volatility (risk) of the market portfolio.

For instance, the historical low correlation numbers between stocks and bonds and real estate is due in part to the fact that real estate prices generally have not represented their true market value but their accounting value, which may not change over time, in contrast to their true sale price, which may often change over time. Similarly, private equity returns and the returns of many hedge fund strategies are model driven. The message sent is clear—beware of past data and doubly beware of bad past data. Today’s market and trading environment is fundamentally different than that of even five years ago. Today, tradable ETFs exist that provide access to a wide range of investment sectors and risk/return scenarios. Tradable forms of private equity, real estate, hedge fund, managed futures, and commodity indices also exist. Moreover, the degree to which these new investment tools are offered and how they are presented to investors is often based on the business model of the firm offering the investment or investment advice. Investors often fail to take into account that the underlying business models of the firms offering asset allocation advice directly impact their product mix, their approach to asset allocation, and the relative return and risk scenarios they use in their asset allocation processes.

While the most basic messages of MPT and CAPM (that diversification is important and that risk has to be measured in the context of an asset’s marginal contribution to the risk of reference market portfolio) are valid and accepted widely by both academics and practitioners, many of their specific recommendations and predictions are not yet fully accepted and in some cases have been rejected by empirical evidence.6 For instance, observed security returns are very weakly, if at all, related to a security’s beta, and most investors find a simple combination of the market portfolio and the riskless asset totally inadequate in meeting their risk-return requirements. ASSET PRICING IN CASH AND DERIVATIVE MARKETS CAPM and EMH As discussed in greater detail later in this book, the CAPM profoundly shaped how asset allocation within and across asset classes was first con- A Brief History of Asset Allocation 7 ducted. Individual assets could be priced using a limited set of parameters. Securities could be grouped by their common market sensitivity into different risk classes and evaluated accordingly; and, to the degree that an expected market risk premia could be modeled, it would also be possible (if desired) to adjust the underlying risk or beta of a portfolio to take advantage of changes in expected market risk premia (i.e., increase the beta of the portfolio if expected market risk premia is high and reduce the beta of the portfolio if the expected market risk premia is low).

Commodity Trading Advisors: Risk, Performance Analysis, and Selection by Greg N. Gregoriou, Vassilios Karavas, François-Serge Lhabitant, Fabrice Douglas Rouah

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Asian financial crisis, asset allocation, backtesting, capital asset pricing model, collateralized debt obligation, commodity trading advisor, compound rate of return, constrained optimization, corporate governance, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, discrete time, distributed generation, diversification, diversified portfolio, dividend-yielding stocks, fixed income, high net worth, implied volatility, index arbitrage, index fund, interest rate swap, iterative process, linear programming, London Interbank Offered Rate, Long Term Capital Management, market fundamentalism, merger arbitrage, Mexican peso crisis / tequila crisis, p-value, Pareto efficiency, Ponzi scheme, quantitative trading / quantitative finance, random walk, risk-adjusted returns, risk/return, selection bias, Sharpe ratio, short selling, stochastic process, survivorship bias, systematic trading, technology bubble, transaction costs, value at risk, zero-sum game

This framework is based on three steps: 1. Creation of different pools of assets, including pools without CTAs. 2. Construction of efficient frontiers with each of the pools. 3. Comparison of the efficient frontiers built with CTAs to those constructed without CTAs and determination if this hedge fund strategy adds value at the portfolio level or not in terms of risk/returns. Recall that, in a risk/return framework, the efficient frontier represents all the risk/return combinations where the risk is minimized for a specific return (or the return is maximized for a specific risk). Each minima (or maxima) is reached thanks to an optimal asset allocation. The process of constructing efficient frontiers through an asset weight optimization is summarized in this definition: For all possible target portfolio returns, find portfolio weights (i.e., asset allocation) such as the portfolio volatility is minimized and the following constraints are respected: no short sale, full investment, and weight limits if any. 316 PROGRAM EVALUATION, SELECTION, AND RETURNS Clearly, the resulting efficient frontier depends on the returns, volatility, and correlations of the considered assets, but it also depends on the constraints (maximum and minimum weight limit, no short selling, and full investment) fixed by the portfolio manager.

The range of weight goes from 0 percent (unconstrained portfolio) to 100 percent (portfolio made of a single asset). As a constraint increases, the efficient surface is reduced and tends to a single risk/return combination (100 percent allocation in a single asset). As an example, let us focus on one portfolio optimization (Figures 17.11a and b). These assumptions are applied on the pool of assets IV (15 members): no constraints, full investment, and no short sell. The optimization includes assets having the best risk/return profiles. Hedge funds strategies like global macro or the REIT equities are immediately selected, which is not the case for CTAs. CTAs are not included in any efficient portfolio construction. The asset allocation is totally different when weight restrictions are applied: The best risk/return assets are rapidly capped, and the optimization process considers other assets such as CTAs.

The third one has traditional assets and all the hedge funds strategies except CTAs. Finally, the last one is made of all traditional assets and hedge funds strategies including CTAs. Whether to consider or not consider CTAs in the pools should affect the generated efficient frontiers and highlight any diversification capacity of CTAs. Concerning the portfolio optimizations, two frameworks are used: a classical two-dimensional risk-return framework and a three-dimensional one (a risk/return/time framework; the time being introduced with rolling statistics). The three-dimensional framework should capture time changes, which are rarely presented in portfolio allocation studies. Portfolio Optimization and Constraints Before being specific about CTAs, it is important to have a brief reminder of portfolio optimization and constraints. As mentioned, the efficient frontier’s shape strongly depends on the weight threshold applied during the 317 CTAs and Portfolio Diversification x x x x x x x x x x x x Pool of assets IV x x x x x x Long/Short Pool of assets II Pool of assets III Fixed Income Arbitrage x Event Driven x Equity Market Neutral x Emerging Markets REIT equity x Dedicated Short Bias Far East equity x Arbitrage North American equity x Convertible North American bonds Pool of assets I Managed Futures Europe bonds Europe equity Hedge Funds Indices x x x x x x x x x x x x x x x x x x FIGURE 17.7 Four Pools of Indices Each pool is made of several assets: equity indices (MSCI), bond indices (MSCI), a REIT index (NAREIT), different hedge funds strategies (CSFB/Tremont), and a CTA index (Barclay Group).


pages: 353 words: 88,376

The Investopedia Guide to Wall Speak: The Terms You Need to Know to Talk Like Cramer, Think Like Soros, and Buy Like Buffett by Jack (edited By) Guinan

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Albert Einstein, asset allocation, asset-backed security, Brownian motion, business process, capital asset pricing model, clean water, collateralized debt obligation, computerized markets, correlation coefficient, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, discounted cash flows, diversification, diversified portfolio, dividend-yielding stocks, equity premium, fixed income, implied volatility, index fund, intangible asset, interest rate swap, inventory management, London Interbank Offered Rate, margin call, market fundamentalism, money market fund, mortgage debt, Myron Scholes, passive investing, performance metric, risk tolerance, risk-adjusted returns, risk/return, shareholder value, Sharpe ratio, short selling, statistical model, time value of money, transaction costs, yield curve, zero-coupon bond

Treasury bill often is used as the risk-free rate. Related Terms: • Modified Internal Rate of Return • Risk-Return Trade-Off • U.S. Treasury • Return on Investment—ROI • Treasury Bill—T-Bill Risk-Return Trade-Off What Does Risk-Return Trade-Off Mean? The principle that potential return rises with an increase in risk. Low levels of uncertainty (low risk) are associated with low potential returns, whereas high levels of uncertainty (high risk) are associated with high potential returns. According to the risk-return trade-off, invested money can render higher profits only if it is subject to the possibility of being lost. Investopedia explains Risk-Return Trade-Off Because of the risk-return trade-off, investors must recognize their personal risk tolerance when choosing investments. Taking on additional risk is the price of achieving potentially higher returns; therefore, if an investor wants to make money, he or she cannot cut out all risk.

It is calculated as follows: The coefficient of variation represents the ratio of the standard deviation to the mean; it is a useful statistic for comparing the degree of variation from one data series to another even if the means are drastically different from each other. Investopedia explains Coefficient of Variation (CV) The coefficient of variation allows investors to determine how much volatility (risk) they are assuming in relation to the amount of expected return from an investment; the lower the ratio of standard deviation to the mean return is, the better the risk-return trade-off is. Note that if the expected return in the denominator of the calculation is negative or zero, the ratio will not make sense. Related Terms: • Beta • Risk-Return Trade-Off • Volatility • Expected Return • Standard Deviation Collateral What Does Collateral Mean? Properties or assets that secure a loan or another debt. Collateral becomes subject to seizure on default. Investopedia explains Collateral Collateral is a form of insurance to the lender in case the borrower fails to pay back the loan.

Also referred to as the equity premium. Investopedia explains Equity Risk Premium The risk premium is the result of the risk-return trade-off, in which investors require a higher rate of return on riskier investments. The risk-free rate in the market often is quoted as the rate on longerterm U.S. government bonds, which are considered risk-free because of the unlikelihood that the government will default on its loans. Compare that with securities that offer no or little guarantees. Remember, companies regularly experience downturns and go out of business. If the return on a stock is 15% and the risk-free rate over the same period is 7%, the equity-risk premium is 8% for this stock over that period. Related Terms: • Equity • Premium • Risk-Return Trade-Off • Gordon Growth Model • Risk 96 The Investopedia Guide to Wall Speak Euro LIBOR What Does Euro LIBOR Mean?

Stocks for the Long Run, 4th Edition: The Definitive Guide to Financial Market Returns & Long Term Investment Strategies by Jeremy J. Siegel

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asset allocation, backtesting, Black-Scholes formula, Bretton Woods, buy low sell high, California gold rush, capital asset pricing model, cognitive dissonance, compound rate of return, correlation coefficient, Daniel Kahneman / Amos Tversky, diversification, diversified portfolio, dividend-yielding stocks, equity premium, Eugene Fama: efficient market hypothesis, fixed income, German hyperinflation, implied volatility, index arbitrage, index fund, Isaac Newton, joint-stock company, Long Term Capital Management, loss aversion, market bubble, mental accounting, Myron Scholes, new economy, oil shock, passive investing, Paul Samuelson, popular capitalism, prediction markets, price anchoring, price stability, purchasing power parity, random walk, Richard Thaler, risk tolerance, risk/return, Robert Shiller, Robert Shiller, Ronald Reagan, shareholder value, short selling, South Sea Bubble, survivorship bias, technology bubble, The Great Moderation, The Wisdom of Crowds, transaction costs, tulip mania, Vanguard fund

Rising bond prices in a tumultuous equity market also occurred during the October 19, 1987, stock market crash, but much of the rise then was predicated on the (correct) belief that the Fed would lower short-term rates. 6 This section, which contains some advanced material, can be skipped without loss of continuity. CHAPTER 2 Risk, Return, and Portfolio Allocation FIGURE 33 2–5 Risk-Return Trade-Offs for Various Holding Periods, 1802 through December 2006 curve means increasing the proportion in stocks and correspondingly reducing the proportion in bonds. As stocks are added to the all-bond portfolio, expected returns increase and risk decreases, a very desirable combination for investors. But after the minimum risk point is reached, increasing stocks will increase the return of the portfolio but only with extra risk. The slope of any point on the efficient frontier indicates the risk-return trade-off for that allocation. By finding the points on the longerterm efficient frontiers that have a slope equal to the slope on the one-year frontier, one can determine the allocations that represent the same risk-return trade-offs for all holding periods. 34 PART 1 The Verdict of History RECOMMENDED PORTFOLIO ALLOCATIONS What percentage of an investor’s portfolio should be invested in stocks?

The historical correlation between the annual returns in U.S. and non-U.S. markets has been about 57 percent, which means that 57 percent of the variation in non-U.S. markets is also seen in U.S. stock returns. Using these historical data allows us to construct Figure 10-2, which shows the risk-return trade-off (called the efficient frontier) for dollar-based investors depending on varying the proportions that are invested in foreign markets (measured by the EAFE Index) and U.S. markets. The minimum risk for this world portfolio occurs when 22.5 percent is allocated to EAFE stocks and thus 77.5 percent to U.S. stocks. But the “best” risk-return portfolio, called the efficient portfolio, is not the one with the lowest risk but the one that optimally balances risk and return. This “best” portfolio is found at a much higher 37.8 percent foreign stock allocation.7 For comparison, in July 2007 the EAFE stocks FIGURE 10–2 Portfolio Allocation between U.S. and EAFE Stocks 13.80% Risk-free rate is 5.0% 0% U.S., 100% EAFE 13.60% 10% U.S., 90% EAFE 20% U.S., 80% EAFE 13.40% Return 13.20% 30% U.S., 70% EAFE 40% U.S., 60% EAFE 13.00% 50% U.S., 50% EAFE 12.80% 12.60% 60% U.S., 40% EAFE 70% U.S., 30% EAFE 80% U.S., 20% EAFE 12.40% 90% U.S., 10% EAFE 12.20% 12.00% 16% U.S.

For more information about this title, click here C O N T E N T S Foreword xv Preface xvii Acknowledgments xxi PART 1 THE VERDICT OF HISTORY Chapter 1 Stock and Bond Returns Since 1802 3 “Everybody Ought to Be Rich” 3 Financial Market Returns from 1802 5 The Long-Term Performance of Bonds 7 The End of the Gold Standard and Price Stability 9 Total Real Returns 11 Interpretation of Returns 12 Long-Term Returns 12 Short-Term Returns and Volatility 14 Real Returns on Fixed-Income Assets 14 The Fall in Fixed-Income Returns 15 The Equity Premium 16 Worldwide Equity and Bond Returns: Global Stocks for the Long Run 18 Conclusion: Stocks for the Long Run 20 Appendix 1: Stocks from 1802 to 1870 21 Appendix 2: Arithmetic and Geometric Returns 22 v vi Chapter 2 Risk, Return, and Portfolio Allocation: Why Stocks Are Less Risky Than Bonds in the Long Run 23 Measuring Risk and Return 23 Risk and Holding Period 24 Investor Returns from Market Peaks 27 Standard Measures of Risk 28 Varying Correlation between Stock and Bond Returns 30 Efficient Frontiers 32 Recommended Portfolio Allocations 34 Inflation-Indexed Bonds 35 Conclusion 36 Chapter 3 Stock Indexes: Proxies for the Market 37 Market Averages 37 The Dow Jones Averages 38 Computation of the Dow Index 39 Long-Term Trends in the Dow Jones 40 Beware the Use of Trend Lines to Predict Future Returns 41 Value-Weighted Indexes 42 Standard & Poor’s Index 42 Nasdaq Index 43 Other Stock Indexes: The Center for Research in Security Prices (CRSP) 45 Return Biases in Stock Indexes 46 Appendix: What Happened to the Original 12 Dow Industrials?

The Smartest Investment Book You'll Ever Read: The Simple, Stress-Free Way to Reach Your Investment Goals by Daniel R. Solin

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asset allocation, corporate governance, diversification, diversified portfolio, index fund, market fundamentalism, money market fund, Myron Scholes, passive investing, prediction markets, random walk, risk tolerance, risk-adjusted returns, risk/return, transaction costs, Vanguard fund, zero-sum game

Su securities industry i$hares (ETF funds). website for, 15 &t also ETFs (exchange traded funds) iShares CON Bond Index Fund (XBB), 1\, 130, 180 iShares C DN Composite Index Fund (XIC). 15. 130, 180 iShares CON Income Trust Sector Index Fund, 135 iShares CON MSCI EAFE Index Fund (XlN). 15, 130. 180 iShares C DN S&P 500 Index Fund (XSP) . 15. 130, 180 rebalancing ponfolio$, 120, 132-33 risk and. 122-23 risk return comparison (01",,), 14,74--76 standard deviation to measure risk, 67-68, 85. 126. 138 value and small-cap equities in. 11 4 Set also asset allocation; Four-Step Process for Smart Investors investment portfolios. four model benefits of, 85-86. 144 chan, risk returns, 125 ETFs in, 15, 130-31 examples of, 85, 125--26, 130,180 how to choose, 124 risk and return summary, 179-80 Slandard d~ations in, 67-68,85, 126,138 Jensen, 153 Jog. Vijay M. , 108, 15 1 journalists. financial. !itt financial media Kahneman, Daniel, 23, 107 Kat, H arry M., 166 Kelly.

Reported at: http://finance. yahoo. com/ columnist/ article/ futureinvest/ 6953 Everyone wants to make as big a return as he or she can. But at what risk? The possibility of gaining a few percentage points on the upside may be dwarfed by the increase in downside risk. Take a look at the chart on page 74, which illustrates this point. 74 Your Broker or Advisor Is Keeping You from Being a Smart Im"eStor RISK RETURN COMPARISON (DitlI'Iri8l: 1911-2005) 11m _ • C*dI Yur lois AmgII AuuaJ II!ln • &1M SIKb 141M iIIJlIk ....... "" .,.. "" ... '" "' "" ,"' "" . . As you can see, if you invested in a diversified portfolio consisting of 100% stocks during the period 1977 to 2005, your average rerum would have been 1 1.7%. Your worst loss in any one calendar year would have been 15.1%. However, if you had a diversified portfolio invested in only 60% stocks and 40% bonds, your average rerum would have been 11.0%--only 0.7% less than the 100% stock portfolio.

., 106, 148 Beck, Peler, 165 Beebowcr, Gilbert L, 12 1, 162 Belsky, Gary, 67 benchmark index, 23-24 Bergstresser, Daniel B., 149- 50 Berkshire Hathaway, 108 Bernstein, William, 142, 182 Bhattacharya, Utpal. 168 Biggs, Barton, 95 Blake, Christopher R., 158 Blirzcr, David M., 105 Bodie, Zvi, 163 Bogle, John c., 48, 89, 129, 147-48,150,159--60,168, 182 Bogk on Mutual Funds (Bogle), 182 bonds abo ut bonds, 13, 7 1 as asser class, 13,40,71, 121, IG2 186 Index risk return comparison (chan), 14,74-76 bond index funds, 19 Set also iShares CON Bond Index Fund (XBS) borrowing on margin, 77-78 Bowen,JohnJ.,84 Brinson, Gary P.. 12 1. 162 brokerage firms. Sf( securities industry Buffett, Warren, 86, 108-9 for index nmds, 147 for management fees, 5, 25, 35,37,62-63,88-90, 147,159--60 for sales and trading, 25, 35- 37, 53, 59-60, 63, 115.119, 128,154 for trading online. 119 for wrap accounts, 65--66 front-load and no-load funds, 60, 63 management expense ratio Cadsby, Ted, 181 Carrick, Rob, 65, 16 1 cash, as asset class, 40, 121 Chalmers, John M.R.• 149-50 C handler, James L. , 162 charitable organi7..ations, as Smart Investors, lOG C hevreau, Jonathan, 44, 77, 93, 146 chimp Story, 3-4. 146 Clements, Jonathan. 26, 29, 93, 152 commissions.


pages: 354 words: 26,550

High-Frequency Trading: A Practical Guide to Algorithmic Strategies and Trading Systems by Irene Aldridge

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algorithmic trading, asset allocation, asset-backed security, automated trading system, backtesting, Black Swan, Brownian motion, business process, capital asset pricing model, centralized clearinghouse, collapse of Lehman Brothers, collateralized debt obligation, collective bargaining, computerized trading, diversification, equity premium, fault tolerance, financial intermediation, fixed income, high net worth, implied volatility, index arbitrage, information asymmetry, interest rate swap, inventory management, law of one price, Long Term Capital Management, Louis Bachelier, margin call, market friction, market microstructure, martingale, Myron Scholes, New Journalism, p-value, paper trading, performance metric, profit motive, purchasing power parity, quantitative trading / quantitative finance, random walk, Renaissance Technologies, risk tolerance, risk-adjusted returns, risk/return, Sharpe ratio, short selling, Small Order Execution System, statistical arbitrage, statistical model, stochastic process, stochastic volatility, systematic trading, trade route, transaction costs, value at risk, yield curve, zero-sum game

The two dimensions of a portfolio that he reviewed are the average return and risk of the individual securities that compose the portfolio and of the portfolio as a whole. Optimization is conducted by constructing an “efficient frontier,” a set of optimal risk-return portfolio combinations for the various instruments under consideration. In the absence of leveraging opportunities (opportunities to borrow and increase the total capital available as well as opportunities to lend to facilitate leverage of others), the efficient frontier is constructed as follows: 1. For every possible combination of security allocations, the risk and return are plotted on a two-dimensional chart, as shown in Figure 14.1. Due to the quadratic nature of the risk function, the resulting chart takes the form of a hyperbola. Return Risk FIGURE 14.1 Graphical representation of the risk-return optimization constructed in the absence of leveraging opportunities. The bold line indicates the efficient frontier. 203 Creating and Managing Portfolios of High-Frequency Strategies 2.

High-frequency strategies focus on the most liquid securities; a security requiring a holding period of 10 minutes may not be able to find a timely counterparty in illiquid markets. While longer-horizon investors can work with either liquid or illiquid securities, Amihud and Mendelson (1986) show that longer-horizon investors optimally hold less liquid assets. According to these authors, the key issue is the risk/return consideration; longer-term A 37 38 HIGH-FREQUENCY TRADING investors (already impervious to the adverse short-term market moves) will obtain higher average gains by taking on more risk in less liquid investments. According to Bervas (2006), a perfectly liquid market is the one where the quoted bid or ask price can be achieved irrespective of the quantities traded. Market liquidity depends on the presence of trading counterparties in the market, as well as the counterparties’ willingness to trade.

The lending investor then ends up on the bold line between RF and the market portfolio point (σ M , RM ). The investor incurs two advantages by lending compared with selecting a portfolio from the efficient set with no lending as represented in Figure 14.1: 1. The investor may be able to attain lower risk than ever possible in the no-lending situation. Return RM RF σM Risk FIGURE 14.2 Graphical representation of the risk-return optimization constructed in the presence of leveraging opportunities. All leveraging is assumed to be conducted at the risk-free rate RF . The bold line indicates the efficient frontier. The point (σ M , RM ) corresponds to the “market portfolio” for the given RF and the portfolio set. 204 HIGH-FREQUENCY TRADING 2. With lending capabilities, the investor’s return gets scaled linearly to his scaling of risk.

The Handbook of Personal Wealth Management by Reuvid, Jonathan.

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asset allocation, banking crisis, BRICs, collapse of Lehman Brothers, correlation coefficient, credit crunch, cross-subsidies, diversification, diversified portfolio, estate planning, financial deregulation, fixed income, high net worth, income per capita, index fund, interest rate swap, laissez-faire capitalism, land tenure, market bubble, merger arbitrage, negative equity, new economy, Northern Rock, pattern recognition, Ponzi scheme, prediction markets, Right to Buy, risk tolerance, risk-adjusted returns, risk/return, short selling, side project, sovereign wealth fund, statistical arbitrage, systematic trading, transaction costs, yield curve

Alternatively, the independent but modest investor can invest in ETFs, COEICs or a specialist investment trust. ឣ 84 REAL ESTATE AND FORESTRY ______________________________________________ Larger-scale investors who are content to place themselves in a limited geography and to move a bit further up the risk–return spectrum can consider a direct forest purchase, managed by an experienced forestry management company. It is essential to obtain good value upon purchase at the outset; efficient sourcing and due diligence on properties are required. Risk–return profiles of forestry investments The typical returns from forestry investments in mature forestry markets, such as the United States or Australasia, have been estimated since the early 2000s to be in a typical range of 6 to 7 per cent per annum after inflation and before tax.

66 2.2 The overseas property market in the economic downturn James Price, Knight Frank LLP A ‘nice to have’ 69; Markets within the market 69; Which buyers are most active? 73; Outlook 74 2.3 Current opportunities in forestry investment Alan Guy and Alastair Sandels, Fountains Plc Introduction 79; The nature of the forestry asset class 79; Special qualities of forestry investment 80; Types of investment in the forestry asset class 82; Risk–return profiles of forestry investments 84; New revenue sources from forestry 85; Summary 85 2.4 Risks and direct investment in forestry Alan Guy and Alastair Sandels, Fountains Plc Risks in forestry investment 87; Direct investment 89; How UK and US forestry has performed in recent years 91; Tax treatment of forestry in the UK and United States 92; Summary 92 2.5 Timber investments in South-East Asia Guy Conroy, Oxigen Investments An ethical way to watch your money grow 94; Timber outperforms the stock market 96; Sri Lanka: the natural forest 97; Malaysia: ideal for teak 98; The science of trees 99; Agroforestry: a new ethical investment 100; What investors want to know 101; Can the experts all be wrong?

The ‘garbage in, garbage out’ adage is apt to describe issues that may potentially arise. No matter how complex the concluding-solution set of investment answers is, that set is effectively meaningless to the client if the underlying inputs are questionable. Effective wealth managers appreciate the importance of this. Most ‘optimal’ outputs incorporate a degree of quantitative science. Such approaches typically embed a series of risk, return and correlation assumptions (and may also incorporate a confidence function). By means of a presumed optimization methodology, a mix of asset classes can be identified that matches an investor’s profile and steers him or her on a path to achieving investment objectives. Since the development of modern portfolio theory, analysts have questioned the validity of certain portfolio approaches. This stemmed from a growing appreciation of risk and issues posed by the inclusion of a broader universe of ‘unconventional’ asset classes.

The Intelligent Asset Allocator: How to Build Your Portfolio to Maximize Returns and Minimize Risk by William J. Bernstein

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asset allocation, backtesting, capital asset pricing model, commoditize, computer age, correlation coefficient, diversification, diversified portfolio, Eugene Fama: efficient market hypothesis, fixed income, index arbitrage, index fund, intangible asset, Long Term Capital Management, p-value, passive investing, prediction markets, random walk, Richard Thaler, risk tolerance, risk-adjusted returns, risk/return, South Sea Bubble, survivorship bias, the rule of 72, the scientific method, time value of money, transaction costs, Vanguard fund, Yogi Berra, zero-coupon bond

Currency risk/return: The risk and return associated with holding a foreign security caused by fluctuations in the exchange rate. Cyclical stock: A security that is particularly sensitive to economic conditions, such as an aircraft or paper company (as opposed to a food or drug manufacturer, whose profits and sales are not sensitive to economic conditions). Discounted dividend model (DDM): A method of estimating the intrinsic value of a company or market by calculating the discounted value of its expected future dividends. The amount by which future 190 The Intelligent Asset Allocator dividends are reduced is called the discount rate ; it typically approximates the risk-adjusted return of the asset. Diversification: Allocating assets among investments with different risks, returns, and correlations in order to minimize nonsystematic risk.

