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  1. 1. UNIVERSITY OF CALIFORNIA Readings and Course Outline Haas School of Business Spring 2009 Version (1.0 – 11/06/08) – subject to revision MFE230K – Dynamic Asset Management Hayne Leland Time, Site: T TH 2:00 – 4:00 pm Instructor: Hayne Leland, Arno Rayner Professor of Finance F688, Faculty Wing (510) 642-8694 or (510) 841-8326 Leland Office Hrs: TH 10:30 – 12:00 am TA TBD Readings: Most readings available on (password required) Course website on Catalyst; lectures will be posted there before class Optional Text: J. Campbell and R. Viceira, Strategic Asset Allocation, Oxford, 2003 Readings with an asterisk (*) are optional, but provide interesting background and formalisms for the results discussed in the lectures. Fun background reading: P. Bernstein, Capital Ideas: The Improbable Origins of Modern Wall Street N. Taleb, The Black Swan: The Impact of the Highly Improbable N. Taleb, Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets B. Schacter & R. Lindsey (eds.), How I Became A Quant: Insights from 25 of Wall Street’s Elite Grading: Three homework assignments: 50% Group Projects: 50% Brief Description: The course examines principles of portfolio choice, recognizing that in the real world, trading is costly, information is imperfect, and there may be substantial risks of extreme events. We show how dynamic strategies, options, and other derivatives can be used to cater to different investor risk appetites, time horizon, and hedging needs. How best to use superior information, and how to implement dynamic strategies in a cost-efficient manner, are also
  2. 2. considered. Required coursework includes homework assignments and a major project, with topic(s) to be assigned, that will be completed by groups of four or five students. 2
  3. 3. I. Introduction: Institutional Setting of Asset Management A. Sources of Saving: Individuals Regular Accounts Retirement Accounts and special tax treatments Regular IRA Roth IRA Pension Funds Defined Benefit vs. Defined Contribution (401(k)) Plans Corporate vs. Individual Contributions Tax Rules ERISA and “Prudent Investor” Rule PBGC Insurance Companies Foreign Sources National investment funds B. Asset Management: Institutional Investors 1. Mutual Funds: Investment Companies Index Funds Actively Managed Funds Regulation: 1940 Act, enforced by SEC Performance Evaluation (Morningstar) 2. Exchange-Traded Funds (ETFs) 3. “Alternative” Investment Funds Hedge Funds Private Equity Real Estate Venture Capital Vulture Funds 4. Investment Advisors Banks, Insurance Companies, Brokerage Firms Consultants (e.g. Russell, Wilshire) Background Sources General/Banking/Insurance: Mutual funds: Exchange Traded Funds: Hedge Funds: ERISA/PBGC: 3
  4. 4. 2. Portfolio Choice in Static Models: Mean-Variance Analysis a. Portfolio Choice in a Mean-Variance World: A Review Assets and asset returns Mean-Variance preferences Rationales Limitations Portfolio Optimization Two fund separation The Sharpe ratio Certainty equivalence Portfolio constraints: short sales, etc. Asset-Liability Management CAPM equilibrium The role of the market portfolio Risk measures and return Readings: Class Notes; Campbell & Viceira, Ch. 1 and Ch. 2 thru Section 2.1.1 S. Andrade handout on M-V frontier P. Jorion, “The Long-Term Risks of Global Stock Markets,” Journal of Portfolio Management, 2004. F. Black, “Universal Hedging: Optimizing Currency Risk and Reward in International Equity Portfolios,” Financial Analysts Journal 45, 1989, 16-22 c. Active Asset Management Sources of alpha Impounding “alpha” into portfolio choice Benchmarks and Tracking Error The “Information Ratio” and its uses “Portable alpha” and market-neutral strategies Tactical Asset Allocation Readings: Class Notes R. Fuller, “Behavioral Finance and the Sources of Alpha”, mimeo, 2000. R. Litterman, “Hot Spots and Hedges,” Journal of Portfolio Management, Dec. 1996, 52-75. F. Black and R. Litterman, “Global Portfolio Optimization,” Financial Analysts Journal 1992, 29-43. C. Lee and B. Swaminathan, “Valuing the Dow: A Bottom-Up Approach,” Association for Investment Management and Research (AIMR), September/October 1999, 4-23. D. Leinwebber, “Algo vs. Algo,” Institutional Investor’s Alpha, February 2007, 45-51. *Garlappi, L., R. Uppal, and T. Wang, “Portfolio Selection with Parameter and Model Uncertainty,” Review of Financial Studies 20, (January 2007), 41-81. d. Performance Measurement and the CAPM Alpha and the Sharpe Ratio Performance attribution: Market timing vs. security selection Style Analysis Readings: Class Notes W. Sharpe, “The Sharpe Ratio," Journal of Portfolio Management, Fall 1994, pp. 49-58. 4
