1. FUNDAMENTALS Flashcards
Client objectives
Stability of principle - most conservative and risk averse. capital preservation is most important = MMI, T-bills, certificates of deposit
Income - still risk averse but marginally less. No specific requirement for capital to be preserved. = IG/sov bonds, preference shares. default risk
Growth of income = income growing over time and eventually exceeding that of standard income objective. Income generating component of bonds and high divi stocks and growth component that will meet projected income needs. bonds vs equity income safety
Capital appreciation = no income req, comps reinvesting capital for max growth. tends to have high equity weighting and high vol. Income tax lower on divi vs bonds and barely any divi. flexibility to have tax via CGT charged at future date
May have multiple objectives over time or at once
Asset liability matching
Wealth management process
info gathering = fact find. Understand liabilities/needs/objectives/expenditure/inheritance
attitude/need to take risk
suitability/vulnerability/potential vulnerability
development of investment policy - passive vs active/ strategical/tactical, asset liability matching,
portfolio construction - sec selection and timin g
portfolio monitoring - agree benchmark and evaluate performance vs benchmark
evaluation - continual evaluation of perf vs benchmark
assessment of market expectation and trends
revise portfolio is desired outcomes not met
Client circs
unlikely to remain static - must be reassessed
encourage client to reach out to inform of any changes (house purchases)
- financial needs and preferences
- risk aversion/tolerance
- need to take risk
- constraints
risk aversion
= 1/ risk tolerance
RT = 1/RA
(triangle with 1 on top)
= tendency to avoid risk
Would prefer preservation of capital>seeking higher returns
not exact science - risk profiling tool may have numeric output but risk not linear
client may also have misunderstood questionnaire
- helps to make risk feel risk with max drawdrown etc
risk tolerance = the amount of loss an investor is prepared to handle while making an investment decision
Benefits and drawbacks of risk aversion scores in portfolio construction (using utility scores)
BENE
-helpful starting point for discussion of risk with client
- easy to calculate
- combines objective investment risk with psych risk tolerance to give holistic risk penality
DRAWBACKS
- doesnt include need or capacity
- scaling if used is subjective
- relies on honesty and openness of client reporting
- wouldnt base decision solely on this in isolation
Merits and drawbacks of risk aversion alone
BENE
- easy to calc and explain
- Means of allocating people to diff investment portfolios who may have similar objectives
- means of tracking changes to client attitude to risk
DRAWBACKS
- doesnt include risk or capacity
- just one of several techniques to find appropriate inv portfolio for client
- risk aversion may change with events/over time so survey responses may not be consistent
Uses of annuities in portfolio construction
Useful when client dependent on portfolio income for daily needs
- capita preservation would also be important as it is needed to generate income
- prevents longevity risk
- could provide inflation linked income (initial value is lower tho)
typically used for pension planning purposes but also can get care annuity
income generally dependent on prevailing annuity rates @ retirement (driven by gilt yields and longevity) - became unpopular with low gilt yields
- non inheritable unlike pension drawdown
taxation of annuitites
Purchased life annuities taxed as interest on the income element (which you buy with your savings)
Pension annuities taxed in full as non savings income (like a salary)
Types of annuity
Conventional - secured inc in XC for lump sum. Pay guaranteed income for rest of life
Variable - income dependent on performance of investments. these have investment risk so less benefit vs drawdown
Deferred - pay regular income @ later date
Guaranteed - income paid for minimum term (paid to estate after death if you die within term)
Can be inflation linked or increase @ fixed % for additional cost
Can be joint - where income continues on first death to benefit other holder (doesnt have to be spouse)
Investment risks
- capital preservation in monetary terms
- capital preservation in real terms
- possibility of undesirable outcomes = loss of wealth etc
- probability that outcome may fail to meet required target set @ beginning
- inability to raise necessary cash sum when required
- reliability of income stream
Attitude to risk
- How much risk client comfortable taking within timeframe
- assessed qualitatively and quantitately
