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2018

CFA® EXAM REVIEW


CRITICAL
CONCEPTS
FOR THE
CFA EXAM

CFA LEVEL III ®

SMARTSHEET
FUNDAMENTALS FOR CFA® EXAM SUCCESS
WCID184
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ETHICAL AND • Adaptive markets hypothesis


• Must adapt to survive (bias towards previously
information.
• Confirmation bias: only accept supporting evidence.
PROFESSIONAL STANDARDS successful behavior due to use of heuristics). • Gamblers’ fallacy: overweight probability of mean
• Risk premiums and successful strategies change over reversion.
STANDARDS OF PROFESSIONAL CONDUCT time. • Hot hand fallacy: overweight probability of similar
returns.
• Thoroughly read the Standards, along with related BEHAVIORAL BIASES
guidance and examples. • Overconfidence, availability, illusion of control, self-
attribution and hindsight biases also possible.
• Cognitive errors (belief persistence biases)
ASSET MANAGER CODE OF • Conservatism: overweight initial information and fail to • Market behavioral biases
PROFESSIONAL CONDUCT update with new information. • Momentum effects due to herding, anchoring,
• Confirmation bias: only accept belief-confirming availability and hindsight biases.
• Firm-wide, voluntary standards information, disregard contradictory information. • Bubbles due to overconfidence, self-attribution,
• No partial claim of compliance. • Representativeness: extrapolate past information into confirmation and hindsight biases.
• Compliance statement: “[Insert name of firm] claims the future (includes base-rate neglect and sample-size • Value stocks have outperformed growth stocks; small-
compliance with the CFA Institute Asset Manager Code of neglect). cap stocks have outperformed large-cap stocks.
Professional Conduct. This claim has not been verified by • Illusion of control: believe that you have more control
CFA Institute.” over events than is actually the case.
• Firms must notify CFA Institute when claiming • Hindsight bias: only remember information that PRIVATE WEALTH
compliance.
• CFA Institute does not verify manager’s claim of •
reinforces existing beliefs.
Cognitive errors (information-processing biases)
MANAGEMENT
compliance. • Anchoring and adjustment: develop initial estimate INVESTMENT POLICY STATEMENT
• Standards cover: and subsequently adjust it up/down.
• Loyalty to clients • Mental accounting: treat money differently depending • Return calculation
• Investment process and actions on source/use. • To maintain real value of portfolio, the required real
• Trading • Framing: make a decision differently depending on after-tax return is calculated as:
how information is presented.
• Risk management, compliance, and support • Availability bias: use heuristics based on how readily Annual after-tax withdrawal from the portfolio / Asset base
• Performance and valuation information comes to mind.
• Disclosures • Emotional biases • To convert after-tax withdrawal to a pre-tax withdrawal
• Loss aversion: strongly prefer avoiding losses to
BEHAVIORAL FINANCE making gains (includes disposition effect, house-
money effect and myopic loss aversion).
Pre-tax withdrawal = After-tax withdrawal / (1 – Tax rate on withdrawals)

• Overconfidence: overestimate analytical ability • Nominal return = Real return + Inflation rate
BEHAVIORAL FINANCE PERSPECTIVE or usefulness of their information (prediction
overconfidence and certainty overconfidence).
• If investor wishes to grow portfolio, use TVM worksheet
• Prospect theory to compute I/Y over investment horizon.
• Self-attribution bias: self-enhancing and self-
• Assigns value to changes in wealth rather than levels protecting biases intensify overconfidence. • Risk tolerance
of wealth. • Self-control bias: fail to act in their long-term interests • Above-average ability if longer time horizon or large
• Underweight moderate- and high-probability (includes hyberbolic discounting). asset base compared with needs.
outcomes. • Status quo bias: prefer to do nothing than make a • Willingness based on psychological profile.
• Overweight low-probability outcomes. change. • Overall tolerance is a combination of ability and
• Endowment bias: value an owned asset more than if willingness.
• Value function is concave above a wealth reference
point (risk aversion) and convex below a wealth you were to buy it. • Time horizon constraint: length and number of stages.
reference point (risk seeking). • Regret aversion: avoid making decisions for fear of • Liquidity constraint: ongoing needs, one-time
being unsuccessful (includes errors of commission and expenditures, emergencies.
• Value function is steeper for losses than for gains. omission).
• Cognitive limitations • Tax constraint: different rates may apply to different
• Goals-based investing sources of income and capital gains.
• Bounded rationality: deciding how much will be done • Base of pyramid: low-risk assets for obligations/needs. • Legal and regulatory constraint: less of a concern for
to aggregate relevant information and using rules of • Moderate-risk assets for priorities/desires; speculative individuals, restricted trading periods may apply to
thumb. assets for aspirational goals. corporate insiders.
• Satisficing: finding adequate rather than optimal • Behaviorally modified asset allocation • Unique constraint: client-imposed restrictions, e.g.
solutions. • Greater wealth relative to needs allows greater socially responsible investing, client-directed brokerage.
• Traditional perspective on portfolio construction adaptation to client biases • Psychological profiling
assumes that managers can identify an investor’s • Advisor should moderate cognitive biases with high • More risk averse: methodical (thinking), cautious
optimal portfolio from mean-variance efficient portfolios. standard of living risk (SLR). (feeling).
• Consumption and savings • Advisor should adapt to emotional biases with a low • Less risk averse: individualist (thinking), spontaneous
• Mental accounting: wealth classified into current SLR. (feeling).
income, currently owned assets, PV of future income. • Strategic asset allocation
INVESTMENT PROCESSES
• Framing: source of wealth affects spending/saving • Return: eliminate portfolios that do not meet return
decisions (current income has high marginal • Behavioral biases in portfolio construction objective. May need to convert a pre-tax nominal
propensity to consume). • Inertia and default: decide not to change an asset return to an after-tax real return.
• Self-control: long-term sources unavailable for current allocation (status quo bias).
spending. • Naïve diversification: exhibit cognitive errors resulting After-tax real return = Pre-tax nominal return × (1 – Tax rate) – Inflation rate
• Behavioral asset pricing models from framing or using heuristics like 1/n diversification.
• Sentiment premium included in required return. • Company stock investment: overallocate funds to • Risk: eliminate portfolios that do not meet shortfall or
company stock. other risk objectives.
• Bullish (bearish) sentiment risk decreases (increases) • Constraints: eliminate portfolios that do not meet
required return. • Overconfidence bias: engage in excessive trading
(includes disposition effect). constraints, e.g. cash holding for liquidity.
• Behavioral portfolio theory • Of the remaining portfolios, select portfolio with
• Home bias: prefer own country’s assets.
• Strategic asset allocation depends on the goal • Mental accounting: portfolio may not be efficient due
highest risk-adjusted performance, usually on Sharpe
assigned to the funding layer. ratio.
to goals-based investing as each layer of pyramid is
• Uses bonds to fund critical goals in the domain of optimized separately.
gains. • Behavioral biases in research and forecasting (expected return
turnn – rrisk
tur isk-free rate)
Sharpe
ar ratio is:
arpe
• Uses risky securities to fund aspirational goals in the • Representativeness: due to excessive structured
expected standard
nda deviation
ndard
domain of losses.

