MANAGING DOWNSIDE RISK IN FINANCIAL MARKETS Butterworth-Heinemann Finance aims and objectives • books based on the work of financial market practitioners,and academics • presenting cutting edge research to the professional/practitionermarket • combining intellectualrigour and practical application • covering the interaction between mathematical theory and financial practice • to improve portfolio performance, risk management and trading book performance • covering quantitativetechniques market Brokers/Traders; Actuaries; Consultants; Asset Managers; Fund Managers; Regulators; Central Bankers; Treasury Officials; Technical Analysts; and Academics for Masters in Finance and MBA market. series titles Return Distributionsin Finance DerivativeInstruments: theory, valuation,analysis Managing DownsideRisk in Financial Markets: theory, practice and implementation Economics for Financial Markets Global Tactical Asset Allocation:theory and practice Performance Measurement in Finance: firms, funds and managers Real R&D Options series editor Dr Stephen Satchell Dr Satchell is Reader in Financial Econometrics at Trinity College, Cambridge; VisitingProfessoratBirkbeckCollege,CityUniversityBusinessSchoolandUniversity of Technology, Sydney. He also works in a consultative capacity to many firms, and edits the journal Derivatives:use,tradingandregulations. MANAGING DOWNSIDE RISK IN FINANCIAL MARKETS: THEORY, PRACTICE AND IMPLEMENTATION Edited by Frank A. Sortino Stephen E. Satchell OXFORD AUCKLAND BOSTON JOHANNESBURG MELBOURNE NEWDELHI Butterworth-Heinemann Linacre House, Jordan Hill, Oxford OX2 8DP 225 WildwoodAvenue, Woburn, MA 01801-2041 A divisionof Reed Educational and Professional PublishingLtd A member of the Reed Elsevier plc group First published2001 © Reed Educational and Professional Publishing Ltd 2001 Except Chapter 12 © The Faculty of Actuaries and the Instituteof Actuaries Allrightsreserved.Nopartofthispublicationmaybereproducedin anymaterialform(includingphotocopyingorstoringinanymediumby electronicmeansandwhetherornottransientlyorincidentallytosome otheruseofthispublication)withoutthewrittenpermissionofthe copyrightholderexceptinaccordancewiththeprovisionsoftheCopyright, DesignsandPatentsAct1988orunderthetermsofalicenceissuedbythe CopyrightLicensingAgencyLtd,90TottenhamCourtRoad,London, EnglandW1P0LP.Applicationsforthecopyrightholder’swritten permissiontoreproduceanypartofthispublicationshouldbeaddressed tothepublishers British Library Cataloguing in Publication Data Managing downsiderisk in financial markets: theory, practice and implementation. – (Quantitativefinance series) 1. Investment analysis 2. Investment analysis – Statistical methods 3. Risk management – Statistical methods I. Sortino, Frank A. II. Satchell, Stephen E. 332.6(cid:2)0151954 ISBN 0 7506 4863 5 Library of Congress Cataloguing in Publication Data A catalogue record for this book is availablefrom the Library of Congress ISBN 0 7506 4863 5 For information on all Butterworth-Heinemann publicationsvisit our websiteat www.bh.com and specifically finance titles: www.bh.com/finance Typeset by Laser Words, Chennai, India Printed and bound in Great Britain Contents List of contributors vii Preface xi Part 1 Applications of Downside Risk 1 1 From alpha to omega 3 Frank A.Sortino 2 The Dutch view: developing a strategic benchmark in an ALM framework 26 Robert vanderMeer 3 The consultant/financial planner’s view: a new paradigm for advising individual accounts 41 Sally Atwater 4 The mathematician’s view: modelling uncertainty with the three parameter lognormal 51 Hal Forsey 5 A software developer’s view: using Post-Modern Portfolio Theory to improve investment performance measurement 59 Brian M. Rom and KathleenW. Ferguson 6 An evaluation of value at risk and the information ratio (for investors concerned with downside risk) 74 JosephMessina 7 A portfolio manager’s view of downside risk 93 NeilRiddles vi Contents Part 2 Underlying Theory 101 8 Investment risk: a unified approach to upside and downside returns 103 Leslie A. Balzer 9 Lower partial-moment capital asset pricing models: a re-examination 156 StephenE. Satchell 10 Preference functions and risk-adjusted performance measures 169 Auke Plantinga andSebastiaan de Groot 11 Building a mean-downside risk portfolio frontier 194 Gustavo M. de Athayde 12 FARM: a financial actuarial risk model 212 Robert S. Clarkson Appendix The Forsey–Sortino model tutorial 245 Index 253 Contributors Sally Atwater is the Vice President of the Financial Planning Business Unit forCheckFreeInvestmentServices,NorthCarolina,USA.Sallyhasoverfifteen years of experience in the financial arena. She began her career in accounting andfinancialmanagement,andasaresultofaninterestinretirementandestate planning, she accepted the position of Chief Operating Officer for Leonard Financial Planning in 1993. Sally joined Mo¨bius Group in April of 1995 and becameVicePresidentin1996.SoonaftertheacquisitionofMo¨biusbyCheck- Free in 1998, Sally became Vice President of the Financial Planning Business Unit. She is currently responsible for business, product, and market devel- opment in the personal financial planning market for CheckFree Investment Services. Sally holds an undergraduate degree in management sciences from Duke University and an MBA from the Duke University Fuqua School of Business. LeslieA.Balzer,PhD(Cantab),BE(Hons),BSc(NSW),GradDipApplFin& Inv (SIA), FSIA, FIMA, FIEAust, FAICD, AFAIM, Cmath, CPEng, is Senior Portfolio Manager for State Street Global Advisors in Sydney, Australia. His experiencecoversindustry,commerce,academiaandincludesperiodsasInvest- mentManagerforLendLeaseInvestmentManagement,asPrincipalofconsult- ing actuaries William M. Mercer Inc. and as Dean of Engineering at the Royal Melbourne Institute of Technology. Dr Balzer holds a BE in Mechanical