Dealing with More Than Two Imperfectly Correlated Assets The above models have been quite useful for demonstrating the effect of diversification on risk and return of two similar assets (Example 2) and two different assets (Example 1) with zero correlation. Unfortunately, the above examples are no more than useful illustrations of the theoretical benefits of diversified portfolios. In the real world of investing, we must deal with mixes of dozens of asset types, each with a different return and risk. Even worse, the returns of these assets are only rarely completely uncorrelated. Worse still, the risks, returns, and correlations of these assets fluctuate considerably over time. In order to understand real portfolios, we shall require much more complex techniques. Thus far we have dealt with portfolios with only two uncorrelated components. Two uncorrelated assets may be represented with four time periods as in Uncle Fred’s coin toss, three assets with eight periods, four assets with 16 periods, etc.

Both Japanese stocks and precious metals have since been horrid investments. A recurring theme in these pages is that you try as hard as you can to identify the diverse strains of current financial wisdom in order that you may ignore them. Now that we’ve ascertained that the popular view of international diversification has been poisoned by the recent poor performance of foreign stocks, what does the “complete” data show? Figure 4-5 is the risk-return plot for the full 30-year period from 1969 to 1998. For this period the returns for the S&P (12.67%) and EAFE (12.39%) were nearly identical. Note also how narrowly spaced the return values on the y axis are, with less than 1% separating all of the portfolio returns. The Behavior of Real-World Portfolios 49 Note how “bulgy” this plot is. Portfolios of up to 80% EAFE have higher returns than either asset alone.


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The Four Pillars of Investing: Lessons for Building a Winning Portfolio by William J. Bernstein

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asset allocation, Bretton Woods, British Empire, buy low sell high, carried interest, corporate governance, cuban missile crisis, Daniel Kahneman / Amos Tversky, Dava Sobel, diversification, diversified portfolio, Edmond Halley, equity premium, estate planning, Eugene Fama: efficient market hypothesis, financial independence, financial innovation, fixed income, George Santayana, German hyperinflation, high net worth, hindsight bias, Hyman Minsky, index fund, invention of the telegraph, Isaac Newton, John Harrison: Longitude, Long Term Capital Management, loss aversion, market bubble, mental accounting, money market fund, mortgage debt, new economy, pattern recognition, Paul Samuelson, quantitative easing, railway mania, random walk, Richard Thaler, risk tolerance, risk/return, Robert Shiller, Robert Shiller, South Sea Bubble, survivorship bias, The inhabitant of London could order by telephone, sipping his morning tea in bed, the various products of the whole earth, the rule of 72, transaction costs, Vanguard fund, yield curve, zero-sum game

But, as we have already seen with Figure 1-1, which is also a semilog plot, this graph can be highly deceptive, as it tends to underplay risk. Figure 1-8. Value of $1.00 invested in stocks, bonds, and bills, 1901–2000 (semilogarithmic scale). (Source: Jeremy Siegel.) Risk—The Second Dimension The study of investment returns is only half of the story. Distilled to its essence, investing is about earning a return in exchange for shouldering risk. Return is by far the easiest half, because it is simple to define and calculate, either as “total returns”—the end values in Figures 1-7 and 1-8, or as “annualized returns”—the hypothetical gain you’d have to earn each year to reach that value. Risk is a much harder thing to define and measure. It comes in two flavors: short-term and long-term. Short-term risk is somewhat easier to deal with. Let’s start with the annual returns of bills, bonds, and stocks, which I’ve plotted in Figures 1-9 through 1-11.

And there is no doubt that some great companies, like Wal-Mart, Microsoft, and GE, produce high returns for long periods of time. But these are the winning lottery tickets in the growth stock sweepstakes. For every growth stock with high returns, there are a dozen that, within a very brief time, disappointed the market with lower-than-expected earnings growth and were consequently taken out and shot. Summing Up: The Historical Record on Risk/Return I’ve previously summarized the returns and risks of the major U.S. stock and bond classes over the twentieth century in Table 1-1. In Figure 1-19, I’ve plotted these data. Figure 1-19 shows a clear-cut relationship between risk and return. Some may object to the magnitude of the risks I’ve shown for stocks. But as the recent performance in emerging markets and tech investing show, losses in excess of 50% are not unheard of.

If your portfolio risk exceeds your tolerance for loss, there is a high likelihood that you will abandon your plan when the going gets rough. That is not to say that your return requirements are immaterial. For example, if you have saved a large amount for retirement and do not plan to leave a large estate for your heirs or to charity, you may require a very low return to meet your ongoing financial needs. In that case, there would be little sense in choosing a high risk/return mix, no matter how great your risk tolerance. Figure 4-6. Portfolio risk versus return of bill/stock mixes, 1901–2000. There’s another factor to consider here as well, and that’s the probability that stock returns may be lower in the future than they have been in the past. The slope of the portfolio curve in Figure 4-6 is steep—in other words, in the twentieth century, there was a generous reward for bearing additional portfolio risk.


pages: 504 words: 139,137

Efficiently Inefficient: How Smart Money Invests and Market Prices Are Determined by Lasse Heje Pedersen

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activist fund / activist shareholder / activist investor, algorithmic trading, Andrei Shleifer, asset allocation, backtesting, bank run, banking crisis, barriers to entry, Black-Scholes formula, Brownian motion, buy low sell high, capital asset pricing model, commodity trading advisor, conceptual framework, corporate governance, credit crunch, Credit Default Swap, currency peg, David Ricardo: comparative advantage, declining real wages, discounted cash flows, diversification, diversified portfolio, Emanuel Derman, equity premium, Eugene Fama: efficient market hypothesis, fixed income, Flash crash, floating exchange rates, frictionless, frictionless market, Gordon Gekko, implied volatility, index arbitrage, index fund, interest rate swap, late capitalism, law of one price, Long Term Capital Management, margin call, market clearing, market design, market friction, merger arbitrage, money market fund, mortgage debt, Myron Scholes, New Journalism, paper trading, passive investing, price discovery process, price stability, purchasing power parity, quantitative easing, quantitative trading / quantitative finance, random walk, Renaissance Technologies, Richard Thaler, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, selection bias, shareholder value, Sharpe ratio, short selling, sovereign wealth fund, statistical arbitrage, statistical model, survivorship bias, systematic trading, technology bubble, time value of money, total factor productivity, transaction costs, value at risk, Vanguard fund, yield curve, zero-coupon bond

When done carefully, portfolio optimization provides a tool to reap the full benefits of diversification, to efficiently exploit high-conviction trades without excessive concentration, to systematically adjust positions based on the time-varying risk and expected return, and to minimize subjectivity in the portfolio choice. In summary, good portfolio construction techniques can help achieve a favorable risk-return profile for a set of trading ideas. A systematic approach helps reduce a trader’s own behavioral biases, that is, his tendencies to make certain mistakes. For instance, people like to hang on to their losing positions even if the reason they liked the securities no longer applies, and they like to sell winners to lock in gains even if the trade has gotten even better. 4.2. RISK MANAGEMENT Measuring Risk Risk can be, and should be, measured in several different ways.

LHP: How do you assess when is the right time to buy and when is the right time to get out of the position? LA: It’s purely driven by the discipline of making sure our portfolio is always focused on the opportunities we judge to be the most attractive. In the utopian world, every single day we would consider the return we think we can achieve in every one of our positions, how much risk we need to take to achieve that return, and how that risk-return profile compares to every other investment opportunity that we have. So if something is being bought or sold, that typically means we have concluded that another investment is more attractive at that point in time than a current investment. Of course, this is all easier in theory than in practice, but that’s our mindset. We are very focused on looking forward, not backwards. At what price we have previously bought or sold a security should not be relevant to our evaluation of the attractiveness of that stock from current prices.

The fact that we are completely indifferent to index weightings gives us a meaningful advantage as well. A significant portion of the capital invested in the markets is invested in a manner that is very aligned with the relevant weightings to an index, typically on a cap-weighted basis. At Maverick, we are blissfully ignorant of a particular stock’s or sector’s weighting in any index—all we care about is the attractiveness of an investment on a risk-return basis. Last but not least, I think stability has been a big advantage for us over the years. We’ve enjoyed stability of both our investment team and our investor base, which really does allow us to invest with a longer term horizon. The vast majority of the capital we manage is attributable to profits we have generated for our investors, and most of the capital we manage has been invested in Maverick for more than ten years.


pages: 345 words: 87,745

The Power of Passive Investing: More Wealth With Less Work by Richard A. Ferri

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asset allocation, backtesting, Bernie Madoff, capital asset pricing model, cognitive dissonance, correlation coefficient, Daniel Kahneman / Amos Tversky, diversification, diversified portfolio, endowment effect, estate planning, Eugene Fama: efficient market hypothesis, fixed income, implied volatility, index fund, intangible asset, Long Term Capital Management, money market fund, passive investing, Paul Samuelson, Ponzi scheme, prediction markets, random walk, Richard Thaler, risk tolerance, risk-adjusted returns, risk/return, Sharpe ratio, survivorship bias, too big to fail, transaction costs, Vanguard fund, yield curve, zero-sum game

See also Jensen’s Alpha beta (β) and futility of seeking manager’s skill and measures of, alpha rankings Amenc, Noël American Association of Individual Investors (AAII) American Stock Exchange (Amex) Amex. See American Stock Exchange (Amex) AQR Capital Management Art of Selling Intangibles, The (Gross) Asness, Cliff Assessments Asset allocation strategy: in 5-step process active asset classes and individual investors and for an IPS market conditions and passive risk/return assessment in strategic tactical Asset class: long-term expected risk/returns non-core asset classes volatility of Assets under management (AUM) AUM. See Assets under management (AUM) Bad accounting Banz, Rolf Barclays Capital Aggregate Bond Index Barra Inc. Basu, Sanjoy Batterymarch Financial Management Beardstown Ladies, the Bear market: advisors and endowment effect and market timing gaps and policy changes and risk and Beat-the-market advice Behavioral finance Benchmarking, improper Benchmark(s): buying defining good definition of identification of proper index funds and strategy index products and Benchmarks and Investment Management (Siegel) Benefits, passive index investing Berkshire Hathaway Inc.

Then they weigh the advantages and disadvantages of including each investment in their portfolio as part of a total portfolio package. The objective of portfolio management is to create and follow an investment policy that provides the resources required to meet current and future obligations. At its core, the portfolio management process relies on a prudent mix of asset classes that’s based on research and reasonable assumptions about future risks, returns, and correlation with each other. Strict adherence to an asset allocation strategy is required for the investment policy to have its desired effect and avoid unwanted drift. This requires the regular monitoring of asset class levels since the markets are constantly moving. Occasional rebalancing back to the target asset allocation ensures that the portfolio stays on track. Risk control through asset allocation and rebalancing can’t protect a portfolio every year.

In satisfying this standard, the trustee must exercise reasonable care, skill, diligence, and caution. Fiduciary 360 and its affiliate the Foundation for Fiduciary Studies are two of many private organizations dedicated to investment fiduciary education, practice management, and support. These organizations have identified similar characteristics of both model acts. There are seven Global Fiduciary Precepts.1 1. Know standards, laws, and trust provisions. 2. Diversify assets to specific risk/return profile of the trust. 3. Prepare investment policy statement. 4. Use prudent experts (for example, an investment advisor) and document due diligence when selecting experts. 5. Monitor the activity of the prudent experts. 6. Control and account for investment expenses. 7. Avoid conflicts of interests and prohibited transactions. All trustees involved in different fields of investing including foundations and endowments, private family trusts, and pension plans (see Chapter 13) have one thing in common: they’re required to live up to the standards of trust law, which are the highest known in the law.


pages: 369 words: 128,349

Beyond the Random Walk: A Guide to Stock Market Anomalies and Low Risk Investing by Vijay Singal

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3Com Palm IPO, Andrei Shleifer, asset allocation, capital asset pricing model, correlation coefficient, cross-subsidies, Daniel Kahneman / Amos Tversky, diversified portfolio, endowment effect, fixed income, index arbitrage, index fund, information asymmetry, liberal capitalism, locking in a profit, Long Term Capital Management, loss aversion, margin call, market friction, market microstructure, mental accounting, merger arbitrage, Myron Scholes, new economy, prediction markets, price stability, profit motive, random walk, Richard Thaler, risk-adjusted returns, risk/return, selection bias, Sharpe ratio, short selling, survivorship bias, transaction costs, Vanguard fund

Whether the government can achieve the desired effect is an open question. 3 4 Beyond the Random Walk Thus, market efficiency is important so that optimal investment ensures optimal growth and maximizes social welfare. Can Capital Markets Be Fully Efficient? While market efficiency is desirable, there are three limitations in achieving that ideal: the cost of information, the cost of trading, and the limits of arbitrage. Strictly speaking, arbitrage refers to a profit earned with zero risk and zero investment. However, in this book the term is used in its more popular interpretation, that is, a superior risk-return trade-off that probably requires both risk and investment. LIMITATION 1: COST OF INFORMATION In an article aptly titled “On the Impossibility of Informationally Efficient Markets,” Sandy Grossman and Joe Stiglitz go about proving just that. The concept behind the impossibility of informationally efficient markets is straightforward. Let us assume that markets are fully efficient, that is, they instantaneously reflect new information in prices.

How can that happen? The idea is that financial assets are perfect substitutes for one another, and the market is huge. Any single supply or demand shock is small compared to the overall size of the market. And since financial assets are perfect substitutes, excess demand for a stock will be met by arbitrageurs. They will short-sell that stock, increasing its supply, and will buy another stock with equivalent risk-return characteristics. In such an event, any price change will be imperceptible. However, as reported in the previous section, there is a permanent 169 170 Beyond the Random Walk price impact. If there is no new information associated with index changes, then the only reason for the price impact is that financial assets do not have perfect substitutes. The assumption of no new information, however, is questionable.

If only the recommended deals are accepted, the annualized raw return increases to more than 16 percent. Execution of one stock deal is illustrated. Bottom Line Merger arbitrage can generate continuous and sustainable abnormal returns of 4–10 percent annually. Evidence relating to the profitability of merger arbitrage is long-term and consistent. Mutual funds specializing in merger arbitrage are a convenient way to earn a reasonable yet low-risk return. Stocks can be used to execute merger arbitrage transactions on an individual basis to possibly generate higher returns. Internet References Mutual Funds Specializing in Merger Arbitrage http://www.gabelli.com/funds/products/408.html: The site for Gabelli’s ABC Fund (GABCX). http://www.thearbfund.com: The site for the Arb Fund (ARBFX). http://www.enterprisefunds.com/funds/sector/ mergers_and_acquisitions.shtml: The site for Enterprise M&A Fund (EMACX).


pages: 337 words: 89,075

Understanding Asset Allocation: An Intuitive Approach to Maximizing Your Portfolio by Victor A. Canto

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accounting loophole / creative accounting, airline deregulation, Andrei Shleifer, asset allocation, Bretton Woods, buy low sell high, capital asset pricing model, commodity trading advisor, corporate governance, discounted cash flows, diversification, diversified portfolio, fixed income, frictionless, high net worth, index fund, inflation targeting, invisible hand, John Meriwether, law of one price, liquidity trap, London Interbank Offered Rate, Long Term Capital Management, market bubble, merger arbitrage, money market fund, new economy, passive investing, Paul Samuelson, price mechanism, purchasing power parity, risk tolerance, risk-adjusted returns, risk/return, Ronald Reagan, selection bias, shareholder value, Sharpe ratio, short selling, statistical arbitrage, survivorship bias, the market place, transaction costs, Y2K, yield curve, zero-sum game

For 2005, the Hong Kong firm viewed the various world regions pretty much as equally attractive in terms of the risk/reward tradeoff. An increased equity exposure is the way the firm moved along the expected returns and the risk/return tradeoff ’s volatility. There were two components to this. First, as the firm moved from the conservative portfolio to the growth portfolio, it increased the equity exposure within each region without affecting the global allocation. Second, it increased the riskier assets’ exposure with the highest expected returns at the equity region’s expense with the lowest expected return. Increased uncertainty reduced the firm’s allocation to variables with the greatest expected returns. The greaterexpected-returns dispersion forced the firm’s risk/return tradeoff to mute increases in equities and regional exposures for all the portfolios. This new allocation was aimed to protect the conservative portfolio against a downside and enabled the growth portfolio to increase its upside by taking into consideration the expected risk/return tradeoff.

Indeed, in the days of the Sharpe ratio and the CAPM, the market portfolio—a portfolio that has bought the market (given that the overall market is in equilibrium)—has become the efficient portfolio. An efficient portfolio is a portfolio that contains returns that have been maximized in relation to the risk level that individual investors desire. In a market that is in equilibrium, where the number of winners and losers must balance out, adding one additional asset class or stock does not increase the portfolio’s risk return ratio. This means the portfolio containing risky assets with the highest Sharpe ratio must be the market portfolio. Asset Allocation and Retirement Will efficiency do the trick over the long haul? Do modern advancements in the financial world guarantee that the returns to an investment plan or portfolio are going to be high enough to generate sufficient funds to meet future obligations? In a word: no.

Allocations Based on the Last 30 Years Traditionally, developing an SAA is a two-step process, and a perilous one for the individual investor. The first step uses the asset classes’ historical returns and the variance–covariance matrix to build a combination of the various asset classes that leads one to the efficient frontier. This step also leads an investor to the point where maximum expected returns are reached for a determined risk level. The second step determines risk tolerance so an investor can choose the risk/return combination best suiting his or her preferences. I have two major objections to this process as it is currently practiced. The first objection is simply empirical: How long of a historical sample does one need to determine long-run historical returns and the variance–covariance matrix? In earlier chapters, I used traditional asset-allocation tools to decide whether individual asset classes—Treasury bonds (T-bonds), small-caps, large-caps, value stocks, growth stocks, and domestic/international stocks—would be included on the efficient frontier and thus be potentially included in an investor portfolio.


pages: 206 words: 70,924

The Rise of the Quants: Marschak, Sharpe, Black, Scholes and Merton by Colin Read

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Albert Einstein, Bayesian statistics, Black-Scholes formula, Bretton Woods, Brownian motion, capital asset pricing model, collateralized debt obligation, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, David Ricardo: comparative advantage, discovery of penicillin, discrete time, Emanuel Derman, en.wikipedia.org, Eugene Fama: efficient market hypothesis, financial innovation, fixed income, floating exchange rates, full employment, Henri Poincaré, implied volatility, index fund, Isaac Newton, John Meriwether, John von Neumann, Joseph Schumpeter, Kenneth Arrow, Long Term Capital Management, Louis Bachelier, margin call, market clearing, martingale, means of production, moral hazard, Myron Scholes, naked short selling, Paul Samuelson, price stability, principal–agent problem, quantitative trading / quantitative finance, RAND corporation, random walk, risk tolerance, risk/return, Ronald Reagan, shareholder value, Sharpe ratio, short selling, stochastic process, The Chicago School, the scientific method, too big to fail, transaction costs, tulip mania, Works Progress Administration, yield curve

This upper locus yields the highest return r for any standard deviation or variance, and is now called the Markowitz bullet, with an optimal capital allocation line superimposed between the risk-free return and the efficient portfolio frontier. Tobin’s insight was to offer investors the opportunity to include in their portfolio a riskless asset or any combination of the optimal security portfolio and the riskless asset. From this framework, an investor is offered a range of investment opportunities that each yield the best possible return for any level of risk, according to each investor’s risk return preferences. While the model assumes that all would require a greater return to take on greater risk, some investors may nonetheless reside at a low level of risk and return, while others may accept a higher combination of risk and return. These qualities can be superimposed on the Markowitz bullet and the capital allocation line. Markowitz’s model is most profound if we accept the assumptions that a security can be priced based on its mean historic return and its Expected return Capital allocation line Efficient portfolio frontier Risk-free return Risk Figure 10.1 The capital allocation line 64 The Rise of the Quants Expected return High risk tolerance Capital allocation line Efficient portfolio frontier Low risk tolerance Risk-free return Risk Figure 10.2 Various choices of risk and return along the capital allocation line variance or standard deviation.

If a security departs from this linear relationship, rational investors will all simultaneously make decisions to realign the price of a security. This approach shares obvious implications with the efficient market hypothesis, as the next volume of this series will describe. In essence, investment in a given security becomes somewhat irrelevant, then, if each security is priced efficiently according to its risk. A risk-free asset and any single asset can then provide any risk-return trade-off if both long and short positions are permitted. The need for a broader market portfolio is obviated. Weaknesses with the CAPM model A model based on the mean and variance approach is accurate only if we accept a number of restrictive assumptions. First, we must assume asset returns are normally distributed or, more generally, elliptically distributed. The assumption of normally or elliptically distributed asset returns predicts that relatively large swings in asset prices greater than two standard deviations should occur extremely infrequently.

Their idea was to The Black-Scholes Options Pricing Theory 111 hold low beta stocks long that they predicted would perform better than the market. The short selling of high beta stocks should then allow the purchase of the low beta stocks, with some profit left over and with very little or, ideally, zero risk. This higher risk-free return could then be used to buy and sell along a Markowitz security line with a higher risk-free return intercept. An investor could then earn a superior risk-return trade-off for any level of desired risk through leverage purchases of the market portfolio. Their clients at Wells Fargo thought the Fischer-Scholes intuition was like financial alchemy that somehow denied the by then in vogue and widely accepted efficient market hypothesis. The firm’s rejection of their insights elicited the same reaction from Black as any such rejection had had on him since adolescence – it made him believe his hypothesis with even greater fervor.


pages: 416 words: 39,022

Asset and Risk Management: Risk Oriented Finance by Louis Esch, Robert Kieffer, Thierry Lopez

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asset allocation, Brownian motion, business continuity plan, business process, capital asset pricing model, computer age, corporate governance, discrete time, diversified portfolio, fixed income, implied volatility, index fund, interest rate derivative, iterative process, P = NP, p-value, random walk, risk/return, shareholder value, statistical model, stochastic process, transaction costs, value at risk, Wiener process, yield curve, zero-coupon bond

xix xix xxi PART I THE MASSIVE CHANGES IN THE WORLD OF FINANCE Introduction 1 The Regulatory Context 1.1 Precautionary surveillance 1.2 The Basle Committee 1.2.1 General information 1.2.2 Basle II and the philosophy of operational risk 1.3 Accounting standards 1.3.1 Standard-setting organisations 1.3.2 The IASB 2 Changes in Financial Risk Management 2.1 Definitions 2.1.1 Typology of risks 2.1.2 Risk management methodology 2.2 Changes in financial risk management 2.2.1 Towards an integrated risk management 2.2.2 The ‘cost’ of risk management 2.3 A new risk-return world 2.3.1 Towards a minimisation of risk for an anticipated return 2.3.2 Theoretical formalisation 1 2 3 3 3 3 5 9 9 9 11 11 11 19 21 21 25 26 26 26 vi Contents PART II EVALUATING FINANCIAL ASSETS Introduction 3 4 29 30 Equities 3.1 The basics 3.1.1 Return and risk 3.1.2 Market efficiency 3.1.3 Equity valuation models 3.2 Portfolio diversification and management 3.2.1 Principles of diversification 3.2.2 Diversification and portfolio size 3.2.3 Markowitz model and critical line algorithm 3.2.4 Sharpe’s simple index model 3.2.5 Model with risk-free security 3.2.6 The Elton, Gruber and Padberg method of portfolio management 3.2.7 Utility theory and optimal portfolio selection 3.2.8 The market model 3.3 Model of financial asset equilibrium and applications 3.3.1 Capital asset pricing model 3.3.2 Arbitrage pricing theory 3.3.3 Performance evaluation 3.3.4 Equity portfolio management strategies 3.4 Equity dynamic models 3.4.1 Deterministic models 3.4.2 Stochastic models 35 35 35 44 48 51 51 55 56 69 75 79 85 91 93 93 97 99 103 108 108 109 Bonds 4.1 Characteristics and valuation 4.1.1 Definitions 4.1.2 Return on bonds 4.1.3 Valuing a bond 4.2 Bonds and financial risk 4.2.1 Sources of risk 4.2.2 Duration 4.2.3 Convexity 4.3 Deterministic structure of interest rates 4.3.1 Yield curves 4.3.2 Static interest rate structure 4.3.3 Dynamic interest rate structure 4.3.4 Deterministic model and stochastic model 4.4 Bond portfolio management strategies 4.4.1 Passive strategy: immunisation 4.4.2 Active strategy 4.5 Stochastic bond dynamic models 4.5.1 Arbitrage models with one state variable 4.5.2 The Vasicek model 115 115 115 116 119 119 119 121 127 129 129 130 132 134 135 135 137 138 139 142 Contents 4.5.3 The Cox, Ingersoll and Ross model 4.5.4 Stochastic duration 5 Options 5.1 Definitions 5.1.1 Characteristics 5.1.2 Use 5.2 Value of an option 5.2.1 Intrinsic value and time value 5.2.2 Volatility 5.2.3 Sensitivity parameters 5.2.4 General properties 5.3 Valuation models 5.3.1 Binomial model for equity options 5.3.2 Black and Scholes model for equity options 5.3.3 Other models of valuation 5.4 Strategies on options 5.4.1 Simple strategies 5.4.2 More complex strategies PART III GENERAL THEORY OF VaR Introduction vii 145 147 149 149 149 150 153 153 154 155 157 160 162 168 174 175 175 175 179 180 6 Theory of VaR 6.1 The concept of ‘risk per share’ 6.1.1 Standard measurement of risk linked to financial products 6.1.2 Problems with these approaches to risk 6.1.3 Generalising the concept of ‘risk’ 6.2 VaR for a single asset 6.2.1 Value at Risk 6.2.2 Case of a normal distribution 6.3 VaR for a portfolio 6.3.1 General results 6.3.2 Components of the VaR of a portfolio 6.3.3 Incremental VaR 181 181 181 181 184 185 185 188 190 190 193 195 7 VaR Estimation Techniques 7.1 General questions in estimating VaR 7.1.1 The problem of estimation 7.1.2 Typology of estimation methods 7.2 Estimated variance–covariance matrix method 7.2.1 Identifying cash flows in financial assets 7.2.2 Mapping cashflows with standard maturity dates 7.2.3 Calculating VaR 7.3 Monte Carlo simulation 7.3.1 The Monte Carlo method and probability theory 7.3.2 Estimation method 199 199 199 200 202 203 205 209 216 216 218 viii Contents 7.4 Historical simulation 7.4.1 Basic methodology 7.4.2 The contribution of extreme value theory 7.5 Advantages and drawbacks 7.5.1 The theoretical viewpoint 7.5.2 The practical viewpoint 7.5.3 Synthesis 8 Setting Up a VaR Methodology 8.1 Putting together the database 8.1.1 Which data should be chosen?

