Case Studies Flashcards
Discuss tools for managing portfolio liquidity risk.
Four key methods to manage liquidity risk include (1) liquidity profiling and time-to-cash tables, (2) rebalancing and commitments, (3) stress testing, and (4) derivatives.
A liquidity classification schedule (time-to-cash table) has three distinct components: (1) amount of time needed to convert assets to cash, (2) liquidity classification level, and (3) liquidity budget.
To maintain the overall risk profile within a desired (quantitative) range, both systematic rebalancing policies and automatic adjustment mechanisms are used.
A multiyear funding strategy tries to determine the right level of annual commitments (investments) from the portfolio to arrive at a long-term optimal exposure to the asset class. Over time, the level of annual commitments will need to be adjusted as needed.
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.
Derivatives require far less cash than investing in underlying assets, which makes derivatives an ideal method of rebalancing (e.g., by their nature, derivatives have significant leverage possibilities).
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.
illiquidity premium (%) = expected return on illiquid asset (%) – expected return on marketable asset (%)
In practice, the illiquidity premium is challenging to accurately determine given all the other factors that interact in determining equity returns.
Analyze asset allocation and portfolio construction in relation to liquidity needs and risk and return requirements and recommend actions to address identified needs.
With some research, it was determined that the primary reasons for the QU 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 QU’s need for cash flows from the endowment. There should be cash flow modeling over several time horizons and under normal and stressed market conditions. Liquidity may deteriorate significantly during a stressed market condition.
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.
Private equity investments are not valued as frequently as public equity. The resulting lagged valuations mean there is a relative increase as a percentage of the portfolio and a relative decrease in liquid assets as a percentage of the portfolio during stressed market conditions.
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. Derivatives are both cash efficient and quite liquid, so their role is threefold: (1) rebalancing, (2) changes in TAA, and (3) meeting short-term liquidity requirements.
Rebalancing with derivatives is most likely to be implemented more quickly, and with no impact on the active managers. That is on the assumption of reasonably high levels of liquidity in the equity futures market, for example.
If the rebalancing transaction is larger, then the transaction is likely to be more permanent or long term in nature. That makes rebalancing with cash more desirable despite the associated cash drag.
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.
Risk exposures during the early career stage:
A family in the early career stage will have few financial assets, and 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.
Managing risk exposures during the early career stage:
Earnings risk: A family should accumulate a savings reserve to protect against unemployment, as well as take out disability insurance.
Premature death risk: A family should 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.
Risk exposures during the career development stage:
Earnings risk: There is a risk of earnings loss from unemployment and disability. Risk increases with rising income, as well as if there is an increase in the number of dependents.
Premature death risk: Early passing can set surviving family members back in lifestyle, plus there may be an additional decrease in income if the surviving spouse becomes the primary caregiver for children.
Investment portfolio: Even if the family has built up investment savings, 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.
Managing risk exposures during the career development stage:
Earnings risk: To protect against unemployment, three to six months of expenses should be accumulated. To protect against disability, disability insurance should be purchased (and updated to reflect revised salary projections).
Premature death risk: Families should purchase and/or update their life insurance policy to reflect expenses and salary projections.
Investment portfolio: This should be 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.
Risk exposures during the peak accumulation stage:
Earnings risk: There is a risk of earnings loss from unemployment and disability. Risk increases with rising income, as well as if there is an increased number of dependents.
Premature death risk: Premature death can set surviving family members back in lifestyle. Employment income may be impacted if the spouse takes on additional childcare duties.
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.
Managing risk exposures during the peak accumulation stage:
Earnings risk: As a hedge against unemployment, three to six months of expenses should be built up. To 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 because the time horizon has been shortened.
Investment portfolio: This should be 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.
Identify and analyze a family’s risk exposures during the early retirement stage.
Risk exposures during the early retirement stage:
Retirement income: The retiree is no longer contributing to a retirement account, so income is known. The family must be able to match expenses with a reasonable income objective.
Investment portfolio: The investment portfolio may not match family goals for this life stage.
Recommend and justify a plan to manage risks to an individual’s retirement lifestyle goals.
Managing risks to an individual’s retirement lifestyle goals:
Retirement income: The family should consider purchasing annuities and/or taking lump sum distributions from pension plans (if applicable) to maximize potential income and tax benefit.
Investment portfolio: The investment portfolio should be allocated to match objectives and the time horizons of those objectives.
Discuss financial risks associated with the portfolio strategy of an institutional investor.
Focus on events that could prevent an organization from meeting its long-term objectives.
Financial risks: (1) market losses, (2) liquidity risk.
Nonfinancial risks: (1) reputational risk, (2) operational risks, (3) environmental, social, and governance risks.
Dimensions of risk: top-down and bottom-up analysis, returns-based and holdings-based, absolute and relative risks, long-term and short-term risk metrics, quantitative and qualitative techniques.
Liquidity risks: define needs and sources for liquidity, in normal and crisis conditions.
Illiquid assets: private equity, real estate, infrastructure
Appraisal valuations result in smoothed returns and volatility.
