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IC311: Alternative Investments in the


21st century 2013-2014

Lecturers: Dr. Andreas Hoepner
Email: a.hoepner@icmacentre.ac.uk
Additional Information provided on handout(s)
Slides are subject to modification on demand
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Module Information
Module Information Handbook
Read in detail!
IC 311 Assignment Handout
To be explained in detail!
Remember: In addition to your Blackboard submission, you
have to hand in 2 hardcopies of your assignments to the
Postgraduate Office!
In doubt, trust up to date Blackboard resource, not
hardcopy from beginning of term

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General Lecturing Style (1):
Please Engage!
Please ask questions in Lectures & Tutorials!
There are no stupid questions!
Without student questions,
a lecture is only as valuable as a Teaching video
a tutorial is nearly useless
You are encouraged to
Bring notebook to lectures & tutorials
Apply techniques to real world data & discuss
Go as far beyond class coverage as you like you will
be supported (e.g. Industry Assignments)
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General Lecturing Style (2):
Communicate Problems anytime!
If you experience problems at other times than
during Lectures or Tutorials, you are encourage
to
Come to my Office Hour
Email me to a.hoepner@icmacentre.ac.uk



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General Lecturing Style (3):
Underlying Philosophy
Assumed Achievement Drivers:
4 Skill Sets Model
Topic Skills
Method Skills
Social Skills
Communication Skills
4 (Personal) Characteristics:
Ambition
Commitment
Sustainable Personal Process Management (e.g. long term, sufficiently
deep thought)
Personal Happiness (= (Quality of Efforts * Quantity of Efforts
Expectations) * Emotionality Function)
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General Lecturing Style (4):
Thinking within Topic- & Method Skills
Two Spheres of Thinking:
Space of Thinking
Breadth of Thinking
(Height of the) Validity of Thinking
Depth of Thinking
Time of Thinking
Endurance of one session of Thinking
Speed of Thinking
Endurance of many sessions of Thinking


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List of Contents
1. Introduction into Alternative Investments
2. Hedge Funds: An Introduction
3. Hedge Funds: Performance Evaluation
4. Responsible Investment: An Introduction
5. Responsible Investment: Performance Evaluation
6. Carbon Finance: An Introduction
7. i-finance (intangibles integrating finance)
8. Microfinance
9. Intermarket Analysis
10. Further Alternative Investments

Lecture 2; 3; 6; and 8 are substantially based on Lhabitant (2006); Anson (2006); Rueddigkeit (2009); and Murphy (2004) respectively / Lectures 1, 4,
and 5 -7 Hoepner
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1. Introduction into Alternative
Investments
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Structure of Introductory Lecture
1st part:
Lecturer discusses the two assignments, which cover 100% of the modules
marks
Lectures gives very brief introduction in all Alternative investment covered in
the module and states data availability chances for student projects
2nd part:
Students skim through the Lecture Slides to indentify topics of their interest
and ideally register an assignment topic by Monday, latest by Friday of 2nd
week. Before registering a topic, however, a student needs to provide
evidence of sufficient data access.
Aim of Introductory Lecture:
Students should be prepared best possible for their very important topic
selection!
Students can choose aspects of one Lecture topic, they can combine lecture
topics or come up with entirely new ideas.
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Hedge Funds
Data Access: (Very) difficult
Jobs: Many for heavy Quants
Market Neutral
Equity Market Neutral (comprise 4% of hedge fund assets in CS/Tremont Index as of May 2006)
Fixed Income Arbitrage (8%)
Convertible Bond Arbitrage (2%)
Event-Driven (24%)
Distressed Securities Funds
Merger Arbitrage Funds
Directional
Long/Short Equity Hedge (28%)
Dedicated Short Bias (1%)
Emerging Markets Funds (6%)
Global Macro Funds (11%)
Managed Futures / Commodity Trading Advisors (5%)
Multi-Strategies (11%)
Fund of Hedge Funds (not included in CS/Tremont Index as of May 2006)

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Responsible Investment
Data Access: Very Easy Often free
Jobs: Hiring
United Nations Principles for Responsible Investment have
been signed by institutions representing assets worth more
than $15 trillion in the first 28 months of their existence, (UNPRI,
2006, 2008a)
This represents nearly 20% of the worldwide assets under professional
management (Maslakovic, 2008a)
PRI growth still very strong (see graph below)
Several governments support RI with legislations such as tax cuts


0
5
10
15
20
25
30
35
0
200
400
600
800
1000
1200
Apr-06 Apr-07 Apr-08 Apr-09 Apr-10 Apr-11 Apr-12
Number of signatories Assets under management (US$ trillion)
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Carbon Finance
Data Access: Very Easy Often free
Jobs: Long term yes, short term cyclical
Cap-and-Trade Systems Project-based
Markets
Kyoto Protocol
Joint Implementation and
Clean Development Mechanism
Emissions Trading
EU-ETS
Flexible Mechanisms
Demand Factors Supply Factors
Market Pricing on the European Carbon Market
Section 4
Section 3
Section 2
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i-finance
Data Access: Not too hard especially with IT skills
Jobs: Coming up
Twitter mood can predict
Box Office Sales on opening weekend
(Asur and Huberman, 2010)
Dow Jones Industrial Average (Bollen,
Mao, Zeng, 2010)
Share price shock in BP crisis (Hoepner
et al., 2012, Project)
Social Media allows for Nowcasting
(Lampos and Christianini, 2011)
e.g. rainfall or illness rates
Emotional Nowcasting also possible (see
graph)
Example of a Social Media Lab
(Andreas Hoepner and Damian Borth, McKinsey
Technology Award Winner of German Centre for
Artificial Intelligence):
http://sociovestix.appspot.com/


Emotional Nowcasting by
DiMatteo, Hoepner, Musolesi &
Schaul (2012, Project)
Microfinance
Data Access: Easy free on MIX Market
Jobs: Enough for the dedicated
Intermarket Analysis
Data Access: Easy at ICMA
Jobs: Coming up
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Further Alternative Investments
Data Access: Some easy some difficult / Jobs: Some in Commodities, FX and Islamaic
Finance; Real Estate: cyclical
Private Equity
Islamic Finance
Real Estate
Commodities
Foreign Exchange (FX) Trading Strategies
Weather Derivatives
Philantrophy / Impact Investing
Collectibles
Wine
Sports Betting
Virtual Investment

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2. Hedge Funds: An Introduction
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History
Alfred Winslow Jones
Sociologist
Fortune Editor
Fund Manager
1949 Partnership called A.W. Jones & Co.
First for-profit hedge fund
market-neutral position
high incentive fee for fund manager
leverage
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Market size
Estimation for end of 2007 (Maslakovic, 2008):
Over 11,000 hedge funds worldwide
Size of about $2.25trillion
However, after Anglo-American Credit Crisis
both figures should today be substantially
reduced
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(Original) Theory of Hedge Funds
Short position finances long position
Short positions exposure matches long
positions
Zero exposure to market movements
This technique is called market neutral
investment
21
Basis of Hedge Fund Performance
Manager skill in identifying opportunities
Not derived from passive long position
Focused on potentially inefficient market
sectors
Depend critically upon special manager skills
and knowledge
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Definition
Hedge funds are private pooled investment limited
partnerships which fall outside many of the rules and
regulations governing mutual funds. Hedge funds
therefore can invest in a variety of securities on a
leveraged basis. Today, the term hedge fund refers
not so much to the hedging techniques, which hedge
funds may employ, as it does to their status as
private investment partnerships. (Maslakovic, 2008:
2)

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Hedge Fund Characteristics (1)
Actively Managed
Represent Securitized Trading Floors
The emergence of new technologies gave
talented individuals and investment banking gurus
(genuine or fake) the opportunity to start doing
for their own account what they had been doing
for several years [on tradeing floors for] large
institutions. (Lhabitant, 2006: 26)
Largely unregulated
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Hedge Fund Characteristics (2)
Limited liquidity
They often do not hold a sufficient cash position
to allow investors daily subscription or
redemption
High incentive fees (15-25%) for managers,
whose performance exceeds a high hurdle
rate
Hedge fund managers are partners, not
employees
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Hedge Fund Characteristics (3)
Limited transparency
Strategies are not scalable
Strategies depend crucially on
available investment opportunities
Manager skills
Both input factors cannot just be scaled by hedge
funds with increasing portfolio inflows as index tracker
funds can do
Main investor type are High Net Worth
Individuals (HNWI)
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Hedge Fund Strategies (CS/Tremont
Classification)
Market Neutral
Equity Market Neutral (comprise 4% of hedge fund assets in CS/Tremont Index as of May 2006)
Fixed Income Arbitrage (8%)
Convertible Bond Arbitrage (2%)
Event-Driven (24%)
Distressed Securities Funds
Merger Arbitrage Funds
Directional
Long/Short Equity Hedge (28%)
Dedicated Short Bias (1%)
Emerging Markets Funds (6%)
Global Macro Funds (11%)
Managed Futures / Commodity Trading Advisors (5%)
Multi-Strategies (11%)
Fund of Hedge Funds (not included in CS/Tremont Index as of May 2006)

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Equity Market Neutral
Market Neutrality involves
Dollar Neutrality (equal $ amount of long and short investment)
eta Neutrality
Sector Neutrality
Factor Neutrality (e.g. Size, Book value to market vaue ratio)
Sub-strategy examples:
Pairs trading of two sister stocks
Statistical Arbitrage based on groups of related stocks with
similar characteristics
Computerized equity market arbitrage (e.g. on multiple
exchanges)

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Fixed Income Arbitrage
Very attractive area for hedge funds due to
Lack of agreement on a standard absolute pricing model
Multiple relative pricing relationships between various fixed income
securities
Influence of irrational but predictable supply and demand factors on
specific asset prices
Complex nature of some fixed income securities
Sub-strategy examples
Treasury Stripping
Artificial creation of undersupplied zero coupon bonds from level coupon
bonds
Carry Trades
Long/Short investment at different interest rates (e.g. due to different
maturities or currency regions)
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Convertible Bond Arbitrage
Exploitation of Arbitarge opportunities between convertible
bonds and their underlying equity
Very attractive area for hedge funds due to
Lack of agreement on a standard absolute pricing model
Multiple relative pricing relationships between various fixed income,
equity and option components of convertible bonds
Very complex nature due to summary of equity, bond and option
characteristics
Sub-strategies are usually hedged for Delta to make them
insensivite of price variations in the underpying asset
Delta measures the sensitivity of a convertible bonds to a one point
change in the underlying equity asset

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Distressed Securities Funds
They focus on the equity or debt of companies that are
expected to be in operational or financial difficulty (e.g.
bankrupcy, restructuring)
Very detailed knowledge and special skills are expected to
lead hedge funds to superior returns
Distressed securities are attractive for hedge funds since
Less competitors, as many institutional investors are for internal or
legal reasons not allowed to invest in distressed securities
Selling pressure leads to attractive discounts
Governments often provide substantial support to rescue parts of
distressed securities

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Merger Arbitrage Funds
Can also relate to Leveraged Buyouts or
Hostile Takeovers
Use of spread between offered price for a
share of the target company and ist last
market quote
Strategies are based on expectation about
success of acquirers bid and market reaction
to failure
32
Long/Short Equity Hedge
Combination of long investments with short sales to reduce
but not completely eliminate market exposure
Sub-strategy examples
Fundamental Analysis (usually based on Discounted Cash Flows)
Assumes at least semi-strong market inefficiencies (e.g. for micro-cap
companies, which are often covered by zero analysts)
Sector Specific Funds (e.g. Life Sciences, New Technologies)
Shareholder Activism Strategies
Attempt to release value of potentially underpriced assets by actively
influencing management or lobbying government for favourable legislation
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Dedicated Short Bias
Use only short positions
Mirror traditional long only investments
Typical Targets are Companies
With weak financials, but high share price
That regularly change auditors
Whose Price/Earnings ratios are much higher than justified by
the growth rate
Which are already shorted by more than 10% of their market
capitalization
With a public image problem
With too much self marketing


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Emerging markets funds
Pure Long Equity or Debt strategies and strategies similar to the ones of Long/Short Equity
Hedge, Equity Market Neutral or Fixed Income Arbitrage Hedge Funds
Developed Markets (24) as defined by MSCI in January 2013 are:
Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland,
Israel, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden,
Switzerland, the United Kingdom and the United States
Emerging Markets (21) as defined by MSCI in January 2013 are:
Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia,
Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey
Frontier Markets (25) as defined by MSCI in January 2013 are:
Argentina, Bahrain, Bangladesh, Bulgaria, Croatia, Estonia, Jordan, Kazakhstan, Kenya, Kuwait,
Lebanon, Lithuania, Mauritius, Nigeria, Oman, Pakistan, Qutar, Romania, Serbia, Slovenia, Sri Lanka,
Tunisia, the United Arab Emirates, Ukraine and Vietnam
Not (yet) classified but index produced (7) in January 2013:
Bosnia-Herzegovina, Botswana, Ghana, Jamaica, Trinidad & Tobago, Saudi-Arabia, and Zimbabwe
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Global Macro Funds
Heterogenouos category of funds trading on macroeconomic
factors
Common characteristics
Global nature of strategy
Primary focus are
Structural macroeconomic imbalances
Detection of macroeconomic trends
3 major approaches
Feedback based approach
Psychology based approach, which tries to profit from irrational investor
reactions (feedbacks) to special circumstances
Model-based approach
Search for empirical disequilibria according to academic economic theories
Information based approach (basically Data Mining)

36
Managed Futures / Commodity Trading
Advisors
Two types of analysis applied to Managed Futures
Technical Analysis
Process of predicting future price behaviour on the basis of past price
behaviour
Underlying assumption that markets are driven more by psychological than
fundamental factors and emotional set up of investors with its resulting price
movements would repeat itself under comparable circumstance
Fundamental Analysis
Process of determining a fair value of an asset based on economic, political,
environmental and other relevant fundamental factors
Provides expected direction of prices, while no entry point or risk
management guidance
Note here that for fundamental factors be included in prices, human beings
have to use fundamental analysis. But the more human beings use
fundamental analysis, the less investment opportnities it unravels. This leads
to Grossmann & Stiglitz (1978) Paradox of Market Efficiency.
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Multi-Strategies
Multi-Strategy funds are characterised by their
ability to allocate capital dynamically among
strategies that fall within several traditional
hedge fund disciplines.
This approach requires more skill than a single
hedge fund strategy ceteris paribus
It rewards fund managers and investors with a
better risk diversification and scalability of
returns than a single hedge fund strategy ceteris
paribus

38
Fund of Hedge Funds
A fund investing its capital in several (usually 30-60)
individual hedge funds
Advantages of Fund of Hedge Funds
Improved risk diversification
Affordable for smaller investors
Access to several top-tier hedge funds, which are closed funds, as they
do not want to dillute their profits
More flexible investment redemption policies
Potential for increased transparency
Disadvantages of Fund of Hedge Funds
Additional fund fees
Additional liquidity need due to better redemption policies

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3. Hedge Funds: Performance
Evaluation
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Plain newspaper returns are dangerous!
Plain daily return (e.g. Price yesterday/Price today) are upwards
biased
To see this, assume that your portfolio won 10% today and lost 10%
tomorrow or vice versa. Are you at par?
No, because 10% of a base value 110 or 90 are different from 10%
of a base value 100.
100 x 1.1 x 0.9 = 100 x 0.9 x 1.1 = 99
Basically, a plain return of -10% today cant be entirely equalized by
a plain return of +10% tomorrow and vice versa
The plain return overstates gains & understates losses!
A dangerous mix for supposedly anyway overoptimistic investors!
41
The appropriate return: The logged return
(1)
The appropriate formula to calculate returns
(r) of stock i at time t for the previous period
(t-[t-1]) is to take the natural logarithm (ln)
of the division of the stock price (P) at time t
by the stock price at time t-1
) ln(
1 ,
,

