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CFA Book 3 Flashcards

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1
Q
A
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2
Q

Bond management | active vs passive

A
  • passive: manager agrees with mkt >> mimics mkt
  • active: manager does not completely agree with mkt >> invests diff from mkt index >> alpha
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3
Q

Bond management | managing against liabilities

A

ALM with math

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4
Q

Bond management | 3 things change as go from passive to active

A
  1. active management increases
  2. expected return increases
  3. tracking error increases
    ◎ portfolio - index return = alpha
    ◎ std dev of alpha = tracking error
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5
Q

Bond management | 5 degrees of management activity

A
  1. pure bond indexing (least)
  2. enhanced indexing by matching primary risk factors
  3. enhanced indexing by small risk factor mismatches
  4. active management by larger risk factor mismatches
  5. full-blown active management
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6
Q

Bond management | pure bond indexing

A
  • mirror specific securities and weights
  • expensive to implement >> lower return than index and rarely implemented
  • low fees, risk, tracking error
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7
Q

Bond management | enhanced indexing by matching primary risk factors

A
  • sample of index (fewer securities) to mirror index’s primary risk factors
  • lower transaction costs to implement, but high corr to index returns >> beats pure bond index strat, but still often less than index
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8
Q

Bond management | enhanced indexing by small risk factor mismatches

A
  • beginning of active management; reduced manager restrictions
  • mirror exposure to large risk factors; same duration as index
  • deviate on small risk factors >> increase return >> cover admin costs
  • eg. of mismatch: relative value strat
  • goal: slightly beat index
  • increased risk, tracking error (volatility), management fees
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9
Q

Bond management | active management by larger risk factor mismatches

A
  • increase mismatches more than in the previous level (diff duration vs index) >> higher return >> cover admin and increased transaction costs
  • reduced manager restrictions
  • eg. mismatch: alter duration of portfolio vs index
  • increased risk, tracking error (volatility), management fees
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10
Q

Bond management | full-blown active management

A
  • no restrictions, very aggressive
  • tilting/mismatching (risk factors), duration, relative value
  • increased risk, tracking error (volatility), management fees
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11
Q

Bond management | 4 criteria for portfolio vs benchmark

A
  1. mkt value risk
    ◎ low risk = short duration
  2. income risk
    ◎ low risk = long duration
  3. credit risk
    ◎ portfolio should equal benchmark risk
  4. liability framework risk
    ◎ managing against liabilities
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12
Q

Bond management | portfolio or index risk profile

A
  1. duration
  2. key rate durations
  3. duration contributions
  4. spread durations
  5. sector weights
  6. cash flow distributions
  7. diversification
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13
Q

Bond management | stratified sampling

A

• goal: mirror index risk/return with fewer securities
• process:
◎ create matrix of risk factors
◎ calc weight of each cell in matrix
◎ mirror risk factors and weights of index
• does NOT need to be same securities as in index, just same risk factor exposure

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14
Q

Bond management | risk profile: duration

A
  • aka effective duration, option adjusted or adjusted duration
  • measures change in bond value given small parallel shift in interest rates
  • duration is tangent >> underestimate increases/overestimate decreases >> add convexity component
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15
Q

Bond management | risk profile: key duration

A

• measures bond value given ‘twists’ in yield curve

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16
Q

Bond management | risk profile: present value distribution of cash flows

A

• aka PVD
• all numbers are PV’d
• process:
◎ calc PV of all cash flows
◎ divide term into equal time periods
◎ find PV of each periods CF
◎ period CF PV / total CF PV = proportion of total duration attributable to that period
◎ duration contribution = period prop of duration * period duration (taken as end of period)
◎ duration contribution / total duration = piece of PVD
◎ aggregate of all pieces = PVD
• PVD shows how duration is distributed across its maturity
• mirroring PVD in a portfolio >> same sensitivities to interest rates changes as benchmark (both parallel and twists)

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17
Q

Bond management | risk profile: sector and quality percent

A

match sector weights and qualities of benchmark

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18
Q

Bond management | risk profile: sector duration contributions

A

match proportion of benchmark duration attributable to each sector

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19
Q

Bond management | risk profile: quality spread duration contribution

A

match proportion of benchmark duration attributable to each quality (ie credit ratings)

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20
Q

Bond managment | risk profile: sector, coupon, maturity cell weights

A

if callability is an issue, match sector, coupon, maturity of benchmark

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21
Q

Bond management | risk profile: issuer exposure

A
  • aka event exposure
  • diversify to reduce exposure to any one issuer
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22
Q

Bond managment | risk profile for MBS: 3 factors (???)

A
  1. sector
  2. prepayment
  3. convexity risk
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23
Q

Bond managment | non-MBS risk profile summary: issue, metric

A
  1. yld curve shift : duration
  2. yld curve twists : PVD, key rate duration
  3. spread changes : spread duration
  4. credit changes : duration contribution by credit rating
  5. call/put exposure : delta
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24
Q

Bond management | scenario analysis

A
  • poor man’s monte carlo
  • providing distribution of possibilities vs a single point estimate
  • three levers to change: bond price, coupons, interest on coupons
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25
Q

Bond management | two key factors in bond risk

A

duration and convexity

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26
Q

Bond immunization | goal

A

minimize interest rate risk:
◎ price (mkt value) risk
◎ reinvestment risk
• applied to a single or multiple liabilities

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27
Q

Bond immunization | classical immunization

A
  • price risk and reinvestment risk (neg corr) offset each other
  • process: set effective duration = liability horizon >> interest rate risk elminated (price risk offsets reinv risk)
  • immunized for instantaneous, small parallel shift in yld curve
  • often needs to be extended to be sufficient
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28
Q

Bond immunization | process

A
  1. select bond w/ effective duration = liability duration
  2. set bond PV = PV of liability >> DONE
    • unmatched duration:
    ◎ if bond duration < liablity duration >> reinv loss > price gain if rates go down
    ◎ if bond duration > liability duration >> price loss > reinv gain if rates rise
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29
Q

