Managing through a Crisis: Practical Insights and Lessons Learned for Quantitatively Managed Equity Portfolios

Peter J Zangari

Contents

Introduction to 'Lessons from the Financial Crisis'

1.

The Credit Crunch of 2007: What Went Wrong? Why? What Lessons Can be Learned?

2.

Underwriting versus Economy: A New Approach to Decomposing Mortgage Losses

3.

The Shadow Banking System and Hyman Minsky’s Economic Journey

4.

The Collapse of the Icelandic Banking System

5.

The Quant Crunch Experience and the Future of Quantitative Investing

6.

No Margin for Error: The Impact of the Credit Crisis on Derivatives Markets

7.

The Re-Emergence of Distressed Exchanges in Corporate Restructurings

8.

Modelling Systemic and Sovereign Risks

9.

Measuring and Managing Risk in Innovative Financial Instruments

10.

Forecasting Extreme Risk of Equity Portfolios with Fundamental Factors

11.

Limits of Implied Credit Correlation Metrics Before and During the Crisis

12.

Another view on the pricing of MBSs, CMOs and CDOs of ABS

13.

Pricing of Credit Derivatives with and without Counterparty and Collateral Adjustments

14.

A Practical Guide to Monte Carlo CVA

15.

The Endogenous Dynamics of Markets: Price Impact, Feedback Loops and Instabilities

16.

Market Panics: Correlation Dynamics, Dispersion and Tails

17.

Financial Complexity and Systemic Stability in Trading Markets

18.

The Martingale Theory of Bubbles: Implications for the Valuation of Derivatives and Detecting Bubbles

19.

Managing through a Crisis: Practical Insights and Lessons Learned for Quantitatively Managed Equity Portfolios

20.

Active Risk Management: A Credit Investor’s Perspective

21.

Investment Strategy Returns: Volatility, Asymmetry, Fat Tails and the Nature of Alpha

What challenges do investment professionals face when they manage portfolios through a financial crisis? What lessons can be learned from such an experience? In this chapter, we discuss how the 2007–10 credit crisis affected11 Throughout this chapter, we refer to the crisis as a past event. We do so simply because we can point to past events or “shock waves” associated with the crisis and explain what they taught us. This is not a statement about whether or not we believe the crisis is over at the time of writing in September 2010. quantitative equity investment management and how this experience will affect this investment style for years to come.22 We use the term “quant” as shorthand for “quantitative equity manager”.

Quantitative equity portfolios invest primarily in stocks and are actively managed against a benchmark. The benchmark may be a well-defined equity portfolio (eg, the S&P 500 Index portfolio) or the risk-free rate (cash). Portfolio weights are derived, in part, from computer-based models and result from a systematic, reproducible33 That is, a manager can reproduce their investment results from first principles. investment process. Their underlying investment

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