We have seen that a well-thought-out risk management limits: • Excessive control (large-scale savings, prevention of doubling-up). 26 Asset and Risk Management • Indirect costs (every risk avoided is a potential loss avoided and therefore money gained). • Direct costs (the capital needed to be exposed to the threefold surface of market, credit and operational risk is reduced). The promotion of a real risk culture increases the stability and quality of profits, and therefore improves the competitive quality of the institution and ensures that it will last. 2.3 A NEW RISK-RETURN WORLD 2.3.1 Towards a minimisation of risk for an anticipated return Assessing the risk from the investor’s point of view produces a paradox: • On one hand, taking the risk is the only way of making the money. In other terms, the investor is looking for the risk premium that corresponds to his degree of aversion to risk. • On the other hand, however, although accepting the ‘risk premium’ represents profit first and foremost, it also unfortunately represents potential loss.

One of the most detailed analyses is that carried out by Fama and Macbeth,42 which, considering the relation Ek = RF + βk (EM − RF ) as an expression of Ek according to βk , tested the following hypotheses on the New York Stock Exchange (Figure 3.27): • The relation Ek = f (βk ) is linear and increasing. • βk is a complete measurement of the risk of the equity (k) on the market; in other words, the specific risk σε2k is not a significant explanation of Ek . 42 Fama E. and Macbeth J., Risk, return and equilibrium: empirical tests, Journal of Political Economy, Vol. 71, No. 1, 1974, pp. 606–36. Equities 97 Ek EM RF 1 bk Figure 3.27 CAPM test To do this, they used generalisations of the equation Ek = f (βk ), including powers of βk of a degree greater than 1 and a term that takes the specific risk into consideration. Their conclusion is that the CAPM model is in most cases acceptable. 3.3.2 Arbitrage pricing theory In the CAPM model, the risk premium Ek − RF for an equity is expressed as a multiple of the risk premium EM − RF for the market: Ek − RF = βk (EM − RF ) The proportionality coefficient is the β of the security.

How I Became a Quant: Insights From 25 of Wall Street's Elite by Richard R. Lindsey, Barry Schachter

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Albert Einstein, algorithmic trading, Andrew Wiles, Antoine Gombaud: Chevalier de Méré, asset allocation, asset-backed security, backtesting, bank run, banking crisis, Black-Scholes formula, Bonfire of the Vanities, Bretton Woods, Brownian motion, business process, buy low sell high, capital asset pricing model, centre right, collateralized debt obligation, commoditize, computerized markets, corporate governance, correlation coefficient, creative destruction, Credit Default Swap, credit default swaps / collateralized debt obligations, currency manipulation / currency intervention, discounted cash flows, disintermediation, diversification, Donald Knuth, Edward Thorp, Emanuel Derman, en.wikipedia.org, Eugene Fama: efficient market hypothesis, financial innovation, fixed income, full employment, George Akerlof, Gordon Gekko, hiring and firing, implied volatility, index fund, interest rate derivative, interest rate swap, John von Neumann, linear programming, Loma Prieta earthquake, Long Term Capital Management, margin call, market friction, market microstructure, martingale, merger arbitrage, Myron Scholes, Nick Leeson, P = NP, pattern recognition, Paul Samuelson, pensions crisis, performance metric, prediction markets, profit maximization, purchasing power parity, quantitative trading / quantitative finance, QWERTY keyboard, RAND corporation, random walk, Ray Kurzweil, Richard Feynman, Richard Feynman, Richard Stallman, risk-adjusted returns, risk/return, shareholder value, Sharpe ratio, short selling, Silicon Valley, six sigma, sorting algorithm, statistical arbitrage, statistical model, stem cell, Steven Levy, stochastic process, systematic trading, technology bubble, The Great Moderation, the scientific method, too big to fail, trade route, transaction costs, transfer pricing, value at risk, volatility smile, Wiener process, yield curve, young professional

Operating at a high level of abstraction makes it easy to switch to a different manifestation of the mathematics, and to think about finance problems in the broadest possible terms. After thinking about infinite universes, it’s easy to deal with the most abstract elements of finance. Around this time, my responsibilities at BARRA expanded beyond bonds. I began working on a project to apply these ideas of risk, return, and cost to equity trading. The portfolio manager trades off these three components, deciding which stocks to buy and sell to optimize the portfolio. The trader has a different problem. The portfolio manager provides the trader with the list of stocks to buy and sell. The trader must decide how to optimally schedule those trades (i.e., how much of each stock to trade each day). The optimal schedule provides the best tradeoff between returns, risk, and cost, with an assumption that costs increase as trading speeds up.

The equity trading project was not another research paper, but the development of a new product for BARRA. As such, it evolved into a multiyear, multiman-year effort to develop the required component models and combine them. It provided me yet another opportunity to JWPR007-Lindsey 42 May 7, 2007 16:30 h ow i b e cam e a quant expand my sphere of knowledge well beyond that original interest rate option model. It also provided further evidence that the risk, return, and cost framework applied very generally to problems in finance. Active Portfolio Management In 1990, Richard Grinold offered an internal course at BARRA, combining academic theories and seminar presentations to sketch out a scientific approach to active management. Richard’s goal was to turn this into a book, and he offered the course as a way to make progress in that direction. But he eventually realized that he wouldn’t be able to do this on his own, and he asked me to join him in the effort.

Then investors included real estate and privately placed bonds. The reported returns of these asset classes were based on appraisals and matrix pricing rather than market transactions; hence, they displayed artificially low volatility. When these asset classes were introduced to the optimizer it indicated that most of the portfolio should be allocated to them. Moreover, it showed that such an extreme allocation would substantially improve the risk/return trade-off. My conjecture is that critics of optimization latched on to this result to hype the sensitivity of optimizers to input errors. Of course, informed users of optimization understand the problem and employ a variety of methods to adjust the volatility assumptions appropriately, and thereby obtain reasonable results. My second conjecture is more cynical. Some quants have devoted a great deal of effort and resources to developing methods to ameliorate estimation error and are therefore vested in the notion that small input errors result in large output errors.


pages: 425 words: 122,223

Capital Ideas: The Improbable Origins of Modern Wall Street by Peter L. Bernstein

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Albert Einstein, asset allocation, backtesting, Benoit Mandelbrot, Black-Scholes formula, Bonfire of the Vanities, Brownian motion, buy low sell high, capital asset pricing model, corporate raider, debt deflation, diversified portfolio, Eugene Fama: efficient market hypothesis, financial innovation, financial intermediation, fixed income, full employment, implied volatility, index arbitrage, index fund, interest rate swap, invisible hand, John von Neumann, Joseph Schumpeter, Kenneth Arrow, law of one price, linear programming, Louis Bachelier, mandelbrot fractal, martingale, means of production, money market fund, Myron Scholes, new economy, New Journalism, Paul Samuelson, profit maximization, Ralph Nader, RAND corporation, random walk, Richard Thaler, risk/return, Robert Shiller, Robert Shiller, Ronald Reagan, stochastic process, the market place, The Predators' Ball, the scientific method, The Wealth of Nations by Adam Smith, Thorstein Veblen, transaction costs, transfer pricing, zero-coupon bond, zero-sum game

The innovations triggered by the revolution in finance and investing provide answers to such questions. They help investors deal with uncertainty. They provide benchmarks for determining whether expectations are realistic or fanciful and whether risks make sense or are foolish. They establish norms for determining how well a market is accommodating the needs of its participants. They have reformulated such familiar concepts as risk, return, diversification, insurance, and debt. Moreover, they have quantified those concepts and have suggested new ways of employing them and combining them for optimal results. Finally, they have added a measure of science to the art of corporate finance. Many of these innovations lay hidden in academic journals for years, unnoticed by Wall Street until the financial turbulence of the early 1970s forced practitioners to accept the harsh truth that investment is a risky business.

An entire profession of investor relations consultants has sprung up to sway those perceptions, and annual reports often carry as much hype as information. Still, research reveals that investors have a sharp nose for smelling out the truth for themselves. Thus, Modigliani and Miller put investors back in the catbird seat, with corporate managers at their mercy. Through arbitrage, profit-seeking investors can eliminate discrepancies in the perceived risk/return trade-offs of one security relative to another to the point where no one has any incentive to buy or sell. Trades take place only when investors disagree about the future of a company or when new information surfaces. Modigliani and Miller’s market is a market in equilibrium. And yet equilibrium is only a rough approximation of reality, because information pours into the marketplace constantly, in every shape and form.

But then he accepted: “If I had stayed at Merrill, they would have made me into a narrow quant.”39 A zealous editor, Treynor encouraged the publication of papers on the new theories, wrote a series of challenging short editorials, and contributed articles himself under the pseudonym Walter Bagehot. His role was not to be an easy one. Concepts like random walks, efficient markets, complicated versions of risk/return tradeoffs, and betas, with their complex mathematical formulations, scandalized the more traditional members of the Journal’s advisory board. James Vertin, then at Wells Fargo in San Francisco and an ally of Treynor’s on the board, recalls, “They were going to close it down because it had all this dumb stuff in it that nobody could understand!”40 The board pressured Treynor to ease up. Some time in the middle 1970s, the members asked him to count up the number of articles he had published along these lines.


pages: 244 words: 79,044

Money Mavericks: Confessions of a Hedge Fund Manager by Lars Kroijer

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activist fund / activist shareholder / activist investor, Bernie Madoff, capital asset pricing model, corporate raider, diversification, diversified portfolio, family office, fixed income, forensic accounting, Gordon Gekko, hiring and firing, implied volatility, index fund, intangible asset, Jeff Bezos, Just-in-time delivery, Long Term Capital Management, merger arbitrage, new economy, Ponzi scheme, risk-adjusted returns, risk/return, shareholder value, Silicon Valley, six sigma, statistical arbitrage, Vanguard fund, zero-coupon bond

I should have been better at occasionally looking up from my desk and appreciating where we had reached, instead of always worrying about the next potential problem. There are employees, counterparties and investors to whom I wish I had shown more gratitude, either financially or verbally. The list goes on … There is nothing intrinsically wrong with hedge funds. This is an industry that attracts some of the best minds in finance and gives them a wide mandate to generate returns that greatly enhance the risk/return profile of any portfolio. If they do well, they are amply rewarded, and if they fail, they are fired. While the hedge-fund industry was still a fairly small sector that profitably exploited selected pockets of market inefficiencies, the premise worked. As the number of hedge funds exploded to the near 10,000 in existence today, I think too many mediocre managers were paid too much for the industry to make sense to the end investor (like Mrs Straw, mentioned earlier).

As per the argument above, if we assume that individual markets are efficient enough that you can’t consistently beat them after fees and expenses it makes sense to buy the entire market via a cheaply constructed index. But if we assume that capital flows between different national markets are less efficient than flows within each market, we might be able to do better than simply allocate capital to each market in accordance with their relative market capitalisation (like the MSCI World does in the example above). In this case we should be able to enhance our risk/return profile by re-allocating capital on the basis of optimal portfolio theory, using inputs on expected market correlations, a reasonable estimate of the risk of each market, a return expectation (we can make this a function of the risk levels) and a few other fairly non-controversial assumptions. What we are trying to do is to create a portfolio of well-diversified liquid markets across the world in a way that is cheap to construct and where we have a reasonable estimate of the risk and expectation of an outperformance relative to the simple market capitalisation index.

In an earlier edition of this book I argued that investors could gain from buying protection against the market scenarios where correlations spiked in a broad-based slump. By buying deep out-of-the-money puts on the market we could protect ourselves against disaster scenarios. This protection would eliminate the high correlation drawdowns and the resulting portfolio would be a lower correlation combination of securities with a better risk/return profile. While a valid idea, in reality this purchase of downside protection is impractical for most investors. First and foremost, many investors are not set up to trade options and are generally inclined to stay away from the space of derivative trading (a healthy trait indeed). Second, consistently buying out-of-the-money puts in a high volatility environment can be prohibitively expensive, particularly when you include the large bid/offer spreads and commissions charged.


pages: 819 words: 181,185

Derivatives Markets by David Goldenberg

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Black-Scholes formula, Brownian motion, capital asset pricing model, commodity trading advisor, compound rate of return, conceptual framework, Credit Default Swap, discounted cash flows, discrete time, diversification, diversified portfolio, en.wikipedia.org, financial innovation, fudge factor, implied volatility, incomplete markets, interest rate derivative, interest rate swap, law of one price, locking in a profit, London Interbank Offered Rate, Louis Bachelier, margin call, market microstructure, martingale, Myron Scholes, Norbert Wiener, Paul Samuelson, price mechanism, random walk, reserve currency, risk/return, riskless arbitrage, Sharpe ratio, short selling, stochastic process, stochastic volatility, time value of money, transaction costs, volatility smile, Wiener process, Y2K, yield curve, zero-coupon bond, zero-sum game

Currency Forward Pricing 225 xii 7.4 DETAILED CONTENTS Stock Index Futures 225 7.4.1 The S&P 500 Spot Index 225 7.4.2 S&P 500 Stock Index Futures Contract Specifications 227 The Quote Mechanism for S&P 500 Futures Price Quotes 230 7.4.3 7.5 Risk Management Using Stock Index Futures 231 7.5.1 Pricing and Hedging Preliminaries 231 7.5.2 Monetizing the S&P 500 Spot Index 231 7.5.3 Profits from the Traditional Hedge 235 7.5.4 Risk, Return Analysis of the Traditional Hedge 236 7.5.5 Risk-Minimizing Hedging 238 7.5.6 Adjusting the Naive Hedge Ratio to Obtain the Risk-Minimizing Hedge Ratio 239 Risk Minimizing the Hedge Using Forward vs. Futures Contracts 241 Cross-Hedging, Adjusting the Hedge for non S&P 500 Portfolios 243 7.5.7 7.5.8 7.6 7.7 The Spot Eurodollar Market 245 7.6.1 Spot 3-month Eurodollar Time Deposits 246 7.6.2 Spot Eurodollar Market Trading Terminology 248 7.6.3 LIBOR3, LIBID3, and Fed Funds 250 7.6.4 How Eurodollar Time Deposits are Created 252 Eurodollar Futures 254 7.7.1 Contract Specifications 254 7.7.2 The Quote Mechanism, Eurodollar Futures 256 7.7.3 Forced Convergence and Cash Settlement 258 7.7.4 How Profits and Losses are Calculated on Open ED Futures Positions 262 DETAILED CONTENTS PART 2 Trading Structures Based on Forward Contracts CHAPTER 8 8.1 Swaps as Strips of Forward Contracts 8.1.1 274 Strips of Forward Contracts 277 Basic Terminology for Interest-Rate Swaps: Paying Fixed and Receiving Floating 278 8.2.2 8.2.3 8.4 273 275 8.2.1 8.3 271 Commodity Forward Contracts as Single Period Swaps 8.1.2 8.2 STRUCTURED PRODUCTS, INTEREST-RATE SWAPS xiii Paying Fixed in an IRD (Making Fixed Payments) 278 Receiving Variable in an IRD (Receiving Floating Payments) 279 Eurodollar Futures Strips 280 Non-Dealer Intermediated Plain Vanilla Interest-Rate Swaps 281 Dealer Intermediated Plain Vanilla Interest-Rate Swaps 284 8.4.1 An Example 284 8.4.2 Plain Vanilla Interest-Rate Swaps as Hedge Vehicles 286 Arbitraging the Swaps Market 292 8.4.3 8.5 Swaps: More Terminology and Examples 293 8.6 The Dealer’s Problem: Finding the Other Side to the Swap 294 8.7 Are Swaps a Zero Sum Game?

HEDGING, BASIS RISK, AND SPREADING TABLE 6.1 207 CME Corn Contract Price Quotes Month Open High Low Last Change Settle Estimated Volume Prior Day Open Interest JLY 14 449’0 459’6 447’0 458’4 +10’0 459’0 163,794 459,758 SEP 14 444’2 457’2 442’6 455’4 +12’0 456’2 96,199 291,061 DEC 14 447’2 458’6 445’2 457’4 +10’4 457’6 81,047 441,580 MAR 15 457’0 468’0 455’0 — +10’4 467’2 11,684 71,328 MAY 15 463’6 474’4 462’0 469’2 +10’0 473’6 2,596 16,284 JLY 15 469’6 480’2 468’0 — +9’6 479’4 3,379 31,593 SEP 15 463’6 470’0 462’2A — +8’4 472’2 708 3,970 DEC 15 458’0 466’4 456’6 464’0 +8’0 465’6 2,506 48,666 MAR 16 470’0 470’0 469’0 — +7’4 474’6 38 1,029 Reprinted by permission of the CME Inc., 2014. n SELECTED CONCEPT CHECK SOLUTIONS Concept Check 1 a. The meaning of the words is: another portfolio of financial instruments that has the same risk, return characteristics as the actual T-bill. This means the same maturity, the same risk, and as we shall see in this example, the same yield. Another way to think about the synthetic instrument is as a replicating portfolio. When we synthesized forward contracts, we saw that a synthetic forward contract is a portfolio consisting of the underlying spot instrument fully financed by a zero-coupon bond maturing at the expiration date of the forward contract. b.

Currency Forward Pricing 225 7.4 Stock Index Futures 225 7.4.1 The S&P 500 Spot Index 225 7.4.2 S&P 500 Stock Index Futures Contract Specifications 227 The Quote Mechanism for S&P 500 Futures Price Quotes 230 7.4.3 7.5 Risk Management Using Stock Index Futures 231 7.5.1 Pricing and Hedging Preliminaries 231 7.5.2 Monetizing the S&P 500 Spot Index 231 7.5.3 Profits from the Traditional Hedge 235 212 FORWARD CONTRACTS AND FUTURES CONTRACTS 7.5.4 Risk, Return Analysis of the Traditional Hedge 236 7.5.5 Risk-Minimizing Hedging 238 7.5.6 Adjusting the Naive Hedge Ratio to Obtain the Risk-Minimizing Hedge Ratio 239 Risk-Minimizing the Hedge Using Forward vs. Futures Contracts 241 Cross-Hedging, Adjusting the Hedge for non S&P 500 Portfolios 243 7.5.7 7.5.8 7.6 The Spot Eurodollar Market 245 7.6.1 Spot 3-month Eurodollar Time Deposits 246 7.6.2 Spot Eurodollar Market Trading Terminology 248 7.6.3 LIBOR3, LIBID3, and Fed Funds 250 7.6.4 How Eurodollar Time Deposits are Created 252 7.7 Eurodollar Futures 254 7.7.1 Contract Specifications 254 7.7.2 The Quote Mechanism, Eurodollar Futures 256 7.7.3 Forced Convergence and Cash Settlement 258 7.7.4 How Profits and Losses are Calculated on Open ED Futures Positions 262 The crown jewels of futures contracts are the financial futures contracts which were introduced to the world in the late 1970s and early 1980s by the CME and the CBOT (since merged) in Chicago.


pages: 348 words: 99,383

The Financial Crisis and the Free Market Cure: Why Pure Capitalism Is the World Economy's Only Hope by John A. Allison

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Affordable Care Act / Obamacare, bank run, banking crisis, Bernie Madoff, clean water, collateralized debt obligation, correlation does not imply causation, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, disintermediation, fiat currency, financial innovation, Fractional reserve banking, full employment, high net worth, housing crisis, invisible hand, life extension, low skilled workers, market bubble, market clearing, minimum wage unemployment, money market fund, moral hazard, negative equity, obamacare, Paul Samuelson, price mechanism, price stability, profit maximization, quantitative easing, race to the bottom, reserve currency, risk/return, Robert Shiller, Robert Shiller, The Bell Curve by Richard Herrnstein and Charles Murray, too big to fail, transaction costs, yield curve, zero-sum game

The smaller banks will eventually follow; if they do not, they will end up with lower returns on equity than their bigger competitors and will be vulnerable to being acquired. The larger company can simply leverage the “excess” equity in the smaller company, acquiring it. Also, anytime there is a downturn in the economy, the Fed consistently “saves” the very large banks, creating an unbalanced risk/ return trade-off. If you manage a large financial institution, why not be leveraged, which increases your profits in good times, because the Fed will always bail out your company during bad times? During my career, the Fed has systematically effectively encouraged banks to increase their leverage (sometimes intentionally, sometimes not). In a free market, where the economic system is in a constant correction process, individuals are aware of risk.

FDIC insurance primarily reduces the short-term risk of bank runs because depositors perceive their deposits to be insured by the federal government. However, I previously described the fact that FDIC insurance substantially increases the credit and liquidity risk that banks take by eliminating market discipline. Based on my long-term observation of the behavior of bank executives (human nature), the existence of FDIC insurance changes the risk/return trade-offs so significantly that in the good times (when bad loans are made), bankers take risks that they would never take in a free market. FDIC insurance is pro-cyclical; that is, it increases both the size of the bubble (the misinvestment) and the magnitude of the bust. In the short term, the Federal Reserve can be important in controlling liquidity risk. Healthy banks can borrow cash from the Federal Reserve, using their sound assets (typically government bonds) as collateral.

It is not surprising that GE has become more of a crony capitalist organization since it was saved by the government. Also, do not be surprised if it returns to the same high-risk financing strategy in the future. After all, there is no downside risk when you have a strong relationship with Big Brother. Many people have declared TARP a success because most of the money will be paid back. This is a totally improper measure of performance. Even if the taxpayers get most of their money back, the risk/return trade-off was irrational at the time the government investments were made. Private investors would not have taken this risk given the relatively low returns to be earned. More significantly, a rational assessment of TARP must consider its short-term and long-term economic consequences. This is a challenging question to answer, but there is a historical precedent that is useful for comparison.


pages: 302 words: 86,614

The Alpha Masters: Unlocking the Genius of the World's Top Hedge Funds by Maneet Ahuja, Myron Scholes, Mohamed El-Erian

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activist fund / activist shareholder / activist investor, Asian financial crisis, asset allocation, asset-backed security, backtesting, Bernie Madoff, Bretton Woods, business process, call centre, collapse of Lehman Brothers, collateralized debt obligation, computerized trading, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, Donald Trump, en.wikipedia.org, family office, fixed income, high net worth, interest rate derivative, Isaac Newton, Long Term Capital Management, Marc Andreessen, Mark Zuckerberg, merger arbitrage, Myron Scholes, NetJets, oil shock, pattern recognition, Ponzi scheme, quantitative easing, quantitative trading / quantitative finance, Renaissance Technologies, risk-adjusted returns, risk/return, rolodex, short selling, Silicon Valley, South Sea Bubble, statistical model, Steve Jobs, systematic trading, zero-sum game

Pure Alpha traded global bond markets, currencies, equities, commodities, and emerging market debt. At any point in time, it would combine these 60 to 100 positions with any client-chosen benchmark. For the Kodak pension fund, an early client, Bridgewater managed Pure Alpha combined with a passive holding in long-duration bonds and inflation-indexed bonds. It was the best way to produce the best risk return. “Now it would be called innovative,” says Dalio. “Back then I guess it would be called crazy.” By doing this, the client could always specify beta. “This is how we manage money now,” says Dalio. “Clients tell us they would like an equity account and set a benchmark, like the S&P 500. We either replicate the benchmark or buy futures to equal the benchmark. After they put money into Pure Alpha, it’s overlaid on that benchmark.

In addition to banks with two-tiered capital structures, Paulson also found opportunities in other financial companies with a holding company structure, such as insurance companies, and in leveraged buyouts. Almost all investors hated shorting bonds because most of the time the bonds paid out, and the negative carry from paying the interest on the short bond was a drag on performance. Paulson had not been dissuaded from this challenge. He liked the asymmetrical risk/return potential, and continued to pursue this area as an investment strategy with periodic success over time. By the spring of 2005, Paulson became increasingly alarmed by weak credit underwriting standards and excessive leverage being used by financial institutions. Credit quality had deteriorated to the point where the worst-performing companies could readily raise financing. And banks had fostered this trend by adding vast quantities of credit assets to their balance sheets and by increasing their leverage.

Between June 30 and September 30 of that year, Paulson bought 15 million shares of Rohm & Haas, according to documents filed with the SEC, at which time the investment was worth $1.05 billion. Since then, numerous obstacles had delayed the deal, and a significant amount of Paulson & Co.’s wealth was on the line. Paulson was doing everything he could to encourage Dow to execute. Paulson feels it is easy to compute returns from a spread, but his and his team’s expertise comes into play when evaluating the risk-return trade-off for a deal in trouble. Deal completion risks are exacerbated when the economy and market weaken. When the economy slipped into a deep recession after Lehman failed, Dow found that the price it had agreed to pay for the company was too high and it wanted to exit the transaction. The spread went from $2 when the deal was announced to $25 as the stock fell to the low 50s. This raises the legal question for investors: can Dow exit the transaction?


pages: 162 words: 50,108

The Little Book of Hedge Funds by Anthony Scaramucci

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Andrei Shleifer, asset allocation, Bernie Madoff, business process, carried interest, corporate raider, Credit Default Swap, diversification, diversified portfolio, Donald Trump, Eugene Fama: efficient market hypothesis, fear of failure, fixed income, follow your passion, Gordon Gekko, high net worth, index fund, John Meriwether, Long Term Capital Management, mail merge, margin call, mass immigration, merger arbitrage, money market fund, Myron Scholes, NetJets, Ponzi scheme, profit motive, quantitative trading / quantitative finance, random walk, Renaissance Technologies, risk-adjusted returns, risk/return, Ronald Reagan, Saturday Night Live, Sharpe ratio, short selling, Silicon Valley, the new new thing, too big to fail, transaction costs, Vanguard fund, Y2K, Yogi Berra, zero-sum game

Using a top-down approach, they attempt to anticipate macroeconomic trends and price changes on capital markets by analyzing the variables associated with the different countries in which they allocate their capital. To do so, they study how certain political events, global macroeconomic factors, and financial fundamentals influence the prices of securities, indices, options, futures contracts, and so on. Simultaneously, they analyze both developed and emerging markets worldwide and the risk/return potential of a given investment.4 Once they determine a global investment thesis, they make leveraged bets on the direction of the movements in the market and earn the difference between the borrowing cost and the profit from their directional bets going the way that they predict. Although global macro strategies are different from the strategies created by A. W. Jones, they are credited with putting hedge funds on the map.

