Volume 10, No. 4, Fourth Quarter 2012

Practitioner’s Digest • Vol. 10, No. 4

The “Practitioners Digest” emphasizes the practical significance of manuscripts featured in the “Insights” and “Articles” sections of the journal. Readers who are interested in extracting the practical value of an article, or who are simply looking for a summary, may look to this section.

Portfolio Monitoring In Theory and Practice

by: Richard O. Michaud, David N. Esch and Robert O. Michaud

The when-to-trade decision is a critical yet neglected component of modern asset management. Typical rebalancing rules are based on suboptimal heuristics. Rebalancing is necessarily a statistical similarity test between current and proposed optimal portfolios. Available tests ignore many real world portfolio management considerations. The first practical test for mean-variance optimality, the Michaud rebalancing rule, ignored the likelihood of information overlap in the construction of optimal and current portfolios. We describe two new algorithms that address overlapping data in the Michaud test and give examples. The method allows large-scale automatable non-calendar based portfolio monitoring and quadratic programming extensions beyond portfolio management.

Coherent Asset Allocation and Diversification in the Presence of Stress Events

by: Riccardo Rebonato and Alexander Denev

We propose a method to integrate frequentist and subjective probabilities in order to obtain a coherent asset allocation in the presence of stress events. Our working assumption is that in normal market asset returns are sufficiently regular for frequentist statistical techniques to identify their joint distribution, once the outliers have been removed from the data set. We also argue, however, that the exceptional events facing the portfolio manager at any point in time are specific to the each individual crisis, and that past regularities cannot be relied upon. We therefore deal with exceptional returns by eliciting subjective probabilities, and by employing the Bayesian net technology to ensure logical consistency. The portfolio allocation is then obtained by utility maximization over the combined (normal plus exceptional) distribution of returns. We show the procedure in detail in a stylized case.

The Controversy in Fundamental Indexation: Why Both Sides of the Argument are (Mostly) Correct

by: Michael Dempsey

We examine the contribution of noise to the theoretical underpinnings of Fundamental Indexation (FI). Although we argue that market capital-weighted indexes do not incur a structural drag due to noise as claimed by the proponents of FI, we conclude, nevertheless, that noise as advanced by FI offers a potential for achieving superior returns to those achieved by market capital-weighted indexes. As such, FI represents an important insight to our understanding of asset pricing.

The Role of Stress Testing in Credit Risk Management

by: Roger M. Stein

In this article, we outline some concepts relating to the use of stress testing in credit risk management. We begin by providing a simple taxonomy of stress scenarios and discussing the trade-offs that different approaches require for implementation. Our taxonomy is modeled after one that is common in the credit literature and involves concepts related to reduced-form and structural approaches to credit modeling. Recently, some have expressed the view that the use of distribution-based measures such as VaR and expected shortfall (ES) for credit risk management should be deemphasized in favor of stress-testing and scenario analysis. We consider this question in the main portion of this article. We discuss the benefits of stress testing and scenario analysis as well as describing some limitations of using scenario-based approaches as a sole mechanism for assessing portfolio risk. We provide a number of examples to illustrate these limitations. In particular, except in special cases, it is difficult to use stress scenarios alone, ex ante, for allocating capital across disparate portfolios. However, stress testing and scenario analysis are integral to prudent credit risk management and can complement measures such as VaR and ES, thereby better informing both risk assessment and business strategy development. While neither stress testing nor VaR type measures, in and of themselves, provide complete descriptions of credit portfolio risk, combining both approaches results in more robust risk analysis. This permits risk managers to integrate quantitative measures with managerial intuition and judgment to arrive at more comprehensive assessments of both portfolio risk and overall firm strategy.

Was the Writing on the Wall? An Options Analysis of the 2008 Lehman Brothers Crisis

by: Zhirong Chen and Wai Mun Fong

This paper uses risk neutral densities (RNDs) of stock options to investigate the markets perceptions of crash risk in the recent U.S. subprime crisis. RNDs were estimated using the double lognormal method for the S&P 500 market index, Lehman Brothers, Merrill Lynch and Goldman Sachs. We find strong evidence of bimodality in the RND of Lehman Brothers and Merrill Lynch as early as April 2008. In contrast, no evidence of bimodality was found for either Goldman Sachs or the S&P 500 index. These results vindicate the usefulness of the RND as a forecasting tool in extreme market conditions.

Providing for Retirement

by: Jack L. Treynor

“Case Studies” presents a case pertinent to contemporary issues and events in investment management. Insightful and provocative questions are posed at the end of each case to challenge the reader. Each case is an invitation to the critical thinking and pragmatic problem solving that are so fundamental to the practice of investment management.

On the Brink - Inside the Race to Stop the Collapse of the Global Financial System

by: Henry Paulson • reviewed by: Javier Estrada

“Book Reviews” identifies important, and often popular, new books from a wide range of investment topics. Beyond providing a summary and review of the content and style of the books, “Book Reviews” seeks to contribute to a conscious, critical, and informed approach to investment literature.

Structured Finance Deals: A Review of the Rating Process and Recent Evidence Thereof

by: Seoyoung Kim

“Surveys& Crossovers” This section provides surveys of the literature in investment management or short papers exemplifying advances in finance that arise from the confluence with other fields. This section acknowledges current trends in technology, and the cross-disciplinary nature of the investment management business, while directing the reader to interesting and important recent work.