Joseph CherianProfessor of Finance (Practice)

Director, Center for Asset Management Research & Investments (CAMRI)NUS Business School

www.bschool.nus.edu.sg/CAMRI

January 22, 2010

Financial Management: Theory & Practice

CENTER FORASSET MANAGEMENTRESEARCH &INVESTMENTS

1. Financial Management 101: Investment Theory, Asset Allocation, and Finance Practice

2. Alpha versus Beta and the Importance of Emerging Markets

3. Global Financial Centers The Race To The Top

The Case for Asia

4. Closing Thoughts

Contents for Today’s Discussion

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1. Financial Management 101: Investment Theory, Asset Allocation, and Finance Practice

A framework for dynamic asset allocation

Asset allocation consists of 3 elements that control for the tradeoff between risk and reward:

diversification hedging insurance

The investment management industry tends to mostly focus on the diversification component.

The other 2 components of risk management, control, and transfer are equally important, but not emphasized as much.

4

0.0%

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3.5%

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-10.0% 0.0% 10.0% 20.0% 30.0%

Prob

abili

ty (%

)

Distribution of annual geometric returns (%)

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

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3.5%

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-10.0% 0.0% 10.0% 20.0% 30.0%

Prob

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ty (%

)

Distribution of annual geometric returns (%)0

2

4

6

8

10

12

0 5 10 15 20

Expe

cted

Ret

urns

(%)

Expected Risk (%)

DIVERSIFICATION HEDGING INSURANCE

Back To The Basics When Structuring A Portfolio

Optimally balancing risk and return tradeoffs

Reducing exposure to bad outcomes by giving up the possibility of some gains

Eliminating exposure to bad outcomes by paying an upfront premium

Common Themes When Implementing An Optimal Portfolio Allocation: The Fundamentals

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DESIRABLE RISK ADJUSTED RETURNS ARE THE ULTIMATE GOAL IN STRUCTURING OPTIMAL PORTFOLIOS, AND IN SOME SITUATIONS MIGHT REQUIRE ALTERING THE SHAPE OF THE PAYOFF

Definitions

1. Diversification

The principle of effectively allocating investable resources across multiple risky assets, as opposed to a concentrated few, so that a higher expected return can be achieved for no increase in overall risk exposure.

Efficient frontier example

•Sample client portfolio

•

••

•Sample

Optimal Portfolio

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Definitions (Cont’d)

2. Hedging

The principle of reducing one’s risk exposure to bad outcomes by giving up the possibility of gains. Usually, the cost of downside protection is paid for by the forgone potential of upside gain. Example 1. Forward contracts can be put in place so that an investor faces no market price risk when liquidating out of a concentrated equity position in ABC stock. The graph and schedule below provide the values for a particular forward-hedged portfolio for different terminal ABC stock prices. Hypothetical 1-year short (or sell a) forward at a forward price of $25.62 written on 5M shares of ABC with a maturity of 1 year.

Forward Hedging

(30.0)

(20.0)

(10.0)

-

10.0

20.0

30.0

40.0

50.0

- 4.00 8.00 12.00 16.00 20.00 24.00 28.00 32.00 36.00 40.00 44.00 48.00

Terminal Stock Price

$

ABC Terminal Stock PriceShort ForwardPortfolio Payoff

ABC Terminal Stock Price ABC Stock Value

Payment from BofA to Client

Client's Portfolio Payoff

20.00 100,000,000$ $ 28,100,324 128,100,324$ 21.00 105,000,000$ $ 23,100,324 128,100,324$ 22.00 110,000,000$ $ 18,100,324 128,100,324$ 23.00 115,000,000$ $ 13,100,324 128,100,324$ 24.00 120,000,000$ $ 8,100,324 128,100,324$ 25.00 125,000,000$ $ 3,100,324 128,100,324$ 26.00 130,000,000$ $ (1,899,676) 128,100,324$ 27.00 135,000,000$ $ (6,899,676) 128,100,324$ 28.00 140,000,000$ $ (11,899,676) 128,100,324$ 29.00 145,000,000$ $ (16,899,676) 128,100,324$ 30.00 150,000,000$ $ (21,899,676) 128,100,324$