=
t i
t i
it
P
P
r
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The appropriate return: The logged return
(2)
With respect to a equal weighted portfolio p of stocks i1
to iN, the appropriate formula to calculate returns (r) at
time t for the previous period (t-[t-1]) is to take the
natural logarithm (ln) of the average division of each
stocks price (P) at time t by the same stocks price at
time t-1
Market value or otherwise weighted portfolio returns are
caculated accordingly with the respective weighted
scheme constructed at time t-1
!!! If market value weight not at t-1 but a t, upwards bias!!!
) ... (
1
ln(
1 ,
,
1 , 2
, 2
1 , 1
, 1

+ + + =
t iN
t iN
t i
t i
t i
t i
pt
P
P
P
P
P
P
N
r
43
Arithmetic mean return
Arithmetic mean return of a portfolio (
p
)


r
t
is the logged return of the portfolio at time t
N is the number of observations in the employed
sample
As the following formulas, this formula applies
equally to an asset i as to a portfolio p

=
=
N
t
pt
p
r
N
r
1
1
44
Arithmetic mean excess return
Arithmetic mean excess return of a portfolio
(
xp
) over the logged risk free asset return (r
ft
)
is:



With the same process, the arithmetic mean
excess returns of an individual asset i (
xi
) or
the market benchmark m (
xm
) are calculated




ft
N
t
pt
xp
r r
N
r =

=1
1
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Excess Return variance
The excess return variance of a portfolio
(
xp
^2) is calculated as follows



r
xpt
equals the excess return of a portfolio over the
risk free asset return at time t [r
xpt
= r
pt
r
ft
]
2
1
2
) (
1
1
xp
N
t
xpt xp
r r
N

=

= o
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Excess return standard deviation
The excess return standard deviation (
xp
) of a
portfolio is the sqaure root of the excess return
variance of it



With the same processes, the excess return variance
and the excess return standard deviation an individual
asset i (
xi
^2 and
xi
) or the market benchmark m
(
xm
^2 and
xm
) are calculated, respectively

2
1
) (
1
1
xp
N
t
xpt xp
r r
N

=

= o
47
Skewness (1)
(+) Positively Skewed
Distribution
(-) Negatively Skewed
Distribution
-
-
+
+
48
Skewness (2)
- - -
+
+ +
Mean=Median=Mode
Mean>Median>Mode Mean<Median<Mode
49
Kurtosis
General
Forms of
Kurtosis
(0) Mesokurtic (normal)
(+) Leptokurtic
(-) Platykurtic
50
Leptokurtic distributions have Fat Tails
51
Covariance
The covariance of the portfolio excess return
with the market excess return is calculated as
follows:



r
xmt
equals the excess return of the market over
the risk free asset return at time t [r
xmt
= r
mt
r
ft
]
) )( (
1
1
) , (
1
mp
xmt
xp
N
t
xpt xm xp
r r r r
N
r r Cov

=

=
52
Correlation
The correlation (Corr) of two return series
with the same number of observations equals
the division of their covariance by the product
of their standard deviations
xm xp
xm xp
xm xp
r r Cov
r r Corr
o o
) , (
) , ( =
53
Systematic risk vs. Specific risk (1)
The return performance of an asset i (e.g. a listed stock or a
fund managers portfolio) is exposed to various sorts of
downside risk
Individual asset risks (e.g. costly mistakes within a company, fraud
within a company)
Risks affecting the industry (group) of an asset (e.g. 9/11 for the
aviation industry, oil prices rises for all heavily oil consuming
industries)
Risks affecting the entire world economy or (large) regions of it (e.g.
Worldwide recession, Anglo american Credit Crisis)
54
Systematic risk vs. Specific risk (2)
A (degree of a) risk of an asset i is specific within a universe of assets, if an
investor can eliminate her exposure to this risk through optimal risk
diversification. Optimal risk diversification in the absence of transaction costs
means that the investors portfolio equals the asset market value weighted
universe of assets.
A (degree of a) risk of an asset i (e.g. a listed stock ora fund managers
portfolio) is systematic within a universe of assets, if an investor cannot
eliminate her exposure to this risk through optimal risk diversification.
Examples and further considerations:
The death of a well performing CEO is a specific risk of one company
A promising substitution product for oil to power cars is a systematic risk of an oil
company within the universe of oil company assets, but a specific risk of an oil
company within the universe of all worldwide assets
Note, however, that diversification does not only dillute the downside risks of a
portfolio but also the specific upside chances (e.g. 9/11 for the defense industry,
Christiano Ronaldo for Manchester United)
55
The standard measure of systematic risk -
eta
The systematic risk of a portfolio p (
p
) within
the universe of the relevant market
benchmark m is calculated as follows:
2
) , (
xm
xm xp
p
r r Cov
o
| =
56
Drawdown (1)
The Drawdown (DD) in a given sub-sample period (s)
with T observations denoted DD
qsTp
is the maximum
relative reduction in portfolio price (P
tp
) occured over
one or more consecutive observation intervals of
maximum length n, which all experienced a negative
average excess return, taken to the power of q



) ( ) 1 ,..., 2 , 1 ( ), ,..., 2 , 1 ( min
,
,
t n and T n T t with
P
P P
q
p n t
p n t tp
qsTp DD
< = =
(
(

0 =
DDqsTp
otherwise



, 1
1
1
, , 1
, , 1
=

=
=
+
+
n m
m
p m t p m t
p m t p m t
P P
P P
n
if
57
Drawdown (2)
The Drawdown measure (DD
qtp
) itself is
simply the average of a samples N sub-
sample periods drawdowns




=
N
s
qsTp qTp
DD DD
N
1
1
1
58
Characteristics of Drawdown measure
Consideration of the relation between subsequent observation
intervals
THUS: Consideration of downward herding behaviour during a crisis, if N is
large enough!
Size of result is observation interval independent
No benchmark
Possibly but not necessarily sensitive to skewness and kurtosis of
return distributions
q allows adjustments for individual investors disutility of losses
No consideration of upwards chances
Consideration of only one drawdown per monthly sample period
Rather random ignorance of all other downside risks

59
Lower Partial Moment (LPM)
While the standard deviation considers any
form of uncertainty (downside risk as well as
upside chances), the LPM only considers
downside risk
This downside risk is defined as realising an
excess return below an investors minimal
acceptable return [ spoken Psi+
The general formula for the LPM is:
| |
q
T
t
pt
qp
r
T
LPM

=

=
1
0 ), ( max
1
1
) (
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Semi-variance & semi-standard deviation
Based on the LPM using the average excess
return as minimal acceptable return, the
concepts of semi-variance (SV) and semi-
standard deviation (SSD) can be calculated
) (
2
xp
p
r
xp
LPM SV =
) (
2
xp
p
xp
r
LPM
SSD =
61
Shortfall Risk
Based on the LPM, the probability that a portfolio return
falls short of the minimal acceptable can easily be
calculated as a special case of the LPM by setting q to 0.
Hence, the formula for the Shortfall Risk (LPM
0p
[]) is:



with 0
0
defined as 0.
| |
0
1
0
0 ), ( max
1
1
) (

=

=
N
t
pt
p
r
N
LPM

62
Characteristics of the LPM
Minimal acceptable return as benchmark, which is
customizable to an investor
Very sensitive to skewness and kurtosis of return distributions
q allows adjustments for individual investors disutility of
unacceptable returns
No consideration of upwards chances
No consideration of the relation between subsequent
observation intervals
Size of result is observation interval dependent
Consideration of all downside risks per sample period



63
Value at Risk (1)
The Value at Risk is the maximum loss a
portfolio p can be expected to experience in
an observation interval (e.g. day, weeks, 2
weeks, month) at a specified confidence level
c (e.g. 95%, 99%)
Statistically, the VaR at the c percent
confidence level is the (1-c)% quantile of the
profit and loss distribution of the portfolio p
64
Value at Risk (2)
Normal Distribution with an arithmetric mean of 0
50% Losses vs. 50% Gains
65
Methods of VaR Calculation
Simple Parametric VaR:
Assuming a normal distribution of asset returns, the following
formula can be used:

For a 95%, 99% and 99.9% confidence level, c needs to be set to
1.645, 2.326, and 3.09, respectively.
Historic VaR
The VaR is represented by the last return in the Top 99% returns of a
historic return distribution with the same observation interval as the
VaR
e.g. the 990th best return in a distribution of 1,000 returns
Several other methods exist (e.g. Monte Carlo VaR)
c r VaR
xp
xp
xp
o =
66
Characteristics of VaR
Historic VaR very sensitive to kurtosis of return distributions and
somewhat sensitive to skewness
Simple Parametric VaR not sensitive to skewness or kurtosis
Relatively intuitive and easy to understand
especially, if calculated with the Simple Parametric VaR or the Historic VaR
Method
No consideration of the return distribution above or below the VaR return
No direct benchmark
No direct adjustment for individual investors disutility of losses
An investor can only customize the confidence level
Size of result is observation interval dependent
No consideration of the relation between subsequent observation
intervals
Consideration of all downside risks per sample period
67
Relevant considerations for the use of an
investment performance measure
There is no universal performance measure (so far), there is only the best available
performance measure for the respective circumstances of a financial market participant
The most relevant financial market perspectives are
Active Investor (Portfolio deviates from market portfolio)
Selection of assets to be included in her portfolio
Evaluation of the performance of the entire portfolio
Passive investor (Portfolio represents market portfolio)
Selection of assets to be included in her portfolio
Evaluation of the performance of the entire portfolio
Any investable asset (e.g. corporation, investment fund)
One portfolio of several within an investable asset (e.g. business unit of
corporation, individual portfolio not offered directly to investors within an asset
management firm)
Government (supposedly the joint utility of all stakeholders)
Society (grants financial markets their right of existence)
68
Categorisation of Downside Risk Adjusted Performance
Measures according to Risk Measure (1)
Standard deviation based measures
Sharpe Ratio (Sharpe, 1966)
Risk Adjusted Performance Alternative [RAPA] (Modigliani & Modigliani, 1997)
Information Ratio (Goodwin, 1998)
Oliver Wymans Shareholder Performance Index
SM
(Oliver Wyman, 2007)
eta based measures
Treynor Ratio (Treynor, 1965)
Jensen Alpha (Jensen, 1968)
Drawdown (DD) based measures
Sterling Ratio (Stein, 1991)
Burke Ratio (Burke, 1994)




69
Categorisation of Downside Risk Adjusted Performance
Measures according to Risk Measure (1)
Lower Partial Moment (LPM) based measures
Sortino Ratio (Sortino & van der Meer, 1991)
Return on Probability of Shortfall [RoPS] (Pedersen & Rudholm-Alfvin, 2003)
Kappa 1 (Kaplan and Knowles, 2004)
Kappa 3 (Kaplan and Knowles, 2004)
Value at Risk (VaR) based measure
Return on Value at Risk [RoVaR] (Dowd, 2000)




70
Sharpe Ratio
Formula:



The most basic measure
Represents the Security Market Line taught in
Corporate Finance
xp
xp
xp
r
S
o
=
71
Risk Adjusted Performance Alternative [RAPA]
Formula:




Basically a re-scaled Sharpe ratio, in which the
result is interpretable as excess return per unit of
market risk as opposed to excess return for a
standard deviation of 1
xp
xm
xp
xp
r RAPA
o
o
=
72
Information Ratio
Formula:




Where
xbp
and
xbm
are the excess return of the
portfolio over the market benchmark return and its
standard deviation, respectively.
Quiet popular in practice
Theoretically, however, questionable
xbp
xbp
xp
r
IR
o
=
73
Oliver Wymans Shareholder Performance
Index
SM
(SPI)
Formula:


The minuend and subtrahend represent the portfolios mean Sharpe
ratio and the market benchmarks median Sharpe ratio
The Median is the middle observation in a sample
Note that the service marked original is calculated with portfolio
returns as opposed to portfolio excess returns
Oliver Wyman uses this investment performance measure service
as one USP within their advisory
Similarly, BarclayHedge has the Barclay Ratio
m
p
p
S S
SPI

=
74
Treynor Ratio
Formula:


Note that the Treynor Ratio only considers the
systematic component of an assets risk, it ignores
any specific risk
It is therefore not particularly useful for the evaluation
of entire investment portfolios, which deviate
substantially from the (asset market value weighted)
market portfolio
p
xp
xp
r
T
|
=
75
Jensen Alpha ()
Formula (Calculation version):


Derived from the Capital Asset Pricing Model (CAPM),
whose formula is the following:


In its regression version, the most common investment
performance measure in academic empirical Finance
research
xm
p
xp
p
r r |
o
=
xm
p
f p
r r r | + =
76
Sterling Ratio
Formula:


The Sterling Ratio as well as the following Burke
Ratio are widely advertised by commodity trading
advisors, who wish to highlight their (perceived)
skill in letting profits run and cutting losses
Note that most people emotionally tend to do the wrong
opposite, let losses run and take profits
Tp
xp
p
DD
r
ST
1
=
77
Burke Ratio
Formula:


In contrast to the Sterling Ratio, the Burke Ratio
assumes an investor to experience an increasing
instead of a linear incremenal disutility as reaction to
a one unit increase in drawdown
Tp
xp
p
DD
r
Burke
2
=
78
Sortino Ratio
Formula:


The standard performance measure based on
the Lower Partial Moment
If an investor chooses =
xp
then she, in
fact, calculates the return on semi-
standard deviation



p
xp
xp
LPM
r
SO
2
) (
=
79
Return on Probability of Shortfall
[RoPS]
Formula:



To understand this formula easier, remember that
x
0
=1
The probability of shortfall represents an
investors chances of achieving an unacceptable
excess return
p
xp
xp
LPM
r
RoPS
0
) (
=
80
Kappa 1 & Kappa 3
Kaplan & Knowles (2004) formalized the
missing intuitive LPM based investment
performance measures
The formula for Kappa 1:


The formula for Kappa 3:

3
3
) (
3
p
xp
xp
LPM
r
K

=
p
xp
xp
LPM
r
K
1
) (
1

=
81
Return on Value at Risk [RoVaR]
Formula:

As with any shown performance measure, a
higher score indicates a higher investor utility
Improvements have been suggested to date like
Gregoriou & Gueyies (2003) Modified Sharpe
Ratio using the Modified Value at Risk, but they
are beyond the scope of this module
xp
xp
xp
VaR
r
RoVaR =
82
4. Responsible Investment (RI): An
Introduction

83
Definition of RI
*R+esponsible investing is an investment
process that considers the social, ..
environmental [and ethical] consequences of
investments, both positive and negative,
within the context of rigorous financial
analysis." (SIF, 2006:2)

84
Megatrends 2010
Predicted in 2005 by Patricia Aburdene, who
foresaw the Internet Revolution (Aburdene &
Naisbett, 1990: Megatrends 2000)
The Megatrend: The Rise of Conscious
Capitalism
1 of the 7 top drivers: The Socially
Responsible Investment Boom!
85
Growth in PRI signatories since launch in April
2006
0
5
10
15
20
25
30
35
0
200
400
600
800
1000
1200
Apr-06 Apr-07 Apr-08 Apr-09 Apr-10 Apr-11 Apr-12
Number of signatories Assets under management (US$ trillion)
86
How relevant will RI likely be in the future and hence
during your career?
Mercer survey (2005):
89% of Asian investment managers
69% of European investment managers
36% of U.S. investment managers
believe that RI becomes mainstream until 2015
(before the credit crisis!)
Recent press on SI and credit crisis:
Thomson Financial News: SI relative beneficiary
FT Adviser & Welt: SI potentially part of solution

87
Examples of social, environmental and ethical (SEE)
criteria
Social
Corporate
Governance
Military
goods/services
(of listed
companies)
Tobacco
Alcohol
Employee
Relations
Stakeholder
Relations
Minority issues
Ethical
Human rights
Third world
pharmaceuticals
Abortion
Breast-milk substitute
marketing
Any religious criteria
Genetic engineering
Gambling
Animal testing
Phornography
Financial institutions
Health care institutions
Environmental
Climate change
Pollution
Deforestation
Biodiversity
Chemicals of
concern
Ozone depletion
Nuclear
Roads
88
Basics of RI (1)
Two responsible investment processes (Sparkes,
2002)
Screening according to social, environmental and
ethical (SEE)
Exclusion of companies or industries of SEE concern
Positive selection of companies or industries with good
SEE rating on relevant criteria
Best in class ~ Selection of the companies in each
industry, which experience the SEE rating
Industries of future (e.g. renewable energies)
Short Selling ! (Barnea et al., 2005)
89
Basics of RI (2)
Shareholder activism
Publicity campaigns
Engagement (Dialogue with management team)
Shareholder resolutions
General use of voting rights
SEE rating institutions:
E.g. EIRIS evaluates all FTSE All World Developed
(about 1,800) constituents on over 300 SEE criteria
Responsible Investment vehicles
Funds (e.g. Pax World fund launched in 1971)
Indexes (e.g. Dow Jones Sustainability Index launched
in 1999 or FTSE4GOOD Index launched in 2001)



