Volume 13, No. 1, First Quarter 2015

Reserve Primary: Fools Rush in Where Wise Men Fear to Tread!

by: Ozgur (Ozzy) Akay, Mark D. Griffiths and Drew B. Winters

This is a clinical analysis of the demise of the Reserve Primary Fund, the first ever money market fund. Reserve Primary was caught in a perfect storm of its own making when the financial markets went into a full-blown crisis mode with the bankruptcy of Lehman Brothers on September 15, 2008. However, if the fund’s management had not abandoned the core principles that had guided the fund for more than 30 years, then the Lehman bankruptcy would likely not have led to the closing and liquidation of the Reserve Primary Fund.

OIS Discounting, Interest Rate Derivatives, and the Modeling of Stochastic Interest Rate Spreads

by: John Hull and Alan White

Before 2007, derivatives practitioners used a zero curve that was bootstrapped from LIBOR swap rates to provide “risk-free” rates when pricing derivatives. In the last few years, when pricing fully collateralized transactions, practitioners have switched to using a zero curve bootstrapped from overnight indexed swap (OIS) rates for discounting. This paper explains the calculations underlying the use of OIS rates and investigates the impact of the switch on the pricing of plain vanilla caps and swap options. It also explores how more complex derivatives providing payoffs dependent on LIBOR, or any other reference rate, can be valued. It presents new results showing that they can be handled by constructing a single tree for the evolution of the OIS rate.

Investing With Style

by: Clifford S. Asness, Antti Ilmanen, Ronen Israel and Tobias J. Moskowitz

Investors are bombarded by a variety of investment strategies from a growing and increasingly complex financial industry, each claiming to improve returns and reduce risk. Amid the clamor, academic research has sifted through the vast landscape and found four intuitive investment strategies that, when applied effectively, have delivered positive long-term returns with low correlation to each other and traditional markets. The four “styles”— value, momentum, carry, and defensive—have uniquely held up across a multitude of asset classes, markets, and time periods using very liquid securities and form the core foundation for explaining the cross-section of returns in most asset classes. We discuss the intuition and evidence for these four pervasive styles and detail how to implement a strategy that can access these style premia to improve the risk and returns of traditional portfolios.

Momentum, Acceleration, and Reversal

by: James X. Xiong and Roger G. Ibbotson

This paper studies the impact of accelerated stock price increases on future performance. Accelerated stock price increases are a strong contributor to both poor future performance and a higher probability of reversals. It implies that accelerated growth is not sustainable and can lead to drops. The acceleration mechanism is also able to reconcile the well-documented 2–12 month momentum phenomenon and 1-month reversal.

Asset Management: A Systematic Approach to Factor Investing

by: Andrew Ang • reviewed by: Bruce Grantier

“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.

Investment, Financial System, Real Output and Macro-Risk Management

by: Thomas S. Y. Ho and Sang Bin Lee

Loan underwriting standards and quantitative easing are examples of macro-risk management tools that affect the financial sector, which in turn affects real sector outputs. And therefore asset returns, real sector outputs, financial sector, and macro-risk management are interrelated. This paper shows that investors need to understand these relationships to enhance investment performance.

Recently, a macro-financial model (Ho et al., 2012, 2013; Ho and Lee, 2015a, 2015b) suggests that financial regulations must be dynamic to ensure optimality of real sector outputs while maintaining safety and soundness of the financial system. Since the real output exhibits a decreasing marginal increase in real growth with an increase in real output risk, an optimal macro-financial leverage exists, given risk and return preference of an economy. Macro-risk management is important to a dynamic economy.

This paper suggests a framework for policy makers to implement macro-risk management and for investors to incorporate changing financial regulations in their investment process.

Cobb-Douglas

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.

Impact of Credit Markets on Dynamic Stochastic Real Aggregate Production

by: Thomas S. Y. Ho and Sang Bin Lee

This paper provides a dynamic stochastic macro-financial model that describes the impact of the credit market on real production risk and provides some empirical evidence of the reasonableness of the model. Our model shows that the uncertain real sector output affects the performance of the credit market, which in turn, impacts the real production of an economy, resulting in a positive feedback effect. Our model shows that an increase in financial sector leverage and household sector leverage would induce a stronger feedback effect and increasing marginal production of financial leverage. Our model identifies the key risk drivers in measuring the performance of an economy that can be used to attribute quarterly gross domestic product (GDP) growth rate over the sample period 2000 Q1 to 2013 Q3. The empirical results can be used to interpret the underlying causes of economic boom–bust cycles and provide insights into a sustainable GDP growth pattern. This macro-finance model has many applications. For example, the risk drivers of the GDP growth rates can be used to study equity broad-based market returns (Ho and Lee, 2014).The model can also be used to specify a structural macro-finance model that can be used to evaluate efficacy of some financial regulations (Ho and Lee, 2015b).

Practitioner’s Digest • Vol. 13, No. 1

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.

Practitioner’s Digest • Vol. 13, No. 1

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.