Just got lost in a couple of concepts below. Can someone help, please? Thanks!
“Unlike futures, forwards dont generate any cash at exercise even when they are deep in the money so there is no advantage to early exercise.” Why there is no cash generated for forward? Why there is cash generated for futures?
"the portfolio with the highest information raio will also be the portfolio with the h ighest Sharpe Raio." If this is correct, can we just choose the portfolio with the highest Sharpe Raio?
"The closet index fund will have the same Sharpe Raio as the benchmark index and a very l ow Information Raio." Why would the fund still have information raio if it is tracking the index already?
Futures are exchange traded - and there is a margin account - to which you deposit / withdraw funds when you mark to market. you get whatever’s in the margin account - when you exercise - so you get cash.
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IR = (Rp - rf )/ Sp-i
SR (Sharpe) = (Rp- rf) / Sp
Sp-i = Tracking error (standard deviation of the difference between returns of the portfolio and the returns of the index)
Sp = Standard Deviation of the Portfolio
So the portfolio with the highest IR would have the highest Sharpe ratio - but the reverse condition - i.e. a Portfolio with the highest Sharpe NEED NOT be the one with the Highest IR.
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Anything could have an IR, even an IR of 0 is an IR. So if Rp = Rf, IR = 0 --> which is still an IR. They say Low IR - which means close to 0… nothing wrong with that.
In fact you will learn, in Level 3 - that IR is used to distinguish between Active Management, Enhanced Indexing and Indexing (IR=0 for this case).
Forwards are off market (OTC) contracts so there is not any fact which would generate cash flow prior execution. It will be executed at date determined at establishing forward.
Futures are exchange traded forwards based on daily margins maintaned and guaranteed by the clearing house.
Each daily gain (loss) of one counterparty is loss (gain) of another counterparty and clearing house is here in the role similar as croupier in a casino so each counterparty default risk does not exist unlike situation at forward contracts.
Information ratio - measures return over benchmark (some index). Since it measues return over benchmark, it is a measure of sucess of active portfolio management.
Thus, in my opinion, highest Information ratio portfolio will also be highest sharpe ratio portfolio but opposite may not be such case, highest Sharpe ratio portfolio may not be highest Information ratio portfolio.
I can understand my quesiton 1 and 3 now. But for 2, I am still a little lost. I know IR and SR are different, how can we know for sure the highest IR will be having the highest Sharpe Raio while the Portfolio with the highest Sharpe NEED NOT be the one with the Highest IR? What is the logic on this? Maybe you already told me but I think I still didnt get this.
Given the denominator of IR is Sp-i (Std deviation of Portfolio - Benchmark returns) - The one with the Maximum IR will hit will have the LOWEST Sp-i - and hence the lowest standard deviation.
Given SR = Same numerator / the lowest Sp - it will be the highest SR.
Thanks for your reply! That makes sense now with the lowest denominator.
I am just wondering now
If the lowest Denominator can cause the IR to be the biggest, can the highest Numerator cause the IR to be the biggest as well? Or we just look at the denominator in this case?
Sorry If I keep asking dumb questions. I just cannot move on this unless I understand completely.