As such, he needs to make sure that the portfolio can be quickly adjusted to the changing global economic realities. Ultimately, the overall performance of a fund of hedge funds is a function of this strategic portfolio construction that is based on hedge fund strategy outlook, hedge fund manager selection, and liquidity and risk management. If done appropriately, this allocation will minimize volatility and maximize risk returns. The Specifics The best and brightest in the fund of funds industry do the following three things for their clients: 1. They have a deep understanding of the macroeconomic situations and the global economy, taking into account what the Federal Reserve and other central banks are doing and also what is going on in the world’s currency and commodities markets. This insight goes deep. It could be talking to Fed officials and the world’s brightest economists and former and current policy makers.


pages: 236 words: 77,735

Rigged Money: Beating Wall Street at Its Own Game by Lee Munson

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affirmative action, asset allocation, backtesting, barriers to entry, Bernie Madoff, Bretton Woods, buy low sell high, California gold rush, call centre, Credit Default Swap, diversification, diversified portfolio, estate planning, fiat currency, financial innovation, fixed income, Flash crash, follow your passion, German hyperinflation, High speed trading, housing crisis, index fund, joint-stock company, money market fund, moral hazard, Myron Scholes, passive investing, Ponzi scheme, price discovery process, random walk, risk tolerance, risk-adjusted returns, risk/return, too big to fail, trade route, Vanguard fund, walking around money

At the time this was a huge idea, but it has a few problems when it’s used in the real world. Modern Portfolio Theory (MPT) assumes that investors will be rational. If given two portfolios with the same expected return, an investor will choose the less risky one. Why would you choose something more risky if it does the same thing as another portfolio with less risk? You wouldn’t if there was a bulletproof way of knowing the risk return of every security. People have different opinions on the matter. What makes the whole exercise of finding the less risky portfolio more dubious is that we use past performance to get this so-called expected return. Did I mention that there is no one way of coming up with this number? There is a whole army of analysts—including people like me—that have our own special ways of guessing what an asset class is expected to do in the future.

That said, how is an investor supposed to commit large allocations of capital in fixed income ETFs with that sinking feeling that this 30-year party may be over? MLPs are neither stock nor bond, but they can be an alternative to a portfolio seeking diversification and income outside of traditional asset classes. If you were thinking of buying higher-volatility bond ETFs like HYG, JNK, or PFD, read on and find another way to capture higher risk return and diversification. In their simplest form, MLPs are publicly traded organizations that are structured as limited partnerships (LP) rather than corporations. MLPs combine the tax benefits of an LP with the liquidity of a publicly traded security. Because the MLP passes through income, the limited partner can achieve higher current cash flow, meaning the company doesn’t pay tax on income by passing that income to the investor.


pages: 270 words: 73,485

Hubris: Why Economists Failed to Predict the Crisis and How to Avoid the Next One by Meghnad Desai

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3D printing, bank run, banking crisis, Berlin Wall, Big bang: deregulation of the City of London, Bretton Woods, BRICs, British Empire, Capital in the Twenty-First Century by Thomas Piketty, Carmen Reinhart, central bank independence, collapse of Lehman Brothers, collateralized debt obligation, correlation coefficient, correlation does not imply causation, creative destruction, Credit Default Swap, credit default swaps / collateralized debt obligations, David Ricardo: comparative advantage, deindustrialization, demographic dividend, Eugene Fama: efficient market hypothesis, eurozone crisis, experimental economics, Fall of the Berlin Wall, financial innovation, Financial Instability Hypothesis, floating exchange rates, full employment, German hyperinflation, Gunnar Myrdal, Home mortgage interest deduction, imperial preference, income inequality, inflation targeting, invisible hand, Isaac Newton, Joseph Schumpeter, Kenneth Arrow, Kenneth Rogoff, laissez-faire capitalism, liquidity trap, Long Term Capital Management, market bubble, market clearing, means of production, Mexican peso crisis / tequila crisis, mortgage debt, Myron Scholes, negative equity, Northern Rock, oil shale / tar sands, oil shock, open economy, Paul Samuelson, price stability, purchasing power parity, pushing on a string, quantitative easing, reserve currency, rising living standards, risk/return, Robert Shiller, Robert Shiller, Ronald Reagan, savings glut, secular stagnation, seigniorage, Silicon Valley, Simon Kuznets, The Chicago School, The Great Moderation, The inhabitant of London could order by telephone, sipping his morning tea in bed, the various products of the whole earth, The Wealth of Nations by Adam Smith, Tobin tax, too big to fail, women in the workforce

The basic idea developed that in buying financial (and by extension real) assets, people weigh up the return versus the risk. Cash carries no risk and yields no return. From then on, one can rank assets by return as measured by the average yield and risk as measured by the variance of the return. The risk–return “frontier” is like a constraint. Each investor can then define his or her preference between risk and return, as with consumer utility functions. To maximize the preference we need the tangent of the preference function with the risk–return frontier, that is, the highest level of return consistent with the risk preference of the consumer. This gives us a theory of portfolio selection for investors, who may choose between cash, bonds, equities and other riskier assets. The growth of knowledge in portfolio selection gave a fillip to the use of mathematical methods.


pages: 431 words: 132,416

No One Would Listen: A True Financial Thriller by Harry Markopolos

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backtesting, barriers to entry, Bernie Madoff, call centre, centralized clearinghouse, correlation coefficient, diversified portfolio, Edward Thorp, Emanuel Derman, Eugene Fama: efficient market hypothesis, family office, financial thriller, fixed income, forensic accounting, high net worth, index card, Long Term Capital Management, Louis Bachelier, offshore financial centre, Ponzi scheme, price mechanism, quantitative trading / quantitative finance, regulatory arbitrage, Renaissance Technologies, risk-adjusted returns, risk/return, rolodex, Sharpe ratio, statistical arbitrage, too big to fail, transaction costs, your tax dollars at work

“In addition, experts ask why no one has been able to duplicate similar returns using the strategy and why other firms on Wall Street haven’t become aware of the fund and its strategy and traded against it, as has happened so often in other cases; why Madoff Securities is willing to earn commissions on the trades but not set up a separate asset management division to offer hedge funds directly to investors and keep all the incentive fees for itself, or conversely, why it doesn’t borrow money from creditors ... and manage the funds on a proprietary basis.” And then he presented Madoff’s responses, describing him as appearing “genuinely amused by the interest and attention aimed at an asset management strategy designed to generate conservative, low-risk returns that he notes are nowhere near the top results of well-known fund managers on an absolute return basis. “The apparent lack of volatility in the performance of the fund, Madoff says, is an illusion based on a review of monthly and annual returns. On an intraday, intraweek, and intramonth basis, he says, ‘the volatility is all over the place, with the fund down by as much as 1 percent.” An illusion?

I also felt absolutely no obligation to tell any of the 14 asset managers that Madoff was a fraud. I had no personal relationship with any of them, and I certainly didn’t want Bernie Madoff to know we were tracking him. Like Access, these funds needed Bernie to survive; they didn’t need me. Where would their loyalty be? And what would happen to me when Madoff found out I had warned them? I did appreciate the fact that they were trapped. They had to have Madoff to compete. No one had a risk-return ratio like Bernie. If you didn’t have him in your portfolio, your returns paled in comparison to those competitors who did. If you were a private banker and a client told you someone he knew had invested with Madoff and was getting 12 percent annually with ultralow volatility, what choice do you have? You’re going to either get Madoff for that client or lose the client to a banker who has him.

And even among the four or five professionals who both express an understanding of the strategy and have little trouble accepting the reported returns it has generated, a majority still expresses the belief that, if nothing else, Madoff must be using other stocks and options rather than only those in the S&P 100. Bernie Madoff is willing to answer each of those inquiries, even if he refuses to provide details about the trading strategy he considers proprietary information. And in a face-to-face interview and several telephone interviews, Madoff sounds and appears genuinely amused by the interest and attention aimed at an asset management strategy designed to generate conservative, low risk returns that he notes are nowhere near the top results of well-known fund managers on an absolute return basis. Lack of Volatility Illusory The apparent lack of volatility in the performance of the fund, Madoff says, is an illusion based on a review of the monthly and annual returns. On an intraday, intraweek and intramonth basis, he says, “the volatility is all over the place,” with the fund down by as much as 1 percent.


pages: 537 words: 144,318

The Invisible Hands: Top Hedge Fund Traders on Bubbles, Crashes, and Real Money by Steven Drobny

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Albert Einstein, Asian financial crisis, asset allocation, asset-backed security, backtesting, banking crisis, Bernie Madoff, Black Swan, Bretton Woods, BRICs, British Empire, business process, capital asset pricing model, capital controls, central bank independence, collateralized debt obligation, commoditize, Commodity Super-Cycle, commodity trading advisor, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency peg, debt deflation, diversification, diversified portfolio, equity premium, family office, fiat currency, fixed income, follow your passion, full employment, George Santayana, Hyman Minsky, implied volatility, index fund, inflation targeting, interest rate swap, inventory management, invisible hand, London Interbank Offered Rate, Long Term Capital Management, market bubble, market fundamentalism, market microstructure, moral hazard, Myron Scholes, North Sea oil, open economy, peak oil, pension reform, Ponzi scheme, prediction markets, price discovery process, price stability, private sector deleveraging, profit motive, purchasing power parity, quantitative easing, random walk, reserve currency, risk tolerance, risk-adjusted returns, risk/return, savings glut, selection bias, Sharpe ratio, short selling, sovereign wealth fund, special drawing rights, statistical arbitrage, stochastic volatility, survivorship bias, The Great Moderation, Thomas Bayes, time value of money, too big to fail, transaction costs, unbiased observer, value at risk, Vanguard fund, yield curve, zero-sum game

How we manage the upside depends on the specific situation. When we get into a trade, we try to have an idea of the risk versus reward, and what type of trade it is. For a short-term tactical trade, we are trying to get a base hit because something seems out of line for a day or a few days. When we have more conviction on a particular theme, we will run a bigger position, going for a double or a triple. In either case, we look for asymmetric risk/return profiles, risking, say, 5 percent to make 10 or 15 percent, or risking 25 percent to make 50 to 100 percent. In general, we always sell winners “too soon” because we are scaling out into strength. It’s more art than science on the upside. We try to balance how consensus our idea has become, what kind of price target makes sense for our time horizon and the market action. And then, of course, we are trading around positions as well.

This is compounded by the fact that managers putting on illiquid trades did not personally face the true costs, meaning real money funds most likely did not charge enough for this in the past. Second, many argue that the ability to control and know the cash flows makes private assets (e.g., real estate) useful liability hedges. This may or may not be true, though my inclination is that these assets can and should stand on their own risk/return merits. “Labeling” something a hedge does not necessarily make it one, leading to misspecified risks and asset weights. Third, there are the tax shield and operational efficiency arguments for private equity, though these have to be weighed against the high management fee structure associated with most private equity funds. Fourth, the relative lack of market pricing results in a (albeit entirely artificial) smoothing of returns, and this likely helped hide the true losses of many plans last year.

See Maximum Sharpe Ratio Multiyear horizons NASDAQ (1995-2003) index (1994-2003) mispricing Negative carry Negative skew risk New Deal New York Mercantile Exchange (NYMEX) Nikkei (1980-1998) Nominal GDP Non-Accelerating Inflation Rate of Unemployment (NAIRU) Nonconstant volatility, presence Nonequity assets, inclusion Nongovernmental organizations (NGOs), data Normal backwardation North Sea crude Notre Dame (university endowment) Ohio, pension fund loss Oil (1986-2009) Oil (1998-2009) Oil fields, Commodity Investor purchase 1% effect One time stimulus programs Optimal portfolio construction, real money funds failure Optionality, usage Options markets, day-to-day liquidity Options, usage Orange County pension fund, problem Outcomes, positive asymmetry (achievement) Overnight index, geometric average Overnight indexed swap (OIS) spreads (2006-2008) Overvaluation zones, examination Overvalued assets (portfolio ownership), diversification (absence) Oxford Endowment, asset management Passive asset mix, importance Passive commodity indices, avoidance Paulson, Henry Peak oil, belief Pension Benefit Guaranty Corporation (PBGC), corporation pension fund guarantees Pensioner, The CalPERS control, example dollar notional thinking illiquid asset avoidance illiquidity premium measurement process illiquidity risk, hedge process interview investment scenario lessons leverage, usage performance, compounding cost post-crash investment, peer performance returns, targeting risk management risk premiums, specification risk/return approach 60-40 policy, standardization Pension funds allocation base currency commodity investment reasons constraint increase investment implementation, changes talent, quality long-term investment horizon real risk swaps/futures, usage Pensions assets, conservative management cash level change contributions, delay funding levels plans, constraints profits structure, impact systems, demographic challenges (impact) underfunding, shortfall Perfection, paradox Personal budgets, problems Philippines, peso (1993-1994) Philosopher, The Physical commodities, front contract advantage Pioneering Portfolio Management (Swensen) Plan assets, value (estimate) Plasticine™ Plasticine Macro Trader, The China perspective commodities, ownership complacency context, creation contrarian perspective diversification interpretation equities, delusion Favorite Trade format disapproval,–370368 hedge funds usage ideas, generation (global macro perspective) information, filtration interview investment safety investment storm investor letter, impact Japan bullishness liquidity, importance long-only community, adaptation long-only investment market behavior entry, awareness irrationality, relationship mentor lessons pension fund portfolio management performance portfolio construction, rethinking creation operation predictability, degree risk management evolution importance lessons success, consideration trade development ideas, importance problem theses, development trading decisions trend, anticipation P&L trading Popper, Karl Portable alpha allocation Portfolio Commodity Hedger construction construction guidelines rethinking diversification risk diversity Equity Trader construction illiquid assets, leverage illiquidity level, risk management levering, risk collars (usage) liquidity management, difficulty management investor approach recipe marginal trade optimization P&L volatility, limits policy activity, increase (impact) real money manager construction replication/modeling risks concentration, increase management size, reduction stress tests, conducting structure Portfolio-level expected alpha Positioning, understanding Positions notional value oversizing running scaling Positive asymmetry, achievement Potash Corporation of Saskatchewan (2008) Precommitments, method Predator, The bearishness, development CalPERS operation inflection points, awareness information collection examination process interview lessons liquidity, valuation macro overlay, profitability markets fundamentals/psychology, impact psychology, understanding mental flexibility optimist, perspective risk management stock market increase, nervousness stocks long position picking, profitability style, evolution tactical approach time horizon trade problem quality trading ideas, origination uniqueness Premium.


pages: 823 words: 220,581

Debunking Economics - Revised, Expanded and Integrated Edition: The Naked Emperor Dethroned? by Steve Keen

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accounting loophole / creative accounting, banking crisis, banks create money, barriers to entry, Benoit Mandelbrot, Big bang: deregulation of the City of London, Black Swan, Bonfire of the Vanities, butterfly effect, capital asset pricing model, cellular automata, central bank independence, citizen journalism, clockwork universe, collective bargaining, complexity theory, correlation coefficient, creative destruction, credit crunch, David Ricardo: comparative advantage, debt deflation, diversification, double entry bookkeeping, en.wikipedia.org, Eugene Fama: efficient market hypothesis, experimental subject, Financial Instability Hypothesis, fixed income, Fractional reserve banking, full employment, Henri Poincaré, housing crisis, Hyman Minsky, income inequality, information asymmetry, invisible hand, iterative process, John von Neumann, laissez-faire capitalism, liquidity trap, Long Term Capital Management, mandelbrot fractal, margin call, market bubble, market clearing, market microstructure, means of production, minimum wage unemployment, money market fund, open economy, Pareto efficiency, Paul Samuelson, place-making, Ponzi scheme, profit maximization, quantitative easing, RAND corporation, random walk, risk tolerance, risk/return, Robert Shiller, Robert Shiller, Ronald Coase, Schrödinger's Cat, scientific mainstream, seigniorage, six sigma, South Sea Bubble, stochastic process, The Great Moderation, The Wealth of Nations by Adam Smith, Thorstein Veblen, time value of money, total factor productivity, tulip mania, wage slave, zero-sum game

With this picture of investor behavior, Sharpe showed that the only investments that are rational for this investor are those that fall on the edge of the cloud of possible investments, which he labels the ‘investment opportunity curve’ or IOC (ibid.: 429). These investments give the highest return and the lowest risk possible. Any other combination that is not on the edge of the cloud can be topped by one farther out that has both a higher return and a lower risk.12 If this were the end of the matter, then the investor would choose the particular combination that coincided with their preferred risk–return trade-off, and that would be that. 11.3 Investor preferences and the investment opportunity cloud However, it’s possible to combine share-market investments with a bond that has much lower volatility, and Sharpe assumed the existence of a bond that paid a very low return, but had no risk. Sharpe linked bond and share investments with one further assumption: that the investor could borrow as much as he wanted at the riskless rate of interest.

This portfolio was represented by a straight line linking the riskless bond with a selection of shares (where the only selection that made sense was one that was on the Investment Opportunity Curve, and tangential to a line drawn through the riskless bond). Sharpe called this line the ‘capital market line’ or CML (ibid.: 425). 11.4 Multiple investors (with identical expectations) With borrowing, the investor’s risk–return preferences no longer determined which shares he bought; instead, they determined where he sat on the CML. An ultra-conservative investor would just buy the riskless bond and nothing else: that would put him on the horizontal axis (where risk is zero) but only a short distance out along the horizontal axis – which means only a very low return. Someone who was happy with the market return – the return on an investment in shares alone – would buy only shares.

.; emphasis added) Though Sharpe doesn’t explicitly say this, he also assumes that investor expectations are accurate: that the returns investors expect firms to achieve will actually happen. With these handy assumptions under his belt, the problem was greatly simplified. The riskless asset was the same for all investors. The IOC was the same for all investors. Therefore all investors would want to invest in some combination of the riskless asset and the same share portfolio. All that differed were investor risk–return preferences. Some would borrow money to move farther ‘northeast’ (towards a higher return with higher risk) than the point at which their indifference map was tangential to the IOC. Others would lend money to move ‘southwest’ from the point of tangency between their indifference map and the IOC, thus getting a lower return and a lower risk. Since all investors will attempt to buy the same portfolio, and no investors will attempt to buy any other investment, the market mechanism kicks in.

All About Asset Allocation, Second Edition by Richard Ferri

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activist fund / activist shareholder / activist investor, asset allocation, asset-backed security, barriers to entry, Bernie Madoff, capital controls, commoditize, commodity trading advisor, correlation coefficient, Daniel Kahneman / Amos Tversky, diversification, diversified portfolio, equity premium, estate planning, financial independence, fixed income, full employment, high net worth, Home mortgage interest deduction, implied volatility, index fund, intangible asset, Long Term Capital Management, Mason jar, money market fund, mortgage tax deduction, passive income, pattern recognition, random walk, Richard Thaler, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, selection bias, Sharpe ratio, survivorship bias, too big to fail, transaction costs, Vanguard fund, yield curve

The correlation between asset classes can and does change often. Investments that were once noncorrelated may become correlated in the future, and vice versa. Past correlations are a hint to future correlations, but not a reliable hint. Don’t trust any research report or book that says, “The correlation between asset class 1 and asset class 2 is X,” because by the time those words are printed, the correlation may have changed. The future risks, returns, and asset-class correlations cannot be known with any degree of certainty. Consequently, a perfect blend can never be known in advance. 3. During a time of extreme volatility when you want low correlation among asset classes, positive correlation can increase dramatically across all asset classes. Almost every asset class with any meaningful risk went down during the 2007–2009 credit crises.

If you are comfortable with the allocation, you will maintain it over a long period of time and during all market conditions. That is what really counts. A FINAL WORD ABOUT MULTI-ASSETCLASS INVESTING There are several ways to select a multi-asset-class portfolio. One way is to answer a few questions on a questionnaire and feed those answers into a computer. The problem with this approach is that the computer is purely mathematical and relies too much on past risks, returns, and correlations. Basically, the computer simulation assumes that whatever happened in past is the most probable scenario for the future. This is an extremely unreliable way to make investment decisions. The world is constantly changing, and no computer simulation can accurately predict the changes that will occur or how these changes will affect a portfolio. 82 CHAPTER 4 In addition, a computer does not know who you are and cannot assess your personality profile so that the allocation it recommends truly fits your needs.


pages: 297 words: 91,141

Market Sense and Nonsense by Jack D. Schwager

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3Com Palm IPO, asset allocation, Bernie Madoff, Brownian motion, collateralized debt obligation, commodity trading advisor, computerized trading, conceptual framework, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, Daniel Kahneman / Amos Tversky, diversification, diversified portfolio, fixed income, high net worth, implied volatility, index arbitrage, index fund, London Interbank Offered Rate, Long Term Capital Management, margin call, market bubble, market fundamentalism, merger arbitrage, negative equity, pattern recognition, performance metric, pets.com, Ponzi scheme, quantitative trading / quantitative finance, random walk, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, selection bias, Sharpe ratio, short selling, statistical arbitrage, statistical model, survivorship bias, transaction costs, two-sided market, value at risk, yield curve

See Minimum acceptable return (MAR) ratio Marcus, Michael Margin Margin calls Marginal production loss Market bubbles Market direction Market neutral fund Market overvaluation Market panics Market price delays and inventory model of Market price response Market pricing theory Market psychology Market risk Market sector convertible arbitrage hedge funds and CTA funds hidden risk long-only funds market dependency past and future correlation performance impact by strategy Market timing skill Market-based risk Maximum drawdown (MDD) Mean reversion Mean-reversion strategy Merger arbitrage funds Mergers, cyclical tendency Metrics Minimum acceptable return (MAR) ratio and Calmar ratio Mispricing Mocking Monetary policy Mortgage standards Mortgage-backed securities (MBSs) Mortgages Multifund portfolio, diversified Mutual fund managers, vs. hedge fund managers Mutual funds National Futures Association (NFA) Negative returns Negative Sharpe ratio, and volatility Net asset valuation (NAV) Net exposure New York Stock Exchange (NYSE) Newsletter recommendation NINJA loans Normal distribution Normally distributed returns Notional funding October 1987 market crash Offsetting positions Option ARM Option delta Option premium Option price, underlying market price Option timing Optionality Out-of-the-money options Outperformance Pairs trading Palm Palm IPO Palm/3 Com Past high-return strategies Past performance back-adjusted return measures evaluation of going forward with incomplete information visual performance evaluation Past returns about and causes of future performance hedge funds high and low return periods implications of investment insights market sector past highest return strategy relevance of sector selection select funds and sources of Past track records Performance-based fees Portfolio construction principles Portfolio fund risk Portfolio insurance Portfolio optimization past returns volatility as risk measure Portfolio optimization software Portfolio rebalancing about clarification effect of reason for test for Portfolio risks Portfolio volatility Price aberrations Price adjustment timing Price bubble Price change distribution The price in not always right dot-com mania Pets.com subprime investment Pricing models Prime broker Producer short covering Professional management Profit incentives Pro-forma statistics Pro-forma vs. actual results Program sales Prospect theory Puts Quantitative measures beta correlation monthly average return Ramp-up period underperformance Random selection Random trading Random walk process Randomness risk Rare events Rating agencies Rational behavior Redemption frequency notice penalties Redemption liquidity Relative velocity Renaissance Medallion fund Return periods, high and low long term investment S&P performance Return retracement ratio (RRR) Return/risk performance Return/risk ratios vs. return Returns comparison measures relative vs. absolute objective Reverse merger arbitrage Risk assessment of for best strategy and leverage measurement vs. failure to measure measures of perception of vs. volatility Risk assessment Risk aversion Risk evaluation Risk management Risk management discipline Risk measurement vs. no risk measurement Risk mismeasurement asset risk vs. failure to measure hidden risk hidden risk evaluation investment insights problem source value at risk (VaR) volatility as risk measure volatility vs. risk Risk reduction Risk types Risk-adjusted allocation Risk-adjusted return Risk/return metrics Risk/return ratios Rolling window return charts Rubin, Paul Rubinstein, Mark Rukeyser, Louis S&P 500, vs. financial newsletters S&P 500 index S&P returns study of Sasseville, Caroline Schwager Analytics Module SDR Sharpe ratio Sector approach Sector funds Sector past performance Securities and Exchange Commission (SEC) Select funds, past returns and Selection bias Semistrong efficiency Shakespearian monkey argument Sharpe ratio back-adjusted return measures vs.


pages: 447 words: 104,258

Mathematics of the Financial Markets: Financial Instruments and Derivatives Modelling, Valuation and Risk Issues by Alain Ruttiens

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algorithmic trading, asset allocation, asset-backed security, backtesting, banking crisis, Black Swan, Black-Scholes formula, Brownian motion, capital asset pricing model, collateralized debt obligation, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, delta neutral, discounted cash flows, discrete time, diversification, fixed income, implied volatility, interest rate derivative, interest rate swap, margin call, market microstructure, martingale, p-value, passive investing, quantitative trading / quantitative finance, random walk, risk/return, Satyajit Das, Sharpe ratio, short selling, statistical model, stochastic process, stochastic volatility, time value of money, transaction costs, value at risk, volatility smile, Wiener process, yield curve, zero-coupon bond

By contrast, in the AR and MA models, having no requirement about the variance of the error term, the series of returns is supposed to be homoskedastic. 8. Tim BOLLERSLEV, “Generalized autoregressive conditional heteroskedasticity”, Journal of Econometrics, 31(3), (1986), pp. 307–327. 9. Tim BOLLERSLEV, Glossary to ARCH (GARCH), CREATES, School of Economics and Management, University of Aarhus, Denmark, 2008, working paper. 10. E. GHYSELS, P. SANTA-CLARA, R. VALKANOV, “There is a risk-return trade-off after all”, Journal of Financial Economics, vol. 76, 2005, pp. 509–548. 10 Option pricing in general 10.1 INTRODUCTION TO OPTION PRICING An option is a contract granting: the right to its holder, the option buyer – but the obligation to its issuer, the seller, to negotiate, that is, either to buy (call option) or to sell (put option), if the option buyer exercises its right, at a price, fixed in advance and called the exercise price or strike price some quantity of underlying instrument (stock, currency, bond, etc.), at a given maturity date or until a given maturity date: in the first case, one refers to a European option, in the second, to an American option.

