Chp 1-2 Risk-Return Trade-offs

Chp 1: Risk-Return Trade-offs Alicia Damley, CFA, CPA, CA, MBA 1 Risk vs Return There is a trade-off between risk and expected return No free lunch! The higher the risk, the higher the expected return To compensate/incentive investors to take...

Chp 1: Risk-Return Trade-offs Alicia Damley, CFA, CPA, CA, MBA 1 Risk vs Return There is a trade-off between risk and expected return No free lunch! The higher the risk, the higher the expected return To compensate/incentive investors to take the higher risk Treasury bill yield 5% vs investment in stock with Table 1.1 outcomes Table 1.1 Probability Return Expected return: 10% = 0.05*50% + 0.25*30% + … 0.05 +50% Accepting higher risk (ie. stock vs T-bill) requires higher return 0.25 +30% 0.40 +10% Risk-return trade-off yields CAPM and Arbitrage Pricing Theory 0.25 -10% 0.05 -30% Alicia Damley, CFA, CPA, CA 1-2 Quantifying Risk Can characterize investments by their expected return and standard deviation of return Example: for the equity investment Expected return = 10%, standard deviation of return = 18.97 Std deviation = , R = return per annum E(R) = 0.10 E(R2) = 0.05*0.502 + 0.25*0.302 + … = 0.046 Std deviation = Alicia Damley, CFA, CPA, CA 1-3 Quantifying Risk – 2 asset portfolio Combining two Risky investments: R1, w1, R2, w2 Expected portfolio return: Standard deviation: If 10%, , Table 1.2 shows p & p for a range of w1 and w2 Alicia Damley, CFA, CPA, CA 1-4 The Efficient Frontier of Risky Investments See Figure 1.3, page 6 E(RI) = (1- Alicia Damley, CFA, CPA, CA 1-5 The Efficient Frontier of All Investments See Figure 1.4, page 7 RF = 0, so (Eqn 1.2) Alicia Damley, CFA, CPA, CA 1-6 Systematic vs Non-systematic Risk Using historical data and regression analysis to determine best-fit linear relationship between returns from an investment and returns from market portfolio: R= Systematic risk Non-systematic risk (non-diversifiable (diversifiable) ie. market risk) Alicia Damley, CFA, CPA, CA 1-7 Capital Asset Pricing Model If (no systematic risk), R = RF If (all systematic risk), R = RM Capital asset pricing model: E(R) = RF + Equity risk premium Alicia Damley, CFA, CPA, CA 1-8 Assumptions Investors care only about expected return and std deviation of portfolio return (requires normal distribution of underlying return; no skewness or kurtosis) ’s of different investment are independent – investment returns are correlated with each other only because of their correlation with market portfolio Investors focus on returns over just one period. Length of the period same for all Investors can borrow and lend at same risk-free rate – not true for large FI vs investor Tax rate does not influence investment decisions Alicia Damley, CFA, CPA, CA 1-9 All investors make same estimates of expected return, std dev of returns and correlations between returns for available investments i.e. Alpha Alpha = excess return earned by the portfolio, above that predicted by CAPM E(RP) = RF + , so that = RP - RF + , where describes systematic risk Alpha can be generated by superior stock selection, market timing etc Weighted average alpha of all investors must be zero Alicia Damley, CFA, CPA, CA 1 - 10 Arbitrage Pricing Theory Extension of CAPM Returns depend on several factors – e.g. domestic interest rate, inflation rate etc Can form portfolio to eliminate dependence on the factors Results in expected return from an investment being linearly dependent on the factors Alicia Damley, CFA, CPA, CA 1 - 11 Risk vs Return for Companies Company should be managed in the best interest of its shareholders If shareholders care only about systematic risk, should company managers evaluate new projects on same basis? In practice, companies are concerned about total risk – systematic and non- systematic Earnings stability and company survival are important managerial objectives Regulators of FIs are primarily interested in total risk Alicia Damley, CFA, CPA, CA 1 - 12 Bankruptcy Costs Include lost sales, loss of key employees, (significant) legal and accounting costs “Bankruptcy costs” arguments show that managers may be acting in the best interests of shareholders when they consider total risk Projects with a high total risk are liable to be rejected as unacceptable Alicia Damley, CFA, CPA, CA 1 - 13 Risk Management by FIs Two broad risk management strategies: Risk decomposition – identify risks one by one and handle each separately Risk aggregation – reduce risks by being well-diversified i.e. eliminate non- systematic risk through sufficient diversification of business / operation In practice, banks use