90
Shareholder vs. Shareowner within RI
Shareowner ~
An investor, who holds a considerable stake in an asset. As she usually
cannot liquidate this considerable stake without a considerable negative
price impact and therefore substantial costs, she would act rational in a
world without Agency conflicts to be considered about the long term
performance and the long term risks (including the social and
environmental) to which her asset is exposed. Thus, she would actively
consider to use her control powers, whenever economically viable.
Alternatively, Shareowners have only invested a small stake in an asset,
but are for (institutional or personal) reasons commited to hold the asset
over a long investment horizon.
Shareholder ~
An investor holding a inconsequential stake in an asset for short term
trading purpose only.
91
RI within Economic Theory
*SRI+ can be said to be about maximizing welfare (rather than
wealth tout court). In this regard, it can be said to have a
broader focus than financial economics but one that is
nevertheless recognized by many economic disciplines.
Welfare analysis concerns itself with the evaluation in the
effects of changes in the consumers environments on *his or
her] well-being (Mas-Colell, Whinston, and Green 1995, p.
80). Welfare economics is more commonly applied in
emerging market contexts than developed market contexts
(but also relevant to economic regulation in developed
markets) and recognizes that markets are not always efficient
and considers the consequences of market failure (Hudson,
2006: 17)

92
RI within Welfare Economics (1)
Private (rational) investors can be expected not to maximize
their own (long term) wealth, but their own (long term)
welfare. This might involve
To invest according to the investors personal values
To consider risk to the life expectancy of the investor and her relatives
in the investment decision
If a corporations externalities cause negative economics
welfare to other economic actors, it might be in the fiduciary
duty of an institutional investor (e.g. a charity) to position
itself against this corporation
93
RI within Welfare Economics (2)
If markets are inefficient with respect to economic welfare
(despite they might be efficient with respect to economic
wealth at the same time), regulators or the market itself (e.g.
Hybrid cars) can be expected to introduce correcting
mechanisms, which might well affect share prices of
previously externalizing companies substantially
Society might perceive market inefficiences with respect to
economic welfare as unjust and start substantials campaigns
(e.g. Sudan Divestment Campaign), which depresses the
campaigned against corporations share price
94
Legal environment of RI (1)
Australia
In a 2001 bill it is stated that all investment firms product disclosure
statements should include a description of the extent to which labor
standards or environmental, social or ethical considerations are taken into
account.
Since 2001, all listed companies on the Australian Stock Exchange are
required to make an annual social responsibility report.
France
In May 2001, the legislation New Economic Regulations came into force
requiring listed companies to publish social and environmental
information in their annual reports
Since February 2001 managers of the Employee Savings Plans are required
to consider social, environmental or ethical considerations when buying
and selling shares.

95
Legal environment of RI (2)
Germany
Since 1991, the Renewable Energy Act gives a tax advantage to closed-
end funds to invest in wind energy.
Since January 2002, certified private pension schemes and occupational
pension schemes must inform the members in writing, whether and in
what form ethical, social, or ecological aspects are taken into
consideration when investing the paid-in contributions
Netherlands
In 1995, the Dutch Tax Office introduced a Green Savings and Investment
Plan, which applies a tax deduction for green investments, such as wind
and solar energy, and organic farming
Sweden
Since January 2002, Swedish national pension funds are obliged to
incorporate environmental and ethical aspects in their investment policies.

96
Legal environment of RI (3)
United Kingdom
In July 2000, the Amendment to 1995 Pensions Act came into force,
requiring trustees of occupational pension funds in the UK to disclose in
the Statement of Investment Principles the extent (if at all) to which
social, environmental and ethical considerations are taken into account in
the selection, retention and realization of investments
The Trustee Act 2000 came into force in February 2001. Charity trustees
must ensure that investments are suitable to a charitys stated aims,
including applying ethical considerations to investments
In 2002, The Cabinet Office in the UK published the Review of Charity Law
in 2002, which proposed that all charities with an annual income of over
1 m should report on the extent to which social, environmental and
ethical issues are taken into account in their investment policy. The Home
Office accepted theses recommendations in 2003.



97
Legal environment of RI (4)
The Association of British Insurers (ABI) published a disclosure guideline in
2001, asking listed companies to report on material social, environmental
and ethical risks relevant to their business activities.
United States
Section 406 of the Sarbanes-Oxley Act, which came into effect in July
2002, requires companies to disclose a written code of ethics adopted by
their CEO, chief financial officer and chief accountant. (Renneboog et al.,
2008: 1727)

98
Proposed Rationales for Responsible Investment
4 lines of reasoning:
Rationale for natural & legal investors caring for societys long
term wellbeing
e.g. governments; philanthropist
Rationale for natural & legal investors caring for their own
long term wellbeing
e.g. younger, non suicidal investors; pension funds
Rationale for natural & legal investors caring for their own
overall financial return of their investments from the financial
and real world
e.g. insurances
Rationale for legal investors caring for their own financial
market return of their investments
e.g. the legal person in the asset management company
99
Rationale for investors caring for societys wellbeing
Global problems
Our general way of life is most likely unsustainable
Humanitys growing population and economic activity demands 21%
more ecological resources than available in 2001 (Loh/Randers, 2005)
In many cases, it is literally a matter of living on borrowed time.
(United Nations, 2000)
Global climate change as biggest threat
Al Gores Inconvenient Truth movie is partially incorrect!
HOWEVER, the trailer is robust and its flooding scenarios appear very
worthwhile seeing [>]
But the climate change critics (Dennis Avery, Fred Singer) appear
worse!
The science stays consistent and sound! (http://www.realclimate.org/)
Scientifically, Global Climate Change is not inconvenient, political or a
matter of faith, it is simply nothing more or less than dangerous!
100
Temperature vs. CO
2
(1)
101
Temperature vs. CO
2
(2)
102
The very worst case for the UK
If the worlds
entire ice sheet
melts and water
heats and
expands, sea
level would rise
84 meters and
the UK would
look like this:
103
The theoretical governmental solutions
appear easy
Stern Report (2006): Action to mitigate climate change costs
184bn annually, while inaction could result in a permanent
loss of 1/5 of the global output (3.68 trillion)
Economist (2006): *G+overnments should act not on the basis
of the likeliest outcome from climate change but on the risk of
something really catastrophic (such as the melting of
Greenland's ice sheet, which would raise sea levels by six to
seven metres). Just as people spend a small slice of their
incomes on buying insurance on the off-chance that their
house might burn down, and nations use a slice of taxpayers'
money to pay for standing armies just in case a rival power
might try to invade them, so the world should invest a small
proportion of its resources in trying to avert the risk of boiling
the planet. The costs are not huge. The dangers are.

104
one reason, why the virtual solution is
not.
A sufficient condition for us (everybody;
democratically elected governments) to
control economic un-sustainable activity (e.g.
CO2 emissions) would be to have effective &
efficient legislation in place:
The GM Malibu case highlights the problem
with this condition
105
GM Chevrolet Malibu case 1973 (1)
GMs had internal directive to place the fuel tank at
least 17 inches from the rear bumper in their Malibu
to avoid a fire in case of a Malibu being hit from
behind. (Bakan, 2004)
This would cost $8.59 per car more than to locate
the fuel tank 12 inches from the rear bumber. But
the latter might lead to a maximum of 500 fatalities
per year in accidents with fuel fires where bodies
were burnt (Internal GM Document, 1973 cited by
SafetyForum, 2006)

106
GM Chevrolet Malibu case 1973 (2)
Of these 500 fatalities, of which each has a value of
$200,000 to GM, 11% would sit in one of the 5
million Malibus produced annually
Hence: For GM it would be worth approximately
$2.20 per new model auto to prevent a fuel fire in all
accidents.(Internal GM Document, 1973 cited by
SafetyForum, 2006) [55 * $200,000 / 5,000,000 =
$2.20]
THUS: GM saved $6.39 per car by willing to let
customers die in a fuel tank fire and take the
responsibility for the deaths by paing the legal fines >

107
108
109
Economic Activity Can we currently
control it?
As long as the virtually worst, which can happen to
corporations for breaking the law, is to be fined, we cannot be
sure, that they do not include the fine multiplied by the
possibility of being detected in their cost/benefit analysis.
HENCE: It seems unlikely that current governments will solve
these global problems using current legislation on their own.
THUS: To save common social, environmental and financial
resources and common people from harm, investors
interested in the general society might want to consider extra-
financial factors in their investments.
110
Rationale for investors caring for their own
wellbeing
3 extreme examples:
ITT, Mr. Hitler & ITTs investors health
Shanghai, Dutch, Calcutta or Florida investors,
Global Warming & investors health
Pension fund workers, the return on their
pension & their wellbeing

111
ITT, Mr. Hitler & ITTs investors health
Mr. Hitler needed help in building his Focke-
Wulf bombers and ITT build them for him
(Micklethwait & Wooldridge, 2003)
ITT is an US corporation, for which - from a
solely financial point of view - it might have
been sensible to invest in Nazi Germany
But what, if ITT would have been English with
a headquarter in London?
112
The other 2 examples
Shanghai, Dutch, Calcutta or Florida investors,
who invest in corporations contributing to
Global Warming, increase the likelihood of
their areas being flooded
Pension fund workers, who encourage their
pension fund to get the maximum return
irrespective any social costs, might be the
ones to be set off to do so

113
Conclusion from these 3 examples
For a selfish individual investor, who values
wellbeing, health or at least his/her life as
precious, it can be rational to consider extra-
financial factors in his/her investing process.
114
Rationale for investors caring for their own overall
financial return of their investments
The possibility of Shanghai flooding or loosing ones job
caused by ones own pension fund shows that there is more
possible financial risk and return than the one directly from
the financial asset invested in.
HENCE:
Overall risk adjusted return from investment process =
Direct risk adjusted return from financial asset +
Indirect risk adjusted return caused the financial assets effect on real
markets
E.g. UK government approximated the economic costs of alcohol (20.1
bn) and tobacco (3 bn) (Topping, 2007)
Indirect return is for instance especially important for
Florida state pension fund
The worlds (re)insuring industry (Figge, 2001)

115
Rationale for investors caring for their own financial market
return of their investments (1)
Diversification
Conventional simplistic view: Smaller universe, worse diversification of
responsible funds
More sophisticated analysis:
Diversification gains end at transaction cost border (Statman, 2004)
Responsible stocks are found to have lower total risk (Boutin-Dufresne
and Savaria, 2004)
Hence, responsible best-in-class funds might well have better
diversification
Legislation to support responsible investors
E.g. tax exemption in Netherlands, SEE transparency requirement for
pension funds in UK (Riess & Welzel, 2006)
Order flow effects and the status in the climate crisis

116
Rationale for investors caring for their own financial market
return of their investments (2)
Nature of climate change
Climate change implies that the majority of environmental risk is not displayed
in historical data
Many environmental risks like climatic risk seems of systematic nature
Not only at one point in time as worldwide economy
BUT also over time (Figge, 2001)
The danger of being locked in an economy wide SEE risk downturn
when corporations treat the environment badly, they treat their investors
badly by exposing their investments to enormous liability and negative
publicity. (Holtzmann, NY pension fund treasurer in 1994 cited by Sparks,
2002)
Big investors cannot quickly offset their positions (Holtzmann, 1994 cited by
Sparks, 2002)
The distribution of the stock return reactions on many environmental (and
also social) measures is very likely strong negatively skewed


PRACTICAL VIEWS
117
Fiduciaries to CalPERS,
such as corporate boards
and external managers, are
accountable for overseeing
the use of our capital
Well-designed compensation
programs should be in place to
reward and align the users of our
capital with CalPERS objective
to achieve sustainable, long-term
investment returns
CalPERS expects fair,
accurate, and timely
reporting on how financial,
human, and physical
capital are employed to
generate sustainable
economic returns
Regulation to protect CalPERS
as an investor, maintain fair,
orderly, and efficient markets,
and facilitate capital formation

CalPERS is a
provider of capital to
corporations, external
managers, and
investment vehicles
The Virtuous Circle of Value Creation
Shareowner rights
Board quality & diversity
Executive compensation
Corporate reporting
Regulatory effectiveness
Generation Investment
119
Fixed Income Example
120
121
5. Responsible Investment:
Performance Evaluation

122
Advanced aspects of RI
Financial performance measurement of
(mainly) equity mutual funds (responsible or
conventional)
Social performance measurement of RI funds
Empirical findings on RI funds
123
Sharpe ratio & Treynor ratio
The Sharpe ratio (S
i
) represents the division of asset is average
excess return over the risk free return (
xi
), which is calculated
difference between the average of asset is logged return (
i
) and
the average logged risk free return (
f
) by the standard deviation of
asset is average excess return over the risk free return (
xi
)
The Treynor ratio (T
i
) has the same numerator as the Sharpe ratio,
while the denominator is asset is beta (
i
) as estimated in the
Capital Asset Pricing Model (CAPM), which you are expected to
remeber from the Corporate Finance Module
In both ratios, a higher value is supposed to indicate a better
financial performance.
xi
f i
i
r r
S
o

=
i
f i
i
r r
T
|

=
124
Capital Asset Pricing Model
To estimate the eta coefficient (
i
) of an asset i, the Capital Asset Pricing
Model (CAPM) needs to be put in a regression framework
In this, the eta-coefficient (
i
) of the markets excess return over the risk
free return (R
mt
-R
ft
) and the constant (
i
) explain the systematic explain
the systematic components of asset is excess return over the risk free
return (R
it
-R
ft
) at time t, while a random disturbance term (
it
) captures the
random component to jointly completely describe the assets excess
return and especially ist variation over time
If
i
, called Jensen Alpha in a CAPM regression, is a significant positive
value, asset i is said to outperform the market benchmark, while if
i
is a
significant negative value, asset i is said to underperform the market
benchmark

it ft mt i i ft it
R R R R c | o + + = ) (
125
Preparing data for a CAPM model
regression (1)
A standard task in many students or analysts projects.
1. Stock prices, interest rates, mutual fund net asset
values, economic data and much more data is
available from the Datastream desktops on the 3rd
floor in the Gateway or in the libary
Note, however, that specialised data such corporate SEE
ratings, hedge fund net asset values, Mergers &
Acquisition or Initial Public Offerings is not (!) available
from Datastream
2. Corporate SEE ratings or SRI fund SEE ratings are
available from Andreas directly

126
Preparing data for a CAPM model
regression (2)
3. After you selected corporations, consciously decide, which of their shares
(A or B class? Index constituents? Traded on which exchange?) you want to
download and analyse
4. Then download their stock price history using the datatype Total Return
Index, which appropriate accounts for dividends, for your sample period
and observation frequency
Note that for equities (!) Datastream provides daily closing prices. Hence, if you
want to analyse monthly stock returns, you have to download data for the last
day of each month and each previous month
Remember also to analyse any asset (stocks, bonds etc.) in the same currency
However, before downloading in the same currency, download every asset in
local currency first to identify securities with constant prices (e.g. dead or illiquid
securities)
Account for non-trading days (e.g. public holidays), which are not always ignored
by Datastream.
127
Preparing data for a CAPM model
regression (3)
5. Once you downloaded the stock prices, you need
to calculate stock returns using the natural
logarithm
In a regression framework, returns need to be calculated
with the natural logarithm, as otherwise +10% does not
represent the same absolute value as -10% for any base
value.
To see this, assume that your portfolio won 10% today
and lost 10% tomorrow or vice versa. Are you at par?
No, because 10% of a base value 110 or 90 are different
from 10% of a base value 100.
100 x 1.1 x 0.9 = 100 x 0.9 x 1.1 = 99