But more and more market participants, like hedge funds, traded these securities in a pseudo-arbitrage way, by combining for example a long position in CB with a short position in equivalent regular bond and call option, so that the market liquidity increased significantly, contributing to make disappear the price anomalies and related pseudo-arbitrage operations. So that, today, funds active on the CB market are more traditionally playing with the traditional advantages of the product, namely offering an intermediate risk/return profile between bonds and stocks, with some opportunities to play the volatility. Before looking after CB pricing, we need to specify some typical parameters of CBs. These will be illustrated with the following CB issue, in EUR: CB issue: DELHAIZE 2.75% 2009 (5 years) coupon: 2.75% (annual) issued amount: EUR 300 M denomination: EUR 250 000 issuing date: 30 April 2004 maturity date: 30 April 2009 conversion date: 24 April 2009 issuing price: 100% redemption amount: 100% conversion price: EUR 57.00 conversion ratio: 4385.9649 per EUR 250 000 call protection: Hard Call 3 years (until 15 May 2007) stock price at issuance date: EUR 40.50 Conversion Ratio For a given nominal value (i.e., a portion of the issued nominal amount), conversion ratio = number of ordinary shares offered in case of conversion “Hard” Call Protection CBs are generally issued with a period during which the issuer cannot early redeem his bond.


pages: 345 words: 86,394

Frequently Asked Questions in Quantitative Finance by Paul Wilmott

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Albert Einstein, asset allocation, beat the dealer, Black-Scholes formula, Brownian motion, butterfly effect, capital asset pricing model, collateralized debt obligation, Credit Default Swap, credit default swaps / collateralized debt obligations, delta neutral, discrete time, diversified portfolio, Edward Thorp, Emanuel Derman, Eugene Fama: efficient market hypothesis, fixed income, fudge factor, implied volatility, incomplete markets, interest rate derivative, interest rate swap, iterative process, London Interbank Offered Rate, Long Term Capital Management, Louis Bachelier, mandelbrot fractal, margin call, market bubble, martingale, Myron Scholes, Norbert Wiener, Paul Samuelson, quantitative trading / quantitative finance, random walk, regulatory arbitrage, risk/return, Sharpe ratio, statistical arbitrage, statistical model, stochastic process, stochastic volatility, transaction costs, urban planning, value at risk, volatility arbitrage, volatility smile, Wiener process, yield curve, zero-coupon bond

Consider a portfolio, Π, of N assets, with Wi being the fraction of wealth invested in the ith asset. The expected return is then and the standard deviation of the return, the risk, is where ρij is the correlation between the ith and jth investments, with ρii = 1. Markowitz showed how to optimize a portfolio by finding the Ws giving the portfolio the greatest expected return for a prescribed level of risk. The curve in the risk-return space with the largest expected return for each level of risk is called the efficient frontier. According to the theory, no one should hold portfolios that are not on the efficient frontier. Furthermore, if you introduce a risk-free investment into the universe of assets, the efficient frontier becomes the tangential line shown below. This line is called the Capital Market Line and the portfolio at the point at which it is tangential is called the Market Portfolio.

References and Further Reading Kelly, JL 1956 A new interpretation of information rate. Bell Systems Tech. J. 35 917-926 Poundstone, W 2005 Fortune’s Formula. Hill & Wang Why Hedge? Short Answer ‘Hedging’ in its broadest sense means the reduction of risk by exploiting relationships or correlation (or lack of correlation) between various risky investments. The purpose behind hedging is that it can lead to an improved risk/return. In the classical Modern Portfolio Theory framework, for example, it is usually possible to construct many portfolios having the same expected return but with different variance of returns (‘risk’). Clearly, if you have two portfolios with the same expected return the one with the lower risk is the better investment. Example You buy a call option, it could go up or down in value depending on whether the underlying go up or down.


pages: 1,088 words: 228,743

Expected Returns: An Investor's Guide to Harvesting Market Rewards by Antti Ilmanen

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Andrei Shleifer, asset allocation, asset-backed security, availability heuristic, backtesting, balance sheet recession, bank run, banking crisis, barriers to entry, Bernie Madoff, Black Swan, Bretton Woods, buy low sell high, capital asset pricing model, capital controls, Carmen Reinhart, central bank independence, collateralized debt obligation, commoditize, commodity trading advisor, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, debt deflation, deglobalization, delta neutral, demand response, discounted cash flows, disintermediation, diversification, diversified portfolio, dividend-yielding stocks, equity premium, Eugene Fama: efficient market hypothesis, fiat currency, financial deregulation, financial innovation, financial intermediation, fixed income, Flash crash, framing effect, frictionless, frictionless market, George Akerlof, global reserve currency, Google Earth, high net worth, hindsight bias, Hyman Minsky, implied volatility, income inequality, incomplete markets, index fund, inflation targeting, information asymmetry, interest rate swap, invisible hand, Kenneth Rogoff, laissez-faire capitalism, law of one price, Long Term Capital Management, loss aversion, margin call, market bubble, market clearing, market friction, market fundamentalism, market microstructure, mental accounting, merger arbitrage, mittelstand, moral hazard, Myron Scholes, negative equity, New Journalism, oil shock, p-value, passive investing, Paul Samuelson, performance metric, Ponzi scheme, prediction markets, price anchoring, price stability, principal–agent problem, private sector deleveraging, purchasing power parity, quantitative easing, quantitative trading / quantitative finance, random walk, reserve currency, Richard Thaler, risk tolerance, risk-adjusted returns, risk/return, riskless arbitrage, Robert Shiller, Robert Shiller, savings glut, selection bias, Sharpe ratio, short selling, sovereign wealth fund, statistical arbitrage, statistical model, stochastic volatility, survivorship bias, systematic trading, The Great Moderation, The Myth of the Rational Market, too big to fail, transaction costs, tulip mania, value at risk, volatility arbitrage, volatility smile, working-age population, Y2K, yield curve, zero-coupon bond, zero-sum game

Chapter 15 concluded that pure volatility risk may not be well rewarded because, while index option selling has been profitable, single-stock option selling has not. A correlation risk premium seems better than a volatility risk premium at explaining index option richness. Given the tradeoff between reward and risk, what would be more natural than to find a positive relation between expected volatility and expected returns? • While a positive risk–return relation tends to work in long-run average returns across asset classes (recall Figure 2.1), cross-sectional relations within asset classes, surprisingly, have the opposite pattern. High-volatility stocks underperform low-volatility stocks, long-duration bonds underperform shorter ones, and credit risk taking at long maturities likewise may earn a negative reward. There are several possible explanations.

Lo; and Igor Makarov (2004), “An econometric model of serial correlation and illiquidity in hedge-fund returns,” Journal of Financial Economics 74, 529–609. Ghayur, Khalid; Ronan G. Heaney; Stephen A. Komon; and Stephen C. Platt (2010), Active Beta Indexes: Capturing Systematic Sources of Active Equity Returns, Hoboken, NJ: John Wiley & Sons, Inc. Ghysels, Eric; Pedro Santa-Clara; and Rossen Valkanov (2005), “There is a risk–return tradeoff after all,” Journal of Financial Economics 76, 509–548. Gibson, Rajna; and Songtao Wang (2010), “Hedge fund alphas: Do they reflect managerial skills or mere compensation for liquidity risk bearing?” Swiss Finance Institute research paper 08-37. Giesecke, Kay; Francis A. Longstaff; Stephen Schaefer; and Ilya Strebulaev (2010), “Corporate bond default risk: A 150-year perspective,” UCLA working paper.

Lopez de Silanes, Florencio; Ludovic Phalippou; and Oliver Gottschalg (2009), “Giants at the gate: Diseconomies of scale in private equity,” working paper, available at SSRN: http://ssrn.com/abstract=1363883 Lustig, Hanno; and Adrien Verdelhan (2007), “The cross-section of foreign currency risk premia and US consumption growth risk,” American Economic Review 97(1), 89–117. Lustig, Hanno; and Adrien Verdelhan (2010), “Business cycle variation in the risk–return tradeoff,” UCLA working paper. Ma, Cindy; and Andrew MacNamara, (2009), “The price of illiquidity: Valuation approaches across asset classes,” Houlihan Lokey research report. Macaulay, Frederick (1938), The Movements of Interest Rates, Bond Yields and Stock Prices in the United States since 1856, New York: National Bureau of Economic Research. Maddison, Angus (2007), The World Economy: A Millennial Perspective/Historical Statistics, OECD.


pages: 483 words: 141,836

Red-Blooded Risk: The Secret History of Wall Street by Aaron Brown, Eric Kim

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activist fund / activist shareholder / activist investor, Albert Einstein, algorithmic trading, Asian financial crisis, Atul Gawande, backtesting, Basel III, Bayesian statistics, beat the dealer, Benoit Mandelbrot, Bernie Madoff, Black Swan, capital asset pricing model, central bank independence, Checklist Manifesto, corporate governance, creative destruction, credit crunch, Credit Default Swap, disintermediation, distributed generation, diversification, diversified portfolio, Edward Thorp, Emanuel Derman, Eugene Fama: efficient market hypothesis, experimental subject, financial innovation, illegal immigration, implied volatility, index fund, Long Term Capital Management, loss aversion, margin call, market clearing, market fundamentalism, market microstructure, money market fund, money: store of value / unit of account / medium of exchange, moral hazard, Myron Scholes, natural language processing, open economy, Pierre-Simon Laplace, pre–internet, quantitative trading / quantitative finance, random walk, Richard Thaler, risk tolerance, risk-adjusted returns, risk/return, road to serfdom, Robert Shiller, Robert Shiller, shareholder value, Sharpe ratio, special drawing rights, statistical arbitrage, stochastic volatility, The Myth of the Rational Market, Thomas Bayes, too big to fail, transaction costs, value at risk, yield curve

As the field was beginning to emerge from traditional nonquantitative practice, the poker player types like me were the best at it. The sports bettor types were the best at analyzing the data to determine what should happen, but they were often lousy at communicating it in a way traders could use. You can’t explain to a trader that, say, he should be willing to leave bigger positions open over a weekend because he had a greater risk-return ratio on those trades than on intraday or intraweek trades. That’s like telling a basketball player he missed more free throws long than short, so in future he should aim a foot in front of the basket instead of at the basket. Your observation might be true statistically, but your advice will just mess up his whole shot. If he doesn’t ignore you, he’ll start by aiming where you tell him, but he’ll know that he really wants it longer, and will probably end up shooting the ball over the backboard.

That superposition creates trans-VaR opportunities is less well known. It’s something the risk manager usually exploits privately, by giving the green light to projects that take advantage of it. People know the risk manager approves some projects and vetoes others, but they seldom ask why. If someone does ask, she is usually satisfied with “It was too risky” if the answer was no, and “It had a risk-return trade-off within our appetite” if the answer was yes. People don’t like long discussions about risk. Adding pure artificial risk to things is the hardest of the three unspeakable truths to explain, and in my experience it is the least known outside the profession. There is a tendency in large organizations to standardize everything. Standardization increases correlation, which creates dangers.


pages: 289 words: 113,211

A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation by Richard Bookstaber

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affirmative action, Albert Einstein, asset allocation, backtesting, beat the dealer, Black Swan, Black-Scholes formula, Bonfire of the Vanities, butterfly effect, commoditize, commodity trading advisor, computer age, computerized trading, disintermediation, diversification, double entry bookkeeping, Edward Lorenz: Chaos theory, Edward Thorp, family office, financial innovation, fixed income, frictionless, frictionless market, George Akerlof, implied volatility, index arbitrage, intangible asset, Jeff Bezos, John Meriwether, London Interbank Offered Rate, Long Term Capital Management, loose coupling, margin call, market bubble, market design, merger arbitrage, Mexican peso crisis / tequila crisis, moral hazard, Myron Scholes, new economy, Nick Leeson, oil shock, Paul Samuelson, Pierre-Simon Laplace, quantitative trading / quantitative finance, random walk, Renaissance Technologies, risk tolerance, risk/return, Robert Shiller, Robert Shiller, rolodex, Saturday Night Live, selection bias, shareholder value, short selling, Silicon Valley, statistical arbitrage, The Market for Lemons, time value of money, too big to fail, transaction costs, tulip mania, uranium enrichment, William Langewiesche, yield curve, zero-coupon bond, zero-sum game

Even with Hilibrand’s efforts, over time it became increasingly difficult to execute a trade without that trade revealing the new opportunity, and then before long the opportunity would vanish. 112 ccc_demon_097-124_ch06.qxd 7/13/07 2:43 PM Page 113 LT C M R I D E S THE LEVERAGE CYCLE TO HELL While opaqueness may have actually been beneficial in normal times, it was a different story when the firm was on the ropes. Short-term lenders have a stunted sense of risk-return trade-offs. Unlike commercial banks, whose creditors can look to the Federal Deposit Insurance Corporation (FDIC) or to the “too big to fail” doctrine, securities firms have no declared sugar daddy to deter runs. It is not a matter of simply paying a higher price if lenders perceive that their capital is at risk. In fact, waving a premium rate in front of them can be counterproductive; it makes them suspicious.

It would be like opening up a program to study all objects made of materials other than wood, or initiating research on contemporary history for every country but France. You could do so, but I don’t know how that study would be much different from simply having a study of all materials or of all modern history. In fact, the proper study of hedge funds cannot be differentiated from a general study of investments. Issues of risk, return, and liquidity apply to all hedge fund strategies, and indeed to the whole range of possible investments. Consider the following scan of articles from various issues of the Journal of Alternative Investments, just one of a number of journals on hedge funds: “Currency Market Trading Performance”; “Timber Investment”; “Current Attitudes to Private Equity”; “Convertible Arbitrage: A Manager’s Perspective”; “Macro Trading and Investment Strategies”; “Commodity Trading Advisor Survey”; “Stock Selection in Eastern European Markets”; “Market Neutral versus Long/Short Equity”; “Merger Arbitrage: Evidence of Profitability”; “Analysis of Real Estate Investments in the U.S.”; “Benefits of International Small Cap Stocks.”


pages: 442 words: 39,064

Why Stock Markets Crash: Critical Events in Complex Financial Systems by Didier Sornette

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Asian financial crisis, asset allocation, Berlin Wall, Bretton Woods, Brownian motion, capital asset pricing model, capital controls, continuous double auction, currency peg, Deng Xiaoping, discrete time, diversified portfolio, Elliott wave, Erdős number, experimental economics, financial innovation, floating exchange rates, frictionless, frictionless market, full employment, global village, implied volatility, index fund, information asymmetry, intangible asset, invisible hand, John von Neumann, joint-stock company, law of one price, Louis Bachelier, mandelbrot fractal, margin call, market bubble, market clearing, market design, market fundamentalism, mental accounting, moral hazard, Network effects, new economy, oil shock, open economy, pattern recognition, Paul Erdős, Paul Samuelson, quantitative trading / quantitative finance, random walk, risk/return, Ronald Reagan, Schrödinger's Cat, selection bias, short selling, Silicon Valley, South Sea Bubble, statistical model, stochastic process, Tacoma Narrows Bridge, technological singularity, The Coming Technological Singularity, The Wealth of Nations by Adam Smith, Tobin tax, total factor productivity, transaction costs, tulip mania, VA Linux, Y2K, yield curve

5 The Crash of October 1987 Chapter 2 fundamentals of financial markets 26 7 7 9 12 Historical Crashes The Tulip Mania The South Sea Bubble The Great Crash of October 1929 15 Extreme Events in Complex Systems 20 Is Prediction Possible? A Working Hypothesis 27 27 30 33 The Basics Price Trajectories Return Trajectories Return Distributions and Return Correlation 38 The Efficient Market Hypothesis and the Random Walk The Random Walk 38 vi contents 42 45 A Parable: How Information Is Incorporated in Prices, Thus Destroying Potential “Free Lunches” Prices Are Unpredictable, or Are They? 47 Risk–Return Trade-Off Chapter 3 49 What Are “Abnormal” Returns? financial crashes are “outliers” 49 51 51 54 Drawdowns (Runs) Definition of Drawdowns Drawdowns and the Detection of “Outliers” Expected Distribution of “Normal” Drawdowns 56 60 60 62 65 69 70 73 75 Chapter 4 positive feedbacks 81 Drawdown Distributions of Stock Market Indices The Dow Jones Industrial Average The Nasdaq Composite Index Further Tests The Presence of Outliers Is a General Phenomenon Main Stock Market Indices, Currencies, and Gold Largest U.S.

In a similar fashion, the decline probability is 47.27% during the 1946–1997 DJIA period and 46.86% during 1897–1945 (about 0.5% lower). Preserving the same qualitative pattern, during the 1897–1997 DJIA period, the weekly decline (rise) probability is 43.98% (55.87%). For the Nasdaq from 1962 to 1995, the daily decline (rise) probability is 46.92% (52.52%). For the IBM stock from 1962–1996, the daily decline (rise) probability is 47.96% (48.25%). RISK–RETURN TRADE-OFF One of the central insights of modern financial economics is the necessity of some trade-off between risk and expected return, and although Samuelson’s version of the efficient markets hypothesis places a restriction on expected returns, it does not account for risk in any way. In particular, if a security’s expected price change is positive, it may be just the reward needed to attract investors to hold the asset and bear the associated risks.


pages: 461 words: 128,421

The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street by Justin Fox

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activist fund / activist shareholder / activist investor, Albert Einstein, Andrei Shleifer, asset allocation, asset-backed security, bank run, beat the dealer, Benoit Mandelbrot, Black-Scholes formula, Bretton Woods, Brownian motion, capital asset pricing model, card file, Cass Sunstein, collateralized debt obligation, complexity theory, corporate governance, corporate raider, Credit Default Swap, credit default swaps / collateralized debt obligations, Daniel Kahneman / Amos Tversky, David Ricardo: comparative advantage, discovery of the americas, diversification, diversified portfolio, Edward Glaeser, Edward Thorp, endowment effect, Eugene Fama: efficient market hypothesis, experimental economics, financial innovation, Financial Instability Hypothesis, fixed income, floating exchange rates, George Akerlof, Henri Poincaré, Hyman Minsky, implied volatility, impulse control, index arbitrage, index card, index fund, information asymmetry, invisible hand, Isaac Newton, John Meriwether, John Nash: game theory, John von Neumann, joint-stock company, Joseph Schumpeter, Kenneth Arrow, libertarian paternalism, linear programming, Long Term Capital Management, Louis Bachelier, mandelbrot fractal, market bubble, market design, Myron Scholes, New Journalism, Nikolai Kondratiev, Paul Lévy, Paul Samuelson, pension reform, performance metric, Ponzi scheme, prediction markets, pushing on a string, quantitative trading / quantitative finance, Ralph Nader, RAND corporation, random walk, Richard Thaler, risk/return, road to serfdom, Robert Bork, Robert Shiller, Robert Shiller, rolodex, Ronald Reagan, shareholder value, Sharpe ratio, short selling, side project, Silicon Valley, South Sea Bubble, statistical model, The Chicago School, The Myth of the Rational Market, The Predators' Ball, the scientific method, The Wealth of Nations by Adam Smith, The Wisdom of Crowds, Thomas Kuhn: the structure of scientific revolutions, Thomas L Friedman, Thorstein Veblen, Tobin tax, transaction costs, tulip mania, value at risk, Vanguard fund, Vilfredo Pareto, volatility smile, Yogi Berra

They followed the 150-year-old “Prudent Man” rule, a legal doctrine that instructed trustees of others’ money to “observe how men of prudence, discretion, and intelligence manage their own affairs” and conduct themselves accordingly.7 This had long been long interpreted to mean that trustees should stick the money in their charge in high-grade bonds and maybe a few blue-chip stocks. That approach was sorely tested in the 1960s, when imprudent investors seemed to be having all the fun and making all the money. It was tested even more in the 1970s, when neither bonds nor blue chips proved safe, leaving a big opening for the new approach to risk, return, and diversification that was introduced two decades before by Harry Markowitz. In this view it wasn’t the riskiness of an individual stock or bond that mattered, but the way it fit in to a portfolio. By the mid-1970s, this approach had a name—modern portfolio theory—and was beginning to make slight inroads in the institutional investing world. Then Washington gave it a huge boost. In the wake of several corporate bankruptcies that left pensions unpaid, Congress passed pension-reform legislation in 1974.

To be more specific, in “The Capital Asset Pricing Model: Some Empirical Tests,” published in Michael C. Jensen, ed., Studies in the Theory of Capital Markets (New York: Praeger, 1972), Black, Jensen, and Scholes found that low-beta stocks had higher returns than predicted by the original CAPM, but that the relationship between beta and returns seemed to fit an asset-pricing model in which borrowing limits and costs were taken into account. Meanwhile, Fama and James D. MacBeth, in “Risk, Return, and Equilibrium: Empirical Tests,” Journal of Political Economy (May–June 1973), concluded that “although there are ‘stochastic nonlinearities’ from period to period,” they could “not reject the hypothesis that in making a portfolio decision, an investor should assume that the relationship between a security’s portfolio risk and its expected return is linear” as CAPM implied. 31. J. Fred Weston, “The State of the Finance Field,” Journal of Finance (Dec. 1967): 539–40. 32.


pages: 226 words: 59,080

Economics Rules: The Rights and Wrongs of the Dismal Science by Dani Rodrik

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airline deregulation, Albert Einstein, bank run, barriers to entry, Bretton Woods, butterfly effect, capital controls, Carmen Reinhart, central bank independence, collective bargaining, Daniel Kahneman / Amos Tversky, David Ricardo: comparative advantage, distributed generation, Donald Davies, Edward Glaeser, endogenous growth, Eugene Fama: efficient market hypothesis, Everything should be made as simple as possible, Fellow of the Royal Society, financial deregulation, financial innovation, floating exchange rates, fudge factor, full employment, George Akerlof, Gini coefficient, Growth in a Time of Debt, income inequality, inflation targeting, informal economy, information asymmetry, invisible hand, Jean Tirole, Joseph Schumpeter, Kenneth Arrow, Kenneth Rogoff, labor-force participation, liquidity trap, loss aversion, low skilled workers, market design, market fundamentalism, minimum wage unemployment, oil shock, open economy, Pareto efficiency, Paul Samuelson, price stability, prisoner's dilemma, profit maximization, quantitative easing, randomized controlled trial, rent control, rent-seeking, Richard Thaler, risk/return, Robert Shiller, Robert Shiller, school vouchers, South Sea Bubble, spectrum auction, The Market for Lemons, the scientific method, The Wealth of Nations by Adam Smith, Thomas Kuhn: the structure of scientific revolutions, Thomas Malthus, trade liberalization, trade route, ultimatum game, University of East Anglia, unorthodox policies, Vilfredo Pareto, Washington Consensus, white flight

Such thinking by economists had legitimized and enabled a great wave of financial deregulation that set the stage for the crisis. And it didn’t hurt that these views were shared by some of the top economists in government, such as Larry Summers and Alan Greenspan. In sum, economists (and those who listened to them) became overconfident in their preferred models of the moment: markets are efficient, financial innovation improves the risk-return trade-off, self-regulation works best, and government intervention is ineffective and harmful. They forgot about the other models. There was too much Fama, too little Shiller. The economics of the profession may have been fine, but evidently there was trouble with its psychology and sociology. Errors of Commission: The Washington Consensus In 1989, John Williamson convened a conference in Washington, DC, for major economic policy makers from Latin America.

