1. Introduction
The detection, monitoring and control of style is perceived as a key preoccupation by hedge fund investors.
- transparency issue: disclosure of strategy drift monitoring
- style drifts should be avoided even though they do not necessarily have a negative impact on performance
- identified relatively easily and measured precisely, either from portfolio holding information or by making use of standard quantitative techniques based on portfolio returns
**Style Drift
- a change in the hedge fund's investment strategy from what was defined in the hedge fund's offering documents
- distort asset allocation and manager selection
- it will be difficult for most investors to detect style drift unless the manager reports its positions as well as its monthly or quarterly profit and losses
2. On Style & Strategies
For the detection of style drifts, investment styles may be identified according to certain parameters and these parameters may be monitored by the investor
**factors driving the performance of hedge funds
- stylistic difference explain a part of the observed performance differences among hedge funds
- return may be interpreted as a premium for an exposure to risk and risk factors that funds are exposed to enables the description of an investment style
- performance-generating process of hedge funds is complex and a linear exposure to factors based on the returns of standard asset classes is not sufficient to describe the risk taken by hedge funds
2-1. Investment Style (0f Hedge Funds)
- long/short position with substantial leverage
- style cannot be determined simply by examining holdings or correlations with indices. traditional investment style analysis must be modified to identify the risk factors to which the hedge fund is exposed
- due to the vast array of hedge fund investing strategies, there are a greater number of specialized or niche hedge fund style versus traditional fund style
3. Style Drift
Hedge fund investing deals primarily with skill-based investing. The potential investor has to understand the particular skill set of a manager and decide whether this skill set is compatible with the investment strategy. In addition, the investor has to assess whether the strategy of the manager fits in with their investment objectives.
Style and/or strategy drift can be defined:
- drift in the exposure to a predefined set of risk factors
- change in the overall quantity
The kinds of style drifts that have to be avoided are the unexpected style drifts that have not been communicated to, and agreed with, the investors for the following reasons:
- from the bottom-up perspective of manager selection and monitoring, the style drifts make part of the analyses conducted and the conclusions drawn during due diligence useless
- from the top-down view of asset allocation and portfolio construction, style drifts invalidate the assumptions made about risk-return profiles and may destroy the expected diversification benefits resulting from style and manager mix.
3-1. Due diligence
Investor should review all factors relevant to making a prudent investment decision.
3-2. Main reasons for style drifts
- poor market environment: poor style market performance
- asset flows & limited capacity of the strategy: excessive cash inflows
- underperformance with respect to their peers: poor manager performance
- large drawdowns: recent losses
- change in key investment professionals: personnel change (leadeship changes)
- change in market structure or regulatory environment
4. Detection, Monitoring & Controlling Style Drifts
- Detection & monitoring: embedded in the ongoing due diligence & risk management processes
- No single analysis gives the investor sufficient comfort to make a definitive judgement
4-1. Approaches for Monitoring & Detecting Style Drift
4-1-1. Monitoring risk factors
- The careful monitoring of the evolution and levels of the identified style- and strategy-specific risk factors = integral part of asset allocation process
- Change in the value of risk factors may precede a change in fund style
4-1-2. Returns-based analysis
- A time series analysis that confirms that the hedge fund has perfromed consistently with its stated investment objective in terms of risk, return, correlation with predefinced asset classes and benchmarks. (assessment of overall hedge fund performance over time & comparability with the strategy of the manager)
- performed during initial due diligence & updated within the context of ongoing due diligence & risk management
- the analysis of time-varying risk & return statistics: a good picture of the dynamic nature of hedge fund strategies
- the extent of style drift can be measured by the extent of changes in the sensitivities of the fund's returns to asset class index returns; significant changes = indication of changes in style and/or risk level of the fund
4-1-3. Analysis of performance attribution & risk exposures
- analysis of profit/loss attribution gives insight into where the performance is coming from
- components of fund return: asset classes, region and currency
- performance attribution analysis provides an insight into potential style drifts
- analysing exposure trends & comparing exposures between managers of the same style provides a cross-sectional and dynamic view of the risks taken by a manager
4-1-4. Peer group comparison
- managers are continuously assessed against their peers and ranked with respect to the various risk, return and performance measure => change in ranking has to be observed regularly
- ideal complement to the returns-based approach
- a cross-sectional analysis of different managers sharing a common investment style in exactly the same market environment
- linear regressions of the single hedge fund returns on the peer group average; alpha = manager's skill, beta = proxy for the level of leverage used relative to the peer group
- underperformance with respect to peers is a leading indicator of a potential style drift
- relative overperformance may be an ex-post indicator of abnormal risk level
- return break-outs (returns lie outside a predefined confidence interval): complementary use of the returns-based and peer group analysis; return break-outs detected during a returns-based analysis may be caused by change in market conditions or by a change in the type and/or level of risk taken by the hedge fund manager
4-1-5. Analysis of Positions
The analysis of single position cannot help to avoid style drifts. However, it may accelerate the detection of drifts and help to validate the accuracy of a manager's reported numbers.
- the style consistency of the fund manager can be examined via a detailed analysis of the separate holdings of the fund (Holdings-based analysis)
- position transparency is necessary
4-1-6. Communication with the fund manager
Ongoing communication with a manager allows warning signals of style drifts to be detected
Thursday, October 15, 2009
Ch8 Funds of Hedge Funds
1. Introduction
1-1. FOFs
- diversification benefits
- attractive risk-return characteristics
- low correlations to traditional asset
- allows easier access to small & institutional investors
- rapidly grown, now compose greater than a quater of all hedge funds
1-2. Crucial Aspect of an increase in the flow of institutional assets into funds
- comprehensive risk monitoring, control, significant improvement in existing risk management practices, effective disclosure, and timely reporting
- risk monitoring tools are used: VaR, stress testing, scenario analysis, and other quantitative tools
1-3. Benefits
- retailing: pooling overcomes denomination limitation
- access: overcomes limitation of small number of investors. easier cash out
- diversification: pooling allows greater diversification
- expertise: in identifying good hedge funds and soliciting information
- due diligence process: follow up and monitoring
**less survivorship bias: a better indicator of aggregate performance of hedge funds
1-4. Drawbacks
- fee: management fee is above each hedge fund's fees
- performance: may not be better than particular hedge funds
- diversification is a double-edged sword: lower risk may mean lower expected return
1-1. FOFs
- diversification benefits
- attractive risk-return characteristics
- low correlations to traditional asset
- allows easier access to small & institutional investors
- rapidly grown, now compose greater than a quater of all hedge funds
1-2. Crucial Aspect of an increase in the flow of institutional assets into funds
- comprehensive risk monitoring, control, significant improvement in existing risk management practices, effective disclosure, and timely reporting
- risk monitoring tools are used: VaR, stress testing, scenario analysis, and other quantitative tools
1-3. Benefits
- retailing: pooling overcomes denomination limitation
- access: overcomes limitation of small number of investors. easier cash out
- diversification: pooling allows greater diversification
- expertise: in identifying good hedge funds and soliciting information
- due diligence process: follow up and monitoring
**less survivorship bias: a better indicator of aggregate performance of hedge funds
1-4. Drawbacks
- fee: management fee is above each hedge fund's fees
- performance: may not be better than particular hedge funds
- diversification is a double-edged sword: lower risk may mean lower expected return
1-5. Risks
- structural risks: derived from operations; potential for deterioration in a firm's reputation, poor information reporting systems, inadequate management oversight
- strategy risks: derived from investment strategy; market risk, credit risk, trading liquidity risk, funding liquidity risk, etc
2. Set-up & Value added of FOF
- designed to blend different hedge fund styles & spread the risks over a wide variety of funds
- target: 10~15% returns & 5~10% volatility
- more challenge to be consistent with returns
2-1. Factors affecting performance
- less direct impact of survivorship bias
- issues with classification and style drift
- new FOFs and old FOFs behave differently
- may be less useful in asset allocation
3. Portfolio Management Strategies
3-1. Three core building blocks underpinning the integrated investment process of FOFs
- strategy sector selection and allocation
- manager selection, evaluation and ongoing due diligence
- continuous manager monitoring and proactive risk management
3-2. Classification of hedge funds by diversification characteristics
- Return-enhancer: high return, high correlation with stock/bond portfolio; equity market-neutral, convertible bond arbitrage
- Risk-reducer: lower return, low correlation with stock/bond portfolio; merger arbitrage, distressed securities, long/short equity
- Total diversifier: high return, low correlation with stock/bond portfolio, global asset allocation
- Pure diversifier: low or negative return with high negative correlation with stock/bond portfolio; short seller
4. Style Risk & Diversification: Selection of Strategy Sectors
An important source of alpha in a FOFs portfolio depends on sector allocation and the right selection of strategies.