- will probs change with time (e.g. 20yo SIPP vs 70 yo SIPP)
- can have different attitude with different pots of money (mental accounting)
- ability, willingness and need
Utility
utility = return on portfolio - (variance/risk tolerance)
optimal portfolio = one that provides highest utility
(bracketed item) = risk penalty: high vol with low risk tolerance will give large risk penalty
certainty equiv = rate of return you would get without taking risk
utility of a T bill = expected return as variance = 0
so then look for which asset gives utility over certainty equivalent
Purpose of subjective scaling in utility calc
Can be any number but usually a half
applying decimal to risk penalty in equation reduces impact of any one quant risj aversion factor
Certainty equivalent rate
Utility scores =return on portfolio - (variance/risk tolerance)
Risk penalty for each investment has been deducted - portoflios are derisked and so can be viewed as certainty equivalent rate
= rate a RF investment would need to return to provide same utility
If portfolio utility> rate on RF sec - then that portfolio is preferable over the risk free investment
socioeconomic characterisitcs + life cycles
gender - women save @ greater rate than men and tend to be more risk averse (fewer years of economic activity and longer life expectancy)
marital status - couples/families have higher propensity to save. marriage decreases male risk tolerance and increases female risk tolerance
age/lifestyle cycles
foundation phase - early and inexperienced, staring to build income. Ambitious wealth creation, high risk tolerance
accumulation phase - more invested and earning more. expenses may increase with family then drop off = more funds for investment and potentially increased risk tolerance
maintenance phase - engine room of pension performance. maybe reduce risk in lead up to retirement. reduced tolerance for investment losses. close to/already retired
distribution phase - retirement and drawdown. accumulated wealth protected in acc phase now ready for distro. tax saving and wealth transfer to beneficiariares
Consumer duty
FCA wants to see higher level of consumer protection in retail financial market
Underpinned by three cross cutting rules
1. Act in good faith toward retail customers.
2. Avoid foreseeable harm to retail customers.
3. Enable and support retail customers to pursue their financial objectives.
Also added a new PRIN of business
‘A firm must act to deliver good outcomes for retail customers’.
High quality IPS
Client info
- client circs, needs, restrictions
- objectives, risks, needs, liabilities, base currency, time horizon
- set out investor expectations
- service relationship
- residence andtax status
- capital and liquidity req
- tax position/wrapper
Organizational and governance info
- investment mission and purpose
- investment objective
- strategy and investment style
-investment team organization and process
investment policy
- benchmark/index
- risk management - limits, liquidity, holding levels
- costs and charges
-reporting reqs
- sentimental holdings/avoidance
strategy element
- investment/house approach, beliefs about markets, weightings
- active/passive
- exclusions
- ESG/stewardship/ethical approach
Types of risk
systematic - market risk, less diversifiable
unsystematic risk - comp specific and can be diversified away
- E.G. management risk, industry, financial
inflation risk - can erode returns over long period
interest rate risk - sharp changes in rates can change shape of yield curve drastically. And growth stocks can derate
exchange rate risk due to overseas operation
liquidity risk - ease with which investment can be bought/sold
default risk - risk that borrower fails to make timely payments of prin/interest
ESG risk - impact that esg issues may have on investments
capital risk - possibility of capital loss
event risk - risk of severe and sudden loss to investment value due to sudden unexpected evetn
political risk - risk returns could suffer due to political changes/instability, also fiscal risk = changes to tax regime
operational risk = risk to investment due to internal ops/excution of company
pension fund deficit risk - risk that liabilities outway funds avail to meet them
Systemic risk
= total risk (systematic and unsystematic) x corr coeff
corr coeff : between sec and market
Portfolio risk (standard dev)
Portfolio diversification
academia says 30-25 holdings = unsystematic risk diversified away
funds may hold more in practise due to liquidity and large holdings in small comps
also likely benchmark aware
Total risk (standard dev) if given systematic and unsystematic
SQUARE THEM, SUM THEM, ROOT THEM
Expected return with probabilities
standard deviation?