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TAXES AND PRIVATE WEALTH • Relative after-tax value of a tax-free gift diversify asset pool.
MANAGEMENT FVGift [1 + rg (1 − tig )]n •
Sale or gift to family members.
RVta reeGift = =
taxx − ffrreeGift
FVBequest [1 + re (1 − tie )]n (1 − Te ) •
Personal line of credit secured by company shares.
• Future value factor with accrual taxes •
Initial public offering.
• Relative after-tax value of a gift taxable to the recipient •
Employee share ownership plan (ESOP) exchange:
( )
n
FVIF
FVI pre-tax = 1 + rpr
Fpre-tax pre-tax
e-tax
FVGift [1 + rg (1 − tig )]n (1 − Tg ) company buys owner’s shares for ESOP distributions.
pre-tax (1 − t I )]
FVIF
FVIFafter-tax = [1 + rpr
n RVtaxable Gift = =
after-tax
after-tax
FVBequest [1 + re (1 − tie )]n (1 − Te ) • Monetization strategies for real estate
• Future value factor when deferring taxes on capital gains • Mortgage financing (no tax consequences and can use
• Trusts proceeds to diversify).
(B is cost basis as a proportion of current market value) • Revocable: owner (settlor) retains right to assets and • Donor-advised funds (contribute property now for tax
can use trust assets to settle claims against settlor.
FVIFCG = (1 + rpre‐tax)n (1 − tCG) + tCGB deduction).
• Irrevocable: owner forfeits right to assets and cannot • Sale and leaseback (frees up capital for diversification
• Future value factor with annual wealth tax use trust assets to settle claims against settlor.
but sale triggers taxable gain).
• Double taxation
( )
n
FW =  1 + rpre-tax (1 − tW ) 
FVIF
FVI
• Credit method: residence country provides a tax credit RISK MANAGEMENT FOR INDIVIDUALS
for taxes paid in source country.
• Effective annual after-tax return after taxes interest, • Financial capital: includes all tangible assets including
tCM =Max (ttRC, tSC)
dividends and realized capital gains family home
• Exemption method: residence country exempts foreign • Human capital: PV of future expected labor income
r* = rT (1 − PI tI − PD t D − PCG tCG ) (higher income volatility requires higher discount rate).
source income from tax.
tEM = tSC
• Income volatility risk can be diversified by appropriate
• Effective capital gains tax rate financial capital, e.g. if human capital is equity-like,
financial capital should contain more bonds.
• Deduction method: residence country allows
 1 − PI − PD − PCG 
T * = tCG  deduction for tax paid in source country. • Economic (holistic) balance sheet
 1 − PI t − PD t D − PCG tCG 
• Assets: financial capital, personal property, human
t DM = t RC + tSC − t RC tSC capital, pension value.
• Future value factor with blended tax regime • Liabilities: total debt, lifetime consumption needs,
CONCENTRATED SINGLE-ASSET POSITIONS bequests.
n
FVIF
FVIFafter- tax = (1 + r *)) ((1 − T *)
* ) + T * − tCG (1 − B)
after-tax
after-tax
• Net wealth is the difference between total assets and
• Objectives: risk reduction (diversification), monetization, total liabilities.
• Accrual equivalent after-tax return tax optimization, control. • Young family has high % of economic assets in human
• Considerations: illiquidity, triggering taxable gains capital. As the household ages, weight of human
Vn = V0 (1 + rAE )
n
on sale, restrictions on amount and timing of sales, (financial) capital will decrease (increase).
rAE = n
Vn
−1 emotional and cognitive biases. • Risks to human and financial capital
V0
• Monetization strategies • Earnings risk: protect against earnings risk related to
• Monetization by (1) hedging the position, and (2) injury with disability insurance.
• Accrual equivalent tax rate borrowing against hedged position. • Premature death (mortality risk): protect with life
rAE = r (1 − TAE ) • Hedging for monetization strategies can be achieved insurance.
rAE by: (1) short sale against the box (least expensive); (2) • Longevity risk: protect with annuities.
TAE = 1 −
r total return equity swap; (3) short forward or futures
• Property risk: protect with homeowner’s insurance.
contract; (4) synthetic short forward (long put and
• Measure of tax drag = Difference between accrual short call). • Liability risk: protect with liability insurance.
equivalent after-tax return and the actual return of the • Hedging strategies • Health risk: protect with health insurance.
portfolio. • Risk management techniques
• Buy puts (protect downside and keep upside while
• Tax-deferred accounts (TDAs): contributions from deferring capital gains tax). Loss Characteristics High Frequency Low Frequency
untaxed ordinary income, tax-free growth during the
holding period, taxed at time of withdrawal
• Use zero-premium collars (long put and short call with High severity Risk avoidance Risk transfer
offsetting premiums) to reduce costs vs buying puts. Low severity Risk reduction Risk retention
FVIFTDA = (1 + r)n (1 – tn) • Use prepaid variable forward (combine hedge and
margin loan in same instrument), with number of • Adequacy of life insurance
• Tax-exempt accounts (TEAs): after-tax contributions, shares delivered at maturity dependent on share price • Human life value method: estimates the PV of earnings
tax-free growth during the holding period, no future tax at maturity. that must be replaced.
liabilities. • Yield enhancement strategies: • Needs analysis method: estimates financial needs of
• Write covered calls to generate income. dependents.
A = (1 + r )
n
FVIF
FVIFTE
TEA
• Does not reduce downside risk.
• TDA offers after-tax return advantage over TEA if tax
rate at withdrawal is lower than tax rate at initial
• Tax optimized equity strategies
• Index-tracking separately managed portfolio: designed
INSTITUTIONAL INVESTORS
contribution.
to outperform benchmark from an investment and tax DEFINED BENEFIT PENSION PLAN
• Investor’s shared of investment risk on a taxed return perspective.
σ AT = σ (1 − t ) • Completeness portfolio: tracks index given • Risk tolerance: greater ability to assume risk if
concentrated portfolio characteristics and new • Plan surplus
investments. • Lower sponsor debt and/or higher current profitability
ESTATE PLANNING • Exchange fund: investors with concentrated positions • Lower correlation of plan asset returns with company
contribute these positions in exchange for a share in a profitability
• Core capital diversified fund (non-taxable event).
• Assets for maintaining lifestyle, funding desired • No early retirement and lump sum distributions
• Monetization strategies for concentrated private shares options
spending goals and providing emergency reserve.
• Strategic buyers: gain market share and earnings • Greater proportion of active versus retired lives
• Joint survival probability for a couple growth.
• Higher proportion of younger workers
urvival J ) = p(
p(sur
surviva rvival H ) + p(sur
p(surviv
survival urvivalW )
surviva • Financial buyers: acquire and manage companies using
− p(survivall H ) × p
surviva
urviva p((surviv
rvivalW )
survival private equity fund. • Risk objective: usually related to shortfall risk of
achieving funding status.
• Leveraged recapitalization: private equity firm uses
• PV of joint spending needs debt to purchase majority of owner’s stock for cash. • Return objective: to achieve a return that will fully fund
liabilities (inflation-adjusted), given funding constraints.
• Management buyout: management borrow money to
PV (spendingJ ) = ∑
N
p(survival J ) × (sspending
pendingJ )
purchase owner’s stock. • Liquidity: to meet required benefit payments.
(1 + r )t
t =1
• Divestiture of noncore assets: owner uses proceeds to • Time horizon: usually long-term and could be multi-
stage.

