Formulae

Final Examination

Fixed Income Valuation and Analysis

Derivatives Valuation and Analysis

Portfolio Management

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 Table of Contents

1. Fixed Income Valuation and Analysis 1

1.1 Time Value of Money ...................................................................................1
1.1.1 Time Value of Money ......................................................................................... 1
1.1.2 Bond Yield Measures......................................................................................... 2
1.1.3 Term Structure of Interest Rates .................................................................... 3
1.1.4 Bond Price Analysis .......................................................................................... 4
1.1.5 Risk Measurement .............................................................................................. 6
1.2 Convertible Bonds ........................................................................................8
1.2.1 Investment Characteristics .............................................................................. 8
1.3 Callable Bonds ..............................................................................................9
1.3.1 Valuation and Duration ..................................................................................... 9
1.4 Fixed Income Portfolio Management Strategies ..................................9
1.4.1 Passive Management......................................................................................... 9
1.4.2 Computing the Hedge Ratio: The Modified Duration Method ............... 10

2. Derivative Valuation and Analysis 11

2.1 Financial Markets and Instruments .......................................................11
2.1.1 Related Markets ................................................................................................ 11
2.2 Analysis of Derivatives and Other Products .......................................13
2.2.1 Futures ................................................................................................................ 13
2.2.2 Options ................................................................................................................ 16
2.2.3 Standard Normal Distribution: Table for CDF ........................................... 24

3. Portfolio Management 25
3.1 Modern Portfolio Theory ...........................................................................25
3.1.1 The Risk/Return Framework .......................................................................... 25
3.1.2 Measures of Risk .............................................................................................. 27
3.1.3 Portfolio Theory ................................................................................................ 29
3.1.4 Capital Asset Pricing Model (CAPM) ........................................................... 30
3.1.5 Arbitrage Pricing Theory (APT) .................................................................... 32
3.2 Practical Portfolio Management .............................................................34
3.2.1 Managing an Equity Portfolio ........................................................................ 34
3.2.2 Derivatives in Portfolio Management .......................................................... 37
3.3 Asset/Liability-Analysis and Management...........................................43
3.3.1 Valuation of Pension Liabilities .................................................................... 43
3.3.2 Surplus And Funding Ratio ........................................................................... 43
3.3.3 Surplus Risk Management ............................................................................. 44
3.4 Performance Measurement ......................................................................46
3.4.1 Performance Measurement and Evaluation .............................................. 46

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 Fixed Income Valuation and Analysis

1. Fixed Income Valuation and Analysis

1.1 Time Value of Money

1.1.1 Time Value of Money

1.1.1.1 Present and Future Value

Simple Discounting and Compounding

Future value
Present value =
( 1  Interest rate p.a.) numberof years

Future value = (Present value)  (1  Interest rate p.a.)numberof years

1.1.1.2 Annuities
The present value of an annuity is given by

N CF CF  1 
Pr esent value     1  
t 1 ( 1  R )t R  (1  R )N 
 

where
CF constant cash flow
R discount rate, assumed to be constant over time
N number of cash flows

The future value of an annuity is given by

 (1  R ) N  1
Future value  CF   
 R 
 

where
CF constant cash flow
R discount rate, assumed to be constant over time
N number of cash flows

1.1.1.3 Continuous Discounting and Compounding

Future value
Present value = numberof years  continuousinterest rate p.a.
e

Future value = (Present value)  e numberof years  continuousinterest rate p.a.

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1.1.2 Bond Yield Measures

1.1.2.1 Current Yield

Annual coupon
Current yield 
Price

1.1.2.2 Yield to maturity

The bond price as a function of the yield to maturity is given by
N CFi CF1 CF2 CF N
P0      ... 
i 1 1  Y  ti
1  Y  t1
1  Y  t2
1  Y  t N
where
Y yield to maturity
P0 current paid bond price (including accrued interest)
CFi cash flow (coupon) received at time t i
CFN cash flow (coupon plus principal) received at repayment date t N
N number of cash flows

Between two coupon dates, for a bond paying coupons annually, the bond price
is given by

 CF1 CF2 CFN 

Pcum, f  Pex, f  f  C  1  Y  f   ... 
 1  Y  1  Y 2 1  Y N 
1

where
Pcum, f current paid bond price (including accrued interest)
Pex, f quoted price of the bond
Y yield to maturity
f time since last coupon date in years
CFi cash flow (coupon) received at time t i
CF N final cash flow (coupon plus principal)
N number of cash flows

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1.1.2.3 Yield to Call

N CFi CF1 CF2 CFN
P0      ... 
i 1 1  Yc  ti
1  Yc  t1
1  Yc  t2
1  Yc  t N
where
P0 current paid bond price (including accrued interest)
Yc yield to call
CFi cash flow (coupon) received at time t i
CFN cash flow (coupon plus principal) received at call date t N
N number of cash flows until call date

1.1.2.4 Relation between Spot Rate and Forward Rate

1
1  R0,t   1  R0,1   1  F1,2   1  F2,3 ...1  Ft 1,t  t
where
R0 ,t spot rate p.a. from 0 to t
R0,1 spot rate p.a. from 0 to 1
Ft 1,t forward rate p.a. from t  1 to t

1  R0,t  t  (1  Ft ,t  t 
 1  R0,t t 2  t2 t1
t2 t1
 1  R0,t2  Ft1 ,t2  2  1
 t
1 ) 2
1 1 2  1 R 1 
 0,t1 

where
R0 ,t1 spot rate p.a. from 0 to t1
R0 ,t 2 spot rate p.a. from 0 to t 2
Ft1 ,t 2 forward rate p.a. from t 1 to t 2

1.1.3 Term Structure of Interest Rates

1.1.3.1 Theories of Term Structures

Expectations hypothesis

~
Ft1 ,t2  E( Rt1 ,t2 )

where
Ft1 ,t2 forward rate from t 1 to t 2
~
Rt1 ,t2 random spot rate from t 1 to t 2
E(.) expectation operator

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Liquidity Preference Theory

~
Ft1,t2  E(Rt1,t2 )  Lt1,t2 , Lt1,t2  0
where
Ft1 ,t2 forward rate from t 1 to t 2
~
Rt1 ,t2 random spot rate from t 1 to t 2
Lt1 ,t2 liquidity premium for the time t 1 to t 2
E(.) expectation operator

Market Segmentation Theory

~ 0
Ft1,t2  E(Rt1,t2 )   t1,t2 ,  t1,t2 

where
Ft1 ,t2 forward rate from t 1 to t 2
~
Rt1 ,t2 random spot rate from t 1 to t 2
 t ,t
1 2
risk premium for the time from t 1 to t 2
E(.) expectation operator

1.1.4 Bond Price Analysis

1.1.4.1 Yield Spread Analysis

Relative Yield Spread

Yield bond B - Yield bond A
Relative yield spread 
Yield bond A

Yield Ratio

Yield bond B
Yield ratio 
Yield bond A

1.1.4.2 Valuation of Coupon Bonds using Zero-Coupon Prices

Valuation of Zero-Coupon Bonds

CFt
P0 
1  Rt  t
where
P0 bond price at time 0
CFt cash flow (principal) received at repayment date t
Rt spot rate from 0 to t

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Valuation of Coupon-Bearing Bonds

N CFi CF1 CF2 CFN
P0     ...
i 1 1  Ri  ti
1  R1  t1
1  R2  t2
1  R N  t N
where
P0 bond price at time 0
CFi cash flow (coupon) received at time t i
CF N cash flow (coupon plus principal) received at repayment date t N
Ri spot rate from 0 to t i
N number of cash flows

Price with accrued interest of a bond paying yearly coupons

N CFi
Pcum, f  Pex, f  f  C  
i 1 1  Rt  t  f
i
i

where
Pcum, f price of the bond including accrued interest
Pex, f quoted price of the bond
f time since the last coupon date in fractions of a year
CFi cash flow at time ti
Rti spot rate from f to ti
C coupon

Valuation of Perpetual Bonds

CF
P0 
R

where
P0 current price of the perpetual bond
CF perpetual cash flow (coupon)
R discount rate, assumed to be constant over time

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1.1.5 Risk Measurement

1.1.5.1 Duration and Modified Duration

Macaulay’s Duration
N t i  CFi t1  CF1 t 2  CF2 t N  CF N
   ... 
N t i  PV( CFi ) i 1 1  Y ti
1  Y t1
1  Y t2
1  Y t N
D  P
 N CFi

CF1 CF2 CF N
i 1
   ... 
i 1 1  Y ti
1  Y  t1
1  Y  t2
1  Y t N
where
D Macaulay’s duration
P current paid bond price (including accrued interest)
Y bond’s yield to maturity
CFi cash flow (coupon) received at time ti
PV(CFi) present value of cash flow CFi
CF N cash flow (coupon plus principal) received at repayment date t N
N number of cash flows

