Combined decks

Question 1

Start

Question 2

R19

Mean Variance Optimisation

Answer 2

• AO approach
• Assume investors are risk averse.
• Find the optimal point of the efficient frontier
• Identofies the portfolio that maximise returns for a given level of risk.
• Inputs are returns, risk, and pair-wise correlations.
• Find the certainty equivalent rate of return:

Um = E(Rm) − 0.005λσ²

^{[input E(Rm) and} σ^{2 in whole numbers if using o.oo5]}

λ - risk coefficient 1-10, average 4

• Contraints - budget (utility) contraint - all asset class weights must sum to 1
• Contraint - non-negativity contraint - all weights in asset class must be positive. No shorting,

Question 3

R19

MVO Issues

Answer 3

• The outputs (asset allocations) are highly sensitive to small changes in the inputs.
• The asset allocations tend to be highly concentrated in a subset of the available asset classes.
• Many investors are concerned about more than the mean and variance of returns, the focus of MVO.
• Although the asset allocations may appear diversified across assets, the sources of risk may not be diversified.
• Most portfolios exist to pay for a liability or consumption series, and MVO allocations are not directly connected to what influences the value of the liability or the consumption series.
• MVO is a single-period framework that does not take account of trading/rebalancing costs and taxes.

Question 4

R19

Black-Litterman

Answer 4

• Focus on constrained models (no shorting, no negative asset weights)
• Generate well diversifed portfolios and incorporates investors own views and their own confidence in their expectations.
• Use reverse optimisation
• Less likely to have asset class concentrated positions

Question 5

R19

Reverse Optimisation

Answer 5

• MVO solves for optimal asset weights based on expected returns, covariances, and a risk aversion coefficient. Based on predetermined inputs, an optimizer solves for the optimal asset allocation weights. As the name implies, reverse optimization works in the opposite direction. Reverse optimization takes as its inputs a set of asset allocation weights that are assumed to be optimal and, with the additional inputs of covariances and the risk aversion coefficient, solves for expected returns.

Question 6

R19

Additional Constraints to use with MVO (5)

Answer 6

1. Specify a set allocation to a specific asset—for example, 30% to real estate or 45% to human capital. This kind of constraint is typically used when one wants to include a non-tradable asset in the asset allocation decision and optimize around the non-tradable asset.
2. Specify an asset allocation range for an asset—for example, the emerging market allocation must be between 5% and 20%. This specification could be used to accommodate a constraint created by an investment policy, or it might reflect the user’s desire to control the output of the optimization.
3. Specify an upper limit, due to liquidity considerations, on an alternative asset class, such as private equity or hedge funds.
4. Specify the relative allocation of two or more assets—for example, the allocation to emerging market equities must be less than the allocation to developed equities.
5. In a liability-relative (or surplus) optimization setting, one can constrain the optimizer to hold one or more assets representing the systematic characteristics of the liability short.

Question 7

R19

Resampled Mean–Variance Optimization

Answer 7

• Combines Markowitz’s mean–variance optimization framework with Monte Carlo simulation and, all else equal, leads to more-diversified asset allocations. In contrast to reverse optimization, the Black–Litterman model, and constraints, resampled mean–variance optimization is an attempt to build a better optimizer that recognizes that forward-looking inputs are inherently subject to error.
• Uses an average processes and creates an efficient frontier that is more stable than what is got from traditional MVO
• Better diversification
• Lacks sound theoretical basis
• Inputs still based on historical data, therefore might lack relevence to current period.

Question 8

R19

Monte Carlo

Answer 8

• Addresses limitations of MVO as a single peroid model
• Can incorpoate taxes and rebalancing
• Can be used to see the probably the client will run out of money (longevity risk)

Question 9

R19

AA liquidity considerations

Answer 9

• Few indices to track illiquid assets
• If there were accurate indexes, there are no low-cost passive investment vehicles to track them.
• Risk / Return for AI can be very different from traditional assets
• Therefore practical options include the following:

1. Exclude less liquid asset classes (direct real estate, infrastructure, and private equity) from the asset allocation decision and then consider real estate funds, infrastructure funds, and private equity funds as potential implementation vehicles when fulfilling the target strategic asset allocation.
2. Include less liquid asset classes in the asset allocation decision and attempt to model the inputs to represent the specific risk characteristics associated with the likely implementation vehicles.
3. Include less liquid asset classes in the asset allocation decision and attempt to model the inputs to represent the highly diversified characteristics associated with the true asset classes.

Question 10

R19

Risk Budgeting

Answer 10

Marginal contribution to risk (MCTR):

Asset beta relative to portfolio × Portfolio standard deviation

ACTR:

Asset weight in portfolio × MCTR

Ratio of excess return to MCTR:

(Expected return – Risk-free rate)/MCTR

% of risk contributed by position_x:

ACTR_x / σ_p

Question 11

R19

MCTR / ACTR

Answer 11

MCTR - the rate at which risk would change with a small (or marginal) change in the current weights of asset

ACTR - for an asset class measures how much it contributes to portfolio return volatility

Question 12

R19

Factor-Based Asset Allocation

Answer 12

• An alternative approach used by some practitioners is to move away from an opportunity set of asset classes to an opportunity set consisting of investment factors.
• Long the overperforming factor, short the underperforming factor
• Typical factors used in asset allocation include size, valuation, momentum, liquidity, duration (term), credit, and volatility.
• Risk and return possibilities are very similar regardless whether implementing MVO using asset classes or factors

Question 13

R19

Surplus Optimisation

Answer 13

• Liability Relative approach
• Surplus return defined as:

(Change in asset value – Change in liability value)/(Initial asset value)

• Surplus optimization exploits natural hedges that may exist between assets and liabilities as a result of their systematic risk characteristics.

Question 14

R19

Two portfolio approach

Hedging/Return-Seeking Portfolio Approach

Answer 14

• Liability Relative approach
• Seperate asset (return-seeking portfolio) portfolio and hedging portfolio
• The hedging portfolio must include assets whose returns are driven by the same factor(s) that drive the returns of the liabilities.
• Often used my insurance companies and pension plans
• Limitations

1. If funding ratio is <1 then difficult to hedging
2. Hedging portfolio might not be able to hedge ALL risks

Question 15

R19

Integrated Asset-Liability Approach

Answer 15

• Liability Relative approach
• Significant decisions regarding the composition of liabilities made in conjunction with the asset allocation
• Banks, long–short hedge funds (for which short positions constitute liabilities), insurance companies, and re-insurance companies routinely fall into this situation
• Within this category, the liability-relative approaches have several names, including asset–liability management (ALM) for banks and some other investors and dynamic financial analysis (DFA) for insurance companies.

Question 16

R19

Goals Based Approach

Answer 16

• More useful for individual investors
• The overall portfolio needs to be divided into sub-portfolios to permit each goal to be addressed individually.
• Both taxable and tax-exempt investments are important.
• Probability- and time horizon-adjusted expectations replace the typical use of mathematically expected average returns in determining the appropriate funding cost for the goal (or “discount rate” for future cash flows).
• Use predetermined sub portfolios
• Ensure that there is no “hidden” goal that should be brought out and that the apparently “single” retirement goal is not in fact an aggregation of several elements with different levels of urgency,
• Higher level of business management complexity. They will naturally expect to have a different policy for each client and potentially more than one policy per client. Thus, managing these portfolios day to day and satisfying the usual regulatory requirement that all clients be treated in an equivalent manner can appear to be a major quandary.

Question 17

R19

Heuristics and Other Approaches to Asset Allocation

Answer 17

• The “120 minus your age” rule for position in equity
• The 60/40 stock/bond heuristic.
• The endowment model - emphasizes large allocations to non-traditional investments than would be recommended by an MVO approach.
• Risk parity - based on the notion that each asset (asset class or risk factor) should contribute equally to the total risk of the portfolio for a portfolio to be well diversified. Only focuses on risk not return. Critics of these back tests (showing good results from this approach) argue that they suffer from look-back bias and are very dependent on the ability to use extremely large amounts of leverage at low borrow rates (which may not have been feasible)
• The 1/N rule.

Question 18

R18

Life Cycle Balanced Fund

Answer 18

• A target date retirement fund (life cycle balance fund) incorporates human capital with asset allocation
• Human capital generally 30% equity, 70% Fixed Income

Question 19

R18

Asset Only

Answer 19

• Does not explicitly model liabilities or goals
• Example Mean Variance Optimisation - best to complement with Monte Carlo analysis.
• Maximize Sharpe ratio for acceptable level of volatility
• Liabilities or goals not defined and/or simplicity is important
• Relevant risk measure is the SD of portfolio returns - taking into account asset class volatilites and correlations

Some foundations, endowments

Sovereign wealth funds

Individual investors

Question 20

R18

Liability relative

Answer 20

• Models legal and quasi-liabilities
• Example Surplus Optimisation
• Fund liabilities and invest excess assets for growth
• Penalty for not meeting liabilities high
• Based on meeting liabilities - focus on institutions
• Relevant risk - not having enough asset in portfolio to cover liabilities. Measure SD of the surplus could be used as the relevant risk measure.

Banks

Defined benefit pensions

Insurers

Question 21

R18

Goals based

Answer 21

• Achieve goals with specified required probabilities of success
• Individual investors
• Each sub portfolio has unique asset allocation depending on goal
• Based on meeting liabilities - focus on individual
• Risk - not being able to achieve the stated goals. Probablity of meeting goals.

Question 22

R18

Asset Class Criteria (5)

Answer 22

1. Assets within an asset class should be relatively homogeneous. Assets within an asset class should have similar attributes. In the example just given, defining equities to include both real estate and common stock would result in a non-homogeneous asset class.
2. Asset classes should be mutually exclusive. Overlapping asset classes will reduce the effectiveness of strategic asset allocation in controlling risk and could introduce problems in developing asset class return expectations. For example, if one asset class for a US investor is domestic common equities, then world equities ex-US is more appropriate as another asset class rather than global equities, which include US equities.
3. Asset classes should be diversifying. For risk control purposes, an included asset class should not have extremely high expected correlations with other asset classes or with a linear combination of other asset classes. Otherwise, the included asset class will be effectively redundant in a portfolio because it will duplicate risk exposures already present. In general, a pairwise correlation above 0.95 is undesirable (given a sufficient number of observations to have confidence in the correlation estimate).
4. The asset classes as a group should make up a preponderance of world investable wealth. From the perspective of portfolio theory, selecting an asset allocation from a group of asset classes satisfying this criterion should tend to increase expected return for a given level of risk. Furthermore, the inclusion of more markets expands the opportunities for applying active investment strategies, assuming the decision to invest actively has been made. However, such factors as regulatory restrictions on investments and government-imposed limitations on investment by foreigners may limit the asset classes an investor can invest in.
5. Asset classes selected for investment should have the capacity to absorb a meaningful proportion of an investor’s portfolio. Liquidity and transaction costs are both significant considerations. If liquidity and expected transaction costs for an investment of a size meaningful for an investor are unfavorable, an asset class may not be practically suitable for investment.

Question 23

R18

SAA (9 Steps)

Answer 23

1. Determine and quantify the investor’s objectives.
2. Determine the investor’s risk tolerance and how risk should be expressed and measured.
3. Determine the investment horizon(s).
4. Determine other constraints and the requirements they impose on asset allocation choices. What is the tax status of the investor? Should assets be managed with consideration given to ESG issues? Are there any legal and regulatory factors that need to be considered? Are any political sensitivities relevant? Are there any other constraints that the investor has imposed in the IPS and other communications?
5. Determine the approach to asset allocation that is most suitable for the investor.
6. Specify asset classes, and develop a set of capital market expectations for the specified asset classes.
7. Develop a range of potential asset allocation choices for consideration. These choices are often developed through optimization exercises.
8. Test the robustness of the potential choices. This testing often involves conducting simulations to evaluate potential results in relation to investment objectives and risk tolerance over appropriate planning horizon(s) for the different asset allocations developed in Step 7. The sensitivity of the outcomes to changes in capital market expectations is also tested.
9. Iterate back to Step 7 until an appropriate and agreed-on asset allocation is constructed

Question 24

R18

Global Market Portfolio

Answer 24

• Global Market Portfolio is tangency portfolio
• The weights of the assets in the Global Market Portfolio can be adjusted up or down.
• Some assets can be difficult to invest in (e.g. residential real estate or private equity) so will use a proxy e.g. ETF’s

Question 25

R18

TAA

Answer 25

• Active managment choices for asset class weights
• Exploting short term opportunities
• However cost-benefit approach required - e.g. taxes, transaction costs.

Question 26

R18

Factors that influence asset owners’ decisions on where to invest on the passive/active spectrum

Answer 26

• Available investments.
• Scalability of active strategies being considered.
• The feasibility of investing passively while incorporating client-specific constraints.
• Beliefs concerning market informational efficiency. A strong belief in market efficiency for the asset class(es) under consideration would orient the investor away from active management.
• The trade-off of expected incremental benefits relative to incremental costs and risks of active choices. Costs of active management include investment management costs, trading costs, and turnover-induced taxes; such costs would have to be judged relative to the lower costs of index alternatives, which vary by asset class.
• Tax status. Holding other variables constant, taxable investors would tend to have higher hurdles to profitable active management than tax-exempt investors.

Question 27

R18

Rebalancing

Answer 27

• Higher transaction costs for an asset class imply wider rebalancing ranges.
• More risk-averse investors will have tighter rebalancing ranges.
• Less correlated assets also have tighter rebalancing ranges.
• Beliefs in momentum favor wider rebalancing ranges, whereas mean reversion encourages tighter ranges.
• Illiquid investments complicate rebalancing.
• Derivatives create the possibility of synthetic rebalancing.
• Taxes, which are a cost, discourage rebalancing and encourage asymmetric and wider rebalancing ranges.

Question 28

What must portfolio management process reconcile?

Answer 28

The portfolio management process must reconcile (balance):

1. Asset owner objectives
2. The possibilities offered by the investment opportunity set

Question 29

Explain the importance of the IPS.

Answer 29

The investment policy statement (IPS) is the foundation of an effective investment program.

• A well-designed IPS serves as the foundation and guidance to investment managers/advisors for ongoing management of scheme assets.
• A well designed IPS assures stakeholders that program assets are managed with the appropriate care and diligence.

Question 30

Six typical key elements of an IPS

Answer 30

1. An introduction that describes the purpose and scope of the document itself and describes the asset owner. The description of the asset owner should allow the reader of the IPS to understand the context within which the investment program exists.
2. A statement of investment objectives, which describes the target investment returns and willingness to endure risk to achieve these returns.
3. A section discussing the investment constraints within which the investment program must operate to include liquidity requirements time horizons tax concerns, legal and regulatory factors, and unique circumstances
4. A statement of duties and responsibilities outlining the allocation of decision rights and responsibilities among the investment committee, investment staff and any third-party service providers.
5. An explanation of the investment guidelines to be followed in implementation and on specific types of assets excluded from investment, if any.
6. A section specifying the frequency and nature of reporting to the investment committee and to the board of directors.

Question 31

R21

IPS currency management policy

Answer 31

The IPS’ currency management policy must address:
• How much currency exposure should be hedged passively
• Degree of latitude for diversion from the above
• How frequently hedges should be rebalanced
• Currency hedge performance benchmark
• Permitted hedging tools (forwards, swaps, options, etc.)

Question 32

R21

Diversification Considerations

Answer 32

Diversification Considerations:

• Time horizon: FX is mean-reverting in long run, so less hedging is needed
• Correlation between R_FC and R_FX : tends to be stronger for fixed income than for equity, so fixed income portfolios are more likely to be hedged

Question 33

R21

Costs of Hedging

Answer 33

• Bid Offer Spread
• Options Premium
• Roll-Over cost of forwards
• Adminstrative infrastructure for trading FX derivatives
• Opportunity Costs

Question 34

R21

When is a highly hedge policy appropriate

Answer 34

A more currency risk -averse and highly hedged policy will be appropriate, if:

• • There are short -term objectives
• • Client is very risk averse
• • There are immediate income/liquidity needs to be met out of the portfolio
• • More fixed income securities are held in a foreign fixed income currency portfolio
• • A low-cost hedging program is possible
• • Financial markets
• • Client does not believe active currency management will improve portfolio returns or reduce risk

Question 35

R21

Forwards and Foreign Currency Receipts

Answer 35

When a company is recieving cashflows in a foreign currency they are long the currency. Company sells its products in many countries >>> therefore short currency forward contract

Question 36

R21

Forwards and Foreign Currency Payment

Answer 36

• When a company has to purchase the foreign currency they are short the currency. Company has to buy resources from foreign company e.g. steel >>> therefore long currency forward contract

Question 37

R21

Hedging Returns - what is earnt

Answer 37

• Hedging the foreign market return only, expect to earn only the risk foreign free rate.
• Hedge foreign market return and exchange rate earn only the domestic risk free rate

Question 38

R21

Direct vs Indirect Quote

Answer 38

Direct Quote:

DC/FC

Note DC (Price Currency)/ FC (Base currency)

Indirect Quote:

FC/DC

• Focus on the denominator

Question 39

R21

DAD acromyn

Answer 39

DAD = Down the Ask and Divide

Question 40

R21

R_dc, R_fc, R_fx definitions

Answer 40

R_dc = return on the portfolio in domestic currency

R_{<strong>fc</strong>} = return on the foreign asset in foreign (local) currency terms

R_fx = return on foreign currency (% change in value of foreign currency

If you hold an asset in a foriegn currency you want the foreign currency to appreciate. If I have a liability I want the foreign currency to depreciate.

domestic currency = home currency

Foreign currency = local currency

Question 41

R21

Currency Hedging Methods (4)

Answer 41

• Passive - eliminate currency risk relevent to the benchmark. Match currency exposure to benchmark. difficult because of rebalancing considerations.
• Discretionary - some deviation from benchmark by a small percentage. To reduce currency risk and enjoy modest incremental currency returns
• Active - large deviations from benchmark. Goal to make incremental returns from managing currency exposure. Within risk limits.
• Currency Overlay manager - external 3rd party manages currency by active manager. Can take exposures seperately from assets held in portfolio. Generatign currency alpha.

