Chapter 3: Revealing the Information Content of Investment Decisions
Noriyuki Okuyama and Gavin Francis INTRODUCTION Conventional performance measurement methods concentrate on investment outcomes rather than the underlying investment process. This chapter examines the effectiveness of the investment process by considering the essential part of any investment strategy: the investment decision. As recognized by Kahneman and Tversky (1979), the essential first step is to decompose returns into gains and losses. We introduce tools to indentify the asymmetries in investment returns available to passive and active investors. The approach fits naturally into an enhanced risk budgeting framework for more effective portfolio construction. INVESTMENT DECISIONS An investment decision results in a change of exposure in an underlying portfolio, exchanging one stream of returns for another. Since this must be based on an assessment of relative performance, we define an investment exposure as a zero size long/short portfolio, holding a position in a risky asset against an equal and opposing position in a risk-free asset. A risk-free asset earns the risk-free rate, but cannot suffer a loss. This is the numeraire against which all other returns are measured. Each currency’s cash rate is considered as the risk-free rate for the assets denominated in that currency. We can broaden the scope for a long/short position created by two assets denominated in different currencies, each considered as a risk exposure against the local cash rate. This approach incorporates the difference of the two currencies’ cash rates: the interest rate differential. It is widely recognized in the field of behavioral finance that the basis of an...
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