Macaulay’s Duration of a perpetual bond

1
Macaulay Duration of a perpetual bond  1
Bond ' s yield

Modified and Price Duration

1 P D
D mod   
P Y 1  Y
 P D
DP    D mod  P  P
Y 1 Y

where
D mod modified duration
DP price or dollar duration
D Macaulay’s duration
P current paid bond price (including accrued interest)
Y bond’s yield to maturity

Price Change Approximated with Duration

D
P   P Y   D mod  P Y   D P  Y
1  Y 
P D  DP
  Y   D mod  Y   Y
P 1  Y  P

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where
P price change of the bond
mod
D modified duration
DP price or dollar duration
D Macaulay’s duration
P current paid bond price (including accrued interest)
Y bond’s yield to maturity
Y small change in the bond yield

Portfolio Duration
N
D P   xi  Di
i 1
where
DP portfolio duration
xi proportion of wealth invested in bond i
Di duration of bond i
N number of bonds in the portfolio

1.1.5.2 Convexity
1  2P 1 1 N
t i (t i  1)  CFi
2 
C    
P Y 2 N
CFi (1  Y ) i 1 1  Y ti
 1  Y 
i 1
ti

CP  C  P
where
C convexity
P
C price convexity
P current paid bond price (including accrued interest)
Y bond’s yield to maturity
CFi cash flow (coupon) received at time ti
CF N cash flow (coupon plus principal) received at repayment date t N

Price change approximated with duration and convexity

1 P
P   D P  Y  C  Y 2
2
P D 1 1
  Y  C Y 2   D mod  Y  C  Y 2
P 1  Y  2 2

where
P price change of the bond
mod
D modified duration
DP price or dollar duration
D Macaulay’s duration
C convexity
CP price convexity
P current paid bond price (including accrued interest)
Y bond’s yield to maturity
Y Small change in the bond yield

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Portfolio Convexity
N
Portfolio convexity   wi  Ci
i 1
where
wi weight (in market value terms) of bond i in the portfolio
Ci convexity of bond i
N number of bonds in the portfolio

1.2 Convertible Bonds

1.2.1 Investment Characteristics

Conversion ratio = Number of shares if one bond is converted

Face value of the convertible bond

Conversion price =
Number of shares per bond (if there is a conversion)

Conversion value = Conversion ratio  Market price of stock

Market price of bond - Conversion value

Conversion premium (in %) =
Conversion value

1.2.1.1 Payback Analysis

(MPCV)/CV Conversion premium

PP  
(CY  DY) (CY  DY)

where
PP payback period in years
MP market price of the convertible
CV conversion value of the convertible
CY current yield of the convertible = (coupon/MP)
DY dividend yield on the common stock = dividend amount / stock price

1.2.1.2 Net Present Value Analysis

CP FV FV  ( Ync  Yc )
NPV  
( 1Ync ) n
( 1Ync )t

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where
NPV net present value
CP call price
FV face value
Ync yield on non-convertible security of identical characteristics
Yc yield on the convertible security
n years before the convertible is called

1.3 Callable Bonds

1.3.1 Valuation and Duration

1.3.1.1 Determining the Call Option Value

Callable bond price = Call-free equivalent bond price – Call option price

1.3.1.2 Effective Duration and Convexity

Call adjusted Price call free  Duration of 

=     1   
duration Price callable  call - free bond 
  Price of   Duration of 
2

Call adjusted Price call free  Convexity of      
=     1      call - free     call - free  
Convexity Price callable  call - free bond   bond   bond  
     

where
 Delta of the call option embedded in the bond
 Gamma of the call option embedded in the bond

1.4 Fixed Income Portfolio Management Strategies

1.4.1 Passive Management

1.4.1.1 Immunisation
AL
DA  DL
A  DA  L  DL
where
A present value of the portfolio
L present value of the debt
DA duration of the portfolio
DL duration of the debt

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1.4.2 Computing the Hedge Ratio: The Modified Duration Method

 S S  DSmod
HR =  S ,F   t
 F Ft ,T  DFmod

N S  S t  DSmod N S  S t  DSmod
NF     CFCTD ,t
k  Ft ,T  DFmod k  S CTD ,t  DFmod

where
HR hedge ratio
St spot price at time t
Ft,T futures price at time t with maturity T
S ,F correlation coefficient between S and F
 S standard deviation of S
 F standard deviation of F
CTD cheapest-to-deliver
DSmod modified duration of the asset being hedged
DFmod modified duration of the futures (i.e. of the CTD)
NF number of futures contracts
NS number of the spot asset to be hedged
k contract size
SCTD,t spot price of the CTD
CFCTD,t conversion factor of the CTD

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2. Derivative Valuation and Analysis

2.1 Financial Markets and Instruments

2.1.1 Related Markets

2.1.1.1 Swaps

Interest rate swap

The swap value for the party that receives fix may be expressed as
V  B1  B2
where
V value of the swap
B1 value of the fixed rate bond underlying the swap
B2 value of the floating rate bond underlying the swap

B1 is the present value of the fixed bond cash flows

n K Q
B1   
ti
i 1 (1  R0,ti ) (1  R0,tn ) tn

where
B1 value of the fixed rate bond underlying the swap
K fixed payment corresponding to the fixed interest to be paid at time t i
Q notional principal in the swap agreement
R0, t i spot interest rate corresponding to maturity t i

When entering in the swap and immediately after a coupon rate reset date, the
value of bond B2 is equal to the notional amount Q . Between reset dates, the
value is

K* Q
B2  
(1  R0,t1 ) t1
(1  R0,t1 ) t1

where
B2 value of the floating rate bond underlying the swap
K * floating amount (initially known) used for the payment at date t1 , the next
reset date.
Q notional principal in the swap agreement
R0 ,t1 spot interest rate corresponding to maturity t1

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Cross Currency Interest Rate Swap

The swap value may be expressed as

V  S  BF  B D

where
V value of the swap
S spot rate in domestic per foreign currency units
B F value of the foreign currency bond in the swap, denoted in the foreign
currency
B D value of the domestic bond in the swap, denoted in the domestic currency

2.1.1.2 Credit Default Swaps (CDS)

CDS contingent payment

The payment in case of default to the buyer of the CDS may be expressed as

N  1  R 
where
N Notional amount of the CDS
R Recovery rate of the reference bond

Default probabilities

The probability of defaulting between t i 1 to t i is

p1  p2  ...  pi 1   1  pi 
where
p i Probability of surviving over the interval t i 1 to t i without a default payment
1  p i Probability of a default being triggered

CDS Evaluation

The theoretical CDS spread s is obtained by equating:

Present Value of expected payments = Present Value of expected payoffs

where
Present Value of expected payment =
T

 Probabilit y of survival · Payment · discount factor

t 1
t t t +
T

 Probabilit y of default
t 1
t · accrual payment in case of default t · discount factort

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and

Present Value of expected payoffs =

T

 Probabilit y of default
t 1
t · (1 - Recovery Rate t ) · discount factort

2.2 Analysis of Derivatives and Other Products

2.2.1 Futures

2.2.1.1 Theoretical Price of Futures

Pricing Futures on Assets that Provide no Income

Ft ,T  S t ( 1  Rt ,T )T t

where
Ft ,T futures price at date t of a contract for delivery at date T
St spot price of the underlying at date t
Rt ,T risk-free interest rate for the period t to T

General Cost of Carry Relationship

Ft ,T  St ( 1  Rt ,T )T t  k( t , S )  FV ( revenues )

where
Ft ,T forward or futures price at date t of a contract for delivery at date
T
St spot price of the underlying at date t
Rt ,T risk-free interest rate for the period t to T
k (t , S ) carrying costs, such as insurance costs, storage costs, etc.
FV(revenues) future value of the revenues paid by the spot

Continuous Time Cost of Carry Relationship

( rt ,T  y )(T t )
Ft ,T  St e

where
Ft ,T futures price at date t of a contract for delivery at date T
St spot price of the underlying at date t
y continuous net yield (revenues minus carrying costs) of the underlying asset
or commodity
rt ,T continuously compounded risk-free interest rate

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Stock Index Futures

N T T t j
Ft ,T  I t  ( 1  Rt ,T )T t    wi  Di ,t j  ( 1  Rt j ,T )
i 1 t j 1

where
Ft ,T futures price at date t of a contract that expires at date T
It current spot price of the index
Di,t j dividend paid by stock i at date tj
wi weight of stock i in the index
Rt ,T risk-free interest rate for the period t to T
Rt j ,T interest rate for the time period tj until T
N the number of securities in the index

Interest Rates Future Cost of Carry Relationship

( St  At )  ( 1  Rt ,T )T  t  Ct ,T  AT
Ft ,T 
Conversion Factor
where
Ft ,T quoted futures “fair” price at date t of a contract for delivery at date T
C t ,T future value of all coupons paid and reinvested between t and T
S t spot value of the underlying bond
At accrued interest of the underlying at time t
Rt ,T risk-free interest rate for the period t to T
AT accrued interest of the delivered bond at time T