ABC Sample Forward Pricing (Quarterly)

Initial Stock Price 25.00 rho (interest rate) 3.45% assume flat

Dividend Yield 1.0% assume constant

Short forward

ABC stockPortfolio payoff on liquidation to Client

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Definitions (Cont’d)

2. Hedging (cont’d)

Example 2. Alternatively, zero-cost collars effectively cap and floor the prices at which liquidation of the concentrated equity position in ABC stock takes place. I.e., selling prices, and hence hedged portfolio values, will be kept within the bands of the collar. (Hypothetical 1-year collar with a fixed floor of $23.75 and a cap of $28.37written on 5M shares of ABC.)

CollarHedging

(30.00)

(20.00)

(10.00)

-

10.00

20.00

30.00

40.00

50.00

- 4.00 8.00 12.00 16.00 20.00 24.00 28.00 32.00 36.00 40.00 44.00 48.00

Terminal Stock Price

$

ABC StockShort CallLong PutPortfolio Payoff

ABC Terminal

Stock Price Client's ABC Stock Value

Payment from BofA to Client

Client's Portfolio Payoff

20.00 100,000,000 18,750,000$ 118,750,000$ 21.00 105,000,000 13,750,000$ 118,750,000$ 22.00 110,000,000 8,750,000$ 118,750,000$ 23.00 115,000,000 3,750,000$ 118,750,000$ 24.00 120,000,000 -$ 120,000,000$ 25.00 125,000,000 -$ 125,000,000$ 26.00 130,000,000 -$ 130,000,000$ 27.00 135,000,000 -$ 135,000,000$ 28.00 140,000,000 -$ 140,000,000$ 29.00 145,000,000 (3,142,593)$ 141,857,407$ 30.00 150,000,000 (8,142,593)$ 141,857,407$

ABC Sample Collar Pricing (Quarterly)

l Stock Price 25.00 Floor price 23.75 5% discount

Volatility 40.95% assume flat (weighted historical and implied vol average)rho 3.45% assume flat

vidend Yield 1.0% assume constant

Short call

ABC stockPortfolio payoff on liquidation to Client

Long put

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Definitions (Cont’d)

3. Insurance

The principle of eliminating one’s risk exposure to bad outcomes by paying an insurance premiumupfront for a put option. The payment of the option premium allows the investor to capture any upside potential without facing downside losses.

Investment value at maturity

SGD 1M

SGD 1M(strike price)

Stock Index Performance > 0%

Call option in-the-moneyBond Principal

Stock fund value at maturity

Put-call ParityStock Index + Put = Call + K*B(0,T)

Diversified portfolio Principalprotection

Present valueof strike price

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The next slide has a more sophisticated insurance-based investment product: a zero-cost, inflation-indexed participating forward

Zero-cost, Inflation-Indexed Participating ForwardLimited downside, some upside given up

ForwardPrice (F)

Future Risky Investment Value ST(SGD)

Future Realized Investment Value

No hedging

Plain forward contract

Retirement Receipts at T + Participating

Forward

Strictly limited downside(indexed to inflation)

Some participation in upside

Receive ST million SGD at T upon retirement= ST million SGD at T

Short inflation-indexed participating forward:

K – ST if ST < KPayoff = 0 if K ≤ ST ≤ F

- ½ (ST – F) if ST > F

Long Put struck at K + Write ½ a Call struck at F

Participating Strike (K)

K F

Investment appreciatesInvestment depreciates

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Case for hedging and insuring

A client would like to dynamically participate in the upside of equities bull markets, yet would like to seek protection of principal by being principally allocated to riskless bonds during the bear markets.

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Motivation - a well-diversified, all equities portfolio

Time (Years)

Wealth (USD)Wealth Percentiles ($b)

1 3 5 10 20 1

30

1

10

95th Percentile Expected Value 5th Percentile 1th Percentile0.5th Percentile

Time (Years)

Compound Annual ReturnReturn Percentiles

1 3 5 10 2030.0%

50.0%

25.0%20.0%15.0%10.0%-5.0%0.0%5.0%

10.0%15.0%20.0%25.0%30.0%35.0%40.0%45.0%

95th Percentile Expected Value 5th Percentile 1th Percentile0.5th Percentile

• Volatility of average compound rate of return on stocks declines with length of time horizon.