Working the Street: What You Need to Know About Life on Wall Street by Erik Banks

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accounting loophole / creative accounting, borderless world, corporate governance, estate planning, fixed income, greed is good, old-boy network, risk/return, rolodex, telemarketer

Bad markets, lack of transaction flow, some bad trades, or a few lost deals can spell the end of a producer’s career. That’s not necessarily true of staffers, who are generally much more insulated, living a bit farther away from the edge of the precipice. Someone still has to keep the books, do the audits, and look after the technology, regardless of how business is faring. So it follows from the risk/return equation we talked about earlier that the relative lack of job security commands a higher risk premium—payable in the form of a larger bonus. Remember, there can be no “free lunch.” If you want more return, you have to take more risk. But there actually is a bit of a free lunch out there. Though it’s true that producers earn more than staffers, an excellent staffer can earn more than a mediocre producer, and sometimes almost as much as a good producer.


pages: 294 words: 82,438

Simple Rules: How to Thrive in a Complex World by Donald Sull, Kathleen M. Eisenhardt

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Affordable Care Act / Obamacare, Airbnb, asset allocation, Atul Gawande, barriers to entry, Basel III, Berlin Wall, carbon footprint, Checklist Manifesto, complexity theory, Craig Reynolds: boids flock, Credit Default Swap, Daniel Kahneman / Amos Tversky, diversification, drone strike, en.wikipedia.org, European colonialism, Exxon Valdez, facts on the ground, Fall of the Berlin Wall, haute cuisine, invention of the printing press, Isaac Newton, Kickstarter, late fees, Lean Startup, Louis Pasteur, Lyft, Moneyball by Michael Lewis explains big data, Nate Silver, Network effects, obamacare, Paul Graham, performance metric, price anchoring, RAND corporation, risk/return, Saturday Night Live, sharing economy, Silicon Valley, Startup school, statistical model, Steve Jobs, TaskRabbit, The Signal and the Noise by Nate Silver, transportation-network company, two-sided market, Wall-E, web application, Y Combinator, Zipcar

It is hard to imagine a simpler investment rule. And yet it works. One recent study of alternative investment approaches pitted the Markowitz model and three extensions of his approach against the 1/N rule, testing them on seven samples of data from the real world. This research ran a total of twenty-eight horseraces between the four state-of-the-art statistical models and the 1/N rule. With ten years of historical data to estimate risk, returns, and correlations, the 1/N rule outperformed the Markowitz equation and its extensions 79 percent of the time. The 1/N rule earned a positive return in every test, while the more complicated models lost money for investors more than half the time. Other studies have run similar tests and come to the same conclusions. The returns from the complicated models, unimpressive as they are, still overstate the returns investors could expect in the real world, because they exclude the fees that asset managers might charge for active management.


pages: 318 words: 77,223

The Only Game in Town: Central Banks, Instability, and Avoiding the Next Collapse by Mohamed A. El-Erian

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activist fund / activist shareholder / activist investor, Airbnb, balance sheet recession, bank run, barriers to entry, break the buck, Bretton Woods, British Empire, capital controls, Capital in the Twenty-First Century by Thomas Piketty, Carmen Reinhart, carried interest, collapse of Lehman Brothers, corporate governance, currency peg, Erik Brynjolfsson, eurozone crisis, financial innovation, Financial Instability Hypothesis, financial intermediation, financial repression, fixed income, Flash crash, forward guidance, friendly fire, full employment, future of work, Hyman Minsky, If something cannot go on forever, it will stop - Herbert Stein's Law, income inequality, inflation targeting, Jeff Bezos, Kenneth Rogoff, Khan Academy, liquidity trap, Martin Wolf, megacity, Mexican peso crisis / tequila crisis, moral hazard, mortgage debt, Norman Mailer, oil shale / tar sands, price stability, principal–agent problem, quantitative easing, risk tolerance, risk-adjusted returns, risk/return, Second Machine Age, secular stagnation, sharing economy, sovereign wealth fund, The Great Moderation, The Wisdom of Crowds, too big to fail, University of East Anglia, yield curve, zero-sum game

Yet these are the same underlying forces that enable machines such as IBM’s Watson to beat humans on game shows. They are also at the basis of work on driverless cars, remote health diagnoses, and a lot more. But this is, in fact, far from a simple dichotomy. Yes, the phenomenon of a “race against the machines” is being felt in the labor market, the value of education, employment remuneration, and the composition of jobs in a modern economy.4 It is also altering the risk/return configuration for new investments, amplifying “winner takes all” effects. The more innovative the economy, the higher the turnover, and the greater the importance of safety nets. Moreover, the dual transformative forces of these innovations—enabling and displacing—come with the potential for both good and bad. It is the reason why Ian Goldin, the director of the Martin School at Oxford University, sees them as constituting a “New Renaissance,” which, just like the old one, can combine great achievements with the possibility of horrible occurrences.


pages: 305 words: 69,216

A Failure of Capitalism: The Crisis of '08 and the Descent Into Depression by Richard A. Posner

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Andrei Shleifer, banking crisis, Bernie Madoff, collateralized debt obligation, collective bargaining, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, debt deflation, diversified portfolio, equity premium, financial deregulation, financial intermediation, Home mortgage interest deduction, illegal immigration, laissez-faire capitalism, Long Term Capital Management, market bubble, money market fund, moral hazard, mortgage debt, Myron Scholes, oil shock, Ponzi scheme, price stability, profit maximization, race to the bottom, reserve currency, risk tolerance, risk/return, Robert Shiller, Robert Shiller, savings glut, shareholder value, short selling, statistical model, too big to fail, transaction costs, very high income

Each security was priced at hundreds of millions of dollars and sometimes at more than a billion dollars and was backed by hundreds or even thousands of residential mortgages —"backed" in the sense that the security entitled its owners to the revenue from the mortgages; the value of the security thus depended on the mortgage revenue. The pooling of the mortgages that backed each security diversified the risk of default geographically and thus reduced it; a rise in defaults in Florida might be offset by a decline in defaults in New York. So far, so good, as far as management of risk was concerned. In addition, each security was sliced into different risk-return combinations and a purchaser could pick the one he wanted. (In other words, shares in each security were sold.) The top tier would have the first claim on the income generated by the pool of mortgages that backed the security, and so it had the highest credit rating and paid the lowest interest rate. The bottom tier would have the last claim on the income of the pool, and so it had the lowest credit rating and paid the highest interest rate.


pages: 239 words: 69,496

The Wisdom of Finance: Discovering Humanity in the World of Risk and Return by Mihir Desai

activist fund / activist shareholder / activist investor, Albert Einstein, Andrei Shleifer, assortative mating, Benoit Mandelbrot, Brownian motion, capital asset pricing model, carried interest, collective bargaining, corporate governance, corporate raider, discounted cash flows, diversified portfolio, Eugene Fama: efficient market hypothesis, financial innovation, follow your passion, George Akerlof, Gordon Gekko, greed is good, housing crisis, income inequality, information asymmetry, Isaac Newton, Jony Ive, Kenneth Rogoff, Louis Bachelier, moral hazard, Myron Scholes, new economy, out of africa, Paul Samuelson, Pierre-Simon Laplace, principal–agent problem, Ralph Waldo Emerson, random walk, risk/return, Robert Shiller, Robert Shiller, Ronald Coase, Silicon Valley, Steve Jobs, The Market for Lemons, The Nature of the Firm, The Wealth of Nations by Adam Smith, Tim Cook: Apple, transaction costs, zero-sum game

When we love our negative-beta assets unconditionally—we give and give and give and expect nothing in return—that’s negative expected returns. The reason that the logic of diversification, the capital asset pricing model, and the idea of betas matches the Aristotelian taxonomy of relationships is that the underlying portfolio problem is the same. In finance, we are trying to figure out how to invest our assets and manage toward the best risk-return tradeoff. In life, we are trying to figure out how to allocate our time and energies across many people. It also matches because the underlying logic of insurance is present in both settings. For me, this parallel prompted several questions: Am I providing insurance to my loved ones and friends? Am I there when they need me the most? Am I dedicating too much time to the high-beta assets in my portfolio rather than realizing that they are relatively low-value relationships?


pages: 397 words: 112,034

What's Next?: Unconventional Wisdom on the Future of the World Economy by David Hale, Lyric Hughes Hale

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affirmative action, Asian financial crisis, asset-backed security, bank run, banking crisis, Basel III, Berlin Wall, Black Swan, Bretton Woods, capital controls, Cass Sunstein, central bank independence, cognitive bias, collapse of Lehman Brothers, collateralized debt obligation, corporate governance, corporate social responsibility, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency manipulation / currency intervention, currency peg, Daniel Kahneman / Amos Tversky, debt deflation, declining real wages, deindustrialization, diversification, energy security, Erik Brynjolfsson, Fall of the Berlin Wall, financial innovation, floating exchange rates, full employment, Gini coefficient, global reserve currency, global village, high net worth, Home mortgage interest deduction, housing crisis, index fund, inflation targeting, information asymmetry, Intergovernmental Panel on Climate Change (IPCC), invisible hand, Just-in-time delivery, Kenneth Rogoff, labour market flexibility, labour mobility, Long Term Capital Management, Mahatma Gandhi, Martin Wolf, Mexican peso crisis / tequila crisis, Mikhail Gorbachev, money market fund, money: store of value / unit of account / medium of exchange, mortgage tax deduction, Network effects, new economy, Nicholas Carr, oil shale / tar sands, oil shock, open economy, passive investing, payday loans, peak oil, Ponzi scheme, post-oil, price stability, private sector deleveraging, purchasing power parity, quantitative easing, race to the bottom, regulatory arbitrage, rent-seeking, reserve currency, Richard Thaler, risk/return, Robert Shiller, Robert Shiller, Ronald Reagan, sovereign wealth fund, special drawing rights, technology bubble, The Great Moderation, Thomas Kuhn: the structure of scientific revolutions, Tobin tax, too big to fail, total factor productivity, trade liberalization, Washington Consensus, Westphalian system, women in the workforce, yield curve

FRAGILE STATES: States that fail to provide basic services to poor people because they are unwilling or unable to do so. FREE TRADE AREA: A group of countries within which tariffs and nontariff trade barriers between members are generally abolished. The group lacks a common trade policy toward nonmembers. FRONTIER MARKET: Emerging market countries with high volatility, low liquidity, and higher risk/return ratios that are not as prominent as major emerging market countries such as China and Brazil. GAAP (GENERALLY ACCEPTED ACCOUNTING PRINCIPLES): The common set of accounting principles, standards, and procedures that companies use to compile their financial statements. They are a combination of formal standards and traditional practices. GDP DEFLATOR: A price index that is used to adjust a country’s output for changes in prices of goods and services included in the GDP.


pages: 335 words: 94,657

The Bogleheads' Guide to Investing by Taylor Larimore, Michael Leboeuf, Mel Lindauer

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asset allocation, buy low sell high, corporate governance, correlation coefficient, Daniel Kahneman / Amos Tversky, diversification, diversified portfolio, Donald Trump, endowment effect, estate planning, financial independence, financial innovation, high net worth, index fund, late fees, Long Term Capital Management, loss aversion, Louis Bachelier, margin call, market bubble, mental accounting, money market fund, passive investing, Paul Samuelson, random walk, risk tolerance, risk/return, Sharpe ratio, statistical model, survivorship bias, the rule of 72, transaction costs, Vanguard fund, yield curve, zero-sum game

However, you can increase the odds of doing so by selecting a good low-cost actively managed fund, such as those offered by Vanguard and other low-cost providers. The mutual fund prospectus is the single best way to find out about the objectives, costs, past performance figures, and other important information about any mutual fund you're considering investing in. Although reading a prospectus may cause your eyes to glaze over, it's a very important step to help you determine if a particular fund satisfies your investment objectives (risk, return, etc.). Since you are planning on investing for the long-term (you are, aren't you?), reading a prospectus and understanding what you're investing in will be well worth the time and effort. We can't emphasize it enough: Read the fund's prospectus and understand what you re investing in! There are at least 10 advantages of investing in mutual funds: 1. Diversification. The costs involved in purchasing a diversified portfolio of individual stocks and bonds could be prohibitive for most investors.


pages: 350 words: 103,270

The Devil's Derivatives: The Untold Story of the Slick Traders and Hapless Regulators Who Almost Blew Up Wall Street . . . And Are Ready to Do It Again by Nicholas Dunbar

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asset-backed security, bank run, banking crisis, Basel III, Black Swan, Black-Scholes formula, bonus culture, break the buck, capital asset pricing model, Carmen Reinhart, Cass Sunstein, collateralized debt obligation, commoditize, Credit Default Swap, credit default swaps / collateralized debt obligations, delayed gratification, diversification, Edmond Halley, facts on the ground, financial innovation, fixed income, George Akerlof, implied volatility, index fund, interest rate derivative, interest rate swap, Isaac Newton, John Meriwether, Kenneth Rogoff, Long Term Capital Management, margin call, market bubble, money market fund, Myron Scholes, Nick Leeson, Northern Rock, offshore financial centre, Paul Samuelson, price mechanism, regulatory arbitrage, rent-seeking, Richard Thaler, risk tolerance, risk/return, Ronald Reagan, shareholder value, short selling, statistical model, The Chicago School, Thomas Bayes, time value of money, too big to fail, transaction costs, value at risk, Vanguard fund, yield curve, zero-sum game

Suppose that a way could be found to stop scrabbling around as a middleman and earn big money instead by making bets—but without the risk. And suppose that the VAR system—the policing mechanism keeping the firm safe—said that the bet had low VAR and didn’t require much capital. Think for a moment about the relationship between traders and those who provide them with capital. As in any business, different traders compete for this capital by trying to offer the best risk-return proposition. If the bottleneck is a mechanism that defines how questions of risk should be addressed, then the winner in the struggle for capital will be the one who best plays that mechanism to their advantage. Presented with this incentive, traders gave statistics and economic theory a much warmer welcome on the trading floor. The smarter traders figured out how to game the scientific governance mechanism.


pages: 389 words: 108,344

Kill Chain: The Rise of the High-Tech Assassins by Andrew Cockburn

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airport security, anti-communist, drone strike, Edward Snowden, friendly fire, Google Earth, license plate recognition, RAND corporation, risk/return, Ronald Reagan, Silicon Valley, South China Sea, too big to fail

In the drug business, pilots had been willing to fly cocaine base from Peru to Colombia for little reward because there was minimal risk. Once that risk went up, as it did when they started getting shot down, the reward for the pilots became insufficient, and they refused to fly. In the insurgency it was people who were working for the money, such as the men digging holes to bury the bombs, who were susceptible to increased risk. Returning to Washington, Rivolo briefed his superiors on his conclusions, bluntly suggesting that the “attack-the-leaders” strategy enjoying the highest priority was “completely unproductive.” Far better, he insisted, to concentrate on those lower down. Later, he would calculate the precise degree of risk involved in planting a bomb. When just fewer than 70,000 bombs had been placed in Iraq, four hundred Iraqis had been killed or wounded while planting those bombs.


pages: 273 words: 34,920

Free Market Missionaries: The Corporate Manipulation of Community Values by Sharon Beder

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anti-communist, battle of ideas, business climate, corporate governance, en.wikipedia.org, full employment, income inequality, invisible hand, liquidationism / Banker’s doctrine / the Treasury view, minimum wage unemployment, Mont Pelerin Society, new economy, old-boy network, popular capitalism, Powell Memorandum, price mechanism, profit motive, Ralph Nader, rent control, risk/return, road to serfdom, Ronald Reagan, school vouchers, shareholder value, spread of share-ownership, structural adjustment programs, The Chicago School, the market place, The Wealth of Nations by Adam Smith, Thomas L Friedman, Torches of Freedom, trade liberalization, traveling salesman, trickle-down economics, Upton Sinclair, Washington Consensus, wealth creators, young professional

They would be less bolshie and more understanding of what management and owners are trying to achieve, as they would all be rewarded along similar lines.52 In its submission, BHP told the same inquiry that employees owned shares or options worth 7.6 per cent of the company’s capital and that its motivation in providing this opportunity was to help wage earners to understand and experience private enterprise; to justify ‘the profit motive in terms of risk return for investors’; and to encourage ‘employees to take a more active interest as co-owners of the company and for them to look beyond their local domain’. 53 Rob Donkersley, Employee Relations Director for Coca-Cola Amatil, told the inquiry about his company’s employee share ownership plan: We feel we have captured the minds of our employees through this plan. We have provided a good vehicle for them to link themselves with the fortunes of the company and take a wider perspective than their individual role in their individual operation could allow . . .


pages: 391 words: 97,018

Better, Stronger, Faster: The Myth of American Decline . . . And the Rise of a New Economy by Daniel Gross

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2013 Report for America's Infrastructure - American Society of Civil Engineers - 19 March 2013, Affordable Care Act / Obamacare, Airbnb, American Society of Civil Engineers: Report Card, asset-backed security, Bakken shale, banking crisis, BRICs, British Empire, business process, business process outsourcing, call centre, Carmen Reinhart, clean water, collapse of Lehman Brothers, collateralized debt obligation, commoditize, creative destruction, credit crunch, currency manipulation / currency intervention, demand response, Donald Trump, Frederick Winslow Taylor, high net worth, housing crisis, hydraulic fracturing, If something cannot go on forever, it will stop - Herbert Stein's Law, illegal immigration, index fund, intangible asset, intermodal, inventory management, Kenneth Rogoff, labor-force participation, LNG terminal, low skilled workers, Mark Zuckerberg, Martin Wolf, Maui Hawaii, McMansion, money market fund, mortgage debt, Network effects, new economy, obamacare, oil shale / tar sands, oil shock, peak oil, Plutocrats, plutocrats, price stability, quantitative easing, race to the bottom, reserve currency, reshoring, Richard Florida, rising living standards, risk tolerance, risk/return, Silicon Valley, Silicon Valley startup, six sigma, Skype, sovereign wealth fund, Steve Jobs, superstar cities, the High Line, transit-oriented development, Wall-E, Yogi Berra, zero-sum game, Zipcar

And even with all the purchases, I still wasn’t getting access to the papers’ online content. So I bit the bullet and bought subscriptions. The result: a savings of $748 while I received the same product, plus the benefit of time-saving delivery and digital access. That’s like buying a stock that doubles in a year and then pays a 124 percent annual dividend. Investments in energy efficiency carry even better risk-return-reward profiles. Like many Americans whose homes are blessed (or cursed) with a swimming pool, I’ve come to look forward to the summers with a certain amount of dread. A wave of ecoguilt washes over me each time the hiss of the propane-fueled water heater pierces the air. It is then replaced by nausea when the propane bill arrives. Our ancient pool is a veritable Hummer; it’s shaded by pine trees and has a ten-foot deep end and creaky circulation.

The End of Accounting and the Path Forward for Investors and Managers (Wiley Finance) by Feng Gu

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active measures, Affordable Care Act / Obamacare, barriers to entry, business process, Claude Shannon: information theory, Clayton Christensen, commoditize, conceptual framework, corporate governance, creative destruction, Daniel Kahneman / Amos Tversky, discounted cash flows, diversified portfolio, double entry bookkeeping, Exxon Valdez, financial innovation, fixed income, hydraulic fracturing, index fund, information asymmetry, intangible asset, inventory management, Joseph Schumpeter, Kenneth Arrow, knowledge economy, moral hazard, new economy, obamacare, quantitative easing, quantitative trading / quantitative finance, QWERTY keyboard, race to the bottom, risk/return, Robert Shiller, Robert Shiller, shareholder value, Steve Jobs, The Great Moderation, value at risk

Record the progress over recent periods in the success of products under development in clinical tests, the number of products/devices in advanced state (Phase III clinical tests, FDA review), the extent of diversification of the development portfolio across therapeutic areas (an important risk measure), and the total size of the market for the main drugs under development (growth potential). These product-development dimensions provide a thorough risk–return profile of the major strategic asset of pharma companies. Regarding products already on the market: consider their therapeutic market share (e.g., HIV drugs) and the patent duration (time to expiration) of the leading drugs. These are the major indicators of the sustainability of the on-the-market drug portfolio. If the size of your investment justifies it, track the monthly prescription rate of the company’s leading drugs (available from vendors) to detect early signs of loss of competitive advantage.


pages: 327 words: 90,542

The Age of Stagnation by Satyajit Das

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9 dash line, accounting loophole / creative accounting, additive manufacturing, Airbnb, Albert Einstein, Alfred Russel Wallace, Anton Chekhov, Asian financial crisis, banking crisis, Berlin Wall, bitcoin, Bretton Woods, BRICs, British Empire, business process, business process outsourcing, call centre, capital controls, Capital in the Twenty-First Century by Thomas Piketty, Carmen Reinhart, Clayton Christensen, cloud computing, collaborative economy, colonial exploitation, computer age, creative destruction, cryptocurrency, currency manipulation / currency intervention, David Ricardo: comparative advantage, declining real wages, Deng Xiaoping, deskilling, disintermediation, Downton Abbey, Emanuel Derman, energy security, energy transition, eurozone crisis, financial innovation, financial repression, forward guidance, Francis Fukuyama: the end of history, full employment, gig economy, Gini coefficient, global reserve currency, global supply chain, Goldman Sachs: Vampire Squid, happiness index / gross national happiness, Honoré de Balzac, hydraulic fracturing, Hyman Minsky, illegal immigration, income inequality, income per capita, indoor plumbing, informal economy, Innovator's Dilemma, intangible asset, Intergovernmental Panel on Climate Change (IPCC), Jane Jacobs, John Maynard Keynes: technological unemployment, Kenneth Rogoff, knowledge economy, knowledge worker, labour market flexibility, labour mobility, light touch regulation, liquidity trap, Long Term Capital Management, low skilled workers, Lyft, Mahatma Gandhi, margin call, market design, Marshall McLuhan, Martin Wolf, Mikhail Gorbachev, mortgage debt, mortgage tax deduction, new economy, New Urbanism, offshore financial centre, oil shale / tar sands, oil shock, old age dependency ratio, open economy, passive income, peak oil, peer-to-peer lending, pension reform, Plutocrats, plutocrats, Ponzi scheme, Potemkin village, precariat, price stability, profit maximization, pushing on a string, quantitative easing, race to the bottom, Ralph Nader, Rana Plaza, rent control, rent-seeking, reserve currency, ride hailing / ride sharing, rising living standards, risk/return, Robert Gordon, Ronald Reagan, Satyajit Das, savings glut, secular stagnation, seigniorage, sharing economy, Silicon Valley, Simon Kuznets, Slavoj Žižek, South China Sea, sovereign wealth fund, TaskRabbit, The Chicago School, The Great Moderation, The inhabitant of London could order by telephone, sipping his morning tea in bed, the various products of the whole earth, the market place, the payments system, The Spirit Level, Thorstein Veblen, Tim Cook: Apple, too big to fail, total factor productivity, trade route, transaction costs, unpaid internship, Unsafe at Any Speed, Upton Sinclair, Washington Consensus, We are the 99%, WikiLeaks, Y2K, Yom Kippur War, zero-coupon bond, zero-sum game

Banks had become excessively reliant on funding from professional money markets rather than from depositors. The shadow banking system, a network of bank-like financing vehicles and investment funds created by banks to circumvent regulation, added to the problem. In a version of the financial shell game, banks shuffled assets to these vehicles so as to reduce capital and boost returns. In theory, banks were not exposed to potential losses from these transactions. In practice, the risk returned to the banks under certain conditions, especially if the ability of the vehicles to raise money was impaired, exposing banks to large losses. Further adding to the problem was the conflict of interest between: banks and rating agencies; investment managers and their institutional clients; and bonus-driven traders and the managers and shareholders of banks. The incestuous relationship between financial institutions and their regulators had led to inadequate and insufficient oversight.


pages: 293 words: 88,490

The End of Theory: Financial Crises, the Failure of Economics, and the Sweep of Human Interaction by Richard Bookstaber

asset allocation, bank run, bitcoin, butterfly effect, capital asset pricing model, cellular automata, collateralized debt obligation, conceptual framework, constrained optimization, Craig Reynolds: boids flock, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, dark matter, disintermediation, Edward Lorenz: Chaos theory, epigenetics, feminist movement, financial innovation, fixed income, Flash crash, Henri Poincaré, information asymmetry, invisible hand, Isaac Newton, John Conway, John Meriwether, John von Neumann, Joseph Schumpeter, Long Term Capital Management, margin call, market clearing, market microstructure, money market fund, Paul Samuelson, Pierre-Simon Laplace, Piper Alpha, Ponzi scheme, quantitative trading / quantitative finance, railway mania, Ralph Waldo Emerson, Richard Feynman, Richard Feynman, risk/return, Saturday Night Live, self-driving car, sovereign wealth fund, the map is not the territory, The Predators' Ball, the scientific method, Thomas Kuhn: the structure of scientific revolutions, too big to fail, transaction costs, tulip mania, Turing machine, Turing test, yield curve

Theoretical Economics 2, no. 4: 355–94. https://econtheory.org/ojs/index.php/te/article/viewFile/20070355/1486. Epstein, Larry G., and Tan Wang. 1994. “Intertemporal Asset Pricing under Knightian Uncertainty.” Econometrica 62, no. 2: 283–322. doi: 10.2307/2951614. Evans, George W., and Seppo Honkapohja. 2005. “An Interview with Thomas J. Sargent.” Macroeconomic Dynamics 9, no. 4: 561–83. doi: 10.1017/S1365100505050042. Fama, Eugene F., and James D. MacBeth. 1973. “Risk, Return, and Equilibrium: Empirical Tests.” Journal of Political Economy 81, no. 3: 607–36. http://www.jstor.org/stable/1831028. Farmer, J. Doyne. 2002. “Market Force, Ecology and Evolution.” Industrial and Corporate Change 11, no. 5: 895–953. doi: 10.1093/icc/11.5.895. Farmer, J. Doyne, and John Geanakoplos. 2009. “The Virtues and Vices of Equilibrium and the Future of Financial Economics.” Complexity 14, no. 3: 11–38. doi: 10.1002/cplx.20261.


pages: 416 words: 118,592

A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing by Burton G. Malkiel

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3Com Palm IPO, accounting loophole / creative accounting, Albert Einstein, asset allocation, asset-backed security, backtesting, beat the dealer, Bernie Madoff, BRICs, capital asset pricing model, compound rate of return, correlation coefficient, Credit Default Swap, Daniel Kahneman / Amos Tversky, diversification, diversified portfolio, Edward Thorp, Elliott wave, Eugene Fama: efficient market hypothesis, experimental subject, feminist movement, financial innovation, fixed income, framing effect, hindsight bias, Home mortgage interest deduction, index fund, invisible hand, Isaac Newton, Long Term Capital Management, loss aversion, margin call, market bubble, money market fund, mortgage tax deduction, new economy, Own Your Own Home, passive investing, Paul Samuelson, pets.com, Ponzi scheme, price stability, profit maximization, publish or perish, purchasing power parity, RAND corporation, random walk, Richard Thaler, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, short selling, Silicon Valley, South Sea Bubble, survivorship bias, The Myth of the Rational Market, the rule of 72, The Wisdom of Crowds, transaction costs, Vanguard fund, zero-coupon bond

Neither fundamental analysis of a stock’s firm foundation of value nor technical analysis of the market’s propensity for building castles in the air can produce reliably superior results. Even the pros must hide their heads in shame when they compare their results with those obtained by the dartboard method of picking stocks. Sensible investment policies for individuals must then be developed in two steps. First, it is crucially important to understand the risk-return trade-offs that are available and to tailor your choice of securities to your temperament and requirements. Part Four provided a careful guide for this part of the walk, including a number of warm-up exercises concerning everything from tax planning to the management of reserve funds and a life-cycle guide to portfolio allocations. This chapter has covered the major part of our walk down Wall Street—three important steps for buying common stocks.


pages: 467 words: 154,960

Trend Following: How Great Traders Make Millions in Up or Down Markets by Michael W. Covel

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Albert Einstein, asset allocation, Atul Gawande, backtesting, beat the dealer, Bernie Madoff, Black Swan, buy low sell high, capital asset pricing model, Clayton Christensen, commodity trading advisor, computerized trading, correlation coefficient, Daniel Kahneman / Amos Tversky, delayed gratification, deliberate practice, diversification, diversified portfolio, Edward Thorp, Elliott wave, Emanuel Derman, Eugene Fama: efficient market hypothesis, Everything should be made as simple as possible, fiat currency, fixed income, game design, hindsight bias, housing crisis, index fund, Isaac Newton, John Meriwether, John Nash: game theory, linear programming, Long Term Capital Management, mandelbrot fractal, margin call, market bubble, market fundamentalism, market microstructure, mental accounting, money market fund, Myron Scholes, Nash equilibrium, new economy, Nick Leeson, Ponzi scheme, prediction markets, random walk, Renaissance Technologies, Richard Feynman, Richard Feynman, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, shareholder value, Sharpe ratio, short selling, South Sea Bubble, Stephen Hawking, survivorship bias, systematic trading, the scientific method, Thomas L Friedman, too big to fail, transaction costs, upwardly mobile, value at risk, Vanguard fund, volatility arbitrage, William of Occam, zero-sum game