Bond immunization | duration changes over what two parameters

A
  1. time
  2. interest rates
    • unlikely bonds and liabilities change in identical ways >> periodic rebalancing of immunization
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30
Q

Bond immunization | bond characteristics to consider

A
  1. credit rating
    2 embedded options
  2. liquidity (neccesary for rebalancing)
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31
Q

Bond immunization | immunization risk

A
  • portfolio shortfall risk vs liability
  • corr with reinv risk (higher reinv risk >> higher immune risk)
  • zero coupon have zero immunization risk
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32
Q

Bond immunization | effective duration

A
  • %change in bond dollar value given 1% change in interest rates (100bp increase)
  • weighted avg (mkt val) of effective durations of bonds in portfolio
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33
Q

Bonds | duration contribution

A

contribution of bond (individual or by some grouping) to portfolio duration = wD
w = bond (mkt val) weight in portfolio = bond mkt val / portfolio mkt val
D = effective duration of bond
• sum of contributions = portfolio duration

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34
Q

Bonds | bond vs grouping of bonds when calcing duration

A

effective duration (weighted by mkt val), duration contribution (weighted by mkt val), dollar duration (not weighted, sum of each bond’s DD) can all be calced on an individual bond or a group of bonds

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35
Q

Bonds | dollar duration

A

DD = -1 * 0.01 * (modified or effective duration) * mkt val

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36
Q

Bonds | dollar duration: rebalancing

A

• process:
◎ calc new DD
◎ rebalancing ratio = DDold / DDnew
◎ (rebalancing ratio - 1) * new portfolio mkt value = new dollar val of bonds to be bot/sold (in same proportion as original portfolio)
• alt: buy/sell bond (the controlling position) with greatest duration >> lower dollar amount req to rebalance

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37
Q

Bonds | 3 type of spread duration

A
  1. nominal spread: %chg price / 100bp chg in nominal spread
  2. zero-volatility spread (aka static spread) = %chg price / 100bp chg zero-vol spread
  3. option adjusted spread (OAS) = %chg price / 100bp change in OAS
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38
Q

Bonds | sum of mkt val weighted sector spread durations =

A

portfolio spread duration

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39
Q

Bonds | spread duration measures

A

100bps parallel shift in spread over Treasuries
• spread measures risk aversion

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40
Q

Bond immunization | 4 immunization extensions

A
  1. multifunctional duration (aka key rate duration)
  2. multiple-liability immunization (multiple horizons)
  3. relaxation of min risk requirement (allow more risk >> higher returns)
  4. contingent immunization (mix of active and passive strats)
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41
Q

Bond immunization | contingent immunization: goal and process

A

• goal: return maximization
• process:
1. set safety net return
2. pursue higher returns with active management 3. if hit safety net return >> immunize to lock in safety net return
• must have procedures to monitor for safety net trigger

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42
Q

Bond immunization | contingent immunization: dollar safety margin

A
  • = Current mkt val - liability PV discounted at immunized rate (current obtainable rate)
  • current assets PV - liability PV
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43
Q

Bond immunization | contingent immunization: safety net trigger

A

If PV of asset CF < liability PV discounted at immunized rate (NEW current obtainable rate) >> safety net is triggered >> passive management

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44
Q

Bond immunization | contingnent immunization: what can go wrong

A
  1. mkt can move to fast and no chance to lock in immunization rate
  2. immunization rate might not be achieved once triggered (???)
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45
Q

Bond immunization | immunization risk: ALM related

A
  1. interest rate risk
    ◎ match duration and convexity
    ◎ neg convexity hard to match
  2. contingent claim risk (call, prepay)
  3. cap risk
    • convexity (non-linear chg) key issue
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46
Q

Bond immunization | minimizing reinvestment risk when managing to a liability

A
  • minimize distribution of cash flow around liability horizon
  • bullet strategy best, barbell worst
  • if maturity too early >> reinv risk; if too late >> interest rate risk (sensitive to int rate chgs)
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47
Q

Bond immunization | maturity variance

A
  • aka M^2
  • var of asset maturities around liability maturity date
  • lower >> better
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48
Q

Bond immunization | cash flows used for immunization that happen at liability maturity

A
  • treat as a zero coupon bond in the immunization portfolio
  • relates to expected cash flow that arrive around or at the time the liability matures/is due
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49
Q

Bond immunization | cash flow matching

A

• process:
◎ select bond that matures on last liability maturity date
◎ combine that bond’s extra cash flows with another bond to meet 2nd to last liability maturity
◎ and so on
• more costly than duration matching
• pros:
◎ reduces non-parallel shift risk
◎ no duration rebalancing necessary
• always have assets mature before liability
• all cash flows from bonds are included >> reinv risk is important

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50
Q

Bond immunization | duration vs cash flow matching

A
  • duration requires duration rebalancing; cash flow does not
  • cash flow reduces non-parallel yld curve movement risk
  • duration matching is easier and less expensive
  • zero-coupon bonds >> eliminate all immunization risk
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51
Q

Bond immunization | combination matching

A
  • aka horizon matching
  • combination of multiple liability matching (duration matching) and cash flow matching
  • usually entails matching cash flow for near term liabilities
  • cash flow matching reduces non-parallel yld curve movement risk and eliminates need to rebalance
  • more expensive than multi-liability matching
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52
Q

Bond relative value | bond relative value analysis

A

• relative value of bonds is compared across:
◎ sector
◎ issuer
◎ duration
◎ structure

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53
Q

Bond relative value | 2 general approaches to bond relative value

A
  1. top-down: macroeconomic
  2. bottom-up: specific undervalued issues
    • same as with equities
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54
Q

Bond relative value | classic relative value analysis

A
  • use both top-down and bottom-up
  • look at total return
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55
Q

Bonds | secular

A

a long term time frame (eg. 10 yrs)

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56
Q

Bonds | cyclical changes

A
  • chg in supply >> chg in demand
  • increase supply >>good credit signal to demand >> lower credit spreads & higher prices
  • reduced supply >> bad credit signal to demand >> higher credit spread & lower prices
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57
Q