Theoretical Futures at the Delivery Date

spot price of cheapest to deliver

FT,T 
conversion factor

Forward Exchange Rates

T t
 1  Rdom 
Ft ,T  S t  
 1  R for 
 
with continuous compounding
Ft ,T  S t e
rdom rfor (T t )
where
Ft ,T forward exchange rate (domestic per foreign currency)
St spot exchange rate (domestic per foreign currency)
Rdom domestic risk-free rate of interest for the period t to T
R for foreign risk-free rate of interest for the period t to T

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rdom continuous domestic risk-free rate of interest for t to T

r for continuous foreign risk-free rate of interest for t to T

Commodity Futures
Ft ,T  St  (1  Rt ,T )  k (t , T )  Yt ,T
where
Ft,T futures price at date t of a contract for delivery at date T
St spot price of the underlying at date t
Rt,T risk-free interest rate for the period (T – t)
k(t,T) carrying costs, such as insurance costs, storage costs, etc.
Yt,T convenience yield

2.2.1.2 Hedging Strategies

The Hedge Ratio

S N k NS
HR   F N F   HR 
F NS k

where
HR hedge ratio
S change in spot price per unit
F change in futures price per unit
NF number of futures
NS number of spot assets
k contract size

The Perfect (Naive) Hedge

 HR  1

 NS
 N F   k

where
HR hedge ratio
NF number of futures
NS number of spot assets
k contract size

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Minimum Variance Hedge Ratio

- Hedged Profit
For a long position in the underlying asset
Hedged profit  ST  St   FT ,T  Ft ,T 

where
ST spot price at the maturity of the futures contract
St spot price at time t
FT ,T futures price at its maturity
Ft ,T futures price at time t with maturity T

- Minimum Variance Hedge Ratio

Cov(S , F ) 
HR    S , F  S
Var (F )  F

where
HR hedge ratio
Cov(S,F) covariance between the changes in spot price (S) and the changes
in futures price (F)
Var(F) variance of changes in futures price (F)
S,F coefficient of correlation between S and F
S standard deviation of S
F standard deviation of F

2.2.2 Options

2.2.2.1 Determinants of Option Price

Put-Call Parity for European and American Options

PE  C E  S  D  Ke r
CUS  S  Ke r  PUS  CUS  S  K  D
where
 time until expiry of the option
K strike or exercise price of the option
r continuously compounded risk-free rate of interest
S spot price of the underlying
CE value of European call option
PE value of European put option
CUS value of American call option
PUS value of American put option
D present value of expected cash-dividends during the life of the option

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2.2.2.2 Option Pricing Models

Black and Scholes Option Pricing Formula

The prices of European Options on Non-Dividend Paying Stocks

C E  S  N (d1 )  Ke r  N (d 2 )

PE  Ke r  N (d 2 )  S  N (d1 )

ln S / K   (r   2 / 2)
d1  , d 2  d1   
 
where
CE value of European call
PE value of European put
S current stock price
 time in years until expiry of the option
K strike price
 volatility p.a. of the underlying stock
r continuously compounded risk-free rate p.a.
N(  ) cumulative distribution function for a standardised normal random
variable
(see table in 2.2.3), and
s2
1 2
x
N ( x)   e ds
 2

European Option on Stocks Paying Known Dividends

C E  S *  N (d1* )  Ke r  N (d 2* )

PE  Ke r  N (d 2* )  S *  N (d1* )

d1* 
 
ln S * / K  (r   2 / 2) I
, d 2*  d1*    , S *  S   Di  e  r i
  i 1
where
CE value of European call
PE value of European put
i time in years until i th dividend payment
Di dividend i
S current stock price
 time in years until expiry of the option
K strike price
 volatility p.a. of the underlying stock
r continuously compounded risk-free rate p.a.
I number of dividend payments
N(  ) cumulative normal distribution function (see table in 2.2.3)

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European Option on Stocks Paying Unknown Dividends

When dividends are unknown, a common practice is to assume a constant
dividend yield y. Then
C E  S  e  y  N (d1 )  Ke r  N (d 2 )
PE  Ke r  N (d 2 )  S  e  y  N (d1 )
ln S / K   (r  y   2 / 2)
d1  , d 2  d1   
 
where
CE value of European call
PE value of European put
y continuous dividend yield
S current stock price
 time in years until expiry of the option
K strike price
 volatility p.a. of the underlying stock
r continuously compounded risk-free rate p.a.
N(  ) cumulative normal distribution function (see table in 2.2.3)

Options on Stock Indices

 J I  r  
C E   S    D j ,i  e j ,i  N ( d1 )  K  e  r   N ( d 2 )
 j 1i 1 

 J I  r  
PE  K  e  r   N ( d 2 )   S    D j ,i  e j ,i   N ( d1 )
 j 1i 1 

 J I  r  
 S t    D j ,i  e j ,i 
 j 1i 1 
ln 
 K  e r  
  1
d1         and d  d    
2 1
  2

where
CE price of the European call at date t
PE price of the European put at date t
S price of the index at date t
K strike price
r continuously compounded risk-free rate p.a.
 standard deviation of the stock index instantaneous return
Dj,i dividend paid at time ti by company j weighted as the company in the
index
 time in years until expiry of the option
j,i time remaining until the dividend payment at time ti by company j
N(  ) cumulative normal distribution function (see table in 2.2.3)

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Options on Futures

C E  e r F  N (d1 )  K  N (d 2 )

PE  e r K  N (d 2 )  F  N (d1 )

ln F / K  1
d1     , d 2  d1   
  2
where
CE value of European call
PE value of European put
F current futures price
 time in years until expiry of the option
K strike price
 volatility p.a. of the futures returns
r continuously compounded risk-free rate p.a.
N(  ) cumulative normal distribution function (see table in 2.2.3)

Options on Currencies
r for 
CE  S  e  N (d1 )  Ke  r  N (d 2 )
r for 
PE  Ke  r  N (d 2 )  S  e  N (d1 )
ln S / K   (r  r for   2 / 2)
d1  , d 2  d1   
 
where
CE value of European call
PE value of European put
S current exchange rate (domestic per foreign currency units)
 time in years until expiry of the option
K strike price (domestic per foreign currency units)
 volatility p.a. of the underlying foreign currency
r continuously compounded risk-free rate p.a.
r for continuously compounded risk-free rate p.a. of the foreign currency
N(  ) cumulative normal distribution function (see table in 2.2.3)

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Binomial Option Pricing Model

The option price at the beginning of the period is equal to the expected value of
the option price at the end of the period under the probability measure  ,
discounted with the risk-free rate.
Ou    Od  (1   )
O
1 R
1 R  d
, u  e  / n , d  , d  1  R  u
1

ud u
where

O value of the option at the beginning of the period

R simple risk-free rate of interest for one period
Ou value of the option in the up-state at the end of the period
Od value of the option in the down-state at the end of the period
 volatility of the underlying returns
 time until expiry of the option
n number of periods  is divided in
u upward factor of the underlying
d downward factor of the underlying
 risk neutral probability

2.2.2.3 Sensitivity Analysis of Option Premiums

The Strike Price

C C
  e  r   N ( d 2 ) (  0)
K K
P P
 e  r   N (  d 2 ) (  0)
K K

lnS / K   ( r   2 / 2 )
d2 
 
where
C value of call option
P value of put option
S current price of the underlying
K strike price
 volatility p.a. of the underlying returns
 time in years until expiry of the option
r continuously compounded risk-free rate p.a.
N (  ) cumulative distribution function (see table in 2.2.3)

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Price of the Underlying Asset (delta (  ) and gamma (  ))

C
c   N (d1 ) (0   c  1)
S
P
P   N (d1 )  1 (1   P  0)
S
 2C n(d1 )
C   (C  0)
S 2 S    
2P n(d1 )
P    C (P  0)
S 2 S   

lnS / K   ( r   2 / 2 )
d1 
 
where
C value of call option
P value of put option
S current price of the underlying
 time in years until expiry of the option
 volatility p.a. of the underlying returns
r continuously compounded risk-free rate p.a.
N (  ) cumulative distribution function (see table in 2.2.3)
n(x) probability density function:
x2
1 
n( x )  N ' ( x )  e 2
2

The Leverage or Elasticity of the Option with respect to S (omega,  )

C S P S
C   P  
S C S P

where
C elasticity of a call
P elasticity of a put
C current value of call option
P current value of put option
S current price of the underlying

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The Time to Maturity (theta,  )

C C S 
C     n(d1 )  K  r  e  r N (d 2 ) ( C  0)
t  2 
P P S 
P     n(d1 )  K  r  e  r N (d 2 )  1
t  2 
lnS / K   ( r   2 / 2 )
d1  , d 2  d1   
 
where
C value of call option
P value of put option
S current price of the underlying
K strike price
 time in years until expiry of the option
r continuously compounded risk-free rate p.a.
 volatility p.a. of the underlying returns
N (  ) cumulative distribution function (see table in 2.2.3)
n(x) probability density function (see formula 0 for definition)

