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Executive Summary
Dynamic asset allocation is a strategy used by investment products such as hedge funds, mutual funds, credit derivatives, index funds, principal protected notes and other structured investment products to achieve exposure to various investment opportunities and provide 100% principal protection.
Dynamic asset allocation includes a zero-coupon bond and an underlying investment. Assets are dynamically shifted between these two components depending largely on the performance of the underlying investments, and based on some.
In some cases, certain products can use a borrowing facility to enhance exposure if the underlying investments experience strong returns. If the underlying investments decline in value, CPPI automatically deleverages, reducing exposure in falling markets.
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Chapter One
Introduction1.1 IntroductionDynamic asset allocation brings out positive return from market segments deemed to be risky by controlling downside risk. An investor can protect his invested portfolio by dynamic asset allocation strategy.
1.2 Background & Origin of the studyThis is the report which we have tried to prepare properly and accurately to fulfill the requirement of the course F-503 titled Financial Derivative. This following report has been assigned to us by our course teacher Dr. Mahmod Osman Imam. I have worked on topic where I had the opportunity to see and learn new things about dynamic asset allocation to insure portfolio. This report reflects about my in-depth understanding about the various aspects of real life application of dynamic asset allocation.
1.3 Rationale of the studyStock market crash occurs due to different reasons. In Bangladesh it occurred three times in its history of six decades. After crash, stabilization package and incentives are offered by government to recover the losses from the stock market by the both institutional and individual investors. After the recent stock market crash in 2011-12, government announced stabilization package and incentives for the investors although there is no positive impact on the stock market of these incentives and package as it was a big enough crash.
1.4 Motivation of the StudyIn recent years Bangladesh stock market has faced serial crashes that made many investors beggars. Investors lost their confidence due to huge loss. Before crash, daily trading volume in Dhaka Stock Exchange (DSE) was around BDT one thousand crore. After crash it was so horrible that the daily volume of trading in DSE never touch the point around half of the previous figure. This is one of the great national problem led us to select the topic to work on.
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1.5 Objectives of the studyGeneral objective
To find out the overall process of dynamic asset allocation to insure portfolio value with immunization by delta.
Other objectives
To understand the impact and importance of dynamic asset allocation in portfolio theory. To acquire knowledge about portfolio management. To identify drawbacks related to traditional portfolio management. To gather knowledge about immunization of portfolio with delta.
1.6 Scope of the studyThe scope of the study is very much effective for the individual and institutional investors to manage portfolio. It is helpful for investors to insure and to immunize the portfolio.
1.7 Limitations of the studyTotal duration of term paper is not sufficient to give us. On the way of our study, we have faced the following problems which may be termed as the limitation/short coming of the study. These are as follows:
The main constraint of the study was insufficiency of information, which is required for the study.
The major limitation of the study was shorter time period. For an analytical purpose, adequate time is required. But we were not given adequate time to prepare such in-depth study.
Such a study was carried out by my for the first time. So, in-experience is one of the main factors that constituted the limitation of the study.
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Chapter Two
Methodology and Approaches of the Study2.1 IntroductionThe study has been performed based on the information extracted from different sources collected by using a specific methodology. The methods of completing the report have included some steps which are followed by one by one.
2.2 Data collectionThe study is descriptive and analytical in nature. First, I have identified the related data which are significant for this study. Then I found out the sources of data which are reliable and easy to acquire and easy to collect and not so time consuming. In order to carry out this study, two sources of data have been used.
Sources of Secondary data
Secondary Sources
Annual Report of DSEDSE WebsitePeriodicals published by the Bangladesh
BankDSE data Archive
JournalsResearch papers, training materials Internet
2.3 Statistical Tools UsedI have used the following mathematical and statistical techniques to analyze and present the collected primary and secondary data in a formalized way.
Tabular presentation Techniques of percentage Graphical presentation using pie chart, line chart, bar chart etc.
2.4 Processing of DataAfter collection of the raw data, by using the following computer packages and software, raw data has done editing and processing to present in a complete and formalized format.
Microsoft Excel-2013 Microsoft Word-2013
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2.5 Data Analysis
The classified and tabulated data has been analyzed elaborately in a number of tables in the analysis part.
Discussing with our group members. Following a sample report. Construct portfolio.