  5. 5. W. Sharpe, “Assset Allocation: Management Style and Performance Measurement,” Journal of Portfolio Management, Winter 1992, pp. 7-19. R. Ibbotson and P. Kaplan, “Does Asset Allocation Policy Explain 40, 90, or 100 Percent of Performance?” Financial Analysts Journal, Jan/Feb 2000, 26-33. *R. Wermers, “Mutual Fund Performance: An Empirical Decomposition into Stock- Picking Talent, Style, Transactions Costs, and Expenses” Journal of Finance 55, 2000, 1655-95. 2. Portfolio Choice: A General Approach a. A General Description of Uncertainty States of nature State-contingent claims Complete markets The (no) Arbitrage Principle Readings: Class Notes *Varian, H., “The Arbitrage Principle in Financial Markets”, Journal of Economic Perspectives 1, 1987, pp. 55-72. b. Expected Utility Theory Measures of Risk Aversion Optimal Portfolio Selection Readings: Class Notes Campbell & Viceira, remainder of Ch. 2 c. The Representative Investor and Asset Pricing The Representative Investor: conditions for existence Complete Markets Incomplete Markets The Representative Investor and state prices: Pricing Implications of optimally holding the market portfolio Special Cases: HARA, CAPM Formulas for state prices Readings: Class Notes *Constantinides, G., “Intertemporal Asset Pricing with Heterogeneous Consumers and Without Demand Aggregation,” Journal of Business, 55, 1982, pp. 253-267. *Breeden, D., and R. Litzenberger, “Prices of contingent Claims Implicit in Option Prices,” Journal of Business 51, 1978, 621-651. d. Performance Measures: Beyond Mean-Variance Theory Hedge Fund Performance Measurement Readings: Class Notes Leland, H., “Beyond Mean–Variance: Performance Measurement in a Nonsymmetrical World,” Financial Analysts Journal, Jan/Feb 1999. Lo, Andrew W. “The Statistics of Sharpe Ratios,” Financial Analysts Journal, July/August 2002, pp. 36-52. 5
  6. 6. *Goetzmann, W., Ingersoll, J., Spiegel, M., and Welch, I., “Portfolio Performance Manipulation and Manipulation-Proof Performance Measures,” Review of Financial Studies, October, 2007. *G. Fama and K. French, “Value vs. Growth: The International Evidence,” Journal of Finance 53, 1998, *H. Kat and Hedge Fund replication in the New Yorker 2007: 3. Dynamic Portfolio Choice In Discrete and Continuous Time a. Utility Maximization and Martingale Methods for Optimal Portfolio and Consumption Choice Myopic vs. strategic behavior Hedging the opportunity set Readings: Class Notes D. Breeden, “Optimal Dynamic Trading Strategies,” Economic Notes by Monte dei Paschi di Siena 33, 2004, 55-81. *R. Merton, “Optimum Consumption and Portfolio Rules in a Continuous Time Model,” Journal of Economic Theory, 1971, 373-413. b. General Characteristics of Optimal Strategies Self-financing Path Independence Improving on path-dependent strategies Readings: Class Notes based on *Cox, J. and Leland, H. “On Dynamic Investment Strategies,” Journal of Economic Dynamics and Control, 2000, pp. . *P. Dybvig, “Inefficient Dynamic Portfolio Strategies, or How to Throw Away a Million Dollars in the Stock Market,” Review of Financial Studies, 1988, pp. 67-88. *Perold, A. and W. Sharpe, “Dynamic Strategies for Asset Allocation,” Financial Analysts Journal 51, 1995, pp. 149-160. c. Alternatives to Expected Utility Theory Choosing from payoff functions From payoffs to strategies—optimal portfolio choice From strategies to payoffs—the inverse function Readings: Class Notes 6
  7. 7. 4. Long Run Strategic Asset Allocation Campbell and Viceira, Chs. 3 – 6 (skim) 4. Active Management: Value vs. Momentum Strategies Strategies providing convex vs. concave payoffs Portfolio insurance and convexity of payoffs Who Should Buy Portfolio Insurance? Who Should Sell? Momentum vs. Value strategies Some empirical evidence Readings: Class Notes based on *H. Leland., “Who Should Buy Portfolio Insurance?” Journal of Finance, 1980. *H. Leland, “Options and Expectations,” Journal of Portfolio Management, December 1996 J. Laskonishok, N. Jegadeesh and L. Chan, "Momentum Strategies," Journal of Finance (1996). **5. Optimal Portfolio Choice with Transactions Costs Readings: Class Notes based on * H. Leland, “Optimal Portfolio Implementation with Transactions Costs and Capital Gains Taxes,” Working Paper, Haas School of Business, University of California, Berkeley, September 2003. Also, * Davis, M., and Norman, A., “Portfolio Selection with Transactions Costs,” Mathematics of Operations Research 15, 1990, pp. 676-713. *Liu, H., “Optimal Consumption and Investment with Transaction Costs and Multiple Risky Assets,” Journal of Finance 59, 2004, 289-338. *Dammon, M., Spatt, C., and Zhang, H., “Optimal Asset Location and Allocation with Taxable and Tax-Deferred Investing,” Journal of Finance 59 (2004), pp. 999-1037. ** If time permits 7