Question 42

R21

Currency hedging conclusions

Answer 42

• Currency volatility in long run has generally been lower in long run
• When + correlation between foreign asset and foreign currency it will increase volatity in domestic returns in the portfolio and therefore increase hedging need.
• When - correlation between foreign asset and foreign currency it will decrease volatity in domestic returns in the portfolio and therefore decrease hedging need.
• Correlations vary by time periods. Therefore diversification varies.
• Higher positive correlation between foreign asset and foreign return in fixed income portfolios then equity portfolios. Therefore increased fixed income in portfolio then increased need for hedging.
• Amount of hedging down to managers preference

Question 43

R21

Hedging costs

Answer 43

• Fully hedging increase costs - reduced returns.
• If options used to hedge expire premium is lost - reduced returns
• If forward contracts need to roll often (if less than hedging period) then could result in gains or loss depending on exchange rate.
• Administrative costs
• 100% hedging has opportunity cost. A 50% strategic hedge is often preferred.

Question 44

R21

Short term strategies (tactical)

Economic Fundemental approach

Answer 44

• Economic Fundemental approach - in the long term currency values will converge to relative PPP. However relative does not hold over short term, but can indicate which currencies have over/under appreciated in the short term.
• Currencies that are expect to appreciate:

1. More undervalued compared to their intrinsic value
2. Greatest rate of increase in its intrinsic value
3. Are those with higher real interest rates or higher nominal rates. Assumes expected inflation is the same.
4. Lower inflation rate compared to other countries
5. Lower, decreasing, risk premium

Question 45

R21

Short term strategies (tactical)

Technical Analysis approach

Answer 45

• Past price date can predict future price movements
• Therefore past price patterns tend to repeat
• It doesnt matter what a currency is really worth just where it will trade
• An overbought market would be expected to do down
• An oversold market would be expected to go up
• Support and resistance levels

Question 46

R21

Short term strategies (tactical)

Carry Trade

Answer 46

• Markets must be very stable
• It is an unhedged trade
• Must be a violation of uncovered Interest Rate Parity to profit
• Borrow in the lower IR currency and invest in higher IR currency.
• If you expect the foreign currency to depreciate by less than the market expectation based on the forward discount you would enter a carry trade. However if the deprecation is far more than market expectation the losses will be great.
• High IR currency in emerging markets can drop very sharply in time of economic stress.

Question 47

R21

Short term strategies (tactical)

Carry Trade: detailed steps

Answer 47

Assume US IR = 1% and SR - 5%

1. Borrow in low IR currency e.g $1,000,000 @ 1%
2. Convert Low IR currency into High IR currency using spot rate e.g. $1,000,000 to SR @ 3.75 / $ = SR3750000
3. Invest in High IR currency asset e.g $3,750,000 x (1.05)^₁ = SR3937500
4. At end of period convert HR IR currency back to into low IR at spot rate. e.g. assuming unchanged at SR 3.75 SR3,937,500 / 3.75 = $1,050,000
5. Pay off original loan e.g. 1,000,000 x 1.01 = 1,010,000. Therefore profit of $40000 on original investment.

Question 48

R21

Short term strategies (tactical)

Volatity Trade

Answer 48

• Straddles and Strangles
• Vega
• Long Straddle - ATM buy call and ATM buy put and expecting high volatility.
• Short Straddle - ATM sell call and ATM sell put and expecting low volatility.
• Strangle - buy call and sell put but using OTM call and puts. Lower premiums.

Question 49

R21

Foward contracts for hedging

Answer 49

• Forward contracts preferred to future for currency hedgin because:

1. Can be customised
2. Can be created between any currency pairs
3. Futures require margins which increase operational complexity
4. Greater liquidity - forward market larger.

Question 50

R21

Dynamic Hedge

Answer 50

• Periodic rebalancing
• Can lead to mismatched FX swap. A forward contract for one month to cover a three month postion will need to be rolled at one month and a second forward contract for two month will need to be entered.
• A dynamic hedge will keep hedge ratio close to target hedge ratio
• Higher transaction costs than static hedge

Question 51

R21

Roll Yield

Answer 51

• Backwardation - forward price is below spot price. Roll return is positive to long side (speculators), and negative to short side (hedgers)
• Contango - forward price is above spot price. Roll return is positive to the short side (hedgers) but negative to the long side (speculator).
• Speculators expect prices to increase, but dont own asset. Will go long.
• Hedgers expect prices to decrease and own the asset. Will go short.
• Spot price assumed not to change. So forward price moves either up or down in relation to spot price. Would depend on interaction between hedgers and speculators.
• Roll yield can be seen as the profit or loss on a forward or future spot price is unchanged at expiration
• Calculate forward premium / discount:

F_dc/fc - S_dc/fc / S_dc/fc

Question 52

R21

Option based hedging strategies

Answer 52

• EUR based investor long CHF. (risk of CHF depeciation)
• Over / underhedge forward contracts based on view of investor. If CHF expected to depreciate then overhedge, if CHF expected to appreciate then underhedge.
• Buy ATM put options. Assymetic protection limits downside risk and retains upside potential. Has a higher cost.
• Buy OTM put options - cheaper, but less downside protection
• Collar - buy OTM put, sell OTM call. Reduce costs. Limits upside potential.
• Put spread - buy OTM put, sell a deeper OTM put. Reduces cost. Reduces downside protection.
• Seagull Spread - Put spread + sell call. Reduces costs further. Downside protection same as for put spread, but more limited upside.

Question 53

R21

Hedging Multiple Currencies

Answer 53

• Cross hedge / proxy hedge - a position in one assets hedges the position in another. If obvious contracts not available to short but if if two currencies are highly correlated then a proxy hedge can be created by using the other currency as a proxy. Indirect hedge.
• Macro hedge - hedge focused on whole portfolio, particularly when individual asset price movements are highly correlated. Views portfolio as a collection of risk exposures. Can use a basket of derivatives, which is less costly than hedging each instrument. Indirect hedge.
• Minimum Variance Hedge Ratio - Indirect. hedge. Uses regression analysis. To minimise tracking error between the value of the hedged asset and the hedging instrument. Not applied to a direct hedge strategy (using a foward contract). Should be re-estimated when new information becomes available.
• Basis Risk - Price movements in the exposure being hedged and the price movements in the cross hedge instrument are not prefectly correlated.

Question 54

R21

Emerging Market Currencies

Answer 54

• Lower trading volume - larger bid-ask spread
• Liquidity can be lower - higher transaction cost
• Non-normal distributions more frequent
• Higher yields, leads to large foward discounts, markets in backwardation, postive roll return to the long side, but negative to short side. Higher yield - larger inflation rate.
• Contagion - correlations between countries increase, therefore diversification benefits decrease.
• Tail-risk - negative events occur more frequently.
• Government intervention

Question 55

R24

Active strategies under assumption of a stable yield curve

Answer 55

1. Buy and hold -Active decision to position the portfolio with longer duration and higher yield to maturity in order to generate higher returns than the benchmark. Note: Portfolio characteristics may diverge from benchmark.
2. Roll down/ride the yield curve - This strategy requires an upward-sloping yield curve; the manager will buy a bond in anticipation of profiting from the price increase as the time to maturity shortens
3. Sell convexity - portfolio manager could sell calls on bonds held in the portfolio, or he could sell puts on bonds he would be willing to own if, in fact, the put was exercised. Would earn additional returns in the form of option premiums. Owning MBS in a portfolio is loosely equivalent to writing options. Could also buy a callable bond.
4. The carry trade -In a common carry trade, a portfolio manager borrows in the currency of a low interest rate country, converts the loan proceeds into the currency of a higher interest rate country, and invests in a higher-yielding security of that country.

Inter-market carry trades, those involving more than one currency are more varied and complex. First, the trade depends on more than one yield curve. Second, the investor must either accept or somehow hedge currency risk. Third, there may or may not be a duration mismatch.

Intra market carry trade - has interest rate risk

Inter market carry trade - has currency risk. Tend to have negative skew and fat tails. Assumes uncovered interest rate parity does not hold.

Question 56

R24

Active strategies for yield curve movement of level, slope, and curvature

Answer 56

1. Duration management - In its simplest form, duration management shortens portfolio duration in anticipation of rising interest rates (decreasing bond prices) and lengthens portfolio duration in anticipation of declining interest rates (increasing bond prices). Requires a manager to correctly anticipate changes in interest rates. A non-parallel shift will make this strategy less effective. Derivatives can be used to Alter Portfolio Duration
2. Buy convexity. To mitigate price declines and enhance price increases. Short a callable bond. Buy options.
3. Bullet and barbell structures

• Bullett is used to take advantage of a steepening yield curve—a bulleted portfolio will have little or no exposure at maturities longer or shorter than the targeted segment of the curve.
• Barbell is typically used to take advantage of a flattening yield curve. If long rates fall more than short rates (and the yield curve flattens), the portfolio’s long-duration securities will capture the benefits of the falling rates in a way that the intermediate-duration securities cannot. are typically used to take advantage of a flattening yield curve.

Question 57

R24

Relative Performance of Bullets and Barbells under Different Yield Curve Scenarios

Answer 57

Yield Curve Scenario Barbell Bullet
Level change Parallel shift Outperforms Underperforms
Slope change Flattening Outperforms Underperforms
Steepening Underperforms Outperforms
Curvature Less curvature Underperforms Outperforms
More curvature Outperforms Underperforms
Rate volatility change Decreased Underperforms Outperforms
Increased Outperforms Underperforms

Question 58

R24

Carry Trade Intra Market

Answer 58

There are at least three basic ways to implement a carry trade to exploit a stable, upward-sloping yield curve:

• Buy a bond and finance it in the repo market.
• Received fixed and pay floating on an interest rate swap.
• Take a long position in a bond (or note) futures contract.

Question 59

R24

Carry Trade Inter Market

Answer 59

• Borrow in low rate currency, convert into a high rate currency and buy a bond denominated in this currency.
• Currency Swap - recieve payments in the high rate currency and make payments in the low rate currency.
• Borrow in high rate currency and use proceeds to buy a bond denominated in this currency. Use FX forward to convert financing position into low rate currency (buy high rate currency forward).

Question 60

R24

Butterfly

Answer 60

• Combination of a barbell and bullett
• A curve trade.
• If curvature increase go long the wings (barbell and short the body (bullet). Long Butterfly
• If curvature decreases then go short butterfly
• Butterfly spread:

2 x medium yield - short term yield - long term yield

• Whether the body goes up or down indicates the direction of the curvature - increase or decrease
• Duration neutral
• Long butterfly has higher convexity and benefits from a rise in interest rate volatility

Question 61

R24

Predicted market value change

Answer 61

Predicted market value change = [Portfolio par amount × (−Key rate PVBP) × Curve shift]/100.

Question 62

R24

Benchmark Spread

Answer 62

The benchmark spread is a simple way to calculate a credit spread; it subtracts the yield on a recently issued benchmark-sized security with little or no credit risk (benchmark bond) of a particular maturity from the yield on a credit security. Typically, the benchmark bond is an on-the-run government bond. A problem with benchmark spread is the potential maturity mismatch between the credit security and the benchmark bond. Unless the benchmark yield curve is perfectly flat, using different benchmark bonds will produce different measures of credit spread.

Question 63

R24

I Spread

Answer 63

The I-spread normally uses swap rates that are denominated in the same currency as the credit security.

Question 64

R24

G Spread

Answer 64

The G-spread is the spread over an actual or interpolated government bond.

Question 65

R24

Credit Relative Value Analysis

Answer 65

In the case of unchanged spreads, credit relative value analysis is essentially about weighing the unknown prospect of default losses or credit rating migration against the known compensation provided by credit spreads.

Excess return can be calculated as:

EXR ≈ (s)(t) – (Δs)(SD) – (t)(p)(L),

where EXR = Excess return, s = Spread, t = Holding period, Δs = Change in spread, SD = Spread duration, p = Expected probability of default, and L = Expected loss severity.

Question 66

R24

The number of futures contracts needed to fully remove the duration gap

Answer 66

The number of futures contracts needed to fully remove the duration gap between the asset and liability portfolios is given by:

N_f = (BPV_L − BPV_A)/BPV_f

where BPV is basis point value (of the liability portfolio, asset portfolio, and futures contract, respectively).

Question 68

R24

Number of futures to close duration gap

Answer 68

The number of futures contracts needed to fully remove the duration gap between the asset and liability portfolios is given by:

N_f = BPV_L−BPV_A / BPV_f, where BPV is basis point value (of the liability portfolio, asset portfolio, and futures contract, respectively)

Question 69

R24

What is Credit Quality of Value Weighted Index

Answer 69

Compared with other weighting schemes, such as equally weighted, value-weighted indexes are tilted toward issuers with higher levels of debt. The more an issuer or sector borrows, the greater the tilt toward that issuer in the index. Leverage and creditworthiness are negatively correlated, so a value-weighted index will be more susceptible to credit quality deterioration than an equally weighted index will be

Question 70

R24

Are Equity or Fixed Income valuation models more accurate?

Answer 70

Equity securities typically trade much more frequently than debt securities, so current market valuations are available. Many fixed-income securities are very illiquid, trading very infrequently. Therefore, pricing and valuation are difficult, and such estimations as matrix pricing, which are subject to error, must be used.

Question 71

R24

Ladder vs Bullett / Barbell

(Convexity / Liquidity / Diversification)

Answer 71

Given the same value and duration, of the three types, the bullet portfolio would have the lowest convexity and the barbell portfolio would have the highest. The laddered portfolio would have a convexity in between the two.

A laddered portfolio would regularly buy new long-term securities to replace maturing securities on the short end. To the extent interest rates are volatile, the laddered portfolio would eventually contain a mixture (diversity) of high- and low-yielding securities. The laddered portfolio would provide better diversification over the interest rate cycle compared with the other portfolio styles.

A laddered portfolio would always have some securities with little time remaining before maturity. These would be good collateral for a repo or loan or would shortly turn into cash (upon maturity), thus providing high liquidity. The laddered portfolio would provide for better liquidity management relative to the other portfolio styles

Question 72

Macaulay Duration

Answer 72

• Macaulay Duration

By reinvesting coupons, the time to realize the initial market discount rate on a bond should be shorter than the full maturity of the bond. The Macaulay duration is a measure of weighted average time to the receipt of the interest and principle payments that realize the original YTM. A Macaulay duration of 7 for a 10-year, 4% YTM bond means that at current market rates, it will be 7 years until the 4% YTM is achieved.

Only time Macaulay Duration is equal to maturity is with a zero coupon bond.

Question 73

Modified Duration

Answer 73

• When rates decrease by a large amount duration will underestimate the price increase.
• When rates increase by a large amount duration will overestimate the price decrease.

Question 74

R15

DB Pension Fund General

Answer 74

• Accumulated benefit obligation (ABO). - The present value of pension benefits, assuming the pension plan terminated immediately such that it had to provide retirement income to all beneficiaries for their years of service up to that date.
• Projected benefit obligation (PBO) - A measure of a pension plan’s liability that reflects accumulated service in the same manner as the ABO but also projects future variables, such as compensation increases.
• Total future liability - With respect to defined-benefit pension plans, the present value of accumulated and projected future service benefits, including the effects of projected future compensation increases.

Question 75

R15

DB Pension Fund RISK

Answer 75

• Higher pension surplus or higher funded status implies greater risk tolerance.
• Lower debt ratios and higher current and expected profitability imply greater risk tolerance.
• Correlation of sponsor operating results with pension asset returns. The lower the correlation, the greater risk tolerance, all else equal.
• Provision for early retirement and provision for lump-sum distributions. Such options tend to reduce the duration of plan liabilities, implying lower risk tolerance, all else equal.
• The younger the workforce and the greater the proportion of active lives, the greater the duration of plan liabilities and the greater the risk tolerance.

Question 76

R15

DB Pension Fund RETURN

Answer 76

• Fund its pension liabilities on an inflation-adjusted basis.
• If pension assets equal the present value of pension liabilities and if the rate of return earned on the assets equals the discount rate used to calculate the present value of the liabilities, then pension assets should be exactly sufficient to pay for the liabilities as they mature. Therefore, for a fully funded pension plan, the portfolio manager should determine the return requirement beginning with the discount rate used to calculate the present value of plan liabilities.
• Return desire may be higher than its return requirement
• If the plan has a young and growing workforce, the sponsor may set a more aggressive return objective than it would for a plan that is currently closed to new participants and facing heavy liquidity requirements.
• May manage investments for the active-lives portion of pension liabilities according to risk and return objectives that are distinct from those they specify for the retired-lives portion.