both approaches Alicia Damley, CFA, CPA, CA 1 - 14 Credit Ratings Measure of credit quality of a debt instrument. Cannot be higher than the credit rating of the issuer itself Moody’ S&P and 3 major credit rating agencies: s Fitch Aaa AAA S&P, Moody’s and Fitch Investment Aa AA grade A A Baa BBB Ba BB B B Non-Investment grade Caa CCC Ca CC Alicia Damley, CFA, CPA, CA 1 - 15 C C Chp 2: Banks Alicia Damley, CFA, CPA, CA, MBA 2 - 16 Nature of Banking Commercial banks Take deposits, make loans (wholesale or retail) Money center banks operate in the wholesale market Often fund loans by borrowing Investment banking Raise debt and equity for companies; advise on M&A, restructurings, trading etc. IPO: Best efforts vs firm commitment; Dutch auction Compare & contrast Canadian vs US banking sector Source: FDIC Statistics at a Glance, as of Mar 31, 2023 Alicia Damley, CFA, CPA, CA 2 - 17 Nature of Banking Sample Dutch auction: how are 1 million shares allocated based on the bids below? Bidder No. of Price ($) Shares A 100,000 30.00 B 200,000 28.00 C 50,000 33.00 D 300,000 29.00* E 150,000 30.50 F 300,000 31.50 G 400,000 25.00 H 200,000 30.25 Alicia Damley, CFA, CPA, CA 2 - 18 Nature of Banking Sample Dutch auction: how are 1 million shares allocated based on the bids below? Bidder No. of Price ($) Allocation Cumulative % Order Filled Shares Order Shares A 100,000 30.00 5 800,000 100% B 200,000 28.00 7 0% C 50,000 33.00 1 50,000 100% D 300,000 29.00* 6 1,000,000 66.7% * Price paid by all bidders to whom shares are E 150,000 30.50 3 500,000 100% allocated F 300,000 31.50 2 350,000 100% G 400,000 25.00 8 0% H 200,000 30.25 4 700,000 100% Alicia Damley, CFA, CPA, CA 2 - 19 Nature of Banking Potential conflicts of interest Bank recommends securities investment bank is trying to sell Commercial bank passes confidential information on a client to investment bank Stock recommended as a “Buy” to please company’s management in order to secure investment banking business Investment bank sells securities for a company so that commercial bank can get ride of a loan Alicia Damley, CFA, CPA, CA 2 - 20 Nature of Banking History of bank regulation in US McFadden Act (1927, 1933) Douglas Amendment (1956) Bank Holding Companies Act (1970) Riegel-Neal Interstate Banking and Branching Efficiency Act (1994) Alicia Damley, CFA, CPA, CA 2 - 21 Simplified Banking Balance Sheet as of December 31, 2022 CDN$ millions Assets Liabilities & S/H Equity Cash 5 Deposits 90 Marketable Securities 10 Subord L.T. Debt 5 Loans 80 Fixed Assets 5 Equity Capital 5 Total Assets 100 Total Liabilities & S/H Equity 100 Note: level of Equity capital supporting Total Assets; impact on RoE? Alicia Damley, CFA, CPA, CA 2 - 22 Simplified Banking Balance Sheet as of December 31, 2022 CDN$ millions Assets Liabilities & S/H Equity Cash 5 Deposits 94 Marketable Securities 10 Subord L.T. Debt 5 Loans 80 Fixed Assets 5 Equity Capital 1 Total Assets 100 Total Liabilities & S/H Equity 100 Note: in a more aggressive balance sheet, level of Equity capital supporting Total assets; impact on RoE? Impact on ability to sustain losses Alicia Damley, CFA, CPA, CA 2 - 23 Simplified Income Statement for the year ended December 31, CDN$ millions 2022 2023 Net interest income 3.0 3.0 Provision for loan losses (0.8) (4.0) Non-interest income 0.90 0.90 Non-interest expense (2.50) (2.50) Pre-tax operating income 0.60 (2.60) Income tax expense (0.15) Net income 0.45 Note: impact of worsening Provision for loan losses? on capital accumulation and stability of bank and banking system Alicia Damley, CFA, CPA, CA 2 - 24 Role of Regulation / External Oversight Regulators set minimum levels for the amount of capital bank is required to hold Types of capital: Tier 1, Tier 2, Tier 3 capital Equity is an example of Tier 1 capital Subordinated long-term debt is an example of Tier 2 capital How much is too little vs just right vs too much? Impact of current vs future economic conditions Alicia Damley, CFA, CPA, CA 2 - 25 Deposit Insurance Most countries have deposit insurance programs which offer protection against fixed level of losses CDIC: up to $100,000 ( https://www.cdic.ca/your-coverage/how-deposit-insurance-works/) CDIC: recent ad campaign to inform Canadians ( https://www.youtube.com/watch?v=Cmg9qEemVpA) FDIC: up to $250,000 (https://www.fdic.gov/resources/deposit-insurance/) Increased from $100,000 to $250,000 in Oct 2008 Relative importance of deposit insurance inversely correlated to economic conditions Deposit insurance and impact on bank to take risks? Alicia Damley, CFA, CPA, CA 2 - 26 Accounting Banking book vs trading book