128
Preparing data for a CAPM model
regression (4)
6. The appropriate formula to calculate returns
(R) of stock i at time t for the previous period
(t-[t-1]) is to take the natural logarithm (ln)
of the division of the stock price (P) at time t
by the stock price at time t-1
) ln(
1 ,
,

=
t i
t i
it
P
P
R
129
Preparing data for a CAPM model
regression (5)
With respect to a equal weighted portfolio j of stocks
i1 to iN, the appropriate formula to calculate returns
(R) at time t for the previous period (t-[t-1]) is to take
the natural logarithm (ln) of the average division of
each stocks price (P) at time t by the same stocks
price at time t-1
Market value or otherwise weighted portfolio returns
are caculated accordingly with the respective weighted
scheme based on the market value or other value of
period t-1!
) ... (
1
ln(
1 ,
,
1 , 2
, 2
1 , 1
, 1

+ + + =
t iN
t iN
t i
t i
t i
t i
jt
P
P
P
P
P
P
N
R
130
Preparing data for a CAPM model
regression (6)
7. As risk free return for a global or U.S. study, one usually
employs United States Treasury Bills calculated as
Investment Yield (also called coupon equivalent rate) or the
respective countrys equivalent interest rate
Investment Yield = [(FV - PP)/PP] x [365.25/M]
FV = face value
PP = purchase price
M = days to maturity of bill. For a 4 weeks T-bill use 28, for a 3
month T-bill (13 weeks) use 91, and for a six-month T-bill (26
weeks) use 182
Compare the less precise Discount Yield, which use FV and a
360 day year:
DY = [(FV - PP)/FV] * [360/M]


131
Preparing data for a CAPM model
regression (7)
Datastream provides data for the US T-Bill coupon equivalent 4, 13 and
26 weeks under the codes USTCE4W, USTCE3M, and USTCE6M,
respectively, since 2002. For longer time series, students are
recommended to select the Datastream series FRTCM3M, FRTCM6M,
and FRTCM1Y, which refer to a very similarly calculated T-Bill of 3
months, 6 months and 1 year maturity, respectively.
If you require the risk free return of another country and have
difficulties to find the respective data series on datastream after a well
organized search process, you are recommended to call the Datastream
24h Helpdesk on 0870-1910581 or chat with Bloombergs Helpdesk.
Note that as zero coupon bonds, the T-Bill yields/returns refer to the
next future period. Hence, if you want to get a T-Bill return for say May,
you have to download the T-Bill yield at the closing of the last April
trading day.
132
Preparing data for a CAPM model
regression (8)
8. Once downloaded the interest rate data needs to be
transformed in the risk free return of the relevant observation
frequency
A stated 4 weeks T-Bill rate (SR
f,t,4w
) is for instance transformed as a
percentage value in a weekly risk free rate (R
f,t,1w
) at time t as shown
below:




As another example, a stated 4 weeks T-Bill rate (SR
f,t,4w
) is transformed
as a percentage value in a monthly risk free rate (R
f,t,1m
) as follows:

)
25 . 365
28
1 ln(
4
4 , , 1 , , w t f w t f
SR R + =
) )
25 . 365
28
1 ln((
28
4375 . 30
4 , , 1 , , w t f m t f
SR R + =
133
Preparing data for a CAPM model
regression (9)
A stated 13 weeks T-Bill rate (SR
f,t,13w
) is for instance transformed as
a percentage value in a monthly risk free rate (R
f,t,1m
) at time t as
shown below:




To transform a stated 4 weeks T-Bill rate (SR
f,t,4w
) into a daily risk
free rate (R
f,t,1d
), one has to consider the average number of trading
days per week TDW [TDW= Observations in Sample / Weeks in
Sample] :

) )
25 . 365
91
1 ln((
91
4375 . 30
13 , , 1 , , w t f m t f
SR R + =
) )
25 . 365
28
1 ln((
4 *
1
4 , , 1 , ,
TDW
w t f d t f
SR R + =
134
Fama-French model
Based on empirical evidence that small stocks outperform large stocks and high
book value to market value (B2M) stocks (so called value stocks) outperform low
B2M stocks (so called growth stocks), Fama and French (1993) construct a 3 factor
model, which adds two explanatory variables to the CAPM
SMB
t
(Small Minus Big) represents the return of a portfolio investing long in small stocks and
short selling large stocks
HML
t
(High Minus Low) represents the return of a portfolio investing high B2M stocks and
short selling low B2M stocks
Gamma (
i
) describes the asset is exposure to the size of stocks A significance positive
value indicates a tilt to small stocks and a significance negative value a tilt to large stocks
Delta (
i
) describes the asset is exposure to the B2M of stocks A significance positive
value indicates a tilt to high B2M stocks and a significance negative value a tilt to low B2M
stocks
As in CAPM, significance and sign of
i
are the primary basis for evaluating the financial
performance of asset i



it t i t i ft mt i i ft it
HML SMB R R R R c o | o + + + + = ) (
135
Preparing Fama-French model factors (1)
After ranking a respective stock universe according to size, Fama and
French (1993) consider the stocks of the upper half to be the big stocks
portfolio (B) and the market value weighted stocks of the lower half to be
the small stocks portfolio (S).
After ranking a respective stock universe according to B2M, Fama and
French (1993) consider the stocks of the Top 30% to be the high B2M
stocks portfolio (H), the market value weighted stocks of the middle 40%
to be the medium B2M stocks portfolio (M), and the market value
weighted stocks of the Bottom 30% to be the low B2M stocks portfolio (L).
From the intersections of the two size and three B2M based portfolios,
Fama and French (1993) calculate six market value weighted portfolio
returns (BH, BM, BL, SH, SM, SL), where BH represents the return of the
portfolio of big and high B2M stock, SM represents the return of the
portfolio of small and medium B2M stocks and so on
136
Preparing Fama-French model
factors (2)
Based on these six portfolio returns, the appropriate
formula for SMB
t
and HML
t
are the following:

)
3 3
1 ln(
t t t t t t
t
BL BM BH SL SM SH
SMB
+ +

+ +
+ =
)
2 2
1 ln(
t t t t
t
SL BL SH BH
HML
+

+
+ =
137
Carhart Model
Based on empirical evidence that previous winner stocks
outperform previous looser stocks, as they are able to utilitize
their performance momentum, Carhart (1997) adds another
explanatory variable to the Fama-French model (MOM)
MOM
t
represents the return of a portfolio investing long in winner stocks and
short selling looser stocks
Zeta (
i
) describes the asset is exposure to the momentum of stocks A
significance positive value indicates a tilt to above average momentum
(winner) stocks and a significance negative value a tilt to beow average
momentum (looser) stocks
As in CAPM, significance and sign of
i
are the primary basis for evaluating the
financial performance of asset i



it t i t i t i ft mt i i ft it
MOM HML SMB R R R R c , o | o + + + + + = ) (
138
Preparing the MOM factor
MOM
t
is constructed based on
a monthly observation interval and
a ranking of a respective universe of stocks according to their
performance over the period from t-12 to t-1, on whose
basis
an equal weighted return of the Top 30% stocks (W) and an equal
weighted return of the Bottom 30% (L) are calculated
The appropriate formula for MOM
t
is as follows:
) 1 ln(
t t t
L W MOM + =
139
Social Performance Measurement of RI
funds
Number of social, environmental or ethical
(SEE) Screens employed by an SRI fund (Barnett
& Salomon, 2006 or Scholtens, 2007)
SRI fund rating (e.g. Muoz-Torres et al., 2004 or Dumke,
Hoepner and Wilson, 2008)
Average SEE rating of assets hold by the SRI
funds (Statman, 2006 or Kempf & Osthoff, 2008)
140
RI Performance studies
The majority of studies found no statistically
significant performance difference between RI Funds
or indices and conventional funds or indices (Mallin et al.,
1995; Ditz, 1995; Sauer, 1997; Reyes & Grieb, 1997; Statman, 2000; Kreander et al.,
2001 & Bauer et al., 2005)
But some found an underperformance of RI funds or
indices (Bauer et al., 2005, Renneboog et al., 2008)
And others found even an outperformance or RI
funds or indices (Luther et al., 1992; Mallin et al., 1995 & Bauer et al.,
2005)
141
Example of a very sophisticated study delivering
inconclusive results (1)
Bauer, R.; Koedijk, K.G. & Otten, R. (2005) Journal of Banking
& Finance, 29: 1751-1767.
Used Carhart 4 factor model (JoF, 1997)
Compare each of 103 U.S., UK or Germany RI mutual funds
with 3 similar conventional funds matched by age and size
(Matched Pair Approach) over a period from 1/90 to 3/01
using 3 subperiods
Categorise funds according to domestic (D) or international (I)
focus
Consider survivorship bias
Find no statistically significant difference over whole period
142
Example of a very sophisticated study delivering
inconclusive results (2)
BUT they find statistically significance performance difference for their
subperiods:
1990-1993: Underperformance of German (I) and U.S. (D) @ 10% as well as
U.S. (I) Responsible Fund @ 5% significance level
1994-1997: Underperformance of German (I) @ 10% % significance level, but
Outperformance of UK (D) and UK (I) @ 5% and 10% significance level,
respectively
1998-2001: Outperformance of UK (I) and U.S. (D) @ 10% and 5% significance
level, respectively
They also find
a lower eta for UK & German Responsible Funds at 1% significance level
LOWER RISK OF RI!
and very surprisingly that the conventional Worldscope and the Fama &
French type index explain more of the internationally and domestically
focused Responsible Funds movements than the Dow Jones Sustainability
Index and Domini Social Index, respectively.
143
Preliminary Meta-Regression-Analysis
(Hoepner & McMillan, 2008)
Analysis of 1,409 Jensen Alpha estimations of 20
largest studies on RIs financial performance
Explains 30% of variability between estimations
Findings
hypothetical RI indexes perform more than 0.8% and 1%
better per month than existing indexes and existing funds,
respectively
RI performed above their average during the period 1986-
2000, while they strongly underperformed their average
from 2001 to 2005
Studies, which received external funding, estimated
monthly Jensen Alphas of 0.43% below average


144
Sudan Divestment Campaign Case
(http://www.clooneystudio.com/movies/darfurnow.html)
Hoepner, McMillan and Mller (2008) study the financial performance of the
recently high media coverage Sudan Divestment Campaign.
We find using a 7 factor model based on Carharts (1997) 4 factor model that
Sudan Divestment with a market neutral strategy earns a statistically significant
substantial premium of 16.9% p.a.
We credit this success to the immense and highly public efforts of the Sudan
Divestment Taskforce
Thus, there appears to be a substantial potential for investors to do well while
doing good, if supported by a sufficiently strong social activist campaign
145
Implications for campaigners
Learning from the South Africa case
Current pressure on Sudan to stop Darfour
Genocide showed effect
Responsible Investment in comparison with
other campaigning tools
146
The South Africa Case (1)
1982: Connecticut became first US legislatur to
establish SR criteria for state investment
1984: New York & California issued SRI guidelines for
their pensions funds, (which had together over
$65bn of assets)
1984: The NY pension funds threatened Citicorp. to
loose $20bn of deposits, if it would make new loans
to South Africa (Sparkes, 2002)

147
The South Africa Case (2)
2/1985: Citicorp. agreed to cease making loans to
South Africa
7/1985: After the state of emergency had been
declared, Chase Manhattan stated, that it would
neither give new loans to South Africa nor renew old
ones.
8/1985: South Africa had to declare default on its loans
despite a rather low debt service ratio of 9%, as they
had been "effectively cut off from the global debt
market (Sparkes, 2002: 56)
148
The South Africa Case (3)
1986: The California State Pension Fund sold $6 bn of assets in
companies, which had activities in South Africa
1987: The Rand had depreciated from 1 USD in 1980 to 0.21 USD
in 1986 despite stringent foreign exchange controls
1990: South Africa needed to repay the bulk of its loans in the
summer ($ 13 bn). The financial pressure overwhelmed it, as
it had virtually no foreign exchange reserves anymore since
the beginning of the year. This was the beginning of the end
of Apartheid. (Sparkes, 2002)



149
RI in comparison to other campaigns
Assume a theoretical world with 200 fund managers and 200 CEOs, both
groups wish to perform as socially as possible by earning a required return
Which group would perform better on average?
RI adresses companies from the resource side (products or services,
human and financial resources), which enables it to impact mainly B2B
companies as well as B2C
On the resources side
Financial resources can go long and short in opposite to the other resources
Financial resources are likely in the better bargaining position as other
resources, as
They do not prefer unlimited interaction in contrast to suppliers
They have much more alternatives to engage themselves as the average human
applicant
150
Implications for policy makers (1)
Due to its potential, responsible investment
can assist them to solve pressing social and
environmental problems
However, it alone cannot be sufficient to solve
most problems, as it pays *for corporations+
to be good, but not too good. (Mintzberg,
1983: 10)
151
Inverted U-shape relation of corporate financial
and social performance
-400
-300
-200
-100
0
100
200
5 10 15 20 25 30
SOCIAL_PERFORMANCE FINANCIAL_PERFORMANCE
Arbitrary
scaling!
It pays to be good, but not too
good. (Mintzberg, 1983: 10)
152
Implications for policy makers (2)
To solve pressing problems, policy makers will eventually have
to price responsible and irresponsible behaviour sufficiently
(e.g. Carbon Markets)
Current examples of legislation include (Riess & Welzel, 2006)
Tax exemption for responsible investments in Netherlands
Tax exemption for an individual responsible investment fund in
California,
Environmental and ethical investment criteria for public Swedish
pension funds
SEE transparency requirement for pension funds in UK (Riess & Welzel,
2006)

153
Implications for investors (1)
With an increasing percentage of investors applying SEE
criteria, RI increasingly affects
order flow
and hence asset return
and asset return risk
They can expect increasing demands on them
to be accountable for the SEE behaviour of their portfolio stocks
to vote their shares
basically to be shareowner instead of shareholder
SEE criteria make financial markets more complex (e.g.
potential legislation, systematic nature of climate change)


154
Implications for investors (2)
RI represents a fast growing industry offering lots of
opportunities for business
Some SEE criteria might well add value (e.g.
responsible, long term focused business practices as
indicators of non short term obsession)
Focusing on return from entire investment process
instead of just financial market can make many of
them better off eventually

155
Project Desertec (1)
Within 6 hours
deserts receive
more energy from the sun
than humankind
consumes within a year.
(Gerhard Knies)
156
Project Desertec (2)
157
Project Desertec (3)
Members of Consortium:
ABB
ABENGOA Solar
Cevital
DESERTEC Foundation
Deutsche Bank
E.ON

HSH Nordbank
MAN Solar Millennium
Munich Re
M+W Zander
RWE
SCHOTT Solar
Siemens


158
Implications for CFOs (1)
Dropping out a major RI index reduces ones investor and
lender base substantially This can be expected to
depress stock price
reduce stock price liquidity
hamper financing activities
increase downside risk of ones stock returns
Responsible business practices can reduce total risk, which
can be expected to
improve financial sustainability of company
Increase attractiveness to investors, if total risk (at least partially)
matters, as very recent research indicates (e.g. Goyal & Santa-Clara,
2003; Spiegel & Wang, 2005)
159
Implications for CFOs (2)
Climatically responsible business practices reduce a
corporations exposure to long term climate change risk and
hence reduces
its expected systematic risk (at one point in time and over time)
decreases its cost of capital
Increases its Economic Value Added
Responsible Investor Relations efforts needed e.g.
Corporate Social Responsibility Reports
Departments for Environmental Management and Corporate Social
Responsibility
Company spinn offs (Altria Kraft spinn off)
160
6. Carbon Finance: An Introduction

[Climate Finance already part of CAIA curriculum]
161
Carbon Finance Definition
[Narrower definition] The science and economics of climate change have
recently lead to climate change mitigating legislation, which transformed
emissions of carbon dioxide and other greenhouse gases from a free good
into a scarce commodity. In this new carbon constrained world, many
organisations need to possess the right to emit carbon. Carbon emission
rights can be obtained under various conditions from governments, they
can be generated through emission reducing projects or they can be
bought in a regulated or voluntary market. As a consequence, many
financial transactions have evolved around the commodity carbon
emission right, which can be subsumed under the term carbon finance.
[Broader definition] Carbon finance means the financial flows associated
with societys response to climate change in particular, the flows
mediated by market mechanisms.