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• Tax: investment income and capital gain usually tax- • Liquidity: limited liquidity needs since cash inflows • Expected return on equity from Grinold-Kroner model
exempt. exceed cash outflows, but need to consider
D
• Legal/regulatory: plan trustees have a fiduciary disintermediation risk (when interest rates are rising) E ( R) ≈ − %∆S + IINFL + gr + %∆PE
NFL
NF %∆PE
PE
P
responsibility to beneficiaries under ERISA (US). and asset marketability risk.
• Unique: limited resources for due diligence, ethical • Time horizon: different product lines have different time • Risk premium (buildup) approach
constraints. horizons and will be funded by duration-matched assets.
• Fixed income buildup model
• Tax: pay corporate tax.
FOUNDATIONS • Legal/regulatory: regulations on eligible investments,
E ( Rb ) = rrF + RPINFL + RPD
INFL efault + RPLiquidity + RPMa
Default turity + RPTax
Maturity Tax

prudent investor rule, NAIC risk-based capital (RBC) and • Equity buildup model
• Risk tolerance/objective: higher risk tolerance due to asset valuation reserve (AVR) requirements.
noncontractually committed payout. E ( Re ) = RF + ERP = YTM 10 − year asury + ERP
• Unique: look out for restrictions on illiquid investments. year T
Tre
reasury

• Return objective: to cover inflation-adjusted spending


goals and overheads not countable toward required NON-LIFE INSURANCE COMPANIES • ICAPM (Singer-Terhaar)
spending minimum. • Expected return
r = % spend
spend + % managementt + % inflation • Risk tolerance/objective E ( Ri ) = RF + βi [ E (R
( RM ) − RF ]
or • Policyholder reserves use lower-risk assets due to
= (1 + % spend)(1
1 + % management)(
management)(1
management 1 + % inflation) − 1
)(1 unpredictable operating claims. • Asset class risk premium in a 100% fully integrated
• Maintaining surplus during high-volatility markets market
• Liquidity: to quickly fund spending needs (including reduces ability to accept higher risk. COVi , M σ i σ M ρi , M  σ 
noncountable overheads) greater than current βi = = =  i  ρi , M
• Risk measured against premiums-to-capital and σ 2M σ 2M  σM 
contributions.
premiums-to-surplus ratios.
• Time horizon: usually infinite.
• Return objective  RP 
• Tax: investment income and capital gain taxable. RPi =  M  σ i ρi,i M
• Investment earnings on surplus assets must be  σM 
• Legal/regulatory: UPMIFA (US). sufficient to offset periodic losses and to maintain
• Unique: May use swap agreements or other transactions policyholder reserves. • Asset class risk premium in a completely segmented
to diversify returns if funding is primarily via large blocks market
• Larger companies use active management strategies
of stocks. for total return rather than yield or investment income  RP 
RPi = σ i  M 
strategies.  σM 
ENDOWMENTS • Liquidity: to meet policyholder claims.
• Expected return with less than 100% integration and
• Risk tolerance/objective • Time horizon: generally shorter duration than life a liquidity risk premium (where RPi* is the weighted
• Greater ability to take risk due to infinite time horizon insurance companies. average of perfectly integrated and completely
and if adopting spending rules based on smoothed • Tax: pay corporate tax. segmented asset class risk premiums)
averages of return and previous spending. • Legal/regulatory: regulations on eligible investments, RPi* + R
E ( Ri ) = RF + RP RP
PLiquidity
• Lower ability to take risk if high donor contributions as risk-based capital (RBC) requirements.
a % of total spend. • Unique: look for restrictions on illiquid investments. • Taylor rule
• Lower ability to take risk if contributing a significant %
to a company’s annual spending or if company relies BANKS ROptimal = RNeutral + [0.5
[0.5 × (GDPgFForecast − GDPgTrend
orecast
or d ) + 0.5 × ( I F
Forecast − I Target ))]
orecast
or

on endowment to cover high fixed costs. • Exchange rate forecasting


• Risk tolerance/objective
• Return objective: same as for foundations. Annual spend • Relative PPP: exchange rates offset inflation
may be calculated in a number of ways. • Below-average risk tolerance.
differentials
Spendingt = Spending rate × Ending market valuet−1
• Leverage-adjusted duration gap (LADG) measure
overall interest rate exposure. ∆FX f / d ≈ INFL
%∆ IN f − INFL
INFLd

Spendingt = Spending rate × 1⁄3 [Ending market valuet−3 LADG = D A − kkD


DL • Relative economic strength: increasing growth attracts
+ Ending market valuet−2 + Ending market valuet−1] k = VL / VA portfolio investment capital, increasing short-term
demand for domestic currency.
Spendingt = Smoothing rate × [Spendingt−1 × (1 + Inflationt−1)] • Value at risk (VAR) measures minimum loss expected • Capital flows forecasting: higher relative direct and
+ [(1 − Smoothing rate) × (Spending rate × Beginning market valuet−1)]
over a specified time period at a given level of
long-term portfolio investment causing currency
probability.
• Liquidity: to fund gifts and planned capital distributions appreciation.
for construction projects as well as to allow portfolio • Credit risk in the bank’s loan portfolio. • Savings-investment imbalance: current account
rebalancing. No minimum spending requirement. • Return objective: interest income allocation focuses on deficits must be met with capital account surplus as
• Time horizon: usually infinite (maintain principal in positive spread over cost of funds, with the remaining foreign investors provide funds to offset domestic
perpetuity). allocation focusing on higher total return. savings deficit.
• Tax: not taxable unless they are unrelated business • Liquidity: driven by demand for loans and net outflows
taxable income. of deposits. EQUITY MARKET VALUATION
• Legal/regulatory: UPMIFA (US). • Time horizon: duration spread of assets over liabilities
constrains time horizon for securities portfolio to an • Cobb-Douglas economic growth with constant returns
• Unique: types of investments constrained by size or intermediate-term. to scale
board member sophistication.
• Tax: pay corporate tax. ∆Y ∆A

A

∆K
+ (1 − α)
∆LL

LIFE INSURANCE COMPANIES • Legal/regulatory Y A K L

• Large % of securities portfolio in government securities


• Risk tolerance/objective as pledge against reserves. • H-model for equity market valuation
• Liquidity risk: arises from changes in investment • Regulators restrict allocation to common shares and V0 =
D0  N
(1 + gL ) + 2 ( gS − gL )
portfolio that affects reserves. below-investment-grade bonds. r − gL  
• Interest rate risk: reinvestment risk and valuation • Risk-based capital requirements.
risk (due to duration mismatch between assets and • Relative value models
• Unique: Lending activities may be influenced by
liabilities). community needs and historical banking relationships. • Fed model: equity market undervalued if S&P earnings
• Credit risk of bond investments. yield > 10-year Treasury note yield (but ignores equity
risk premium and earnings growth).
• Cash volatility risk: relates to timely receipt and
reinvestment of cash. ECONOMIC ANALYSIS • Yardeni model: equity markets undervalued if model’s
justified earnings yield < market’s earnings yield.
• Disintermediation risk: policy owners withdraw
funds to reinvest with other intermediaries in higher- CAPITAL MARKET EXPECTATIONS E1
= yB − d × LTEG
returning assets. P0
• Expected return on equity from Gordon growth model
• Return objective: minimum return requirement (based
on rate initially specified to fund life insurance contract) D0 (1 + g) D
• Cyclically adjusted P/E (CAPE) ratio
E ( R) = +g= 1 +g
and net interest spread. P0 P0 • 10-year moving average CAPE ratio controls for
business cycle effects and is mean reverting.

