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CFA Level III > Asset Allocation > Flashcards

Asset Allocation Flashcards

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1
Q

SAA vs TAA

A

SAA: Combines CMA (return, std, correlation) with an investor’s risk, return, and investment constraints (IPS)

TAA: active management where managers deviate from the SAA to take advantage of short term opportunities

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2
Q

ALM Definition

Asset Only Definition

A

ALM: Tailoring asset alloication to meet liabilities and maximize surplus (high fixed income)

Asset Only: only focus is highest return for risk taken

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3
Q

Dynamic vs Static Asset Allocation

A

Dynamic: multi-period view (one period affects others)
Very difficult and costly to implement
↓ transaction costs
ALM uses Dynamic

Static: Use inputs at a point in time and build a long-term allocation

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4
Q

Required Return Geometric Calculation

A

(1 + r)(1 + r)(1 + r) - 1

Example:

Foundation needs 4% for distributions, inflation is 3%, fees are 0.5%.

(1.04)(1.03)(1.005) - 1 = 7.66%

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5
Q

Utility-Adjusted Return

A

UP = Rp - .005(A)(stdp)2

A = risk tolerance score 1-8. (8 being most risk adverse)

Example: risk score of 5, choose best portfolio

Portfolio A r = 11.5%, std 18% 11.5 - 0.005(5)(18)2 = 3.4
Portfolio B r = 8.-%, std 14% 8 - 0.005(5)(14)2 = 3.1
Portfolio C r = 6.0%, std 10% 6 - 0.005(5)(10)2 = 3.5
Select C

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6
Q

Roy’s Safety First Measure

A

RSF = (Rp - RMAR) / stdp

RMAR = minimum acceptable return

Example: Wants to minimize chances to earn less than 3.5%

Portfolio A r = 11.5%, std 18% (11.5 - 3.5) / 18 = 0.44
Portfolio B r = 8.-%, std 14% (8 - 3.5) / 14 = 0.32
Portfolio C r = 6.0%, std 10% (6 - 3.5) / 10 = 0.25

Select A

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7
Q

Shortfall Risk

Semivariance

A

Shortfall risk = risk of exceeding a maximum acceptable dollar loss

Semivariance = bottom half of the variance (only using returns below expected return)

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8
Q

Asset Class Approprately Specified

A
  1. Assets in the class are similar (statistical and descriptive)
  2. Asset classes are not highly correlated
  3. Individual assets only in ONE class
  4. Mostly liquid assets
  5. Cover majority of all possible assets
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9
Q

When should an additional asset class be added to an existing portfolio?

A

If Si > Sp * cori,p

Remember: Sharpe = (r - Rf) / std

Example 1:

Sharpe ratio: P = 0.41, Inv1 = 0.30, Inv2 = 0.31, Inv3 = 0.19
Cor with P: Inv1 = 0.77, Inv2 = 0.80, Inv3 = 0.40

Inv1: S = 0.30, 0.41 * 0.77 = .316 - DONT add
Inv2 S = 0.31, 0.41 * 0.80 = 0.328 - DONT add
Inv3 S = 0.19, 0.41 * 0.40 = 0.164 - ADD

Example 2:

Rf = 3%, Portfolio R = 12%, Std = 18%
New Investment R = 12%, Std = 30%

  1. Sharpe ratio A (12-3)/18 = 0.5, Sharpe B (12-3) / 30 = 0.3
  2. Si = Sp * cori,p 0.30 = 0.50 * cori,p
  3. Solve for cori,p = 0.30/0.50 = 0.60

If correlation is 0.60 sharpe is unchanged
If correlation is less than 0.60 adding will increase Sharpe
If correlation is more than 0.60 adding will decrease Sharpe

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10
Q

Nondomestic Equity and Bonds Risk

A
  1. Currency risk (reduced by low correlation)
  2. Political risk
    1. irresponsible fiscal/monetary policy
    2. lacks legal and regulatory rules
  3. Home country bias
  4. Higher costs or less liquid
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11
Q

Contagion/Conditional Correlation

A

Lower correlations for normal conditions

HIgher correlations during market crises

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12
Q

MVO Strengths/Weaknesses

A

Strengths

Identifies portfolio with highest expected return for risk
Widely available and understood

Drawbacks

Must specify all returns (input bias)
Tends to select concentrated allocations

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13
Q

CML

A

CML: Line between Rf and the market portfolio

If an investor can borrow and lend at Rf all portfolios on the CML dominate the normal EF

Drawbacks:

  • Hard to find a Rf asset over multiple periods
  • Borrowing increases risk
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14
Q

Resampled EF

A

Running MC on all portfolios to get a range. Then take the average

Advantages:

  1. More stable EF (but it does fall below original frontier)
  2. Considered more diversified
  3. Can see a range of what assets can be held. (Less turnover)

Diadvantages:

  1. Lack of sound theoretical basis
  2. Based on historical data
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15
Q

Black-Litterman

A

Addresses instability issues

Two Models:

  1. UBL Model - unconstrained (can short-sell).
  2. BL Model - no short selling
    1. Take consensus return expectations (global market index)
    2. Manager adjusts asset class weights based on his opinion
    3. Runs the MVO again

If an asset class increases return, it will have more weight.

