Portfolio ManagementGrenoble Ecole de ManagementMSc Finance2011

Learning Objectives

Mastering the principles of the portfolio management process:

•Execution•Market efficiency

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Portfolio ManagementExecution of Portfolio Decisions

Execution

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• How mangers and traders interact with the market.

• Investors give order to buy or sell assets directly to financial intermediaries or to buy side traders.

• These buy side traders are the professional traders employed by investment managers who places the trade that execute the decisions of the portfolio manager.

Market organization

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Markets are organized to provide:

• liquidity, • transparency (information on quotes is easy to

get)• to assure completion (trades settle without

problems under all market conditions).

Fixed income and equity markets have evolved very rapidly, trading is partly or fully automated. Also settlement may be partly automated.

Market organization

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Global custodian

Trading hours

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Continuously-traded securities 09:00-17:35

Trading at Last (TAL) Phase 17.35-17.40

Double auction-traded securities - Brussels, Lisbon and Paris

11:30-16:30*

Double auction-traded securities - Amsterdam 10:30-16:30*

Trade Confirmation System (TCS) reporting tool for off-orderbook trades 07:15-19:00

Trading hours

Note: * For auction-traded securities, orders are managed through an orderbook that operates continuously from 07:00 to 18:00, but are matched just twice daily.

Order type

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Market order is an instruction to execute an order promptly in the market at the best price available.

A limit order is an instruction to trade at the best price available but only if the price is at least as good as the limit price specified in the order. Expiration date is always mentioned.

Order types

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Market orderLimit orderVWAP orderBest efforts orderUndisclosed limit orderMarket on open orderMarket on close order Basket tradeA block order is an order large relative to the liquidity ordinarily available.

Quote driven market

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• A dealer or market maker is a business entity that is ready to buy an asset for inventory or sell an asset from inventory to provide the other side of an order to buy or sell the asset.

• The dealers provide bridge liquidity, the price of which is the bid-ask spread.

Order driven market

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• Transaction prices are established by public limit orders to buy or sell a security at specified prices.

• There is no intermediation by a dealer.

• The book order is central to the order driven market.

• The market may be automated

Types of orders

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Order book

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bid ask

Orders volume Buy   Sell Volume Orders

2 5562 8,284   8,285 42 1

2 7629 8,28   8,289 4467 1

1 79 8,278   8,29 26571 2

1 3202 8,276   8,298 6758 2

1 500 8,275   8,301 16304 1

2 990 8,272   8,31 55479 2

1 100 8,27   8,311 12075 1

1 1572 8,268   8,314 56211 2

1 1063 8,262   8,319 35808 1

1 813 8,261   8,32 20148 3

The bid – ask spread.

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Bid price is the price at which the market will buy a specified quantity of a security. Ask price is for sell. Bid is always higher than ask. The spread measure the cost of trading.

Empirical analysis confirms that effective bid-ask spreads are lower in higher volume securities. Spreads are wider for riskier and less liquid assets.

The bid – ask spread.

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04/1

0/20

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07/0

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Volatility Bid-Ask spread

%

Evaluating market quality.

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The market has relatively low bid ask spreads liquidity

The market is deep (big trade tend not to cause large price movements).

Market is resilient if any discrepancies between market price and intrinsic value tend to be small and corrected quickly.

Finalization of the trade

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Settlement, clearing house (clearstream, euroclear), back office.

Regulations: CESR Center of European securities regulator, AMF, FSA Financial Service Authorities.

http://www.cesr-eu.org/

http://www.amf-france.org/

http://www.fsa.gov.uk/

Order: exercises

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Buy Sell

Quantity Bid Price Quantity Ask Price

1 031 111,0 900 111,2

13 110,5 357 111,3

320 110,3 824 111,5

71 110,2 3 799 111,6

315 110,1 1 111,8

The latest operation on stock AA concerned 78 shares at 111,20 €. The 5 best limits are in the following table. A fund manager likes to buy 1500 shares at the market price (market order).• Is the order immediately executed ? Describe the transaction, the new order book, and the market price.• Describe the transaction if passed at the best limit ?

Order: exercises

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Buy Sell

Quantity Bid Price Quantity Price

5 082 59,85 3 527 59,90

8 114 59,80 3 688 59,95

1 000 59,75 10 535 60,00

4 374 59,70 1 124 60,05

5 029 59,65 2 002 60,10

The latest operation on stock BB concerned 68 shares at 59.85 €. The 5 best limits are in the following table. A fund manager likes to sell 15000 shares at 59.80 € (limit order). • is the order immediately and fully executed ? Describe the transaction, the new order book and the new market price . • what become the remaining shares ?