162
Carbon Finance Overview
Cap-and-Trade Systems Project-based
Markets
Kyoto Protocol
Joint Implementation and
Clean Development Mechanism
Emissions Trading
EU-ETS
Flexible Mechanisms
Demand Factors Supply Factors
Market Pricing on the European Carbon Market
Section 4
Section 3
Section 2
163
Kyoto Protocol (1)
The Kyoto Protocol can be recognized as the origin of todays
carbon markets.
The international environmental treaty was established in
Kyoto, Japan in December 1997, when 38 countries agreed to
reduce their GHG emissions to an average of 5.2% compared
to the 1990 levels in the so-called first commitment period
from 2008 to 2012.
The Kyoto Protocol is the first comprehensive agreement that
established legally binding targets for the reduction of GHG
emissions. In doing so, it transformed GHGs from a free good
to a scarce commodity
This was the fundamental prerequisite for a carbon market!
164
Kyoto Protocol (2)
According to article 25 of the Kyoto Protocol, the
agreement shall enter into force "on the ninetieth day
after the date on which [1st requirement] not less than
55 Parties to the Convention, [2nd requirement]
incorporating Parties included in Annex I which
accounted in total for at least 55% of the total carbon
dioxide emissions for 1990 of the Parties included in
Annex I, have deposited their instruments of ratification,
acceptance, approval or accession" (Kyoto Protocol,
1998).
The first requirement was fulfilled on 23 May 2002 when
Iceland ratified the protocol.
165
Kyoto Protocol (3)
However, after the exit of the USA, the largest per
capita emitter of carbon dioxide from burning fossil
fuels, out of the protocol in 2001, the United Nations
had to wait for the participation of Russia, which
took place on 18 November 2004, in order to fulfil
the second requirement. Consequently, the
agreement entered into force on 16 February, 2005.
As of today, 184 countries including the European
Union (EU) have ratified the Kyoto Protocol

166
Kyoto Protocol Participation
167
Greenhouse Gas Reduction Targets
of Kyoto Protocol
Selected Country
GHG Emissions in base year 1990
(million tons CO
2
e)
Emission Reduction Target
under the Kyoto Protocol (%)
Austria 78.9 -8 (-13)
Canada 598.9 -6
Denmark 70.4 -8 (-21)
European Community 4252.5 -8
France 567.1 -8 (0)
Germany 1226.3 -8 (-21)
Iceland 3.3 +10
Italy 519.6 -8 (-6.5)
Japan 1272.1 -6
Netherlands 213.0 -8 (-6)
Norway 49.8 +1
Poland 564.4 -6
Portugal 60.0 -8 (+27)
Romania 262.3 -8
Russian Federation 2974.9 0
Spain 287.2 -8 (+15)
Sweden 72.4 -8 (+4)
Switzerland 52.8 -8
Ukraine 925.4 0
United Kingdom 776.1 -8 (-12.5)
168
Greenhouse Gas Reduction
Because of their low per capita GHG emissions, developing countries
and emerging markets such as Brazil, China and India do not have to
meet any reduction targets
In order to ensure that the individual reduction commitments will be
fulfilled, each country receives a specified number of so-called emission
allowances, which represent the amount of GHG emissions a country is
allowed to produce according to the Kyoto protocol
Since the location of the emission reduction actions is irrelevant for
global climate protection, the protocol established 3 flexible
mechanisms, marked-based instruments, to provide geographic
flexibility and encourage cost-effective implementation:
(1) Emissions Trading (i.e EU ETS)
(2) Joint Implementation
(3) Clean Development Mechanism
169
Comparison of Cap & Trade with
Baseline & Credit
Features Cap-and-Trade Baseline-and-Credit
Exchanged Commodity Allowances Carbon Credits
Quantity Available Determined by overall cap Generated by each new project
Market Dynamic
Buyers and sellers have competing and
mutually balanced interests in
allowances trades.
Buyers and sellers both have an interest in
maximizing the offsets generated by a
project.
Independent Third Party
Minor role in verifying emissions
inventories.
Fundamental role in verifying the credibility of the
counterfactual baseline and thus the
additionality of the claimed emission
reductions.
Emissions Impact of Trade
Neutral, as ensured by zero-sum nature of
allowance trades.
Neutral, providing projects are additional.
Otherwise, net increase in emissions.
Possible decrease in emissions in the
voluntary market.
170
Overview on all 3 flexible mechanisms
Flexible Mechanisms
Home Country Foreign Country
Non-Annex B Annex B
Emissions Trading
Clean Development
Mechanism
Joint Implementation
Emission Allowances
(AAUs)
Carbon Credits
(CERs)
Carbon Credits
(ERUs)
Fulfillment of National
Reduction Targets
Sale on the
Carbon Market
Location of the
Reduction Activity
Instrument
Compensation for the
Emission Reductions
Possible Applications
171
Carbon Markets Overview (3)
Carbon Market
Regulatory
Compliance Markets
Voluntary Markets
Project-based
Markets
Cap-and-Trade
Systems
Voluntary, but legally binding
Cap-and-Trade Systems
Non-binding
Over-the-Counter
Transactions
EU-ETS
Kyoto AAU
New South Wales
RGGI
Albertas SGER
Primary CDM
Secondary CDM
JI
CCX Others
Other Exchanges
172
EU-ETS (1)
Commenced in 2005
EU-ETS is the worlds largest and most ambitious emissions
trading programme and an essential component of the EUs
strategy to reduce its GHG emissions to an average of 8%
compared to the 1990 levels in the period from 2008 to 2012.
It is installation-based cap-and-trade system. This means that
the European Union Allowances (EUAs) are allocated to
individual factories and power plants, rather than to entire
companies or countries.
Covers only CO
2
currently, while Kyoto defines six greenhouse
gases


173
EU-ETS (2)
Emission trading under the EU-ETS takes place in different trading periods,
each period covering a particular sequence of years.
Emission allowances are issued annually. However, they are valid for the
whole ongoing trading period.
If an installations emission allowances do not cover the produced
emissions in that year, fine payments of 100 per excess ton CO
2
will be
due.
There are no restrictions regarding the banking and borrowing of emission
allowances within a particular trading period. This means the participants
are allowed to store allowances for the next year of the trading period or
to use allowances of a future year of the trading period to cover current
shortfalls.
However, banking and borrowing between different trading periods is not
allowed. With the termination of each trading period the current allocated
EUAs will become invalid and new allowances will be issued
174
EU-ETS Trading Periods (1)
The first trading period expired in December 2007 and can be recognized
as a trial or pilot phase before the Kyoto commitments began.
Within Phase I the EU did not achieve any significant CO2 emissions
reductions
However, the main intention of this three year trading period was to
build up the required infrastructure and gain the necessary experience
for the successful use of the trading scheme during Phase II
Phase II is running since January 2008 and consistent with the first
commitment period of the Kyoto Protocol (2008-2012). The objective of
the second trading period is to cut down the EU-wide emissions to 2.08
Billion tones CO2, which would equal a reduction of approximately 5%
compared to first trading period.
175
EU-ETS Trading Periods (2)
The linkage of the EU-ETS to the project based markets of the Kyoto
Protocol is defined by the so-called EU-Linking Directive, which was
adopted in 2004.
The directive allows companies participating in the EU-ETS to apply credits
from JI and CDM projects in order to meet their emission reduction targets
within the EU-ETS. While CDMs Certified Emissions Reductions (CER). can
be traded since 2005, JIs Emission Reduction Units (ERUs) can be
purchased and sold since 2008.
The member countries of the EU-ETS thereby have to define how many
external credits individual companies are allowed to use to comply with
the EU-ETS. The country-specific limits range from 0% of the allocated
allowances in Estonia to 22% of the allocated allowances in Germany.

176
EU-ETS Trading Periods (3)
The transition from Phase II to Phase III will be accompanied by fundamental
changes:
Due to the large and steadily growing emissions of the aviation sector,
aviation emissions will be included in EU-ETS from 2012 onwards.
With the beginning of Phase III in 2013, the trading scheme will be
mandatory for principally all installations in the EU that produce yearly
emission of over 10,000 metric tons CO2.
Additional GHGs such as nitrous oxide and perfluorocarbons will be
included. In doing so, the EU-ETS will cover 95% of the emissions sources
in the European industry sector.
177
EU-ETS Trading Periods (4)
Trial Phase
Overall cap: 2.19 Billion t CO2
24 European countries participating
Includes the energy sector as well as
selected industries such as oil
refineries, iron and steel plants and
factories making cement, glass, bricks,
ceramics and pulp and paper.
Trade of CERs since 2005
Distribution of EUAs via National
Allocation Plans
Kyoto Commitment Period
Overall cap: 2.08 Billion t CO2
Additional emission sources such as
chemical plants are included
So far, the EU-ETS covers more than
12,000 installations in 30 European
countries (27 EU members plus
Liechtenstein, Iceland and Norway).
Trade of ERUs since 2008
Inclusion of the aviation sector from
2012 on
Post Kyoto Period
Overall cap: 1.88 Billion t CO2 in
2013, annually decreasing to 1.49
Billion t CO2 in 2020
Mandatory for all installations with yearly
CO2 emissions over 10,000 tones
Inclusion of additional GHGs such as
nitrous oxide and perfluorocarbons
Important changes regarding the
allocation of EUAs (centralized
allocation instead of National
Allocation Plans)
Phase I (2005-2007) Phase II (2008-2012) Phase III (2013-2020)
178
EU Allocation Process (1)
In order to put pressure on the participants to reduce their emissions and
hence secure the functioning of the cap-and-trade system, the total
amount of allocated allowances has to be smaller than the forecasted CO2
emissions of the installations participating in the trading scheme.
Hence, the EU will gradually decrease the total amount of allowances from
trading period to trading period in order to meet its Kyoto targets.
The overall emission reduction target for the EU is determined by the
Kyoto Protocol in the form of a burden-sharing agreement. In order to
meet this target the EU annually receives a specified amount of AAUs,
which then has to be divided between the member countries. The
particular member state is thereby responsible for the achievement of the
country-specific reduction target. Every member country has to create a
National Allocation Plan at the beginning of each trading period, which has
to be approved by the European Commission.
179
EU Allocation Process (2)
1. Determination of the National Emissions Budget
EU-ETS
(Energy & Industry Sector)
No Emissions Trading
(Remaining Sectors)
Individual Installations
2. Macro Allocation
3. Micro Allocation
(Grandfathering, Benchmarking, Auctioning)
Other Actions (e.g. Taxes)
180
National Allocation Plans (NAPs)
NAPs incorporate two segmentation instruments the macro and the micro
allocation.
The macro allocation determines the national cap for the EU-ETS, which
represents the maximum amount of CO2 emissions the installations in the
national energy and industry sector are allowed to produce. In this stage, a
portion of the countrys allocated AAUs is converted one-to-one into EUAs.
Furthermore, the maximum amount of emissions for the remaining sectors
(transport and logistics, commerce, households, etc.) and the other GHGs
included in the Kyoto Protocol is defined.
The second component of the NAP, the micro allocation, deals with the
distribution of the converted EUAs to the single installations within the energy
and the selected industry sectors. In this context, article 10 of the European
Emissions Trading Directive does not prescribe any mandatory distribution
method. Basically, there are three different approaches discussed in financial
theory: grandfathering, benchmarking and auctioning .
181
Grandfathering, Benchmarking and Auctioning
(1)
Grandfathering refers to the cost-free allocation of allowances based on
historic emissions
The majority of the countries participating in Phase I and Phase II of the EU-ETS
issued their allowances cost-free using the grandfathering method. The number of
allowances allocated to the individual installations thereby corresponded to the
result of the calculation of their average annual CO2 emissions during the baseline
period, adapted to several impacts such as economic growth and average weather
conditions.
Benchmarking approach uses a performance formula, which could include
measures like the average heat input or production output of a firm multiplied
by an industry average efficiency factor. The related factor could then be tons
of emissions per joule of heat input or tons of emissions per ton of production
output.
In contrast to grandfathering, benchmarking elements were only applied by a few
member states (e.g. Germany, Netherlands or Portugal). This was mainly because
benchmarking is relatively complex and much more data intensive than
grandfathering.
182
Grandfathering, Benchmarking and Auctioning
(2)
The auctioning approach allows participants in a trading scheme to
determine their individual allocation themselves through bidding in
auctions.
However, by doing so, installations would have to pay for the allowances
instead of receiving them free-of-charge, which is the main reason the greater
part of the industry has been so far rejecting this approach. Similarly to
benchmarking, auctioning has seen greater use in Phase II. However, the
proportion of auctioned allowances is still very low.


183
Problems with Grandfathering (1)
Grandfathering played an important role for the over-allocation in
Phase I. Since hardly any information about historic emissions was
available, the governments had to rely on self-reported company data
in order to determine the individual amounts of emissions, which led
to a kind of bargaining behaviour on the side of the companies.
Eventually, the EU-ETS had a surplus in allowances during the first
trading period, mainly because the grandfathering baseline from which
projections of business-as-usual emissions were made was biased and
did not reflect the actual conditions. In some cases, this surplus of
allowances lead prices to drop below levels, which justify the
transaction costs of selling.
Hence, the grandfathering method was often criticized for creating so-
called windfall profits and being less efficient than benchmarking and
auctioning.
184
Problems with Grandfathering (2)
8. Ceramics 0.9%
7. Glass 1.1%
9. Pulp and Paper 1.8%
6. Cement 9.1%
3. Coke Ovens 1.1%
4. Metal Ore 0.4%
2. Oil Refineries 7.6%
5. Iron and Steel 8.1%
1. Energy 70.0%
Allowance Allocation by Sector in Phase I of the EU-ETS
185
Problems with Grandfathering (3)
1.9%
3.9%
18.5%
18.3%
17.2%
17.0%
10.4%
10.1%
4.0%
6.8%
17.4%
20.4%
7.7%
10.6%
6.5%
15.8%
5.7%
5.3%
-1.5%
0.6%
-5% 0% 5% 10% 15% 20% 25%
All sectors
9. Paper
8. Ceramics
7. Glass
6. Cement
5. Iron and steel
4. Metal ore
3. Coke ovens
2. Oil refineries
1. Energy
2005
2006
Net Short/Long Position of EU-ETS Sectors in 2005 and 2006
The numbers represent the differences between allocations and emissions (in
% of the allocation). A positive number indicates a long position and vice versa.
186
Future Improvements in the Allocation
Process (1)
The upcoming third trading period of the EU-ETS will bring some
fundamental changes regarding the allocation of emission allowances
within the EU-ETS. With the beginning Phase III in 2013, there will be no
country-specific National Allocation Plans anymore.
Instead, the European Commission will prescribe an EU-wide emissions
cap (EU, 2009). This emissions cap will only amount to 1.88 billion metric
tons CO2 and will annually decrease by 1.74% of the 2005 emissions in
order to achieve an overall reduction of 21% below the 2005 emissions in
2020.
187
Future Improvements in the Allocation
Process (2)
There will be a significant increase in auctioning as an allocation method
in order to enable companies to decide themselves how many allowances
they require. The motivation of this approach is to better include the cost
of emissions into business decisions. Compared to only 3% in Phase II, at
least 60% of all EUAs will be auctioned by 2020.
There will be also a major change regarding the allocation of the
remaining cost-free allowances. While these were mainly issued on a
country-base using the grandfathering method in the first two phases, the
cost-free allowances will now be solely distributed using the
benchmarking approach, whereas the best available technology will
represent the new standard. Meaning, installations using outdated and
inefficient technologies will only receive as many allowances as they
would need if they had applied the best available technology.
188
EU-ETS Market Participants
Market Participants in the EU-ETS
Companies committed to participate
in the EU-ETS
Companies/Individuals allowed to
participate in the EU-ETS
Brokers Banks Funds Others Individual Installations
Direct Market Participants Indirect Market Participants
PhDs are especially useful
in industries, where trust
matters a lot, as customers
cannot really assess the
product/service until long
after consumption.
189
EU-ETS Transaction Types
C
l
e
a
r
i
n
g