Bonds | secular changes

A

• corp bond mkt is dominated by intermediate term, bullet structures
• high yld mkt dominated by callable issues
◎ this is expected to decline as credit quality improves >> easier credit
• 3 results:
◎ bonds with embedded options trade at premium due to scarcity
◎ longer durations trade at premium due to scarcity
◎ credit-based derivatives will increase in use for diversification and tailoring structure

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58
Q

Bonds | liquidity vs risk

A
  • greater liquidity >> lower risk premium
  • bonds becoming more liquid due to cheaper, faster transactions due to technology and other factors
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59
Q

Bonds | secondary market purpose

A
  1. yld spread/pickup trades: more yld given credit rating (ignores total return)
  2. credit upside trades: buy before credit upgrade
  3. credit defense trades: sell bonds in risk of downgrade
  4. new issues swap: swap into newer issues for liquidity
  5. sector rotation: move into outperforming sectors; out of underperforming
  6. yld curve adjustment: adjust portfolio given yld curve forecast
  7. structure trades: adjust portfolio given volatility and yld curve forecast
  8. cash flow reinvestment
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60
Q

Bonds | 3 yield spread measures

A
  1. nominal spread
    ◎ corp yld - govt yld of similar maturities
    ◎ basic unit of price and relative value analysis for global mkt
  2. swap spreads:rate paid by fixed-rate payer over on-the-run T’s with same maturity
    ◎ widely used in Europe for indication of credit spreads
  3. option adjust spread
    ◎ good for comparing corp vs MBS
    ◎ declining due to reduction in bonds w/ optionality
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61
Q

Bond relative value | 3 spread analysis methods

A
  1. spread mean reversion
    ◎ most common reason
  2. quality spread analysis: high credit quality spreads vs low credit quality spreads
  3. percentage yld spread analysis: corp yld / T ylds with simiar duration
    ◎ not commonly used
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62
Q

Bond relative value | bond structures: bullet

A

• short term: 1 - 5 yrs
• medium term: 5 - 12 yrs
◎ most common (esp in europe)
• long term: 12 - 30 yrs

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63
Q

Bond relative value | bond structures: early retirement provision

A

• callable bonds:
◎ underperform with rates rise
◎ outperform when rates fall
• sinking funds
◎ portion of issue is retired on a schedule
◎ don’t fall as much when rates rise due to buy back provision
• putable bonds: few bonds have puts

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64
Q

Bond relative value | credit analysis factors

A
  1. corp: ability to pay
  2. ABS: collateral & servicer
  3. Municipal: ability to assess and collect taxes
  4. govt: ability (econ) and willingness (political) to pay
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65
Q

Bond relative value | methodolgies

A
  1. total return analysis
  2. primary mkt analysis (supply/demand effects)
  3. liquidity and trading analysis (liquidity effects)
  4. secondary trading rationales
  5. secondary trading constraints
  6. spread analysis (volatility effects; mean rev, quality spread, % yld)
  7. structural analysis (derivatives + macro econ)
  8. credit curve analysis (yld curve + macro econ)
  9. credit analysis (up/down grades)
  10. asset allocation / sector analysis (econ: sectors/firm performance)
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66
Q

Bond relative value | secondary trading constraints

A
  1. portfolio constraints
    ◎ quality
    ◎ structure
    ◎ foreign bonds
    ◎ floating rate for commercial banks
    ◎ high yld limit for insurance firms
    ◎ structure, quality for european investors
    cause of global bond mkt inefficiency
  2. ‘story’ disagreement: buy/sell side disagreement
  3. buy and hold
    ◎ desire not to recoganize loss
  4. seasonality
    ◎ trading slows at end of mon, qtr, yr due to paper work
    • cause of global bond mkt inefficiency
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67
Q

Leverage effect on p/l

A
  • magnifies outcome, good or bad
  • return generated on assets, but return rate is off of equity
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68
Q

Levered return calculation

A

Re = Ri + (D/E * (Ri - Rd)
Re = return on equity
Ri = return on assets
D/E = debt/equity ratio
Rd = cost of debt
• as leverage OR investment return increase, return variability increases

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69
Q

Levered duration calculation

A 
De = (Di \* I - Db \* B) / E 
De = equity duration 
Di = asset duration 
Db = borrowed funds duration 
I = assets 
B = debt 
E = equity
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70
Q

repurchase agreement

A

• repo agreement: collateralized loan
• repo rate = loan rate
• process:
◎ A sells B a security with a promise to repurchase with a specified date and price
◎ A buys the security back from B
◎ diff in price is the cost of borrowing (at the repo rate)
• 360 days/yr

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71
Q

repo agreement | 4 collateral delivery methods

A
  1. none: small credit risk or short loan period
  2. physical delivery (most expensive)
  3. custodial acct at borrower’s clearing firm
  4. electronic bank transfer (expensive)
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72
Q

repo agreement | factors affecting repo rate

A
  1. credit risk & delivery
    ◎ high credit risk & no delivery >> high repo rate
  2. quality of collateral
  3. repo term: longer >> higher repo rate
  4. collateral scarcity: if scarce and lender needs it >> lower repo rate
  5. seasonal factors
    • fed funds rate (bank to bank) is repo rate benchmark
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73
Q

seasonal factors

A

not Christmas, but end of period (mon, qtr, yr) where trading slows due to paper work

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74
Q

bonds | risk measures: standard deviation: cons

A
  1. bond returns often not norm dist
  2. many inputs into calc: N * (N + 1) / 2, N = # bonds
  3. estimates for inputs is hard
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75
Q

bonds | risk measures: semi-variance

A

• only measures variance below the mean
• cons:
◎ computation is hard
◎ if returns symmetric >> same as var, but var is better understood
◎ if returns not symmetric, semi-var may not be the best
◎ estimated with 1/2 the dist >> smaller sample >> less statistifcally accurate

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76
Q

bonds | risk measures: shortfall risk

A
  • prob return will be below target
  • cons: no info as to size of shortfall
  • similar to VAR
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77
Q

bonds | risk measures: value at risk (VAR)