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Chapter Three
Theoretical Issue3.1 IntroductionDifferent persons have different portfolio management needs, some want to maximize the return, some want to minimize risks with steady investment growth, some want constant earnings, and some others want to earn more spending least time. Dynamic asset allocation is one such portfolio management strategy which aims at maximizing the portfolio return by active management of portfolio components.
To construct an asset allocation portfolio, one invests among various asset classes, such as stocks, bonds, cash and others. The returns of the asset classes tend to be affected by different factors and thus, face different risks. Establishing an appropriate asset mix is a dynamic process, and it plays a key role in determining portfolio’s overall risk and return. A very important asset allocation strategy is dynamic asset allocation, with which investor constantly adjusts the mix of assets as markets rise and fall and the economy strengthens and weakens.
3.2 Dynamic Asset AllocationDynamic Asset Allocation is a portfolio management strategy that involves rebalancing a portfolio so as to bring the asset mix back to its long-term target. Such rebalancing would generally involve reducing positions in the best-performing asset class, while adding to positions in underperforming assets. The general premise of dynamic asset allocation is to reduce the fluctuation risks and achieve returns that exceed the target benchmark.
Unlike two other popular portfolio management strategies, strategic and tactical asset allocations strategies, dynamic asset allocation does not involve keeping a fixed investment ratio. Dynamic investors diversify their investments by investing in equities, mutual funds, index funds, currencies, derivatives and fixed income securities. They buy instruments which are rising (or are predicted to rise) and they sell instruments which are falling (or are predicted to fall). Although not common, many dynamic investors keep a reasonable proportion between high-return/high-risk instruments such as stocks and low-return/low-risk instruments such as treasury bonds.
Evaluation of current trends and prediction of future trends on investments are very important with dynamic asset allocation. Investors can use a range of technical and fundamental analysis tools for this purpose. Successful dynamic investors are those who make right buy and sell decisions at right time. There are a few different strategies of establishing asset allocations, and there are outlined some of them and examined their basic management process.
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3.3 Methods of Asset AllocationStrategic Asset AllocationStrategic asset allocation is a method that establishes and adheres to what is a 'base policy mix'. This is a proportional combination of assets based on expected rates of return for each asset class. For example, if stocks have historically returned 10% per year and bonds have returned 5% per year, a mix of 50% stocks and 50% bonds would be expected to return 7.5% per year.Constant-Weighting Asset Allocation:Strategic asset allocation generally implies a buy-and-hold strategy; even as the shift in the values of assets causes a drift from the initially established policy mix. For this reason, may choose to adopt a constant-weighting approach to asset allocation. With this approach, portfolio can be rebalanced. For example, if one asset were declining in value, would be purchase more of that asset, and if that asset value should increase, would sell it. There are no hard-and-fast rules for the timing of portfolio rebalancing under strategic or constant-weighting asset allocation. However, a common rule of thumb is that the portfolio should be rebalanced to its original mix when any given asset class moves more than 5% from its original value. Tactical Asset Allocation Over the long run, a strategic asset allocation strategy may seem relatively rigid. Therefore, it may necessary to occasionally engage in short-term, tactical deviations from the mix in order to capitalize on unusual or exceptional investment opportunities. This flexibility adds a component of market timing to the portfolio, allowing you to participate in economic conditions that are more favorable for one asset class than for others. Tactical asset allocation can be described as a moderately active strategy, since the overall strategic asset mix is returned to when desired short-term profits are achieved. Insured Asset Allocation With an insured asset allocation strategy, establish a base portfolio value under which the portfolio should not be allowed to drop. As long as the portfolio achieves a return above its base, try to increase the portfolio value as much as possible. If, however, the portfolio should ever drop to the base value, invest in risk-free assets so that the base value becomes fixed. Integrated Asset AllocationWith integrated asset allocation there are considered both economic expectations and your risk in establishing an asset mix. Integrated asset allocation, on the other hand, includes aspects of all strategies, accounting not only for expectations but also actual changes in capital markets and risk tolerance. Dynamic Asset Allocation Another active asset allocation strategy is dynamic asset allocation, with which investor constantly adjusts the mix of assets as markets rise and fall and the economy strengthens and weakens. With this strategy investor sell assets that are declining and purchase assets that are increasing, making dynamic asset allocation the polar opposite of a constant-weighting strategy. For example, if the stock market is showing weakness, one sell stocks in anticipation of further decreases, and if the market is strong, one purchase stocks in anticipation of continued market gains.