H
o
u
s
e
Direct Participant
Direct Participant
Direct Participant
Direct Participant
Direct Participant
Direct Participant Indirect Participant
Direct Participant
Indirect Participant
Direct Participant
Direct Participant
Indirect Participant
C
l
e
a
r
i
n
g

H
o
u
s
e
Indirect Participant
Indirect Participant
Indirect Participant
Indirect Participant
Indirect Participant
Indirect Participant
Exchange
Bank/Broker
Bank/Broker
Bank/Broker
Bilateral
OTC Deals
Intermediary
Transactions
Transactions
on Exchanges
Comment:
While market
participants who
are conducting
OTC transactions
have to bear the
counterparty risk
by themselves,
this risk will be
carried by a
clearing house
when the
transaction is
accomplished
through an
exchange.
190
Carbon Trading Platforms in EU-ETS
Trading Platforms:
European Climate Exchange (ECX) in London (initially Amsterdam)
ECX is the largest and most liquid marketplace for carbon trading.
It accounts for approximately 75% of the trading volume of all
carbon exchanges.
European Energy Exchange in Leipzig
Energy Exchange Austria in Vienna
Bluenext Exchange in Paris (former Powernext)
Nord Pool Exchange in Oslo
However, not all of the above mentioned exchanges trade the same
financial instruments. While the European Climate Exchange provides
trading with futures, options and swaps, the Bluenext Exchange in Paris,
solely offers spot trading. The other exchanges provide various
combinations of spot, forward, and futures contracts
191
Transaction volumes and values of carbon
markets in 2007 & 2008
Markets
Volume (MtCO
2
e) Value (US$ Million)
2007 2008 2007 2008
EU-ETS 2,061.0 2,982.0 50,097.0 94,971.7
Primary CDM 551.0 400.3 7,426.0 6,118.2
Secondary CDM 240.0 622.4 5,451.0 15,584.5
Joint Implementation 41.0 8.0 499.0 2,339.8
Kyoto AAU 0.0 16.0 0.0 177.1
New South Wales 25.0 30.6 224.0 151.9
RGGI - 27.4 - 108.9
Alberta's SGER 1.5 3.3 13.7 31.3
Total Regulated Markets 2,919.5 4,090.0 63,710.7 119,483.4
Voluntary OTC 43.1 54.0 262.9 396.7
CCX 22.9 69.2 72.4 306.7
Other Exchanges 0.0 0.2 0.0 1.3
Total Voluntary Markets 66.0 123.4 335.3 704.7
Total Global Markets 2,985.5 4,213.4 64,046.0 120,188.1
192
Assets and Transactions in 2007 and 2008
While carbon trading within the EU-ETS is still dominated by futures and
forward deals, the spot and option markets continued to show a
significant growth.
Regarding the types of transactions, brokered OTC deals remained the
largest segment in the EU-ETS with a share of 49% of all transactions.
However, the share of EUA transactions conducted on exchanges has
significantly increased from 26% in 2007 to 37% in 2008. The main reason
for that is that market participants have become more worried about the
increased counterparty risk due to the ongoing financial crisis
193
GDP and Carbon Prices
0
5
10
15
20
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Aug-08 Sep-08 Oct-08 Nov-08 Dec-08 Jan-09 Feb-09 Mar-09 Apr-09 May-09 Jun-09 Jul-09
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EUA Futures
CER Spot
GDP World
194
EUA Price Development in Phase I
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EUA Future Dec08 Sett EUA Future Dec07 Sett
Soaring oil and
gas prices
EC demand cuts
in Italian NAPs
Sharp decline in
UK gas prices
High oil price due
to Hurricane Katrina
Bullish analyst
comment
Final rejection
of UK NAP
Increasing UK
gas and German
power prices
First published
Verified Emissions:
Emissions were much
lower than expected
Germany announces
ex-post adjustments
France and Poland
confirm banking
possibilities of
EUAs into Phase II
Insecurity in the
Market over actual
position in Phase I
Sharp decline in oil,
gas and German
power prices
Reductions in Belgium
and the Netherlands
are slightly above
expectations
No banking of Phase I
EUAs into Phase II:
value of certificates
gradually decreases
to zero
195
Drivers of Carbon Prices (1)
Main Carbon
Price Drivers
Demand Factors Supply Factors
Energy Prices
Weather Conditions
Economic Growth
National Allocation
Plans
International Regulations
and Policy Issues
196
Drivers of Carbon Prices (2)
The price of allowances in the EU-ETS is determined by the supply and
demand and hence by the scarcity of the certificates available on the
market.
The supply of allowances is fixed by the cap and thus determined by the
individual National Allocation Plans and international regulations such as
the EU Linking Directive.
The allowance demand can be recognized as a function of the expected
CO2 emissions. The level of CO2 emissions in turn is influenced by several
factors:
Short-term abatement decisions, and hence the demand for EUAs in
the short run, are primarily affected by changes in (1) absolute and
relative energy prices as well as (2) variations in weather conditions
The demand for EUAs in the long run is mainly driven by economic
growth and the market participants individual marginal abatement
costs
197
Drivers of Carbon Prices (3)
The order flow or even only judgement of powerful market participants
can, of course, also effect prices in the short term. A study of Trotignon
and Delbosc (2008), for example, which analyses the distribution of the
EUAs in Phase I of the EU-ETS, shows that only ten out of all participating
companies held more than one third of the allocated allowances.
However, the potential problem of market power will be mitigated anyway
in the long term, as the EU-ETS will become more liquid and mature.
198
Energy Prices as Driver of Carbon Prices (1)
In Phase I of the EU-ETS, the energy sector accounted for 70% of the
allocated allowances and hence dominated the demand for EUAs. The
installations covered by the EU-ETS energy sector are primarily power
plants. As of today, the majority of power producers are using two
different kinds of fossil fuel inputs, coal and natural gas.
Coal is usually cheaper than natural gas. However, coal is also less efficient
and the CO2 emissions from firing coal are much higher than the
emissions from firing gas. A coal-fired power plant, for example, is usually
producing more than twice as much CO2 emissions per MWh of electricity
as a comparable modern gas-fired power plant. Therefore, by switching
from a high-carbon energy source to a low-carbon source, power
generators are able to decrease their emissions by over 50% and sell the
surplus allowances on the market, which in turn would lead to a decrease
of the EUA price. Meaning, the ability to switch between coal and natural
gas has a direct impact on the carbon price.
199
Energy Prices as Driver of Carbon Prices (2)
However, the choice of the most profitable fuel input is not only dependent on
the CO2 intensity but rather on the relative prices of coal and natural gas.
Without accounting for CO2 emissions, the profitability of a switch in fuels is
usually determined by calculating and comparing so-called dark and spark
spreads.
The dark spread is the theoretical profit that a coal-fired plant generates from
selling one unit of electricity having purchased the fuel required to produce
that unit of electricity. The spark spread refers to the equivalent for natural
gas-fired power plants. However, with the start of the EU-ETS, power
operators also have to include carbon prices in their variable costs of
production, since an emission allowance is needed for each ton of CO2
emitted.
Therefore, the dark and spark spread have to be corrected by the current EUA
price and are subsequently called clean dark and clean spark spread.
Accordingly, these clean spreads represent the difference between the
particular fuel selling price and the cost of the fuel, including the current
carbon costs.
200
Energy Prices as a Cyclical Driver of Carbon
Prices (3)
Clean Dark Spread
&
Clean Spark Spread
EUA
price
Natural gas
price
Coal
price
Clean Dark Spread
>
Clean Spark Spread
Clean Spark Spread
>
Clean Dark Spread
Switch from natural
gas to coal
Switch from coal to
natural gas
CO2 emissions
increase
Demand for EUAs
increases
CO2 emissions
decrease
Demand for EUAs
decreases
EUA price
increases
EUA price
decreases
201
Weather Conditions as Carbon Price Driver
Change in
weather conditions
Temperature
variations
Variations in
amount of rainfall,
sunshine hours
and wind speed
Change in energy
demand
(e.g. cold winters, hot summers
-> increase in energy demand)
Change in energy
source
(e.g. too little rainfall -> switch
from hydro power to carbon
emitting energy generation)
Change in
CO2 emissions
202
Economic Growth as Carbon Price Driver
The projected emissions and hence the umber of allowances initially
allocated to the individual installations participating in Phase I and Phase II
of the EU-ETS were based on a range of assumptions. Besides average
weather conditions, assumptions regarding the future economic growth
were the most important influencing factor.
The fundamental relation between economic growth and CO2 emissions is
perhaps the most obvious, but at the same time, less understood carbon
price driver. In simple terms, economic growth leads to an increase in
industrial production and energy demand, which in turn results in an
increase in emission levels and hence in a higher demand for allowances.
However, economic growth is influenced by numerous factors and thus
difficult to predict over a longer period of time. As a result, a change in the
projected economic growth rate can have a major impact on the expected
amount of emissions produced in the sectors covered by the EU-ETS and
therefore significantly affect the demand for allowances.

203
Supply side drivers of carbon prices
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EUA Futures Dec07 Sett
Short-term Impact
Long-term Impact
In April 2006, the first verified emission data and hence the first official news of the over-allocation was released. While
the short-term (psychological) impact was that the EUA price collapsed from about 30 to about 15 in less than a
week, a long-term impact can be recognized as well. The EUA prices did not recover, since the number of emission
allowances allocated to the installations was larger than the number of allowances required to cover their emissions.
As a result, there was no real demand for EUAs anymore and Phase I allowances became basically worthless.
Supply side effects can, of course,
also happen in the other direction.
204
Overview on Carbon Price Drivers
Price Driver
Change of EUA price if factor
factor
Impact
...increases decreases
Demand Factors
Energy Prices
Gas-to-Coal Price short- & long-term
Coal-to-Gas Price short- & long-term
Oil Price short- & long-term
Weather Conditions
Average Temperature in Winters short-term
Average Temperature in Summers short-term
Amount of Rainfall short-term
Wind Speed short-term
Sunshine Hours short-term
Economic Growth
Economic Growth medium-term
Production Output medium-term
Supply Factors
Amount of Allocated EUAs in NAPs short- & long-term
CER and ERU Price medium-term
Banking of EUAs long-term
Borrowing of EUAs long-term
Political Decisions ? ? short- & long-term
205
7. i-finance
[Intangibles integrating finance]
Independent views on classic financial
economics (1)
The series of unfortunate events in the global economy
since 2008 make it natural to ask where the economists have
been. If you have a leaky boiler, you expect the plumber to
mend it; a dentist should cure your toothache; so why havent
the economists been able to fix the economy?
Even Her Majesty the Queen has shown an interest in why
economists didnt predict the crisis, a question she posed to
academics on a visit to the LSE.
Diane Coyle (2012), PhD in Econ (Harvard), OBE, Visiting Professor, Uni of
Manchester
Independent views on classic financial
economics (2)
Classic economic theory, based as it is on an
inadequate theory of human motivation,
could be revolutionized by accepting the
reality of higher human needs, including the
impulse to self actualization and the love for
the highest values.

Abraham H. Maslow (1971) The Farther Reaches of Human Nature

Independent views on classic financial
economics (3)
Key to a scientific understanding of the global economy is better access to
and analysis of vast amounts of financial data. These data need to be
tackled with new models, based on computing techniques such as data
mining, non-linear dynamics, simulation-based analysis, statistical physics
and machine learning. Everything needs to be rebuilt on the basis of
observations alone, without any of the assumptions of classical
economics, says Edward Tsang, director of the centre for computational
finance and economic agents at the University of Essex.
Financial Times (March 30, 2012) How to forecast a financial
crisis?,

GOOD with numbers? Fascinated by data? The sound you hear is
opportunity knocking.
New York Times (February 11, 2012) The Age of Big Data
Independent views on classic financial
economics (4)
What is risk?
A risk describes the perception of the probability of a future negative
outcome.
Current negative outcomes happening in this (atomic) second are
problems, crises, disasters or catastrophes but have not been referred to
as risks in the past if nobody perceived them as such. However, they will
very likely be perceived as risks in the future as consequence of their
appearance.
Hence, risk is a (i) perception dependent, (ii) probability driven, (iii)
forward looking assessment of (iv) downside events.

Operationalized, one can think of risk as the distribution of decision
makers perception of the possible downside events in their organisations
PESTLE-DV: Political, Economical, Sociological, Technological, Legal,
Environmental, Demographic and Viral
Classic financial economics
originates from the 50s and 60s, when statistical computations
were very time consuming, and is hence largely theory and hence
assumption driven
Academic financial economists are largely incentivised to impress
older academics and hence often lack interest to study (recent) real
practical contexts
Personal Example: Our School of Economics and Finance declined to
receive Bloomberg access at the expense of the University Library.
Now, Bloomberg is only available from the School of Management.
To discuss further, lets do a reality check of standard
theories

Capital Structure Theory: Assumptions underlying
Modigliani and Miller
Homogeneous Expectations
Homogeneous Business Risk Classes (!!!)
Perpetual Cash Flows
Perfect Capital Markets:
Perfect competition
Firms and investors can borrow/lend at the same rate
Equal access to all relevant information
No transaction costs
No taxes
How many appear realistic to you?

Efficient Frontier
Efficient Frontier

Market Equilibrium
Market Equilibrium

Market Efficiency (in common memory)
*An assets+ market is efficient with respect to information set
[i], if it is impossible to make economic profits by trading on
the basis of information set [i]. By economic profits we mean
the risk adjusted returns net of all costs. (Jensen, 1978: 96)
Grossman & Stiglitz (1976, 1980):
Paradox of Market Efficiency
Far less well known than Famas Efficient Market
Hypothesis/Theory, but maybe more insightful
The paradox of market efficiency states that the degree of
market efficiency is cyclical, as the success of active investor
leads to their own failure and inactivity
In other words, the more active investors search for
opportunities, the less opportunities they will find and hence
the less incentives they have to continue their level of resource
and time commitment to their search for opportunities.
However, the less resources and time investors allocate to the
search for opportunities, the more opportunities will be
provided.
A theory of active management and
contextual and cyclical market inefficiencies

So, opportunities should exist at some point in some
contexts for some information sets (i)
Lets establish the conditions under which investment
opportunities are likely in terms of
Alpha (return)
Beta (systematic risk)
Sigma (total risk)
Inspired by Porters 5 forces, we start from the
commercial relevance of an information set (i) and
the attention investors pay to it
Irrelevance
Zone
Waste of
Time Zone
Opportunity
Zone
CFA Zone
Investors attention towards information set(i) in asset class (a)
C
o
m
m
e
r
c
i
a
l

r
e
l
e
v
a
n
c
e

o
f

I
n
f
o
r
m
a
t
i
o
n

s
e
t

(
i
)


f
o
r

a
s
s
e
t

c
l
a
s
s

(
a
)

Low High
Low
High
Investment Zones
Irrelevance
Zone
Waste of
Time Zone
Opportunity
Zone
CFA Zone
C
o
m
m
e
r
c
i
a
l

r
e
l
e
v
a
n
c
e

o
f

I
n
f
o
r
m
a
t
i
o
n

s
e
t

(
i
)


f
o
r

a
s
s
e
t

c
l
a
s
s

(
a
)

Low High
Low
High
Investment Zones
Investors attention towards information set(i) in asset class (a)
Windows of
Chance
Silver Mines
Silver
Windows of
Opportunity
Gold Mines
Complexity/ Entry barriers of information set(i) in asset class (a)
I
n
v
e
s
t
m
e
n
t

O
p
p
o
r
t
u
n
i
t
y

o
f

i
n
f
o
r
m
a
t
i
o
n

s
e
t

(
i
)


i
n

a
s
s
e
t

c
l
a
s
s

(
a
)


Low High
High
Very High
Investments in the
Opportunity Zone
Windows of
Chance
Silver Mines
Silver
Windows of
Opportunity
Gold Mines
Complexity/ Entry barriers of information set(i) in asset class (a)
I
n
v
e
s
t
m
e
n
t

O
p
p
o
r
t
u
n
i
t
y

o
f

i
n
f
o
r
m
a
t
i
o
n

s
e
t

(
i
)


i
n

a
s
s
e
t

c
l
a
s
s

(
a
)


Low High
High
Very High
Investments in the
Opportunity Zone
Other drivers of investment value
Consistency and Predictability of information sets
influence on asset prices
Competition in investment sub-process (e.g. ex-ante vs.
ex-post investment decision value generation)
Non-financial aspects of investors utility functions
Attention and Accuracy of Alpha/Beta/Sigma
Opportunity search algorithm
Customisation of Alpha/Beta/Sigma Opportunity search
algorithm to investor utility function
Understanding of contemporary culture
http://vimeo.com/16638983 (We all want to be young!)


