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Sensitivity Analysis

Monte Carlo simulation fits the factor returns to a multivariate normal distribution but fails to account for negative skewness and fat tails. This is what informs the need for a sensitivity analysis. The analysis is done by fitting a different…

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Inputs and Decisions in Simulation

Historical Simulation Historical simulation employs randomness by drawing returns from historical data randomly, instead of following each period chronologically. An election can be made on whether to sample from the historical returns with or without replacement. Analysts prefer drawing samples…

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Simulation Analysis

Simulation provides a complete picture when backtesting because it accounts for the dynamic nature of financial markets, which carry extreme downside and upside risk. The basic types of simulation are historical simulation and Monte Carlo simulation. Historical simulation involves the…

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Historical Scenario Analysis

Historical scenario analysis is a form of backtesting that examines the risk and performance of an investment strategy at different structural breaks and structural regimes. The most common types of regime changes are from economic expansion to recessions and from…

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Problems in Backtesting

I. Survivorship Bias Survivorship bias occurs when a conclusion is drawn from data whose scope only captures companies that survived until the date the backtesting was done. It is worth clarifying that many practitioners fail to quantify the effects of…

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Metrics and Visuals Interpretation

Most quantitative stock selection models use a multifactor structure. For example, fundamental managers use multiple filters to screen stocks. The two multifactor equity portfolio strategies most commonly used to illustrate backtesting are benchmark (BM) factor portfolio and risk parity (RP)…

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Backtesting an Investment Strategy

Backtesting is an investment strategy evaluation technique. It uses past data to test real-life investment processes to assess whether a strategy would yield desirable outcomes. Objectives of Backtesting Backtesting offers investment strategy-related rigor and insight to investors. Backtesting is used…

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The Backtesting Process

There are three steps in backtesting: strategy design, historical investment simulation, and analysis of backtesting. Step 1: Strategy Design The first step is to formulate the investment hypothesis and goals. An active strategy would aim to achieve excess returns above…

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Arbitrage Pricing Theory (APT), Its Assumptions and Relation to Multifactor Models

Arbitrage Pricing Theory (APT) Arbitrage pricing theory (APT) is a theory of asset pricing. It asserts that the expected return of an asset can be expressed as a linear function of multiple systematic risk factors priced by the market. APT…

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Study Notes for CFA® Level II – Portfolio Management – offered by AnalystPrep

Reading 38: Exchange-Traded Funds: Mechanics and Applications -a. Explain the creation/redemption process of ETFs and the function of authorized participants; -b. Describe how ETFs are traded in secondary markets; -c. Describe sources of tracking error for ETFs; -d. Describe factors…

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