- sector allocation: achieve & maintain effective diversification and match the targeted risk/reward profile
- diversification: sector & strategy correlations across the different sources of return
- balance between a predetermined sector allocation and an opportunistic switching between strategies
- qualitative understanding of the key performance drivers, main strengths/weakness of the relevant strategy is needed to select the appropriate mix of strategies in a portfolio
- dynamic risk/return profile of the different strategy sectors & correlations between strategies needs to be actively monitored and reassessed.
** Historical Performance
- superior return performance relative to other traditional asset classes
- structural risks: derived from operations; potential for deterioration in a firm's reputation, poor information reporting systems, inadequate management oversight
- strategy risks: derived from investment strategy; market risk, credit risk, trading liquidity risk, funding liquidity risk, etc
2. Set-up & Value added of FOF
- designed to blend different hedge fund styles & spread the risks over a wide variety of funds
- target: 10~15% returns & 5~10% volatility
- more challenge to be consistent with returns
2-1. Factors affecting performance
- less direct impact of survivorship bias
- issues with classification and style drift
- new FOFs and old FOFs behave differently
- may be less useful in asset allocation
3. Portfolio Management Strategies
3-1. Three core building blocks underpinning the integrated investment process of FOFs
- strategy sector selection and allocation
- manager selection, evaluation and ongoing due diligence
- continuous manager monitoring and proactive risk management
3-2. Classification of hedge funds by diversification characteristics
- Return-enhancer: high return, high correlation with stock/bond portfolio; equity market-neutral, convertible bond arbitrage
- Risk-reducer: lower return, low correlation with stock/bond portfolio; merger arbitrage, distressed securities, long/short equity
- Total diversifier: high return, low correlation with stock/bond portfolio, global asset allocation
- Pure diversifier: low or negative return with high negative correlation with stock/bond portfolio; short seller
4. Style Risk & Diversification: Selection of Strategy Sectors
An important source of alpha in a FOFs portfolio depends on sector allocation and the right selection of strategies.
- sector allocation: achieve & maintain effective diversification and match the targeted risk/reward profile
- diversification: sector & strategy correlations across the different sources of return
- balance between a predetermined sector allocation and an opportunistic switching between strategies
- qualitative understanding of the key performance drivers, main strengths/weakness of the relevant strategy is needed to select the appropriate mix of strategies in a portfolio
- dynamic risk/return profile of the different strategy sectors & correlations between strategies needs to be actively monitored and reassessed.
** Historical Performance
- superior return performance relative to other traditional asset classes
- considerable variation in the risk and return among styles
- hedge fund strategies performance depends on the market conditions affecting that strategy
***Historical Data Biases
- self-selection bias
- instant history bias or backfill bias
- survivorship bias
- smothed pricing: infrequently traded assets
- option-like investment strategies: not normal distributed
- fee structure and gaming
5. Risks of FOFs Manager Selection: Due Diligence Process
5-1. Investment Process
- manager selection
- evaluation & ongoing due dilegence
- continuous risk monitoring
5-2. Business Model
- careful assessment & analysis of the business model used by a FOFs manager
5-3. Quality & Depth of Resources
- pay attention to the credentials, experience and the incentive used to attract and retain top industry talent by the FOFs manager
- due diligence questionnaire by AIMA(alternative investment management association)
5-1. Investment Process
- manager selection
- evaluation & ongoing due dilegence
- continuous risk monitoring
5-2. Business Model
- careful assessment & analysis of the business model used by a FOFs manager
5-3. Quality & Depth of Resources
- pay attention to the credentials, experience and the incentive used to attract and retain top industry talent by the FOFs manager
- due diligence questionnaire by AIMA(alternative investment management association)
6. Post-Investment Risk Management Process for Multi-Manager Portfolios
** Pillars underlying successful & profitable hedge fund inveting:
- astute strategy sector selection and allocation
- pragmatic manager due deligence
- proactive & systematic manager risk monitoring
7. Defining & Managing Hedge Fund Portfolio Risk
* 2003 KPMG Financial Advisory Service Report
- FOFs dominated hedge funds
- Most common investment styles were multi-strategy and short selling
- 55% of participants distributed FOFs across several jurisdiction
- FOFs' NAV were mostly reported on a monthly basis
- Most FOFs managers used both an in-house system and one of the most common risk management packages to monitor risks
- Concentration measures(71%), sensitivities(62%) & VaR(54%) were the most common risk management measures
- 56% of FOFs managers used software programs to price some of the FOFs investment
** Pillars underlying successful & profitable hedge fund inveting:
- astute strategy sector selection and allocation
- pragmatic manager due deligence
- proactive & systematic manager risk monitoring
7. Defining & Managing Hedge Fund Portfolio Risk
* 2003 KPMG Financial Advisory Service Report
- FOFs dominated hedge funds
- Most common investment styles were multi-strategy and short selling
- 55% of participants distributed FOFs across several jurisdiction
- FOFs' NAV were mostly reported on a monthly basis
- Most FOFs managers used both an in-house system and one of the most common risk management packages to monitor risks
- Concentration measures(71%), sensitivities(62%) & VaR(54%) were the most common risk management measures
- 56% of FOFs managers used software programs to price some of the FOFs investment
8. Issue of Transparency
- most significant challenges for the industry
- most significant challenges for the industry
9. Active Risk Management & Issue of Liquidity
-integral part of the dynamic portfolio management process
- portfolio risk management team needs to identify, evaluate and monitor exposure limits to individual sectors and managers
- FOFs managers need to monitor the underlying market, liquidity and credit risks using qualitative and quantitative risk management
-integral part of the dynamic portfolio management process
- portfolio risk management team needs to identify, evaluate and monitor exposure limits to individual sectors and managers
- FOFs managers need to monitor the underlying market, liquidity and credit risks using qualitative and quantitative risk management
**FOFs manager needs to monitor individual managers as regards whether leverage limits are exceeded, stop losses are triggered, any significant style drifts occurred, or credit/liquidity/event risks emerged
Wednesday, October 14, 2009
Ch8 Hedge Funds: Past, Present, and Future
1. Hedge Funds & Mutual Funds
1-1. Mutual Funds
- active(managed) funds: most funds are actively managed
- passive (index or unmanaged) funds: tracking a benchmark
- short & borrow: prohibited, derivatives: limited
- operate on a larger scale than hedge funds
1-2. Hedge Funds
- deliver complex strategies
- short position allowed
- avoid registering with SEC by having fewer than 15 clients
**open-end vs. close-end
- open-end: share price = NAV
- close-end: share price by secondary market
***Net Asset Value(NAV) = (Asset - Liability) / (# of shares)
2. Hedge Fund Incentive Structures
2-1. Mutual Fund Managers
- Strict regulations
- Symmetric Compensation Method: % of assets under management
2-2. Hedge Fund
- Asymmetric Compensation
- 1~2% fixed base management fee (operating expenses) of asset base
