Investment Theory and Risk Management, + Website

STEVEN PETERSON is the Director of Research and Senior Risk Officer for the Virginia Retirement System and an Associate Professor at Virginia Commonwealth University’s School of Business. He is directly responsible for the measurement, forecasting, and attribution of risk at both the program and plan levels, with risk broadly defined to include various market and nonmarket risks. Peterson has done consulting for Crestar Investment Bank, SunTrust Bank, Ford Motor Company, Virginia Center for Urban Development (VCU Center for Public Policy), Virginia Department of Social Services, Virginia Division of Child Support Enforcement, LandAmerica, Virginia Retirement System, and Virginia Department of Corrections.

• Preface xvAcknowledgments xixCHAPTER 1 Discount Rates and Returns 1Estimating Returns 1Geometric and Arithmetic Averages 4Caveats to Return Extrapolation 5Discounting Present Values of Cash Flow Streams 7Internal Rate of Return and Yield to Maturity 11Real and Nominal Returns 14Summary 14CHAPTER 2 Fixed Income Securities 17Coupon-Bearing Bonds 19Infinite Cash Flow Streams (Perpetuities) 21General Pricing Formulas for Finite Cash Flow Streams 22Interest Rate Risk 24Analysis of Duration 29Interest Rate Risk Dynamics 31Immunization and Duration 32Applications—Liability Discounting and Cash Matching 36Pension Logic 39Risky Coupons 42Inflation Risk and TIPS 43A Bond Portfolio Strategy (Optional) 45Summary 48Appendix 2.1: Solving Infinite and Finite Power Series 49Reference 50CHAPTER 3 Term Structure 51Discounting Using Spot Rates 51Forward Rates 53NPV Revisited 56Short Rates 57The Bootstrap Method 58Duration Redux 62Summary 66CHAPTER 4 Equity 67The Determination of Stock Prices 68Discount Rates Redux 70Price and Dividend Multiples 73Extrapolating Multiples to Forecast Returns 74Pitfalls of Trend Analysis 75The Gordon Growth Model 78Sources of Return 82Summary 85References 86CHAPTER 5 Portfolio Construction 87Stochastic Returns and Risk 87Diversification 92The Efficient Frontier 93Markowitz Portfolio Selection Criteria 97Capital Market Line and the CAPM 101Performance Evaluation 106Summary 108Appendix 5.1: Statistical Review 108Appendix 5.2: Risk-Adjusted Performance 112Reference 113CHAPTER 6 Optimal Portfolios 115Portfolio 1: Minimum Variance Portfolio (Fully Invested) 115Portfolio 2: Minimum Variance Portfolios withTargeted Return 118Portfolio 3: Minimum Variance Portfolios with No Short Sales 119Portfolio 4: Minimum Variance Portfolios with Capped Allocations 122Portfolio 5: Maximum Risk-Adjusted Return 123Performance Attribution 125The Efficient Frontier (Again) 127Summary 129Appendix 6.1: Matrix Operations 129CHAPTER 7 Data and Applications 135Analyzing Returns on a 10-Asset Portfolio 135Performance Attribution 137Changing the Investment Horizon Returns Frequency 139Benchmarking to the Market Portfolio 141The Cost of Constraints 144A Bond Strategy 145Summary 147CHAPTER 8 Anomalies 149Deviations from the CAPM 150Behavioral Finance 155Summary 161References 162CHAPTER 9 Factor Models 165Arbitrage Pricing Theory (APT) 166Factor Selection 170Model Estimation 172Principal Components 177Applications and Examples 181Summary 186References 186CHAPTER 10 Active Portfolio Management 187Active Portfolio Construction and Attribution Analysis 190Performance Attribution 192Summary 194Appendix 10.1: Active Space 195CHAPTER 11 Risk 197The Failure of VaR 198Taxonomy of Risk 200Visualizing Risk 202Estimating Volatilities 208Maximum Likelihood Estimation (Optional) 213Credit Risk 215Adjusting for Leverage 217Adjusting for Illiquidity 221Other Risks 221Summary 222References 222CHAPTER 12 Monte Carlo Methods 225Example 12.1: Generating RandomNumbers—Estimating P 226Example 12.2: Confirming the Central Limit Theorem 227Example 12.3: Credit Default Risk 228Non-Normal Distributions 232The Gaussian Copula 234Summary 239References 239CHAPTER 13 Systemic Risk 241Extreme Value Theory 242Estimating the Hazards of Downside Risks 246A Systemic Risk Indicator 252Summary 255References 256CHAPTER 14 Incorporating Subjective Views 257Methodological Concepts 258An Example Using Black-Litterman 263Active Space 266Risk Attribution 267Summary 268References 269CHAPTER 15 Futures, Forwards, and Swaps 271Institutional Detail and Futures Mechanics 271The Relationship between Spot Prices and Forward (Futures) Prices 274Hedging Basis Risk 276Hedging Portfolio Risk 278Futures Pricing 280Swaps 287Summary 291References 292CHAPTER 16 Introduction to Options 293Option Payoffs and Put-Call Parity 294Pricing European Call Options 297Pricing European Put Options 301Option Strategies 302Real Options 308Summary 314References 314CHAPTER 17 Models of Stock Price Dynamics 315Stock Price Dynamics 315Ito Processes 318Lognormal Stock Prices 321Deriving the Parameters of the Binomial Lattice 325Black-Scholes-Merton Model 327The Greek Letters 330Monte Carlo Methods 335Summary 338Appendix 17.1: Derivation of Ito’s Lemma 339CHAPTER 18 Hedging Portfolio Risk 341Simple Hedging Strategies 341S&P 500 Index Puts 343Selling Volatility 345VIX Calls 346Liability-Driven Investment 350Summary 353References 354CHAPTER 19 Private Equity 355The Private Equity Model 357Return and Risk Methodology 360Summary 366Appendix 19.1: CAPM 366References 369CHAPTER 20 Structured Credit 371Securitization 372Credit Enhancement 374Basics of Pricing Interest Rate Derivatives 379Interest Rate Dynamics 381CMO Valuation 383The Crash of the Housing Bubble 385Summary 387Reference 388CHAPTER 21 Optimal Rebalancing 389Trigger Strategies and No-Trade Regions 390An Optimal Control Problem 392Implications 395Optimal Rebalancing in a StaticOptimization Model 396The Comparative Statics of Transaction Costs 398Reference 400CHAPTER 22 Data Problems 401Covariance Estimation 402An Example 405Empirical Results 407Overlapping Observations 413Conclusions 416Appendix 22.1: Covariance Matrix Estimation 417References 420About the Author 423Index 425