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• CAPE value is current-year real S&P 500 index value • Liability-relative asset allocation approaches CURRENCY MANAGEMENT
divided by average real earnings over previous 10
Surplus optimization t
two-Portfolio Integrated Asset-liability
years. • Domestic return on global asset (where exchange rate is
Simplicity Simplicity Increased complexity
• Asset-based models Linear correlation Linear or nonlinear correlation Linear or nonlinear correlation expressed as SDC/FC)
• Tobin’s q: market value of debt and equity capital All levels of risk
Any funding ratio
Conservative level of risk
Positive funding ratio for
All levels of risk
Any funding ratio RDC = (1 + RFC )(1
)(1 + RFX ) − 1
divided by replacement cost of assets (undervalued if q basic approach
ratio < 1 assuming mean reversion). Single period Single period Multiple periods
• Portfolio return in domestic currency terms
• Equity q: market value of equity divided by RDC = [ w1 × (1
(1 + RFC1 ))(1
(1 + RFX 1 ) + w2 × (1 + RFC 2 )(1
)(1 + RFX 2 )]
)] − 1
replacement cost of net assets (undervalued if q ratio < • Goal-based asset allocations
1 assuming mean reversion). • Creation of differentiated portfolio modules based on • Variance of the domestic return
capital market expectations.
• Identifying clients’ goals and matching the goals to σ 2 ( RDC ) ≈ σ 2 ( RFC ) + σ 2 ( RFX ) + [2 × σ ( RFC ) × σ ( RFX ) × ρ( RFC , RFX )]
ASSET ALLOCATION appropriate sub-portfolios and modules.
• Factors favouring more currency hedging
ASSET ALLOCATION APPROACHES ASSET ALLOCATION WITH REAL-WORLD • Significant short-term objectives, e.g. income/liquidity
requirements.
CONSTRAINTS
• Asset-only: does not explicitly model liabilities •
Global fixed-income investments.
• Liability-relative (liability-driven investing): aims at an • Constraints on asset allocation due to: •
Markets with high currency or asset volatility.
asset allocation that can pay off liabilities when they • Asset size: more acute issue for individual rather than •
High risk aversion.
come due. institutional investors. •
Doubt about value of currency return potential.
• Goals-based investing: specifies sub-portfolios • Liquidity: liquidity needs of asset owner and liquidity •
Lower possibility of regret if the hedge is not profitable.
aligned with a specific goal (sum of all sub-portfolio characteristics of different asset classes. •
Low costs of hedging.
asset allocations results in an overall strategic asset
• Time horizon: asset allocation decisions evolve • Hedging strategies
allocation).
with changes in time horizon, human capital, utility • Passive hedging: manager protects portfolio with full
PRINCIPLES OF ASSET ALLOCATION function, financial market conditions, characteristics of hedging.
liability and the asset owner’s priorities. • Discretionary hedging: manager reduces risk with
• Mean variance optimization (MVO) • Regulatory: financial markets and regulatory entities hedging but has discretion to make currency bets for
• Produces an efficient frontier based on returns, often impose additional constraints. return enhancement.
standard deviation of returns and pairwise • Taxes • Active currency management: manager seeks alpha by
correlations. making currency bets.
• Place less tax-efficient assets in tax-advantaged • Currency overlay: currency management outsourced
• Find optimal asset allocation mix that maximizes accounts to achieve after-tax portfolio optimization.
client’s utility. to specialists.
rat = pd rpt (1 − td ) + pa rpt (1 − tccgg ) • Active currency management
Up = E 0.005 × A × σ 2p
E(( R p ) − 0.005 • Economic fundamentals: real exchange rate will
eventually converge to fair market values, with short-
• Rebalancing range for a taxable portfolio (Rtaxable) can term increases in the domestic currency due to (1)
• MVO limitations be wider than those of an otherwise identical tax- increase in domestic currency’s real purchasing power,
• Asset allocations are highly sensitive to small changes exempt portfolio (Rtax exempt). (2) higher domestic interest rates, (3) higher expected
in input variables. foreign inflation, and (4) higher foreign risk premiums.
R taxable = R tax exempt / (1 − t )
• Asset allocations can be highly concentrated. • Technical analysis: based on belief that historical
• Only focuses on mean and variance of returns. currency patterns will repeat over time and those
• Revision to asset an allocation repetitions are predictable.
• Sources of risk may not be well diversified.
• Changes in goals • Carry trade: borrow in lower interest rate (or forward
• Asset-only strategy. premium) currencies and invest in higher interest rate
• Single-period framework and ignores trading/ • Changes in constraints (or forward discount) currencies, based on assumption
CurrenCy ManageMent: an IntroduCtIon
rebalancing costs and taxes. • Changes in investment beliefs that uncovered interest rate parity does not hold.
• Does not address evolving asset allocation strategies, • Tactical asset allocation (TAA) approaches • Roll yield: positive when trading the forward rate bias
options expire within that range. The “short” position comes from the fact that the out-of-
path-dependent decisions, non-normal distributions. (buying
the-money put andbase currency
call in the athave
seagull spread forward discount or selling
been shorted.
• Discretionary TAA: uses market timing skills to avoid or base currency at forward premium); negative when
• Approaches to improve quality of MVO asset allocation hedge negative returns in down markets and enhance Exotic Options
trading against the forward rate bias (selling base
• Use reverse optimization to compute implied returns positive returns in up markets. Exotic options are those that are creative in nature and cannot be categorized as being
currency at forward discount or buying base currency
and improve quality of inputs, e.g. Black-Litterman • Systematic TAA: uses signals to capture asset-class-
“plain.” Exotic strategies provide the lowest cost investment to achieve a specific outcome.
These atoptions
forward
are quitepremium).
helpful for clients with significant unique circumstance constraints
model. level return anomalies that have been empirically in the investment policy statement or who have specific income needs that cannot be
produced by traditional financial securities.
• Adding constraints to incorporate short-selling and demonstrated as producing abnormal returns. 1 + (i
(i FC × Actual 360)
F =S ×
other real-world restrictions into optimization. OneFC commonly
/DC used
DC exotic option isActual
FC/DC
C/
(i DC × a knock‐in
1 + (i 360 )
option in which the option does not
• Behavioral biases in asset allocation actually exist until a barrier spot rate is realized. Keep in mind that the barrier rate is not
• Resampled MVO technique combining MVO and Monte 1 + (i
the same as the strike price.
= ×
(For × Actual 360
i PCexample, )
consider a call option with an exercise rate of

Carlo approaches to seek the most efficient and


• Loss aversion: mitigate by framing risk in terms of F
CAD1.15/USD
PC/BC S and a barrier
PC/BC
(irate
1 + (i ofACAD1.12/USD.
× ctual ) If the spot rate is currently CAD1.10/
USD, the option does not evenBC exist until 360
the spot rate rises to CAD1.12/USD. It works
shortfall probability or funding high-priority goals with
consistent optimization. like a regular option, but if the barrier rate is never realized, it’s as if the option never
low-risk assets. existed. A knock-out option ceases to exist when the exchange rate touches the barrier.
• Monte Carlo simulation and scenario analysis •
ThinkVolatility
of a put optiontrade:
of the baselong (short)
currency straddle
with a barrier slightly or strangle
below if
the strike price.
• Illusion of control: mitigate by using the global market If the base currency appreciates above the barrier, then the option no longer exists. These
volatility expected to increase (decrease).
• Used in a multiple-period framework to improve portfolio as a starting point and using a formal asset exotics are cheaper than regularly traded options and offer less protection.
single-period MVO. allocation process based on long-term return and risk •Exhibit
Currency management
5‐1: Select tools
Currency Management Strategies
• Provides a realistic picture of distribution of potential forecasts, optimization constraints anchored around Forward Contracts Over‐/under‐hedging Profit from market view
future outcomes. asset class weights in the global market portfolio, and Option Contracts OTM options Cheaper than ATM
• Can incorporate trading/rebalancing costs and taxes. strict policy ranges. Risk reversals Write options to earn premiums