- 15~25% incentive fees (portfolio management incentive) of total profits
* profits measured above a risk free rate
- high water mark: need to recover previous losses first
3. Withdrawing Capital
Hedge Fund investors can only withdraw funds at certain times during the year and only after having given some notice
e.g.) Withdraw at the end of the quater given 30 days notice
4. Disclosure Requirements
4-1. Mutual Funds
Required to audit all financial statement & to disclose holdings to the SEC
4-2. Hedge Funds
- not required to disclose holdings to investors
- transparency might compromise investor returns for a hedge fund with an information-sensitive strategy
- high frequency transparency not efficient for a strategy characterized by illiquid investments
5. Hedge Fund Diversification
- concentrated, unique risk exposures, large investment -> diversification is important
- past: low correlation, present: increasingly becoming correlated with overall market moves
- diversification with the lack of transparency require costly due diligence
- fund of funds hedge fund: a diversified portfolio with risk management service
6. Market Efficiency
- arbitrage opportunities
- activity of hedge fund managers may be increasing market efficiency using short sales and derivatives (but, no real direct evidence)
7. Hedge Fund Strategies
- Equity long/short
- Event-driven hedge
- Global macro hedge
- Fixed income arbitrage
8. Hedge Fund Considerations
- from 1994 to 2006: slightly higher average return with a much smaller standard deviation
- hedge funds growth: $1 trillion in 2005 whereas mutual funds $8.5 trillion, dramatical growth after 2000
8-1. Gauging Hedge Fund Performance
**difficult to gauge performance because of the following reasons:
- biased data can result from the low level of regulations: survivorship bias
- adjusting returns for risk exposures is difficult given the complicated strategies: complicated strategies over a given time period & risks/returns are non linear
- past performance may give a very selective view of risk
- nature of the investments make computing the value and return of a hedge fund difficult
- serially correlated rates: evidence of managers massaging their reported returns in that they are probably trying to reduce the period-to-period variability of the returns -> downward bias in the measures of risk associated with the fund
- December Effect: average return of hedge funds in December is much higher than that of the average monthly return for the rest of the year
9. Hedge Fund Performance
- non-negative alpha on average and after fees
- alphas for individual funds are persistent: a hedge fund with a high alpha in the first period has a greater probability of a high alpha in the second period
10. Risk Concerns
- relatively high mortality rate (about 10% annum)
- regulators need not be concerned about investors and financial institutions
- no evidence that liquidity risks have produced disastrous outcomes
- no clear proof that hedge funds have created volatility risk
11. Futures of Hedge Funds
11-1. Institutionalization
- increasing proportion of investments are from pensions and endowments -> requires more transparent & institutionalized
11-2. Regulation
- more hedge fund regulations
11-3. Trends in Hedge Funds & Mutual Funds
12. Hedge Fund Legal Structure
12-1. Types
- limited partnership
- limited liability corp.
- offshore corp.
12-2. Allowed
- taking short & long positions in any asset
- use all kinds of derivatives
- leverage without restrictions
12-3. Section 3(c)(1) Investment Company Act
- exemption from SEC regulations
- limited to equal or less than 100 partners (accredited investors)
- individual: greater than $1M or income greater than $200K
- entity: greater than $5M
- prohibited from advertising
12-4. Section 3(c)(7) Investment Company Act
- exemption from SEC regulations
- limited to equal or less than 500 partners (qualified purchasers)
- individual: greater than $5M
- entity: greater than $25M
- prohibited from adversing
1-1. Mutual Funds
- active(managed) funds: most funds are actively managed
- passive (index or unmanaged) funds: tracking a benchmark
- short & borrow: prohibited, derivatives: limited
- operate on a larger scale than hedge funds
1-2. Hedge Funds
- deliver complex strategies
- short position allowed
- avoid registering with SEC by having fewer than 15 clients
**open-end vs. close-end
- open-end: share price = NAV
- close-end: share price by secondary market
***Net Asset Value(NAV) = (Asset - Liability) / (# of shares)
2. Hedge Fund Incentive Structures
2-1. Mutual Fund Managers
- Strict regulations
- Symmetric Compensation Method: % of assets under management
2-2. Hedge Fund
- Asymmetric Compensation
- 1~2% fixed base management fee (operating expenses) of asset base
- 15~25% incentive fees (portfolio management incentive) of total profits
* profits measured above a risk free rate
- high water mark: need to recover previous losses first
3. Withdrawing Capital
Hedge Fund investors can only withdraw funds at certain times during the year and only after having given some notice
e.g.) Withdraw at the end of the quater given 30 days notice
4. Disclosure Requirements
4-1. Mutual Funds
Required to audit all financial statement & to disclose holdings to the SEC
4-2. Hedge Funds
- not required to disclose holdings to investors
- transparency might compromise investor returns for a hedge fund with an information-sensitive strategy
- high frequency transparency not efficient for a strategy characterized by illiquid investments
5. Hedge Fund Diversification
- concentrated, unique risk exposures, large investment -> diversification is important
- past: low correlation, present: increasingly becoming correlated with overall market moves
- diversification with the lack of transparency require costly due diligence
- fund of funds hedge fund: a diversified portfolio with risk management service
6. Market Efficiency
- arbitrage opportunities
- activity of hedge fund managers may be increasing market efficiency using short sales and derivatives (but, no real direct evidence)
7. Hedge Fund Strategies
- Equity long/short
- Event-driven hedge
- Global macro hedge
- Fixed income arbitrage
8. Hedge Fund Considerations
- from 1994 to 2006: slightly higher average return with a much smaller standard deviation
- hedge funds growth: $1 trillion in 2005 whereas mutual funds $8.5 trillion, dramatical growth after 2000
8-1. Gauging Hedge Fund Performance
**difficult to gauge performance because of the following reasons:
- biased data can result from the low level of regulations: survivorship bias
- adjusting returns for risk exposures is difficult given the complicated strategies: complicated strategies over a given time period & risks/returns are non linear
- past performance may give a very selective view of risk
- nature of the investments make computing the value and return of a hedge fund difficult
- serially correlated rates: evidence of managers massaging their reported returns in that they are probably trying to reduce the period-to-period variability of the returns -> downward bias in the measures of risk associated with the fund
- December Effect: average return of hedge funds in December is much higher than that of the average monthly return for the rest of the year
9. Hedge Fund Performance
- non-negative alpha on average and after fees
- alphas for individual funds are persistent: a hedge fund with a high alpha in the first period has a greater probability of a high alpha in the second period
10. Risk Concerns
- relatively high mortality rate (about 10% annum)
- regulators need not be concerned about investors and financial institutions
- no evidence that liquidity risks have produced disastrous outcomes
- no clear proof that hedge funds have created volatility risk
11. Futures of Hedge Funds
11-1. Institutionalization
- increasing proportion of investments are from pensions and endowments -> requires more transparent & institutionalized
11-2. Regulation
- more hedge fund regulations
11-3. Trends in Hedge Funds & Mutual Funds
12. Hedge Fund Legal Structure
12-1. Types
- limited partnership
- limited liability corp.