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16
Q

Black-Litterman Pros and Cons

A

Pros

Starting with a global portfolio generally produces a well diversified portfolio
Reduces input bias

Cons

Complex and utilizes historical std

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17
Q

Asset Liablity Management for MVO

A
  • ALM searches for allocations that maximize the surplus between assets and liabilities
  • MSVP = Minimum Surplus Variance Portfolio (could be negative)
  • Choosing above the MSVP is a beta decision
  • Can combine ALM with BL or resampling
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18
Q

Experience-Based Techniques (EBTs)

A
  • Process of elimination, “rules of thumb”
  • Starts with a 60/40 and then adjust based on risk tolerance and time horizon
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19
Q

Corner Portfolios

A

Definition: A portfolio on the EF

Three criteria of a corner portfolio:

  • Must be a portfolio on the EF
  • To identify: asset class weight from + to 0 or 0 to +.
  • Global minimum-variance portfolio (GMVP) - the bottom left corner portfolio
20
Q

Using 2 portfolios to construct another

A

Step 1: solve for the return and weights
Rp = wB(RB) + (1 - wB)(RA)

Step 2: calculate the weighted average of the std

Example:

Portfolio A: 10% return, 12% std, Portfolio B: 15% return 16% std
Construct a portfolio with an 11% expected return:

Step 1: 11 = wB(15) + (1 - wB)(10)
11 = 15wB + 10 - 10wB
1 = 15wB - 10wB
1 = 5wB
1/5 = 20% into portfolio B

21
Q

CAL (Capital Allocation Line)

A

CAL: Line between Rf and the tangency portfolio (portfolio with highest Sharpe ratio)

  1. If required return < tangency: portion will be invested in Rf
  2. If required return > tangency: use margin to leverage return

Basically says you can borrow to get up to the CAL line

22
Q

CAL Formula

A

Rp = wt(Rt) + (1 - wt)(Rf)

t is for tangent portfolio. Same as CP formula except Rf

Example:

Allocate between tangent portfolio E and Rf of 2% to meet return target of 8.7%

  1. 61We + 2(1 - WE) = 8.7
  2. 61WE = 6.7

WE = 1.86 This means borrow 86% to invest

23
Q

Currency Exchange Details

A
  1. Bid: price to buy
  2. Offer (ask): Price to sell
  3. Spread: Difference between bid and ask

AKA: PIPS –> They are stated in the 10,000

  1. Bid = 1/ask Ask = 1/bid
24
Q

Currency Saying

A

Going up = bid (multiply)

Going down = ask (divide)

Use the % from the top currency

Note: $1.55 per E1 means: 1.55 USD (quote) 1 E (base)

So USD is domestic, E is foreign

25
Q

Forward Points

A

Adjustment to the spot price to determine forward price

**move decimal right by same # of decimal places shown

Spot FP Points w/ Decimal Forward Price

  1. 33 1.1 1,1/100 = 0.011 1.33 + 0.011 = 1.341
  2. 554 -9.6 -9.6/1000 = -0.0096 2.554-0.0096=2.5444
  3. 7654 13.67 13.67/10000=0.001367 .7654+.001367=0.766767
26
Q

What is an FX Swap?

A

Rolls over a maturing forward contract using a spot transaction (2 days prior to expiration)

Step 1: offset the maturing contract

Step 2: Enter a new forward contract

27
Q

Option Basics (Call & Put)

A
  • Call: right to buy
    • gains when underlying rises above strike price (delta approaches 1.00)
  • Put: right to sell
    • gains when underlying falls below strike price (delta apporaches 0.00)
28
Q

Currency Options Means What?

A

A call on one currency and a put on the other

Always for the base currency

Example: A put option to sell 100,000 at MXN/EUR at 20.1

  1. Right to sell 100,000 EUR and buy 2,010,000 MXN
  2. Right to buy 2,010,000 MXN and sell 100,000 EUR
29
Q

Currency Trading Option Strategies

A
  1. Buy ATM put; removes downside risk and retains upside (high cost)
  2. Buy OTM put; remove some downside risk and returns upside
  3. Buy high strike put and sell low strike put
    1. downside protection between strikes, retains upside
  4. Collar (sell a call and buy a put); downside protection to put strike, upside only to call strike
  5. Seagull (buy high strike put, sell low price put, sell OTM call)
    1. downside protection between put strikes, upside only to call strike
30
Q

Currency Option Relationships

A

Price of Base ^ Call Option Put Option

From 0 –> Strike OOM and rising ITM and falling
Delta 0.00 –> 0.5 Delta -1.0 –> -0.5