Interest Rate (rho,  )

C
C   K    e  r   N (d 2 ) (  C  0)
r
P
P   K    e  r   ( N (d 2 )  1) (  P  0)
r
lnS / K   ( r   2 / 2 )
d2 
 
where
C value of call option
P value of put option
S current price of the underlying
K strike price
 time in years until expiry of the option
 volatility p.a. of the underlying returns
r continuously compounded risk-free rate p.a.
N (  ) cumulative distribution function (see table in 2.2.3)

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Volatility of the Stock Returns (vega,  )

C
C   S    n( d1 ) ( C  0 )

P
P   S    n( d1 )   C ( P  0 )


lnS / K   ( r   2 / 2 )
d1 
 

where
C value of call option
P value of put option
S current price of the underlying
K strike price
 time in years until expiry of the option
 volatility p.a. of the underlying returns
r continuously compounded risk-free rate p.a.
n(x) probability density function (see formula 0 for definition)

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2.2.3 Standard Normal Distribution: Table for CDF

Numerically defines function N(x): probability that a standard normal random
variable is smaller than x. Property of N(x): N(-x)=1-N(x).

x 0 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09

0.0 0.5000 0.5040 0.5080 0.5120 0.5160 0.5199 0.5239 0.5279 0.5319 0.5359
0.1 0.5398 0.5438 0.5478 0.5517 0.5557 0.5596 0.5636 0.5675 0.5714 0.5753
0.2 0.5793 0.5832 0.5871 0.5910 0.5948 0.5987 0.6026 0.6064 0.6103 0.6141
0.3 0.6179 0.6217 0.6255 0.6293 0.6331 0.6368 0.6406 0.6443 0.6480 0.6517
0.4 0.6554 0.6591 0.6628 0.6664 0.6700 0.6736 0.6772 0.6808 0.6844 0.6879
0.5 0.6915 0.6950 0.6985 0.7019 0.7054 0.7088 0.7123 0.7157 0.7190 0.7224
0.6 0.7257 0.7291 0.7324 0.7357 0.7389 0.7422 0.7454 0.7486 0.7517 0.7549
0.7 0.7580 0.7611 0.7642 0.7673 0.7704 0.7734 0.7764 0.7794 0.7823 0.7852
0.8 0.7881 0.7910 0.7939 0.7967 0.7995 0.8023 0.8051 0.8078 0.8106 0.8133
0.9 0.8159 0.8186 0.8212 0.8238 0.8264 0.8289 0.8315 0.8340 0.8365 0.8389
1.0 0.8413 0.8438 0.8461 0.8485 0.8508 0.8531 0.8554 0.8577 0.8599 0.8621
1.1 0.8643 0.8665 0.8686 0.8708 0.8729 0.8749 0.8770 0.8790 0.8810 0.8830
1.2 0.8849 0.8869 0.8888 0.8907 0.8925 0.8944 0.8962 0.8980 0.8997 0.9015
1.3 0.9032 0.9049 0.9066 0.9082 0.9099 0.9115 0.9131 0.9147 0.9162 0.9177
1.4 0.9192 0.9207 0.9222 0.9236 0.9251 0.9265 0.9279 0.9292 0.9306 0.9319
1.5 0.9332 0.9345 0.9357 0.9370 0.9382 0.9394 0.9406 0.9418 0.9429 0.9441
1.6 0.9452 0.9463 0.9474 0.9484 0.9495 0.9505 0.9515 0.9525 0.9535 0.9545
1.7 0.9554 0.9564 0.9573 0.9582 0.9591 0.9599 0.9608 0.9616 0.9625 0.9633
1.8 0.9641 0.9649 0.9656 0.9664 0.9671 0.9678 0.9686 0.9693 0.9699 0.9706
1.9 0.9713 0.9719 0.9726 0.9732 0.9738 0.9744 0.9750 0.9756 0.9761 0.9767
2.0 0.9772 0.9778 0.9783 0.9788 0.9793 0.9798 0.9803 0.9808 0.9812 0.9817
2.1 0.9821 0.9826 0.9830 0.9834 0.9838 0.9842 0.9846 0.9850 0.9854 0.9857
2.2 0.9861 0.9864 0.9868 0.9871 0.9875 0.9878 0.9881 0.9884 0.9887 0.9890
2.3 0.9893 0.9896 0.9898 0.9901 0.9904 0.9906 0.9909 0.9911 0.9913 0.9916
2.4 0.9918 0.9920 0.9922 0.9925 0.9927 0.9929 0.9931 0.9932 0.9934 0.9936
2.5 0.9938 0.9940 0.9941 0.9943 0.9945 0.9946 0.9948 0.9949 0.9951 0.9952
2.6 0.9953 0.9955 0.9956 0.9957 0.9959 0.9960 0.9961 0.9962 0.9963 0.9964
2.7 0.9965 0.9966 0.9967 0.9968 0.9969 0.9970 0.9971 0.9972 0.9973 0.9974
2.8 0.9974 0.9975 0.9976 0.9977 0.9977 0.9978 0.9979 0.9979 0.9980 0.9981
2.9 0.9981 0.9982 0.9982 0.9983 0.9984 0.9984 0.9985 0.9985 0.9986 0.9986
3.0 0.9987 0.9987 0.9987 0.9988 0.9988 0.9989 0.9989 0.9989 0.9990 0.9990
3.1 0.9990 0.9991 0.9991 0.9991 0.9992 0.9992 0.9992 0.9992 0.9993 0.9993
3.2 0.9993 0.9993 0.9994 0.9994 0.9994 0.9994 0.9994 0.9995 0.9995 0.9995
3.3 0.9995 0.9995 0.9995 0.9996 0.9996 0.9996 0.9996 0.9996 0.9996 0.9997
3.4 0.9997 0.9997 0.9997 0.9997 0.9997 0.9997 0.9997 0.9997 0.9997 0.9998
3.5 0.9998 0.9998 0.9998 0.9998 0.9998 0.9998 0.9998 0.9998 0.9998 0.9998
3.6 0.9998 0.9998 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999
3.7 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999
3.8 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999 0.9999
3.9 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000
4.0 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000 1.0000

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3. Portfolio Management

3.1 Modern Portfolio Theory

3.1.1 The Risk/Return Framework

3.1.1.1 Return

Holding Period Return

Pt  Pt 1 
J
 Dt j 
 1  Rt*j ,t  t t j

j 1
Rt 
Pt 1
where
Rt simple (or discrete) return of the asset over period t  1 to t
Pt price of the asset at date t
Dt j dividend or coupon paid at date t j between t  1 and t
tj date of the jth dividend or coupon payment

Rt*j ,t risk-free rate p.a. for the period t j to t

J number of intermediary payments

Arithmetic versus Geometric Average of Holding Period Returns

Arithmetic average of holding period returns
1 N
rA    ri
N i 1

where
rA arithmetic average return over N sequential periods
ri holding period returns (continuously compounded)
N number of compounding periods in the holding period

Geometric average return over a holding period using discrete compounding

R A  N (1  R1 )  (1  R2 ) ... (1  R N )  1
where
RA geometric average return over N sequential periods
Ri discrete return for the period i
N number of compounding periods in the holding period

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Time Value of Money: Compounding and Discounting

Compounded returns
m
 R 
1  Reff  1  nom 
 m 
where
Reff effective rate of return over entire period
Rnom nominal return
m number of sub-periods

Continuously compounded versus simple (discrete) returns

In the case no dividends paid between time t-1 and t

 ln 1  Rt 
Pt
rt  ln
Pt 1
Rt  ert  1
where
Pt price of the asset at date t
rt continuously compounded return between time t  1 and t
Rt simple (discrete) return between time t  1 and t

Annualisation of Returns
Annualising holding period returns (assuming 360 days per year)
Assuming reinvestment of interests at rate R

Rann  1  R 360 /  1

where
Rann annualised simple rate of return
R simple return for a time period of  days
Note: convention 360 days versus 365 or the effective number of days varies
from one country to another.

Annualising continuously compounded returns (assuming 360 days per year)

360
ran   r

where
ran annualised rate of return
r continuously compounded rate of return earned over a period of 
days

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Nominal versus Real Returns

With simple returns

Rtreal  Rtnominal  I t  Rtreal  I t  Rtnominal  I t

With continuously compounded returns

rtreal  rtnominal  it

where
Rtreal real rate of return on an asset over period t (simple)
Rtnominal nominal rate of return on an asset over period t (simple)
It rate of inflation over period t (simple)
rtreal real rate of return on an asset over period t (cont. comp.)
rtnominal nominal rate of return on an asset over period t (cont. comp.)
it rate of inflation over period t (cont. comp.)