• Probability of a shortfall declines with length of time horizon.

• However, the severity of the shortfall (the “penalty of being wrong” function) increases with length of time horizon.

Time

ProbabilityTarget Probabilities

1 3 5 10 200.0%

100.0%

5.0%10.0%15.0%20.0%25.0%30.0%35.0%40.0%45.0%50.0%55.0%60.0%65.0%70.0%75.0%80.0%85.0%90.0%95.0%

Target = 6%

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Time

Return ValuesFrequency: Monthly

Return Line Graph

-20.0%

10.0%

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8.0%

-7.9%-9.0%

Jan1994

Nov2000

Jun1994

Dec1994

Jun1995

Dec1995

Jun1996

Dec1996

Jun1997

Dec1997

Jun1998

Dec1998

Jun1999

Dec1999

Jun2000

S&P 500 TR Russell MidCap TR

sharp interest rate hike

LTCM crisis

Recession blues

“high degree of co-movement”

S&P 500 Large Cap versus Russell Mid CapS&P 500 Large Cap and Russell Mid Cap performance

Systematic risk is not eliminated

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Client wishes to be fully invested in the broad market but doesn’t want to expose the initial invested capital ($K) to loss.

Time

Return ValuesFrequency: Monthly

Return Line Graph

-20.0%

10.0%

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-16.0%

-14.0%

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-8.0%

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2.0%

4.0%

6.0%

8.0%

-7.9%-9.0%

Jan1994

Nov2000

Jun1994

Dec1994

Jun1995

Dec1995

Jun1996

Dec1996

Jun1997

Dec1997

Jun1998

Dec1998

Jun1999

Dec1999

Jun2000

S&P 500 TR Russell MidCap TR

sharp interest rate hike

LTCM crisis

Recession blues

“high degree of co-movement”

S&P 500 Large Cap versus Russell Mid Cap

Elimination of downside risk

The requisite dynamic strategy to achieve the client’s desired (or altered) payoff can be financially engineered using a (buy and hold) put option on the basket of diversified equities benchmarks.

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Role of intermediaries

Efficient and competitive financial intermediation would allow investors and institutions to achieve their “lifetime” consumption and spending allocations, risk management and transfer needs, bequests functions, etc., without the need for (costly) dynamic trading in securities.

Given the set of (preferred) intermediate consumption and/or spending program, the intermediary can structure the right set of buy-and-hold mutual funds, fixed income instruments, and traded (or customized) derivative solutions to meet those needs.

These solutions can serve as a substitute for costly dynamic trading in securities for both investors and institutions.

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2. Alpha versus Beta and the Importance of Emerging Markets

Identify and quantify sources of incremental expected return Finding new sources of alpha Increased emphasis on finding investment manager skill

Greater use of synthetic solutions toward an efficient use of capital

Greater emphasis on risk management: Identification and quantification of the sources of risk Evaluating impact of incremental non-additive active alpha risk exposure Assessing risk beyond normality: tail risks, correlation breakdowns, importance of

skewness (higher moments) Risk management via options and financial engineering

Taking Stock: Leveraging the Investment Decision Process

QUANTITATIVE TECHNIQUES HELP IDENTIFY SOURCES OF ALPHA AND MANAGE RISK EXPOSURE TO ACHIEVE OBJECTIVES – “A RISK-CONTROLLED ALPHA-GENERATING PROCESS”

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Two key sources of potential excess return in an investment portfolio

– Market returns (Beta): the tendency of an investment to move with the “market”

– Skill returns (Alpha): average return earned in excess of market return

Alpha is measurable, distinguishable and associated with “skill”

“Portable alpha” is a mechanism through which the manager seeks to separate alpha from

beta for deployment in other strategies

Defining Alpha, Beta and Portable Alpha Strategies

Σ β i,jE(rmj – rf )αi=E (rp

i - rf ) j

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“ALPHA”

“BETA”

Sources of incremental expected return Incremental returns over nominal cash (riskless asset) represents potential reward

for bearing risk

The Beta component (a.k.a. Relative Return strategies) Expected return premium for bearing systematic risk Return from “Beta” exposure to a market or asset class

The Alpha component (a.k.a. Absolute Return strategies) “Traditional” money managers moving into this space Alternative alpha managers: Global Macro, Equity Market Neutral, Convert Arb, etc.

