Reference no: EM132291318

Assessment Option A question

Aclient of your investment company has a 2bn US$ multi-asset portfolio under management with you. The client wants tomake a significant change to the portfolio but is unsure what option from several to choose. The choices arewhether to take a constant proportion portfolio insurance (CPPI), asset liability (AL), or risk parity (RP) approach to the overall security allocation, as well as whether to automatically re-set the investment weights at each year end or to have you make discretionary and deliberate active investment changes to the portfolio based on therelative valuations of securities.

In order to make the decision the client asks you to perform a back-test of each different portfolio approach. The client has set the following guidelines:

For the CPPI back-test:

- The safe portfolio comprisesonly a US Government bond ETF.
- The risky portfolio hasthe following starting allocation: 20% emerging market equity ETF, 40% US equity ETF, 20% Europe equity ETF, 20% Japan equity ETF.
- The maximum expected loss is to be calculated using the 95% confidence level. To calculate the maximum expected loss set the loss value at the 95% 2-tail confidence level for the whole time period. Calculate once at the beginning. Do not recalculate each year.
- The floor to not lose is US$ 1bn.
For the AL back-test:
- The protection portfolio starts with US$ 1bn. Assume the investments hedge inflation and interest rate risk andwill grow at an average annual 3% over time.
- The performance portfolio has the following starting allocation: 50% emerging market equity ETF, 50% world equity ETF.
- Leverage is to be used. The maximum expected loss is to be calculated using the 95% confidence level. To calculate the maximum expected loss set the loss value at the 95% 2-tail confidence level for the whole time period.Calculate once at the beginning. Do not recalculate each year.
- Borrowing costs for the leverage shall be 1% per annum(ignore interest on interest).
- Show how much capital should be allocated to the performance portfolio after borrowing.
- Show how much is set aside to fund the borrowing.

For the RPback-test:
- The portfolio willcomprise the following securities: US Government bond ETF,US equity ETF, Japan equity ETF.
- Set the risk (standard deviation) weights of each security for the whole time period and do not subsequently recalculate.
- Do not use any leverage, or gearing.
- Ignore security covariances when forming the risk parity security allocation.

For the 3 approaches outlined above, calculate the following 3 back-test portfolios:

1. Passive. Setthe appropriate starting allocation. The security weights areto naturally develop over time so make no further change.This is a passive reference portfolio, or yardstick.

2. Rules-based. The starting allocation is as 1. above. At the close of 31stDecember each year, the rule is to re-set each security's investment weight to the starting allocation.

3. Discretionary active. The starting allocation is as 1. above. Changes to security weights are then made according to relative valuation signals from relative valuation metrics developed by you. You decide therelative valuation signals and rules that instruct what is to happen when there is a signal.

The 9 back-test portfolios required are summarised in the table below:

Additional information
The back-test portfolios shall commence the 1st working day of 1996. This is proxied by close of 31/12/1995. The back-testcontinues to the most recent time period for which data are available.

The portfolio back-tests are to use the total returns in US$.

Data are to be monthly.
Relative valuations are to use the prices, dividends, earnings, ratios, and yields given.
Both capital protection and additional capital gains are desirable.

Instruction
Calculate the portfolio back-tests,calculate their investment performance, create relative valuations, apply the relative valuations, and make recommendations.

Attachment:- Aassessment question.rar