Under a new accounting (IFRS 9 and an FASB update) lenders have to estimate expected credit losses and subtract them from amount owed on loans Accounting evolves as business changes and new types of transactions are introduced Alicia Damley, CFA, CPA, CA 2 - 27 Originate-to-Distribute Model Very populate way of handling mortgages during 2000 – 2007 period Mortgage-backed securities (MBS) originally developed at 1970s Banks originated loans and then packaged them into products that were sold to investors Credit standards underlying loan book remain key Frees up funds (and capital backing loan book) to make more loans Alicia Damley, CFA, CPA, CA 2 - 28 Chp 3: Insurance Companies & Pension Plan Alicia Damley, CFA, CPA, CA, MBA 3 - 29 Life Insurance Types of life insurance Term life, whole life, variable life, universal life, endowment life, group life Expected cash flow to insurance company on a whole life policy (Male aged 40 yrs) Figures 3.1 15000 10000 5000 Year of Policy 0 Expected cash flow 0 10 20 30 40 50 60 -5000 -10000 -15000 -20000 -25000 -30000 -35000 Alicia Damley, CFA, CPA, CA 3 - 30 Life Insurance Investment of surplus in early years Some contracts allow policyholder to choose how surplus is invested Tax deferral advantages – policyholders and/or beneficiary Annuity contracts Typically lump sum payment used to buy lifetime annuity – risk transfer Can start immediately or be deferred Accumulation value can depend in complicated way on performance of investments May be penalty-free withdrawals Alicia Damley, CFA, CPA, CA 3 - 31 Life Insurance Mortality tables Basis of actuarial pricing Minimum premium approximates PV inflows = PV outflows Extract from US Mortality Tables (2019) Male Female Age Prob. death with 1- Prob. Life expectancy Prob. death with 1- Prob. Life expectancy year Survival (yrs) year Survival (yrs) 30 0.001798 0.97371 47.83 0.000811 0.98594 52.26 31 0.001860 0.97196 46.92 0.000872 0.98514 51.30 32 0.001926 0.97015 46.00 0.000933 0.98428 50.34 33 0.001994 Alicia Damley, CFA, CPA, CA 0.96828 45.09 0.000990 0.98336 49.39 3 - 32 Life Insurance Longevity derivatives Used by life insurance companies and pension funds Define population and coupon on bond depends on the number of members of population still alive Alicia Damley, CFA, CPA, CA 3 - 33 Non-Life (Property-Casualty) Insurance Property insurance: concerned with loss or damage to property from fire, theft, etc. Casualty (liability) insurance: concerned with legal liability exposures What are the biggest risks facing these insurers? Payout profile – amount and timing Alicia Damley, CFA, CPA, CA 3 - 34 CAT Bonds CATastrophe bonds – alternative to traditional reinsurance Bond issued by subsidiary of insurance company that pays higher-than- normal interest rate If claims of certain type are above a certain level, interest and possible principal on the bond are used to meet claims Alicia Damley, CFA, CPA, CA 3 - 35 Ratios for Non-Life Insurance Loss ratio 75% Expense ratio 30% Combined ratio 105% Dividends paid 1% Combined ratio after dividends 106% Investment income (9%) Ope Alicia Damley, CFA, CPA, CA 3 - 36 When do Premiums Change? Life insurance: typically remain same over life of contract Property-casualty insurance: change on contract renewal as risks are reassessed Health insurance: generally tied to health care cost inflation Mortality tables do not fluctuate over short time horizon Alicia Damley, CFA, CPA, CA 3 - 37 Moral Hazard and Adverse Selection Moral hazard: risk that existence of insurance policy causes policyholder to take more risk Adverse selection: tendency for insurance company to attract bad risks when it cannot perfectly distinguish between good and bad risks Alicia Damley, CFA, CPA, CA 3 - 38 Simplified Balance Sheet: Life Insurance As of year ended Dec 31, 202x CDN$ millions Assets Liabilities & S/H Equity Investments 90 Policy Reserves 80 Other assets 10 Sub L-T Debt 10 Equity Capital 10 Total Assets 100 Total Liabilities & S/H Equity 100 Alicia Damley, CFA, CPA, CA 3 - 39 Simplified Balance Sheet: P&C Insurance As of year ended Dec 31, 202x CDN$ millions Assets Liabilities & S/H Equity Investments 90 Policy Reserves 45 Other assets 10 Unearned premiums 15 Sub L-T Debt 10 Equity Capital 30 Total Assets 100 Total Liabilities & S/H Equity 100 Alicia Damley, CFA, CPA, CA 3 - 40 Regulation US and Canada: mostly at state / provincial level Europe: mostly at EU level Alicia Damley, CFA, CPA, CA 3 - 41 Pension Plans Defined benefit plan Contributions are pooled Benefits determined by formulas usually dependent on final salary of employee and number of