- offshore corp.
12-2. Allowed
- taking short & long positions in any asset
- use all kinds of derivatives
- leverage without restrictions
12-3. Section 3(c)(1) Investment Company Act
- exemption from SEC regulations
- limited to equal or less than 100 partners (accredited investors)
- individual: greater than $1M or income greater than $200K
- entity: greater than $5M
- prohibited from advertising
12-4. Section 3(c)(7) Investment Company Act
- exemption from SEC regulations
- limited to equal or less than 500 partners (qualified purchasers)
- individual: greater than $5M
- entity: greater than $25M
- prohibited from adversing
Tuesday, October 13, 2009
Ch8 Individual Hedge Fund Strategies
1. Equity Hedge Strategies
1-1. Long/Short Equity
- Long a core set of stocks
- Short sales of other borrowed stocks (partially or fully hedging): generating returns when price declines, hedging brad market risk, and earning interest on proceeds
- leverage
- exposure to broad equity risk premium, small firm & value stock risk premia
- significant alpha -> experience- & skill-driven
- dead weight in traditional index-benchmark equity investment
- most managers have a long bias
- the focus of strategy: stock selection with regional, sector-specific or particular style emphasis
- NOT market timing, prediction of the broad stock market direction
e.g.) long undervalued and short overvalued, core long positions with a partial hedge overlay with short index futures, long OTM puts and short covered call
Bottom-Up Approach
- fundamental analysis -> determination of undervalued or overvalued
- analysis of industry sector
- qualitative analysis: a detailed due diligence process & analysis of maangement
Top-Down Approach
- economic trends & upcoming investment themes in certain industry sectors: vlaue vs. growth
- inefficiencies on micro & small capitalization stocks
Index
- HFR Long/Short Equity Hedge Index
- CSFB Tremont Long/Short Equity Index
1-2. Equity Market Neutral
- simultaneously long & short matched stock positions -> taking advantage of a relative outperormance of the long positions vs. the short positions
- generating returns that are completely uncorrelated to the overall equity market
- insulating portfolios from broad market rist factors = total portfolio net exposure = zero; dollar neutral, country neutal, currency neutral, sector neutral, size neutral, style neutral (value vs. growth)
Statistical Arbitrage
- model-based short-term trading
- quantitative & technical analysis
- profit opportunity in undervalued & overvalued; mean-reversion
- pair trading: long & short position in two stocks that are closely related
- black box investing; characteristics of the model are usually not disclosed to investors
three Steps
- screening & ranking: rule-based decision
- stock selection: value factors (rule-based decition; selection criteria: price-to-book, price-to-earning, price-to-sales, discounted CF, ROE, operating margins, earnings growth) or momentum factors (price or earnings momentum, moving average, relative strength & trading volumes)
- portfolio construction
e.g.) long outperformed (winner stocks) & short underperformed (loser stocks),
Fama-French HML (high minus low; long high book-to-market stock & short low book-to-market), SMB (small minus big; long small firms & sell large cap), and UMD (up minus down; long recent winner & short recent loser)
Market Neutral Long/Short Equity
1-3. Equity Market Timing
- mutual fund timing
- using a variety of technical trading models to screen the global equity markets for short-term opportunities in particular industry or geographic sectors
- switch between long equity exposure (taken at favorable moment) and risk-free
- inefficiencies of equity markets
- technical trend-following models based on short & medium-term momentum -> buy and sell signals
two strategies:
- sector timing: micro upward trends in single industry sectors **stale prices
- time zone arbitrage
studies:
- small cap lag the price action of large cap by 1~2 days
1-4. Short Selling
- selling of stocks not currently owned by the seller in order to take a directional bet on their anticipated price decline
- short rebate interest: interest earnings on proceeds
- substantial collateral: 30~50% of the market value
- short with derivatives or short with long/OTM call options (= long/short equty strategy with a short bias)
- key driver = security selection
payoff:
- profit from buying back stock at a lower price
- short debate interest
approaches:
- bottom-up approach: aggressive accounting techniques
consideration:
- share availability
- stability of the borrowing (call back)
- level of short rebate interest
- short squeezes
- invers relationship between performance and exposure
2. Relative Value Strategies
2-1. Convertible arbitrage
- long convertible security and short underlying stock
- equivalent to holding a bond position plus an option on some underlying stock
- arbitrage opportunities by identifying pricing disparities between the equity and the convertible bond
- buying volatility (cheap convertible securities) & hedging
- leverage: 1:1 to 5:1
- credit risk & interest risk
e.g.) long convertible bonds & short underlying stock/option or index futures/options,
low credit quality or distressed convertibles & stock
income sources:
- static returns: coupon & short stock rebates
- gamma trading on stock volatility
- price inefficiencies
Static Returns
- coupon/dividend plus short rebate (minus dividends)
- consideration: credit risk, omicron (dependency between bond price and credit spread)
- related to systematic risk factor; not related to pricing inefficiency
Gamma Trading
- long valatility; achieved from long gamma & long vega
- Long Gamma: delta neutral = when a stock price increases, delta increases, and sells more stock
- being long gamma: changing delta always works out in favor of the overall position of long convertible bond with a hedged short position in the underlying stock
- being long vega: as the stock price volatility changes, the convertible's value will change due to the commensurated change in the inherent option value (conversion premium)
- long gamma & vega has little to do with exploiting pricing inefficiencies -> driver of convertible arbitrage strategy
- short theta
2-2. Fixed Income Arbitrage
- profits by trading the spread relationship (spread position) between related fixed income securities and their derivatives to profit from relative movements or to accrue positive carry retusns over time
- neutralizing exposure to most systematic risk factors (e.g. yiedl curve changes, interest rate, credit, FX, etc)
- short volatility strategies
- flight to quality: when interest rates move rapidly, creadit spreads widen & liquidity dries up
- complexity premium
e.g.) spread trades
- yield curve trades (bonds with different maturities), corporate vs. Treasury yield spreads, municipal vs. Treasury yield spreads, cash vs. future, on-the-run vs. Treasury bonds
- arbitrage between similar bonds: different duration
- Butterflies (yield curve arbitrage): e.g. long cheap 5-year, 7-year & short expensive 6-year
- Basis trades: spread between physical securities and their futures
- Asset swap: long fixed-rate bonds vs. pay fixed positions in interest swaps or vice versa (reverse asset swaps)
- TED spread: spread between T-bill futures and Eurodallar futures
- yield spread between on-the-run & off-the-run bonds
other strateges (non-market neutral)
- yield curve spread trading based on a forecast of the directional changes of the yield curve
- credit spread trading
- cross-currency government vs. government spread trades
- ABS
- MBS against CMO
pricing inefficiencies:
- agency biases
- structural reasons: tax, accounting or regulatory issues
- market segmentation
2-3. Volatility Arbitrage
- benefit from the level and change of volatilities in particular instruments
- long position in cheap volitalities and short position in expensive volatilities
2-4. Capital Structure Arbitrage
- long and short positions in difference financial instruments within the capital structure of an idividual company.
