ABOUT THE BOOK
A unique perspective on applied investment theory and risk management from the Senior Risk Officer of a major pension fund
Investment Theory and Risk Management is a practical guide to today's investment environment. The book's sophisticated quantitative methods are examined by an author who uses these methods at the Virginia Retirement System and teaches them at the Virginia Commonwealth University. In addition to showing how investment performance can be evaluated, using Jensen's Alpha, Sharpe's Ratio, and DDM, he delves into four types of optimal portfolios (one that is fully invested, one with targeted returns, another with no short sales, and one with capped investment allocations).

In addition, the book provides valuable insights on risk, and topics such as anomalies, factor models, and active portfolio management. Other chapters focus on private equity, structured credit, optimal rebalancing, data problems, and Monte Carlo simulation.

Contains investment theory and risk management spreadsheet models based on the author's own real-world experience with stock, bonds, and alternative assets
Offers a down-to-earth guide that can be used on a daily basis for making common financial decisions with a new level of quantitative sophistication and rigor
Written by 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
Investment Theory and Risk Management empowers both the technical and non-technical reader with the essential knowledge necessary to understand and manage risks in any corporate or economic environment.


TABLE OF CONTENTS
Preface xv

Acknowledgments xix

CHAPTER 1 Discount Rates and Returns 1

Estimating Returns 1

Geometric and Arithmetic Averages 4

Caveats to Return Extrapolation 5

Discounting Present Values of Cash Flow Streams 7

Internal Rate of Return and Yield to Maturity 11

Real and Nominal Returns 14

Summary 14

CHAPTER 2 Fixed Income Securities 17

Coupon-Bearing Bonds 19

Infinite Cash Flow Streams (Perpetuities) 21

General Pricing Formulas for Finite Cash Flow Streams 22

Interest Rate Risk 24

Analysis of Duration 29

Interest Rate Risk Dynamics 31

Immunization and Duration 32

Applications—Liability Discounting and Cash Matching 36

Pension Logic 39

Risky Coupons 42

Inflation Risk and TIPS 43

A Bond Portfolio Strategy (Optional) 45

Summary 48

Appendix 2.1: Solving Infinite and Finite Power Series 49

Reference 50

CHAPTER 3 Term Structure 51

Discounting Using Spot Rates 51

Forward Rates 53

NPV Revisited 56

Short Rates 57

The Bootstrap Method 58

Duration Redux 62

Summary 66

CHAPTER 4 Equity 67

The Determination of Stock Prices 68

Discount Rates Redux 70

Price and Dividend Multiples 73

Extrapolating Multiples to Forecast Returns 74

Pitfalls of Trend Analysis 75

The Gordon Growth Model 78

Sources of Return 82

Summary 85

References 86

CHAPTER 5 Portfolio Construction 87

Stochastic Returns and Risk 87

Diversification 92

The Efficient Frontier 93

Markowitz Portfolio Selection Criteria 97

Capital Market Line and the CAPM 101

Performance Evaluation 106

Summary 108

Appendix 5.1: Statistical Review 108

Appendix 5.2: Risk-Adjusted Performance 112

Reference 113

CHAPTER 6 Optimal Portfolios 115

Portfolio 1: Minimum Variance Portfolio (Fully Invested) 115

Portfolio 2: Minimum Variance Portfolios with

Targeted Return 118

Portfolio 3: Minimum Variance Portfolios with No Short Sales 119

Portfolio 4: Minimum Variance Portfolios with Capped Allocations 122

Portfolio 5: Maximum Risk-Adjusted Return 123

Performance Attribution 125

The Efficient Frontier (Again) 127

Summary 129

Appendix 6.1: Matrix Operations 129

CHAPTER 7 Data and Applications 135

Analyzing Returns on a 10-Asset Portfolio 135

Performance Attribution 137

Changing the Investment Horizon Returns Frequency 139

Benchmarking to the Market Portfolio 141

The Cost of Constraints 144

A Bond Strategy 145

Summary 147

CHAPTER 8 Anomalies 149

Deviations from the CAPM 150

Behavioral Finance 155

Summary 161

References 162

CHAPTER 9 Factor Models 165

Arbitrage Pricing Theory (APT) 166

Factor Selection 170

Model Estimation 172

Principal Components 177

Applications and Examples 181

Summary 186

References 186

CHAPTER 10 Active Portfolio Management 187

Active Portfolio Construction and Attribution Analysis 190

Performance Attribution 192

Summary 194

Appendix 10.1: Active Space 195

CHAPTER 11 Risk 197

The Failure of VaR 198

Taxonomy of Risk 200

Visualizing Risk 202

Estimating Volatilities 208

Maximum Likelihood Estimation (Optional) 213

Credit Risk 215

Adjusting for Leverage 217

Adjusting for Illiquidity 221

Other Risks 221

Summary 222

References 222

CHAPTER 12 Monte Carlo Methods 225

Example 12.1: Generating Random

Numbers—Estimating P 226

Example 12.2: Confirming the Central Limit Theorem 227

Example 12.3: Credit Default Risk 228

Non-Normal Distributions 232

The Gaussian Copula 234

Summary 239

References 239

CHAPTER 13 Systemic Risk 241

Extreme Value Theory 242

Estimating the Hazards of Downside Risks 246

A Systemic Risk Indicator 252

Summary 255

References 256

CHAPTER 14 Incorporating Subjective Views 257

Methodological Concepts 258

An Example Using Black-Litterman 263

Active Space 266

Risk Attribution 267

Summary 268

References 269

CHAPTER 15 Futures, Forwards, and Swaps 271

Institutional Detail and Futures Mechanics 271

The Relationship between Spot Prices and Forward (Futures) Prices 274

Hedging Basis Risk 276

Hedging Portfolio Risk 278

Futures Pricing 280

Swaps 287

Summary 291

References 292

CHAPTER 16 Introduction to Options 293

Option Payoffs and Put-Call Parity 294

Pricing European Call Options 297

Pricing European Put Options 301

Option Strategies 302

Real Options 308

Summary 314

References 314

CHAPTER 17 Models of Stock Price Dynamics 315

Stock Price Dynamics 315

Ito Processes 318

Lognormal Stock Prices 321

Deriving the Parameters of the Binomial Lattice 325

Black-Scholes-Merton Model 327

The Greek Letters 330

Monte Carlo Methods 335

Summary 338

Appendix 17.1: Derivation of Ito’s Lemma 339

CHAPTER 18 Hedging Portfolio Risk 341

Simple Hedging Strategies 341

S&P 500 Index Puts 343

Selling Volatility 345

VIX Calls 346

Liability-Driven Investment 350

Summary 353

References 354

CHAPTER 19 Private Equity 355

The Private Equity Model 357

Return and Risk Methodology 360

Summary 366

Appendix 19.1: CAPM 366

References 369

CHAPTER 20 Structured Credit 371

Securitization 372

Credit Enhancement 374

Basics of Pricing Interest Rate Derivatives 379

Interest Rate Dynamics 381

CMO Valuation 383

The Crash of the Housing Bubble 385

Summary 387

Reference 388

CHAPTER 21 Optimal Rebalancing 389

Trigger Strategies and No-Trade Regions 390

An Optimal Control Problem 392

Implications 395

Optimal Rebalancing in a Static

Optimization Model 396

The Comparative Statics of Transaction Costs 398

Reference 400

CHAPTER 22 Data Problems 401

Covariance Estimation 402

An Example 405

Empirical Results 407

Overlapping Observations 413

Conclusions 416

Appendix 22.1: Covariance Matrix Estimation 417

References 420

About the Author 423

Index 425


ABOUT THE AUTHOR
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.