3.1.2 Measures of Risk

Probability Concepts
Expectation value E(.), variance Var(.), covariance Cov(.) and correlation
Corr(.) of two random variables X and Y if the variables take values xk , y k in
state k with probability p k
K K
E( X )   pk  xk , E(Y )   pk  y k
k 1 k 1

Var ( X )   X
2
  K
 E ( X  E( X )) 2  E( X 2 )  E( X ) 2   pk ( xk  E( X )) 2
k 1
K
Cov( X , Y )   XY  E( X  E( X ))  (Y  E(Y ))   pk ( xk  E( X ))  ( y k  E(Y ))
k 1

 XY
Corr ( X , Y ) 
 X  Y
K
where  p k  1 , and
k 1
pk probability of state k
xk value of X in state k
yk value of Y in state k
K number of possible states

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The mean E(.), variance Var(.), covariance Cov(.) of two random variables X
and Y, in a sample of N observations of xi and yi , are given by
1 N 1 N
E( X )  x   xi , Var( X )   X
2
  ( xi  x ) 2
N i 1 N  1 i 1
1 N
Cov( X , Y )   XY   ( xi  x )  ( y i  y )
N  1 i 1
where
xi , yi observation i
x, y mean of X and Y
 X , Y standard deviations
 XY covariance of X and Y
N number of observations

Normal Distribution
Its probability density is given by the following function:


 x   2
1 2 2
f ( x)  e
2  

where
x the value of the variable,
 the mean of the distribution,
 standard deviation.

Computing and Annualising Volatility

Computing volatility

1 N 1 N
  (rt  r ) 2 , r  rt
N  1 t 1 N t 1

where
 standard deviation of the returns (the volatility)
N number of observed returns
Pt
rt  ln continuously compounded return of asset P over period t
Pt 1

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Annualising Volatility
Assuming that monthly returns are independent, then


 ann  12   m  


where
 ann annualised volatility
m volatility of monthly returns
 volatility of returns over periods of length 
 length of one period in years

Value at Risk (for normally distributed portfolio returns)

VaR  R   z α  σR   R 

where
VaR  R  value at risk of the portfolio return
zα alpha percentile of standard normal distribution
σR  volatility of portfolio return
R  expected portfolio return

3.1.3 Portfolio Theory

3.1.3.1 Diversification and Portfolio Risk

Average and Expected Return on a Portfolio

- Ex-Post Return on a Portfolio P in period t

N
RP ,t   xi Ri ,t  x1 R1,t  x 2 R2 ,t    x N R N ,t
i 1

where  xi  1 , and
R P,t return on the portfolio in period t
Ri, t return on asset i in period t
xi initial (at beginning of period) proportion of the portfolio invested in asset
i
N number of assets in portfolio P

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- Expectation of the Portfolio Return

N
E( RP )   xi E( Ri )  x1E( R1 )  x2 E( R2 )    x N E( R N )
t 1
where
E( RP ) expected return on the portfolio
E( Ri ) expected return on asset i
xi relative weight of asset i in portfolio P
N number of assets in portfolio P

Variance of the Portfolio Return

N N N N
Var( RP )   P2    xi x j  ij    xi x j  ij i j
i 1 j 1 i 1 j 1

where
 P2 variance of the portfolio return
 ij covariance between the returns on assets i and j
 ij correlation coefficient between the returns on assets i and j
i ,  j standard deviations of the returns on assets i and j
xi initial proportion of the portfolio invested in asset i
xj initial proportion of the portfolio invested in asset j
N number of assets in portfolio P

3.1.4 Capital Asset Pricing Model (CAPM)

3.1.4.1 Capital Market Line (CML)

E( R M )  r f
E( R P )  r f  P
M

where
E( RP ) expected return of portfolio P
rf risk free rate
E( RM ) expected return of the market portfolio
M standard deviation of the return on the market portfolio
p standard deviation of the portfolio return

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3.1.4.2 Security Market Line (SML)


E( Ri )  r f  E( RM )  r f   i 
Cov( Ri , RM )
i 
Var( RM )
where
E( Ri ) expected return of asset i
E( RM ) expected return on the market portfolio
rf risk free rate
i beta of asset i
Cov( Ri , RM ) covariance between the returns on assets i and market portfolio
Var( RM ) variance of returns on the market portfolio

Beta of a Portfolio

N
 p   xi  i
i 1

where
P beta of the portfolio
i beta of asset i
xi proportion of the portfolio invested in asset i
N number of assets in the portfolio

3.1.4.3 International CAPM

 
K 1

Eri   r f   i  ErM   r f     i ,k  Es k   r fk  r f
k 1
where
E( ri ) expected return of asset i
E( rM ) expected return on the market portfolio
i beta of asset i
rf continuous compounded risk-free rate in the domestic country
sk return on the exchange rate of country k
r fk continuous compounded risk-free rate in country k
K number of countries considered
and
Covri , s k 
 i ,k 
Var s k 

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3.1.5 Arbitrage Pricing Theory (APT)

N
ERi   R f    j  ij
j 1

where
ERi  expected return on asset i
Rf risk free rate
j expected return premium per unit of sensitivity to the risk factor j
 ij sensitivity of asset i to factor j
N number of risk factors

3.1.5.1 One Factor Models

Single-Index Model
Rit   i   i  Rindex , t   it
where
Rit return on asset or portfolio i over period t
i intercept for asset or portfolio i
i sensitivity of asset or portfolio i to the index return
Rindex ,t return on the index over period t
 it random error term ( E( it )  0 )

Market Model
Rit   i   i  RMt   it

Market model in expectation terms

E( Rit )   i   i  E( RMt )
where
Rit return on asset or portfolio i over period t
i intercept for asset or portfolio i
i sensitivity of asset or portfolio i to the index return
RMt return on the market portfolio
 it random error term ( E( it )  0 )

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Covariance between two Assets in the Market Model or the CAPM Context

 ij   i   j   M
2

where
 ij covariance between the returns of assets i and j
i beta of portfolio i
j beta of portfolio j

M
2
variance of the return on the market portfolio

Decomposing Variance into Systematic and Diversifiable Risk

In the case of a single security

 i2   i2 M
2
  2
 i
market residual
risk risk

where
 i2 : total variance of the return on asset or portfolio i
 i2 M
2
: market or systematic risk (explained variance)

 2 : idiosyncratic or residual or unsystematic risk (unexplained variance)

i

Quality of an index model: R 2 and  2

 i2   I2  i2   I2  2
2
R   1 i
  iI2
 i2  i2   I2   2  i2
i

where
R2 coefficient of determination in a regression of Ri on R I

 i2 : total variance of the returns on asset i

 i2  2I : Market index or systematic risk (explained variance)
 2 : idiosyncratic or residual or unsystematic risk (unexplained variance)
i

iI correlation between asset i and the index I

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3.1.5.2 Multi-Factor Models

Multi-Index Models

ri   i   i1I1   i 2 I 2  ...   in I n   i

where
Ri return on asset or portfolio i
 ij beta or sensitivity of the return of asset i to changes in index j
Ij index j
i random error term
n number of indices

Portfolio variance under a multi-index model (every index is assumed to be

uncorrelated with each other)
 P2   P2 ,1   12     P2 ,n   n2   2P
where
 P2 variance of the portfolio
 i2 variance of the asset or portfolio i
 P2 , j 2j systematic risk due to index j
 2P : residual risk
n number of indices

3.2 Practical Portfolio Management

3.2.1 Managing an Equity Portfolio

Active Return
R AP,,tB  RtP  RtB
where
R AP,,tB active return in period t
RtP return of the portfolio in period t
RtB return of the benchmark in period t

Tracking Error

TE P, B  V ( R AP, B )

where
TE P, B tracking error

V R AP, B  variance of the active return

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The Multi-Factor Model Approach

Asset excess return

NF
Ri   xi , j F j   i
j 1

where:
Ri excess return of an asset i (i = 1, …, N)
xi , j exposure (factor-beta respectively factor-loading) of asset i to factor j
Fj excess return of factor j (j = 1, … , NF)
i specific return of asset i (residual return)
NF number of factors

Portfolio excess return

RP  x P'  F   P

where:
N
x'P  ( x P ,1 , , x P ,NF ), x P , j   wiP  xi , j (j=1,…,NF)
i 1
and
xi , j exposure (factor-beta respectively factor-loading) of asset i to factor j
xP, j exposure of the portfolio to factor j
F  ( F1 ,..., FNF ) is the NF x 1 vector of factor returns,
wiP is the weight of asset i in the portfolio
N
 P   wiP   i specific return of the portfolio, where  i is the specific
i 1
return
of asset i
NF number of factors
N number of assets in the portfolio

Volatility of the portfolio

N
V RP   x'P  W  x P  s P2 s P2   (wiP ) 2  si2
i 1

where:
x'P 1 x NF vector of portfolio exposures to factor returns
W covariance matrix of vector F, i.e. of the factor returns
s i2 variance of asset i specific return
s P2 variance of the portfolio’s specific return
N number of assets in the portfolio