- discrepancies movements of the equity & bond prices
e.g.) buying bond & selling stock vice versa, short CDS & long a stock put vice versa, long one bond issue & short another bond tranche
3. Event-Driven Strategis
- event: firm-specific (idosyncratic nature)
strategies:
- cash takeovers & stock-for-stock mergers (merger arbitrage)
- divestments, spin-offs, special dividends and refinancings
- ligigation plays: legal case such as bankruptcy
- post-bankruptcy: companies emerging out of Chapter 11 proceedings
- index events: changes in index composition
- holding company and share calss arbitrage: buying shares of holding company & selling shares of its assets or vice versa
3-1. Merger Arbitrage
Before the effective date of a merger, the stock of the acquired company will typically sell at a discount to its acquisition value as officially announced.
- buying stock in a company being acquired and selling stock in its acuqirers.
3-2. Distressd Securities
- investing in the debt and/or equity of companies having financial difficulty
- deeply discounted prices
- successful reorganization and profitable returns
3-3. Regulation D
- investing in publicly listed companies, mostly of micro and small cap, that are in need of capital through privately negotiated structure.
- private equity placements pursuant to Regulation D
- the investment is structured in the form of privately placed, unregistered, high coupon, convertible securities or debentures with maturities ranging anywhere from 18 to 60 months.
- invetment are made pursuant to an exemption from registration as provided by Regulation D of the U.S. Securities Act of 1933
- selling the fully tradable and registered shares in the public markets & realizing the spread between the market price and the discounted price of the stock (15 ~ 40%)
- bottom-up analysis
4. Opportunistic/Global Macro Strategies
- bets on the direction of a market, a currency, an interest rate, a commodity, or any macroeconomic variable
- high leverage & extensive use of derivatives
4-1. Futures Funds (Managed Future Funds)
- commodity pools that include commodity trading advisor funds
- bets on directional moves in the positions they hold in a single asset class, such as currency, fixed income, or commodities and tend to use may actively traded futures contracts
Systematic Strategies
- generating buy & sell decisions from computer models combining various technical factors and indictors
- executed in highly liquid markets with low transaction costs
- trend-following: dominant trading style
- long straddle
- short-term models using counter-trend signals
- trading based on technical pattern recognitions (Elliot waves)
- Taking positions according to the degree to which a commodity is trading in contango or backwardation
- overfitting (curve fitting)
Discretionary Strategies
- proprietary approaches based on fundamentals
- directional long-term positions based on fundamentals & short-term bets based on information flow
4-2. Emerging-Market Funds
best on all types of securities in emerging markets
5. Funds of Funds
- created to allow easier acces to small investors as well as instituional investors
benefits:
- retailing
- access
- diversification
- expertise
- due diligence process
drawbacks:
- fee
- performance
- diversification is a two-edged sword
1-1. Long/Short Equity
- Long a core set of stocks
- Short sales of other borrowed stocks (partially or fully hedging): generating returns when price declines, hedging brad market risk, and earning interest on proceeds
- leverage
- exposure to broad equity risk premium, small firm & value stock risk premia
- significant alpha -> experience- & skill-driven
- dead weight in traditional index-benchmark equity investment
- most managers have a long bias
- the focus of strategy: stock selection with regional, sector-specific or particular style emphasis
- NOT market timing, prediction of the broad stock market direction
e.g.) long undervalued and short overvalued, core long positions with a partial hedge overlay with short index futures, long OTM puts and short covered call
Bottom-Up Approach
- fundamental analysis -> determination of undervalued or overvalued
- analysis of industry sector
- qualitative analysis: a detailed due diligence process & analysis of maangement
Top-Down Approach
- economic trends & upcoming investment themes in certain industry sectors: vlaue vs. growth
- inefficiencies on micro & small capitalization stocks
Index
- HFR Long/Short Equity Hedge Index
- CSFB Tremont Long/Short Equity Index
1-2. Equity Market Neutral
- simultaneously long & short matched stock positions -> taking advantage of a relative outperormance of the long positions vs. the short positions
- generating returns that are completely uncorrelated to the overall equity market
- insulating portfolios from broad market rist factors = total portfolio net exposure = zero; dollar neutral, country neutal, currency neutral, sector neutral, size neutral, style neutral (value vs. growth)
Statistical Arbitrage
- model-based short-term trading
- quantitative & technical analysis
- profit opportunity in undervalued & overvalued; mean-reversion
- pair trading: long & short position in two stocks that are closely related
- black box investing; characteristics of the model are usually not disclosed to investors
three Steps
- screening & ranking: rule-based decision
- stock selection: value factors (rule-based decition; selection criteria: price-to-book, price-to-earning, price-to-sales, discounted CF, ROE, operating margins, earnings growth) or momentum factors (price or earnings momentum, moving average, relative strength & trading volumes)
- portfolio construction
e.g.) long outperformed (winner stocks) & short underperformed (loser stocks),
Fama-French HML (high minus low; long high book-to-market stock & short low book-to-market), SMB (small minus big; long small firms & sell large cap), and UMD (up minus down; long recent winner & short recent loser)
Market Neutral Long/Short Equity
1-3. Equity Market Timing
- mutual fund timing
- using a variety of technical trading models to screen the global equity markets for short-term opportunities in particular industry or geographic sectors
- switch between long equity exposure (taken at favorable moment) and risk-free
- inefficiencies of equity markets
- technical trend-following models based on short & medium-term momentum -> buy and sell signals
two strategies:
- sector timing: micro upward trends in single industry sectors **stale prices
- time zone arbitrage
studies:
- small cap lag the price action of large cap by 1~2 days
1-4. Short Selling
- selling of stocks not currently owned by the seller in order to take a directional bet on their anticipated price decline
- short rebate interest: interest earnings on proceeds
- substantial collateral: 30~50% of the market value
- short with derivatives or short with long/OTM call options (= long/short equty strategy with a short bias)
- key driver = security selection
payoff:
- profit from buying back stock at a lower price
- short debate interest
approaches:
- bottom-up approach: aggressive accounting techniques
consideration:
- share availability
- stability of the borrowing (call back)
- level of short rebate interest
- short squeezes
- invers relationship between performance and exposure
2. Relative Value Strategies
2-1. Convertible arbitrage
- long convertible security and short underlying stock
- equivalent to holding a bond position plus an option on some underlying stock
- arbitrage opportunities by identifying pricing disparities between the equity and the convertible bond
- buying volatility (cheap convertible securities) & hedging
- leverage: 1:1 to 5:1
- credit risk & interest risk
e.g.) long convertible bonds & short underlying stock/option or index futures/options,
low credit quality or distressed convertibles & stock
income sources:
- static returns: coupon & short stock rebates
- gamma trading on stock volatility
- price inefficiencies
Static Returns
- coupon/dividend plus short rebate (minus dividends)