• Can model non-normal distributions, serial and cross- • Mental accounting: goal-based investing incorporates Exotic Options Put/call spreads Write options to earn premiums

sectional correlations, evolving asset allocations, path- this bias directly into the asset allocation solution by Seagull spreads Write options to earn premiums

dependent decisions, non-traditional investments, aligning each goal with a discrete sub-portfolio. Knock‐in/out features Reduced downside/upside exposure
Digital options Extreme payoff strategies
human capital. • Recency or representativeness bias: mitigate by using
• Risk budget a formal asset allocation policy with prespecified
allowable ranges.
•Apredetermined,
Minimum variance
digital option, which hedge
might also be calledratio for a cross-hedge
an “all‐or‐nothing” or binary option, earns a
• Identifies total amount of risk and allocates risk to the• life
Obtained
fixed payout if the underlying reaches the strike price at any time during
of the option.from a regression
It does not of change
have to cross the strike in value
price, nor does it have toof
remain
different asset classes. • Framing bias: mitigate by presenting the possible asset in‐the‐money until expiration to earn the payoff amount. This feature makes the option
moreunderlying assetspeculation
appropriate for currency in domestic currency terms against
than hedging.
• Asset allocation is optimal when ratio of excess return allocation choices with multiple perspectives on the change in value of the hedging security.
to MCTR is the same for all assets. risk-reward tradeoff.
• Beta (slope coefficient) of the regression equation is
• Familiarity or availability bias: mitigate by using the the optimal hedge ratio.
cont bution to total risk (MCTR) = Asset beta × Portf
Marginal contri ortfolio
tfolio standard
nda deviation
ndard
global market portfolio as the starting point in asset
Absolute contribution to total risk ( ACTR
ACTR ) = Asse
Asset
A eightt × M
ssett weigh
weight
w MCTR
allocation and carefully evaluating any potential • Basis risk occurs due to imperfect correlation between
Ratio of excess return
etur R = (Expected
eturn to MCTR (Expected return − Risk-free rate)/ MCTR
return
return
deviations. currency price movement and hedging instrument.

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MARKET INDEXES LIABILITY-DRIVEN STRATEGIES • Buy and hold: choose parts of curve where yield
changes will not affect return or purchase longer-
• Market cap weighted index: weight of each security • Immunization: reduces or eliminates the risks to liability duration/higher-yield securities.
is security’s capitalization value as a % of total index funding arising from interest rate volatility over the • Rolldown: riding the yield curve when yield curve is
market cap. planning horizon. upward-sloping.
• Advantages: broad acceptance; requires less • Immunizing a single liability • Selling convexity: sell lower-yielding higher-convexity
rebalancing as index remains properly weighted after • Market value of assets is greater than or equal to PV of bonds if expecting low interest rate volatility.
a price change. liability • Carry trade: buy longer-maturity, higher-yielding
• Disadvantages: overly influenced by overpriced • Macaulay duration of assets matches liability’s due securities and finance them with shorter-maturity,
securities; price movements overly concentrated in a date lower-yielding securities.
few large companies. • Changing yield curve strategies
• Convexity of asset portfolio is minimized.
• Price weighted index: weight of each security is • Portfolio needs rebalancing as time passes. • Duration management: shorten (lengthen) duration if
proportional to its price (represents portfolio holding expect yield increases (decreases).
one share of each security). • Risk: non-parallel shifts in yield curve (risk is reduced
by minimizing convexity). • Buying convexity: with falling yields, portfolios with
• Advantages: simple; long track record. greater convexity will increase more in value than
• Cash flow matching for multiple liabilities
• Disadvantages: not relevant to most strategies; portfolios with less convexity; with rising yields,
influenced by highest priced securities; must be • Portfolio has cash flows matching the amount and portfolios with greater convexity will decrease less.
rebalanced after stock splits. timing of liabilities.
• Bullet and barbell structures
• Equal weighted index: all securities are held in equal • Duration matching for multiple liabilities
weights at rebalancing (represents portfolio holding an • Market value of assets is greater than or equal to the Relative Outperformance Given Scenario
equal $ amount of each security). market value of liabilities. Yield Curve Scenarios Structure
• Advantages: more diversified away from highest-priced • Asset basis point value (BPV) equals the liability BPV. Level change Parallel shift Barbell
companies. • Dispersion of cash flows and convexity of assets are Slope change Flattening Barbell
Steepening Bullet
• Disadvantages: must be rebalanced frequently to greater than those of the liabilities.
maintain weighting; price movements of smaller Curvature change Less curvature Bullet
• Derivatives overlay More curvature Barbell
companies may be overrepresented.
• Uses bond futures contracts to immunize liabilities. Volatility change Decreased volatility Bullet
• Fundamental weighted index: uses accounting data or increased volatility Barbell
other valuation metrics to weight the securities. Liability portfolio
por BPV – Asset portfolio
por BPV
Nf =
• Advantages: better representation of economic
Futures BPV • Duration management methods
importance. Futures BPV ≈
BPVCTD
CTD • Buy (sell) bond futures to increase (decrease) duration.
CFCTD
CTD
• Disadvantages: rely on creator’s subjective judgment; # Contracts required =
BPT − PVBP
PVBP PVBPP
restrictive valuation screens may result in less • Contingent immunization PVBP
BPF

diversification; investability constraints of smaller where the subscripts on PVBP indicate the target value T, actual portfolio value P,
• Active management if surplus (assets less liabilities) is
companies; not transparent because of proprietary and futures value F.
above a designated threshold.
valuation weightings.
• If the surplus falls below threshold, revert to a pure • Use leverage to increase duration
immunization strategy.
FIXED INCOME PORTFOLIO • Use gains on actively managed funds to reduce cost of
meeting liabilities.
Leveraged =
VLeve
Additional PVBP
DModified
odif
odified of bonds
× 10,000

