Quantitative Finance and Insurance

Asset Pricing and Portfolio Choice

Asset Pricing and Portfolio Choice

Academic year 2013/2014

Sommario del corso

• Course objectives
• Results of learning outcomes
• Learning assessment methods
• Program
• Suggested textbooks and readings
• Notes
• Teaching tools

Course objectives

This course teaches advanced investment management techniques and asset pricing models. The first part deals with the theory of asset pricing. It also presents asset pricing tests as well as portfolio strategies based on the cross-section of returns.
We then deal with portfolio choice models that account for investors’ horizons, return predictability and estimation risk. Last but not least, we discuss investment management for pension purposes.

Results of learning outcomes

1) Knowledge and understanding ability.

At the end of this course a student will be able to address the following issues (numbers refer to each part of the program above).

1. Is the expected return on a security related to its own risk?

2. How are the different pricing models related to one another? Can we reconcile return predictability and market efficiency? Is the cost of bankruptcy higher if we consider the risk-adjusted probability instead of the historical one? Is the possibility to trade assets improving on agents’ welfare and, if yes, how and under which conditions?

3. Is the SDF improving on the explanation of asset returns relative to the Fama French factors? Are higher-order moments priced?

5. Why should investors diversify across assets? Which are relevant characteristics of asset classes?

7. Is it possible to predict future asset returns? Are stock returns more predictable over a day, a month, a year, a decade? If markets are efficient, how can returns be predictable?

8. Do ex ante optimal portfolios perform better relative to simpler ones in ex post experiments? How large are gains from portfolio diversification across assets?

9. Are stocks safer in the long run? How large are gains from portfolio diversification over time? Are there gains from long-horizon investing?

10. Is it true that “alternative assets” increase the Sharpe ratio of portfolios? Are the returns on such assets similar to those of other assets?

2) Capability to apply knowledge and understanding

The course enables to choose from a set of tools to cope with practical problems of risk assessment, portfolio management and asset pricing. For instance:

1. How to measure expected returns on different stocks on the basis of a small set of determinants of priced risk. How to use existing assets to price redundant assets. How to identify arbitrage opportunities.

3. How can I use asset pricing models to design long-short strategies? And portfolios with desired risk exposures? How can I replicate a stock index? How to use asset pricing models to evaluate ex post performance of mutual funds?

6. How can a worker smooth consumption during working years (given labor income risk) and during retirement? Is she saving enough for retirement? Should a worker reduce investment into stocks as retirement approaches? Which is the optimal asset allocation for a pension fund?

8. Which techniques can a portfolio manager use to improve on ex- post performance?

9. How can we exploit predictability while optimizing the risk/return trade-off?

10. Can we use standard portfolio optimization tools to invest in alternatives? And what about ex-post performance measures: should we modify them to evaluate portfolios that include alternatives?

3) Capability to approach the subject in a critical manner

This is a key challenge.

The asset and risk management industry acts upon an evolving body of knowledge, so that the portfolio manager must be able to critically cope with new concepts and techniques. So as to train to this, we will present some unsettled issues - such as the possibility to exploit return predictability for improving portfolio performance -and the different actions to take depending on one's own critical assessment of the matter.
We will also emphasize the difficulty in choosing to reduce risk taking when the asset manager's incentives are tilted towards maximizing short term returns.

4) Communication abilities

Students are expected to solve three problem sets in randomly-formed teams.
If time allows, random participants in each team will be asked to present some results.

5) Learning ability

The reading list includes a variety of materials, from beginners' textbooks (BKM) to technical hadbooks (FF) and scientific papers.
This ought to teach how to refer to different sources, when necessary. Lecture notes ease the approach to complex sources.

Learning assessment methods

The exam follows general rules: it can be taken 3 times during the academic year, with no possibility to withdraw. A student is admitted to the exam only if s7he brings a valid "statino" and has signed up electronically.
The exam
° is written form.
° contains 3 questions or exercises.