calc when given probability set
measure how widely actual returns vary around mean/expected return
- cal return diff vs mean
- square differences
- times differences by prob
- sum to get variance
- root to get SD
standard deviation of a population or sample
Geometric mean
Used when return/growth is compounded
arithmetic mean doesnt consider compounding
Non normal distro (kurtosis)
skew and kurtosis can help measure the degree by which returns differ from normal distro
Leptokurtosis = more pointed/taller middle with long skinny tails = long tail risk. small prob of v large losses
platykurtosis= fewer results @ mean, fatter distro with shorter tails
Sharpe uses SD which assumes normal distro but results may show kurtosis
Non normal distro (skew)
skew and kurtosis can help measure the degree by which returns differ from normal distro
skew = measure of asymmetry of distro around mean - normal distro = zero skew
negative skew = longer negative tail. positive skew = longer positive tail
Normal distro
often assume in finance that returns are normally distributed
= symmetric bell shaped distribution around mean
68 - 95 - 99.7% rule
in real life - asset returns often not normally distributed
arithmatic mean, median and mode, are all the
same and lie at the centre (differences between the median and mean suggest that the distribution
is skewed)
Correlation of 2 assets
measured from -1 to +1
most effective diversification comes from combining negatively correlated assets
observation of correlation doesnt = causation
Cov triangle (stock and market)
m = market
s= stock
Beta calc (stock and market)
Cov (ra,rb) = Corr(a,b) x SDa x SDb
var = SD squared
Cov sm calc (incl beta)
Cov (ra,rb) = Corr(a,b) x SDa x SDb
var = SD squared
Portfolio Variance
Markowitz formula
Cov (ra,rb) = Corr(a,b) x SDa x SDb
var = SD squared
covariance formula
Covariance calc
3 asset Markowitz
+ (wc2 x SDc2) + (2wc wb Cov rc,rb) + (2wc wa Cov rc,ra)
Expected return when combining assets
= Weighted avg return from each sec included
Value averaging
VA = means buying shares such that the portfolio value increases by a fixed amount at fixed intervals of time
when prices are low - investor forced to invest more money to bring portfolio value up to set amount.
so avg price paid is less than avg price of shares over same period (as with PCA
Forward XC rates and interest rate parity
Interest rate parity is a theory in which the interest rate differential between two
countries is equal to the differential between the forward exchange rate and the spot
exchange rate. Interest rate parity plays an essential role in foreign exchange
markets, connecting interest rates, spot exchange rates and foreign exchange rates.
Real return formula
for foreign clients use domestic rate as this is the rate they are exposed to
counter argument = international fisher eq would double count for inflation and UK inflaiton would already be reflected in currency XC rate
counter to this is that Fisher is LT but currency may not reflect
Single index model
(Ri-Rf) = Rt = return on investment - rfr
(Rm - Rf) = return on market - rfr
sometimes Rmt
ei = unexplained residual error: assume = 0
VaR
Value at risk (VaR) quantifies potential financial risk for an investment or a portfolio @ specific probability
offering a quant estimate of the maximum probable downside over a specified time horizon.
VAR = Expected return - (portfolio vol x t-stat for the confidence level)
How to work out VAR confidence levels
t stat = no. of SDs from mean
% values = % of values within that no. of SDs
only concerned with neg tail SO 95% of values = (100-95)/2 + 95 = 97.5% confidence level
(2.5% negative tail)
Diversification by asset class
Cash: useful to have emergency fund. May be wise to hold some in variable rate deposits as hedge against rates
FI - secure income and negatively correlated to equity markets when rates are low
Equtiies: diversified bucket for growth and divi income
CIS: can further spread risk across sector, geog, asset class
Property: brick and mortar illiquid, property shares can be correlated to equities
Unconventional: e.g. coins/art. can diversify but reqs expert knowledge, may not be liquid
Short term money market product nominal yield
Nominal yield for longer term products
NY ST = real yield + inflation rate
Liquidity premium
LP = additional compensation used to encourage investments in assets that cannot be easily or quickly converted into cash at fair market value
Can be measured as difference in yields between sampled sec and its comparator with same qualities but exhibiting liquidity differences