MANAGEMENT • Horizon matching: cash flow matching for short-term VEquity + VLeve
Leveraged
New = DO
DNew ld ×
liabilities (< 5 years), duration matching for long-term Old
VEquity
INTRODUCTION liabilities.
• Fixed-income returns model • Interest rate swap overlay to reduce duration gap • Use interest rate swaps: receive-fixed, pay-floating
• Expected return decomposition Liability po
portfolio BPV – Asset por
portfolio BPV swaps increase duration; pay-fixed, receive-floating
NP = × 100
Swap BPV swaps reduce duration.
E(R) ≈ Yield income
• Convexity management methods
+ Roll down return
• Shift bonds in portfolio (difficult with large portfolios).
+ E(( ∆ Price due to yields and spread
r s)
read • Risks when managing portfolio against a liability • Buying callable bonds and MBS (equivalent to selling
− E(Credit losses) structure: model risk, spread risk, counterparty credit
+ E(Currency gains and losses) convexity).
risk.
• Portfolio positioning strategy
• Yield income equals current yield assuming no INDEX-BASED STRATEGIES • Parallel upward shift: bonds with forward implied yield
reinvestment income change greater than forecast yield change will enjoy
Annual coupon payment • Total return mandates higher return as they roll down the yield curve (upward
Current yield = sloping).
Bond pric
pr e • Pure indexing (full replication): match benchmark
weights and risk factors by owning all bonds in the • Parallel yield change of uncertain direction: increase
• Rolldown return: value change as bond approaches index with the same weighting. convexity by using barbell strategy.
maturity (pull to par) • Enhanced indexing: sampling approach to match
B1 − B0 primary risk factors; slight mismatch with benchmark
etur =
Roll-down return
eturn
B0 weights to achieve a higher return compared to full
replication.
• Expected price change due to change in yield or spread • Active management: aggressive mismatches with
benchmark weights and primary risk factors to achieve • Using butterflies: long the wings (barbell) and short the
∆Y 2 )
%∆P) = (− D Mod × ∆Y) + (C × 0.5∆Y
E(%
outperformance. body (bullet) if flattening curve, volatile interest rates,
• Laddered bond portfolio buying convexity or parallel yield curve increase; short
• Expected credit losses the wings and long the body if steepening curve, stable
• Maturities and par values spread evenly along the yield interest rates or selling convexity.
curve.
• Using options: sell convexity bonds (30-year maturity)
• Effect of leverage on portfolio return • Protection from yield curve shifts and twists by and purchase call options to outperform in both rising
 Portfolio return  rI (V
(VE + VB ) − rB VB
balancing the position between cash flow reinvestment and falling rate scenarios.
rP = 
 Portfolio equity 
=
VE
and market price volatility.
V
= rI + B (rI − rB )
• Suited to stable, upwardly sloped yield curve CREDIT STRATEGIES
VE environments.
• Leverage with futures • Higher convexity and liquidity. • Risk considerations
• High yield bonds: credit risk (includes default risk and
Notional value – Margin YIELD CURVE STRATEGIES loss severity).
Leverage Futures =
Margin • Investment grade bonds: interest rate risk, credit
• Stable yield curve strategies migration risk, spread risk.

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• Spread duration (measure of spread risk): percentage • Returns-based: regressing portfolio returns on companies at a discount to intrinsic value; capturing
increase in bond price for a 1% decrease in spread. returns of a set of securities indices (betas are the gains from debt structuring.
• Credit spread measures portfolio’s proportional exposure to the particular style • Compensation to fund manager of private equity fund
• G-spread: bond’s yield to maturity less interpolated represented by index). consists of management fee plus incentive fee (carried
yield of correct maturity benchmark bond. • Price inefficiency on the short side interest).
• I-spread: uses swap rates rather government bond • Restrictions to short selling. • Benchmarks: IRR, benchmarks for VC funds and buyout
yields. • Management’s tendency to deliberately overstate funds provided by Cambridge Associates and Thomson
• z-spread: spread added to each yield-curve point so profits. Venture Economics.
that PV of bond’s cash flows equals price. • Sell-side analysts issue fewer sell recommendations. • Commodities
• Option-adjusted spread (OAS) for bonds with • Sell-side analysts are reluctant to issue negative • Direct investment: purchase of physical commodities
embedded options: spread added to one-period opinions. and commodity derivatives.
forward rates that sets arbitrage-free value equal to • Sell disciplines • Indirect investment: companies specializing in
price • Substitution: opportunity cost sell and deteriorating commodity production.
• Excess return and expected excess return on credit fundamentals sell. • Energy and precious metals provide significant
securities • Rule-driven: valuation-level sell, down-from-cost sell, inflation hedge.
XR ≈ (s × t ) − ( ∆s × SSD
D) up-from-cost sell, target price sell. • Benchmarks: RJ/CRB, S&P GSCI, DJ-AIGCI and S&P CI
• Semiactive equity strategies are indices based on futures prices.
EXR ≈ (s × t ) – ( ∆s × SSD
D) − (t × p × L ) • Derivative-based semiactive equity strategies: • Hedge funds
exposure to equity market through derivatives and • Broad range of strategies
• Bottom-up approach to credit strategy (security enhanced return through non-equity investments, e.g. • Compensation structure consists of management fee
selection): for two issuers with similar credit risks, fixed income. plus incentive fee and may include high-water mark
purchase bond with greater spread to benchmark rate. • Stock-based enhanced indexing strategies: portfolio and hurdle rate.
• Top-down approach to credit strategy: macro approach looks like benchmark except in those areas on which • Differences in hedge fund indices due to: selection
to determine and overweight sectors with better relative the manager explicitly wishes to bet on (within risk criteria, style classification, weighting scheme,
value. limits) to generate alpha. rebalancing scheme, investability, survivorship bias,
• Managing liquidity risk • Information ratio (Grinold and Kahn) backfill bias.
• Cash IR ≈ IC Breadth
• Hedge fund performance appraisal measures
• Liquid, non-benchmark bonds (higher incremental • Sharpe ratio (inappropriate with illiquid holdings
return vs cash). • Core-satellite portfolio: index and semiactive managers and when returns are asymetrical/skewed or serially
• Credit default swaps index derivatives (more liquid constitute core holding while active managers represent correlated).
than credit markets). satellites. • Sortino ratio
• ETFs (liquid but unpredictable price movements in • Total active return and risk Sortino ratio = (Annualized rate of return - Minimum
volatile markets). • Manager’s true active return = Manager’s return – acceptable return)/Downside deviation
• Tail risk Manager’s normal benchmark • Gain-to-loss ratio
• Assess tail risk by modelling unusual return • Manager’s misfit active return = Manager’s normal Gain-to-loss ratio = (Number months with positivee rretur
eturns / Number months
eturns
patterns and using scenario analysis (historical and benchmark – Investor’s benchmark etur ) × ((Average up-month
with negative returns
eturns month retur
mont eturn /
hypothetical). • Total active risk Average down-month
month return)
mont etur
• Manage tail risk using (1) diversification strategies and Manager’s total activee rrisk = • Distressed securities
(2) hedges using options and credit default swaps.
“t e” activee rrisk)2 + (Manager
(Manager’s “tru (Manager’s
(Manager’s
’s “mis
“misfit”
“misfi
fit”
t” active isk)2
active rris • Hedge fund structure or private equity fund structure.
• Advantages of using structured financial securities such
as ABSs, MBS, CDOs and covered bonds • Risks: event risk, market liquidity risk, market risk,
J-factor risk (past judicial precedents on bankrupt
• Higher returns vs other types of bonds. • Information ratio as measure of manager’s risk proceedings).
• Improved portfolio diversification. adjusted performance
• Different exposures to investment grade and high yield
IR =
Manager’s “true
tr ” active return
true etur
eturn RISK MANAGEMENT
bonds. Manager’s “true
tr ” activee rrisk
true
• Financial risks: market, credit, liquidity, asset price,
EQUITY PORTFOLIO MANAGEMENT exchange rate, interest rate.
ALTERNATIVE INVESTMENTS • Non-financial risks: operational, model, settlement
• Approaches to managing equity portfolios (Herstaat), regulatory, legal/contract, tax, accounting,
• Passive management: try to match benchmark • Common features of alternative investments sovereign/political.
performance. • Relative illiquidity • VaR
• Active management: seek to outperform benchmark • Diversifying potential • Minimum amount we expect to lose in a given
by buying outperforming stocks and selling reporting period with a given level of probability.
underperforming stocks.
• High due diligence costs
• Difficult performance appraisal • Analytical (variance-covariance) method: assumes
• Semiactive management (enhanced indexing): seek normality in asset return distributions.
to outperform benchmark with limited tracking risk • Informationally less efficient markets
(highest information ratio). • Real estate Miniumum $ VaR = VP × [ E
E(( RP ) − Zα σ P ]