Program

Part I: Asset Pricing

1. Equilibrium and Arbitrage Pricing: CAPM and APT
2. Multifactor models and their use
3. Pricing with the Stochastic Discount Factor
3.1 Generalized Efficient Frontier and CCAPM
3.2 Return Predictability and Market Efficiency
3.3 Contingent Claim Pricing
3.4 Risk Neutral Probabilities
3.5 Risk sharing in complete markets
4. The Cross Section of Returns
4.1 Pricing with the SDF
4.2 Pricing coskewness

Portfolio Choice
5. A Simple Portfolio Problem
6. Human Capital, Life Cycle Saving and Investing
7. Return Predictability: Stylized Facts
8. Estimation risk and ex post performance of optimal portfolios.
9. Return Predictability and long term asset allocation
10. Investing in alternative assets

Suggested readings below are either papers or chapters of the following textbooks:
Bodie Kane Marcus, Investments, Mc Graw Hill, International Edition
Fabozzi F., Focardi S, Financial Modelling of the Equity Market, Wiley, 2006
Cochrane J., Asset Pricing, Princeton University Press, 2001
Campbell J.Y and L. M. Viceira, Strategic Asset Allocation, Oxford Un. Press, 2002

BKM is a prerequisite. It explains very clearly the basics of portfolio and asset pricing theories, as well as their applications. Students who do not know markets and intermediaries should read also ch.1-4. Students who are already familiar with BKM may refer to FF, which covers the same material but explains in detail implementation (how to optimize, impose constraints, forecast returns...).
We use Cochrane for the theory of asset pricing, but it contains thorough material also on estimation. We refer CV for advanced material on portfolio choice.

1,2 *BKM, Cap. 9,10,11,12, 13 (or Fabozzi Ch.7-8)

3 *Cochrane Ch.1-5
Almeida H. and T. Philippon, The Risk Adjusted Cost of Financial Distress, JF, 62(6), 2007

4 *Bansal R. et al., Consumption, Dividends and the Cross Section of Equity Returns, JF, 60(4), 2005, 1639-72
*Harvey C.R. e A. Siddique, Conditional Skewness in Asset Pricing Tests, JF, XV,3, 2000, 1263-1295 Acharya V., and L., Pedersen, Asset Pricing with Liquidity Risk, Journal of Financial Econ, 2004

5. *CV, ch.2
- *BKM, ch.5-8 (or FF ch. 2,)
- FF, Ch.3-6

6.* CV, Ch. 6, Introduction; Ch. 6.1.1; Ch. 7
- * Cocco J., Gomes F., Maenhout P. Consumption and Portfolio Choice Over the Life Cycle, Review. Financial Studies 2004
- * Bagliano F. et al. Pension Funds, Life Cycle Asset Allocation and Performance Evaluation, World Bank, 2009

7. * Campbell J.Y., A. Lo, McKinlay, The Econometrics of Financial Markets, Princeton University Press, 1997, ch.2.4 and 7.2
* Jegadeesh, N., and S.Titman, 1993, "Returns to Buying Winners and Selling Losers: Implications for Market Efficiency," Journal of Finance, 48, 65-91.
Campbell Shiller, Valuation Ratios and the Long Run Stock Market Outlook, NBER wp 8221
A. Goyal and I. Welch, 2008, “A Comprehensive Look at The Empirical Performance of Equity Premium Prediction”, Review of Financial Studies, 21(4),455-508

8. *Jorion P., International Portfolio Diversification with Estimation Risk, Journal of Business, 58(3), 1985, 259-277
Black, Fischer, and Robert Litterman, Global Asset Allocation With Equities, Bonds, and Currencies, Goldman Sachs, 1991
Garlappi Uppal, 1/N, The Review of Financial Studies, 2009
* Avramov D. and T. Chordia, Predicting Stock Returns, Journal of Financial Economics, 2006.
*Fabozzi, Ch. IX

9.* Barberis N., Investing For the Long Run when Returns Are Predictable, Journal of Finance, Feb 2000
*Campbell J.Y. and L. M. Viceira, The Term Structure of the Risk Return Trade Off, Financial Analyst Journal
*Fugazza C., Guidolin M. e G. Nicodano, Time and Risk Diversification in Real Estate Investments: The Ex Post Performance, Real Estate Economics, 2009
CV, Ch. 4

10. *Jondeau E., M. Rockinger, Optimal Portfolio Allocation under Higher
Moments, European Financial Management, 12(1), 2006, 29-55
*Fabozzi, Ch 5

Note

Giulio Casuccio will hold three lectures in the midddle of the course. He is head of research of Fondaco Asset Management (s.g.r.), member of the investment committee and in charge of funds managed through quantitative methods.

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