- consideration: credit risk, omicron (dependency between bond price and credit spread)
- related to systematic risk factor; not related to pricing inefficiency
Gamma Trading
- long valatility; achieved from long gamma & long vega
- Long Gamma: delta neutral = when a stock price increases, delta increases, and sells more stock
- being long gamma: changing delta always works out in favor of the overall position of long convertible bond with a hedged short position in the underlying stock
- being long vega: as the stock price volatility changes, the convertible's value will change due to the commensurated change in the inherent option value (conversion premium)
- long gamma & vega has little to do with exploiting pricing inefficiencies -> driver of convertible arbitrage strategy
- short theta
2-2. Fixed Income Arbitrage
- profits by trading the spread relationship (spread position) between related fixed income securities and their derivatives to profit from relative movements or to accrue positive carry retusns over time
- neutralizing exposure to most systematic risk factors (e.g. yiedl curve changes, interest rate, credit, FX, etc)
- short volatility strategies
- flight to quality: when interest rates move rapidly, creadit spreads widen & liquidity dries up
- complexity premium
e.g.) spread trades
- yield curve trades (bonds with different maturities), corporate vs. Treasury yield spreads, municipal vs. Treasury yield spreads, cash vs. future, on-the-run vs. Treasury bonds
- arbitrage between similar bonds: different duration
- Butterflies (yield curve arbitrage): e.g. long cheap 5-year, 7-year & short expensive 6-year
- Basis trades: spread between physical securities and their futures
- Asset swap: long fixed-rate bonds vs. pay fixed positions in interest swaps or vice versa (reverse asset swaps)
- TED spread: spread between T-bill futures and Eurodallar futures
- yield spread between on-the-run & off-the-run bonds
other strateges (non-market neutral)
- yield curve spread trading based on a forecast of the directional changes of the yield curve
- credit spread trading
- cross-currency government vs. government spread trades
- ABS
- MBS against CMO
pricing inefficiencies:
- agency biases
- structural reasons: tax, accounting or regulatory issues
- market segmentation
2-3. Volatility Arbitrage
- benefit from the level and change of volatilities in particular instruments
- long position in cheap volitalities and short position in expensive volatilities
2-4. Capital Structure Arbitrage
- long and short positions in difference financial instruments within the capital structure of an idividual company.
- discrepancies movements of the equity & bond prices
e.g.) buying bond & selling stock vice versa, short CDS & long a stock put vice versa, long one bond issue & short another bond tranche
3. Event-Driven Strategis
- event: firm-specific (idosyncratic nature)
strategies:
- cash takeovers & stock-for-stock mergers (merger arbitrage)
- divestments, spin-offs, special dividends and refinancings
- ligigation plays: legal case such as bankruptcy
- post-bankruptcy: companies emerging out of Chapter 11 proceedings
- index events: changes in index composition
- holding company and share calss arbitrage: buying shares of holding company & selling shares of its assets or vice versa
3-1. Merger Arbitrage
Before the effective date of a merger, the stock of the acquired company will typically sell at a discount to its acquisition value as officially announced.
- buying stock in a company being acquired and selling stock in its acuqirers.
3-2. Distressd Securities
- investing in the debt and/or equity of companies having financial difficulty
- deeply discounted prices
- successful reorganization and profitable returns
3-3. Regulation D
- investing in publicly listed companies, mostly of micro and small cap, that are in need of capital through privately negotiated structure.
- private equity placements pursuant to Regulation D
- the investment is structured in the form of privately placed, unregistered, high coupon, convertible securities or debentures with maturities ranging anywhere from 18 to 60 months.
- invetment are made pursuant to an exemption from registration as provided by Regulation D of the U.S. Securities Act of 1933
- selling the fully tradable and registered shares in the public markets & realizing the spread between the market price and the discounted price of the stock (15 ~ 40%)
- bottom-up analysis
4. Opportunistic/Global Macro Strategies
- bets on the direction of a market, a currency, an interest rate, a commodity, or any macroeconomic variable
- high leverage & extensive use of derivatives
4-1. Futures Funds (Managed Future Funds)
- commodity pools that include commodity trading advisor funds
- bets on directional moves in the positions they hold in a single asset class, such as currency, fixed income, or commodities and tend to use may actively traded futures contracts
Systematic Strategies
- generating buy & sell decisions from computer models combining various technical factors and indictors
- executed in highly liquid markets with low transaction costs
- trend-following: dominant trading style
- long straddle
- short-term models using counter-trend signals
- trading based on technical pattern recognitions (Elliot waves)
- Taking positions according to the degree to which a commodity is trading in contango or backwardation
- overfitting (curve fitting)
Discretionary Strategies
- proprietary approaches based on fundamentals
- directional long-term positions based on fundamentals & short-term bets based on information flow
4-2. Emerging-Market Funds
best on all types of securities in emerging markets
5. Funds of Funds
- created to allow easier acces to small investors as well as instituional investors
benefits:
- retailing
- access
- diversification
- expertise
- due diligence process
drawbacks:
- fee
- performance
- diversification is a two-edged sword
Saturday, October 10, 2009
Ch6 Credit Derivatives (1)
1. Credit Default Swaps
The most poplular credit derivatives
1-1. Terminology
- reference entity
- credit event
- notional principal: par value
- CDS spread
- settlement
1-2. Credit Default Swaps & Bond Yields
The n-year CDS spread should be approximately equal to the excess of the par yield on an n-year corporate bond over the par yield on an n-year risk-free bond.
- if CDS spread less than the difference: buying assets & buying protection
- if CDS spread greater than the difference: borrowing @risk-free, shorting & selling CDS protection
**CDS Spread = Risk-free rate; approximately equal to (LIBOR/Swap - 10 basis points)
1-3. Cheapest-to-Diliver (CTD) Bond
In the event of default, the protection buyer choose for delivery the bond that can be purchased most cheaply.
e.g.) the most recent settlement price = 93_08
Bond 1: quoted price = $99.50, conversion factor = 1.0382
Bond 2: quoted price = $143.50, conversion factor = 1.5188
Bond 3: quoted price = $119.75, conversion factor = 1.2615
2. Valuation of Credit Default Swaps
Step 1: Calculate P.V. of expected payment
Step 2: Calculate P.V. of expected payoff in the event of default
Step 3: Calculate P.V. of accrual payment in the event of default
Step 4: Calculate CDS spread
2-1. Marking to Market a CDS
e.g.) CDS spread = 150 basis points, P.V. of expected payments = 4.1130 x CDS spread, P.V. of expected payoff = 0.0511 per $
=> P.V. of expected payments = 4.1130 x .0150 = 0.0617 per $
0.0617 - 0.0511 = 0.0106 per $
Mark-to market value of swap to buyer of protection = -0.0106 per $
2-2. Estimating Default Probabilities
The default probabilities used to value a CDS should be risk-neutal default probabilities.
2-3. Binary Credit Default Swaps
A binary credit default swap is structured similarly to a regular CDS except that the payoff is a fixed dollar amount.
3. Credit Indices
- CDX NA 1G: a portfolio of 125 investment grade companies in North America
- iTraxx Europe: a portfolio of 125 investment grade names in Europ
4. CDS Forwards & Options
4-1. Forward CDS: obligation to buy or sell a particular CDS on a particular reference entity at a particular future time T.