Intangible ESG criteria as drivers of investment
value (1)
Do ESG factors have commercial relevance?
Yes, certain criteria in many industries and cultural contexts.
How much attention do ESG factors receive from the average
investor/analyst?
Little, the CFA barely covers ESG and many analysts are
obsessed with fundamentals and shy on hard-to-quantify,
intangible factors.
Do ESG factors represent a complex information set with high entry
barriers?
Yes/No: while some ESG criteria are rather simple, others are
conceptually complex and (very) hard to quantify/estimate.


Intangible ESG criteria as drivers of investment
value (2)
Are ESG factors consistent and predictable in their influence
on asset prices?
Yes, ESG factors and their relationship to asset prices are
usually quite consistent and predictable.
Can ESG factors create non-financial utility among investors
and is this customisable?
Yes, this purpose is the source of ESG factors.

Hence, ESG factors can conceptually deliver investment
value in terms of Alpha, Beta or Sigma.

Investment and ESG: a conceptual note
Investment performance is conceptually based on a few crucial
factors, which include:
Capitalising on opportunities
Managing risks
Building and preserving client trust
ESG criteria supports
In certain areas capitalising on opportunities
Managing risk in general
Building and preserving client trust in general
The match between investment and ESG is conceptually good,
but it might not always have been culturally though things
might change





Intangible aspects of Banking &
Finance
The proportion of S&P 500 market value not
explained by physical and financial aspects has
risen from 17% in 1975 to about 80%.
For certain stocks (e.g. Amazon), these so
called intangible assets make accounting
values (esp. on the balance sheet) appear like
a small by-product of corporate activity
Three questions arise:
How to best estimate management quality?
Has the CFA shifted its curricula accordingly?
If not, does the monopolistic CFAs lack of interest in
intangible assets create a large market inefficiency, as
few analysts are trained to assess a large part of
firms market values?
IIRC
Integration of Intangible Information
S
t
a
t
i
s
t
i
c
a
l

S
o
p
h
i
s
t
i
c
a
t
i
o
n

IFRS Accounting
CAIA
MSc
Economics
CFA
MA in
Business
A Matrix of Financial Education
Integration of Intangible Information
S
t
a
t
i
s
t
i
c
a
l

S
o
p
h
i
s
t
i
c
a
t
i
o
n

IFRS Accounting
CAIA
MSc
Economics
Our
Ambition at
RBF
CFA
MA in
Business
A Matrix of Financial Education
Research Case
Hoepner, Yu & Ferguson (2010)

World Economic Forums
Global 100 Most Sustainable Companies

Research Question:
What is the financial value of sustainability
criteria across industries?
We investigate the monthly stock performance equal weighted portfolios of
the Global 100 most sustainable companies published each year end since
2005 by Corporate Knights and Innovest against industry benchmarks
Only companies from MSCI World (Developed) eligible, which had a
AAA Innovest rating based on 36 different performance areas
(Stakeholder Capital, Environment, Human Capital etc.)
As Global 100 has same industry exposure than MSCI World,
companies are Industry leaders





Research Method (1)
Carhart (1997) model employed


2 types of the relationship studied
the years before list publication (Jan2004 - May2008) Privately
informed investor perspective
the years after list publication (Jan2005 - May2008) Publicly
informed investor perspective
[Sample ends in May 2008, as due to recent crisis, some industries excess market returns would
otherwise go negative, which would question validity of Carhart model]



it i i i ft mt i i ft it
MOM HML SMB R R R R c | o + + + + + =
3 2 1
) (
Research Method (2)
233
GICS Industry Alpha p.a. (before) eta to industry (be.) Alpha p.a. (after) eta to industry (af.)
Consumer
Discretionary
7.20%*** 0.96*** 4.08% 1.09***
Consumer Staples 4.92% 1.40*** -0.84% 1.29***
Energy 3.48% 0.71*** 1.80% 0.84***
Financials 3.48% 1.02*** 0.96% 0.97***
Health Care 7.20%*** 0.80*** 10.80%** 0.73***
Industrials 6.96%** 1.00*** 6.48%** 1.17***
IT -0.72% 1.09*** 3.12% 0.95***
Materials -2.04% 0.88*** 3.84% 0.78***
Telecom. Services 9.00% 0.83*** -3.84% 0.87***
Utilities 6.72% 0.99*** -0.72% 1.04***
***, ** and * indicate the 1%, 5% and 10% significance level, respectively
ESG integration in 10 GICS industries (Hoepner, Yu & Ferguson, 2010):
We analysed the performance of investing in the Global 100 most (likely) sustainable companies in the year before and after the
companies from each Global Industry Classification Standard (GICS) industry received the annual award at the World Economic
Forum. The average firm in any industry outperformed 3.12%** before the announcements, but not afterwards.
Live Research Mini Case
Barnett & Hoepner (2012)


Trust in the financial services industry

Research Question:
How and possibly why does trust vary in the
financial services industry?

ESG issues in banking: the last decade

Number of news items on banking
# of news items on social responsibility in banking
# of news items on ethics in banking # of news items on climate change in banking
German banking: a similar trust effect
(Barnett and Hoepner, 2012b Project with Yougov)
Overall Brand Index (10 days moving average)
-15.00
-10.00
-5.00
0.00
5.00
10.00
15.00
20.00
25.00
J
a
n
-
0
8
M
a
r
-
0
8
M
a
y
-
0
8
J
u
l
-
0
8
S
e
p
-
0
8
N
o
v
-
0
8
J
a
n
-
0
9
M
a
r
-
0
9
M
a
y
-
0
9
J
u
l
-
0
9
S
e
p
-
0
9
N
o
v
-
0
9
J
a
n
-
1
0
M
a
r
-
1
0
M
a
y
-
1
0
J
u
l
-
1
0
S
e
p
-
1
0
N
o
v
-
1
0
J
a
n
-
1
1
M
a
r
-
1
1
M
a
y
-
1
1
J
u
l
-
1
1
S
e
p
-
1
1
N
o
v
-
1
1
J
a
n
-
1
2
Commerzbank
Sparkasse
Trust in German banking
(Barnett and Hoepner, 2012b Project with Yougov)
-15.00
-10.00
-5.00
0.00
5.00
10.00
15.00
20.00
25.00
J
a
n
-
0
8
M
a
r
-
0
8
M
a
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-
0
8
J
u
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-
0
8
S
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-
0
8
N
o
v
-
0
8
J
a
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-
0
9
M
a
r
-
0
9
M
a
y
-
0
9
J
u
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-
0
9
S
e
p
-
0
9
N
o
v
-
0
9
J
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-
1
0
M
a
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-
1
0
M
a
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-
1
0
J
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0
S
e
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-
1
0
N
o
v
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0
J
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1
M
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-
1
1
M
a
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-
1
1
J
u
l
-
1
1
S
e
p
-
1
1
N
o
v
-
1
1
J
a
n
-
1
2
Commerzbank
Deutsche Bank
Volks- und Raiffeisenbank
Sparkasse
Overall Brand Index (10 days moving average)
Live Research Mini Case
Barnett, Hoepner & Linares-Zegarra (2012)


Trust in industries across countries

Research Question:
How and possibly why does trust vary in
industries across countries?

Trust across industries
239
Live Research Case
Barnett, Chen, Hoepner & Li (2012)


ESG investment in Chinese stocks

Research Question:
How do Chinese stocks react to intangible ESG
issues?

Background
The first research of ESG risk coverage
and financial performance in Chinese
stock markets.
RepRisk data makes this possible.
1806 Chinese companies on local and
international listings over the period
from 2006 to 2011.
143 Chinese companies involved in 1219
issues matched with stock return data.

Listings of Chinese firms around the
world
Share
Name
Main Investors Descriptions Exchanges
A
Share
Mainland
Chinese
nationals and
QFII participants
Shares denominated in RMB
and listed on either the
Shenzhen or Shanghai stock
exchange

B
Share
International
investors and
Mainland
Chinese
nationals
Shares denominated in
foreign currencies but traded
on either the Shenzhen or
Shanghai stock exchange
H
Share
Hong Kong
residents,
international
investors and
QDII participants
Mainland Chinese
incorporated companies listed
on the Hong Kong stock
exchange

Other
Shares
International
investors
Mainland Chinese
incorporated companies listed
elsewhere
Other Exchanges all
over the world
ESG Data in Western and Chinese view
Views Portfolios Issues
Western

Views
Environmental
footprint
Global pollution and climate change; local pollution; impacts on ecosystems
and landscapes; overuse and wasting of resources; waste issues; animal
mistreatment
Social
Forced labour; child labour; freedom of association and collective bargaining;
discrimination in employment; health and safety issues; poor employment
conditions; human rights abuses; corporate complicity; impacts on
communities; local participation issues; social discrimination
Corporate
governance
Corruption; bribery; extortion; money laundering; executive compensation;
misleading communication; fraud; tax evasion; anti-competitive practices
Community relations
Human rights abuses; corporate complicity; impacts on communities; local
participation issues; social discrimination
Employee relations
Forced labour; child labour; freedom of association and collect bargaining;
discrimination in employment; health and safety issues; poor employment
conditions
Product-portfolio
related risk
Controversial products and services; product related health and environmental
issues
Violation of codes Violation of national legislation and international standards
Supply chain Supply chain related environmental; social and legal issues
Chinese
Views
China strict *
Violation of national legislation; corruption; bribery; extortion; money
laundering; health and safety issues; fraud
China very strict *
Violation of national legislation; corruption; bribery; extortion; money
laundering; health and safety issues; fraud; misleading communication;
controversial products and services
Research Questions

Data Analysis
How do Western ESG
criteria affect Chinese
A share companies?
How do Chinese ESG
criteria affect Chinese
A share companies?
Data Analysis
How do Western ESG
criteria affect Chinese
non-A share companies?
How do Chinese ESG
criteria affect Chinese
non-A share companies?



rxp,t = portfolios excess return
p = Jensens (1968) alpha
nat,p, reg,p, glo,p = portfolios systematic exposure to the broad market portfolio on national, regional and global
level, repectively.
rnat,t = market benchmarks excess return on national level
, , = the exposure of a portfolio to the small cap, value, and momentum investment styles.
SMB, HML, MOM

= the return of a portfolio investing long in small stocks and short selling large stocks, investing
high book to market value stocks and short selling low book to market value stocks, and investing long in winner
stocks and short selling looser stocks, respectively
Extended Carhart (1997) Four-Factor Model

Econometric Model
This 3-level Carhart Four-Factor model captures the designated
portfolios exposures to regional and global equity markets (if any).
Chinese A share
ESG Issues
Category

nat

reg

glo

nat

nat

nat
Adj. R
2

Environmental
footprint
-0.0099*** 1.0526*** -0.5557*** 0.4733 0.5033*** 0.3081*** -0.0527 0.9282
Social -0.0119** 1.0775*** -0.4138*** 0.0717 0.4698*** 0.3624*** -0.0442 0.8850
Corporate
governance
-0.0061 0.8510*** -0.0302 -0.1259 0.4852*** 0.2773 0.0992 0.8838
Community
relations
-0.0185** 0.9949*** -0.3101* 0.0021 0.6191*** 0.4977*** -0.1122 0.7560
Employee relations -0.0063 1.1621*** -0.2228 -0.4272 0.5794*** 0.1283 0.0922 0.8100
Product-portfolio
related risks
-0.0230** 0.8804*** 0.0218 -0.8167* 0.8224*** 0.6874*** 0.1069 0.6543
Violation of codes -0.0159*** 1.0571*** -0.2700* -0.1064 0.6230*** 0.4890*** 0.0580 0.9082
Supply chain -0.0221** 1.1075*** 0.1081 0.9826 0.7432*** 0.1979 0.2072 0.6183
China strict -0.0145*** 1.0472*** -0.3192*** -0.0167 0.5807*** 0.4496*** 0.0854 0.9338
China very strict -0.0241*** 1.0023*** -0.1616 -0.4728 0.7397*** 0.6151*** 0.0361 0.8371
Note: ***, ** and * indicate statistical significance at 1%, 5% and 10% levels, respectively.

Results: Chinese A share
Chinese non-A share
ESG Issues
Category

nat

reg

glo

nat

nat

nat
Adj. R
2

Environmental
footprint
0.0027 0.9481*** 1.0347*** 0.4231 -0.2710*** -0.1082 0.0651 0.8741
Social -0.0001 0.9818*** 0.9924*** 0.1841 -0.2280*** -0.1425** 0.0095 0.8856
Corporate
governance
0.0080 0.9899*** 0.6275*** 0.1950 -0.4704*** -0.3479*** 0.0586 0.8610
Community
relations
-0.0020 0.9648*** 1.1373*** 0.1700 -0.2447*** -0.1502** 0.0397 0.8751
Employee relations 0.0115* 0.9803*** 0.8148*** 0.0321 -0.3923*** -0.1138 0.1106* 0.8378
Product-portfolio
related risks
-0.0018 0.9774*** 1.1649*** -0.2489 -0.2548 -0.0801 -0.0480 0.7578
Violation of codes -0.0018 1.0440*** 0.9649*** 0.1269 -0.1353 -0.0959 0.0706 0.8767
Supply chain -0.0071 0.8210*** 1.6748*** 2.0650*** -0.2501 -0.5243 0.2380 0.7217
China strict 0.0039 1.0695*** 0.6563*** 0.2456 -0.2859** -0.1152 0.0486 0.8520
China very strict -0.0042 1.0747*** 0.7858*** 0.1032 -0.1801** -0.1023 0.0085 0.8021
Note: ***, ** and * indicate statistical significance at 1%, 5% and 10% levels, respectively.

Results: Chinese non-A share
1. How do Western ESG criteria do in
Chinese A share companies?
Six out of eight portfolios generate
significant negative returns at either
the 1% or 5% level.
Specifically, the product-portfolio
related risks portfolio presents the
worst performance.
Some Western ESG criteria
matter for Chinese investors
2. How do Chinese ESG criteria do in
Chinese A share companies?
Both portfolios generate significant
negative returns at the 1% level.
Specifically, the China very strict
issues portfolio presents the worst
performance among all.
Chinese ESG criteria matter
strongly for Chinese investors
3. How do Western ESG criteria do in
Chinese non-A share companies?
Only one out of eight portfolios
generates a marginally significant
alpha at the10% level.
Western ESG issues of Chinese
firms listed outside China do not
matter.
4. How do Chinese ESG criteria do in
Chinese non-A share companies?
No significant alphas are observed.
Chinese ESG issues of Chinese
firms listed outside China do not
matter.