Defining Then Separating Alpha From Beta – A Paradigm Shift

OPTIMIZING INVESTORS’ PORTFOLIOS ALONG INTEREST RATE, MARKET AND ACTIVE RISK DEMENSIONS LEADS TO IMPROVED RISK ADJUSTED RETURNS

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What’s Going On In The Global Equities (Beta) Space?

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The Growing Importance of Emerging Markets (Beta – Cont’d))

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The Diminishing Importance of the U.S. (Beta – Cont’d)

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Exhibit 11 shows that over the last two decades, the correlation between European equities and other regional equity markets has risen significantly.

Increasing Correlations (Beta – Cont’d)

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More Correlations – Regional versus Global Sector (Beta –Cont’d)

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Sources of Low Correlations – How About Some Alpha?

Uncorrelated Strategies:

Absolute return strategies / Alpha strategies

– Hedge Funds and Fund of Hedge Funds. Examples of hedge fund:

– Global Macro

– L/S Equity Market Neutral

Overlay manager strategies / Alpha strategies

– Global Tactical Asset Allocation (GTAA) overlay strategy

Low-correlation Strategies:

– Commodities

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Investing in Absolute Return Strategies

Advantages:

– Stability of alpha

– Unique distribution of returns

– Breadth and diversity of investment strategies

Disadvantages:

– Lack of liquidity and transparency

– No standardized benchmark, and multiple biases in estimates

– Possible co-cyclicality to market returns and correlation breakdowns

– Necessitate a new asset allocation framework to allow for efficient use of capital and risk

budget

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“Set Active Managers Free From Those ‘No Shorting’ Shackles”

Financial Times, December 19, 2005

Interest in uncorrelated alpha generating strategies like Global Macro and Long-Short Equity Market Neutral are expected to continue fueling growth in Hedge Funds

Source: Russell Alternative Investments Survey, 2008

Appeal of Absolute Return Strategies: A New Look At The Market

North America Europe

Australia Japan

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INSTITUTIONS’ ACTUAL AND PROJECTED STRATEGIC ALLOCATION TO ALTERNATIVE ASSET CLASSES

3. Global Financial CentersThe Race To The Top: The Case for Asia

OUTLINE Global Financial Centers: Off to the Race Treks

Where is the financial world heading? Hope for the best, prepare for the worst Beware of data biases in indices and performance reports

Let’s take stock (no pun intended) The U.S. situation A “special” on liquidity Market outlook F/X outlook

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Part 1: History speaks louder than words

• All major cities of the world are, inextricably, centers of capital & wealth concentration andfinancial excellence

• New York, London, Hong Kong, Singapore, Tokyo, Zurich, Amsterdam

• Resilient global financial centers survive political, financial and civil conflicts

• They succeed through innovation and specialization, which takes a combination of humancapital, financial infrastructure, and laissez-faire capitalism

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OUTLINE

Global Financial Centers: Off to the Race Treks

Where is the Financial World Heading?

Let’s take stock (no pun intended) The U.S. situation Market outlook

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Global financial ranking charts

• Global Financial Centers Index by Z/Yen Group of UK rank orders London, New York, HongKong and Singapore as the 4 most competitive global financial centers (Sep 2009)

• World Economic Forum’s 2009 Financial Development Report placed Singapore 4th and HongKong 5th in its global rankings

• Bloomberg’s Global Poll of its subscribers ranked New York (29%), Singapore (17%), andLondon (16%) as the top 3 global financial centers in 3Q2009. Shanghai (11%) is fast rising theranks

• Of Asia’s top 25 M&A lawyers, 7 spots went to HK, 5 to China, 2 each to Japan and India, just 1to Singapore (Asian Legal Business)

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(As of September 2009)Global