A
  • prob, given a period of time, return will be less than target
  • con: no info as to size magnitude of shortfall
  • similar to shortfall
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78
Q

bonds | futures contracts

A
  • adjust portfolio without as big capital outlay • contracts not securities
  • 30 days - 30 years
  • react the same as bonds, but exactly the same
  • exchange: CBOT
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79
Q

bonds | futures contracts: cheapest to deliver bond

A
  • CTD
  • exchange allows short position to deliver various bonds to fulfill contract
  • options: quality or swap, timing, wild card
  • use conversion factor (from exchange) to calc correct price for bonds delivered
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80
Q

bonds | 3 advantages of futures contracts

A
  1. more liquid
  2. less expensive
  3. easier to short
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81
Q

bonds | futures contracts: duration

A
  • same as bonds
  • buy futures >> increase duration
  • sell futures >> decrease duration
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82
Q

bonds | duration vs dollar duration

A

dollar duration = duration * 0.01 * mkt value

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83
Q

bonds | futures contracts: hedging bonds

A

DDt = DDp + DDfut
DDt = total DD
DDp = portfolio DD
DDf = futures DD
• if DDfut > 0, then but futures; if

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84
Q

bonds | futures contracts: calcing # of futures to buy/sell

A

• # contracts = (DDt - DDp) / DDf
DDt = total DD
DDp = portfolio DD, DDf = ONE futures DD
• OR # contracts = (Dt - Dp) * Pp * CTD conversion factor / (Dctd * Pctd)
D = duration
P = price

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85
Q

trade horizon date

A

date when the trade is complete, taken off, matures, etc

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86
Q

bonds | futures contracts: basis risk

A
  • risk the price basis will not be the same at the horizon date
  • price basis = spot price - futures delivery price
  • risk of using futures rather than identical bonds; more risky with ‘cross hedge’
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87
Q

cross hedge

A
  • using one security to hedge a different security
  • if derivatives: using a diff underlying than the asset to be hedged
88
Q

bonds | futures contracts: hedge ratio

A
  • hedge ratio = bond exposure to risk factor / futures exposure to risk factor
  • OR = (bond exposure to risk factor / CTD exposure to risk factor) * (CTD exposure to risk factor / futures exposure to risk factor)
  • when risk is interest rates: = Dp * Pp * CTD conversion factor * yld beta / (Dctd * Pctd)
  • hedge ratio and # contracts for when hedge is finished (lifted)
89
Q

exam note: CTD is a bond. It is the cheapest to deliver bond

A
90
Q

bonds | futures contracts: yield beta

A

• when cross hedging
• bond yld = a + b(CTD yld)
b = yld beta
• needed because change in spreads will not be identical (if they are then yld beta = 1)
• if b > 1, then # contracts > than if b = 1, and vice versa

91
Q

bonds | futures contracts: 3 hedging errors

A
  1. forecast of basis when hedge is lifted
  2. estimated duration
  3. estimated yld beta
92
Q

swaps | interest rate swaps

A
  • contract
  • one party pays floating, receives fixed; other party pays fixed, receives floating
93
Q

swaps | interest rate swaps and duration

A
  • fixed receiver increases duration (pos duration)
  • fixed payer decreases duration (neg duration)
  • floating sides don’t have much duration because bond value is continually reset
94
Q

options | interest rate options

A
  • options on interest rate futures (to go long or short the futures)
  • call protects existing lenders and future borrowers from an increase in interest rates
  • put protects existing borrowers and future lenders from a decrease in interest rates
  • collars are sometimes used
95
Q

options | bond options

A
  • options on bond futures
  • call protects existing bond issuers
  • put protects existing bond owners
  • collars are sometimes used
96
Q

options | interest rate caps and floors

A
  • same as call (caps) and puts (floors)
  • caps are for future borrowers (and existing lenders)
  • floors are for future lenders (and existing borrowers)
  • eg. caps: future ST bank borrowings; floors: future insurance lending
  • collars are sometimes used
97
Q

options | duration

A

3 factors
◎ underlying contract
◎ option delta
◎ leverage
• out-of-money options have more leverage, smaller delta
• duration and delta have same sign (pos call; neg put)

98
Q

existing lenders/future borrowers vs existing borrowers/future lenders

A
  • existing lenders and future borrowers have same risk: higher interest rates
  • existing borrowers and future lenders have same risk: lower interest rates
99
Q

Bonds | 3 Credit risks addressed by credit derivatives

A
  1. Default risk (only one actually based on firm’s actions)
  2. Credit spread risk
  3. Downgrade risk
100
Q

Bonds | 3 types of credit derivatives

A

1 credit options
◎ binary credit option = based on underlying’s price
◎ credit spread option = based on underlyng’s yld spread
2. credit forwards
3. credit swaps

101
Q

Bonds | credit derivatives: binary credit option

A

• trigger both must happen
◎ defined event
◎ option is in-the-money
• upon exercise:
◎ long gives short the bonds
◎ short pays long the strike price

102
Q

Bonds | credit derivatives: credit spread options

A
  • trigger (‘credit event’): asset’s spread (asset’s yld - benchmark yld) > option spread strike
  • upon exercise: payoff = max[(spread - strike) * notional * risk factor, 0]
  • inputs: strike, risk factor, notional
  • both calls and puts available
103
Q

Bonds | credit derivatives: credit forwards

A

• payoff = (spread at maturity - contract spread) * notional * risk factor

104
Q

options & futures

A

options are similar to futures, except one side has the obligation (as in a future), but the other side has the choice (not like a future)
• could be called half of a future

105
Q

bonds | credit derivatives: credit (default) swaps

A

• insurance on a bond
• specified credit events >> insurance trigger
• 2 types of payoffs:
◎ cash = par - bond value; long side keeps the bonds
◎ physical delivery = short pays par to long; long delivers bonds to short

106
Q

bonds | 6 areas of international bond excess returns

A
  1. market selection (best nat’l mkts)
  2. currency selection
  3. duration management
  4. sector selection
  5. credit analysis (of individual securities)
  6. mkts outside benchmark
    ◎ usually int’l is govt debt; adding int’l corp can increase returns
107
Q

bonds | foreign yld as a function of domestic yld

A

chg foreign yld = b * chg domestic yld

108
Q

bonds | foreign bond price change as a function of domestic yld

A

%chg foreign bond price = foreign bond duration * chg yld * b
b = yield beta (country beta)