Conclusion
Sustainability and Social Media Opportunities
Twitter mood can predict
Box Office Sales on opening weekend (Asur and Huberman, 2010)
Dow Jones Industrial Average (Bollen, Mao, Zeng, 2010)
Share price shock in BP crisis (Hoepner et al., 2012, Project)
Social Media allows for Nowcasting (Lampos and Christianini, 2011)
e.g. rainfall or illness rates
Example of a Social Media Lab
(with Damian Borth, McKinsey Technology Award Winner of German
Research Centre for Artificial Intelligence):
http://sociovestix.appspot.com/

Social Media Highlights
(Borth & Hees, 2012)
10 information sources
184 days captured
200k items analyzed
1,374 trending topics discovered
Top 20 Trending Topics
(09/11 - 03/12)
Emotional Nowcasting
(DiMatteo, Hoepner, Musolesi and Schaul 2012)
253
8. Further Alternative Investments
254
Further Alternative Investments
Real Estate
Commodities
Foreign Exchange Trading Strategies
Weather Derivatives
Microfinance
Collectibles
Wine
Sports Betting
Virtual Investment

255
Real Estate
Data Access: Difficult
Jobs: in booms
First Real Estate boom: Late 1960s: interest rates rose above
deposit rate ceilings at banks, depositors fled to mortgage
REITs. But, with recession of 1974, many REITs defaulted.
Economic Recovery Tax Act of 1981 favored partnerships.
Second Real Estate boom: Tax Reform Act of 1986 eliminated
advantages of partnerships, so investors switched to REITs.
Third Real Estate boom: Starting 1992, many private real
estate companies found it advantageous to go public as REITs,
specialized REITs developed.
Fourth Real Estate Boom lead to Subprime Mortgage Crisis

256
Commodities (1)
Commodities are, for instance:
Grains & Oilseeds: Corn, Oats, Rough Rice,
Soybeans, Soybean Oil, Wheat
Cattle, Pork & Meat: Feeder Cattle, Live Cattle,
Lean Hogs, Frozen Pork Bellies
Petroleum & Energy: Crude Oil, Ethanol, Gas,
Heating Oil, Natural Gas
Soft Metals: Copper, Gold, Palldium, Platinum,
Silver, Uranium, Lithium


257
Commodities (2)
Advantages of Commodities
Unique risk/return characteristics make them an
attractive for portfolio diversification
In contrast to bonds, they are real assets, which tend
to be resistent to inflation
Vehicles:
Commodity Futures Indices for passive investors,
which roll over every month
Spot and Future trading for active investors, which can
also try to exploit the pre-determined future roll over
cycle

258
Foreign Exchange Trading Strategies
Some Academic might criticise that foreign exchange is a legitmate asset
class, BUT
Active foreign exchange (FX) trading strategies have several advantages:
The FX market is the worlds largest and most liquid market
There is a large degree of non-profit seeking players in the FX market
(central banks, non financial corporations)
Beta of FX trading schemes is zero, hence their expected return
benchmark is low: the risk free rate
Several patterns are known (e.g. Japanese companies repatriate
profits shortly bevor the end of their fiscal year in March)
Carry Trades are very popular
Borrowing in a low interest rate currency and investing in a high
interest rate currency, while expecting the difference not to be
outweighted by exchange rate changes
259
Weather Derivatives (1)
Weather affects economic activity through
disasters and more gradually (temperature,
snowfall, frost)
Temperature, for instance, affects energy
producers, agricultural production, tourism and
other leasure industries as well as temperature
related products and services (ice cream, theme
parks)
Weather Derivatives can be used to hedge
weather
260
Weather Derivatives (2)
In simple terms, a standard weather derivative might pay the
average temperature difference between the contracted
temperature and the eventual temperature of the contracted
month times the day of the month and the contract value.
Hence, assume in January everybody expects the June (30
days) average temperature in south Florida to be 70F and a
weather derivative with a contracted temperature of 65F
trades at $3,000 with a contract value of $20.
(70-65)x30x20 = 3,000
If you buy the derivatives and the average temperature turns
out to be 80F, you earn $6,000
(80-65)x30x20-3,000=6,000

261
Microfinance
United Nations Definition: Microfinance can be broadly defined as the provision
of small scale financial services such as savings, credit and other basic financial
services to the poor and low income people.
Some Microfinance institutions are non-for-profits, but others are for-profits or
more-than-profit instutions (e.g. make profit and win a Nobel Peace Price)
Microfinance institutions use innovative ways to reach their clients and ensure
repayment often with very high interest rates due to the risky business
Going to poorest clients homes
Group lending to ensure repayment via peer pressure
As their credits give many small vendors a once in a life time opportunity to build
op their existence, the creditors entrepreneurial motivation is immense and
microfinance institutions can generate lucrative long term business relations with
some entrepreneurs
Many Microfinance Investment Funds (MIFs) have been launched in recent years
Microfinance Project Example

Client protection and financial performance in microfinance:
win-win business cases or trade offs?
Summary of Insights
from research in progress
Client Protection matters, financially!
There is a clear information value of client protection
ratings/assessments.
Indirectly financial client protection principles (e.g. transparency,
privacy) are positively related to returns on capital.
However, the relationship is less clear for directly financial client
protection principles (avoidance of over-indebtedness, appropriate
debt collection) and seems to depend on capital providers
Research currently in progress: Deeper analyses might modify
insights.
Background
The relationship between social aspects of business and financial performance has been
studied in depth for many industries but not for microfinance, despite its multiple
ambitions
Previous research in microfinance scarce:
Industry studies (e.g. by Cerise, Incofin, Microfinanza Rating)
Academic Studies on Outreach using average loan size as proxy (e.g. Cull et al.,
2007; Hermes et al., 2011)
One study on non-linear relationship between external and internal social
responsibility and financial performance using data from Microfinanza Rating
(Hoepner, Liu & Wilson, 2012)
In this context, nine organizations joined forces to organize a large scale analysis of the
relationship between social performance and financial performance in microfinance
This presentations covers the first step of this large scale analysis: a study of the
relationship between client protection principles and financial performance
Context of study
Aim of Analysis:
Explain the relationship between financial performance measures and client protection
ratings while controlling for MFI characteristics
Dataset Construction:
Pooling of the datasets of Blue Orchard, Cerise, Incofin, Microfinanza Rating, Mix, and Triple
Jump without one data provider dominating the others
Final Sample: 1,278 observations (MFI x year)
Matching of client protection data-items in datasets to the Smart Campaign 6 Principles of
client protection principles and rescaling them to a 0 to 1 scale
Expected Conceptual Insights from Analysis:
Understanding of the contemporaneous relationships between financial performance and
client protection principles (e.g. Are MFIs associated with good financial outcomes, on
average, also associated with good aspects of client protection?)
Impossibilities: (i) Explaining causality over time; (ii) Studying non-linearities in pooled
dataset



Method
Dependent Variables (to be explained):
Operating Expense Ratio
ROE
ROA
PAR30
Key Independent Variables (to explain):
Transparent and Responsible Pricing
Mechanisms for Redress of Grievances
Privacy of Client Data
Ethical Staff Behavior
Avoidance of Over-Indebtedness
Appropriate Collections Practices.



Technical Details
Control Variables:
Region
Age
Size
Year of Assessment
Assessor
Technical Details:
Pooled OLS regression with robust standard errors clustered at regional level
Regions classified according to Worldbank
Mean imputation of control factors (age, size)
Automatic multicollinearity adjustments
Use of strict significance levels 95%, 99%, 99.9%
Robustness test without Mix data


Results (full sample)
Results
(Sample excluding the Mix)
Implications
Client Protection ratings matter! There is a business case.
Indirectly financial aspects of client protection such as transparency or
privacy can have performance enhancing effects, especially in terms of
ROA
However, when it comes to directly financial aspects such as preventing
over-indebtedness or appropriately collecting debts, the relationship
seems less clear and dependent on capital providers.
Furthermore, client protection principles and non-performing loans or
efficiency seem rather unrelated
Further research will go deeper into contextual aspects, study potential
non-linearities, and eventually understand causalities a little better.
271
Collectibles (1)
Figures from Burton & Jacobson (1999)
Advantages:
Potential Inflation Hedge
Wellbeing/Reputation resulting from collection
Disadvantages:
Very illiquid
Value highly erratic, as often no use value
Highly uncertain payoffs
Examples
Antique Furniture (Annual Real Return: 0% to 6%)
Books (1% to 12%)
Ceramics (0% to 16%)
Coins (-9% to 14%)
272
Collectibles (2)
Figures from Burton & Jacobson (1999)
Further Examples
Paintings & Drawings (-4% to 48%)
American (-1% to 14%)
Barbizon School (-4%)
Chinese (48%)
Expressionists (29%)
Impressionists (0% to 15%)
Old Masters (0% to 17%)
Photographs (9% to 26%)
Prints (0% to 21%)
Stamps (3% to 10%)
Toy Soldiers (-1% to 5%)
273
Wine
Advantages:
Potential Inflation Hedge
Wellbeing, Occasional Taste and Reputation resulting from collection
Unique return/risk characteristics
Good to diversify portfolio
Disadvantages:
Storage cost
Somewhat illiquid
Annual Real Return: -8% to 18% (usually Red Bordeaux analysed)
Wine focused mutual funds:
Ascot Wine Management Fine Wine Fund
Orange Wine Fund

274
Sports Betting
Racetrack, American Football, Soccer etc.
In-sample profitable trading strategies can often be
generated, as structural relations appear to exist at
least temporary
The return from betting on favourites is usually higher
than for betting on longshots in many sports
In European soccer, betting on outsiders in meaningless,
lower class games should be very profitable
However, realising consistent out-of-sample profits is
much more challenging, albeit not impossible
275
Virtual Investment (Second Life)
Second Life, a virtual world, whose virtual money can directly
be converted in US$, comprises stocks exchanges
Prices for virtual game assets are also common in the sale of Avatars
on Ebay
In spring 2009, Second Life covered 4 exchanges with about
69 stocks
The first exchange was launched in February 2007
These virtual stocks returns, which can become real cash, are
likely entirely unrelated from real world return/risk
characteristics
The exchanges appear, to date, largely unexplored and hence
are likely considerably inefficient


276
Real Estate Investment Trusts
Real Estate Investment Trusts (REITs) were created by
US Congress in 1960 to allow small investors access
to real estate investments.
Before 1960, public companies that owned real
estate would be considered businesses, for which
their earnings would be subject to corporate profits
tax. So, until 1960, real estate was typically owned by
partnerships, not suitable for small investors.
Today, institutions invest in REITs too.
277
Restrictions on REITs
75% of assets must be in real estate or cash
75% of income must be from real estate
90% of their income must be from real estate,
dividend, interest & capital gains
95% of income must be paid out
No more than 30% of income from sale of properties
held less than four years
This prevents regular businesses from being REITS

278
The 4 REIT Booms
First boom: Late 1960s: interest rates rose above
deposit rate ceilings at banks, depositors fled to
mortgage REITs. But, with recession of 1974, many
REITs defaulted. Economic Recovery Tax Act of 1981
favored partnerships.
Second boom: Tax Reform Act of 1986 eliminated
advantages of partnerships, so investors switched to
REITs.
Third boom: Starting 1992, many private real estate
companies found it advantageous to go public as
REITs, specialized REITs developed.
Fourth Boom lead to Subprime Mortgage Crisis

279
History of Mortgages
In 1920s, 5-year term loans common, balloon
payment due in five years, or refinance or sell
house.
In 1930s, decline in nominal home prices and
rise in unemployment caused massive defaults
Mortgage lending industry turned to long-
term annuities
280
Types of Mortgages
Conventional, fixed rate mortgage
Adjustable rate mortgage (ARM)
Price level adjusted mortgage (PLAM)
payment adjusted to inflation so constant in
real terms
Dual rate mortgages (DRAMs) same as PLAM
but interest rate floats
281
Behavior of Single Family Home
Prices
Not a random walk, substantial inertia
Occasional booms and busts
Shared movements over wide regions of
country, but not shared over entire country
Boom of late 1980s infected many of largest
cities of world
Subprime mortgage bust affected thousands
of people worldwide
282
Subprime Mortgages
A subprime mortgage is a type of loan granted to individuals with
poor credit histories, who would not be able to qualify for
conventional mortgages.
Subprime mortgages charge interest rates that are above the typical
interest rate due to the risk that is involved on the part of the lender.
Subprime mortgages are most commonly adjustable rate mortgages
After a mortgage is sold, it is usually put in a group with other
mortgages into a mortgage backed security (MBS)
The riskier portions of these securities are securitized into
collateralized debt obligations, or CDOs. These are the portion of the
MBS that other investors do not want.

283
Build up of subprime mortgage crisis
Real house prices were relatively stable from
1890 to 1997, but climbed 6 percent per
annum from 1998 onwards
The internet bubble in the late 90s increased
households wealth, which lead to more
demand for houses
The internet bubble burst did not affect house
prices substantially. Moreover, the low interest
rates in the recovery made especially
adjustable rate mortgages look very attractive
to normal people.

284
Interesting statistics
The U.S. home ownership rate increased from 64% in 1994 to
an all-time high of 69.2% in 2004.
A typical house was 124% more expensive in 2006 than in
1997
In 2006, the national median home price was 360% higher
than the national median household income.
The bubble lead extremely opportunistic homeowners to
finance consumer spending by taking out second mortgages
secured by the price appreciation.
The U.S. household debt as a percentage of the annual
disposable personal income rose from 77% in 1990 to 127% in
2007
285
Burst of subprime mortgage bubble
Easy and cheap access to mortgages overheated the U.S. housing
market until 2006
However, when the economy comes slowly out of recession,
interest rates inevitably rise
This substantially increase home owners payments on their
adjustable rate mortgages
Some people cannot make their mortgage payments anymore,
especially those who already took on a second mortgage to fund
their far too high personal spending
These people try to sell their houses, but prices are much lower
than they expected, often insufficient to pay back their mortgage.
The result: Mortgage Defaults
After default comes Foreclosure, which leads to the house being
auctioned. This auction process in a crisis usually decreases housing
prices further
286
The aggregation of individual defaults lead to gigantic
losses in Mortgage Backed Securities
Credit Default Swaps were thought to protect most
financial institutions, but especially AIG sold far too many
far too cheap
AIGs respective business unit had since its emergence always
been headed by a financial engineer. Sometime before the crisis,
however, this job was overtaken by a back office guy, who holds a
degree in Political Science from Brooklyn College
Bear Sterns got into trouble and was acquired by JP Morgan
Chase

Financial Institutions lost the
overview (1)
287
The Bush Administration did not save Lehman Brothers and it
filed for bankruptcy on September 15th 2008
Consequently, financial institutions lost so much trust in each
other that the interbank market basically died, which caused
gigantic liquidity problems This was an event most professionals
did not imagine to be possible
The resulting mess (e.g. state bankcruptcies) seems cleared
since about March 2009
Financial Institutions lost the
overview (2)
288
Are there still ticking bombs?
However, there are still several other ticking
bombs in the world economy
On how many credit cards can Angloamerican consumers
live?
What happens to the gigantic US current account deficit,
when the Dollar looses its status as dominating currency?
What happens to the Middle East, once their oil resources
are exploited?
On which pillar does the UK want to rebuild its economy?
(Projections see it dropping out of the Top 10 GDP
countries by 2015.)

289
Real Estate Markets
Real Estate Markets are typically very cyclical
The following slides show a couple of
statistics, where the markets have recently
been
290
International Real Estate Markets
Transaction Values in $ bn by country (2007)
(1) United States 510.3
(2) United Kingdom 104.4
(3) Germany 60.8
(4) China 59.6
(5) Japan 38.1
(6) France 37.3
(7) Australia 29.6
(8) Canada 19.7
(9) Singapore 18.6
(10) Sweden 16.9
Adapted from Tiwari & White (2010: 5)
291
Global Property Market by Type
Office 42%
Retail 28%
Residential 13%
Industrial 12%
Other (e.g. hotels) 5%
292
Key Office Markets (1)
1. London West End 300$ (per square foot p.a.)
2. Moscow 232$
3. Tokyo Inner City 220$
4. Mumbai 210$
5. Tokyo Outer Central 175$
6. London City 164$
7. New Dehli 145$
8. Paris 142$
9. Singapore 139$
10. Dubai 129$

293
Key Office Markets (2)
11. Hong Kong 127$
12. Dublin 127$
13. New York Midtown 103$
15. Birmingham 100$
18. Zurich 93$
20. Edinburgh 92$
26. Frankfurt 83$
33. Athens 74$
38. Sidney Core 69$
39. Shanghai (Pudong) 68$
40. Munich 68$
49. Jersey 61$