Question 77

R15

DB Pension Fund LIQUIDITY

Answer 77

• The net cash outflow (benefit payments minus pension contributions) constitutes the pension’s plan liquidity requirement.
• 3 Main issues affecting liquidity:

1. The greater the number of retired lives, the greater the liquidity requirement, all else equal.
2. The smaller the corporate contributions in relation to benefit disbursements, the greater the liquidity requirement. The need to make contributions depends on the funded status of the plan. For plan sponsors that need to make regular contributions, young, growing workforces generally mean smaller liquidity requirements than older, declining workforces.
3. Plan features such as the option to take early retirement and/or the option of retirees to take lump-sum payments create potentially higher liquidity needs.

• When a pension fund has substantial liquidity requirements, it may hold a buffer of cash or money market instruments to meet such needs.

Question 78

R15

DB Pension Fund TIME HORIZON

Answer 78

• Overall time horizon for many going-concern DB plans is long.
• Depends on:

1. whether the plan is a going concern or plan termination is expected
2. the age of the workforce and the proportion of active lives. When the workforce is young and active lives predominate, and when the DB plan is open to new entrants, the plan’s time horizon is longer.

Question 79

R15

DB Pension Fund TAX

Answer 79

• Investment income and realized capital gains within private defined-benefit pension plans are usually exempt from taxation

Question 80

R15

DB Pension Fund LEGAL REGULATORY

Answer 80

• All retirement plans are governed by laws and regulations that affect investment policy.
• United States, corporate plans and multi-employer plans are governed by the Employee Retirement Income Security Act of 1974 (ERISA)
• The institutional practitioner to understand and apply the law and regulations of the entity having jurisdiction when developing investment polic

Question 81

R15

DB Pension Fund UNIQUE

Answer 81

• Investment in alternative investments often requires complex due diligence
• Self-imposed constraint against investing in certain industries viewed as having negative ethical or welfare connotations, or in shares of companies operating in countries with regimes against which some ethical objection has been raised.

Question 82

R15

DC Pensions

Answer 82

• participant-directed v sponsor-directed plan [similar to DB]
• The principal investment issues for DC plans are as follows:

1. Diversification - sponsor must offer a menu of investment options that allows participants to construct suitable portfolios.
2. Company Stock -oldings of sponsor-company stock should be limited to allow participants’ wealth to be adequately diversified.

• An IPS for a participant-directed DC plan is the governing document that describes the investment strategies and alternatives available to the group of plan participants characterized by diverse objectives and constraints.

Question 83

R15

Hybrid Pensions

Answer 83

• 2 main types - cash balance and ESOP
• Cash Balance:

1. employer bears the investment risk
2. To employee it looks like a DC plan because they are provided a personalized statement showing their account balance, an annual contribution credit, and an earnings credit
3. Traditional DB plans that have been converted in order to gain some of the features of a DC plan.
4. Unfair to older workers - “grandfather” clause

• ESOP:

1. DC plans that invest all or the majority of plan assets in employer stock.
2. Have been used by companies to liquidate a large block of company stock held by an individual or small group of people, avoid a public offering of stock, or discourage an unfriendly takeover by placing a large holding of stock in the hands of employees via the ESOP trust.
3. An important concern for ESOP participants is that their overall investments (both financial and human capital) reflect adequate diversification.

Question 84

R15

Independent foundation (private or family)

Answer 84

• Independent foundation (private or family)
• Independent grant-making organization established to aid social, educational, charitable, or religious activities.
• Generally an individual, family, or group of individuals are source of funds
• Donor, members of donor’s family, or independent trustees make decisions
• At least 5% of 12-month average asset value, plus expenses associated with generating investment return.

Question 86

R15

Company-sponsored foundation

Answer 86

• Company-sponsored foundation
• A legally independent grant-making organization with close ties to the corporation providing funds.
• Endowment and/or annual contributions from a profit-making corporation are source of funds
• Board of trustees, usually controlled by the sponsoring corporation’s executives make decisions
• Same as independent foundation.

Question 87

R15

Operating foundation

Answer 87

• Organization that uses its resources to conduct research or provide a direct service (e.g., operate a museum).
• Largely the same as independent foundation. Source of funds from profit making corporation
• Independent board of directors make decisions
• Must use 85% of interest and dividend income for active conduct of the institution’s own programs. Some are also subject to annual spending requirement equal to 3.33% of assets.

Question 88

R15

Community foundation

Answer 88

• A publicly supported organization that makes grants for social, educational, charitable, or religious purposes. A type of public charity.
• Multiple donors; the public provide funds
• Board of directors make decisions
• No spending requirement.

Question 89

R15

Foundations: RISK

Answer 89

• Foundations can have a higher risk tolerance.
• Pension funds have a contractually defined liability stream in contrast, foundations have no such defined liability
• It is also acceptable, if risky, for foundations to try to earn a higher rate of return than is needed to maintain the purchasing power of assets

Question 90

R15

Foundations: RETURN

Answer 90

• Some foundations are meant to be short lived; others are intended to operate in perpetuity.
• For those foundations with an indefinitely long horizon, the long-term return objective is to preserve the real (inflation-adjusted) value of the investment assets while allowing spending at an appropriate (either statutory or decided-upon) rate
• Intergenerational equity or neutrality - an equitable balance between the interests of current and future beneficiaries of the foundation’s support.

Question 91

R15

Foundations: LIQUIDITY

Answer 91

• Anticipated or unanticipated needs for cash in excess of contributions made to the foundation.
• Smoothing rule - With respect to spending rates, a rule that averages asset values over a period of time in order to dampen the spending rate’s response to asset value fluctuation.
• It is prudent for any organization to keep some assets in cash as a reserve for contingencies, but private and family foundations need a cash reserve for a special reason: They are subject to the unusual requirement that spending in a given fiscal year be 5 percent or more of the 12-month average of asset values in that year.

Question 92

R15

Foundations: TIME HORIZON

Answer 92

• The majority of foundation wealth resides in private and other foundations established or managed with the intent of lasting into perpetuity.
• Some institutions, however, are created to be “spent down” over a predefined period of time; therefore, they pursue a different strategy, exhibiting an increasing level of conservatism as time passes.

Question 93

R15

Foundations: TAX CONCERNS

Answer 93

• unrelated business income will be subject to regular corporate tax rates
• Income from real estate is taxable as unrelated business income if the property is debt financed, but only in proportion to the fraction of the property’s cost financed with debt.

Question 94

R15

Foundations: LEGAL REGULATORY

Answer 94

• Foundations may be subject to a variety of legal and regulatory constraints.
• In the United States, many states have adopted the Uniform Management of Institutional Funds Act (UMIFA) as the primary legislation governing any entity organized and operated exclusively for educational, religious, or charitable purposes.

Question 95

R15

Foundations: UNIQUE

Answer 95

• A special challenge faces foundations that are endowed with the stock of one particular company and that are then restricted by the donor from diversifying.
• With the permission of the donor, some institutions have entered into swap agreements or other derivative transactions to achieve the payoffs of a more diversified portfolio.

Question 96

R15

Endowments: General

Answer 96

• Provide a significant amount of budgetary support for universities, colleges, private schools, hospitals, museums, and religious organizations.
• Legally and formally, however, the term “endowment” refers to a permanent fund established by a donor with the condition that the fund principal be maintained over time. In contrast to private foundations, endowments are not subject to a specific legally required spending level.
• Generally are exempt from taxation on investment income derived from interest, dividends, capital gains, rents, and royalties.

Question 97

R15

Endowments: Spending Rules

Answer 97

• Spending is typically calculated as a percentage, usually between 4 percent and 6 percent of endowment market value (endowments are not subject to minimum spending rates as are private foundations in the United States).
• Frequently use an average of trailing market values rather than the current market value to provide greater stability in the amount of money distributed annually
• One problem with this rule is that it places as much significance on market values three years ago as it does on more recent outcomes
• A more refined rule might use a geometrically declining average of trailing endowment values adjusted for inflation, placing more emphasis on recent market values and less on past values.
• 3 possible spending rules:

1. Simple spending rule. Spending equals the spending rate multiplied by the market value of the endowment at the beginning of the fiscal year.
2. Rolling three-year average spending rule. Spending equals the spending rate multiplied by the average market value of the last three fiscal year-ends.
3. Geometric smoothing rule. Spending equals the weighted average of the prior year’s spending adjusted for inflation and the product of the spending rate times the market value of the endowment at the beginning of the prior fiscal year. The smoothing rate is typically between 60 and 80 percent.

Question 98

R15

Endowments: RISK

Answer 98

• Spending policies with smoothing or averaging rules can dampen the transmission of portfolio volatility to spending distributions.
• If the same market forces affect both its donor base and its endowment, an institution that relies heavily on donations for current income may see donations drop at the same time as endowment income
• On a short-term basis, an endowment’s risk tolerance can be greater if the endowment has experienced strong recent returns and the smoothed spending rate is below the long-term average or target rate.
• On the other hand, endowment funds with poor recent returns and a smoothed spending rate above the long-term average run the risk of a severe loss in purchasing power.

Question 99

R15

Endowments: RETURN

Answer 99

• Endowment funds should maintain their long-term purchasing power after inflation.
• An endowment’s returns need to exceed the spending rate to protect against a long-term loss of purchasing power.
• Endowments are not subject to specific payout requirements.
• Can use a smoothing rule, to dampen the effects of portfolio volatility on spending distributions.
• Monte Carlo simulations illustrate the effect of investment and spending policies on the likelihood that an endowment will provide a stable and sustainable flow of operating funds for an institution.

Question 100

R15

Endowments: LIQUIDITY

Answer 100

• The perpetual nature and measured spending of true endowments limit their need for liquidity.
• In general, endowments are well suited to invest in illiquid, non-marketable securities given their limited need for liquidit

Question 101

R15

Endowments: TIME HORIZON

Answer 101

• Endowment time horizons are extremely long term because of the objective of maintaining purchasing power in perpetuity.
• Annual draws for spending, however, may present important short-term considerations

Question 102

R15

Endowments: TAX

Answer 102

• Taxes are not a major consideration for endowments
• Unrelated business taxable income (UBTI) from operating businesses or from assets with acquisition indebtedness may be subject to tax.
• A portion of dividends from non-US securities may be subject to withholding taxes that cannot be reclaimed or credited against US taxes.

Question 103

R15

Endowments: LEGAL REGULATORY

Answer 103

• UMIFA
• To achieve and maintain tax-exempt status under Section 501(c)(3) of the US Internal Revenue Code, an institution must ensure that no part of its net earnings inure or accrue to the benefit of any private individual

Question 104

R15

Endowments: UNIQUE

Answer 104

• Vary widely in their size, governance, and staff resources, and thus in the investment strategies that they can intelligently and practically pursue
• Endowments should have significant resources and expertise before investing in nontraditional asset classes.
• Some endowed institutions develop ethical investment policies that become constraints to help ensure that portfolio investment activity is consistent with the organization’s goals and mores.

Question 105

R15

Life Insurance: General

Answer 105

• Risk of disintermediation, which often becomes acute when interest rates are high
• Exposure to interest-rate-related risk is one major characteristic of life insurers’ investment setting.
• When interest rates are high there is the risk that policyholders will surrender their cash value life insurance policies for their accumulated cash values, in order to reinvest the proceeds at a higher interest rate

Question 106

R15

Life Insurance: RISK

Answer 106

• Conservative fiduciary principles limit the risk tolerance of an insurance company investment portfolio.
• Valuation concerns. In a period of changing interest rates, a mismatch between the duration of an insurance company’s assets and that of its liabilities can lead to erosion of surplus
• Reinvestment risk
• Credit risk
• Cash flow volatility. Loss of income or delays in collecting and reinvesting cash flow from investments is another key aspect of risk for which life insurance companies have low tolerance.

Question 107

R15

Life Insurance: RETURN

Answer 107

• minimum return requirement.
• The insurer desires to earn a positive net interest spread, and return objectives may include a desired net interest spread
• Consistently above-average investment returns should and do provide an insurance company with some competitive advantage in setting premiums
• Segmentation of insurance company portfolios has promoted the establishment of sub-portfolio return objectives to promote competitive crediting rates for groups of contracts.

Question 108

R15

Life Insurance: LIQUIDITY

Answer 108

• insurers may be forced to sell bonds at a loss to meet surrenders of insurance policies in periods of sharply rising interest rates.
• Disintermediation - In a period of rising interest rates, a mismatch between the duration of an insurance company’s assets and its liabilities can create a net loss if the assets’ duration exceeds that of the liabilities. If disintermediation occurs concurrently, the insurer may need to sell assets at a realized loss to meet liquidity needs. Thus, an asset/liability mismatch can exacerbate the effects of disintermediation.
• Asset marketability risk - The marketability of investments is important to insure ample liquidity.

Question 109

R15

Life Insurance: TIME HORIZON

Answer 109

• Life insurance companies have long been considered the classic long-term investor.
• One reason that life insurance companies have traditionally segmented their portfolios is the recognition that particular product lines or lines of business have unique time horizons and return objectives.

Question 110

R15

Life Insurance: TAX

Answer 110

• Subject to income, capital gains, and other types of taxes in the countries where they operate
• Life insurance companies’ investment income can be divided into two parts for tax purposes: the policyholders’ share (that portion relating to the actuarially assumed rate necessary to fund reserves) and the corporate share (the balance that is transferred to surplus). Under present US law, only the latter portion is taxed.

Question 111

R15

Life Insurance: LEGAL REGULATORY

Answer 111

• Insurance is a heavily regulated industry
• Eligible investments. Insurance laws determine the classes of assets eligible for investment and may specify the quality standards for each asset class.
• Prudent investor rule. Replacing traditional “laundry lists” of approved investments with prudent investor logic simplifies the regulatory process and allows life insurance companies much needed flexibility to keep up with the ever-changing array of investment alternatives.
• Valuation methods. In the European Union, International Accounting Standards specify a set of valuation procedures. In the United States, uniform valuation methods are established and administered by the NAIC.

Question 112

R15

Life Insurance: UNIQUE

Answer 112

• Each insurance company, whether life or non-life, may have unique circumstances attributable to factors other than the insurance products it provides.

Question 113

R15

NON-Life Insurance: General

Answer 113

• Non-life liability durations tend to be shorter, and claim processing and payments periods are longer, than for life companies;
• Some (but not all) non-life liabilities are exposed to inflation risk, although liabilities are not directly exposed to interest rate risk as those of life insurance companies
• A life insurance company’s liabilities are relatively certain in value but uncertain in timing, while a non-life insurance company’s liabilities are relatively uncertain in both value and timing, with the result that non-life insurance companies are exposed to more volatility in their operating results.
• One of the primary factors that limits the duration of a non-life company’s assets is the so-called underwriting (profitability) cycle, generally averaging three to five years.

Question 114

R15

NON-Life Insurance: RISK

Answer 114

• Cash flow characteristics. Not surprisingly, cash flows from casualty insurance operations can be quite erratic. Have low tolerance for loss of principal or diminishing investment income. Investment maturities and investment income must be predictable in order to directly offset the unpredictability of operating trends.
• Common stock to surplus ratio. Many casualty companies have adopted self-imposed limitations restricting common stocks at market value to some significant but limited portion (frequently one-half to three-quarters) of total surplus

Question 115

R15

NON-Life Insurance: RETURN

Answer 115

• Competitive policy pricing. Low insurance policy premium rates, due to competition, provide an incentive for insurance companies to set high desired investment return objectives. The flip side is that high investment returns may induce insurance companies to lower their policy rates, even though a high level of returns cannot be sustained. I
• Profitability. Casualty insurance portfolios are managed to maximize return on capital and surplus to the extent that prudent asset/liability management, surplus adequacy considerations, and management preferences will allow.
• Growth of surplus. An important function of a casualty company’s investment operation is to provide growth of surplus, which in turn provides the opportunity to expand the volume of insurance the company can write.
• Tax considerations. Over the years, non-life insurance companies’ investment results have been very sensitive to the after-tax return on the bond portfolio and to the tax benefits of certain kinds of investment returns.
• Total return management. Active bond portfolio management strategies designed to achieve total return, rather than yield or investment income goals only, have gained popularity among casualty insurance companies, especially large ones

Question 116

R15

NON-Life Insurance: LIQUIDITY

Answer 116

• Liquidity has always been a paramount consideration for non-life companies.
• Quite often it maintains a portfolio of short-term securities, such as commercial paper or Treasury bills, as an immediate liquidity reserve.
• may also hold a portfolio of readily marketable government bonds of various maturities

Question 117

R15

NON-Life Insurance: TIME HORIZON

Answer 117

• Durations of casualty liabilities are typically shorter than those of life insurance liabilities.
• Casualty companies find that they must invest in longer maturities (15 to 30 years) than the typical life company to optimize the yield advantage offered by tax-exempt securities
• In terms of common stock investments, casualty companies historically have been long-term investors

Question 118

R15

NON-Life Insurance: TAX

Answer 118

• A very important factor in determining casualty insurance companies’ investment policy
• A computer model is generally needed to determine the appropriate asset allocation, if any, between tax-exempt and taxable securities for both new purchases and existing holdings

Question 119

R15

NON-Life Insurance: LEGAL REGULATORY

Answer 119

• Casualty company investment regulation is relatively permissive
• A casualty company is not required to maintain an asset valuation reserve.