109
Q

bonds | foreign bond’s ‘domestic’ duration

A

= duration * yld beta

110
Q

bonds | foreign bond’s ‘domestic’ duration contribution

A

= duration * yld beta * mkt val weight in portfolio

111
Q

currency | interest rate parity

A

F = So * (1 + Cd) / (1 + Cf)
F = forward fx rate
So = current fx rate
C = short term rate
• if foreign currency appreciates >> premium; depreciates >> discount

112
Q

currency | interest rate parity: premium/discount

A

prem/discount = (F - So) / So =~ Cd - Cf
F = forward fx rate
So = current fx rate
C = short term rate
• aka forward currency differential

113
Q

currency | covered interest arbitrage

A

• given fx spot and fx forward contracts, interest rate parity must hold otherwise there are arb opportunities

114
Q

currency | covered interest differential

A

• is there arb opportunity?
• = (1 + Cd) - (1 + Cf) * (F / So)
F = forward fx rate
So = current fx rate
C = short term rate
• >0 >> forward rate too high >> buy domestic, buy foreign thru spot, lend foreign, sell foreign thru forward; < 0 vice versa

115
Q

currency | 3 currency hedges on a foreign investment

A
  1. forward hedge: sell the foreign currency forward
  2. proxy hedge: when foreign currency is hard/expensive to hedge, use third currency corr to foreign currency
  3. cross hedge: sell foreign currency forward into a third currency >> change risk to third currency; not a hedge
116
Q

bond | return on foreign bond with forward hedge

A

Rd =~ Rf + Rc =~ Id + (Rf - If)
Rc = exp currency return (ie forward prem/discount)
Id = dom risk free rate
If = foreign risk free rate
• choose foreign bonds with greatest excess return

117
Q

currency | foreign investments and hedging

A
  • if mkt overestimates foreign currency appreciation (but actually appreciates less) >> hedge (sell foreign currency forward) to take advantage of over estimation
  • if underestimates >> no hedge
118
Q

bonds | breakeven spread analysis

A

• determine how much spread between two bonds must widen before returns are equal
• must 1) be over a specific period 2) use the bond with the higher duration
• yld chg = price chg / - duration
• proces:
◎ calc necessary price change to make returns equal
◎ calc yld chg that leads to the price change (rem: de-annualize)

119
Q

bonds | core-plus approach

A
  • manager holds ‘core’ of investment grade debt
  • outside of core, invests in higher return/higher risk debt, such as emerging mkt debt (EMD)
120
Q

bonds | advantages of emerging mkt debt

A
  1. diversification benefit
  2. increased quality of sovereign EMD
  3. sovereign EMD often able to reduce impact from negative events
  4. resilient
  5. undiversified index, such as EMBI+, offers higher returns
121
Q

bonds | risks of emerging mkt debt

A
  1. corp EMD does not have ability to reduce impact like sovereigns
  2. high volatility
  3. negative skew
  4. lack of transparency
  5. lack of strong legal system and protection from govt
  6. lack of standard covenants
  7. political risk (geopolitical risk): instability, taxation, fx restrictions, bankruptcy frequency, fx manipulation (pegging) 8. lack of diversification with EMBI+ index
122
Q

bonds | selecting a fixed income manager

A
  1. style analysis
  2. selection bets (credit spread analysis, relative value)
  3. investment process
  4. alpha corr (need diversification)
123
Q

bonds | MBS traits

A
  • MBS structured as an annuity with identical payments over its life
  • due to even payments (no bullet payment), MBS is affected more by rates across the yld curve (eg. twists), not just at the end
  • MBS has prepayment (call)
  • due to even annuity structure and prepayment, cash flow is weighted on the front end than bullet bonds
124
Q

bonds | MBS risks

A
  1. spread risk
  2. interest rate risk
  3. prepayment risk
  4. volatility risk
  5. model risk
125
Q

bonds | MBS risks: spread risk

A
  • risk: spread between MBS and benchmark widens
  • often not hedged
  • avoid by only buying when spread is attractive
126
Q

bonds | MBS risks: interest rate risk

A

• risk: interest rates rise
• hedge:
◎ duration hedge (simple)
◎ 2-bond hedge (better)
• 2-bond hedge does not address prepay (neg convexity issue)

127
Q

bonds | MBS risks: prepayment risk

A

• risk: prepayment (call)
• hedge:
◎ options: buy calls and puts (why not just calls???)
◎ dynamic hedging (neg gamma): buy/sell futures to adjust short futures duration hedge
◎ 2-bond hedge does not help

128
Q

bonds | MBS risks: volatility risk

A

• risk: volatility increases >> increasing short call value
• hedge:
◎ if implied option vol in mkt < estimated vol >> buy options
◎ if implied option vol in mkt > estiimated vol >> dynamic hedge

129
Q

bonds | MBS risks: model risk

A

• risk:
◎ incorrectly assuming past interest rate behavior predicts future
◎ ignoring technology and other changes
• cannot be hedged; manager must pay close attention; MBS is complex

130
Q

bonds | key rate duration

A
  • measure the sensitivity of the portfolio to a inidividual changes in a set of key rates along the yld curve (often 11)
  • sum(key rate durations) = effective duration
131
Q

bonds | MBS: principal only and interest only bonds

A
  • aka PO and IO
  • PO has negative duration short and intermediate term (to 10 yrs) and positive duration after #IO is reverse; positive duration early on, then negative
132
Q

bonds | MBS: 2-bond hedge assumptions

A

the portfolio manager:

  1. incorporations reasonable yld curve shifts
  2. adequate prepayment model
  3. reasonable assumptions in Monte Carlo model
  4. knows security’s price chg given small yld chg
  5. knows avg price chg method >> good approximations
133
Q

bonds | MBS: 2-bond hedge process

A

Given:
1. MS (MBS security), H1 (hedge 1 security), H2 (hedge 2 security)
2. Pms (MBS pricce), Ph1 (hedge 1 price), Ph2 (hedge 2 price)
Steps:
1. calc avg absolute price chg per $100 for all 3 securities given parallel shift in yld curve
2. calc avg absolute price chg for all 3 securities give twist of yld curve
3. simultaneously solve for
◎ given shift: H1 * chgPh1 + H2 * chgPh2 = - chgPms
◎ given twist: H1 * chgPh1 + H2 * chgPh2 = - chgPms
◎ essentially H1 * chgPh1 + H2 * chgPh2 + chgPms = 0 for both equations
◎ simultaneously solve by subtracting one equation from the other where one of the H terms is subtracted out

134
Q

bonds | MBS: negative convexity signal

A

if increase in value with drop in rates < drop in value with equal increase in rates >> negative convexity

135
Q

bonds | MBS: 2-bond hedge traits

A
  • goal: better hedge the cash flows of MBS; single bond is better for bullet bonds, not MBS
  • uses 2 bonds to hedge the MBS
  • often with shorter durations (eg. 2, 10 yr) to match front loaded cash flow of MBS
  • hedge does NOT address negative convexity from prepay; use options and dynamic hedging for that
136
Q

bonds | MBS: cuspy coupon bond

A
  • coupon just above current ylds
  • in danger of prepay if rates fall
  • often attractive OAS
137
Q

exam note: bonds | adjustable rate MBS have caps on interest rates

A
138
Q

equities | US equity mkt cap / world equity market cap

A

0.5

139
Q

equities | are equities an inflation hedge

A

yes - especially equities that can pass on inflation to customers (less competitive industries)

140
Q

equities | passive, active, semi-active strategies

A
  • passive: indexing, meet benchmark, lower exp return and tracking risk, no forecasts
  • active: outperform benchmark, higher exp return and tracking risk, majority of managers opt for this strategy
  • semi-active: inbetween passive and active
141
Q

equities | active return and tracking risk

A
  • active return = portfolio return - benchmark return
  • tracking risk = std dev of active return
  • information ratio = active return / tracking risk
142
Q

equities | information ratio

A
  • risk / return metric for managers
  • =active return / tracking risk (aka tracking error)
143
Q

equities | optimal policy for taxable investments: passive or active

A

passive: less portfolio turnover

144
Q

equities | passive vs active performance

A

• active underperforms passive by about the extra expense >> sans expenses, active = passive performance

145
Q

equities | index weighting methods

A
  1. price: artimetic avg of prices
    ◎ sum(prices) / # stocks
    ◎ hold one share of each stock
  2. mkt cap (aka value)
    ◎ sum (mkt caps)
    ◎ hold each stock in proportion to mkt cap
  3. free float adjusted mkt cap: same as mkt cap, but mkt cap is calced from free float
    ◎ best metric; most major indices are free float
  4. equally: each stock given indentical weight
    ◎ hold same dollar value in each stock
146
Q

equities | index weighting methods: price weight bias

A
  • stock price relative to other stock prices is not indicative of relative value or performance
  • higher priced stocks impact vs lower priced
  • stock impact changes as price changes
  • unrealistically assumes investor holds equal shares of each stock
147
Q

equities | index weighting methods: mkt cap and free float weight bias

A
  • higher mkt cap firms have larger impact
  • larger firms may be mature and/or overvalued
  • too little diversification if dominated by large firms
  • institutional investors may not be able to mirror due to max holding restrictions
148
Q

equities | index weighting methods: equal weight bias

A
  • small caps have same weight as large caps
  • often index has many small camps, compounding small cap issue
  • high rebalancing costs
  • small cap liquidity issues
149
Q

equities | eg. of indices and their weighting methods

A

price: DJIA, Nikkei
value: SP, Russell, MSCI, CAC40, DAX30 equal: Value Line Composite Avg

150
Q

equities | index reconstitution

A

rebalancing an index

151
Q

equities | Index mutual fund vs ETF: 5 differences

A
  1. trade frequency: mutual once per day; ETF like a stock
  2. recordkeeping for shareholders: mutual funds have to; ETFs do not
  3. license fees to index creator (eg. S&P): mutuals pay lower fees than ETFs
  4. tax efficiency: ETF more efficient due to fewer taxable events
  5. fees: ETF usually have lower fees
152
Q

equities | separate and pooled accounts

A
  • for indexed institutional portfolios
  • advantageous to small funds that cannot afford full time manager
  • fees can be as low as a few basis points
153
Q

equities | equity futures

A

• alternative to ETF
• popular due to ‘portfolio trades’ (aka basket or program trades)
• 2 cons relative to ETFs:
◎ finite life >> roll over >> fees and slippage
◎ basket trade + futures strat has basket shorting issue (uptick rule); ETFs do not

154
Q

equities | equity total return swap

A

swap return on a single stock or interest rate for return on an equity index

155
Q

equities | indexing a portfolio: 3 methods

A
  1. full replication
  2. stratified sampling
  3. optimization
156
Q

equities | indexing a portfolio: full replication

A
  • exactly mirroring stocks and weights
  • return = index return - mng fees, transaction fees, cash drag (cash kept for redemptions)
  • good method for few stock (< 1000), liquid stocks, large investment pool
  • pro: low tracking risk
  • con: expensive
157
Q

equities | indexing a portfolio: stratified sampling

A

• aka representative sampling
• good when index has many (>1000), illiquid stocks
• process:
◎ breakdown index by trait (eg. industry, PE, size)
◎ pick a representative stocks from each bucket
◎ purchase stocks so weight = bucket weight
• pros: fewer stocks to track
• cons: more tracking error