RankingAsian

RankingMarket

Capitalisation

US$ (billion)US (NYSE) 1 11,255Japan 2 1 3,413US (NASDAQ) 3 3,026Europe (Euronext) 4 2,787UK 5 2,614China (Shanghai) 6 2 2,250Hong Kong 7 3 2,059Canada 8 1,568Spain 9 1,322Germany 10 1,273Australia 11 1,188India (BSE) 12 4 1,187India (NSE) 12 4 1,113Brazil 13 1,173Switzerland 14 1,034Korea 15 5 807NOTES

Ranking is based on market capitalisation. Market capitalisation excludes investment funds. All World Federation of

Exchanges (WFE) member stock exchanges, not solely the main exchange for each country, are included in the ranking.

Market capitalisation of the world's top stock exchanges (as of end Sep 2009)

SGX, Asia's 2nd largest listed bourse and 9th largest Asian bourse has a market cap of US$445 billion33

$-

$200

$400

$600

$800

$1,000

$1,200

$1,400

$449

$190

$465

$584

$791

$1,235

$755

$164 $159

$351

$433

$581

$815

$602

US$

Bill

ion

YEAR

Fund Management AUM in Hong Kong and Singapore (US$ billion)

HK AUM - USD (bn) Spore AUM - USD (bn)

Fund assets under management (AUM – USD billions)

Source: SFC (Hong Kong) and MAS (Singapore)Note: Singapore AUM excludes Sovereign Wealth Funds and Central Provident Fund. HK AUM includes government funds and Mandatory Provident Fund.

Excluding SWFs and the CPF, Singapore appears to lag behind Hong Kong in terms of total assets under management. Singapore had S$864 billion (US$602 billion) in AUM in 2008

compared with Hong Kong's HK$5.85 trillion (US$755 billion)

Note: According to Z-Ben Advisors, China has about RMB 2 trillion (US$ 295 billion) in fund AUM, of which 30% is controlled by the top 5 domestic managers

Retail funds HK: US$ 58.5 billionSG: US$ 59.9 billion

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Innovations

• “Co-location”, where servers are placed steps away from the exchange, has increased highfrequency & algorithmic trading, trade execution, and trade confirmation to the order ofmilliseconds in Asia. Tokyo Stock Exchange’s new Arrowhead platform executes stock trades infive milliseconds, increasing total trading capacity six fold

• “Dark Pools” of liquidity (non-displayed trading platforms) are catching on, too• Chi-East, a joint venture between trading venue operator Chi-X Global and the

Singapore Exchange, scheduled to launch in mid-2010• BlocSec, a pan-Asian trading system owned by Pan-Asian broker CLSA

• Singapore is Asia’s 2nd largest F/X trading center, the world’s 3rd largest oil trading center, andthe 8th largest in OTC derivatives trading. Singapore Mercantile Exchange goes live in January2010

• China, the world’s 2nd largest energy and largest metals consumer, actively trades variousenergy/metal futures at its 3 futures exchanges. Shanghai futures exchange adding many newcontracts in 2010

• The financial center to watch: Shanghai

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Regional Overview – Asian Financial Centers

• Asia’s big 3 (HK, Singapore, Tokyo) will certainly play a bigger role in the global financialeconomy going forward, as will newcomers Shanghai

• An interconnected, co-existence model with unique specializations and focus – e.g., China’scommodities, Singapore’s private wealth management, Singapore/HK’s fund management(Asian securities & hedge funds), etc. Partnerships with Western financial centers

• Geopolitical and financial stability is key – steps taken by Asian countries to ensure thatreflected by stability during recent financial crisis and subsequent recovery – along with goodinfrastructure, legal & regulatory framework, well-trained human capital, a (common) linguafranca

• Singapore will be more closely-linked with ASEAN (Indonesia/Malaysia) and India’s economicgrowth & prospects, Hong Kong’s fortunes will lie more closely with China’s

• Singapore’s competitive threat: HK traditionally has a more “can-do” / entrepreneurial mentality

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Part 2: Where is the financial world heading?• Liquidity, Transparency, and Downside Risk Control & Management will be paramountconcerns of management

• Leverage, compensation, fees will come down. Bonuses paid in toxic assets partially, and withclaw back provisions