• Approaches to constructing an indexed portfolio • Direct investment: ownership in residences,


• Full replication: minimal tracking risk but high costs. commercial real estate, agricultural land.
• Historical method: VaR estimates based on historical
• Stratified sampling: retains basic characteristics of • Indirect investment: real estate companies, REITs, realizations of past returns.
index without costs associated with buying all the ETFs, mutual funds, CREFs, infrastructure funds.
• Monte Carlo method: uses a probability distribution for
stocks. • Benchmarks: NCREIF (sample of commercial each variable to randomly generate portfolio returns
• Optimization: seeks to match portfolio’s risk exposures properties), NAREIT. and to compute VaR based on the simulated returns.
(including covariances) to those of the index but can • Private equity • Limitations: can be difficult to estimate; considers only
be misspecified if historical risk relationships change • Direct private equity investment is structured as downside risk; may be based on invalid distributional
over time. convertible preferred stock: provides priority for assumptions.
• Value style investing: low P/E, contrarian, high yield. dividends and liquidation claims over common shares; • Stress testing as a complement to VaR
• Growth style investing: consistent growth, earnings buyout or acquisition of the common equity will trigger
conversion of convertible prefs into common shares.
• Used to identify unusual conditions that would lead to
momentum. losses in excess of a threshold.
• Market-oriented (blend or core style) investors: market- • Indirect investment primarily through private equity
funds (venture capital and buyout funds).
• Can be based on stylized scenarios (historical or
oriented with a value bias, market-oriented with a hypothetical), stressing models, maximum loss
growth bias, growth at a reasonable price, style rotators. • Formative-stage investment: seed, start-up, first stage optimization and worst-case scenario analysis.
• Market cap approach: small-cap, mid-cap, large-cap capital.
• Credit risk
investors. • Expansion-stage investment: second stage, third stage,
pre-IPO (mezzanine) capital.
• Current credit risk (jump-to-default): risk of ongoing or
• Investment style analysis pending default in the immediate future.
• Holdings-based: analyses characteristics of individual • Buyout funds seek to add value by: restructuring
operations and improving management; purchasing
• Potential credit risk: risk of possible default in the
security holdings. future.

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• Credit VaR: minimum expected loss due to a negative credit • Interest rate options • Explicit: commissions, exchange fees, duties and taxes.
event with a given probability during a period of time. • Buy interest rate call option to protect a future • Implicit: bid-ask spread, market impact, missed trade
• Forwards: counterparty with positive value has credit risk. borrowing against interest rate increases. opportunity cost, delay (or slippage) costs.
• Interest rate and equity swaps: potential credit risk is ayofff = Notiona
Interest rate call option payoff
ayof Notionall pri ncipal × max (Underlying rate at
pprincipal
rincipal • Volume-weighted average price (VWAP)
highest during the middle of swap’s life. expirationn − Exe
Exercise
Exerc
rcis
isee rat 0) ×
rrate,0)
ate,
e,0)
Days in underlying rate
• Advantages: easy to compute/understand; useful for
• Currency swap: potential credit risk is highest between 360
comparing smaller trades in nontrending markets.
the middle and end of swap’s life. • Buy interest rate put option to protect a future lending • Disadvantages: Does not include costs of delayed/
• Options: option buyers hold credit risk. (or investing) transaction against interest rate declines. cancelled trades; misleading for large trades; can be
• Managing risk: apply effective risk governance model; use ayofff = Notiona
Interest rate put option payoff
ayof Notionall pri ncipal × max (Exercise rate
pprincipal
rincipal gamed by delaying trades; not sensitive to trade size or
ERM system; use risk budgeting; reduce or transfer risk. − Unde
Underlying
Underl
rlying
ying rate
rate at expira 0) ×
expiration,0)
expiratio
tion,
n,0)
Days in underlying rate market conditions.
• Performance evaluation 360
• Implementation shortfall (IS)
• Sharpe ratio • Cap: series of interest rate call options. • IS is the return difference between the return on a
• Risk-adjusted return on capital (RAROC) • Floor: series of interest rate put options. notional portfolio and the actual portfolio’s return,
• Return over maximum drawdown (RoMAD) • Interest rate collar to protect a future borrowing: buy expressed as a % of the investment in the notional
• Sortino ratio interest rate cap and sell interest rate floor. portfolio.
• Option Greeks • Explicit costs (for purchases)

RISK MANAGEMENT • Option delta: positive for long call; negative for long
put
Expicit costs =
Commissions, taxes, and fees
S H × PH
f

APPLICATION OF DERIVATIVES Option delta =


Change in option price
=
∆c
• Realized profit/loss (for purchases)
Change in underlying stock price ∆S
FORWARD AND FUTURES RPL =
S × ( PE − PR )
• Option gamma: greatest for options that are at-the- S H × PH
• Managing equity market risk and changing equity asset money and close to expiration.
allocation by beta adjustment Change in option delta • Delay or slippage costs (for purchases)
Option gamma =
 β − βS   S  Change in underlying stock price S × ( PR − PH )
Nf =  T   Delay =
 βf  f  S H × PH
SWAPS
• Creating synthetic stock index fund or converting equity • Unrealized profit/loss or missed trade opportunity cost
into cash • Duration of interest rate swaps (for purchases)
Duration [Payy ffixed and receive floating interes wa = Duration(Floating-rate bond)
nter t rate swap]
nteres wap]
 V (1 + r )T  ( S H − S ) × ( PL − PH )
N *f = Round  − Duration (Fixed-rate bond) UP =
UPL
 S H × PH
 fq 
Duration [pay
y ffloating and receive fixed interes wa = Duration (Fixed-rate bond)
nter t rate swap]
nteres wap]
where V is the amount of money to be invested, r is the risk-free rate, T is the
investment horizon, q is the futures contract price multiplier, f is the stock index
− Duration (Floating-rate bond) • IS is the sum of explicit costs, RPL, delay costs and UPL
futures price, and N *f is an integer representing the number of long stock index • Use pay floating and receive fixed interest rate swap to (for sales, reverse the prices used in the numerator).
futures contracts to convert a cash position to an equity position or the number
of short stock index futures contracts to convert an existing equity position into increase duration of bond portfolio. • Advantages: relates execution costs to value of
a cash position. • Use pay fixed and receive floating interest rate swap to investment idea; recognizes tradeoff between
reduce duration of bond portfolio. immediacy and price; attribution of execution costs;
• Changing bond asset allocation can be used to optimize turnover and improve
• Duration management using an interest rate swap
 MDUR MDURS  B
performance; cannot be gamed.
M T − MDUR
N Bf =  βy
 MDUR f
MDUR

 fB
 MDUR
NP = VP 
M MDURP 
T − MDUR • Disadvantages: requires extensive data collection;

 M
MDUR S unfamiliar framework.
• Uses of currency swap • Types of traders
OPTIONS t
trader type Motivation Preference Holding Period
• Convert loan in one currency into a loan in another Information Unassimilated information Time Minutes/hours
• Option strategies currency. Value Valuation errors Price Days/weeks