Question 120

R15

NON-Life Insurance: UNIQUE

Answer 120

• Casualty insurance companies develop a significant portfolio of stocks and bonds and generate a high level of income to supplement or offset insurance underwriting gains and losses.
• Casualty companies seek some degree of safety from the assets offsetting insurance reserves

Question 121

R15

NON-Life Insurance: Variation in returns between companies

Answer 121

1. the latitude permitted by insurance regulations;
2. differences in product mix, and thus in the duration of liabilities;
3. a particular company’s tax position;
4. the emphasis placed on capital appreciation versus the income component of investment return; and
5. the strength of the company’s capital and surplus positions.

Question 122

R15

Banks: General

Answer 122

• Banks’ liabilities consist chiefly of time and demand deposits but also include purchased funds and sometimes publicly traded debt
• Measures ALCO monitor:

1. net interest margin -With respect to banks, net interest income (interest income minus interest expense) divided by average earning assets.
2. interest spread - With respect to banks, the average yield on earning assets minus the average percent cost of interest-bearing liabilities.
3. leverage-adjusted duration gap - A leverage-adjusted measure of the difference between the durations of assets and liabilities which measures a bank’s overall interest rate exposure.
4. Value at Risk (VaR)

Question 123

R15

Banks: Role of bank’s securities portfolio

Answer 123

1. To manage overall interest rate risk of the balance sheet. Bank-held securities are negotiable instruments trading in generally liquid markets that can be bought and sold quickly. Therefore, securities are the natural adjustment mechanism for interest rate risk
2. To manage liquidity. Banks use their securities portfolios to assure adequate cash is available to them.
3. To produce income. Banks’ securities portfolios frequently account for a quarter or more of total revenue.
4. To manage credit risk. The securities portfolio is used to modify and diversify the overall credit risk exposure to a desired level

• Bank’s security portfolios consist almost exclusively of fixed-income securities.

Question 124

R15

Banks: RISK

Answer 124

• Dominated by ALM considerations that focus on funding liabilities. Therefore, risk relative to liabilities, rather than absolute risk, is of primary concern

Question 125

R15

Banks: RETURN

Answer 125

• A bank’s return objectives for its securities portfolio are driven by the need to earn a positive return on invested capital. For the interest-income part of return, the portfolio manager pursues this objective by attempting to earn a positive spread over the cost of funds.

Question 126

R15

Banks: LIQUIDITY

Answer 126

• A bank’s liquidity position is a key management and regulatory concern. Liquidity requirements are determined by net outflows of deposits, if any, as well as demand for loans.

Question 127

R15

Banks: TIME HORIZON

Answer 127

• A bank’s time horizon for its securities portfolio reflects its need to manage interest rate risk while earning a positive return on invested capital. A bank’s liability structure typically reflects an overall shorter maturity than its loan portfolio, placing a risk management constraint on the time horizon length for its securities portfolio. This time horizon generally falls in the three- to seven-year range (intermediate term).

Question 128

R15

Banks: TAX

Answer 128

• Banks’ securities portfolios are fully taxable.
• Realized securities losses decrease reported operating income, while securities gains increase reported operating income. According to some observers, this accounting treatment creates an incentive not to sell securities showing unrealized losses, providing a mechanism by which earnings can be managed.

Question 129

R15

Banks: LEGAL REGULATORY

Answer 129

• Regulations place restrictions on banks’ holdings of common shares and below-investment-grade risk fixed-income securities.
• Risk-based capital (RBC) regulations are a major regulatory development worldwide affecting banks’ risk-taking incentives.- BASAL.

Question 130

R15

Banks: UNIQUE

Answer 130

• There are no common unique circumstances to highlight relative to banks’ securities investment activities. That situation stands in contrast to banks’ lending activities, in which banks may consider factors such as historical banking relationships and community needs, which may be viewed as unique circumstances.

Question 131

R29

Active Return

Answer 131

• The portfolio’s return in excess of the return on the portfolio’s benchmark.
• (R_p-R_b)
• Benefits of active management

Question 132

R29

3 sources of Active Return

Answer 132

1. Strategic or long term exposures to rewarded factors (size,value, growth, market risk (beta))
2. Tactical exposture to mispriced sectors, securities and rewarded factors that generate alpha
3. Idiosyncratic risk - returns generated by luck

Question 133

R29

3 Building Blocks Used in Equity Portfolio Construction

Answer 133

1. Factor Weightings (Active return due to beta differences with portfolio and benchmark). Underweight / overweighting rewarded risk factors.
2. Alpha Skills (factor timing). active returns arising from skillful timing of exposure to rewarded factors, unrewarded factors (e.g. region exposure, industry sector), or even other asset classes (such as cash) constitute a manager’s alpha—the second building block.
3. Position Sizing (diversification vs concentration). The stock picker with high confidence in her analysis of individual securities may be willing to assume high levels of idiosyncratic risk. On the other hand, a manager focused on creating balanced exposures to rewarded factors is unlikely to assume a high level of idiosyncratic risk and is, therefore, quite likely to construct a highly diversified portfolio of individual securities.

• Need to integrate this blocks with breadth of expertise

Question 134

R29

Fundamental law: expected active portfolio return E(R_A)

Answer 134

E(R_A) = IC√BR_σRATC

where

IC = Expected information coefficient of the manager—the extent to which a manager’s forecasted active returns correspond to the managers realized active returns

BR = Breadth—the number of truly independent decisions made each year. Higher breadth = higher active returns. Looking at multiple factors will lead to higher breadth.

TC = Transfer coefficient, or the ability to translate portfolio insights into investment decisions without constraint (a truly unconstrained portfolio would have a transfer coefficient of 1)

σ_RA = the manager’s active risk

Question 135

R29

Approaches to Active Equity Portfolio Construction

Answer 135

1. Systematic - following rules. Seek to reduce exposure to idiosyncratic risk and often use broadly diversified portfolios to achieve the desired factor exposure while minimizing security-specific risk. Typically more adaptable to a formal portfolio optimization process.
2. Discretionary -generally more concentrated portfolios, reflecting the depth of the manager’s insights on company characteristics and the competitive landscape.
3. Bottom up - may embrace such styles as Value, Growth at Reasonable Price, Momentum, and Quality.
4. Top Down - contains an important element of factor timing. is Likely to run a portfolio concentrated with respect to macro factor exposures

• Portfolio construction can be seen as an optimisation problem.

Question 136

R29

Summary of the Different Approaches

Answer 136

Question 138

R29

Active Risk

Answer 138

• The annualized standard deviation of active returns, also referred to as tracking error (also sometimes called tracking risk).
• Active risk is affected by the degree of cross correlation, but Active Share is not.
• A portfolio manager can completely control Active Share, but she cannot completely control active risk because active risk depends on the correlations and variances of securities that are beyond her control
• The active risk of a portfolio is a function of the variance attributed to the factor exposure and of the variance attributed to the idiosyncratic risk .
• High net exposure to a risk factor will lead to a high level of active risk, irrespective of the level of idiosyncratic risk;
• If the factor exposure is fully neutralized, the active risk will be entirely attributed to Active Share;
• The active risk attributed to Active Share will be smaller if the number of securities is large and/or average idiosyncratic risk is small;
• the level of active risk will rise with an increase in factor and idiosyncratic volatility

Question 139

R29

Active Share

Answer 139

• It measures the extent to which the number and sizing positions in a manager’s portfolio differ from the benchmark.
• Two sources of active share:

1. Including securities in the portfolio that are not in the benchmark
2. Holding securities in the portfolio that are in the benchmark but at weights different than the benchmark weights

• 0.5∑[Weight_portfolio,i−Weight_benchmark,i]
• 1 - active share = % overlap between portfolio and benchmark
• Value from 0 to 1
• Will be 0 when weights in portfolio and benchmark the same
• Will be 1 when weights in portfolio and benchmark are all different

Question 140

R29

Effective risk management process

Answer 140

1. Determine which type of risk measure is appropriate given the fund mandate.

• Absolute risk measures are appropriate when the investment objective is expressed in terms of total returns (e.g., total volatility of portfolio returns).
• Relative risk measures are appropriate when the investment objective is to outperform a market index.

2. Understand how each aspect of the strategy contributes to overall risk.
   * Does risk come from exposure to rewarded factors or allocations to sectors/securities?
3. Determine what level of risk budget is appropriate.
   * This is the overall level of risk targeted.
4. Properly allocate risk among individual positions/factors.

Question 141

R29

Causes and Sources of Absolute Risk

Answer 141

• The contribution of an asset to total portfolio variance is equal to the product of the weight of the asset and its covariance with the entire portfolio
• CV i= ∑ = x_ix_jC_ij = x_iC_ip

_{xj = the asset’s weight in the portfolio}

_{Cij = the covariance of returns between asset i and asset j}

_{Cip = the covariance of returns between asset i and the portfolio}

• _{“assets” might also be sectors, countries, or pools of assets representing risk factors (Value versus Growth, Small versus Large)}

Question 142

R29

Causes and Sources of Relative/Active Risk

Answer 142

• Relative risk becomes an appropriate measure when the manager is concerned with her performance relative to a benchmark.
• The contribution of each asset to the portfolio active variance (CAV_i) is:

CAV_i = (x_i−bi)RC_ip

_{xi = the asset’s weight in the portfolio}

_{bi = the benchmark weight in asset i}

_{RCij = the covariance of relative returns between asset i and asset j}

• Adding up the contributions for active variance (CAVi) for all assets in the portfolio produces the variance of the portfolios active return.
• Can be done on a factor level

Question 143

R29

Risk Constraints

Answer 143

• Heuristic Constraints e.g. portfolio must have a weighted average capitalization less than 75% of that of the index; portfolio’s carbon footprint must be limited to no more than 75% of the benchmark’s exposure.
• Formal Constraints e.g Volatility, Active risk, VaR, Skewness, Drawdowns.

Question 144

R29

Long-Only Investing

Answer 144

• Can take long positions
• choice of whether to pursue a long-only strategy or some variation of a long/short strategy is likely to be influenced by several considerations:

1. Long-term risk premiums
2. Capacity and scale (the ability to invest assets, liquidity)
3. Limited legal liability and risk appetite. Long only will only lose the amount invested. Short sellers losses can be unlimited - stock could go up indefinetly
4. Regulatory constraints. Some countries ban short selling.
5. Transactional complexity. Long -only transactions simple.
6. Management costs. Long-only is less expensive.
7. Personal ideology - morally wrong to short? Unwilling to use risk.

Question 145

R29

Long-Short Investing

Answer 145

• Net exposure is 0
• Equal number of long and short positions

Question 146

R29

Long Extension Portfolio Construction

Answer 146

• A hybrid of long-only and long/short strategies.
• A 130/30 strategy builds a portfolio of long positions worth 130% of the wealth invested in the strategy—that is, 1.3 times the amount of capital. At the same time, the portfolio holds short positions worth 30% of capital
• This strategy offers the opportunity to magnify total returns
• Could also lead to greater losses if the manager is simultaneously wrong on both his long and short picks.
• Beta not zero - more equal to 1.

Question 147

R29

Market-Neutral Portfolio Construction

Answer 147

• Dollar neutral is not the same thing as market neutral, because the economic drivers of returns for the long side may not be the same as the economic drivers for the short side.
• True market-neutral strategies hedge out most market risk
• A simple example of zero-beta investment would be a fund that is long $100 of assets with a Market beta of 1 and short $80 of assets with a Market beta of 1.25
• The main constraint is that in aggregate, the targeted beta(s) of the portfolio be zero.
• Seek to remove major sources of systematic risk from a portfoli
• Use of pairs trading or statistical arbitrage
• Market-neutral strategies have two inherent limitations:

1. It is no easy task to maintain a beta of zero
2. Market-neutral strategies have a limited upside in a bull market unless they are “equitized.” Some investors, therefore, choose to index their equity exposure and overlay long/short strategies.

Question 148

R29

Benefits of Long/Short Strategies

Answer 148

• Ability to more fully express short ideas than under a long-only strategy
• Efficient use of leverage and of the benefits of diversification
• Greater ability to calibrate/control exposure to factors (such as Market and other rewarded factors), sectors, geography, or any undesired exposure (such as, perhaps, sensitivity to the price of oil)
• Short positions can reduce market risk.
• Shorting potentially expands benefits from other risk premiums and alpha.

Question 149

R29

Drawbacks of Long/Short Strategies

Answer 149

• Unlike a long position, a short position will move against the manager if the price of the security increases.
• Long/short strategies sometimes require significant leverage. Leverage must be used wisely.
• The cost of borrowing a security can become prohibitive, particularly if the security is hard to borrow.
• Collateral requirements will increase if a short position moves against the manager. In extreme cases, the manager may be forced to liquidate some favorably ranked long positions (and short positions that might eventually reverse) if too much leverage has been used. The manager may also fall victim to a short squeeze. A short squeeze is a situation in which the price of the stock that has been shorted has risen so much and so quickly that many short investors may be unable to maintain their positions in the short run in light of the increased collateral requirements.
• Lender can call back shares at any time
• Shorting may amplify the active risk.
• Short positions might reduce the market return premium.
• There are higher implementation costs and greater complexity associated with shorting and leverage relative to a long-only approach.

Question 150

R29

Slippage

Answer 150

• Slippage is the difference between execution price and mid point of the bid and ask quotes
• Slippage costs usually more important than commission costs
• slippage costs greater for small cap than large cap
• slippage costs not necessarily greater in emerging markets
• Slippage costs can vary over time, especially when market volatility is higher.

Question 151

R14

Human Capital, Financial Capital, Economic Balance Sheet

Answer 151

• Human Capital - An implied asset; the net present value of an investor’s future expected labor income weighted by the probability of surviving to each future age. Also called net employment capital.
• Financial Capital - The tangible and intangible assets (excluding human capital) owned by an individual or household.
• Economic Balance Sheet - A balance sheet that provides an individual’s total wealth portfolio, supplementing traditional balance sheet assets with human capital and pension wealth, and expanding liabilities to include consumption and bequest goals. Also known as holistic balance sheet.

Question 152

R14

Comparing Financial and Human Capital

Answer 152

Human capital is commonly defined as the mortality-weighted net present value of an individual’s future expected labor income. Financial capital includes the tangible and intangible assets (outside of human capital) owned by an individual or household.

Question 153

R14

Net Wealth

Answer 153

The difference between an individual’s assets and liabilities; extends traditional financial assets and liabilities to include human capital and future consumption needs.

Question 154

R14

4 Key Steps in Risk Management Process

Answer 154

1. Specify the objective.
2. Identify risks.
3. Evaluate risks and select appropriate methods to manage the risks.
4. Monitor outcomes and risk exposures and make appropriate adjustments in methods.

Question 155

R14

4 Risk Techniques

Answer 155

1. Risk Avoidance
2. Risk Reduction
3. Risk Transfer
4. Risk Retention

Question 156

R14

Financial Stages of Life

Answer 156

• Education phase - could benefit from products, such as life insurance, that hedge against the risk of losing human capital.
• Early career - Human capital represents such a large proportion of total wealth.Use of life insurance. 18 - 30’s.
• Career development - 35–50 age range. Retirement saving tends to increase.
• Peak accumulation - ages of 51–60. Emphasize income production for retirement and become increasingly concerned about minimizing taxes, given higher levels of wealth and income
• Pre-retirement - typically represents an individual’s maximum career income. May consider investments that are less volatile. There is further emphasis on tax planning
• Early retirement - 10 years of retirement. use resources to produce activities that provide enjoyment. Some retirees seek a new career. Need for asset growth does not disappear
• Late retirement - unpredictable because the exact length of retirement is unknown. Longevity risk. Cognitive decline can present a risk of financial mistakes, which may be hedged through the participation of a trusted financial adviser or through the use of annuities.

Question 157

R14

Traditional vs. Economic Balance Sheet

Answer 157

A traditional balance sheet includes assets and liabilities that are generally relatively easy to quantify. An economic balance sheet provides a useful overview of one’s total wealth portfolio by supplementing traditional balance sheet assets with human capital and pension wealth and including additional liabilities, such as consumption and bequest goals.

Question 158

R14

Changes in Human and Financial Capital

Answer 158

The total value of human capital and the total value of financial capital tend to be inversely related over time as individuals attempt to smooth consumption through borrowing, saving, and eventual spending. When human capital becomes depleted, without financial capital, an individual will have no wealth to fund his or her lifestyle. Human capital is generally largest for a younger individual, whereas financial capital is generally largest when an individual first retires.

