Measuring Performance

IC, information coefficient - A correlation value that measures the relatinoship between a variable's predicted & actual values, used for evaluating forecasting skill.

In our active quant strategies, an IR of .10 in considered excellent. An IR of .05 would be considered good.

IR, information ratio - A measure of the risk-adjusted return of a financial security (or asset or portfolio), defined as expected active return divided by tracking error. Top-quartile investment managers typically achieve information ratios of about one-half.

tracking error - the standard deviation of the active return

Why we use log returns

Log Returns

If $100 grows to $120, what is the single period return?

Discretely... +20% because 120/100-1 = 20%

Continuously... log return is given by LN(P1/P0) or ~18.2%. (If the asset paid dividends, they are included in the numerator).

Period log returns are typically used in quantitative finance

Benefits of log return

* Time additive: Note that the two-period log return is identical to the sum of the each period’s log return. To get the n-period log return, we can simply add the consecutive single period log returns. Conversely, notice the simple return is not time additive.

* Mathematically convenient: logs and exponents are easier to manipulate with calculus. Theoretical models tend to assume, unrealistically but conveniently, continuously compounded rates of return. For example, if LogReturn = LN(P1/P0), then EXP[LogReturn] = P1/P0. If f(y) = EXP[LogReturn] then the first derivative, f’(y) is quite wonderfully also EXP[LogReturn]. In short, d/dx EXP[x] = EXP[x].

* Approximately good: for short periods (e.g., daily), the log return approximates the discrete return anyway

Drawbacks of log return

* Not "linear" in portfolio return: We would like to be able to say that portfolio return is a weighted sum of components (assets). However, we cannot say this under log returns: the log return is not linearly additive across portfolio components. But, the discrete return is linearly additive.

* Unrealistic: Markets tend to quote discrete returns

Trade Finance Definitions

Export Credit Agencies (ECAs)

Are private or quasi-governmental institutions that act as intermediaries between national governments & exporters to issue export financing, in the form of credits (financial support) or credit insurance and guarantees (pure cover) or both, much like normal banking activities

letter of credit

* Document issued which usually provides an irrevocable payment undertaking; can be source of payment for a transaction (i.e. redeeming the letter of credit will pay an exporter)

* Parties involved:

+ beneficiary - who is to receive the money

+ issuing bank - of whom the applicant is a client

+ advising bank - of whom the beneficiary is a client

* bill of landing (BOL or B/L) - document issued by carrier to shipper acknowledging that specified goods have been received on board as cargo for conveyance toa named place for delivery to the consignee

factoring

* Financial transaction where by business sells its accounts receivables to a third party (called a factor) at a discount in exchange for immediate money w/which to finance continued business

* Firm based operation (i.e. firm sells all its receivables); vs. forfaiting, which is a transaction based operation

* Parties involved:

+ seller of receivables

+ debtor

+ factor

Bonds and Inflation

Inflation breakeven rate refers to the difference between the nominal yield on a conventional bond and the real yield on an inflation-indexed bond of the same maturity. It has been used extensively as a tool to obtain the expected inflation.

If the breakevens are rolling over... one possible explanation is that, while the real yield holds steady, yields on conventional bonds are falling (i.e. conventional bonds are being bid higher) (hence the difference between the two yields is also falling). Funds could be flowing into bonds because deflation is considered more of a threat than inflation.

REITs - Capitalization Rate

cap rate = NOI/Cost (or Value)

* Measures rate of return

* Direct capitalization... income generating property is often valued according to projected cap rates used as investment criteria... i.e. asset price = cash flow / cap rate

* NOI takes net income and backs out adjustments made for depreciation, interest expense, profit tax, & reserves for repairs

+ Because depreciation doesn't directly affect cash generated by asset.

+ But more careful & realistic definition... est annual maintenance expenses or capital expenditures will be included in non-interest expenses

* NOI, and thus cap rate, is a capital structure-neutral valuation measure

* Lower cap rates for properties indicate less risk associated w/investment (& and thus lower rate of return demanded for investment)

* Factors considered when assessing risk include... creditworthiness of tenants, terms of lease, quality & location of property & general volatility of market

* ERV (Estimated Rental Value)... states valuer's opinion as to the open market rent which could reasonably be expected to be achieved on the subject property at the time of valuation

* reversionary... diff between the "in-place" (or "passing") rent and the ERV (Estimated Rental Value)

* "rack rented"... if the passing rent payable on property is equivalent to its ERV

Gold Hedging II

The argument goes that hedging causes gold price to decline because it increases supply when borrowed gold is sold into the spot market.

De-hedging (i.e. closing out a hedgebook), on the other hand, is thought to strengthen the gold price because it either decreases supply, when the mining companies deliver production to repay gold loans instead of selling it, or because the mining companies pay their loans off w/gold purchased from the market

Treasury Auctions

primary dealers - large securities dealers/financial institutions that are active in buying & selling US government securities & have established business relationships with the NY Fed

* The US Government auctions Treasury bills & notes to finance the public debt.

* Most are bought by primary dealers; A small amount are bought by individual investors (who buy them directly from the Treasury Dept @ auction)

* Currently... bills in three- & six-month maturities; notes in two-, five-, and ten-year maturities;

* Occasionally, Treasury auctions cash management bills (CMBs) (w/maturities that are set on an issue-by-issue basis) to meet short-term financial needs

Bidding

* Bids are accepted up to 30 days in advance of the auction, & may be submitted electronically through the Treasury Automated Auction Processing System (TAAPS) and by mail. All bids are confidential & kept sealed until auction date.

* Two types of bids may be submitted...

(1) Non-competitive tenders... generally submitted by small investors & individuals... guaranteed to receive securities... amount of securities that may be sold to single non-competitive bidder is limited to $1MM per auction for bills & $5MM for coupon issues

(2) Competitive bids... usually submitted by primary dealers for own accounts, or on behalf of customers... bids are submitted in terms of yield or discount rate... to ensure that 2ndary market for Treasury securities remains competitive, bidders are restricted to receiving no more than 35% of total amount of securities available to public

* Three categories of bidders; Dealers + Directs + Indirects = 100%

(1) Dealers submit bidding for their own house accounts & are required to make bids

(2) Directs are non-primary dealer submitters. They may make bids for their own books or on behalf of clients. Some direct bidders may make bids to look to eventually become primary dealers.

(3) Indirects are customers placing competitive bids through a primary dealer, and are largely foreign and international monetary authorities placing bids through the NY Federal Reserve Bank

Determining the winning bids

* The non-competitive tenders (which automatically receive securities) are subtracted from the total offering to determine amount awarded to competitive bidders

* The Treasury works down the list off competitive bidders, accepting highest bid prices until all securities have been awarded... all lower competitive bids are rejected

* Single-price auction... successful competitive bidders & noncompetitive bidders buy securities at price that equals the highest accepted yield or highest accepted discount rate (i.e. lowest bid)

* Total amount of bids received & total accepted are made available to the public.

* The high, low, & weighted averages of the price, discount rate, and equivalent bond yield of the accepted competitive bids are released to the public

* The weighted average price & yield from the successful competitive bids are applied to the non-competitive tenders

Treasury auctions tail

* In bond market jargon the tail is the distance from the level at which bonds were trading on a when issued basis immediately prior to the auction, to where the Treasury was able to complete the sale. A long tail represents a lack of interest from clients and dealers who would normally underwrite the security.

* It's the spread in price between the lowest competitive bid accepted by the U.S. Treasury for bills, bonds, and notes and the average bid by all those offering to buy such Treasury securities.