158
Q

equities | indexing a portfolio: optimization

A
  • good when index has many (>1000), illiquid stocks
  • factor model of factor exposures of index
  • pros vs stratifed sampling: less tracking error; takes factor corr into account
  • cons: based on historical data that may change; historical data may be flawed; frequent rebalancing due to changing risk sensitivities
  • optimization + partial replication (of largest stocks) has lower tracking risk
159
Q

equities | 3 + 1 equity styles

A
  1. value
  2. growth
  3. market oriented
    • also mkt cap (eg. micro, small, mid, large)
160
Q

equities | equity style: value

A

• focus on the numerator in P/E and P/B
• rationale:
◎ firm’s earnings are temporarily depressed
◎ growth style is too risky; P/E can contract
• 3 sub-groups: high dividend yld, low price multiple, contrarian

161
Q

equities | equity style: growth

A
  • focus on denominator in P/E
  • 2 sub-styles:consisten earnings growth, momentum (play)
162
Q

equities | equity style: market oriented

A
  • hard to define: broad mkt avg over time
  • sub-stylyes: value-tilt, growth-tilt, growth at reasonable price (GARP), style rotation
163
Q

equities | equity style: market cap

A
  • micro, small, mid, large
  • can be combined with value, growth, mkt oriented
164
Q

equities | equity style: returns based style analysis

A
  • determine mng’s style using their returns
  • mng’s returns (dep var) are regressed against various style indices (eg. large cap value)
  • ind vars: mutually exclusive, uncorr risk, comprehensive (cover all investments)
  • output is mng’s benchmark portfolio or ‘normal’ portfolio
  • Rsquared = proportion of mng’s returns explained by indices (style fit)
  • unexplained is ‘selection return’
  • pro: de facto analysis of mng’s style
165
Q

equities | 2 style analysis methods

A
  1. returns based
  2. Holdings based style analysis
166
Q

equities | equity style: holdings based style analysis

A
  • observe mng’s holdings to determine style
  • high earnings growth >> growth; high earnings volatility >> value
  • sectors also help identify (eg. tech >> growth)
167
Q

equities | equity style: comparing return and holdings based analysis

A
  • return pros: assesses entire portfolio, backed by theory, few inputs, robust across models, low cost
  • holdings pro: assesses each security, looks at current portfolio snapshot >> style drift detection
  • return cons: historical data >> miss style drift, mis-specified model
  • holdings cons: subjective analysis, diff from common mng stock selection, more data requited than returns based
168
Q

equities | equity style box

A
  • display portfolio style traits
  • 3 x 3 box; mkt size x style (value, core, growth)
169
Q

equities | style drift

A

manager strays from original, stated style

170
Q

equities | socially responsible investing

A
  • investing based on ‘ethics’
  • positive and negative screens (ie filters)
171
Q

equities | long vs long-short strategy

A
  • long-short is less restricted >> 2 alphas (long and short)
  • long only in ability to express negative sentiment (max is zero position in stock)
  • long-short can eliminate SYSTEMIC risk eith a ‘pairs trade’ in same industry to play relative value
  • long-short considered alternative investment, not equity strat
172
Q

equities | 4 reasons for short side price inefficiencies

A
  1. barriers to short selling
  2. firm’s promote their stock >> constant overvaluation
  3. sell recommendations have small audience and large counter-audience, so sell-side avoids making them
  4. pressure from companies (eg. investment banking business) on sell-side analysts
173
Q

equities | equitizing a long-short strategy

A

doing a long-short strategy and then buying futures or ETFs to go long the mkt (seems like two independent strategies)

174
Q

equities | short extension strategy

A
  • extension of long-only strats
  • eg. 120% long / 20% short
  • beta around 1.0 (as opposed to L-S strat of beta 0) >> considered equity strat (not alternative)
175
Q

equities | short extension pros and cons

A

pros:
◎ implement positive/negative sentiment better than long-only
◎ equity strat, not alternative
◎ can invest over 100% of funds
◎ no derivatives needed
◎ more efficient that 100/0 + 20/20 (long-only + long-short) bc/long only would include short stocks in long-short
cons:
◎ more than 100% >> more transaction fees
◎ mkt-neutral long-short portfolio (EMNLSP) has more ways to generate return

176
Q

equities | sell disciplines

A
  1. substitution (loss)
  2. opportunity cost (loss)
  3. deteriorating fundamentals (loss)
  4. valuation level (profit)
  5. down-from-cost (loss) 6. up-from-cost (profit) 7. target price (profit)
177
Q

equities | growth vs value turnover

A

growth: 60 - 200+%
value: 20 - 80%

178
Q

equities | enhanced indexing

A
  • aka semi-active
  • higher information ratio than passive or active
  • cons: copy-cats will elminate alpha, historic data may not reflect future
179
Q

equities | enhanced indexing: stock-based

A

over/under weight certain stocks; all other stocks same weight as index (in active, neutral stocks would not be held at all)

180
Q

equities | enhanced indexing: derivatives-based

A
  • equity exposure with derivatives
  • equitize cash: cash (in bonds) + equity futures; alter duration of cash position to generate alpha
181
Q

equities | fundamental law of active management

A

IR =~IC * sqrt(IB)
IR = information ratio
IC = information coefficient (depth of knowledge)
IB = breadth of knowledge = # of decisions (eg. invest in energy sector)
• this is an alternative way to calc IR (vs active return / tracking error)

182
Q

equities | picking managers: efficient frontier

A

instead of return by risk, it is active return by tracking error

183
Q

equities | picking managers: 3 hurdles

A
  1. must believe alpha is possible and that investor can pick successful manager
  2. if investor has a boss, boss will judge against passive benchmark >> safest path is passive
  3. less diversification with active
184
Q

equities | picking managers: active risk target

A

1.5 - 2.5%

185
Q

equities | strategies: core-satellitte approach

A
  • portfolio = indexed or enhanced index + satellite of active managers
  • indexed core mitigates risk of active management
186
Q

equities | calc active return and active risk

A
  • active return = sum(Wi * Ri), Wi = weight, Ri = return
  • active risk = sqrt(sum(Wi^2 * VARi)), Wi = weight, VARi = variance, assume 0 corr
187
Q

equities | completeness fund approach

A
  • active managment risk factors + completeness fund risk factors =~ index fund risk factors
  • completeness fund compliments the active portfolio by providing risk factors in benchmark, but not in active portfolio
  • cons: misfit risk
188
Q