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Tracking error
N
TE P,B  (x'P  x'B )  W  (xP  x B )   (wiP  wiB )2  si2
i 1
where:
TE P ,B tracking error of the portfolio with respect to the benchmark
x 'P 1 x NF vector of portfolio exposures to factor returns
x 'B 1 x NF vector of benchmark exposures to factor returns
W covariance matrix of vector F, i.e. of the factor returns
wiP weight of asset i in the portfolio
wiB weight of asset i in the benchmark
s i2 variance of asset i specific return
N number of assets in the portfolio

Forecasting the tracking error

~ ~ N
TE P,B  (x'P  x'B )  W  (xP  x B )   (wiP  wiB )2  ~
si2
i 1
where:
~
TE P ,B forecasted tracking error of the portfolio with respect to the benchmark
x 'P 1 x NF vector of portfolio exposures to factor returns
x 'B 1 x NF vector of benchmark exposures to factor returns
~
W is the forecast covariance matrix of vector F, i.e. of the factor returns
wiP weight of asset i in the portfolio
wiB weight of asset i in the benchmark
~
si 2 is the forecast of the variance of asset i specific return.
N number of assets in the portfolio

3.2.1.1 Active management

Excess Return and Risk

Expected active return

~ ~ ~ N ~ ~
R AP,B  RP  RB   (wiP  wiB )  ( Ri  R B )
i 1
where
wiP weight of asset i in the portfolio
wiB weight of asset i in the benchmark
~
Ri expected return of asset i
~
RP expected return of the portfolio
~
RB expected return of the benchmark
N number of assets in the portfolio

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Expected tracking error

~ N ~
T E AP,B   (wiP  wiB )  Ci, j  (wPj  w Bj )
i 1; j 1
where
~ is the forecast of the covariance of asset i and j returns
Ci , j
wiP weight of asset i in the portfolio
wiB weight of asset i in the benchmark
N number of assets in the portfolio

Information Ratio

~
~ P,B R AP,B
IR A  ~ P,B
TE A
where
~
IR AP ,B information ratio for portfolio P with respect to benchmark B
~
R AP ,B the expected active return of the portfolio
~
T E AP ,B the expected tracking error

3.2.2 Derivatives in Portfolio Management

3.2.2.1 Portfolio Insurance

Static Portfolio Insurance

Portfolio Return
rPC  rPD  r f   ( rMC  rMD  r f )

where
rPC capital gain of the portfolio
rPD dividend yield of the portfolio
rMC price index return
rMD dividend yield of the index
rf risk-free rate
 portfolio beta with respect to the index

The protective put strategy

Portfoliovalue S
NP     0
Index level  Option contractsize I0  k
where
NP number of protective put options
S0 initial value of the portfolio to be insured
I0 initial level of the index
 portfolio beta with respect to the index
k option contract size

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Initial Value of Insured Portfolio (per unit of option contract size)

S0
V0  S 0    P( I 0 ,T , K ) 
I0
where
V0 initial total value of the insured portfolio
S0 initial value of the portfolio to be insured
I0 initial level of the index
 portfolio beta with respect to the index
P(I0,T,K) put premium for a spot I0, a strike K and maturity T

Floor

f 
V0
where
f insured fraction of the initial total portfolio value
 floor [= minimum final portfolio value, capital + dividend income]
V0 initial total value of the insured portfolio

Paying Insurance on Managed Funds

 K  S 
VT  (1  )(1  rf )    rMD      S0  f   S0    P( I 0 , T, K) 0 
 I0   I0 
Strike price

I0   P( I 0 , T, K)  
K f  1      (1  )(1  rf )    rMD 
   I0  

where
VT total final value of the insured portfolio
S0 initial value of the portfolio to be insured
I0 initial level of the index
 portfolio beta with respect to the index
f insured fraction of the initial total portfolio value
rMD dividend yield of the index
rf risk-free rate
P(I0,T,K) put premium for a spot I0, a strike K and maturity T

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In Case of Insurance Paid Externally

 K
VT  ( 1   )(1  r f )    rMD      S 0  f  S 0
 I0 

Strike price
K
I0

 f  (1   )(1  r f )    rMD 
where
VT total final value of the insured portfolio
S0 initial value of the portfolio to be insured
I0 initial level of the index
 portfolio beta with respect to the index
f insured fraction of the initial total portfolio value
rMD dividend yield of the index
rf risk-free rate

Dynamic Portfolio Insurance

Price of a European Put on an Index Paying a Continuous Dividend Yield y

Black&Scholes Model

P( S t , T , K )  K  e
r f (T t )

 N (d 2 )  S t  e  y(T t )  N (d1 ) 
S 
ln  t   (r f  y ) (T  t )
d1   
K 1
   T  t d 2  d1    T  t
  T t 2

where
P( S t , T , K ) put premium for a spot St, a strike K and maturity T
St index spot price at time t
K strike price
rf risk-free rate (continuously compounded, p.a.)
y dividend yield (continuously compounded, p.a.)
 volatility of index returns (p.a.)
Tt time to maturity (in years)
N(.) cumulative normal distribution function

Delta of a European Put on an Index Paying a Continuous Dividend Yield y

 P  e  y( Tt )  N(d1 )  1 (1)

where
P delta of a put
y dividend yield (continuously compounded, p.a.)
Tt time to maturity (in years)

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Dynamic Insurance with Futures

 e rf ( T  t )  N(d1 )  1   
NS
N F  e y( T T )
* *
(2)
k

where

N F number of futures
T* maturity of the futures contract
T maturity of the replicated put
 risky asset beta with respect to the index
NS number of units of the risky assets
k futures contract size

Equation (2) is simplified by substituting for the put delta and becomes:
N S  St
NF  P  β 
k  Ft,T (3)

where
P delta of the put (formula (1) above)
 beta of the risky asset with respect to the index
NF number of futures
NS number of units of the risky asset
St spot price at time t
Ft,T futures price at time t with maturity T
k futures contract size

Constant Proportion Portfolio Insurance (CPPI)

Cushion
ct = Vt – t
where
ct cushion
Vt value of the portfolio
t floor

Amount Invested in Risky Assets

At = NS,t  St = m  ct

where
At total amount invested in the risky assets at time t
NS,t number of units of the risky assets
St unit price of the risky assets
m multiplier
ct cushion

Amount Invested in Risk-Free Assets

Bt =Vt – At

where
Bt value of the risk-free portfolio at time t
Vt value of the total portfolio at time t
At value of the risky portfolio at time t

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3.2.2.2 Hedging with Stock Index Futures

Hedging when Returns are Normally Distributed (OLS Regression)

S t F
     t  t
St Ft ,T
St
HR   
Ft ,T

where
St changes in spot price at time t
St spot price at time t
 intercept of the regression line
 slope of the regression line
Ft changes in the futures price at time t
Ft,T futures price at time t with maturity T
t residual term
HR hedge ratio

And the number of futures contracts to use:

N S
NF  β  S t
k  Ft,T
where
 slope of the regression line
NF number of futures
NS number of spot assets
St spot price at time t
Ft,T futures price at time t with maturity T
k contract size

Adjusting the Beta of a Stock Portfolio

St
HRadj  (  actual   target ) 
Ft ,T
N S  St
N F  (  target   actual ) 
k  Ft ,T
where
HRadj hedge ratio to adjust the beta to the target beta
 actual
actual beta of the portfolio
target target beta of the portfolio
St spot price at time t
Ft,T futures price at time t with maturity T
NF number of futures contracts
NS number of the spot asset to be hedged
k contract size

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3.2.2.3 Hedging with Interest Rate Futures

Hedge Ratio
 B  DBmod
HR   B ,F B  0
 F F0 ,T  DFmod
where
HR hedge ratio
 B ,F is correlation between bond portfolio and futures value
 is volatility of portfolio and futures returns respectively
D mod is modified duration of bond portfolio and futures respectively
B0 is the value of the bond portfolio at time 0
F0 ,T is the value of the futures at time 0

Adjusting the Target Duration

S0  (D St arg et  D Sactual )
HR 
F0,T  D F

where
HR hedge ratio
S0 is the value of the spot price at time 0
D St arg et is the target duration
actual
D S is actual duration
F0,T is the futures price at time 0
DF is the duration of the futures (i.e. of the CTD)

And the number of futures contracts to use:

M arket value  Target   Portfolio 

Number of   
of portfolio  duration   duration 
futures  
M arket value  Duration 
contracts  
of futures  of CTD 

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3.3 Asset/Liability-Analysis and Management

3.3.1 Valuation of Pension Liabilities

Lt   t  Wt  RFt ,T   t ,T  a x  d t ,T

where
Lt value of liabilities at time t
T time of retirement
t pension benefit accrual factor at time t
Wt salary of the future retiree at time t
RFt ,T revaluation factor at time t
 t ,T retention factor at time t
ax annuity factor for a (future) retiree retiring at age x
dt ,T discount factor between time t and retirement age T