• Stocks aren’t as safe in the long run (Bodie, 1995). If they were

they wouldn’t command a risk premium

longer-term put options (a.k.a. insurance) on stocks with a floor rising at the riskless ratewould be cheaper than their shorter-term counterparts:

Strike / Floor = KerT

• Pension plans should match asset to liabilities using inflation-protected bonds and annuities.Then offer guaranteed minimum lifetime benefits that is integrated with participants’ medical andlong-term care benefits

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Hope for the best, prepare for the worst

• Ageing population and changing demographics in Japan, Hong Kong, Singapore

• In Singapore, 9% of the population over 65 years of age. By 2030, that increases to 20%

• An attendant issue: the development of cutting-edge financial solutions to meet retirementplanning needs

• Starting point: 100% inflation-proof, guaranteed annuities

• Principal-protected investment products, escalating equity-indexed annuities (a.k.a. ratchet orclick funds), etc.

• See next page for Business Times’ excellent summary article on Professor Zvi Bodie’s visit toNUS / CAMRI:

Media Coverage of Professor Zvi Bodie's NUS Public Lecture on 8 December 2009Exposing fallacies in investmentsBusiness Times, 9 December 2009

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Visit CAMRI website: www.bschool.nus.edu.sg/CAMRI

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The last economic contraction ended in Nov 2001 (“NBER trough”); we hit the latest peak in Dec 2007, yielding an expansion of 73 months. Is the new trough in sight?

7.3 million jobs lost since Dec 2007 (highest 2-year job losses since 1945). 5.6 million people now collecting jobless benefits, unemployment rate is 10.2 percent (26-year high)

S&P 500 is trading around 22.2x trailing earnings, above its 25-year average of 20x, and well above the 9.9x of Mar 09 (cheapest multiple over that period)

3MO Libor hit a high of 4.8% in Oct 08 from a low of 2.5% just 7 months prior (now a paltry 26 basis points)

The Conference Board’s U.S. consumer confidence fell to 37.7 in Jan 09, the lowest since monthly records began in 1967. The reading now is a respectable 47.7

Fresh talk of a potential double-dip recession and/or inflation (perhaps stagflation?)

The new jargon

Recent Bubbles: Real Estate, Hedge Funds, Private Equity, Commodities, Wall Street Talent

Recapitalization, Deleveraging, Risk Management, Liquidity, Transparency

Source: Bloomberg

Part 3: Let’s take stock (no pun intended) of the U.S.

41Source: Bloomberg (updated Nov 2009)

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Can it happen again? “Old” VIX (S&P 100) showed extreme fear twice

Source: Bloomberg (updated Nov 2009)

W h i l e t h espike appears“fatter” in Nov2008 then inOct 1987, the“ O l d ” V I Xr e a c h e d adaily high of87 on Nov 202008 versusa daily high of150 on Oct1 9 , 1 9 8 7 .

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HSBC Financial Clog Index measures the aggregate level of stress in the U.S. financial system that includes 1) interbank stress (measured by TED spread and Libor-OIS spread); 2) financial institution default risk (measured by CDS swap spreads); mortgage agency credit spreads (measured by Fannie and Freddie credit spreads); and 4) equity volatility (measured by VIX index). All four are equally-weighted.

So did the HSBC Financial Clog Index in Oct / Nov 2008Source: Bloomberg

Market Outlook

Equities supposed to be forward-looking and all that, but markets have gotten ahead of itself, especially in emerging equities (BRIC / LatAm)

Given the up move since March 09, equities are short-term technically overbought and vulnerable to disappointing earnings

Period of consolidation in the next few months likely (potentially moderate downside), with rotation into larger cap, higher quality, liquid companies that have lower leverage, lower betas. Some hope for lower Credits and Emerging Market debt via further tightening of spreads

Funding will come out of emerging equity liquidations. Medium to longer term, the emerging equity story remains intact

Liquidity reigns. Demand for bonds, EM debt, recovering distressed, credits, inflation-linked will increase over equities as Boards / CIOs are pressured to seek new investment paradigms, especially w.r.t. funding ongoing operations

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