years of service Defined contribution plan Contributions for each employee are kept separate and invested on behalf of the employee On retirement, accumulated value of the contributions usually converted to an annuity Alicia Damley, CFA, CPA, CA 3 - 42 Pension Plans Defined benefit plan Actuarial estimate of liabilities and corresponding calculations of plan surplus or deficit Discount rate used for private plans is AA borrowing rate Deficits must be funded by the company within a prescribed period A perfect storm: ↓ equity prices coupled with ↓ interest rates Plan viability: Employer + employee contributions 15% of salary; actuarial estimates should ~25% of salary is necessary for most plans Typical investment mix of 60% equities relies on good equity market return Risk sharing of equity returns by DB members i.e. employees? Alicia Damley, CFA, CPA, CA 3 - 43 Chp 4: Fund Managers Alicia Damley, CFA, CPA, CA, MBA 4 - 44 Open-End vs Closed-End Mutual Funds US mutual fund investments have grown from $0.5 bn in 1940 to >$33 tn in 2023 Open-ended fund: most common type of fund Numbers of shares in fund goes up as investors buy more shares, down as shares redeemed Net asset value (NAV): fund value / number of shares All purchases and sales of shares are at 4pm NAV Mutual fund types: equity, bond, hybrid, money market, index Costs: annual fee, front load, back load; relatively low in US; varies by country (see Table 4.2) Closed-end fund: Consists of fixed number of shares that are traded in the same way as company shares Share price tends to be < NAV based on MV of investments Alicia Damley, CFA, CPA, CA 4 - 45 Exchange-Traded Funds (ETFs) Often designed to track an index Setup by an institutional investor that deposits a block of securities and obtains shares in fund Shares traded on an exchange (similar to equity shares) Large institutional investors can exchange shares in fund for underlying assets and vice versa This keep share price close to NAV of fund’s investments Alicia Damley, CFA, CPA, CA 4 - 46 ETFs vs Open- and Closed-End Mutual Funds Can be bought or sold (i.e. shorted) at any time of day Holdings are disclosed twice a day Investments do not have to be sold to cover redemptions Share price close to NAV of underlying investments Alicia Damley, CFA, CPA, CA 4 - 47 Performance of Mutual Funds Classic study by Jensen (1969) whose results have been confirmed in later studies Average alpha (outperformance) of all funds before expenses is ~0 Past performance by a No. of Consecutive fundNumber Years manager is not a good of Observations guide to for Observations future which of Positive Alpha performance Next Alpha is Positive (%) 1 574 50.4 2 312 52.0 3 161 53.4 4 79 55.8 5 41 46.4 Alicia Damley, CFA, CPA, CA 6 17 35.3 4 - 48 Mutual Fund Scandals Late trading Market timing Front running Directed brokerage Alicia Damley, CFA, CPA, CA 4 - 49 Hedge Funds (Alternative Investments) Mutual funds are restricted because: Shares must be redeemable at any time NAV must be calculated daily Investment policies must be disclosed Use of leverage is limited Hedge funds are not subject to these restrictions Alicia Damley, CFA, CPA, CA 4 - 50 Hedge Funds (Alternative Investments) Fees: Typical fee structure: 2 + 20% Lock-up period may be applicable Other features: hedge rates, high-water marks, clawbacks Manager incentives: Incentive component gives manager call option on each year’s fund performance Consequently, incentivized to take high risk Should manager choose investment with 0.4 probability of 60% profit or 0.6 probability of 60% loss? Types of strategies: long/short, dedicated short, distressed securities, merger arbitrage, convertible arbitrage, FI arbitrage, emerging markets, global macro, managed futures Alicia Damley, CFA, CPA, CA 4 - 51 Other Notable Points Fund of Funds Portfolios of hedge funds Typical fee 1 + 10%, but is now lower Prime Brokers Handle hedge fund trades Determine maximum leverage and collateral requirements Borrow securities when hedge fund has a short position Large hedge funds typically use more than one prime broker Risks that hedge funds can take are to some extent controlled by their prime brokers Alicia Damley, CFA, CPA, CA 4 - 52 Hedge Fund Returns Barclays hedge fund index: hedge funds have not outperformed market in most years Many hedge funds have low betas and therefore cannot be expected to outperform when market is doing well However, statistics may bias hedge fund performance upward because only funds that choose to report returns are included in statistics i.e. self-selection bias Alicia Damley, CFA, CPA, CA 4 - 53