Annuity factor

w  x px,t
ax  
t
t 0 (1  r)

where
ax annuity factor for a (future) retiree retiring at age x
w ending age of the mortality table
px ,t probability of a person aged x to survive until age x+t
r (deterministic) interest rate

3.3.2 Surplus And Funding Ratio

3.3.2.1 Surplus

SPt  At  Lt

where
SPt surplus at time t
At value of assets at time t
Lt value of liabilities at time t

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3.3.2.2 Funding Ratio

A
FRt  t
Lt

where
FRt funding ratio at time t
At value of assets at time t
Lt value of liabilities at time t

3.3.3 Surplus Risk Management

3.3.3.1 One Period Surplus Return

SP1  SP0
RSP   FR 0  R A  RL
L0

where
RSP one period surplus return
SPt surplus at time t
L0 value of liabilities at time 0
FR0 funding ratio at time 0
R A return on assets
RL return on liabilities

Mean surplus return

SP  FR0   A   L

where
SP mean surplus return
FR0 funding ratio at time 0
 A mean return on assets
L mean return on liabilities

Surplus risk

σ SP  (FR0  σ A )2  2  (FR0  σ A )  σ L  ρAL  σ L2

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where
 SP surplus risk
FR0 funding ratio at time 0
 A risk (volatility) on assets
 L risk (volatility) on liabilities
ρAL correlation coefficient of assets and liabilities

3.3.3.2 Shortfall Risk

P[RSP  SPmin ]  

 shortfall risk
RSP one period surplus return
SPmin minimal (threshold) surplus

Shortfall constraint for normally-distributed surplus return

SP  SPmin  z SP

SP mean surplus return

SPmin minimal (threshold) surplus
 tolerated level of shortfall risk
z -percentile of the standard normal distribution
 SP surplus risk

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3.4 Performance Measurement

3.4.1 Performance Measurement and Evaluation

3.4.1.1 Risk-Return Measurement

Internal Rate of Return (IRR)

N CFt
CF0  
t 1 ( 1  IRR )t
where
CF0 initial net cash flow
CFt net cash flow at the end of period t
IRR internal rate of return (per period)
N number of periods

Time Weighted Return (TWR)

Simple Return
MVend ,t  MVbegin,t MVend ,t
TWRt / t 1   1
MVbegin,t MVbegin,t
where
TWRt/t1 simple time weighted return for sub-period t
MVbegin,t market value at the beginning of sub-period t
MVend,t market value at the end of sub-period t

Continuously Compounded Return

 MVend ,t 
twrt / t 1  ln 
 MVbegin,t 
 
where
twrt/t1 continuously compounded time weighted return for sub-period t
MVbegin,t market value at the beginning of sub-period t
MVend,t market value at the end of sub-period t

Total period simple return

N
1  TWRtot   ( 1  TWRt / t-1 )
t 1
where
TWR tot simple time weighted return for the total period
TWR t / t 1 simple time weighted return for sub-period t

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Total Period Continuously Compounded Return

N
twrtot   twrt / t-1
t 1
where
twrtot continuously compounded time weighted return for the total period
twrt / t 1 continuously compounded time weighted return for sub-period t

Money Weighted Return (MWR)

Gain or Loss Incurred on a Portfolio

Gain = (Ending Market Value  Beginning Market Value)  Net Cash Flow

Net Cash Flow (NCF)

NCF = ( Ct +  Pt +  Et)  ( Wt +  St +  Dt +  Rt)
where
NCF net cash flow
Ct effective contributions
Pt purchases
Et immaterial contributions measured by the expenses they generate
Wt effective withdrawals
St sales
Dt net dividend and other net income
Rt reclaimable taxes

Average Invested Capital (AIC)

Average Invested Capital = Beginning Market Value + Weighted Cash Flow

Dietz Formula
1
AIC = MVbegin   NCF
2
where
AIC average invested capital
MVbegin market value at the beginning of the period
NCF net cash flow

Dietz formula
( MVend  MVbegin )  NCF
MWR =
1
MVbegin   NCF
2
where
MWR money weighted return
MVbegin market value at the beginning of the period
MVend market value at the end of the period
NCF net cash flow

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Value Weighted Day (VWD)

 CF j , i  ti
VWD j 
 CF j , i

where
VWDj value weighted day of the total cash flow of type j (contributions, purchases,
sales, ...)
CFj,i i-th cash flow of type j (contributions, purchases, sales, ...)
ti day when the i-th cash flow takes place

Day Weighted Return

t end  t i
AIC  MVbegin   t end  t begin
 CFi
cash
flow i

 MVbegin   pC   Ci  p P   Pi  p E   Ei    pW   Wi  p S   S i  p D   Di  p R   Ri 
  
WCF
where
AIC average invested capital
MVbegin market value at the beginning of the period
ti time of cash flow I
tbegin time corresponding to the beginning of the period
tend time corresponding to the end of the period
CFi cash flow
Ci effective contributions
Pi purchases
Ei immaterial contributions measured by the expenses they generate
Wi effective withdrawals
Si sales
Di net dividend and other net income
Ri reclaimable taxes
WCF weighted cash flow
pC, pP, pE, pW, pS, pD and pR are the weights calculated as follows:

 ( tend  ti )  CF j ,i t end  VWD j

weight = p j  
( t end  tbegin )   CF j ,i t end  tbegin

where
j various cash flow types (contributions, purchases, expenses etc.)
CFj,i i-th cash flow of type j
VWDj value weighted day

Day weighted return

( MVend  MVbegin )  ( Ci   Pi   Ei )  (Wi   S i   Di   Ri ) 

MWR 
MVbegin  ( pC   Ci  p P   Pi  p E   Ei )  ( pW  Wi  p S   S i  p D   Di  p R   Ri ) 

where
MVend market value at the end of the period

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3.4.1.2 Risk Adjusted Performance Measures

Sharpe Ratio or rP  r f
Reward-to-Variability Ratio RVAR P 
P
Treynor Ratio or rP  r f
Reward-to-Volatility Ratio RVOL P 
P
Jensen’s   P  (rP  r f )   P  (rM  r f )

Information Ratio 
AR P 
(Appraisal Ratio) 

where
rP average portfolio return
rM average market return
rf average risk-free rate
P Jensen’s alpha
α Active Return (Excess return)
P portfolio beta
P portfolio volatility
 Active Risk (standard deviation of the tracking error)

3.4.1.3 Relative Investment Performance

Elementary Price Indices

pt
Pt / 0   B  ( 1  Rt / 0 )  B
p0
where
Pt / 0 elementary price index at time t with basis at time 0
p0 price of the original good at time 0
pt price of the unchanged good at time t
Rt / 0 index return for the period starting at 0 and ending at t
B index level at the reference time

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Price-Weighted Indices
n
 p tj
j 1 p1t  pt2    ptn p1t  pt2    ptn
Ut / 0  B B B
n
p1  p 02    p 0n Dt / 0
 p0j 0  
j 1 n
Dt / 0   ctj/ 0  p 0j
j 1
where
Ut /0 price-weighted index at time t with basis 0
n number of securities
t actual time
0 reference time (the index basis)
j security identifier
Dt / 0 divisor
j j
pt , p 0 price of security j at time t, respectively at time 0

ctj/ 0 adjustment coefficient for a corporate action on security j (=1 at time 0)

B index level at the reference time

Equally Weighted Price Indices

Arithmetic average of the elementary price indices:
1 n j P1  Pt2/ 0    Ptn/ 0
Pt / 0    Pt / 0  t / 0
n j 1 n

where
Pt / 0 arithmetic average of the elementary price indices
n number of elementary price indices
pj
Pt j/ 0  j t j elementary index for security j where:
ct / 0  p 0
ptj , p0j price of security j at time t, respectively at time 0
ctj/ 0 adjustment coefficient for a corporate action on security j (=1 at time 0)

Geometric average of the elementary price indices:

1/ n
 n 
 
1/ n
Pt / 0, g    Pt j/ 0   Pt1/ 0  Pt2/ 0    Ptn/ 0  n Pt1/ 0  Pt2/ 0    Ptn/ 0
 j 1 
 
where
P t / 0 ,g geometric average of the elementary price indices
n number of elementary price indices
p tj
Pt / 0  j
j
elementary index for security j
ct / 0  p 0j
ptj , p0j price of security j at time t, respectively at time 0
ctj/ 0 adjustment coefficient for a corporate action on security j (=1 at time 0)

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Capital Weighted Price Indices (Laspeyres Indices)

n
 pt  q0
j j
j 1 n n p0j  q0j
PILt / 0  n
  w0
j
 Pt /j 0  n
 Pt /j 0
j 1 j 1
 p0  q0  p0  q0
j j i i
j 1 i 1
j
pt
Pt j/ 0   1  Rt j/ 0
p 0j
where
PILt/0 Laspeyres capital-weighted index
j
pt actual price of security j
q 0j number of outstanding securities j at the basis

p 0j price of security j at the basis

w0j weight of security j in the index at the basis i.e. relative market capitalization
of security j at the basis
Rt j/ 0 return in security j between the basis and time t