Question 159

R14

6 Individual Risk Exposures

Answer 159

• Earnings risk - The risk associated with the earning potential of an individual. Loss or reduction of earnings and may also include the loss of employer contributions to one’s retirement fund. The loss of income represents a reduction in both human and financial capital.
• Premature Death Risk - The risk of an individual dying earlier than anticipated; sometimes referred to as mortality risk. Effecton human and financial capital. Death expenses (including funeral and burial), transition expenses, estate settlement expenses, and the possible need for training or education for the surviving spouse may be needed
• Longevity risk - Financial planners often run a Monte Carlo simulation. Insufficient assets may exacerbate the situation and many pension programs do not consider inflation. Individual may choose to work longer.
• Liability Risk - individual or household may be held legally liable for the financial costs associated with property damage or physical injury. May affect the individual’s financial and/or human capital.
• Health Risk - risks and implications associated with illness or injury. Significant implications for human capital as well as for financial capital. An added risk is that inflation in long-term care costs (i.e., medical costs) has historically been higher than base inflation.
• Property Risk - a person’s property may be damaged, destroyed, stolen, or lost. Direct loss refers to the monetary value of the loss associated with the property itself. Indirect loss are expenses incurred asa resultof direct loss. Because property represents a financial asset, property risk is normally considered to be associated with a potential loss of financial capital. But property used in a business to create income is rightfully considered in a discussion of human capital.

Question 160

R14

Types of Life Insurance

Answer 160

• Temporary life insurance - A type of life insurance that covers a certain period of time, specified at purchase. Commonly referred to as “term” life insurance. The cost of term insurance is less than that of permanent insurance, and the cost per year is less for shorter insured period
• Permanent life insurance - A type of life insurance that provides lifetime coverage. Policy premiums for permanent life insurance are usually fixed.

1. Whole life insurance - in force for an insured’s entire life, requires regular, ongoing fixed premiums. Cash value associated with a whole life insurance policy that may be accessed if the insured chooses to do so. Can be participating (in profits) or non-participating (fixed rate).
2. Universal life insurance - more flexibility than whole life insurance. Ability to pay higher or lower premium payments and often has more options for investing the cash value.

Question 161

R14

Insurable interest for life insurance.

Answer 161

An insurable interest means that the policy owner must derive some type of benefit from the continued survival of the insured that would be negatively affected should the insured pass away. For example, an individual may rely on a spouse for his or her financial well-being.

Question 162

R14

Life Insurance Pricing

Answer 162

1. Mortality Expectations - estimate mortality based on both historical data and future mortality expectations. Actuaries typically make adjustments to consider additional factors e.g. health history,excess weight, risky activities. May require physical exam. All to avoid adverse selection - individuals who know that they have higher-than-average risk are more likely to apply for life insurance.
2. Net Premium - represents the discounted value of the future death benefit. Must also consider the fact that the individuals who die within the five-year period will not be paying premiums for the remaining outstanding term. Some consumers buy an annually renewable term policy with the intention of taking advantage of the “loss-leader” pricing in the early years and then, when rates rise too much, switching to another company that has a lower premium at the newly attained age
3. Gross Premium - adds a load to the net premium, allowing for expenses and a projected profit for the insurance company. Expenses are incurred by the insurer for both writing a life insurance policy and managing it on an ongoing basis. Premiums for level term policies are higher than those for annually renewable (one-year) policies in the early years. But premiums are lower in the later years of the policies—most notably for longer periods, such as a 20-year level term—because annually renewable term policies often have rapidly increasing premiums.
4. Life insurers - stock companies and mutual companies. The former has a profit motive.

Question 163

R14

3 most relevant elements of life insurance pricing.

Answer 163

• Mortality expectations: The insurer is concerned about the probability that the insured will die within the term of the policy. Actuaries evaluate mortality expectations based on historical experience, considering such factors as age and gender, the longevity of parents, blood pressure, cholesterol, whether the insured is a smoker, and whether the insured has had any diseases or injuries that are likely to lead to death during the policy term.
• Discount rate: A discount rate, or interest factor, representing an assumption of the insurance company’s return on its portfolio, is applied to the expected outflow.
• Loading: After calculating the net premium for a policy, which may be considered the pure price of the insurance, the insurance company adjusts the premium upward to allow for expenses and profit. This adjustment is the load, and the process is called loading

Question 164

R14

Comparisons of Life Insurance Costs

Net Payment Cost Index

Answer 164

Assumes that the insured person will die at the end of a specified period, such as 20 years.

1. Calculate the future value of an annuity due of an amount equal to the premium, compounded at a 5% discount rate for 20 years. An annuity due—an annuity for which the premium payment is received at the beginning of the period (versus an ordinary annuity, for which the premium payment is received at the end of the period)—is used because premiums are paid at the beginning of the period.
2. Calculate the future value of an ordinary annuity of an amount equal to the projected annual dividend (if any), compounded at 5% for 20 years. An ordinary annuity is used because dividend payments are made at the end of the period.
3. Subtract B from A to get the 20-year insurance cost.
4. Calculate the payments for a 20-year annuity due with a future value equal to C and a discount rate of 5%. This amount is the interest-adjusted cost per year. Again, an annuity due is used because premium payments occur at the beginning of the year.
5. Divide by the number of thousand dollars of face value.

Question 165

R14

Comparisons of Life Insurance Costs

Surrender Cost Index

Answer 165

Assumes that the policy will be surrendered at the end of the period and that the policy owner will receive the projected cash value.

1. Calculate the future value of an annuity due of an amount equal to the premium, compounded at 5% for 20 years. We use an annuity due here for the same reason indicated for the net payment cost index.
2. Calculate the future value of an ordinary annuity of an amount equal to the projected annual dividend (if any), compounded at 5% for 20 years. We use an ordinary annuity here for the same reason indicated for the net payment cost index.
3. Subtract B and the Year 20 projected cash value from A to get the 20-year insurance cost.
4. Calculate the payments for a 20-year annuity due with a future value equal to C and a discount rate of 5%. This amount is the interest-adjusted cost per year.
5. Divide by the number of thousand dollars of face value.

Question 166

R14

2 Main Types of Annuities

Answer 166

1. Immediate Annuity - An annuity that provides a guarantee of specified future monthly payments over a specified period of time.
2. Deferred Annuity - An annuity that enables an individual to purchase an income stream that will begin at a later date.

Question 167

R14

5 Classification of Annuities

Answer 167

1. Deferred Variable Annuities - similar to a mutual fund, although it is structured as an insurance contract. Menu of potential investment options from which an individual can choose. May include a death benefit. Does not guarantee lifetime income unless the individual (1) adds an additional feature (a contract rider) or (2) annuitizes the contract
2. Deferred Fixed Annuities - provide an annuity payout that begins at some future date. Once in retirement, the individual has two options: (1) cash out or (2) begin withdrawing the accumulated funds. In either case, the “economic value” of the accumulated purchases is annuitized, converting the deferred fixed annuity into an immediate fixed annuity. In contrast to deferred variable annuities, which most investors choose not to annuitize, most deferred fixed annuities are eventually annuitized.
3. Immediate Variable Annuities - exchanges a lump sum for an annuity contract that promises to pay the annuitant an income for life. Amount of the payments varies over time based on the performance of the portfolios. Income floor often added to hedge againsta down market.
4. Immediate Fixed Annuities - trades a sum of money today for a promised income benefit for as long as he or she is alive.
5. Advanced Life Deferred Annuities (ALDA) - payments begin later in life. Lower cost: As payments on the deferred annuity begin so far in the future, the insurance company has ample time to earn money on the amount tendered. Second, life expectancy is much shorter , so the number of payments made will be fewer. Third, the annuitant may actually die before any payments are made

Question 168

R14

5 Factors suggesting increased demand for annuity

Answer 168

1. Longer-than-average life expectancy
2. Greater preference for lifetime income
3. Less concern for leaving money to heirs
4. More conservative investing preferences (i.e., greater risk aversion)
5. Lower guaranteed income from other sources (such as pensions)

Question 169

R14

Mortality Credits

Answer 169

• Each payment received by the annuitant is a combination of principal, interest, and mortality credits.
• Mortality credits are the benefits that survivors receive from those individuals in the mortality pool who have already passed away.
• “retirement income efficient frontier” whereby the decision of how much to annuitize is based on an individual’s preference for wealth maximization and aversion to running out of money.

Question 170

R14

Advantages and Disadvantages of Fixed and Variable Annuities

Answer 170

• Volatility of Benefit Amount - Retirees seeking a high level of assurance need a fixed annuity. Retirees who are risk tolerant could use a variable annuity.
• Flexibility - variable annuities can provide the flexibility to access the funds should he need to do so. There may be penalties associated.
• Future Market Expectations - fixed annuity locks the annuitant into a portfolio of bond-like assets at whatever rate of return exists at the time of purchase. This scenario creates some interest rate risk. Variable annuities without growth-limiting features, such as minimum income guarantees, are most likely to provide a future income that outpaces inflation on average.
• Fees - fees associated with variable annuities tend to be higher than those for fixed annuities
• Inflation Concerns - significant negative impact on the real income received from a fixed annuity. Partial inflation hedge by having benefits “step up” some predetermined amount each year (e.g., 3%). There are a number of variable annuities (and riders on fixed annuities) that allow the payments to increase or decrease based on changes in inflation.
• Annuity Benefit Taxation - In some locations, annuities can offer attractive tax benefits, such as tax-deferred growth.
• Appropriateness of Annuities - individual can choose either to receive periodic withdrawals from an investment portfolio (i.e., not annuitize) or to purchase an annuity (i.e., annuitize)

Question 171

R14

Annuity Payout Methods

Answer 171

Payout Methods

1. Life annuity: Payments are made for the entire life of the annuitant and cease at his or her death.
2. Period-certain annuity: Payments are made for a specified number of periods without regard to the lifespan or expected lifespan of the annuitant.
3. Life annuity with period certain: This payment type combines the features associated with a life annuity and a period-certain annuity, so payments are made for the entire life of the annuitant but are guaranteed for a minimum number of years even if the annuitant dies.
4. Life annuity with refund: This type is similar to a life annuity with period certain, but instead of guaranteeing payments for life or for a certain number of years, a life annuity with refund guarantees that the annuitant (or the beneficiary) will receive payments equal to the total amount paid into the contract, which is equal to the initial investment amount less fees.
5. Joint life annuity: With a life annuity on two or more individuals, such as a husband and a wife, payments continue until both members are no longer living

Question 172

R14

Risk Management Techniques

Answer 172

• *Loss characteristics** High frequency Low frequency** **High severity Risk avoidance Risk transfer
• *Low severity** Risk reduction Risk retention
• loss control refers to efforts to reduce or eliminate the costs associated with risks:

1. Risk avoidance
2. Loss Prevention
3. Loss Reduction

Question 173

R13

Single Asset Position Overview

3 Main assets classes and risks

Answer 173

3 Main asset classes effected:

1. publicly traded single-stock positions,
2. privately held businesses (including family-owned businesses), and
3. investment real estate.

3 Main Risks:

1. Systematic risk
2. Company specfic risk
3. Property Specfic risk

Question 174

R13

3 Main objectives when dealing with concentrated positions

Answer 174

1. Reduce the risk of wealth concentration
2. Generate liquidity in order to diversify and satisfy spending needs
3. Optimise Tax effiency

Question 175

R13

Goal Based Planning

Answer 175

1. Personal Risk Bucket
2. Market Risk Bucket
3. Aspirational Risk Bucket

Personal Risk Bucket + Market Risk Bucket = Primary Captial

Aspiration Risk Bucket = Surplus Capital

Question 176

R13

Concentrated Wealth Decision Making: A Five-Step Process

Answer 176

1. Identify and establish objectives and constraints
2. Identify tools/strategies that can satisfy these objectives
3. Compare tax advantages and disadvantages.
4. Compare non-tax advantages and disadvantages.
5. Formulate and document an overall strategy.

Question 177

R13

3 primary strategies in the case of a concentrated position in a common stock

Answer 177

• Equity monetization
• Hedging
• Yield enhancement

Question 178

R13

Equity Monetization Tool Set (4)

Answer 178

1. Short sale against the box - Shorting a security that is held long. Long and short positions together constitute a riskless position. The least expensive technique that is available to hedge, monetize, and potentially defer the capital gains tax on a concentrated position. Will earn a money market rate of return.
2. Total return equity swap - A swap contract that involves a series of exchanges of the total return on a specified asset or equity index in return for specified fixed or floating rate payments. a very high LTV ratio should be possible.Money market return slightly less than short sale against the box.
3. Forward conversion with options -The construction of a synthetic short forward position against the asset held long. Position created is riskless, should a money market rate of return.
4. Equity forward sale contract - A private contract for the forward sale of an equity position. If the market price is above the forward price at the termination of the contract, the investor will receive the forward price and will not participate in any market increase above that price.

Question 179

R13

Hedging concentrated stock position

Answer 179

1. Purchase of Puts - can purchase put options to (1) lock in a floor price, (2) retain unlimited upside potential, and (3) defer the capital gains tax. Downside protection with unlimited upside price participation.But has a permium cost. Reduce premium:

• Further out of money put
• Shorter maturity put
• Put spread
• Knock out option
• Cashless collar

1. Zero Premium Collar - (1) hedge against a decline in the price of a stock, (2) retain a certain degree of upside potential with respect to the stock, and (3) defer the capital gains tax while avoiding any out-of-pocket expenditure. The investor retains any dividend income and voting rights.

Question 180

R13

Prepaid Variable Forwards

Answer 180

• Where the hedge (e.g.collar) and the margin loan are combined in one instrument that achieves an identical economic result

Question 182

R13

Mismatch in character

Answer 182

• The potential tax inefficiency that can result if the instrument being hedged, and the tool that is being used to hedge it, produce income and loss of a different character.
• For example, when an employee exercises employee stock options, any gains are typically treated like cash salary and bonus—that is, as ordinary income. In contrast, most derivative-based hedging tools give rise to capital gains or losses. Therefore, in some jurisdictions, the use of a derivative-based collar to hedge employee stock options can create the potential for ordinary income on one hand (i.e., the employee stock options) and capital losses on the other (i.e., the derivative-based hedge

Question 183

R13

Yield Enhancement of concentrated stock positions

Answer 183

• Writing covered calls against some or all of the shares.
• Allows the investor to establish a liquidation value
• Psychologically prepare the owner to dispose of those shares.
• Attractive if the holder believes the stock will be stuck in a trading range for the foreseeable future

Question 184

R13

Tax-Optimized Equity Strategies (4)

Answer 184

1. Index-tracking strategy - Funded by cash, from a partial sale of the investor’s concentrated stock position. Track benchmark closely.
2. Completeness portfolio - build a portfolio such that the combination of the two portfolios tracks the broadly diversified market benchmark to the best extent possible. Capital loss harvesting in the completeness portfolio allows a concurrent sale of the concentrated stock position without a tax liability. Over time, the size of the concentrated stock position is whittled down to zero, whereas the completeness portfolio becomes an index-tracking one. This strategy is intended to be implemented over time.
3. Cross Hedging - A hedge involving a hedging instrument that is imperfectly correlated with the asset being hedged. By using derivatives on a substitute asset with an expected high correlation with the investor’s concentrated stock position. using a cross hedge. The investor is at least able to hedge market and industry risk.Investor retains all of the company-specific risk of the concentrated position.
4. Exchange Fund - an investment fund structured as a partnership in which the partners have each contributed their low-basis concentrated stock positions to the fund. Participating in the exchange fund is not considered a taxable event. For tax purposes, each partner must remain in the fund for a minimum of seven years.

Question 185

R13

Managing Private Equity Concentration

Sale to third-party investor

Answer 185

• Sale to third-party investor:

1. Strategic buyer- Will typically pay the highest price for a business because of potential revenue, cost, and other potential synergies
2. Financial buyer - look for companies that they can create significant value. They target earning a high internal rate of return on their invested capital over a fairly short period of time, typically three to five years, at which time the company will ideally either be sold to a strategic buyer or go public.

Question 186

R13

Managing Private Equity Concentration

Sale to insider

Answer 186

• Sale to insider:

1. Management (management buyout, or MBO) - key employees may not, in fact, be successful entrepreneurs. Owner is often asked to finance a substantial amount of the purchase price in the form of a promissory note. Failed attempt to do an MBO has the potential to negatively affect the dynamics of the employer–employee relationship.
2. Employees (employee stock ownership plan, or ESOP, in the United States)-

By using an ESOP, the owner can partially diversify his or her holdings, in a tax-advantaged manner, and diversify while retaining control of the company and maintaining upside potential in the retained shares. Disadvantages, include setup and maintenance costs.

3. Sale or transfer to next generation of family - Gifting strategies are often used to transfer ownership to the next generation.Family members may not have the necessary capital to buy the business.

Question 187

R13

Managing Private Equity Concentration

Other strategies (4)

Answer 187

1. Recapitalization - leveraged recapitalization. A leveraging of a company’s balance sheet, usually accomplished by working with a private equity firm. Owner transfers a portion of her stock for cash and retains a minority ownership interest in the freshly capitalized entity. An example of a “staged” exit strategy in that it allows the owner to have two liquidity events, one up front and another typically within three to five years, when the private equity firm seeks to cash out its investment (which could be an IPO, a sale to a strategic or financial buyer, or another recapitalization).
2. Divestiture - Sale or Disposition of Non-Core Assets.Exiting a certain line of business or closing a division that does not fit in with the future growth plans of the company, yet this business line or division may have value to a competitor.
3. Personal Line of Credit Secured by Company Shares - a personal loan secured by his or her shares in the private company. Owner maintains full ownership and control of the company, has access to cash to diversify his or her concentration risk, and avoids triggering a taxable event. At some point the debt will need to be repaid.
4. IPO - costs are significant. if the owner’s objective is to exit from the company in the near term, an IPO is not a viable exit strategy.

