Feedback on Course / Checklist

1. Please provide feedback on the course.

What did you like about this course?
Gaining a in-depth understanding of the different investment strategies and tools while also getting a better understanding of the risks and rewards associated to investing.

What do you think should be eliminated?
We are glade that we moved the video component of the blog as that took up too much time. In the classroom we believe more time should be spent reviewing previous problems and also prep for the next chapter. Furthermore if an element of "real-life" actual cases could be discussed that would make the topic more lively.

What do you think should be added?
Given that this is an investment course shouldn't we be investing? Therefore, have a competition within an investment strategy/portfolio against the teams in class and even against classes. Use the strategies we learn in class in our portfolio. ie Bonds, ETFs, Stocks, FX, Options and given the performance of our portfolio have us calculate our financial ratios.


2. Read this checklist and add your own items to the checklist based on what you learned in the course.

In addition to the year-end checklist provided some additional items to consider are:
1- review the performance of your portfolio and decide which stocks, bonds, ETFs, Mutual Funds are performing at your level.
-Consider investing in ibonds or TIPS if you have not already done so to ensure inflation protected returns.

AlphaSimplex

Alpha Simplex Overview

Alpha Simplex, founded by MIT professor, Dr. Andrew W. Lo, "specializes in absolute-return investment strategies that are implemented primarily with futures and forward contracts."

Dr. Lo has derived an adapted hypothesis from the Efficient Market Hypothesis in which he calls the Adaptive Market Hypothesis (AHM). AMH states that "markets are not perfectly efficient, but they are highly adaptive and competitive. Investors experience fear and greed and can at times be overconfident or overly risk-averse, but they learn from their mistakes and adapt as they compete for economic survival."

Using this hypothesis the firm employs several different strategies to maximize performance for its investors. Those strategies include:

- Quantitative Global Macro Strategy (QGM)
- Global Tactical Asset Allocation (GTAA)
- Laser and Global Alternatives
-Active Volatility Management
- Risk Parity Plus

To learn more about a specific strategy please click here.

In a February 2012 video by WealthTrack, Dr. Andrew Lo was interviewed to discuss his perspective of the market. Specifically he stated in the video that government is the biggest reason for systemic risk. And that in this day in age we are faced with what Dr. Lo calls Volatility of Volatility: within a volatility market there are times in which the market is calm via the VIX and then can swing 20-40%.
Dr. Lo mentioned that given this volatility the traditional approach of investing is no longer valid and therefore investors need to address three key items that he highlights.

Given this new environment Dr. Lo has provided three concerns/guidance.

1) Markets are not stable and therefore investors need to be more active in managing and reducing their risk
2) Diversification deficit disorder - need to be more proactive in diversify portfolio across sectors, commodities, instruments and regions.
3) Manage our ways around market dislocation. Be more aware and active in managing portfolio.

Even with these three concerns/guidance, Dr. Lo was hesitant to have small individual investors become day traders

How AlphaSimplex uses future contracts to implement its strategies.... 

 As mentioned earlier one of AlphaSimplex strategies is the Laser and Global Alternatives. As stated on AlphaSimplex website, "Laser and Global Alternatives uses futures and forwards to replicate exposures to a diversified set of the most common liquid risk premia driving hedge-fund returns. This strategy provides similar diversification benefits as fund of hedge funds, and is well-suited for large institutional investors who cannot otherwise find adequate capacity among hedge-fund managers, as a liquidity buffer with an otherwise less liquid portfolio, and for smaller investors who would not otherwise have access to the diversification benefits of hedge funds because of minimum-investment requirements."

Using this Laser and Global Alternatives strategy AlphaSimplex invests in forwards and future contracts across a heavily diversified asset class, from commodities and currencies to stocks, bonds, mutual funds, and ETFs. Specifically this strategy tries to help hedge funds better manage, monitor and even rebalance their portfolio to reduce the volatility.

Merton Model or Contingent Claims Analysis

Read the attached explanation of how to use the option pricing model to evaluate risky debt and equity. This is called the Merton Model or Contingent Claims Analysis. Answer the following questions:

1. What is the yield to maturity on Debtco's bonds?

The yeild to maturity on Debtco's bonds is equal to 10.87% when the riskfree interest rate is 8%.

The Mkt value of the firm is given as $100MM and the value of the equity of the firm is determined from the following equation:

E = N(d1)*V - N(d2)*Be^(rT)

d1 = [ln(V/B) + (r + sigma^2 / 2)*T] / [sigma*sqrt(T)]

d2 = d1 - sigma *sqrt(T)

where; V = value fo the firm

E = value of the equity in the firm

B = face value of the pure discount debt

r = riskless interest rate

T = time to maturity of the debt in years

sigma = standard deviation of the annualized continuously compounded rate of return on the firm's assets

ln = natural logarithm

e = the base of the natural log function (~ 2.71828)

N(d) = the probability that a random draw from a standard normal distribution will be less that d

Where the value of the debt = Mkt Value of the firm - value of the equity in the firm; i.e. $100MM - $28.24MM.