4-2. CDS option: option to buy or sell a particular CDS on a particular reference entity at a particular future time T
5. Baset CDS
- add-up basket CDS
- first-to-default CDS & nth-to-default CDS
6. Total Return Swaps (TRS)
- TRS buyer (protection seller): Total return + Depreciation Amount
- TRS issuer (protection buyer): LIBOR + spread
7. Asset-Backed Security (ABS)
8. Collateralized Debt Obligations (CDOs)
8-1. Cash CDOs
8-2. Synthetic CDOs
8-3. Single Tranche Trading
The market uses CDS indices portfolios to define standard CDO tranches. The trading of these standard tranches is know as single tranche trading.
A single tranche trade is an agreement where one side agrees to sell protection against losses on a tranche and the other side agrees to buy the protection. The tranche is not part of a synthetic CDO that someone has created but cash flows are calculated in the same way as if it were part of such a synthetic CDO.
9. Valuation of Synthetic CDO
10. Alternatives to the Standard Market Model
10-1. Heterogeneous Model
The standard market model is a homogeneous model in the sense that the time-to-default probability distributions are assumed to be the same for all companies and the copula correlations for any pair of companies are the same. The homogeneity assumption can be relaxed sh that the more general model is used.
10-2. Other Copulas
- one-factor Gaussian copulas: Student t copula, Clayton copula, Archimedean copula, Marshall-Olkin copula
10-3. Multiple Factors
10-4. Random Factor Loadings
10-5. Implied Copula Model
10-6. Dynamic Models
The most poplular credit derivatives
1-1. Terminology
- reference entity
- credit event
- notional principal: par value
- CDS spread
- settlement
1-2. Credit Default Swaps & Bond Yields
The n-year CDS spread should be approximately equal to the excess of the par yield on an n-year corporate bond over the par yield on an n-year risk-free bond.
- if CDS spread less than the difference: buying assets & buying protection
- if CDS spread greater than the difference: borrowing @risk-free, shorting & selling CDS protection
**CDS Spread = Risk-free rate; approximately equal to (LIBOR/Swap - 10 basis points)
1-3. Cheapest-to-Diliver (CTD) Bond
In the event of default, the protection buyer choose for delivery the bond that can be purchased most cheaply.
e.g.) the most recent settlement price = 93_08
Bond 1: quoted price = $99.50, conversion factor = 1.0382
Bond 2: quoted price = $143.50, conversion factor = 1.5188
Bond 3: quoted price = $119.75, conversion factor = 1.2615
2. Valuation of Credit Default Swaps
Step 1: Calculate P.V. of expected payment
Step 2: Calculate P.V. of expected payoff in the event of default
Step 3: Calculate P.V. of accrual payment in the event of default
Step 4: Calculate CDS spread
2-1. Marking to Market a CDS
e.g.) CDS spread = 150 basis points, P.V. of expected payments = 4.1130 x CDS spread, P.V. of expected payoff = 0.0511 per $
=> P.V. of expected payments = 4.1130 x .0150 = 0.0617 per $
0.0617 - 0.0511 = 0.0106 per $
Mark-to market value of swap to buyer of protection = -0.0106 per $
2-2. Estimating Default Probabilities
The default probabilities used to value a CDS should be risk-neutal default probabilities.
2-3. Binary Credit Default Swaps
A binary credit default swap is structured similarly to a regular CDS except that the payoff is a fixed dollar amount.
3. Credit Indices
- CDX NA 1G: a portfolio of 125 investment grade companies in North America
- iTraxx Europe: a portfolio of 125 investment grade names in Europ
4. CDS Forwards & Options
4-1. Forward CDS: obligation to buy or sell a particular CDS on a particular reference entity at a particular future time T.
4-2. CDS option: option to buy or sell a particular CDS on a particular reference entity at a particular future time T
5. Baset CDS
- add-up basket CDS
- first-to-default CDS & nth-to-default CDS
6. Total Return Swaps (TRS)
- TRS buyer (protection seller): Total return + Depreciation Amount
- TRS issuer (protection buyer): LIBOR + spread
7. Asset-Backed Security (ABS)
8. Collateralized Debt Obligations (CDOs)
8-1. Cash CDOs
8-2. Synthetic CDOs
8-3. Single Tranche Trading
The market uses CDS indices portfolios to define standard CDO tranches. The trading of these standard tranches is know as single tranche trading.
A single tranche trade is an agreement where one side agrees to sell protection against losses on a tranche and the other side agrees to buy the protection. The tranche is not part of a synthetic CDO that someone has created but cash flows are calculated in the same way as if it were part of such a synthetic CDO.
9. Valuation of Synthetic CDO
10. Alternatives to the Standard Market Model
10-1. Heterogeneous Model
The standard market model is a homogeneous model in the sense that the time-to-default probability distributions are assumed to be the same for all companies and the copula correlations for any pair of companies are the same. The homogeneity assumption can be relaxed sh that the more general model is used.
10-2. Other Copulas
- one-factor Gaussian copulas: Student t copula, Clayton copula, Archimedean copula, Marshall-Olkin copula
10-3. Multiple Factors
10-4. Random Factor Loadings
10-5. Implied Copula Model
10-6. Dynamic Models
Friday, October 9, 2009
Ch2 Estimating Volatilities & Correlations
1. Video clips
EWMA: http://www.youtube.com/watch?v=P_tr9_Ue220&feature=PlayList&p=DC2DBF1418970E52&playnext=1&playnext_from=PL&index=51
Moving Average Approaches: http://www.youtube.com/watch?v=8D9jEFSI1w8&feature=PlayList&p=DC2DBF1418970E52&index=52&playnext=2&playnext_from=PL
GARCH(1,1): http://www.youtube.com/watch?v=KJbR0nRinD4
Ch6 Understanding the Securitization of Subprime Mortgage Credit
1. Subprime Securitization Process
*internal credit enhancement:
- subordination: first internal credit enhancement
- hold back: SPV buy assets at discount by originator
- cash colleral account
- excess spread
*external credit enhancement:
- insurance, wraps & guarantees
- LOC
- basket CDS
- put option on assets
*Subprime
- Debt Servie-to-Income > 50%
- FICO less than 660
- 60 day delinquency in last 24 months
- 2+ 30 day delinquencies in last 12 months
- Judgment, foreclosure in prior 24 months
- Bankruptcy in last 5 years
1-1. Mortgage Process
- Friction 1: Mortgagor & Originator; possibility of predatory (unfair) lending -> stretch the bounds of the application resulting in larger than optimal lending
- Friction 2: Originator & Arranger (issuer) - the originator creates bankruptcy the remote trust and the arranger perform due diligence, but operate at an information disadvantage to the originator -> adverse selection problem
- Friction 3: Arranger & Third-Parties; adverse selection and information problem; retain higher quality mortgage & securitize lower quality mortgage; Warehouse lender fund less than 100% of estimated collateral value; Asset portfolio manager use a adequate due diligence; Rating agencise determine the amount of credit enhancement but dependent on the information provided by the arranger
- Friction 4: Servicer & Mortgagor; the servicer manage the CF of the MBS pool and follow up on delinquencies and foreclosure; moral hazard problem
- Friction 5: Servicer & Third-Parties; lack of effort can impact the asset manager and credit rating agencies without directly affecting CF distribution -> moral hazard problem
- Friction 6: Asset manager & Investor; moral hazard by managers & principle agency problem
- Friction 7: Investor & Credit Rating Agencies; conflict of interest (compensated by the arranger) -> model error
**video clips: Frictions in subprime securitization http://www.youtube.com/watch?v=F_GwmUUJX3E
2. Characteristics of the Subprime Mortgage Market