Question 188

R13

Monetization Strategies for Real Estate Owners

Answer 188

1. Mortgage Financing - proceeds could be invested in a liquid, diversified portfolio of securities. Net rental income derived from the property exactly covers the cost of servicing the debt and other expenses of the property. Non-recourse loan (meaning that the lender’s only recourse upon an event of default is to look to the property that was mortgaged to the lender), the investor has economically acquired the equivalent of a put issued by the lender.
2. Real Estate Monetization for the Charitably Inclined - use of tax-exempt charitable trust e.g. DAF.he trust would have a defined and charitable purpose, the contributor would receive a tax deduction from the donation to trust, and the trust would not be taxed on property sale proceeds or investment income emanating from the property.
3. Sale and Leaseback - a transaction wherein the owner of a property sells that property and then immediately leases it back from the buyer at a rental rate. ny debt that was associated with the real estate is removed from the balance sheet.There is typically complete rental payment deductibility for tax purposes. Provides 100% of the value of the asset compared with traditional mortgage debt financing, which rarely exceeds 75%

Question 189

R12

Basic Concepts

Answer 189

Civil Law

A legal system derived from Roman law, in which judges apply general, abstract rules or concepts to particular cases. In civil systems, law is developed primarily through legislative statutes or executive action.

Common Law

A legal system which draws abstract rules from specific cases. In common law systems, law is developed primarily through decisions of the courts.

Forced Heirship

Legal ownership principles whereby children have the right to a fixed share of a parent’s TOTAL estate.

Community property regimes

A marital property regime under which each spouse has an indivisible one-half interest in property received during marriage.

Seperate property regimes

A marital property regime under which each spouse is able to own and control property as an individual.

Question 190

R12

Core Capital and Excess Capital Definitions

Answer 190

• Human Capital :An implied asset; the net present value of an investor’s future expected labor income weighted by the probability of surviving to each future age. Also called net employment capital.
• Core Capital: The amount of capital required to fund spending to maintain a given lifestyle, fund goals, and provide adequate reserves for unexpected commitments.
• Excess Capital: An investor’s capital over and above that which is necessary to fund their lifestyle and reserves.

Question 191

R12

Core Capital and Excess Capital Calculations

Answer 191

Survival probability:

p(Survival) = p(Husband survives) + p(Wife survives) − p(Husband survives) × p(Wife survives)

Present value of the spending need:

PV (Spending need )= ∑ (Survival^j) × Spending^j / (1+r)^j

(Numerator is Expected Spending)

Core Capital Estimation with Monte Carlo Analysis

• Estimates the size of a portfolio needed to generate sufficient withdrawals to meet expenses, which are assumed to increase with inflation.
• More fully captures the risk
• Can incorporate recurring spending needs, irregular liquidity needs, taxes, inflation
• Expected returns are derived from the market expectations of the assets comprising the portfolio.

Question 192

R12

Tax Free Gift

Answer 192

The relative after-tax value of a tax-free gift made during one’s lifetime compared to a bequest that is transferred as part of a taxable estate is:

Question 193

R12

Taxable Gift

Answer 193

The value of making taxable gifts rather than leaving them in the estate to be taxed as a bequest, can be expressed as ratio of the after-tax future value of the gift and the bequest, or:

Question 194

R12

Donor pays gift tax and when the recipient’s estate will not be taxable

Answer 194

The relative after-tax value of the gift when the donor pays gift tax and when the recipient’s estate will not be taxable

Question 195

R12

Charitable Gratuitous Transfers

Answer 195

Question 200

R12

Trust Terminology

Answer 200

• Revocable trust - A trust arrangement wherein the settlor (who originally transfers assets to fund the trust) retains the right to rescind the trust relationship and regain title to the trust assets. Settlor is responsible for tax payments and reporting. Trust assets vulnerable to the reach of creditors having claims against the settlor.
• Irrevocable trust. - A trust arrangement wherein the settlor has no ability to revoke the trust relationship.Greater asset protection from claims against a settlor.
• Fixed trust - A trust structure in which distributions to beneficiaries are prescribed in the trust document to occur at certain times or in certain amounts.
• Discretionary trust - A trust structure in which the trustee determines whether and how much to distribute in the sole discretion of the trustee.

The legal concept of a trust is unique to the common law. Civil law countries may not recognize foreign trusts because it is a legal relationship, not a legal person

Question 201

R12

Double Taxation Terminology

Answer 201

• residence–residence conflict - When two countries claim residence of the same individual, subjecting the individual’s income to taxation by both countries.
• source–source conflict - When two countries claim source jurisdiction of the same asset; both countries may claim that the income is derived from their jurisdiction.
• residence–source conflict - When tax jurisdiction is claimed by an individual’s country of residence and the country where some of their assets are sourced; the most common source of double taxation
• Source tax system - A jurisdiction that imposes tax on an individual’s income that is sourced in the jurisdiction.
• Residence tax system - A jurisdiction that imposes a tax on an individual’s income based on residency whereby all income (domestic and foreign sourced) is subject to taxation.

Question 202

R12

Credit method

Answer 202

When the residence country reduces its taxpayers’ domestic tax liability by the amount of taxes paid to a foreign country that exercises source jurisdiction.

T_CreditMethod = Max[T_Residence,T_Source]

Question 203

R12

Exemption method

Answer 203

When the residence country imposes no tax on foreign-source income by providing taxpayers with an exemption, in effect having only one jurisdiction impose tax.

T_{ExemptionMethod} = T_Source

Question 204

R12

Deduction method

Answer 204

When the residence country allows taxpayers to reduce their taxable income by the amount of taxes paid to foreign governments in respect of foreign-source income.

T_{DeductionMethod}=T_Residence+T_Source−T_ResidenceT_Source

The residence country makes a partial concession recognizing the primacy of source jurisdiction.

Question 205

R12

Reduce / avoid forced heirship

Answer 205

• moving assets into an offshore trust governed by a different jurisdiction;
• gifting or donating assets to others during their lifetime to reduce the value of the final estate upon death; or
• purchasing life insurance, which can move assets outside of realm of forced heirship provisions.
• Such strategies, however, may be subject to “clawback” provisions that provide a basis for heirs to challenge these solutions in court.

Question 206

R28

5 Types of Active Strategies

Answer 206

1. Factor Based
2. Activism
3. Statistical Arbitrage
4. Fundamental
5. Quantative

Question 207

R28

Fundamental Approach

Based on opinions

Answer 207

• Subjective in nature
• Discretion of analyst. Use financial statements etc.
• Human skill, experience, judgment
• Research (company/industry/economy)
• Conviction (high depth) in stock-, sector-, or region-based selection
• Forecast future corporate parameters and establish views on companies
• Use judgment and conviction within permissible risk parameters
• Likely to be fewer positions in portfolio, but allocate more to each position.
• Risk analyst is incorrect in his analysis
• Postions closely monitored by analyst and rebalanced based on their opinion

Question 208

R28

Quantative Approach

Based on models

Answer 208

• Objective. Relies on models to generate rules for selection of stocks.
• Systematic, non-discretionary
• Expertise in statistical modeling
• A selection of variables, subsequently applied broadly over a large number of securities
• Attempt to draw conclusions from a variety of historical data
• Use optimizers
• Quant managers will spread factor bets across many postions with smaller allocation
• Risk - of factors selected to not perform as predicated by the models.

Question 209

R28

Bottom Up Strategies General

Answer 209

• Starts with individual stocks / companies
• Value based and growth based strategies
• Value - finding companies trading below NAV
• Growth - identify conpanies that are expected to grow faster than the overall market

Question 210

R28

Bottom Up Strategies Value

Answer 210

1. Relative Value - compare price multiples (low P/E, P/S, P/B)
2. Contrarian Investing - contrarian managers invest in depressed cyclical stocks with low or even negative earnings or low dividend payments. Expect stocks to rebound once the company’s earnings have turned around
3. High-Quality Value - equal emphasis on financial strength and demonstrated profitability. Warren Buffett approach
4. Income Investing - Focus on shares with high dividend yields and postice growth in dividend.
5. Deep-Value Investing - extremely low valuation relative to their assets (e.g., low P/B). Increases chance of informational inefficiencies. Risk of falling into value trap (price continues to go down)
6. Restructuring and Distressed Investing - invest just prior to or after bankruptcy proceedings. J-Factor risk.
7. Special Situations - exploit mispricings from spin-offs, divestitures and mergers

Question 211

R28

Bottom Up Strategies Growth

Answer 211

1. Consistent Long Term Growth
2. Short Term Earnings Momentum
3. GARP - Use PEG ratio [calculated as the stock’s P/E divided by the expected earnings growth rate (in percentage terms)]. Often referred to as a hybrid of growth and value investing.

Question 212

R28

Top Down Strategies

Answer 212

• Macro Economic environment > industries > companies
• Often use EFT and derivatives to over / under weight market sectors

1. Country and Geographic Allocation to Equities - investing in different geographic regions depending on their assessment of the regions’ prospects.
2. Sector and Industry Rotation - a view on the expected returns of various sectors and industries across borders
3. Volatility-Based Strategies - view on volatility and is usually implemented using derivative instruments.
4. Thematic Investment Strategies - use broad macroeconomic, demographic, or political drivers

Question 213

R28

Factor Based Strategies

Answer 213

• Risk factor or style factor (i.e. variable or characteristics with which asset returns are generally correlated such as size, value, growth, price momentum, quality)
• Some factors (most commonly, size, value, momentum, and quality) have been shown to be positively associated with a long-term return premium and are often referred to as rewarded factors
• Unrewarded factors - not been empirically proven to offer a persistent return premium
• Factors used must make sense

Question 214

R28

Factor Based Strategies: Hedged Portfolio Approach

Answer 214

• Most traditional and widely used method for implementing factor-based portfolio.

Process

1. Choose the factor e.g. size
2. Ranking the investable stock universe by that factor e.g. by Market Cap
3. Divide the universe into groups referred to as quantiles to form quantile portfolios.
4. Stocks are either equally weighted or capitalization weighted within each quantile
5. Long/short hedged portfolio is typically formed by going long the best quantile and shorting the worst quantile
6. Performance of the hedged long/short portfolio is then tracked over time.

Question 215

R28

Factor Based Strategies: Hedge Portfolio Approach

Disadvantages

Answer 215

1. Middle quantiles is not utilized. Best performing companies may be in the middle.
2. Assumed the relationship between the factor and future stock returns is linear, which may not be the case
3. Portfolios built using this approach tend to be concentrated, and if many managers use similar factors, the resulting portfolios will be concentrated in specific stocks
4. The hedged portfolio requires managers to short stocks. Shorting may not be possible in some markets and may be overly expensive in others.
5. The hedged portfolio is not a “pure” factor portfolio because it has significant exposures to other risk factors.

Question 216

R28

Factor Based Strategies: Style Factors

Answer 216

1. Value - Value factors can also be based on other fundamental performance metrics of a company, such as dividends, earnings, cash flow, EBIT, EBITDA, and sales. Investors often add two more variations on most value factors by adjusting for industry (and/or country) and historical differences
2. Price Momentum - Researchers have also found a strong price momentum effect in almost all asset classes in most countries. Commonly attributed to behavioral biases, such as overreaction to information. Subject to extreme tail risk. To reduce downside risk removethe effect of sector exposure from momentum factor returns: sector-neutralized price momentum factor
3. Growth - Growth factors can also be classified as short-term growth (last quarter’s, last year’s, next quarter’s, or next year’s growth) and long-term growth (last five years’ or next five years’ growth)
4. Quality - using accounting ratios and share price data as fundamental style factors
5. Unconventional Factors Based on Unstructured Data - Using large data sets. Use of alternative or unstructured data such as satellite images, textual information, credit card payment information, and the number of online mentions of a particular product or brand.
6. Factor Timing - e.g. equity style rotation. Regression of factors against a specfic variable to decide the best style rotation.

Question 217

R28

Activist Strategies: Tactics

Answer 217

Tactics:

• Seeking board representation and nominations
• Engaging with management by writing letters to management calling for and explaining suggested changes, participating in management discussions with analysts or meeting the management team privately, or launching proxy contests whereby activists encourage other shareholders to use their proxy votes to effect change in the organization
• Proposing significant corporate changes during the annual general meeting (AGM)
• Proposing restructuring of the balance sheet to better utilize capital and potentially initiate share buybacks or increase dividends
• Reducing management compensation or realigning management compensation with share price performance
• Launching legal proceedings against existing management for breach of fiduciary duties
• Reaching out to other shareholders of the company to coordinate action
• Launching a media campaign against existing management practices
• Breaking up a large conglomerate to unlock value

Question 218

R28

Activist Strategies: Defenses

Answer 218

• Multi-class share structures whereby a company founder’s shares are typically entitled to multiple votes per share
• “Poison Pill” plans allowing the issuance of shares at a deep discount, which causes significant economic and voting dilution
• Staggered board provisions whereby a portion of the board members are not elected at annual shareholders meetings

Question 219

R28

Activist Strategies: 3 main Impacts

Answer 219

1. Lead to improvements in growth, profit and corporate governance
2. Forced companies to take on higher levels of debt
3. Activist funds have enjoyed Sharpe Ratios slightly above broad equity market

Question 220

R28

Strategies Based on Statistical Arbitrage and Market Microstructure

Answer 220

• Mean reversion
• Use statistical and technical analysis to exploit pricing anomalies

Tools used

1. Traditional technical analysis
2. Sophisticated time-series analysis and econometric models
3. Machine-learning techniques

Pairs trading is an example of a popular and simple statistical arbitrage strategy. Pairs trading uses statistical techniques to identify two securities that are historically highly correlated with each other. When the price relationship of these two securities deviates from its long-term average, managers that expect the deviation to be temporary go long the underperforming stock and simultaneously short the outperforming stock. If there is no mean reversion then there will be a loss. Use stop-loss.

Question 221

R28

7 steps of Fundamental Active Investment Process

Answer 221

1. Define the investment universe and the market opportunity—the perceived opportunity to earn a positive risk-adjusted return to active investing, net of costs—in accordance with the investment mandate. The market opportunity is also known as the investment thesis.
2. Prescreen the investment universe to obtain a manageable set of securities for further, more detailed analysis.
3. Understand the industry and business for this screened set by performing: industry and competitive analysis and analysis of financial reports.
4. Forecast company performance, most commonly in terms of cash flows or earnings.
5. Convert forecasts to valuations and identify ex ante profitable investments.
6. Construct a portfolio of these investments with the desired risk profile.
7. Rebalance the portfolio with buy and sell disciplines.

Question 222

R28

3 Pitfalls in Fundamental Investing

Answer 222

1. Behavioral biases
2. Value trap - Stock looks attractively priced but the stock price has not reached bottom.
3. Growth trap - The favourable prospects of stock are fully priced (or over priced) into stock. Further growth does not happen.

Question 223

R28

5 steps of Quantitative Investment Process

Answer 223

1. Defining the Market Opportunity (Investment Thesis)
2. Acquiring and Processing Data: Company mapping, Company fundamentals, Survey data, Unconventional data. Investors spend a significant amount of time checking data for consistency, cleaning up errors and outliers, and transforming the data into a usable format.
3. Back-testing the Strategy. Pearson IC (+1 to -1) - sensitive to outliers therefore Spearman Rank IC is preferred.
4. Evaluating the Strategy. Do an out-of-sample back-test, in which a different set of data is used to evaluate the model’s performance. Managers generally compute various statistics—such as the t-statistic, Sharpe ratio, Sortino ratio, VaR, conditional VaR, and drawdown characteristics—to form an opinion on the outcome of their out-of-sample back-test.
5. Portfolio Construction. Consideration of risk models and trading costs.

Question 224

R28

7 Pitfalls of quantitative active management

Answer 224

1. Survivorship Bias - leads to overly optimistic results and sometimes even causes investors to draw wrong conclusions.
2. Look-Ahead Bias - using information that was unknown or unavailable at the time an investment decision was made
3. Data Mining - excessive search analysis of past financial data to uncover patterns. Results in model overfitting
4. Turnover - may be limits on turnover
5. Transaction Costs - can easily erode returns significantly
6. Short Availability - difficulties in establishing short positions in certain markets
7. Quant Crowding - lots of managers following same strategy. If there is a period of poor performance and they may all need to exit positions at the same time - resulting in margin calls. This would cause even more unwinding of positions

Question 225

R28

Equity Investment Style Classification

Answer 225

• Whats is really the managers style.
• Examine the holdings and returns to determine style

Main methods:

1. Return based style analysis
2. Holdings based style analysis
3. Equity Style Box (subset of holding based)

Question 226

R28

Returns-Based Style Analysis

Answer 226

• Used find the style concentration of underlying holdings by identifying the style indexes that provide significant contributions to fund returns with the help of statistical tools.
• Indices should be mutually exclusive and exhaustive
• Key inputs are the historical returns for the portfolio and the returns for the style indexes
• Such an analysis attributes fund returns to selected investment styles by running a constrained multivariate regression
• 1-R² is how much of the regression is down to the managers stock selections capabilities (i.e. not explained by the market indices)
• A single factor model with have a low R² which might be misleading
• An inappropriate benchmark for the portfolio or fund may produce an inaccuate R²
• Helps determine the consistency of managers style. Limited if analysis is over one period.