And there is no real indication that a quick end is in sight.”16 The story of Tiger resembles a Greek tragedy, where the protagonist is the victim of his own self-pride. Tiger’s spiral downward started in the fall of 1998 when a catastrophic trade on dollar-yen cost the fund billions. An ex-Tiger employee was quoted as saying: “There’s a certain amount of hubris when you take a position so big you have to be right and so big you can’t get out when you’re wrong. That was something Julian never would have done when he was younger. That isn’t good risk-return analysis.”17 The problem with Tiger was its philosophically shaky foundation. Robertson stated: “Our mandate is to find the 200 best companies in the world and invest in them, and find the 200 worst companies in the world and go short on them. If the 200 best don’t do better than the 200 worst, you probably should go into another business.” I am of the belief that the individual out there is actually not throwing money at things that they do not understand, and is actually using the news and using the information out there to make smart investment decisions.


pages: 402 words: 110,972

Nerds on Wall Street: Math, Machines and Wired Markets by David J. Leinweber

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AI winter, algorithmic trading, asset allocation, banking crisis, barriers to entry, Big bang: deregulation of the City of London, butterfly effect, buttonwood tree, buy low sell high, capital asset pricing model, citizen journalism, collateralized debt obligation, corporate governance, Craig Reynolds: boids flock, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Danny Hillis, demand response, disintermediation, distributed generation, diversification, diversified portfolio, Emanuel Derman, en.wikipedia.org, experimental economics, financial innovation, fixed income, Gordon Gekko, implied volatility, index arbitrage, index fund, information retrieval, intangible asset, Internet Archive, John Nash: game theory, Kenneth Arrow, Khan Academy, load shedding, Long Term Capital Management, Machine translation of "The spirit is willing, but the flesh is weak." to Russian and back, market fragmentation, market microstructure, Mars Rover, Metcalfe’s law, moral hazard, mutually assured destruction, Myron Scholes, natural language processing, negative equity, Network effects, optical character recognition, paper trading, passive investing, pez dispenser, phenotype, prediction markets, quantitative hedge fund, quantitative trading / quantitative finance, QWERTY keyboard, RAND corporation, random walk, Ray Kurzweil, Renaissance Technologies, Richard Stallman, risk tolerance, risk-adjusted returns, risk/return, Robert Metcalfe, Ronald Reagan, Rubik’s Cube, semantic web, Sharpe ratio, short selling, Silicon Valley, Small Order Execution System, smart grid, smart meter, social web, South Sea Bubble, statistical arbitrage, statistical model, Steve Jobs, Steven Levy, Tacoma Narrows Bridge, the scientific method, The Wisdom of Crowds, time value of money, too big to fail, transaction costs, Turing machine, Upton Sinclair, value at risk, Vernor Vinge, yield curve, Yogi Berra, your tax dollars at work

The reason for this underweighting, rather than eliminating an unattractive stock completely, is because of index tracking risk. Totally eliminating a company increases the risk of the portfolio return differing substantially from the index if these forecasts are wrong and the stock moves in an opposite direction. The sizes of these decisions, called “active bets,” are constrained by the willingness to risk returns that stray from the index in either direction, in the hope of adding value by straying in a positive direction. 116 Nerds on Wall Str eet Constraints on Active Managers These constraints require active managers to keep a certain portion of their assets in an indexlike subportfolio, either by replication or by sampling, and to use the rest of the portfolio to make active bets trying to outperform the index.


pages: 436 words: 124,373

Galactic North by Alastair Reynolds

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back-to-the-land, Buckminster Fuller, hive mind, information retrieval, risk/return, stem cell, trade route

Eventually someone died who was responsible for keeping the fusion reactor running properly. It didn't blow up, did it?” “No. Just spewed out a lot more neutrons than normal, too much for the shielding to contain. Then it went into emergency shutdown mode. Some people were killed by the radiation but most died of the cold that came afterward.” “Hm. Except you.” Iverson nodded. “If I hadn't had to go back for that component, I'd have been one of them. Obviously, I couldn't risk returning. Even if I could have got the reactor working again, there was still the problem of the contaminant.” He breathed in deeply, as if steeling himself to recollect what had happened next. “So I weighed my options, and decided dying -- freezing myself -- was my only hope. No one was going to come from Earth to help me, even if I could have kept myself alive. Not for decades, anyway. So I took a chance.”


pages: 443 words: 51,804

Handbook of Modeling High-Frequency Data in Finance by Frederi G. Viens, Maria C. Mariani, Ionut Florescu

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algorithmic trading, asset allocation, automated trading system, backtesting, Black-Scholes formula, Brownian motion, business process, continuous integration, corporate governance, discrete time, distributed generation, fixed income, Flash crash, housing crisis, implied volatility, incomplete markets, linear programming, mandelbrot fractal, market friction, market microstructure, martingale, Menlo Park, p-value, pattern recognition, performance metric, principal–agent problem, random walk, risk tolerance, risk/return, short selling, statistical model, stochastic process, stochastic volatility, transaction costs, value at risk, volatility smile, Wiener process

A potential extension of this research is the application of boosting for portfolio selection using the Black–Litterman model (Black and Litterman, 1990,1991). This model includes the subjective expectations of investors in a risk variance optimization model. An alternative line of research is to use the scores of boosting instead of the subjective expectations of the investors. Creamer (2010) has followed this approach combining the optimal predictive capability of boosting with a risk return optimization model. Finally, this research can also be extended using boosting for the design of the enterprise BSC and by including other perspectives of those reviewed in this study. References 69 Initially, the corporate governance variables did not seem to be very relevant to predicting corporate performance. However, when the results of these variables were interpreted together with the accounting variables using representative ADTs, the effect of corporate governance on performance became evident as the BSC demonstrated.


pages: 349 words: 134,041

Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives by Satyajit Das

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accounting loophole / creative accounting, Albert Einstein, Asian financial crisis, asset-backed security, beat the dealer, Black Swan, Black-Scholes formula, Bretton Woods, BRICs, Brownian motion, business process, buy low sell high, call centre, capital asset pricing model, collateralized debt obligation, commoditize, complexity theory, computerized trading, corporate governance, corporate raider, Credit Default Swap, credit default swaps / collateralized debt obligations, cuban missile crisis, currency peg, disintermediation, diversification, diversified portfolio, Edward Thorp, Eugene Fama: efficient market hypothesis, Everything should be made as simple as possible, financial innovation, fixed income, Haight Ashbury, high net worth, implied volatility, index arbitrage, index card, index fund, interest rate derivative, interest rate swap, Isaac Newton, job satisfaction, John Meriwether, locking in a profit, Long Term Capital Management, mandelbrot fractal, margin call, market bubble, Marshall McLuhan, mass affluent, mega-rich, merger arbitrage, Mexican peso crisis / tequila crisis, money market fund, moral hazard, mutually assured destruction, Myron Scholes, new economy, New Journalism, Nick Leeson, offshore financial centre, oil shock, Parkinson's law, placebo effect, Ponzi scheme, purchasing power parity, quantitative trading / quantitative finance, random walk, regulatory arbitrage, Right to Buy, risk-adjusted returns, risk/return, Satyajit Das, shareholder value, short selling, South Sea Bubble, statistical model, technology bubble, the medium is the message, the new new thing, time value of money, too big to fail, transaction costs, value at risk, Vanguard fund, volatility smile, yield curve, Yogi Berra, zero-coupon bond

Modern fund management was born. Insurance companies reengineered market grow. themselves into wealth managers. New fund managers sprang up everywhere. DAS_C04.QXP 8/7/06 110 8:39 PM Page 110 Tr a d e r s , G u n s & M o n e y Fund managers competed with each other on the basis of returns and new investment products. They used derivatives for higher returns, leverage, access or to provide different types of risk/return tradeoffs. Private banks and investors also discovered derivatives as returns plummeted. Dealers had worked out how to embed derivatives in a note so that investors could trade them without trading them. Now all investors did derivatives. Today 70% + of derivatives activity is with investors. It is with your money. Investors even created new products. The ‘death swap’ was a Canadian specialty involving life insurance companies and pension funds.


pages: 320 words: 33,385

Market Risk Analysis, Quantitative Methods in Finance by Carol Alexander

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asset allocation, backtesting, barriers to entry, Brownian motion, capital asset pricing model, constrained optimization, credit crunch, Credit Default Swap, discounted cash flows, discrete time, diversification, diversified portfolio, en.wikipedia.org, fixed income, implied volatility, interest rate swap, market friction, market microstructure, p-value, performance metric, quantitative trading / quantitative finance, random walk, risk tolerance, risk-adjusted returns, risk/return, Sharpe ratio, statistical arbitrage, statistical model, stochastic process, stochastic volatility, Thomas Bayes, transaction costs, value at risk, volatility smile, Wiener process, yield curve, zero-sum game

Yet, whether for organizational reasons or out of ignorance, risk management is often confined to setting and enforcing risk limits. Most firms, especially financial firms, claim to have well-thought-out risk management policies, but few actually state trade-offs between risks and returns. Attention to risk limits may be unwittingly reinforced by regulators. Of course it is not the role of the supervisory authorities to suggest risk–return trade-offs; so supervisors impose risk limits, such as value at risk relative to capital, to ensure safety and xxii Foreword fair competition in the financial industry. But a regulatory limit implies severe penalties if breached, and thus a probabilistic constraint acquires an economic value. Banks must therefore pay attention to the uncertainty in their value-at-risk estimates. The effect would be rather perverse if banks ended up paying more attention to the probability of a probability than to their entire return distribution.


pages: 543 words: 157,991

All the Devils Are Here by Bethany McLean

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Asian financial crisis, asset-backed security, bank run, Black-Scholes formula, break the buck, call centre, collateralized debt obligation, corporate governance, corporate raider, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, Exxon Valdez, fear of failure, financial innovation, fixed income, high net worth, Home mortgage interest deduction, interest rate swap, laissez-faire capitalism, Long Term Capital Management, margin call, market bubble, market fundamentalism, Maui Hawaii, money market fund, moral hazard, mortgage debt, Northern Rock, Own Your Own Home, Ponzi scheme, quantitative trading / quantitative finance, race to the bottom, risk/return, Ronald Reagan, Rosa Parks, shareholder value, short selling, South Sea Bubble, statistical model, telemarketer, too big to fail, value at risk, zero-sum game

But it had suddenly become difficult to obtain prices on the securities they owned, so they couldn’t be sure what their funds were truly worth. Plus, they’d often told investors that the funds operated like a boring, old-fashioned bank—they were supposed to earn the difference between their cost of funds (a good chunk of which were provided through the repo market) and the yield on the super-safe, mostly triple- and double-A-rated securities that they owned. Investors expected fairly steady, low-risk returns. Any losses, no matter how small, could spook them. The Bear team had made money on short positions they had placed on the ABX, but the volatility was worrisome. Because the higher-rated securities were supposed to be nearly riskless, the Bear Stearns hedge funds were highly leveraged: only about $1.6 billion of the $20 billion was equity. The rest was borrowed. Earlier in February, they’d started to get margin calls, meaning that their lenders were demanding more collateral.


pages: 565 words: 151,129

The Zero Marginal Cost Society: The Internet of Things, the Collaborative Commons, and the Eclipse of Capitalism by Jeremy Rifkin

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3D printing, active measures, additive manufacturing, Airbnb, autonomous vehicles, back-to-the-land, big-box store, bioinformatics, bitcoin, business process, Chris Urmson, clean water, cleantech, cloud computing, collaborative consumption, collaborative economy, Community Supported Agriculture, Computer Numeric Control, computer vision, crowdsourcing, demographic transition, distributed generation, en.wikipedia.org, Frederick Winslow Taylor, global supply chain, global village, Hacker Ethic, industrial robot, informal economy, Intergovernmental Panel on Climate Change (IPCC), intermodal, Internet of things, invisible hand, Isaac Newton, James Watt: steam engine, job automation, John Markoff, John Maynard Keynes: Economic Possibilities for our Grandchildren, John Maynard Keynes: technological unemployment, Julian Assange, Kickstarter, knowledge worker, labour mobility, Mahatma Gandhi, manufacturing employment, Mark Zuckerberg, market design, mass immigration, means of production, meta analysis, meta-analysis, natural language processing, new economy, New Urbanism, nuclear winter, Occupy movement, off grid, oil shale / tar sands, pattern recognition, peer-to-peer, peer-to-peer lending, personalized medicine, phenotype, planetary scale, price discrimination, profit motive, QR code, RAND corporation, randomized controlled trial, Ray Kurzweil, RFID, Richard Stallman, risk/return, Ronald Coase, search inside the book, self-driving car, shareholder value, sharing economy, Silicon Valley, Skype, smart cities, smart grid, smart meter, social web, software as a service, spectrum auction, Steve Jobs, Stewart Brand, the built environment, The Nature of the Firm, The Structural Transformation of the Public Sphere, The Wealth of Nations by Adam Smith, The Wisdom of Crowds, Thomas Kuhn: the structure of scientific revolutions, Thomas L Friedman, too big to fail, transaction costs, urban planning, Watson beat the top human players on Jeopardy!, web application, Whole Earth Catalog, Whole Earth Review, WikiLeaks, working poor, zero-sum game, Zipcar

The Economist, in an editorial titled “Capital Markets with a Conscience” described the evolution of social entrepreneurialism. The notion of social capital markets can seem incoherent because it brings together such a diverse group of people and institutions. Yet there is a continuum that connects purely charitable capital at one extreme and for-profit capital at the other, with various trade-offs between risk, return and social impact in between. Much of the discussion . . . is expected to focus on that continuum and to figure out, for any given social goal, which sort of social capital, or mix of different sorts of it, is most likely to succeed.33 For example, while the benefit corporation is an attempt to modify the profit-making drive of capitalist firms to edge closer to the social and environmental priorities of nonprofits in the social Commons, nonprofit organizations are making their own modifications, edging closer to the profit orientation of capitalist firms.


pages: 512 words: 162,977

New Market Wizards: Conversations With America's Top Traders by Jack D. Schwager

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backtesting, beat the dealer, Benoit Mandelbrot, Berlin Wall, Black-Scholes formula, butterfly effect, commodity trading advisor, computerized trading, Edward Thorp, Elliott wave, fixed income, full employment, implied volatility, interest rate swap, Louis Bachelier, margin call, market clearing, market fundamentalism, money market fund, paper trading, pattern recognition, placebo effect, prediction markets, Ralph Nelson Elliott, random walk, risk tolerance, risk/return, Saturday Night Live, Sharpe ratio, the map is not the territory, transaction costs, War on Poverty

BEING RIGHT IS MORE IMPORTANT THAN BEING A GENIUS I think one reason why so many people try to pick tops and bottoms is that they want to prove to the world how smart they are. Think about winning rather than being a hero. Forget trying to judge trading success by how close you can come to picking major tops and bottoms, but rather by how well you can pick individual trades with merit based on favorable risk/return situations and a good percentage of winners. Go for consistency on a trade-to-trade basis, not perfect trades. 24. DON’T WORRY ABOUT LOOKING STUPID Last week you told everyone at the office, “My analysis has just given me a great buy signal in the S&P. The market is going to a new high.” Now as you examine the market action since then, something appears to be wrong. Instead of rallying, the market is breaking down.


pages: 524 words: 143,993

The Shifts and the Shocks: What We've Learned--And Have Still to Learn--From the Financial Crisis by Martin Wolf

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air freight, anti-communist, Asian financial crisis, asset allocation, asset-backed security, balance sheet recession, bank run, banking crisis, banks create money, Basel III, Ben Bernanke: helicopter money, Berlin Wall, Black Swan, bonus culture, break the buck, Bretton Woods, call centre, capital asset pricing model, capital controls, Capital in the Twenty-First Century by Thomas Piketty, Carmen Reinhart, central bank independence, collateralized debt obligation, corporate governance, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency manipulation / currency intervention, currency peg, debt deflation, deglobalization, Deng Xiaoping, diversification, double entry bookkeeping, en.wikipedia.org, Erik Brynjolfsson, Eugene Fama: efficient market hypothesis, eurozone crisis, Fall of the Berlin Wall, fiat currency, financial deregulation, financial innovation, financial repression, floating exchange rates, forward guidance, Fractional reserve banking, full employment, global rebalancing, global reserve currency, Growth in a Time of Debt, Hyman Minsky, income inequality, inflation targeting, information asymmetry, invisible hand, Joseph Schumpeter, Kenneth Rogoff, labour market flexibility, labour mobility, light touch regulation, liquidationism / Banker’s doctrine / the Treasury view, liquidity trap, Long Term Capital Management, mandatory minimum, margin call, market bubble, market clearing, market fragmentation, Martin Wolf, Mexican peso crisis / tequila crisis, money market fund, moral hazard, mortgage debt, negative equity, new economy, North Sea oil, Northern Rock, open economy, paradox of thrift, Paul Samuelson, price stability, private sector deleveraging, purchasing power parity, pushing on a string, quantitative easing, Real Time Gross Settlement, regulatory arbitrage, reserve currency, Richard Feynman, Richard Feynman, risk-adjusted returns, risk/return, road to serfdom, Robert Gordon, Robert Shiller, Robert Shiller, Ronald Reagan, savings glut, Second Machine Age, secular stagnation, shareholder value, short selling, sovereign wealth fund, special drawing rights, The Chicago School, The Great Moderation, The Market for Lemons, the market place, The Myth of the Rational Market, the payments system, The Wealth of Nations by Adam Smith, too big to fail, Tyler Cowen: Great Stagnation, very high income, winner-take-all economy, zero-sum game

Moreover, the central bank, not the banks, controls the quantity of reserves (with a little help from the public’s desire for cash).12 It can create and liquidate reserves, by buying and selling assets or by lending and withdrawing loans to and from the banks. Finally, the central bank can sterilize reserves by changing reserve requirements, and it can decide how onerous to make such requirements by determining the rate of interest it pays on reserves. Figure 41. US ‘Money Multiplier’ Source: Federal Reserve Bank of St Louis If interest rates were to remain at zero when a normal appetite for risk returns, credit and money would start to grow too fast, the economy would overheat, and everything would end up as critics fear. But the conditions that caused interest rates to fall to zero are the very conditions that prevent such a credit explosion. When the conditions change, policies must change. And, we must assume, they will. Yet even if the hysteria about hyperinflation is wrong, the objections to an exclusive reliance on monetary policy create a prima facie case for using fiscal policy.


pages: 385 words: 128,358

Inside the House of Money: Top Hedge Fund Traders on Profiting in a Global Market by Steven Drobny

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Albert Einstein, asset allocation, Berlin Wall, Bonfire of the Vanities, Bretton Woods, buy low sell high, capital controls, central bank independence, Chance favours the prepared mind, commoditize, commodity trading advisor, corporate governance, correlation coefficient, Credit Default Swap, diversification, diversified portfolio, family office, fixed income, glass ceiling, high batting average, implied volatility, index fund, inflation targeting, interest rate derivative, inventory management, John Meriwether, Long Term Capital Management, margin call, market bubble, Maui Hawaii, Mexican peso crisis / tequila crisis, moral hazard, Myron Scholes, new economy, Nick Leeson, oil shale / tar sands, oil shock, out of africa, paper trading, Paul Samuelson, Peter Thiel, price anchoring, purchasing power parity, reserve currency, risk tolerance, risk-adjusted returns, risk/return, rolodex, Sharpe ratio, short selling, Silicon Valley, The Wisdom of Crowds, too big to fail, transaction costs, value at risk, yield curve, zero-coupon bond, zero-sum game

That expected return is influenced by the boundaries of the trade—that is, where the trade can go and how far away the stop is—and by the probability you attach to it going the way that you think it’s going to go.Therefore, strength of view is relevant. If you get stopped out, think it through, and still have very strong views, then the expected return is still pretty good but with one very important proviso:You have to add in the loss to your trade because you’ve already incurred it.Thus the risk/reward must be less the second time than it was the first. Your risk/return ratio should at least be 4 to 1 in any given trade (the great traders think in terms of 8 to1 or 10 to 1).After you’ve hit the 1 a couple of times, all of a sudden what was a 4 to 1 trade is now a 4 to 3 trade, at which point you should move on to another trade, even if you don’t want to. Do you think managers should have specific rules regarding when they can get back in a trade after a stop-loss gets hit, such as a cooling-off period or the trade has to move back your way by X percent?


pages: 473 words: 132,344

The Downfall of Money: Germany's Hyperinflation and the Destruction of the Middle Class by Frederick Taylor

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Albert Einstein, anti-communist, banking crisis, Berlin Wall, British Empire, central bank independence, centre right, collective bargaining, falling living standards, fiat currency, fixed income, full employment, German hyperinflation, housing crisis, Internet Archive, Johann Wolfgang von Goethe, mittelstand, offshore financial centre, Plutocrats, plutocrats, quantitative easing, rent control, risk/return, strikebreaker, trade route, zero-sum game

Though Genoa limped on to its inglorious conclusion, nothing was decided there that made any real difference to the direction Europe in general was heading. If Lloyd George was disappointed – his coalition government, already in serious difficulties, finally fell in October – the French were furious, interpreting the separate agreement between Germany and Russia both as a cause of Genoa’s failure and as a typical act of bad faith. As for Rathenau himself, he had fought against the Rapallo Treaty, believing that Germany risked returning relations with the Western powers to the dark days of 1919. Only when it became clear that the Russians might otherwise make a deal with Britain and France and the rest which would leave Germany out in the cold again, did the Foreign Minister relent. The final decision to sign the Russian treaty came during what was described as a ‘pyjama party’ in Rathenau’s hotel suite during the night of 15/16 April.


pages: 483 words: 134,377

The Tyranny of Experts: Economists, Dictators, and the Forgotten Rights of the Poor by William Easterly

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air freight, Andrei Shleifer, battle of ideas, Bretton Woods, British Empire, business process, business process outsourcing, Carmen Reinhart, clean water, colonial rule, correlation does not imply causation, creative destruction, Daniel Kahneman / Amos Tversky, Deng Xiaoping, desegregation, discovery of the americas, Edward Glaeser, en.wikipedia.org, European colonialism, Francisco Pizarro, fundamental attribution error, germ theory of disease, greed is good, Gunnar Myrdal, income per capita, invisible hand, James Watt: steam engine, Jane Jacobs, John Snow's cholera map, Joseph Schumpeter, Kenneth Arrow, Kenneth Rogoff, M-Pesa, microcredit, Monroe Doctrine, oil shock, place-making, Ponzi scheme, risk/return, road to serfdom, Silicon Valley, Steve Jobs, The Death and Life of Great American Cities, The Wealth of Nations by Adam Smith, Thomas L Friedman, urban planning, urban renewal, Washington Consensus, World Values Survey, young professional

A later study of the Nationalist Government found that the organization meant to control corruption, the Control Yuan, had received allegations of corruption from 1931 to 1937 on 69,500 officials. Of these, the Control Yuan fired thirteen. Condliffe faced a problem that would recur again and again throughout the history of development. The horrible political situation in China seemed itself to be a huge barrier to development. Anyone mixed up in this politics would seem to be part of the problem, not part of the solution. But if he didn’t deal with the Guomindang, Condliffe risked returning home empty-handed. In this environment, the technocratic approach, which ignored politics, came to the rescue. The technocratic mind-set would allow Chinese economists to present themselves as neutral experts, no politics implied. In particular, Chinese economists who had been educated in the United States would have expert qualifications, some apparent distance from internal Chinese politics, and the ability to communicate with their funders.