2-1. Characteristics
- subprime borrower
- ARM (adjustable rate mortgage) & a teaser rate for a short period
- borrowers bear interest rate risk
- performance of subprime pools indicates defaults and foreclosures way above historical levels
2-2. Structure of securitization process
**protection
- subordination: creating tranches of differing priority levels
- excess spread: excess spread = (weighted average coupon) - (servicing, hedging & other expenses) - (weighted average payout)
- shifting interest: senior receive all principal in the pool while mezzanine interest only
- performance trigger: overcollateralization
- interest rate swaps: fixed rate & LIBOR
3. Credit Rating Process
3-1. Rating process
An unconditional view: through-the-cycle
Two Steps:
- estimation of loss distribution
- simulation of CF
After obtaining the estimates, rating agencies indicate the level of credit enhancement necessary to achieve the desired rating
**video clips: credit enhancements in a securitization: http://www.youtube.com/watch?v=Ip0lZ-TjdHI&feature=related
3-2. Difference between credit ratings for subprime securities & corporate ratings
- corporate bond ratings based on the firm-specific characteristics <-> MBS: systematic risk & degree of correlation between assets are important, claims on a static pool
- MBS: future economic conditions
- if PDs are same, the MBS will exhibit much wider variation in losses
3-3. Credit ratings cycle & housing cycle
- through-the-cycle: no excessive upgrades (downgrades) even though housing market heats up (slow down)
- AAA rating during a boom period -> as the housing market slow down, MBS would migrate to AA
- As economic conditions change, the effect may amplify up and down markets
3-4. CF Analysis of Excess Spread
3-4-1. Interrelated factors for forcasting the degree of excess spread
- credit enhancement: amount of collateral that can be impaired before the tranche suffers an economic loss
- timing of losses: front-loading the losses (conservative approach)
- prepayment rates: CPR (conditional prepayment rate); hybrids will have higher than predicted defaults on or about the reset date due to the sudden change
- interest rates
- trigger events
- weighted average loan rate decrease
- prepayment penalties
- pre-funding accounts
- hedging instruments
3-5. Annual review of mortgage pools
- Important performance measures: Loss Coverage Ratio (LCR)
LCR = (current credit enhance ment for tranche) / (estimated unrealized losses)
- if the LCR is breached, a full review is warranted
4. Predatory Lending & Borrowing
4-1. Predatory lending: borrower becomes worse off
4-2. Predatory borrowing: misrepresentation in the mortgage application from the borrower side or overstating (falsifying) creditworthiness for rapid home application in high price real estate markets
*internal credit enhancement:
- subordination: first internal credit enhancement
- hold back: SPV buy assets at discount by originator
- cash colleral account
- excess spread
*external credit enhancement:
- insurance, wraps & guarantees
- LOC
- basket CDS
- put option on assets
*Subprime
- Debt Servie-to-Income > 50%
- FICO less than 660
- 60 day delinquency in last 24 months
- 2+ 30 day delinquencies in last 12 months
- Judgment, foreclosure in prior 24 months
- Bankruptcy in last 5 years
1-1. Mortgage Process
- Friction 1: Mortgagor & Originator; possibility of predatory (unfair) lending -> stretch the bounds of the application resulting in larger than optimal lending- Friction 2: Originator & Arranger (issuer) - the originator creates bankruptcy the remote trust and the arranger perform due diligence, but operate at an information disadvantage to the originator -> adverse selection problem
- Friction 3: Arranger & Third-Parties; adverse selection and information problem; retain higher quality mortgage & securitize lower quality mortgage; Warehouse lender fund less than 100% of estimated collateral value; Asset portfolio manager use a adequate due diligence; Rating agencise determine the amount of credit enhancement but dependent on the information provided by the arranger
- Friction 4: Servicer & Mortgagor; the servicer manage the CF of the MBS pool and follow up on delinquencies and foreclosure; moral hazard problem
- Friction 5: Servicer & Third-Parties; lack of effort can impact the asset manager and credit rating agencies without directly affecting CF distribution -> moral hazard problem
- Friction 6: Asset manager & Investor; moral hazard by managers & principle agency problem
- Friction 7: Investor & Credit Rating Agencies; conflict of interest (compensated by the arranger) -> model error
**video clips: Frictions in subprime securitization http://www.youtube.com/watch?v=F_GwmUUJX3E
2. Characteristics of the Subprime Mortgage Market
2-1. Characteristics
- subprime borrower
- ARM (adjustable rate mortgage) & a teaser rate for a short period
- borrowers bear interest rate risk
- performance of subprime pools indicates defaults and foreclosures way above historical levels
2-2. Structure of securitization process
**protection
- subordination: creating tranches of differing priority levels
- excess spread: excess spread = (weighted average coupon) - (servicing, hedging & other expenses) - (weighted average payout)
- shifting interest: senior receive all principal in the pool while mezzanine interest only
- performance trigger: overcollateralization
- interest rate swaps: fixed rate & LIBOR
3. Credit Rating Process
3-1. Rating process
An unconditional view: through-the-cycle
Two Steps:
- estimation of loss distribution
- simulation of CF
After obtaining the estimates, rating agencies indicate the level of credit enhancement necessary to achieve the desired rating
**video clips: credit enhancements in a securitization: http://www.youtube.com/watch?v=Ip0lZ-TjdHI&feature=related
3-2. Difference between credit ratings for subprime securities & corporate ratings
- corporate bond ratings based on the firm-specific characteristics <-> MBS: systematic risk & degree of correlation between assets are important, claims on a static pool
- MBS: future economic conditions
- if PDs are same, the MBS will exhibit much wider variation in losses
3-3. Credit ratings cycle & housing cycle
- through-the-cycle: no excessive upgrades (downgrades) even though housing market heats up (slow down)
- AAA rating during a boom period -> as the housing market slow down, MBS would migrate to AA
- As economic conditions change, the effect may amplify up and down markets
3-4. CF Analysis of Excess Spread
3-4-1. Interrelated factors for forcasting the degree of excess spread
- credit enhancement: amount of collateral that can be impaired before the tranche suffers an economic loss
- timing of losses: front-loading the losses (conservative approach)
- prepayment rates: CPR (conditional prepayment rate); hybrids will have higher than predicted defaults on or about the reset date due to the sudden change
- interest rates
- trigger events
- weighted average loan rate decrease
- prepayment penalties
- pre-funding accounts
- hedging instruments
3-5. Annual review of mortgage pools
- Important performance measures: Loss Coverage Ratio (LCR)
LCR = (current credit enhance ment for tranche) / (estimated unrealized losses)
- if the LCR is breached, a full review is warranted
4. Predatory Lending & Borrowing
4-1. Predatory lending: borrower becomes worse off
4-2. Predatory borrowing: misrepresentation in the mortgage application from the borrower side or overstating (falsifying) creditworthiness for rapid home application in high price real estate markets
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