Question 227

R28

Holdings Based Style Analysis

Answer 227

• Good for capturing style drift
• Looking at characteristics of stocks in the managers portfolio
• For accuracy need to analyse current portfolio holdings

Style Boxes

• Style score assigned to each individual stock in fund. The scores are scaled to a range of 0 to 100, and the difference between the stock’s growth and value scores is called the net style score.
• If this net style score is strongly negative, approaching –100, the stock’s style is classified as value. If the result is strongly positive, the stock is classified as growth. If the scores for value and growth are similar in strength, the net style score will be close to zero and the stock will be classified as core.

e.g. for Value factors, assign score 0-100 for P/E, P/B Dividend Yield etc. A security with a value score of 0.6 will have 60% of its market capitalization allocated to the value index and the remaining 40% to the growth index.

Question 228

R28

Strengths and Limitations of Style Analysis

Answer 228

• Holdings-based style analysis is generally more accurate than returns-based analysis because it uses the actual portfolio holdings
• Holdings-based style analysis requires the availability of all the portfolio constituents as well as the style attributes of each stock in the portfolio. While this information may be accessible for current portfolios, an analyst who wants to track the historical change in investment styles may face some difficulty.
• limited availability of data on derivatives often makes holdings-based style analysis less effective for funds with substantial positions in derivatives.
• Returns-based style analysis models impose unnecessary constraints that limit the results within certain boundaries, making it difficult to detect more aggressive positions, such as deep value or micro cap.
• Ideally, use both approaches: Returns-based models can often be more widely applied, while holdings-based models allow deeper style analysis.

Question 229

R11

General Income Tax Regimes

Common Progressive

Answer 229

Ordinary Tax Rate Structure:

Progressive

Interest Income:

Some interest taxed at favorable rates or exempt

Dividends:

Some dividends taxed at favorable rates or exempt

Capital Gains:

Some capital gains taxed favorably or exempt

Examples:

UK, US, France

Question 230

R11

General Income Tax Regimes

Heavy CGT

Heavy Interest

Heavy Dividend

Answer 230

Same as Common Progressive but with CGT / Interest / Dividend taxed at ordinary rates respectively.

Question 231

R11

General Income Tax Regimes

Light Capital Gain Tax

Answer 231

Ordinary Tax Rate Structure:

Progressive

Interest Income:

Taxed at ordinary rates

Dividends:

Taxed at ordinary rates

Capital Gains:

Some capital gains taxed favorably or exempt

Examples:

Australia, Spain, Norway

Question 232

R11

General Income Tax Regimes

Flat and Light

Answer 232

Ordinary Tax Rate Structure:

Flat

Interest Income:

Some interest income taxed favorably or exempt

Dividends:

Some dividends taxed favorably or exempt

Capital Gains:

Some capital gains taxed favorably or exempt

Examples:

Russia, Saudi Arabia

Question 233

R11

General Income Tax Regimes

Flat and Heavy

Answer 233

Ordinary Tax Rate Structure:

Flat

Interest Income:

Some interest income taxed favorably or exempt

Dividends:

Taxed at ordinary rates

Capital Gains:

Taxed at ordinary rates

Examples:

Ukraine

Question 234

R11

Returns-Based Taxes: Accrual Taxes on Interest and Dividends

Answer 234

FVIF_i = [1 + r(1 – t_i)]ⁿ 

• Tax Drag = gain wih no tax - gain after taxes
• Tax Drag % = tax drag / gain after taxes

Question 235

R11

Returns-Based Taxes: Deferred Capital Gains

Answer 235

FVIF_cg = (1 + r)ⁿ(1 – t_cg) + t_cg  

Question 236

R11

Taxes: Cost Basis

Answer 236

FVIF_cgb = (1 + r)ⁿ(1 – t_cg) + t_cgB  

Question 237

R11

Wealth-Based Taxes

Answer 237

FVIF_w = [(1 + r)(1 – t_w)]ⁿ  

Question 238

R11

Blended Taxing Environments

Answer 238

Annual return after realized taxes:

r* = r(1 – p_iti – p_dt_d – p_cgt_cg)

Effective capital gains tax rate:

T* = t_cg(1 – p_i – p_d – p_cg)/(1 – p_it_i – p_dt_d – p_cgt_cg)

P= return

Future after-tax accumulation for each unit of currency in a taxable portfolio:

FVIF_Taxable = (1 + r*)ⁿ(1 – T*) + T* – (1 – B)t_cg

Question 239

R11

Accrual Equivalent Returns

Answer 239

Portifolio Value(1 + R_AE)ⁿ = after-tax accumulation

Question 240

R11

Accrual Equivalent Tax Rates

Answer 240

r(1 – T_AE) = R_AE

Question 241

R11

Tax-Deferred Accounts

Answer 241

FVIF_TDA = (1 + r)ⁿ(1 – Tn)  

• Tax-deferred accounts allow tax-deductible contributions and/or tax-deferred accumulation of returns, but funds are taxed when withdrawn.

Question 242

R11

Tax-Exempt Accounts

Answer 242

FVIF_TaxEx = (1 + r)ⁿ  

• Tax-exempt accounts do not allow tax-deductible contributions, but allow tax-exempt accumulation of returns even when funds are withdrawn.

Question 243

R11

Taxes and Investment Risk

Answer 243

After-tax standard deviation:

σ(1 − t_i)

• Taxes not only reduce an investor’s returns, but also absorb some investment risk
• By taxing investment returns, a taxing authority shares investment risk with the taxpayer. As a result, taxes can reduce investment risk.

Question 244

R11

Tax Drag

Answer 244

• The negative effect of taxes on after-tax returns
• Tax drag on capital accumulation compounds over time when taxes are paid each year
• When taxes on gains are deferred until the end of the investment horizon, the tax rate equals the tax drag on capital accumulation
• Tax drag increases with the investment return and time horizon
• The difference between the accrual equivalent return and the taxable return is a measure of the tax drag imposed on a portfolio.
• An analogous way to measure tax drag is with the accrual equivalent tax rate
• Active management can create a tax drag

Question 245

R11

Tax Loss Havesting

Answer 245

• Tax loss harvesting defers tax liabilities from current to subsequent periods and permits more after-tax capital to be invested in current periods.
• Selling a security at a loss and reinvesting the proceeds in a similar security effectively resets the cost basis to the lower market value, potentially increasing future tax liabilities.
• A subtle benefit of tax loss harvesting is that recognizing an already incurred loss for tax purposes increases the amount of net-of-tax money available for investment. Realizing a loss saves taxes in the current year, and this tax savings can be reinvested. This technique increases the amount of capital the investor can put to use.

Question 246

R11

Tax Alpha

Answer 246

• The value created by using investment techniques that effectively manage tax liabilities (tax loss harvesting and HIFO) is sometimes called tax alpha
• Although cumulative tax alphas from tax loss harvesting increase over time, the annual tax alpha is largest in the early years and decreases through time as deferred gains are ultimately realized.The complementary strategies of tax loss harvesting and HIFO tax lot accounting have more potential value when securities have relatively high volatility, which creates larger gains and losses with which to work.

Question 247

R11

highest-in, first-out (HIFO) tax lot accounting

Answer 247

• Depending on the tax system, investors may be allowed to sell the highest cost basis lots first, which defers realizing the tax liability associated with lots having a lower cost basis.
• Harvesting losses is not always an optimal strategy. For example, in cases where an investor is currently in a relatively low tax rate environment and will face higher tax rates on gains in a subsequent period (either because her tax bracket will increase or because tax rates generally are increasing)

Question 248

R11

Conclusions for Accural Taxes

Answer 248

1. Over a longer time horizon: Tax Drag % > Current Tax Rate
2. Over a longer time horizon: Tax Drag $ and Tax Drag % increases
3. If pre-tax return increases: Tax Drag $ and Tax Drag % increases
4. If time horizon and pre-tax return increases: Tax Drag $ and Tax Drag % increases even more

Question 249

R11

Conclusions for Deferred Capital Gains

Answer 249

1. The is no lost compounding of return (compared to accural taxation). All taxes are paid at the end of the time horizon.
2. As the time horizon and/or the rate if return increases the tax drag $ amount increases because the tax paid will be on a larger pre-tzx ending value.
3. The tax drag % versus current (stated) tax rate depends on the basis:

• Tax Drag % = Tax Rate if B = 1
• Tax Drag % > Tax Rate if B < 1 because there is an additional gain subject to tax.
• Tax Drag % =< Tax Rate if B > 1 because the portion of the return earning during the period back to the cost basis is not taxed

Question 250

R11

Conclusions for Wealth Based Taxes

Answer 250

1. Wealth based taxes apply to total value not just return. So they are more burdensome than other taxes.
2. As the time horizon increases both tax drag $ and tax drag % increase due to the loss of pre-tax compounding
3. As the rate of return increases the tax drag $ increases but the tax drag % decreases.

Question 251

EMH: Anomalies

Answer 251

1. Fundamental Anomalies. Value and Growth investing - but are they a function of incomplete models of asset pricing?
2. Technical Anomalies. Moving averages and Trading Range break (Support and Resistance). Disputed.
3. Calendar Anomalies. The January Effect and turn-of-the-month effect.

Question 252

Behavioral Approach to Consumption and Savings

Answer 252

• Incorporates self-control, mental accounting, and framing biases
• People classify their sources of wealth into three basic accounts: current income, currently owned assets, and the present value of future income
• Individuals are hypothesized to first spend current income, then to spend based on current assets, and finally to spend based on future income.

Question 253

Behavioral Approach to Asset Pricing

Answer 253

• Stochastic discount factor-based (SDF-based) asset pricing model
• Model focuses on market sentiment as a major determinant of asset pricing,
• Sentiment pertains to erroneous, subjectively determined beliefs.

Question 254

Behavioral Portfolio Theory

Answer 254

• BPT uses a probability-weighting function rather than the real probability distribution used in Markowitz’s portfolio theory
• Investors construct their portfolios in layers and expectations of returns and attitudes toward risk vary between the layers.
• Construction is primarily a function of five factors:

1. Allocation to different layers depends on investor goals and the importance assigned to each goal
2. Allocation of funds within a layer to specific assets will depend on the goal set for the layer
3. Number of assets chosen for a layer depends on the shape of the investor’s utility function.
4. Concentrated positions in some securities may occur if investors believe they have an informational advantage with respect to the securities
5. Investors reluctant to realize losses may hold higher amounts of cash so that they do not have to meet liquidity needs by selling assets that may be in a loss position

Question 255

Adaptive Markets Hypothesis

Answer 255

(AMH) A hypothesis that applies principles of evolution—such as competition, adaptation, and natural selection—to financial markets in an attempt to reconcile efficient market theories with behavioral alternatives.

• The AMH is a revised version of the EMH that considers bounded rationality, satisficing, and evolutionary principles
• Under the AMH, individuals act in their own self-interest, make mistakes, and learn and adapt; competition motivates adaptation and innovation; and natural selection and evolution determine market dynamics

Question 256

Five implications of the AMH

Answer 256

1. The relationship between risk and reward varies over time (risk premiums change over time) because of changes in risk preferences and such other factors as changes in the competitive environment
2. Active management can add value by exploiting arbitrage opportunities
3. Any particular investment strategy will not consistently do well but will have periods of superior and inferior performance
4. The ability to adapt and innovate is critical for survival
5. Survival is the essential objectiv

Question 257

Bounded Rationality

Answer 257

• The notion that people have informational and cognitive limitations when making decisions and do not necessarily optimize when arriving at their decisions.
• The term satisfice combines “satisfy” and “suffice”
• Instead of looking at every alternative, people set constraints as to what will satisfy their needs
• Decision makers may use heuristics to guide their search. An example of heuristics is means-ends analysis.
• Portfolio decisions are based on a limited set of factors, such as economic indicators, deemed most important to the end goal

Question 258

Prospect Theory

Answer 258

• Prospect theory considers how prospects (alternatives) are perceived based on their framing, how gains and losses are evaluated, and how uncertain outcomes are weighted.
• Prospect theory assigns value to gains and losses (changes in wealth) rather than to final wealth
• There are two phases to making a choice: an early phase in which prospects are framed (or edited) and a subsequent phase in which prospects are evaluated and chosen
• Depending on the number of prospects, there may be up to six operations in the editing process: codification, combination, segregation, cancellation, simplification, and detection of dominance.
• People are risk-averse when there is a moderate to high probability of gains or a low probability of losses; they are risk-seeking when there is a low probability of gains or a high probability of losses.

Question 259

Rational Economic Man

Answer 259

• Traditional Finance Perspective
• Principles of perfect rationality, perfect self-interest, and perfect information govern REM’s economic decisions.
• Those who challenge REM do so by attacking the basic assumptions of perfect information, perfect rationality, and perfect self-interest.

Question 260

Utility Theory

Answer 260

• Traditional Finance Perspective
• Generally assumes that individuals are risk-averse
• Theory whereby people maximize the present value of utility subject to a present value budget constraint.
• May be thought of as the level of relative satisfaction received from the consumption of goods and services
• Basic axioms of utility theory: Completeness, Transitivity, Independence , Continuity
• If the individual’s decision making satisfies the four axioms, the individual is said to be rational
• The rational decision maker, given new information, is assumed to update beliefs about probabilities according to Bayes’ formula

Question 261

EMH

Answer 261

• Weak Form - All past market price and volume data are fully reflected in securities’ prices. Technical analysis will not generate excess returns
• Semi-Strong Form - all publicly available information, past and present, is fully reflected in securities’ prices. Technical and fundamental analyses will not generate excess returns
• Strong-form - assumes that all information, public and private, is fully reflected in securities’ prices. Even insider information will not generate excess returns.

Question 262

R25

Advantages of MBS

Answer 262

1. Portfolio diversification
2. Liquidity - Agency MBS (better returns and liquidity than high quality corp bonds.
3. Investment in real estate - can express more targeted or levered investment views than REITS
4. Exposure to expected changes in interest rate volatility [note prepayment risk and extension risk]. If interest rate volatility will decrease, buy agency MBS.
5. Credit cycle and the real estate cycle often behave differently

Question 263

R25

Features of CDO

Answer 263

1. Do not provide much diversification benefit compared with corporate bonds, and they do not offer unique exposure to a sector or market factor
2. The valuation of CDOs may vary from the valuation of their underlying collateral
3. Correlation of expected defaults on the collateral of a CDO affects the relative value between the senior and subordinated tranches of the CDO: As correlations increase, the value of mezzanine tranches usually increases relative to the value of senior and equity tranches.
4. Leveraged Exposure to Credit. Can gain additional return but also suffer large losses.

Question 264

R25

Emerging Market Credit Market Features

Answer 264

1. Concentration in commodities and banking
2. Government ownership. Recovery rates lower
3. Credit quality. Concentration in both the lower portion of the investment-grade rating spectrum and the upper portion of high yield - “sovereign ceiling”

Question 265

R25

Components of Credit Risk

Answer 265

1. Default Risk
2. Loss Severity (Loss given default)

Question 266

R25

4 ‘Cs’ of Credit Analysis

Answer 266

1. Capacity
2. Collateral
3. Covenants
4. Character

(+ 5. Capital)

Question 267

R25

What is Credit Loss Rate?

Answer 267

Represents the percentage of par value lost to default for a group of bonds.

Default Rate x Loss Severity

Question 268

R25

Spread Duration

Answer 268

1. A measure used in determining a portfolio’s sensitivity to changes in credit spreads.
2. Spread duration measures the effect of a change in spread on a bond’s price
3. For non-callable, fixed-rate corporate bonds, spread duration is generally very close to modified duration.
4. For floating-rate bonds (also called floaters) and some other types of bonds, however, the spread duration can differ substantially from the modified duration.

Question 269

R25

Empirical duration

Answer 269

1. A measure of interest rate sensitivity that is determined from market data
2. To calculate a bond’s empirical duration, run a regression of its price returns on changes in a benchmark interest rate.
3. Corporate bonds with low credit spreads tend to have greater empirical duration

Question 270

R25

What is Benchmark Spread

Answer 270

The yield on a credit security over the yield on a security with little or no credit risk (benchmark bond) and with a similar duration.

A problem with benchmark spread is the potential maturity mismatch between the credit security and the benchmark bond

Question 271

R25

What is G Spread

Answer 271

The yield on a credit security over the yield of an actual or interpolated government bond.

It is easy to calculate and understand, and different investors usually calculate it the same way.

Question 272

R25

What is I Spread

Answer 272

The yield on a credit security over the swap rate (denominated in the same currency as the credit security). Also known as interpolated spread.

A key advantage of using swap rates over yields on government bonds is that swap curves may be “smoother” (less disjointed) than government bond yield curves

Question 273

R25

What is Z spread

Answer 273

The yield spread that must be added to each point of the implied spot yield curve to make the present value of a bond’s cash flows equal its current market price. Also known as zero-volatility spread.

A good measure of the bond’s credit spread.