Engi- neering with First Class Honours and a BSc in Mathematics & Physics from the University of New South Wales, Australia. His PhD is from the Control and Management Systems Division of the University of Cambridge, England. HealsoholdsaGraduateDiploma inAppliedFinanceandInvestmentfromthe SecuritiesInstituteofAustralia.Hehaspublishedwidelyinscientificandfinan- cial literature and was awarded the prestigious Halmstad Memorial Prize from the American Actuarial Education and Research Fund for the best research contribution to the international actuarial literature in 1982. He was the first non-AmericantowinthePaperoftheYearawardfromtheJournalofInvesting. viii Contributors Robert Clarkson – after reading mathematics at the University of Glasgow, Scotland,UK,RobertClarksontrainedasanactuaryandthenfollowedacareer in investment management at Scottish Mutual Assurance, latterly as General Manager (Investment). Over the past twelve years he has carried out extensive researchinto the theoretical foundations of finance and investment, particularly in the areas of financial risk and stockmarket efficiency. He has presented numerous papers on finance and investment to actuarial and other audiences bothintheUKandabroad,andheiscurrentlyaVisitingProfessorofActuarial Science at City University, London. Gustavo M. de Athayde is a Senior Quantitative Manager with Banco Itau´ S.A. at Sa˜o Paulo, Brazil. He has consulting experience in econometrics and finance models for the Brazilian Government and financial market. He holds a PhD in Economics, and his present research interests are portfolio design, in static and dynamic settings, econometrics of risk management models and exotic derivatives. Kathleen Ferguson is currently Principal of Investment Technologies. She has experience of consulting to both plan sponsors and investment consultants in matters relating to investment policy and asset management, with partic- ular emphasis on asset allocation. Ms Ferguson has broad experience in areas relatingtoinvestmentmanagementforemployeebenefitplansincludinginvest- ment policy, strategies, and guidelines, selection and monitoring investment managers, and performance measurement and ranking. She has contributed to the Journal of Investing and Investment Consultant’s Review and is a member oftheInvestmentManagementConsultantsAssociationandtheNationalAsso- ciation of Female Executives. She holds an MBA in Finance from New York University, New York, USA. Hal Forsey is Professor of Mathematics emeritus from San Francisco State University, USA. He has worked with Frank Sortino and the Pension Research Institute for the last ten years. He has degrees in Business (A.A. San Fran- cisco City College), Statistics (B.S. San Francisco State), Mathematics (PhD University of Southern California) and Operations Research (MS University of California, Berkeley), and presently lives on an island north of Seattle. SebastiaandeGrootcurrentlyworksasanInvestmentAnalystforAcamAdvi- sors LLC, a hedge funds manager in New York. Previously, he worked as an AssistantProfessorandPhDstudentattheUniversityofGroningen,TheNether- lands. His research includes work on behavioural finance and decision models, primarily applied to asset management. Contributors ix Robert van der Meer holds a degree in Quantitative Business Economics, is a Dutch CPA (registered accountant) and has a PhD in Economics from the Erasmus University Rotterdam. His business career started in 1972 with Pakhoed (international storage and transport) in The Netherlands, andfrom1976 until 1989 he workedwith Royal Dutch/Shell in several positions in The Netherlands and abroad. During this time,hewasalsoManagingDirectorofInvestmentsoftheRoyalDutchPension Fund. From 1989 until 1995 Robert van der Meer was with AEGON as a member of the Executive Board, responsible for Investments and Treasury. In March 1995 he joined Fortis as a member of the Executive Committee of FortisandMemberoftheBoardofFortisAMEVN.V.InJanuary1999hewas appointed member of the Management Committee of Fortis Insurance and of the Board of Directors of Fortis Insurance, Fortis Investment Management and Fortis Bank. RobertvanderMeerisalsoapart-timeProfessorofFinanceattheUniversity of Groningen, The Netherlands. JosephMessinaisProfessorofFinanceandDirectoroftheExecutiveDevelop- ment Center (EDC) at San Francisco State University, USA. Prior to assuming his position as Director of EDC, Dr Messina was Chairman of the Finance Department at San Francisco State University. Dr Messina received his PhD in Financial Economics from the University of California at Berkeley and his Masters Degree in Stochastic Control Theory from Purdue University. Dr Messina has carried out research and consulting in the areas of the term structure of interest rates, interest rate forecasting, risk analysis, asset allo- cation, performance measurement, and behavioural finance. His behavioural finance research has revolved around the theme of calibrating experts and how informationisexchangedbetweenexperts(moneymanagers,staffanalysts)and decision makers (pension plan sponsors, portfolio managers). His research and consulting reports have been presented and published in many proceedings and journals. Auke Plantinga is an Associate Professor at the University of Groningen, The Netherlands. He is currently conducting research in the field of performance measurement and asset-liability management. Neil Riddles serves as Chief Operating Officer with Hansberger Global Investors, Inc., USA, where he oversees the performance measurement, portfolio accounting, and other operational areas. He has a Master of Business Administration degree from the Hagan School of Business at Iona College, and he is a Chartered Financial Analyst (CFA) and a member of the Financial Analysts Society of South Florida, Inc.