Index Scaling

Itoriginal Btk
Itscaled
/0  /0  Btk  Itoriginal
/ 0 
Itoriginal
/0
Itoriginal
/0
k k

where
Itscaled
/0 scaled index at time t with base 0 and level Bt at scaling time tk
k

I toriginal
/0 unscaled original index at time t with basis 0

I toriginal
/0
unscaled original index at scaling time tk with basis 0
k
Btk scaling level (typically 100 or 1000)

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Index Chain-Linking
I tnew
I tchained
/0  /0
 I told
k /0
 f t / tk  I told
k /0
I tnew
k /0
where
I tchained
/0 chained index level at time t, with original basis in 0
I tnew
/0 new index computed at time t
new
I tk / 0 new index computed at chain-linking time tk
I told
k /0
old index level at chain-linking time tk
f t / tk chaining factor at time t, with chain-linking time tk = 1 + Rt / tk

I tchained
/0  f t / t 1  f t 1 / t 2  ...  f 2 / 1  f1 / 0  B0
 ( 1  Rt / t 1 )  ( 1  Rt 1 / t 2 )  ...  ( 1  R2 / 1 )  ( 1  R1 / 0 )  B0
where
Rt/t-1 elementary index return for period t
B0 index level at reference time 0

Sub-Indices
General Index
Ki Ki
I tgeneral
/0   wt/ 0t  I t/ 0t
segmentsK ti

where
Itgeneral
/0 index level for the general index at time t with reference time 0
Ki
I t/ 0t index level for the segment Ki at time t with reference time 0
Ki
wt/ 0t the relative market capitalization of the segment Ki at time t

Sub-Index Weight
p0j  q0j
w0K   w0j   n
jK jK
 p0i  q0i
i 1
where
w0K the relative market capitalisation of the segment K

w0j the relative market capitalisation of security j

 the sum over all securities in segment K
jK
n
 the sum over all n securities in the general aggregated index
i 1

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Performance Indices

Elementary Performance Index

perf perf perf
I t / 0  f t / s  I s / 0  (1  Rt / s )  I s / 0
 (1  Rt / s )  (1  Rs / s 1 )  (1  Rs 1/ s 2 )  ...  (1  R2 /1 )  (1  R1/ 0 )  B0
where
I tperf
/0 index level at time t
I sperf
/0 index level at time s
ft/s compounding or chain-linking factor
Rt/s elementary index performance from time s until time t
B0 index level at reference time 0

Compounding Factor in the Presence of Income

 ( pt  d sj1 )  q sj
j

jK si
f ti/ s 
 p sj  q sj
jK si

where
j security identifier in segment i
f ti/ s compounding factor for segment i
j
qs number of outstanding shares of security j at previous closing/chaining time
s
psj cum-dividend price of security j at previous closing time s

ptj ex-dividend price of security j at actual time t

d sj1 dividend detached from security j on day s+1

Compounding Factor in the Presence of Subscription Rights

 ( pt  rs 1)  qsj
j j
jK si
fti/ s 
 psj  qsj
jK si

where
f ti/ s compounding factor for segment i
j
qs number of outstanding shares of security j at previous closing/chaining time s
psj cum-right price of security j at previous closing time s
ptj ex-right price of security j at actual time t
rsj1 price quoted for the right detached from security j on day s+1

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Multi-Currency Investments and Interest Rate Differentials

Simple Currency Return CBC/LC

S BC / LC ,t
1  C BC / LC 
S BC / LC ,t 1

where
CBC/LC simple currency return
SBC/LC,t spot exchange rate at the end of the period
SBC/LC,t-1 spot exchange rate at the beginning of the period

Forward Exchange Rate Return CF,BC/LC

FBC / LC ,T 1  R f ,BC  ( T  t )
1  C F ,BC / LC  
S BC / LC ,t 1  R f ,LC  ( T  t )

where
CF,BC/LC simple currency forward return
SBC/LC,t spot exchange rate at time t
FBC/LC,T frward exchange rate at time t with expiration in T
Rf,BC risk-free rate on the base currency
Rf,LC risk-free rate on the local currency

Unexpected Currency Return EBC/LC

S t 1  R f ,BC
1  C BC / LC    1  E BC / LC   1  C F ,BC / LC 
Ft 1,1 1  R f ,LC

where
CBC/LC simple currency return
EBC/LC unexpected currency return
CF,BC/LC simple currency forward return
St spot price at the end of the period
Ft-1,1 forward rate at the beginning of the period for one period
Rf,BC risk-free rate on the base currency
Rf,LC risk-free rate on the local currency

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3.4.1.4 Performance attribution analysis

Attribution Methods Based on Simple Linear Regression

Jensen’s alpha
 P  RP  RE  ( RP  RB )  ( RB  RE )
 
Net selectivity Diversification
where
P
RB  R f   ( RM  R f )
M .
R E  R f   P  ( RM  R f )
and
P Jensen’s alpha
RP actual portfolio return
RM actual market return
Rf risk-free rate
RE portfolio return at equilibrium with beta equal to P
RB portfolio return at equilibrium with volatility equal to P
P portfolio volatility
M market volatility

Fama’s Break-up of Excess Return

R P  R f  ( R P  R B )  ( R B  R E )  ( R E  RM )  ( RM  R f )
   
Net selectivity Diversification return premium return premium
abovemarket risk for market risk

where
RP actual portfolio return
Rf risk-free rate
RB portfolio return at equilibrium with volatility equal to P
RE portfolio return at equilibrium with beta equal to P
RM actual market return

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3.4.1.5 Special Issues

Performance Evaluation of International Investments

Simple Return

1  RDt  1  RFt   1  st 

where
RDt simple rate of return denominated in domestic currency
RFt simple rate of return denominated in foreign currency
st relative change (depreciation or appreciation) in the value of the domestic
currency

Continuously Compounded Return

rDt  rFt  stcc

where
rDt continuously compounded rate of return denominated in domestic
currency
rFt continuously compounded rate of return denominated in foreign
currency
s tcc continuously compounded relative change (depreciation or
appreciation) in the value of the domestic currency

Variance of Continuously Compounded Returns

 
Var rDt   Var rFt   Var s cc
t

 2  Cov rFt , s cc
t

where
Var 
 the covariance operator.
Cov the covariance operator.
rDt continuously compounded rate of return denominated in domestic
currency
rFt continuously compounded rate of return denominated in foreign currency
s tcc continuously compounded relative change (depreciation or appreciation)
in the value of the domestic currency

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A Single Currency Attribution Model by Brinson & al.

VA = R  I =  wP,j  RP,j   wI,j  RI,j

=  ((wP,j  wI,j) RI,j + wI,j  (RP,j RI,j) + (wP,j  wI,j)  (RP,j  RI,j))

where
VA value added
R portfolio return
I benchmark return
 sum over every market in the portfolio and in the benchmark
RP,j portfolio return in each market
RI,j index return in each market
wP,j portfolio weight in each market at the beginning of the period
wI,j index weight in each market at the beginning of the period

Practitioners’ Break-up of Value Added

VA = R  I =  (wP,j  wI,j)  (RI,j – I) +  wP,j  (RP,j  RI,j)

where
VA value added
R portfolio return
I benchmark return
 sum over every market in the portfolio and in the benchmark
RP,j portfolio return in each market
RI,j index return in each market
wP,j portfolio weight in each market at the beginning of the period
wI,j index weight in each market at the beginning of the period

Multi-Currency Attribution and Interest Rate Differentials

Value Added in Base Currency

vaBC = rBC  iBC

where
vaBC value added in base currency
rBC portfolio return in base currency(continuously compounded)
iBC benchmark return in base currency(continuously compounded)

Base Currency Adjusted Market Return

rBC,adj = rLC + rf,BC  rf,LC

where
rBC,adj adjusted local market return in base currency
rLC local market return in local currency
rf,BC risk-free rate in base currency at the beginning of the period
rf,LC risk-free rate in local currency at the beginning of the period

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Unexpected Currency Return

eBC/LC = cBC/LC  rf,BC + rf,LC

where
eBC/LC unexpected currency return
cBC/LC actual currency return
rf,BC risk-free rate in base currency at the beginning of the period
rf,LC risk-free rate in local currency at the beginning of the period

Break-up of Value Added in Base Currency

vaBC = ( wP  rBC,P,adj   wI  rBC,I,adj) + ( wP  eP   wI  eI)

where
vaBC value added in base currency
 sum over every market in the portfolio and in the benchmark
rBC,P,adj adjusted portfolio return of the local market in base currency
rBC,I,adj adjusted index return of the local market in base currency
eP unexpected portfolio currency return
eI unexpected passive currency return
wP portfolio weight in each market at the beginning of the period
wI index weight in each market at the beginning of the period

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