R = ln(face value of pure discount bond / value of the debt) / time to maturity of the debt; R = ln(80/71.76)/1 = 10.87%

2. Assume that the firm's management swaps its assets for riskier assets of the same total value. How would this asset swap affect the value of its debt and equity? Explain

The swap would increase the value of the equity and decrease the value of the debt.

Based on the equations used above, increasing sigma (standard deviation of the continuously compounded rate of return) for d1 would increase the numerator in the equation for d1. Since d1 has sigma to a higher power than the equation for d2, the value of Equity would increase. The value of the firm is unchanged, therefore, the value of the debt must decrease to balance the equation.

Hartford Questions

1.     What is a variable annuity?

From SEC website – “A variable annuity is a contract between you and an insurance company, under which the insurer agrees to make periodic payments to you, beginning either immediately or at some future date. You purchase a variable annuity contract by making either a single purchase payment or a series of purchase payments.”

The value of each annuity may differ and will vary depending on the investment option chosen. Variable annuities let you receive periodic payments for the rest of your life or the life of a designated beneficiary and the annuities are tax-deferred. They are suitable for investors looking for a long-term investment and those that are concerned they may outlive their other retirement streams of income.

2.     Why is Hartford Financial Services Group seeking permission to ask its variable-annuity owners to give up their guarantee of lifetime income streams? What is Hartford offering in exchange?

Hartford Financial Services Group is seeking to have its variable annuity owners give up their guarantee of lifetime income streams due to the substantial boost in reserves and capital they have had to keep in order to fulfill their obligations to the annuity holders during the 2008-09 financial crisis. The executives at Hartford believe exchanging these annuities will help to limit the company’s overall risk exposure in the long-term. They are offering to cash out the owners’ variable annuities at an amount greater than the current balance by transferring that amount to the account that they have invested in underlying stock and bond funds. 

3.     Who would benefit from accepting an offer from Hartford? Who would be made worse off from accepting an offer? Explain.

Those who are in poor health and do not expect to need to draw on lifetime income checks would consider accepting the offer from Hartford. Given that these people might not live as long, a larger payout earlier on would be more valuable given time value of money. Variable annuity owners who are likely to outlive their savings account and worry about their future income stream during retirement would not benefit from accepting this offer, as they are likely to need these funds in the future.

Chapter 18 | Problems 15 & 16

Below are screen shots of how we calculated the results for question 15 and 16 in Chapter 18 of Investments.


For question 15 we are asked to:

Recalculate the instrinsic value of Honda in each of the following scenarios by using the three-stage growth model of spreadsheet 18.1. Treat each scenario independently.

a) ROE in the constant-growth period with be 10%
b) Honda's actual beta is 1.0
c) The market risk premium is 8.5%

For 15A we saw that the present value using a Return on Equity of 10% was $25.17.

15B

15C

For question 16 we were asked to:

Recalculate the intrinsic value of Honda shares using the free cash flow model of spreadsheet 18.2 under each of the following assumptions. Treat each scenario independently.

a) Hond'a P/E ratio starting in 2013 will be 16.
b) Honda's unlevered beta is 0.8.
c) the market risk premium is 9%

16A

16B

16C

Jennifer's 401K

Vanguard IRA vs I Bonds Case Study

Tuesday September 18, 2012

Transcript:

Hey Jennifer and other fellow investors,

My name is Rafi and this week at Team Ark we are going to be discussing the advantages and disadvantages of US government saving bonds, specifically I bonds and IRAs or Individual retirement accounts.

But before we begin please note that the information provided in this video may not fit your risk tolerance and therefore any recommendations or suggestions should be taken into consideration with a professional financial advisor.

So if you are like Jen and you are able to save $5,000 a year what should you do with it? That’s a great question.. so lets dig in.

In our first option Jen could invest that $5,000 in something called US government I bonds.  What are I bonds you might ask? The I in I bond stands for inflation.  So basically I bonds always earn what the current inflation is and also depending on the financial environment in the US could also earn a fixed rate.  This fixed rate would be on top of the inflation percentage.  In addition, I bonds can be purchased online via the US treasury direct website in denominations as small as $25 to up to a max of $10,000 per year. The best part of these bonds are that they come with zero risk.

Another option to US government bonds is something called an IRA or an individual retirement account. Nowadays you can pretty much get an IRA account with most financial institutions such as vanguard, TD Ameritrade and the likes. So what’s an IRA account? We’ll if you familiar with a regular investment account and IRA has all the same capabilities meaning you can invest in bonds, CDs, mutual funds, stocks, ETFs, options, etc.  The major difference between a traditional investment account and an IRA are:

-       You can only deposit money into the account without penalty until you have reached the aged of 59 ½. With an exception to use the money in the IRA for your first mortgage

-       You can only invest $5,000 per year in an IRA.

-       Also there are two types of IRA accounts that have different tax implications

The reason why team Ark recommends Roth IRA is because you will most likely be at a higher tax bracket when you are closer to retirement than you are in your twenties.

Therefore Team Arks recommendation for Jen and other young investors out there is to invest in both ibonds and IRAs.

Team Ark signing off till next time.