Investment: A History by Norton Reamer, Jesse Downing

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activist fund / activist shareholder / activist investor, Albert Einstein, algorithmic trading, asset allocation, backtesting, banking crisis, Berlin Wall, Bernie Madoff, break the buck, Brownian motion, buttonwood tree, California gold rush, capital asset pricing model, Carmen Reinhart, carried interest, colonial rule, credit crunch, Credit Default Swap, Daniel Kahneman / Amos Tversky, debt deflation, discounted cash flows, diversified portfolio, equity premium, estate planning, Eugene Fama: efficient market hypothesis, Fall of the Berlin Wall, family office, Fellow of the Royal Society, financial innovation, fixed income, Gordon Gekko, Henri Poincaré, high net worth, index fund, information asymmetry, interest rate swap, invention of the telegraph, James Hargreaves, James Watt: steam engine, joint-stock company, Kenneth Rogoff, labor-force participation, land tenure, London Interbank Offered Rate, Long Term Capital Management, loss aversion, Louis Bachelier, margin call, means of production, Menlo Park, merger arbitrage, money market fund, moral hazard, mortgage debt, Myron Scholes, negative equity, Network effects, new economy, Nick Leeson, Own Your Own Home, Paul Samuelson, pension reform, Ponzi scheme, price mechanism, principal–agent problem, profit maximization, quantitative easing, RAND corporation, random walk, Renaissance Technologies, Richard Thaler, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, Sand Hill Road, Sharpe ratio, short selling, Silicon Valley, South Sea Bubble, sovereign wealth fund, spinning jenny, statistical arbitrage, survivorship bias, technology bubble, The Wealth of Nations by Adam Smith, time value of money, too big to fail, transaction costs, underbanked, Vanguard fund, working poor, yield curve

This is known as the constant beta approach and is indeed the most straightforward way to forecast beta, though there are more mathematically sophisticated alternative approaches as well. Fama-French Three-Factor Model In 1992, Eugene Fama and Kenneth French wrote a famous paper entitled “The Cross-Section of Expected Stock Returns” that appeared in The Journal of Finance, in which they said that beta alone is insufficient to capture the risk-return trade-off. They introduced two additional factors—size (as measured by the market capitalization) and value (as measured by the book-to-market equity ratio)—as explanatory variables in the performance of stocks. They found that value firms (or firms with low price-to-book value, as compared with growth firms) and small firms (low market capitalization) have higher expected returns in the aggregate but also have higher risk.


pages: 433 words: 125,031

Brazillionaires: The Godfathers of Modern Brazil by Alex Cuadros

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affirmative action, Asian financial crisis, big-box store, BRICs, cognitive dissonance, creative destruction, crony capitalism, Deng Xiaoping, Donald Trump, Elon Musk, facts on the ground, family office, high net worth, index fund, invisible hand, Jeff Bezos, Mark Zuckerberg, NetJets, offshore financial centre, profit motive, rent-seeking, risk/return, Rubik’s Cube, savings glut, short selling, Silicon Valley, sovereign wealth fund, stem cell, The Wealth of Nations by Adam Smith, too big to fail, transatlantic slave trade, transatlantic slave trade, We are the 99%, William Langewiesche

Despite his reputation for cunning, I found myself disarmed by his boyish face and toothy smile. As he shook my hand, he effusively thanked me as if I personally had anything to do with the list. Then he launched straight into an attack on his own industry. He blamed his fellow bankers in the United States and Europe for the financial crisis. “The money people were making on Wall Street didn’t make sense,” he said. “It was too easy. Obviously the risk/return was imperfect. A guy would make millions and millions of dollars without running any personal risk. He would screw everything up, switch jobs, and not lose a thing. It can’t be like this.” What he described was Eike’s system, meritocracy gone amok, on a much grander scale. I wondered how much of Esteves’s criticism was just arrogance. BTG officially stood for Banking and Trading Group, but unofficially it stood for Better Than Goldman—as in Goldman Sachs, the most profitable firm on Wall Street.


pages: 422 words: 113,830

Bad Money: Reckless Finance, Failed Politics, and the Global Crisis of American Capitalism by Kevin Phillips

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algorithmic trading, asset-backed security, bank run, banking crisis, Bernie Madoff, Black Swan, Bretton Woods, BRICs, British Empire, collateralized debt obligation, computer age, corporate raider, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, currency peg, diversification, Doha Development Round, energy security, financial deregulation, financial innovation, fixed income, Francis Fukuyama: the end of history, George Gilder, housing crisis, Hyman Minsky, imperial preference, income inequality, index arbitrage, index fund, interest rate derivative, interest rate swap, Joseph Schumpeter, Kenneth Rogoff, large denomination, Long Term Capital Management, market bubble, Martin Wolf, Menlo Park, mobile money, money market fund, Monroe Doctrine, moral hazard, mortgage debt, Myron Scholes, new economy, oil shale / tar sands, oil shock, old-boy network, peak oil, Plutocrats, plutocrats, Ponzi scheme, profit maximization, Renaissance Technologies, reserve currency, risk tolerance, risk/return, Robert Shiller, Robert Shiller, Ronald Reagan, Satyajit Das, shareholder value, short selling, sovereign wealth fund, The Chicago School, Thomas Malthus, too big to fail, trade route

Consumers Lose Faith in Fed, Financial System,” Reuters, October 10, 2008. 97 “Americans Want Regulation More Than Rescue,” Gallup.com, November 11, 2008. 98 “Americans Oppose Bailouts, Favor Obama,” Bloomberg News, September 24, 2008. 99 “Americans Turn Negative on Economy, Expect Recession, Poll Says,” Bloomberg News, October 25, 2008. 1. INTRODUCTION: THE PANIC OF AUGUST 1 See Charles P. Kindleberger, Manias, Panics, and Crashes (New York: Harper Torchbooks, 1978), pp. 106, 254-56. 2 David Fromkin, Europe’s Last Summer (New York: Knopf, 2004), p. 168. 3 “The Loan Comes Due,” New York Times, August 5, 2007, Week in Review. 4 “Inside the Sub-prime Storm,” Schwab Investing Insights, August 16, 2007, p. 2. 5 “Risk Returns with a Vengeance,” Fortune, August 20, 2007; www.cnnmoney.com, August 21, 2007. 6 “Mortgage Fraud Is the Thing to Do Now,” Chicago Tribune, September 22, 2007; www.foreclosurepulse.com, July 12, 2007. 7 www.ml-implode.com. 8 Niall Ferguson, The Pity of War (New York: Basic Books, 1999), p. 192. 9 “Loan by Loan, the Making of a Credit Squeeze,” New York Times, Sunday Business, August 19, 2007. 10 S&P/Case-Shiller from “U.S.


pages: 264 words: 115,489

Take the money and run: sovereign wealth funds and the demise of American prosperity by Eric Curt Anderson

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asset allocation, banking crisis, Bretton Woods, business continuity plan, business intelligence, business process, collective bargaining, corporate governance, credit crunch, currency manipulation / currency intervention, currency peg, diversified portfolio, fixed income, floating exchange rates, housing crisis, index fund, Kenneth Rogoff, open economy, passive investing, profit maximization, profit motive, random walk, reserve currency, risk tolerance, risk-adjusted returns, risk/return, Ronald Reagan, sovereign wealth fund, the market place, The Wealth of Nations by Adam Smith, too big to fail, Vanguard fund

According to Lyons, “Investment policies vary, [depending on] the sovereign wealth fund’s primary aim and purpose.”57 More specifically, Lyons concludes sovereign wealth fund investments in 2007 reveal: • A number of funds have acquired significant stakes in foreign companies. • “Future generations” funds with high levels of transparency, such as Norway’s Government Pension Fund-Global, have a high level of diversification and hold only small stakes. • Stabilization funds, such as Russia’s, are tasked with delivering stable and low-risk returns, and therefore they are limited to investment in AAA-rated sovereign bonds, with a given currency composition to manage risk. • Low-transparency funds, such as the Abu Dhabi Investment Authority, usually prefer investing in small stakes to avoid disclosure requirements.58 In short, Lyons’ transparency rating suggests there is a pattern to sovereign wealth fund investment that might lend itself to establishing a set of “best practices.”


pages: 504 words: 126,835

The Innovation Illusion: How So Little Is Created by So Many Working So Hard by Fredrik Erixon, Bjorn Weigel

Airbnb, Albert Einstein, asset allocation, autonomous vehicles, barriers to entry, Basel III, Bernie Madoff, bitcoin, Black Swan, blockchain, BRICs, Burning Man, Capital in the Twenty-First Century by Thomas Piketty, Cass Sunstein, Clayton Christensen, Colonization of Mars, commoditize, corporate governance, corporate social responsibility, creative destruction, crony capitalism, dark matter, David Graeber, David Ricardo: comparative advantage, discounted cash flows, distributed ledger, Donald Trump, Elon Musk, Erik Brynjolfsson, fear of failure, first square of the chessboard / second half of the chessboard, Francis Fukuyama: the end of history, George Gilder, global supply chain, global value chain, Google Glasses, Google X / Alphabet X, Gordon Gekko, high net worth, hiring and firing, Hyman Minsky, income inequality, income per capita, index fund, industrial robot, Internet of things, Jeff Bezos, job automation, job satisfaction, John Maynard Keynes: Economic Possibilities for our Grandchildren, John Maynard Keynes: technological unemployment, joint-stock company, Joseph Schumpeter, Just-in-time delivery, Kevin Kelly, knowledge economy, labour market flexibility, laissez-faire capitalism, lump of labour, Lyft, manufacturing employment, Mark Zuckerberg, market design, Martin Wolf, mass affluent, means of production, Mont Pelerin Society, Network effects, new economy, offshore financial centre, pensions crisis, Peter Thiel, Potemkin village, price mechanism, principal–agent problem, Productivity paradox, QWERTY keyboard, RAND corporation, Ray Kurzweil, rent-seeking, risk tolerance, risk/return, Robert Gordon, Ronald Coase, Ronald Reagan, savings glut, Second Machine Age, secular stagnation, Silicon Valley, Silicon Valley startup, Skype, sovereign wealth fund, Steve Ballmer, Steve Jobs, Steve Wozniak, technological singularity, telemarketer, The Chicago School, The Future of Employment, The Nature of the Firm, The Wealth of Nations by Adam Smith, too big to fail, total factor productivity, transaction costs, transportation-network company, tulip mania, Tyler Cowen: Great Stagnation, University of East Anglia, unpaid internship, Vanguard fund, Yogi Berra

In the extreme case, governments have the privilege of raising fiscal deficits, printing money, and creating inflation, or cutting actual pensions. More moderately, they can set the rules for their own borrowing. Providers of private retirement savings, especially with defined benefits, do not have the same luxury. They cannot always cut pensions or invent their own financial rules. Private providers can change their products away from defined benefits, but generally not retroactively. Naturally, private pension providers will push the risk–return profile when they invest, but when the regulatory environment is pulling in the opposite direction, investment gets ever more complex. And this is where gray capitalism gets grayer, or changes color. Gray capital has in fact another option to manage the quest for cash. Given their ownership role in the economy, investment institutions representing retirement savers can turn to their cash-strong investees and demand that they return more capital to shareholders.


pages: 419 words: 130,627

Last Man Standing: The Ascent of Jamie Dimon and JPMorgan Chase by Duff McDonald

bank run, Bonfire of the Vanities, centralized clearinghouse, collateralized debt obligation, conceptual framework, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Exxon Valdez, financial innovation, fixed income, housing crisis, interest rate swap, Jeff Bezos, John Meriwether, laissez-faire capitalism, Long Term Capital Management, margin call, market bubble, money market fund, moral hazard, negative equity, Northern Rock, profit motive, Renaissance Technologies, risk/return, Rod Stewart played at Stephen Schwarzman birthday party, Saturday Night Live, sovereign wealth fund, statistical model, Steve Ballmer, Steve Jobs, technology bubble, The Chicago School, too big to fail, Vanguard fund, zero-coupon bond, zero-sum game

Although Salomon had for years delivered outsize profits on its arbitrage bets, Dimon and Weill began to sense that maybe the jig was up. With a number of defections from Salomon, most prominently John Meriwether and his team at the powerful hedge fund Long-Term Capital Management, other firms were using similar if not identical strategies, with the inevitable result that the arbitrage opportunity was shrinking. This, in turn, meant that the risk-return trade-off on the unit’s big bets was heading in the wrong direction. The arbitrage group’s members had also done a surprisingly poor job of ingratiating themselves with their new bosses. In his insightful indictment of financial innovation, A Demon of Our Own Design, Richard Bookstaber recalls a series of meetings in which the heads of Salomon’s proprietary trading—Rob Stavis, Costas Kaplanis, and Sugar Myojin—were tasked with making Weill, Dimon, and Travelers’ CFO Heidi Miller comfortable with their strategies and positions.


pages: 584 words: 187,436

More Money Than God: Hedge Funds and the Making of a New Elite by Sebastian Mallaby

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Andrei Shleifer, Asian financial crisis, asset-backed security, automated trading system, bank run, barriers to entry, Benoit Mandelbrot, Berlin Wall, Bernie Madoff, Big bang: deregulation of the City of London, Bonfire of the Vanities, Bretton Woods, capital controls, Carmen Reinhart, collapse of Lehman Brothers, collateralized debt obligation, computerized trading, corporate raider, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, currency manipulation / currency intervention, currency peg, Elliott wave, Eugene Fama: efficient market hypothesis, failed state, Fall of the Berlin Wall, financial deregulation, financial innovation, financial intermediation, fixed income, full employment, German hyperinflation, High speed trading, index fund, John Meriwether, Kenneth Rogoff, Long Term Capital Management, margin call, market bubble, market clearing, market fundamentalism, merger arbitrage, money market fund, moral hazard, Myron Scholes, natural language processing, Network effects, new economy, Nikolai Kondratiev, pattern recognition, Paul Samuelson, pre–internet, quantitative hedge fund, quantitative trading / quantitative finance, random walk, Renaissance Technologies, Richard Thaler, risk-adjusted returns, risk/return, rolodex, Sharpe ratio, short selling, Silicon Valley, South Sea Bubble, sovereign wealth fund, statistical arbitrage, statistical model, survivorship bias, technology bubble, The Great Moderation, The Myth of the Rational Market, the new new thing, too big to fail, transaction costs

The more you introduced new uncorrelated trades to the portfolio, the more risk could be dampened. The third uncorrelated position would add only $32 million of risk to the portfolio, even if, taken by itself, it threatened a loss of $100 million.19 The fifth uncorrelated position would add $24 million of risk; the tenth would add only $16 million; and so on. Through the magic of diversification, risk could almost disappear. Trades that seemed crazy to others on a risk/return basis could appear highly profitable to Meriwether and his partners. Ten years later, when the credit bubble imploded in 2007–2009, value-at-risk calculations fell out of favor. Warren Buffett admonished fellow financiers to “beware of geeks bearing formulas.” Nevertheless, Meriwether’s metric represented an advance on the traditional leverage ratio as a way of gauging risk. The traditional ratio failed to account for swaps and options, even though these could be a huge source of risk to a portfolio.


pages: 741 words: 179,454

Extreme Money: Masters of the Universe and the Cult of Risk by Satyajit Das

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affirmative action, Albert Einstein, algorithmic trading, Andy Kessler, Asian financial crisis, asset allocation, asset-backed security, bank run, banking crisis, banks create money, Basel III, Benoit Mandelbrot, Berlin Wall, Bernie Madoff, Big bang: deregulation of the City of London, Black Swan, Bonfire of the Vanities, bonus culture, Bretton Woods, BRICs, British Empire, capital asset pricing model, Carmen Reinhart, carried interest, Celtic Tiger, clean water, cognitive dissonance, collapse of Lehman Brothers, collateralized debt obligation, corporate governance, corporate raider, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Daniel Kahneman / Amos Tversky, debt deflation, Deng Xiaoping, deskilling, discrete time, diversification, diversified portfolio, Doomsday Clock, Edward Thorp, Emanuel Derman, en.wikipedia.org, Eugene Fama: efficient market hypothesis, eurozone crisis, Fall of the Berlin Wall, financial independence, financial innovation, financial thriller, fixed income, full employment, global reserve currency, Goldman Sachs: Vampire Squid, Gordon Gekko, greed is good, happiness index / gross national happiness, haute cuisine, high net worth, Hyman Minsky, index fund, information asymmetry, interest rate swap, invention of the wheel, invisible hand, Isaac Newton, job automation, Johann Wolfgang von Goethe, John Meriwether, joint-stock company, Joseph Schumpeter, Kenneth Arrow, Kenneth Rogoff, Kevin Kelly, labour market flexibility, laissez-faire capitalism, load shedding, locking in a profit, Long Term Capital Management, Louis Bachelier, margin call, market bubble, market fundamentalism, Marshall McLuhan, Martin Wolf, mega-rich, merger arbitrage, Mikhail Gorbachev, Milgram experiment, money market fund, Mont Pelerin Society, moral hazard, mortgage debt, mortgage tax deduction, mutually assured destruction, Myron Scholes, Naomi Klein, negative equity, Network effects, new economy, Nick Leeson, Nixon shock, Northern Rock, nuclear winter, oil shock, Own Your Own Home, Paul Samuelson, pets.com, Philip Mirowski, Plutocrats, plutocrats, Ponzi scheme, price anchoring, price stability, profit maximization, quantitative easing, quantitative trading / quantitative finance, Ralph Nader, RAND corporation, random walk, Ray Kurzweil, regulatory arbitrage, rent control, rent-seeking, reserve currency, Richard Feynman, Richard Feynman, Richard Thaler, Right to Buy, risk-adjusted returns, risk/return, road to serfdom, Robert Shiller, Robert Shiller, Rod Stewart played at Stephen Schwarzman birthday party, rolodex, Ronald Reagan, Ronald Reagan: Tear down this wall, Satyajit Das, savings glut, shareholder value, Sharpe ratio, short selling, Silicon Valley, six sigma, Slavoj Žižek, South Sea Bubble, special economic zone, statistical model, Stephen Hawking, Steve Jobs, survivorship bias, The Chicago School, The Great Moderation, the market place, the medium is the message, The Myth of the Rational Market, The Nature of the Firm, the new new thing, The Predators' Ball, The Wealth of Nations by Adam Smith, Thorstein Veblen, too big to fail, trickle-down economics, Turing test, Upton Sinclair, value at risk, Yogi Berra, zero-coupon bond, zero-sum game

Paulson’s fund assets increased from $6 billion to $27.5 billion, entering the top ten global funds. Philip Falcone’s Harbinger Capital, Mike Burry’s Scion Funds and Lahde Capital, a Santa-Monica-based fund set up by Andrew Lahde, all recorded substantial returns. Burry wrote to his investors: “The opportunity in 2005 and 2006 to short subprime mortgages was an historic one.” Lahde, a small fund, returned money to investors, recognizing that: “The risk/return characteristics are far less attractive than in the past.”17 The funds that profited from the collapse were generally smaller funds, outside the mainstream. Before the crisis, when asked about John Paulson, a banker at Goldman Sachs told a potential investor that he was “a third rate hedge fund guy who didn’t know what he was talking about.”18 One person noted: “In the hedge-fund industry the only bad thing you can do is lose people’s money.”19 Even that wasn’t strictly speaking true.


pages: 272 words: 19,172

Hedge Fund Market Wizards by Jack D. Schwager

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asset-backed security, backtesting, banking crisis, barriers to entry, beat the dealer, Bernie Madoff, Black-Scholes formula, British Empire, Claude Shannon: information theory, cloud computing, collateralized debt obligation, commodity trading advisor, computerized trading, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, delta neutral, diversification, diversified portfolio, Edward Thorp, family office, financial independence, fixed income, Flash crash, hindsight bias, implied volatility, index fund, intangible asset, James Dyson, Long Term Capital Management, margin call, market bubble, market fundamentalism, merger arbitrage, money market fund, oil shock, pattern recognition, pets.com, Ponzi scheme, private sector deleveraging, quantitative easing, quantitative trading / quantitative finance, Right to Buy, risk tolerance, risk-adjusted returns, risk/return, riskless arbitrage, Rubik’s Cube, Sharpe ratio, short selling, statistical arbitrage, Steve Jobs, systematic trading, technology bubble, transaction costs, value at risk, yield curve

In your own trading book, what is the breakdown between directional and relative value trades? It completely depends. Sometimes I have no directional trades on, and sometimes directional trades dominate my book. Basically, I like buying stuff cheap and selling it at fair value. How you implement a trade is critical. I develop a macro view about something, but then there are 20 different ways I can play it. The key question is: Which way gives me the best risk/return ratio? My final trade is rarely going to be a straight long or short position. How would you characterize yourself as a trader? I don’t have any tolerance for trading losses. I hate losing money more than anything. Losing money is what kills you. It is not the actual loss. It’s the fact that it messes up your psychology. You lose the bullets in your gun. What happens is you put on a stupid trade, lose $20 million in 10 minutes, and take the trade off.


pages: 897 words: 210,566

Shake Hands With the Devil: The Failure of Humanity in Rwanda by Romeo Dallaire, Brent Beardsley

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airport security, colonial rule, failed state, global village, invisible hand, Khartoum Gordon, land reform, risk/return, Ronald Reagan

F oldiers i ut 1600, di with no problem, but later in the day, mobs again sealed off 192 SHAKE HANDS WITH THE DEVIL the city. After sending Tikoka to check out the current state of unrest north of Kadafi Crossroads, I decided the convoy would not be safe coming back that afternoon and issued an order for them not to return but to stay in Mulindi until the all-clear was given. But the Belgian escort deliberately disobeyed that order; they decided to risk returning to Kigali after dark with the whole convoy rather than spend an uncomfortable night camped out in their vehicles. They had just entered the suburb north of Kadafi Crossroads, which had been a major flashpoint that day, when a grenade was tossed at the lead vehicle, followed by machine-gun fire. The Belgians returned fire and manoeuvred to get out of the ambush. One of the MILOB vehicles ended up in the ditch, and the two observers scrambled out and jumped onto one of the Belgian Jeeps; the other MILOB vehicle managed to do a U-turn to get out of there.


pages: 726 words: 172,988

The Bankers' New Clothes: What's Wrong With Banking and What to Do About It by Anat Admati, Martin Hellwig

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Andrei Shleifer, asset-backed security, bank run, banking crisis, Basel III, Bernie Madoff, Big bang: deregulation of the City of London, Black Swan, bonus culture, break the buck, Carmen Reinhart, central bank independence, centralized clearinghouse, collapse of Lehman Brothers, collateralized debt obligation, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, diversified portfolio, en.wikipedia.org, Exxon Valdez, financial deregulation, financial innovation, financial intermediation, fixed income, George Akerlof, Growth in a Time of Debt, income inequality, invisible hand, Jean Tirole, joint-stock company, joint-stock limited liability company, Kenneth Rogoff, Larry Wall, light touch regulation, London Interbank Offered Rate, Long Term Capital Management, margin call, Martin Wolf, money market fund, moral hazard, mortgage debt, mortgage tax deduction, negative equity, Nick Leeson, Northern Rock, open economy, peer-to-peer lending, regulatory arbitrage, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, Satyajit Das, shareholder value, sovereign wealth fund, technology bubble, The Market for Lemons, the payments system, too big to fail, Upton Sinclair, Yogi Berra

Quarterly Journal of Economics 106 (1): 33–60. Hu, Henry T. C. 2012. “Too Complex to Depict? Innovation, ‘Pure Information’ and the SEC Disclosure Paradigm.” Texas Law Review 90: 1601–1715. Huertas, Thomas F. 2010. Crisis: Cause, Containment and Cure. Houndmills, Basingstoke, Hampshire, England: Palgrave Macmillan. Hughes, Joseph P., and Loretta J. Mester. 2011. “Who Said Large Banks Don’t Experience Scale Economies? Evidence from a Risk-Return Driven Cost Function.” Financial Institutions Center, Wharton School, University of Pennsylvania, Philadelphia. Hull, John. 2007. Risk Management and Financial Institutions. Upper Saddle River, NJ: Pearson Prentice Hall. Hyman, Louis. 2012. Borrow: The American Way of Debt. New York: Vintage. ICB (Independent Commission on Banking). 2011. “Final Report: Recommendation.” http://www.financialregulationforum.com/wpmember/the-independent-commission-on-banking-final-report-6873/.

Debtor Nation: The History of America in Red Ink (Politics and Society in Modern America) by Louis Hyman

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asset-backed security, bank run, barriers to entry, Bretton Woods, card file, central bank independence, computer age, corporate governance, credit crunch, declining real wages, deindustrialization, diversified portfolio, financial independence, financial innovation, fixed income, Gini coefficient, Home mortgage interest deduction, housing crisis, income inequality, invisible hand, late fees, London Interbank Offered Rate, market fundamentalism, means of production, mortgage debt, mortgage tax deduction, p-value, pattern recognition, profit maximization, profit motive, risk/return, Ronald Reagan, Silicon Valley, statistical model, technology bubble, the built environment, transaction costs, union organizing, white flight, women in the workforce, working poor, zero-sum game

Revolvers who revolved for convenience made for good business. Revolvers who borrowed because they spent more than they earned— persistently—made for bad business. No model could screen for these kinds of revolvers. But computer models, in general, had begun to acquire an accuracy that was impossible only a decade earlier, and it was on the basis of these models that lenders delved further down the risk/return curve, relying on their ability to transfer that default risk to the holders of the credit card securities and, ultimately, the insurance companies that backed those tranches. The Seduction of the Risk Model Beginning in 1987, Household Finance Company, by now one of the largest credit card issuers in the United States, began to segment its existing portfolio ever finer, building on the discriminant analysis techniques of the 1970s.


What Makes Narcissists Tick by Kathleen Krajco

Albert Einstein, anti-communist, British Empire, experimental subject, Norman Mailer, risk/return

Though the tactics are different, the strategy is the same in the woman who can't let anyone get a word in edgewise during a conversation. She is monopolizing the conversation to monopolize attention. One slick technique I have observed is what I call the Drive-By: The narcissist barges into a room loudly talking to drown out and stifle the extant conversation. Thus he butts in on it to take attention away from whoever is talking and suck it to himself. But he is only passing through, so he doesn't risk return fire. That is, he needn't be there for a reply to his announcement or remark. Nobody can get him to pause long enough to hear one short sentence. He just accelerates to exit the other end of the room faster if someone draws a breath and opens their mouth to speak to him. OperationDoubles.com © 2004 – 2007, Kathleen Krajco — all rights reserved worldwide. Meet the Narcissist: A Wolf in Sheep's Clothing 137 We see variations of the Drive-By technique in administrators who find innumerable ways to always have their unanswered say.


pages: 1,042 words: 266,547

Security Analysis by Benjamin Graham, David Dodd

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activist fund / activist shareholder / activist investor, asset-backed security, backtesting, barriers to entry, capital asset pricing model, carried interest, collateralized debt obligation, collective bargaining, corporate governance, corporate raider, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, diversified portfolio, fear of failure, financial innovation, fixed income, full employment, index fund, intangible asset, invisible hand, Joseph Schumpeter, locking in a profit, Long Term Capital Management, low cost carrier, moral hazard, mortgage debt, Myron Scholes, p-value, Right to Buy, risk-adjusted returns, risk/return, secular stagnation, shareholder value, The Chicago School, the market place, the scientific method, The Wealth of Nations by Adam Smith, transaction costs, zero-coupon bond

Even complex derivatives not imagined in an earlier era can be scrutinized with the value investor’s eye. While traders today typically price put and call options via the Black-Scholes model, one can instead use value-investing precepts—upside potential, downside risk, and the likelihood that each of various possible scenarios will occur—to analyze these instruments. An inexpensive option may, in effect, have the favorable risk-return characteristics of a value investment—regardless of what the Black-Scholes model dictates. Institutional Investing Perhaps the most important change in the investment landscape over the past 75 years is the ascendancy of institutional investing. In the 1930s, individual investors dominated the stock market. Today, by contrast, most market activity is driven by institutional investors—large pools of pension, endowment, and aggregated individual capital.


pages: 892 words: 91,000

Valuation: Measuring and Managing the Value of Companies by Tim Koller, McKinsey, Company Inc., Marc Goedhart, David Wessels, Barbara Schwimmer, Franziska Manoury

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activist fund / activist shareholder / activist investor, air freight, barriers to entry, Basel III, BRICs, business climate, business process, capital asset pricing model, capital controls, Chuck Templeton: OpenTable, cloud computing, commoditize, compound rate of return, conceptual framework, corporate governance, corporate social responsibility, creative destruction, credit crunch, Credit Default Swap, discounted cash flows, distributed generation, diversified portfolio, energy security, equity premium, fixed income, index fund, intangible asset, iterative process, Long Term Capital Management, market bubble, market friction, meta analysis, meta-analysis, Myron Scholes, negative equity, new economy, p-value, performance metric, Ponzi scheme, price anchoring, purchasing power parity, quantitative easing, risk/return, Robert Shiller, Robert Shiller, shareholder value, six sigma, sovereign wealth fund, speech recognition, survivorship bias, technology bubble, time value of money, too big to fail, transaction costs, transfer pricing, value at risk, yield curve, zero-coupon bond

However, such benefits need to outweigh any potential unintended consequences that inevitably arise with the complexity of financial engineering. This section considers three of the more common tools of financial engineering: derivative instruments that transfer company risks to third parties, off-balance-sheet financing that detaches funding from the company’s credit risk, and hybrid financing that offers new risk/return financing combinations. Derivative Instruments With derivative instruments, such as forwards, swaps, and options, a company can transfer particular risks to third parties that can carry these risks at a lower cost. For example, some airlines hedge their fuel costs with derivatives to be less exposed to sudden changes in oil prices. Of course, this does not make airlines immune to prolonged periods of high oil prices, because the derivative positions must be renewed at some point.