In the culminating project, you will develop new trading strategies, evaluate them using the tools learned in the course, integrate them with the existing portfolio and also develop a plan to start a hedge fund.

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From the course by Indian School of Business

Design your own trading strategy – Culminating Project

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Indian School of Business

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Course 5 of 5 in the Specialization Trading Strategies in Emerging Markets

In the culminating project, you will develop new trading strategies, evaluate them using the tools learned in the course, integrate them with the existing portfolio and also develop a plan to start a hedge fund.

From the lesson

Week 5 - Strategy Evaluation

In this module, you will evaluate the strategy that you had designed. For this purpose you will make use of various performance measures discussed in the course.

- Ramabhadran ThirumalaiAssistant Professor

Indian School of Business

Learning Outcomes. After watching this video, you will be able to discuss the need for risk-adjusted performance measures. List and calculate various risk-adjusted performance measures.

Investors should compare the returns of their investments to what they would have obtained from investing in an alternative portfolio with an identity risk. Performance must always be evaluated on a relative basis and not on a absolute basis. However, it may be difficult to identify portfolios with identical risk and so it is better to use risk registered measures of performance.

The Sharpe ratio is one of the more widely used measures. It is similar to the Sharpe ratio we saw earlier. The Sharpe measure of a portfolio is the difference between it's average return over the sample period, minus the risk fee rate divided by the standard deviation of it's returns over the sample period. It measures the return to total variability trade-off. If we believe that CAPM holds, then we know that returns compensate only systematic risk while the Sharpe measure is based on total risk. The Treynor measure uses the CAPM beta as a measure of risk. It is the difference between the portfolio's average return over the sample period, minus the risk free rate, divided by it's beta.

A drawback of both sharp and trainer measures is that they don't quantify how much additional value the portfolio manager is adding.

Jensen's measure, denoted by alpha sub p, is the difference between the average portfolio returns minus within square brackets the risk free rate plus the portfolio's beta times the differences between the average market returns and the risk free rate. The term within the square brackets is CAPM's prediction of portfolio's returns.

A fourth risk adjusted performance measure is the appraisal or information ratio. It is defined as the portfolio alpha or Jensen's measure divided by the diversifiable risk of the portfolio.

We have two portfolios, P and Q. P has an average return of 35%, a beta of 1.2, standard deviation of returns of 42% and diversifiable risk of 18%. Q as an average return of 28% of beta of 1, standard deviation of returns of 30% and diversifiable risk of 0%. The risk-free rate is 6%. We can say that Q is the market portfolio, why is that?

Let's start off by calculating the Sharpe measure of P. It is 35% minus 6% divided by 42%, which is 0.69.

Q has a Sharpe measure of 28% minus 6% divided by 30%, which comes out to 0.73. P's Treynor measure is 35%- 6% divided by 1.2, which is 24.17%.

Q standard measure is 28% minus 6% divided by 1 which is 22%. P's alpha is 35% minus within square brackets 6% plus 1.2 times 28% minus 6% which comes out to 2.6%. Since Q is a market portfolio, its alpha will be zero. Finally, P is the operational ratio with its alpha 2.6% divided by its diversifiable risk of 18% which gives us 0.14. Since Q's alpha is zero, its appraisal ratio is also zero.

Looking at these values, the Sharpe measures say that P performed worse than Q. But the other measures say that it has performed better than Q.

The rule of thumb is as follows. If you have to decide on the portfolio manager's compensation, then use the Jensen measure. It tells us how much value the manager has actually added.

If you have to decide an optimal portfolio choices, use the Sharpe measure if the portfolio represents your entire investment.

Use the appraisal ratio for actively managed funds that are held in combination with passively-managed portfolios.

There are still some drawbacks of using these risk-adjusted performance measures. One, they rely on the validity of the CAPM. Two, they use a proxy for true market portfolio rather than the true market portfolio itself.

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