Case Studies

The objective of this chapter is to illustrate how some of the models developed in the first part of the book can be useful to address practical investment management questions. We consider four short cases. The first one explores the interest of including a factor X(t) compared to the traditional formulation of asset management models initially proposed by Merton. The second case discusses the range of investment strategies available to an equity manager whose performance is assessed against a replicable benchmark. The third case illustrates how the correlation between assets and liabilities impact the asset and liability management strategy of funded investors. When the assets cannot track the liabilities effectively, the manager should implement a lower leverage and possibly leave more assets in the money market. The ALM strategy is resolutely defensive. On the other hand, when assets are closely related to the liabilities, the manager will accept more leverage and invest predominantly in risky assets in an effort to generate additional return. The fourth and final case demonstrates the dangers of overbetting for funded investors such as banks and insurance companies. Overbetting refers to the behaviour of investors and managers whose risk sensitivity θ is negative and who invest in a more aggressive portfolio than the Kelly portfolio. Overbetting is particularly dangerous for funded investors as it results in very high leverage ratios (net leverage) and a highly levered asset allocation (gross leverage)…