equities | total active return

A
  • true active return = mng’s return - mng’s normal portfolio return
  • misfit active return = mng’s normal portfolio return - benchmark return
  • total active return = true active return + misfit return
  • total active risk = sqrt(true active risk ^ 2 * misfit active risk ^ 2)
189
Q

equities | true information ratio

A

= true active return / true active risk
• a third way to calc information ratio

190
Q

equities | alpha and beta separation approach

A
  • two distinct and separate strats (ETF and long-short)
  • eg. invest in S&P ETF for beta strat, employ mng for long-short alpha strat
  • portable alpha: can switch beta strat, but keep alpha strat untouched
  • cons: long-short strat not always mkt neutral
191
Q

equities | picking managers: 3 types of considerations

A
  1. qualitative: investment approach, research, personnel
  2. quantitative: performance, style, fees
  3. consistency of stated vs actual approach
192
Q

equities | picking managers: 5 part questionnaire

A
  1. staff and org structure
  2. investment philosophy and procedures: alpha strat, risk management, stock selection
  3. resources, research, quant models, trade execution
  4. performance
  5. fees
193
Q

equities | management fees

A
  1. ad valorem (aka AUM fees): known in advance, but not aligned interests
  2. performance based: volatile, but aligned interest; highwater marks and fee caps
  3. combo
194
Q

equities | research sources

A
  • buy-side: non-public, internal to a management company
  • sell-side: public (for fee), provided by investment banks
195
Q

corp gov & ethics | corp governance

A

designed to minimize ethics problems and address underlying business ethics problem, principal-agent relationship

196
Q

corp gov & ethics | stakeholders

A
  • groups with interest or claim in company
  • internal or external
  • make contributions to company >> company must consider their interests
197
Q

corp gov & ethics | internal stakeholders

A
  1. stockholders (risk capital / ROIC and growth): principal in principal-agent; information disadvantage
  2. employees (labor / wages)
  3. managers (run company / wages+): agent in principal-agent; information advantage
  4. board of directors (oversee mng’s / wages): also information advantage; can be too close to mng’s
198
Q

corp gov & ethics | external stakeholders

A
  1. customers (make purchases / products): stable relationship, lower prices
  2. suppliers (inputs / cash): stable relationship, higher prices
  3. creditors (debt / interest)
  4. unions (stability / higher wages): potentially disruptive and damaging to ST & LT company health
  5. gov’t (rules & regs / comliance): potentially disruptive
  6. local communities (infrastructure / good citizenship): potentially disruptive
  7. general public (infrastructure / higher quality of life): potentially disruptive
199
Q

corp gov & ethics | stakeholder impact analysis (SIA)

A

• goal: force company to make choices between stakeholders and ID which are most critical to company:
◎ ID relevant stakeholders
◎ ID critical interest of each group
◎ ID demands of each group
◎ prioritize stakeholders
◎ business strategy to meet critical demands

200
Q

corp gov & ethics | stakeholders: ROIC and growth

A

• the company should focus on return on invested capital (ROIC) and growth in order to increase the pie that is divided among many stakeholders

201
Q

corp gov & ethics | principal-agent relationship

A
  • principal delegates power to agent
  • PAR problems (PAP) often arise due to asymmetric information in favor of agents and agent’s self interest
  • in corporations, board of directors job is to oversee managers on behalf of stockholders; this often fails when BOD is co-opted by managers
202
Q

corp gov & ethics | controlling principal agent problems

A

• aka PAP
• 3 measures:
◎ set goals and principals of behavior
◎ reduce asymmetry of information
◎ remove agents who misbehave/violate ethics

203
Q

corp gov & ethics | unethical behavior

A
  1. self-dealing
  2. information manipulation
  3. anti-competitive behavior (even if legal)
  4. opportunistic behavior of suppliers
  5. substandard working conditions
  6. environmental degredation
  7. corruption
204
Q

corp gov & ethics | 5 roots of unethical behavior

A
  1. agents with flawed personal ethics
  2. failure to realize issue may lead to ethics violations
  3. too focused on profit and growth
  4. management sets unrealistic goals
  5. unethical leadership set unethical tone
205
Q

corp gov & ethics | ethics & noblesse oblige

A

concept that successful companies have obligation to give back to society

206
Q

corp gov & ethics | 5 business ethics philosophies

A
  1. Friedman doctrine
  2. Utilitarianism
  3. Kantian ethics
  4. Rights theories
  5. Justice theories
207
Q

corp gov & ethics | ethics philosophies: friedman doctrine

A
208
Q

corp gov & ethics | Utilitarianism

A
209
Q

corp gov & ethics | Kantian ethics

A
210
Q

corp gov & ethics | Rights theories

A
211
Q

corp gov & ethics | Justice theories

A
212
Q

corp gov & ethics | 7 steps for managers to ensure ethics

A
  1. Hire, promote those with strong personal, business ethics
  2. culture of ethics
  3. leaders that will implement #2
  4. systematic decision process that incorporates ethics philosophies
  5. appoint good ethics officers
  6. corp gov procedures that include:
    ◎ majority BOD are independent
    ◎ separate chaiman and CEO
    ◎ comp directors are independent and outsiders
    ◎ BOD use outside, independent auditors
213
Q

indices | crossholding

A

two companies hold ownership stakes in each other >> double accounting in an index

214
Q

indices | float and tradable value

A

• float (aka free float) = shares available for purchase by the public
• tradable value = float * stock price
◎ most important in emerging mkts, but often hard to calc

215
Q

int’l indices | 4 trade offs

A
  1. breadth vs investability
    ◎ # stocks vs liquidity
  2. liquidiy, crossing opportunity vs reconstitution effects
    ◎ reconstitution effects: popular, liquid index >> mng pays more for added stocks, receives less for deleted stocks
  3. precise float adjustment vs rebalancing transaction costs
  4. objectivity, transparency vs judgement
    ◎ subjective judgement of index composition >> frequent reconstitution >> higher transaction costs
216
Q

int’l indices | effectively developed country in an emerging country index

A

leads to upward biases in average size and performance

CFA (11 decks)

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