Strategy Construction using Motivation


• Convert foreign cash receipts into domestic currency. Liquidity Divest securities, invest
cash, buy things
Time Minutes/hours

European options • Uses of equity swap Passive Rebalance (to index) Price Days/weeks

Covered Own underlying share and Earn premium to • Diversify a concentrated portfolio. Dealers/Day traders Accommodate other traders Indifferent Minutes/hours

call sell call on share. cushion losses. • Trading tactics


• Achieve international diversification.
Protective Own underlying share and Downside protection
put buy put on share. with upside potential.
• Change asset allocation between stocks and bonds. Focus Purpose costs Advantages Disadvantages

Bull Buy call at lower strike and Speculation on stock • Swaptions Liquidity at
any cost
Immediately
execute large
Upsetting
supply/demand
Guaranteed
execution
Information
leakage and
spread sell call at higher strike (can price increase in a • Payer swaption: holder has right to enter interest rate blocks market impact
possible
use puts instead of calls) range swap as fixed-rate payer (in-the-money when interest Need Low level Higher Price Lose trade control
Bear Buy call at higher strike and Speculation on stock rates go up). trustworthy advertising on commissions; improvement
spread sell call at lower strike (can price decrease in a agent large trades; information due to ability
• Receiver swaption: holder has right to enter interest possible leakage to wait
use puts instead of calls) range
rate as fixed-rate receiver (in-the-money when interest hazardous
Butterfly Buy call at lower strike, Bet on low volatility situation
rates go down). Costs are not Certain Spread; potential Market‐ Lose trade control
spread buy call at higher strike, sell
important execution price impact determined
two calls at strike halfway price
between strikes of long calls
(can use puts instead of calls) TRADING, MONITORING Advertise to
draw liquidity
Large trades
without
High
(organizational
Market‐
determined
Possible front
running

AND REBALANCING
information and operational) price
Collar Buy stock, buy put and sell Downside protection advantage cost
call. (zero-cost collar if and with limited Low cost Indifferent to High search and Favorable Execution
call and put premiums are upside whatever the timing; non‐ monitoring costs; price possible uncertainty;
the same) EXECUTION OF PORTFOLIO DECISIONS liquidity informational
trades
low commission possible
movement away
Straddle Buy call and put with same Bet on high volatility from price
strike • Effective spread point results in
“chasing” the
Strap Buy two calls and one put Bet on high volatility pr e + A
(Bid pric Ask pric
pr e)  market with limit
with same strike (stock price rise more Effectiv
ff
ffective spread = 2 ×  E
Execution price − orders
 2 
likely)
• Algorithmic trading
Strip Buy one call and two puts Bet on high volatility
• Market quality • Simple logical participation strategies: VWAP strategy
with same strike (stock price fall more
likely) • Liquidity: resilience, quote depth, narrow bid-ask aims to match expected volume for the stock; TWAP
Strangle Buy call and put, put has Bet on high volatility spreads. strategy breaks order up for exposure at various time
different exercise price • Transparency: pre-trade and post-trade periods during the day; percentage of volume strategy
Box Bull call spread and bear Replicate risk-free makes trades as some % of overall market volume until
• Assured completion: trade completion is guaranteed.
spread put spread return or make completed.
arbitrage profit • Execution costs • Implementation shortfall (arrival price) strategies:

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minimize execution costs by front-loading executions PERFORMANCE EVALUATION quality management; return from selection of specific
into the early part of the trading day. securities; return from trading activities.
• Opportunistic strategies: involve passive holdings and • Characteristics of a valid benchmark: unambiguous, • Risk-adjusted performance measures
opportunistically seizing liquidity. investable, measurable, appropriate, reflective of • Ex post alpha
• Specialized strategies: smart routing, “hunter” current investment opinions, specified in advance,
acknowledged. Rt − r fftt = α + β( RM
Mtt − r fftt ) + ε t
strategies and benchmark-based algorithms.
• Types of benchmarks: absolute return, manager
MONITORING AND REBALANCING universe, broad market index, investment style index, • Treynor measure
factor-model-based, return-based, custom security- RA − rf
• Rebalancing disciplines based. TA =
β A
• Calendar rebalancing: simple but unrelated to market • High quality benchmark: low systematic bias; minimal
behavior. tracking error; similar risk exposure to portfolio; • Sharpe ratio
• Percentage-of-portfolio (or interval) rebalancing: significant overlap of holdings with portfolio; low RA − rf
provides tighter control and triggers rebalancing turnover; positive active positions. Shar ratioA =
Sharpe
A
σ
related to market performance. • Macro attribution (fund sponsor level)
• Calendar and percentage-of-portfolio: rebalancing • Net contributions • M2
occurs at calendar intervals only if corridors have been
exceeded (lower monitoring and rebalancing costs). • Risk-free rate  RA − rf 

M 2 = rf +   σM
• Equal probability rebalancing: corridors are based on • Asset categories  σ A 

a common multiple of asset class standard deviation; • Benchmarks


does not address transaction costs or correlations.
• Ex post alpha and Treynor measure provide the same
• Investment managers conclusion on manager performance as they are based
• Tactical rebalancing: less frequent rebalancing during • Allocation effects on systematic risk.
trending markets; more frequent rebalancing during
• Micro attribution (investment manager level) • Sharpe ratio and M2 provide the same conclusion on
reversals.
• Explains three components of value-added return manager performance as they are based on total risk.
• Optimal corridor width of asset class
(difference between the returns on the portfolio and • Information ratio
Factor Effect the benchmark).
Higher transaction costs Wider corridor S S S
rv = rP − rB = ∑ [( wPi − wBi ) × (rBi − rB )] + ∑ [( wPi − wBi ) × (rPi − rBi )] + ∑ [ wBi × (r
(rPi − rBi )] RA − RB
IRA =
Higher risk tolerance Wider corridor i =1 i =1 i =1  A− B
σ
Higher correlation with rest of Wider corridor
portfolio • First term is pure sector allocation effect. • Manager continuation policies
Higher volatility of asset class Narrower corridor • Second term is allocation/selection interaction effect. • Type I error: keeping (or hiring) managers who do not
Higher volatility of remaining Narrower corridor • Third term is stock selection effect. have investment skills.
portfolio • Type II error: firing (or not hiring) managers who do
• Fixed income micro attribution
• Rebalancing strategies • Decomposes total return of a fixed-income portfolio have investment skills.
into two groups of components: effect of external
Market conditions
constant Mix buy‐and‐hold cPPI
interest environment (out of manager’s control) and GLOBAL INVESTMENT PERFORMANCE
UP—Momentums Underperform Outperform Outperform contribution of the investment manager. STANDARDS
FLAT—Reversals Outperform Neutral Underperform
• Effect of external interest environment: return on
DOWN — Momentums Underperform Outperform Outperform
the default-free benchmark, assuming no change in
• Focus on required disclosures, and presentation and
Implications
reporting requirements and recommendations of GIPS.
Payoff curve Concave Linear Convex forward rates; return due to changes in forward rates.
Portfolio insurance Selling insurance None Buying insurance
• Contribution of the investment manager: return • Be able to identify and correct errors in a performance
Multiplier 0<m<1 m=1 m>1 presentation that claims to be GIPS compliant.
from interest rate management; return from sector/

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