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3.4 Importance of dynamic asset allocationA number of factors make dynamic asset allocation a viable strategy:
a) The cyclical moves of financial markets: Over a century of market history has clearly shown that dissimilar investment categories behave differently at different times in the economic cycle. The dynamic asset allocation’s challenge is to use technical and/or fundamental analysis to attempt to identify where the cycle are existed and what investment categories appear to have the strongest potential for appreciation.
b) Increase in returns utilizing efficient investing decision: This is a key reason that dynamic asset allocators do not have to be 100% right to produce higher risk-adjusted returns. It is not uncommon for top-performing sectors to experience advances of 50% or more annually. While the downside risk of some market sectors makes investing in these areas potentially dangerous in a fixed asset allocation strategy, dynamic asset allocation can harness their positive features and energize investor portfolios.
c) Efficiency of the strategy with mutual fundsUsing mutual funds in a dynamic asset allocation strategy further reduces risk by providing instant diversification across hundreds of securities within each asset class and allowing investors to move assets overnight between funds with little or no cost.
d) Existence of Bear marketsProperly implemented, a dynamic asset allocation strategy should lessen an investor's exposure to declining markets, blunting the impact of bear markets and preserving capital the majority of prior gains. The more investors lose money in a down market, the more they lose valuable time and opportunity.
e) Importance of technologyComputers and on-line databases have given investment managers powerful tools for analyzing the market and developing complex dynamic allocation models. By back testing these models against historical data, dynamic asset allocators have developed parameters and models, which indicate the asset classes that appear to be in sustained upward trends and should surpass other investments in the current market climate. Given a working knowledge of the markets and cycles, today's allocator can track a multitude of indicators to determine what people are doing in the market and which actions or data signal a fundamental change in economic climate. After weighing the attractiveness of different asset classes, the money manager develops an asset allocation strategy, which distributes monies among different funds/asset classes based on return probabilities. When the asset allocation model indicates changes in the attractiveness of an asset class, monies are moved to different funds.
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3.5 Goals of dynamic asset allocationo Reducing risk & achieving higher risk adjusted return The objective of dynamic asset allocation is to reduce the risk or fluctuation in the value of an investor's account while achieving higher returns than other investments with similar risk. The success of a dynamic asset allocation approach depends upon the ability of the investment advisor to identify those asset classes achieving the highest returns in each market phase. Not every investment decision will be perfect, but over a full market cycle, a dynamic asset allocation approach offers the potential for superior risk-adjusted results, outperforming the impact of taxes and inflation, and leaving the investor with real growth.
o Reducing risk without sacrificing performanceDynamic asset allocation, like a "fixed" asset allocation strategy, seeks to reduce risk through diversification among different investment categories. Using dynamic asset allocation, however, the investor selects or weights investments based on those categories with the greatest potential for superior returns, given current market conditions. The allocation of assets becomes dynamic -- changing in response to market conditions and perceived opportunities for profit. In studies of the performance of money managers, asset allocation decisions, rather than individual stock selection, have been shown to account for 80 to 90% and more of a portfolio's performance. Top performing managers are those who are invested in the best performing asset classes during different periods of the market.
3.6 Benefits of dynamic asset allocationThe practice of dynamic asset allocation (also called tactical or active asset allocation) has grown in recent years due to the success of various computerized market-timing techniques in analyzing market trends. These new technologies typically do not predict future market movements as much as they identify changes in trend direction and evaluate the risk of changes in a trend. With this advanced technology, the asset allocation practitioner can respond dynamically to the market and significantly increase risk-adjusted return over time by:
o Avoiding bear markets and periods of under-performance in the various asset classes--either by reducing or eliminating the allocation of the under-performing asset (e.g., getting out of the market).
o Increasing the allocation of asset classes currently in bull markets that are over-performing.
o Dynamic asset allocation eliminates the key weakness found in the traditional, fixed approach that routinely allows periods of under-performance.
o The portfolio mix of our generic Model Portfolios will shift dynamically over time to avoid periods of under-performance and move into investment types that are performing well. The net effect is reduced losses, lower volatility, higher average returns and a much stronger risk-adjusted return.