To Strike ATM ATM
Delta at 0.5 Delta at -0.5

Strike –> upward ITM and rising OOM and falling
Delta 0.5 –> 1.0 Delta -0.5 –> 0.00

31
Q

Domestic and Foreign Currency Definitions

A
  • Domestic (home) currency: investor’s currency that is reported
  • Foreign (local) currency: all currency’s outside of domestic
  • RFC = local market return
  • RFX = local currency return (% change)
  • RDC considers both local market and currency returns
32
Q

Domestic Currency Return Formula

A

RDC = (1 + RFC)(1 + RFX) - 1

Note: foreign currency must be the base currency

Example:

1 year EUR increased 5% and exchange rates went from 1.300 USD/EUR to 1.339 USD/EUR

Step 1: RFX = (1.339 / 1.3) - 1 = 3%

Step 2: RDC = (1.05 * 1.03) - 1 = 8.15%

33
Q

Portfolio Currency Formula

A

Step 1: Calculate RDC for each

Step 2: Apply the weights for each

Note: foreign currency must be the base currency

34
Q

Currency Risk Formula

A

std2RDC = std2RFC + std2RFX + 2(stdRFC * stdRFX * cor)

35
Q

Types of Currency Hedges

Reasons to or not to hedge

A
  • Passive hedging: matching benchmark
  • Discretionary hedging: some deviation (goal is risk reduction)
  • Active hedging

Reasons to NOT hedge:

  • Time and cost
  • Zero-sum game

Reason TO hedge:

  • Extreme short-term movements
  • Inefficient pricing
36
Q

What is the Currency Economic Fundamentals Approach?

Currencies increase when?

A

Reversion to fair value and based on PPP

Currencies increase when:

  1. Low inflation
  2. higher real/nominal rates
  3. undervalued
37
Q

Carry Trade Approach

A

Borrowing in lower interest rate country and investing in higher one

  • CIRP exists (high interest rate currency trades at a discount)
  • UCIRP is violated
  • Volatility spikes can create losses

Calculate the forward rate by: Spot * (1 + RDC / 1 + RFC)

Example

S = 1.100 USD/EUR rUSD = 4%, rEUR = 1%, calculate Forward rate

1.100/(1.04/1.01) = 1.133 USD/EUR

38
Q

Active Trading Actions

Currency

Volatility

Market Conditions

A

Expectation Action

Relative Currency App Reduce hedge or go long
Dep Increase hedge / decrease long

Volatility Rising Long straddle, long strangle (OOM)
Falling Short straddle, short strangle (OOM)

Market conditions Stable Carry trade
Crisis Stop carry trade

39
Q

Why use forward (as opposed to futures) contracts for hedging?

A
  1. Customizable
  2. Can be used for all currencies
  3. Does not require margin
  4. Better liquidity
40
Q

Static vs Dynamic Hedging

A
  • *Static:** buying a hedge and leaving alone
  • *Dynamic:** buying a hedge and adjusting during duration

Approaches for a 3 month hedge

  1. Buy one month hedge 3 times
    1. creates interim cash needs
  2. Buy 3 month hedge and offset each month with a new hedge
    1. more accurate BUT costs more
  3. Buy 3 month hedge and leave alone
41
Q

Hedged vs Unhedged Formula

A

Forward Premium/Discount

(Forward / Spot) - 1

Spot Appreciate/Depreciate

(Forecast / Spot) - 1

Example:

Spot Forward Forecast Spot Prem/Dis Spot app/depr

BRL/AUD 2.1046 2.1523 2.0355 2.27% -3.28%

BRL/CHF 2.5309 2.4641 2.5642 -2.64% 1.32%

You would over-hedge (hedge ratio > 1) AUD
Not hedge CHF (hedge ratio < 1)

42
Q

What is Roll Yield?

How does it affect the hedge?

A

Return on the movement of the forward price towards the spot price

Hedge Price Curve Upward Price Curve Downward

Long Negative roll yield Positive roll yield

Short Positive roll yield Negative roll yield

Negative RY = higher costs, discourages hedging
Positive RY = lower costs, encourges hedging

43
Q

Using Cap weighting Pros/Cons

A

Pros

  • Based on objective measure
  • Macro consistent
  • Does not require rebalancings for splits/dividends

Cons

  • Exposed to market bubbles
  • Lead to overconcentration
44
Q

Using Price Weighting Pros/Cons

A

Pros

  • Easy
  • Lots of price history

Cons

  • Not tied to economics of company
  • Splits can impact a security
  • Does not relfect portfolio construction
45
Q

Daily VaR Formula

A

(Rannual/days) - stdfrom the mean * (stdannual / √days)

46
Q

Leverage and Std Using Corner Portfolios

A

Tangency = Highest sharpe portfolio

Std would be lowest on the levered portfolio

CFA Level III (13 decks)

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