Portfolio ManagementMarket efficiency

Market efficiency.

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Market efficiency: prices seem to follow a random walk. Successive changes in value are independent. Mean return and variance are stable.

1) Information is widely and cheaply available to investors and that all relevant and ascertainable information is already reflected in security prices.

2) There is strong competition in the market.

The market reaches an equilibrium price which incorporates all the information available. Prices change only under new information arrival.

Market efficiency.

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There is no useful information in the sequence of past changes in stock price.

MSCI Energy index

17/0

4/19

95

17/1

1/19

95

17/0

6/19

96

17/0

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97

17/0

8/19

97

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080

50

100

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Market efficiency.

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There is no useful information in the sequence of past changes in stock price.

-0.0

3-0

.02

-0.0

1

-1.7

3472

3475

9768

1E-1

7

0.00

9999

9999

9999

999

0.02

0.03

-0.03

-0.02

-0.01

-1.73472347597681E-17

0.00999999999999999

0.02

0.03

Daily returns ranked according to past daily returns

Market efficiency

•Weak efficiency: prices reflect all information contained in the record of past prices.

•Semi-strong efficiency: past information and other published information.

•Strong efficiency: all information

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Empirical studies

Testing the weak form. Is there a relationship between present and past returns ?

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Empirical studies

The relationship between present and past returns is often found non significant.

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t=1,38 t=-0,9

There is no useful information in the sequence of past changes in stock price.

Empirical studies

• Testing the semi strong efficiency

• Cumulative abnormal return test following an announcement.

• Abnormal returns might be calculated using peer comparisons or CAPM. Residuals must fluctuate around the mean.

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Empirical studies: peer comparisons

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Objective: Examine if new (company specific) information is incorporated into the stock price in one single price jump upon public release?

1.Define as day “zero” the day the information is released2.Calculate the daily returns Rit the 30 days around day “zero”: t = -30, -29,…-1, 0, 1,…, 29, 303.Calculate the daily returns Rmt for the same days on the market (or a comparison group of firms of similar industry and risk)4.Define abnormal returns as the difference ARit= Rit–Rmt

5.Calculate average abnormal returns over all N events in the sample for all 60 reference days

6.Cumulate the returns on the first T days to

Empirical studies

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Cumulative abnormal returns around earning announcements

(MacKinlay1997)

Empirical studies

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Cumulative abnormal returns around take over announcements

Empirical studies: CAPM

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Abnormal returns (Ri – R M)

Days from announcement Delta Unite

dAmer

icanSum

Average abnormal return

Cumulative

average residual

-4 -0.2 -0.2 -0.2 -0.6 -0.2 -0.2  -3 0.2 -0.1 0.2 0.3 0.1 -0.1  -2 0.2 -0.2 0.0 0.0 0.0 -0.1  -1 0.2 0.2 -0.4 0.0 0.0 -0.1  0 3.3 0.2 1.9 5.4 1.8 1.7  1 0.2 0.1 0.0 0.3 0.1 1.8  2 -0.1 0.0 0.1 0.0 0.0 1.8  3 -0.2 0.1 -0.2 -0.3 -0.1 1.7  4 -0.1 -0.1 -0.1 -0.3 -0.1 1.6  

Cumulative Abnormal Returns

-0.2 -0.1 -0.1 -0.1

1.71.8 1.8

1.7 1.6

-0.5

0

0.5

1

1.5

2

-4 -3 -2 -1 0 1 2 3 4

Days from announcement

CA

R

Empirical studies

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Grossman Grossman-Stiglitz Paradox

•If the market is (strong-form) efficient and all information (including insider information) is reflected in the priceNo one has an incentive to expend resources to gather information and trade on it.

•How, then can all information be reflected in the price?

⇒markets cannot be strong-form informationally efficient, since agents who collect costly information have to be compensated with trading profits.

Anomalies

• Behavioral finance Kahneman and Tversky (1979).

• Week end effect (Monday’s returns are lower).

• January returns are higher especially for small caps.

• Returns are lower in winter.

• Etc…

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Summary

• In an efficient market, news are incorporated immediately.

• On average, the price signals the value of the asset.

• The book order summarizes recent orders flow thus market local equilibrium.

• Orders might specify market conditions.

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