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Dynamic approaches to asset allocation are inherently more efficient than the traditional, fixed approach. They can significantly boost returns over time by quickly reacting to changing market conditions for various asset classes and sectors, capturing periods of over-performance and avoiding periods of under-performance.
3.7 Portfolio Insurance ProcessPortfolio insurances a dynamic trading strategy designed to protect a portfolio from market declines while preserving the opportunity to participate in market advances.Several portfolio insurance methods exist and are used in practice. The best-known strategy involves trading in “real” or “synthetic” options. With the introduction of exchange-traded index put options, it seemed theoretically possible for an investor to use these contracts to insure well-diversified portfolios, especially index funds. For some reasons, most investors prefer not to use the option market for insuring the portfolios. Hence it calls for the dynamic trading strategy replicating the option strategy to insure the portfolio. In this strategy the manager replicates an option through a process of continually revising, in a prescribed manner, the proportions of a portfolio consisting of the underlying the asset and the risk-less asset. Besides, the complex nature of the underlying option pricing theory , the dynamic strategy calls for buying more stock when the market is going up and selling off some stock as the market goes down.The basic dynamic trading approach involves replicating the insured portfolio’s price with an ever-changing combination of positions in the underlying portfolio and the risk less asset. The proportions allocated to the underlying portfolio and the risk less asset change every period, so that the dynamic insurance strategy requires a significant amount of trading. We will see in the report that how the same replication is accomplished (approximately) with either a stock portfolio and short futures positions or the risk less futures.The number of units of the underlying portfolio that must be held long at any given moment will be given by the call option’s “delta”, the reciprocal of how many calls it takes to hedge a unit of the underlying portfolio. The call delta tells us the number of units of the underlying portfolio to hold. The amount of the risk less asset to hold is determined by subtracting the value of the held units of the underlying portfolio from the total value of the insured portfolio.
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Chapter Four
Application of Dynamic Asset Allocation4.1 Introduction
4.2 Selected Companies
Code no. Category Name Industry Face Value11137 A IPDC NBFI 1012164 A ISLAMI BANK Banking 1025745 B PADMALIFE Life Insurance 1099613 A BEXIMCO Pharmaceutical 1023603 A BATASHOE Lather 1015302 A PADMAOIL Power 1013201 A AFTABAUTO Engineering 1014293 A RDFOOD Food 1027001 A GP Telecommunication 1018481 A MARICO Manufacturing 10
4.3 Criteria for Company SelectionIn the selection of company I have followed the following conditions
Company must be listed in the Dhaka Stock Exchange.
Listed before January 2013.
Ten different companies from minimum seven different industries
4.4 Static allocationThis part has been done in 2 parts- static allocation and dynamic allocation. In doing the static
asset allocation, 4 scenarios are considered namely-
100% Investment in Equity portfolio i.e. Risky Portfolio. 100% Investment in T – Bill i.e. Risk free portfolio. 50% - 50% investment in Equity and T – Bill (Constant weight) Static 50% - 50% investment in Equity and T – Bill
The stocks have been selected from Dhaka Stock Exchange (DSE). Stocks are selected from five
different industries with the cyclical and counter-cyclical nature of business for diversification.
There are considered T- Bill as risk free asset and there are also considered 91 days T- Bill rate.
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4.5 Scenario 1100% investment in equity portfolio (risky asset)
Assumptions: Amount to be invested is 1000000 tk. Investment horizon is one year. Portfolios are equally weighted after every quarter. Numbers of shares to be invested are determined with closing price of last quarter.
When 100% investment is in risky asset, then money is allocated among the stocks equally. In
first quarter the BDT 100000 amount of money allocated to each company is divided by the
closing price of last quarter of 2012 to get the no. of shares. After finding that, there are
considered the high, low and closing prices for quarter 1. The final number of shares is found by
adjusting the stock dividend. The portfolio value is found out by multiplying the no. of shares
with the corresponding prices. Thus the closing value at and of 1st quarter are BDT 1706270.62.
It will be the amount available for investment for second quarter and the procedure goes like this for