Case Studies Flashcards
What are the 4 methods for managing portfolio liquidity risk?
- liquidity profiling and time-to-cash tables
- rebalancing and commitments
- stress testing
- derivatives
A liquidity classification schedule (time-to-cash table) has what 3-distinct components:
- amount of time needed to convert assets to cash
- liquidity classification level
- liquidity budget
How to maintain the overall risk profile within a desired (quantitative) range?
Both are used
* systematic rebalancing policies
* automatic adjustment mechanisms
What is Stress testing and how is it used?
Stress testing: explicitly considers how the liquidity needs of a portfolio will change during a period of market stress.
The idea is to conduct analysis to assume “worst case” or very extreme market conditions and the impact on both assets and liabilities at the same time.
Discuss capture of the illiquidity premium as an investment objective.
The illiquidity (or liquidity) premium: refers to the additional return (over the market return) for taking on the risk of holding up capital for an unknown amount of time. Studies have shown that the illiquidity premium increases with the amount of time.
Analyze asset allocation and portfolio construction in relation to liquidity needs and risk and return requirements and recommend actions to address identified needs.
Endowment’s underperformance relative to its peers was the lower amount of risk taken and the lower allocation to illiquid investments, especially private equity.
Managing liquidity: is paramount for the endowment given the need for cash flows from the endowment. There should be cash flow modeling over several time horizons and under normal and stressed market conditions.
For private equity: capital calls are greater than capital distributions, resulting in a greater concentration of private equity in the portfolio.
Certain investments made by the portfolio may restrict investors from withdrawing their funds during stressed market conditions, which decreases the portfolio’s overall liquidity.
Analyze actions in asset manager selection with respect to the Code of Ethics and Standards of Professional Conduct.
Potential violations of the Code and Standards with respect to the process of asset manager selection include:
* Standard I(B): Independence and Objectivity.
* Standard I(C): Misrepresentation.
* Standard III(D): Performance Presentation.
* Standard III(E): Preservation of Confidentiality.
* Standard IV(A): Loyalty.
* Standard V(A): Diligence and Reasonable Basis.
* Standard VI(A): Disclosure of Conflicts.
Analyze the costs and benefits of derivatives versus cash market techniques for establishing or modifying asset class or risk exposures.
Because changes in the market will often result in asset allocation drifts, the endowment portfolio will need to be periodically rebalanced.
Rebalancing with derivatives: is most likely to be implemented more quickly, and with no impact on the active managers.
1. both cash efficient and quite liquid
2. rebalancing
3. changes in TAA
4. meeting short-term liquidity requirements
Rebalancing with cash: If the rebalancing transaction is larger, then the transaction is likely to be more permanent or long term in nature.
Demonstrate the use of derivatives overlays in tactical asset allocation and rebalancing.
Derivatives overlays: would allow the endowment to periodically rebalance exposures to asset classes without impacting the existing allocations to external active managers.
That makes overlays more desirable for making smaller, short-term adjustments that could easily be reversed later.
Identify and analyze a family’s risk exposures during the early career stage.
A family will have:
* few financial assets
* economic assets will be primarily human capital
Earnings risk: There is a risk of earnings loss from unemployment and/or disability.
Premature death risk: Spouses and children need protection against an untimely death of a spouse and the subsequent loss of income.
Recommend and justify methods to manage a family’s risk exposures during the early career stage.
Earnings risk: Accumulate a savings reserve to protect against unemployment, as well as take out disability insurance.
Premature death risk: Purchase life insurance. The amount can be determined using the human life value and/or needs analysis methods.
Identify and analyze a family’s risk exposures during the career development stage.
Earnings risk: Earnings loss from unemployment and disability. Risk increases with rising income, and the number of dependents.
Premature death risk: Early passing can set surviving family members back in lifestyle.
Investment portfolio: The portfolio may not be properly diversified or may be too correlated to human capital.
Retirement goals: Retirement income objectives must be met.
Recommend and justify methods to manage a family’s risk exposures during the career development stage.
Earnings risk:
* To protect against unemployment, 3-6 months of expenses should be accumulated.
* To protect against disability, disability insurance should be purchased.
Premature death risk: Purchase and/or update their life insurance policy to reflect expenses and salary projections.
Investment portfolio: Properly allocated and diversified against human capital.
Retirement goals: Proper savings goals should be developed. Asset allocation in retirement and savings accounts should match the objectives of these goals.
Identify and analyze a family’s risk exposures during the peak accumulation stage.
Earnings risk: Earnings loss from unemployment and disability. Risk increases with rising income, and the number of dependents.
Premature death risk: Premature death can set surviving family members back in lifestyle.
Investment portfolio: Investment portfolios may not be appropriately allocated for current life stage and/or for the objectives to be met in retirement.
Retirement goals: Income objectives in retirement should be identified.
Recommend and justify methods to manage a family’s risk exposures during the peak accumulation stage.
Earnings risk:
* Hedge against unemployment, 3-6 months of expenses should be built up.
* Protect against disability, disability insurance should be purchased and/or updated to reflect updated salary projections.
* It may be appropriate to decrease insurance coverage at this stage to reflect the shortened time horizon.
Premature death risk: Life insurance should be updated. It is likely that the appropriate amount of insurance will decrease.
Investment portfolio: Reallocated and rebalanced to reflect shortened time to retirement. It may be appropriate to reallocate to a balanced fund.
Retirement goals: Savings goals and asset allocation recommendations should reflect income objectives in retirement.