Question 274

R25

What is OAS

Answer 274

The constant spread that, when added to all the one-period forward rates on the interest rate tree, makes the arbitrage-free value of the bond equal to its market price.

Theoretical measure of credit spread.

Most useful for comparing bonds with different features, such as embedded options

Main shortcoming of OAS is that it depends on assumptions regarding future interest rate volatility

The most appropriate measure for a portfolio-level spread is the OAS

Question 275

R25

Measures of Secondary Market Liquidity in Credit (3)

Answer 275

1. Trading Volume
2. Spread Sensitivity to Fund Outflows. Increase in spread relative to percentage outflow [from funds] greatest during the global financial crisis.
3. Bid–Ask Spreads. High-yield bonds are usually quoted in price terms, whereas investment-grade bonds are usually quoted as a spread over a benchmark government bond.

Question 276

R25

Management of Liquidity Risk

Answer 276

1. Holding cash
2. Managing position sizes. More-liquid credit securities are given greater portfolio weight. Holding greater weights of liquid credit securities and cash may decrease expected credit portfolio returns,
3. Holding liquid, non-benchmark bonds
4. Credit default swap (CDS) index derivatives
5. Exchange-traded funds (ETFs). ETFs are easy to trade so the funds may experience unusual market movements during periods of high credit volatility, and their prices may deviate from their net asset values.

Question 277

R25

What is Tail Risk?

Answer 277

The risk that there are more actual events in the tail of a probability distribution than would be predicted by probability models.

Question 278

R25

Assessing Tail Risk in Credit Portfolios

Answer 278

Scenario Analysis

• Historical Scenario Analysis
• Hypothetical Scenario Analysis. May include large moves in interest rates, exchange rates, credit spreads, or the price of oil or other commodities.
• Correlations in Scenario Analysis. During periods of financial crisis, correlations tend to move closer to 1.0.

Question 279

R25

Managing Tail Risk in Credit Portfolios

Answer 279

1. Portfolio Diversification. May have only a modest incremental cost. May be difficult to identify attractively valued investment opportunities that can protect against every tail risk
2. Tail Risk Hedges. Often using CDS and options. Typically has a cost and therefore lowers portfolio returns if the tail risk event does not occur. Some investors restricted from using derivatives.

Question 280

Features of a Market Cap Weighted Index

Answer 280

• Constituent company’s weight in the index is calculated as its market capitalization divided by the total market capitalization of all constituents of the index
• The capitalization-weighted market portfolio is mean–variance efficient
• Most common form of market-cap weighting is free-float weighting
• Reflects a strategy’s investment capacity
• Can be thought of as a liquidity-weighted index because the largest-cap stocks tend to have the highest liquidity
• Bias to large cap stocks

Question 281

Features of a Price Weighted Index

Answer 281

• The weight of each stock is its price per share divided by the sum of all share prices in the index
• Represents one share of each constituent company - this is unrealistic however.
• Stock split for any constituent of the index complicates the index calculation
• e.g. DJIA

Question 282

Features of a Equally Weighted Index

Answer 282

• Have constituent weights of 1/n, where n represents the number of stocks in the index.
• Equally weighted indexes require regular rebalancing because immediately after trading in the constituent stocks begins, the weights are no longer equal
• Small-cap bias
• Limited investment capacity. The smallest-cap constituents of an equally weighted index may have low liquidity.

Question 283

HHI

Answer 283

Σw²

^{M<span>easure of stock-concentration risk in a portfolio</span>}

^{HHI of 1/n would signify an equally weighted portfolio, and a value of 1.0 would signify portfolio concentration in a single security.}

^{As HHI increases so does risk.}

Question 284

Effective number of stocks

Answer 284

1/HHI

Estimation of the effective (or equivalent) number of stocks, held in equal weights, that would mimic the concentration level of the chosen index

Question 285

Common Equity Risk Factors & Strategies

Answer 285

1. Growth
2. Value
3. Size
4. Yield
5. Momentum
6. Quality
7. Volatility

Strategies:

1. Risk orientated
2. Return Orientated
3. Diversification Orientated

Question 286

Equity Universe Segmentation

Answer 286

1. Size (large, mid, small cap)
2. Style (growth, value, core)
3. Geography (developed, emerging and frontier markets)
4. Economic activity (Production orientated e.g. coal company = mining sector. Market orientated e.g. coal company = energy sector)
5. Equity Indexes and benchmarks (can reflect some or all of approaches in 1-4)

Question 287

Equity Income

Answer 287

1. Dividend Income (including Special dividends and stock dividends)
2. Securities lending income (0.2-0.5% fee in developed markets; 1-2% emerging markets, ‘specials’ 5-15%)
3. Dividend Capture (Buy just before ex-div, capture dividend, sell after)
4. Writing options (e.g. Covered call, cash-covered put)

Question 288

Equity Fees

Answer 288

1. Management Fees (usually % funds under management)
2. Performance fees (often associated with Hedge Funds. High water Mark provisions)
3. Administration fees (for corporate actions but also including Custody, Depository and Registration fees)
4. Marketing and Distribution costs
5. Trading Costs

Question 289

Advantages of Shareholder engagement

Answer 289

1. Can assist in developing a more effective corporate governance culture
2. “Free rider problem” - some investors could benefit from the shareholder engagement of others
3. Stakeholders can gain or lose influence with companies depending on the outcomes of shareholder engagement
4. ESG can benefit from shareholder engagement

Question 290

Disadvantages of shareholder engagement

Answer 290

1. Time consuming and can be costly for both shareholders and companies
2. Pressure on company management to meet near-term share price or earnings targets
3. Engagement can result in selective disclosure of important information to a certain subset of shareholders, which could lead to a breach of insider trading
4. Conflicts of interest can result for a company

Question 291

R26

Role of Equity in Portfolio

Answer 291

1. Capital Appreciation
2. Dividend Income. More stable than capital appreciation.
3. Diversification benefits (not constant over time)
4. Infaltion Hedges (Varies. Companies must be able to pass on costs to customers.Broad based (oil, industrial metals) commodity companies do well)
5. Consider facets of IPS: RRLTTLU
6. ESG (Postive / negative screening, thematic investing, impact investing)

Question 292

R35

What are the two main types of order and their use?

Answer 292

Market Order - an instruction to execute an order promptly in the public markets at the best price available.

Limit Order - to trade at the best price available but only if the price is at least as good as the limit price specified in the order

Question 293

R35

What is a Market Not Held Order

Answer 293

A variation of the market order designed to give the agent greater discretion than a simple market order would allow. “Not held” means that the floor broker is not required to trade at any specific price or in any specific time interval.

Question 294

R35

What is a Participate (do not initiate) order

Answer 294

A variant of the market-not-held order. The broker is deliberately low-key and waits for and responds to the initiatives of more active traders. Buy-side traders who use this type of order hope to capture a better price in exchange for letting the other side determine the timing of the trade.

Question 295

R35

What is a Best Efforts order

Answer 295

A type of order that gives the trader’s agent discretion to execute the order only when the agent judges market conditions to be favorable. Some degree of immediacy is implied, but not immediacy at any price.

Question 296

R35

What is a Market on Open / Close Order

Answer 296

A market order to be executed at the opening / closing of the market. Many markets provide good liquidity. at open or close.

Question 297

R35

What is a Principle Trade

Answer 297

A trade with a broker in which the broker commits capital to facilitate the prompt execution of the trader’s order to buy or sell. Often used when order is large / urgent.

Question 298

R35

What is a Portfolio Trade?

Answer 298

A trade in which a number of securities are traded as a single unit. Also called program trade or basket trade. Often low cost. The diversifcation in the basket reduces risk to counterparty.

Question 299

R35

What is inside Bid-Ask spread

Answer 299

Market (Inside) ask (The lowest available ask price) price minus market (inside) bid (The highest available bid price) price.

Also called market bid–ask spread, inside spread, or market spread.

Question 300

R35

What is effective spread for a buy and sell order?

Answer 300

Effective spread for a sell order = 2 × (Midquote – execution price). Effective spread for a buyorder = 2 × ( execution price - Midquote ).

Question 301

R35

What is midquote?

Answer 301

bid+ask / 2

Question 302

R35

What is a quote driven Market?

Answer 302

Dealers establish firm prices at which securities can be bought and sold. Also called dealer markets, as trades are executed with a dealer. A dealer (market maker) is ready to buy an asset for inventory or sell an asset from inventory to provide the other side of an order to buy or sell the asset.

Question 303

R35

What is an order driven market?

Answer 303

Markets in which transaction prices are established by public limit orders to buy or sell a security at specified prices. Usually no involvement of market makers and trades are with public investors.

Question 304

R35

The four components if Implementation Shortfall

Answer 304

1. Explicit costs, including commissions, taxes, and fees.
2. Realized profit/loss, reflecting the price movement from the decision price (usually taken to be the previous day’s close) to the execution price for the part of the trade executed on the day it is placed.
3. Delay costs (slippage), reflecting the change in price (close-to-close price movement) over the day an order is placed when the order is not executed that day; the calculation is based on the amount of the order actually filled subsequently.
4. Missed trade opportunity cost (unrealized profit/loss), reflecting the price difference between the trade cancellation price and the original benchmark price based on the amount of the order that was not filled.

Question 305

R35

Advantages of VWAP

Answer 305

1. Easy to compute.
2. Easy to understand.
3. Can be computed quickly to assist traders during the execution.
4. Works best for comparing smaller trades in nontrending markets.

Question 306

R35

Disadvantages of VWAP

Answer 306

1. Does not account for costs of trades delayed or cancelled.
2. Becomes misleading when trade is a substantial proportion of trading volume.
3. Not sensitive to trade size or market conditions.
4. Can be gamed by delaying trades

Question 307

R35

Advantages of Implementation Shortfall

Answer 307

1. Links trading to portfolio manager activity; can relate cost to the value of investment ideas.
2. Recognizes the tradeoff between immediacy and price.
3. Allows attribution of costs.
4. Can be built into portfolio optimizers to reduce turnover and increase realized performance.
5. Cannot be gamed.

Question 308

R35

Disadvantages of Implementation Shortfall

Answer 308

1. Requires extensive data collection and interpretation.
2. Imposes an unfamiliar evaluation framework on traders.

Question 309

R35

Roll of Broker (6)

Answer 309

1. Representing an order
2. Find the opposite side of a trade
3. Supplying Market information
4. Providing descretion and secrecy
5. Providing other supporting investment services (Prime Brokerage)
6. Supporting the Market mechanism

Question 310

R35

Characteristics of a Liquid Market

Answer 310

1. The market has relatively low bid–ask spreads.
2. The market is deep. (Big trades do not cause big price movements. High quoted depth)
3. The market is resilient. (Discepencies between price and value corrected quickly)

Question 311

R35

Factors that make a Market Liquid

Answer 311

1. Many buyers and seller
2. Diversity of opinion, information, and investment needs among market participants
3. Convenience.
4. Market integrity.

Question 312

R35

3 Main qualities of a Market

Answer 312

1. Liquidity
2. Transparency (pretrade - quotes and trades & Posttrade - reporting)
3. Assurity of Completion (Assurity of contract - parties fulfill their obligations)

Question 313

R35

4 Major types of traders

Answer 313

1. Information-motivated traders (who trade on information with limited time value. Very short trading time horizons and are more sensitive to time than price in execution)
2. Liquidity-motivated traders (who trade based on liquidity needs. Very short trading time horizons and are more sensitive to time than price in execution)
3. Value-motivated traders (who trade on valuation judgments. Have longer trading time horizons and are more sensitive to price than time in execution. )
4. Passive traders (who trade for indexed portfolios. Have longer trading time horizons and are more sensitive to price than time in execution. )

Question 314

R35

5 Objectives in Trading

Answer 314

1. Liquidity at any cost (I must trade. Often Market Orders)
2. Need trustworthy agent (Possible hazardous trading situation. Use a floor broker to skillfully “work” such orders by placing a best efforts, market-not-held, or participate order)
3. Costs are not important
4. Advertise to draw liquidity (Risk of front running)
5. Low cost whatever the liquidity (Often Limit Orders)

Question 315

R35

Imp Shortfall detailed calculation

Answer 315

Total Imp Shortfall =

Paper gain - Real gain / Paper Investment

Question 316

Delta Neutral Dealer Perspective

Answer 316

From the buyers perspective:

Buy Call. Delta between 0 and +1

Buy a Put. Delta between 0 and -1

From Dealer Perspective:

Dealer has sold call. Delta between 0 and -1

Dealer to buy stock to cover position

Dealer has sold put. Delta between 0 and 1+

Dealer to short stock to cover position

Calculating number of shares needed to get to delta neutral:

-(delta)(#options)

Question 317

Delta Neutral Observations

Answer 317

• Is done for a short period of time only - days or weeks
• Assumes normal market conditions
• Earns the risk free rate
• Delta is only an approximation
• Delta changes over time even without any other changes

Question 318

Delta Neutral Rebalancing

Answer 318

• Day 1 position:

-(delta)(#options)

• Day 2 position

-(delta)(#options)

• Buy or sell options based on the difference between Day 1 and Day 2
• If options are sold, the proceeds can be invested at risk free rate
• If options need to be bought, then borrow at risk free rate

Question 319

Swaps General

Answer 319

• Value of swap at initiation is zero
• A Swap’s Libor rate is paid in arrears e.g Libor rate on Day 0 is paid out on Day 180.
• Swaps not just used for speculation. They are used for risk management.

Question 320

Swap Duration General

Answer 320

• For a floating rate instrument the duration is half the reset period
  e. g. for a quarterly reset period duration = 0.25/2 = 0.125
• Dur_{pay floating} = Dur_{recieve fixed} - Dur_{pay floating} > 0 (Dur increases)
• Dur_{pay fixed} = Dur_{recieve floating} - Dur_{pay fixed} < 0 (Dur decreases)

Question 321

Fixed and floating rate liabilities and risks

Answer 321

• Floating rate liability:

Cash Flow Risk but no Market Value Risk

• Fixed rate liability:

No Cash Flow Risk but has Market Value Risk

Question 322

Using Swaps to adjust duration

Answer 322

NP = V (MDur_t - MDur_p) / (MDur_swap)

Question 323

Currency Swap

Answer 323

• Banks have advantage of borrowing in their local market, rather than borrowing from the foreign bank which would charge an unfavourable rate.
• Principle is exchanged. Interest rate payments will be subject to exchange rate. The principle is not as the rate is locked in.
• Counterparty will have to pay interest on the amount/currency they borrowed at the Interest Rate of the borrowed currency

E.G. A US bank borrows £2mil (principle) and will pay interest in £ at the £ Interest Rate. At the end of the swap the US bank will pay back the principle of 2mil plus the last interest payment.

Question 324

Converting Foreign Cash Receipts into Domestic Currency

Answer 324

• Determine notional principle in foreign currency:
• Foreign Currency / Swap Fixed Rate of Foreign currency (deannualise)*
• Translate notional principle in foreign currency into domestic currency:
• Foreign currency notional / current exchanage rate*
• Calculate interest in domestic currency
• Domestics currency x Swap Fixed Rate of Domestic currency (deannualise)*

Question 325

Swaptions

Answer 325

• When considering whether to exercise a swaption based on the interest rate movements - consider from the perspective of both the fixed rate and floating rate legs.
  e. g. in a 6% payer swaption if the rates increased you would exercise for two reasons. Firstly you would be recieving LIBOR (floating leg) at a higher rate. However entering a swap in the new interest rate environment would mean paying a fixed rate above 6 %.

Question 326

R30

AI advantages / disadvantages

Answer 326

• Low liquidity - therefore higher liquidity premium and returns
• Higher information and diligence costs
• Difficulty of performance evaluation
• Low correlation with traditional asset classes - therefore offer diversification benefits.

Question 327

R30

Real Estate Direct v Indirect

Answer 327

• Direct investment - residences, business (commercial) real estate, and agricultural land.
• Indirect investment - RIET’s, company’s that develop and manage real estate, Commingled real estate funds (CREFs), Separately managed accounts, Infrastructure funds (stable returns, low correlation with equity)

Question 328

R30

Real Estate Advantages

Answer 328

• Low volatility of returns (Direct investments)
• Low correlation with Equity (Direct investments)
• Good hedge against inflation (Direct investments). Can increase rental rates or leases.
• Tax advantages
• Leverage returns
• Direct real estate investors have direct control over their property and may take action, such as expanding or modernizing, to increase the market value of the property.
• Geographical diversification can be effective in reducing exposure to catastrophic risks (e.g., the risk of hurricanes or floods). The values of real estate investments in different locations can have low correlations; substantial geographical distance is often not necessary to achieve risk reduction benefits.

Question 329

R30

Real Estate Disadvantages

Answer 329

• Higher information and transaction costs
• Regulatory risk e.g. tax law changes
• High operating expense
• Cannot subdivide real estate investment
• Large idiosyncratic risk
• Real estate investors are exposed to the risk of neighborhood deterioration, which may be caused by conditions that are beyond the investor’s control.

Question 330

R30

Real Estate: REITs

Answer 330

• Reacts to changes to macro economic (inflation etc) environment differently from other asset classes
• More properties will reduce unsystematic (idiosyncratic) risks
• REITs have less unsystematic risks as they have a pool of properties. Have professional management that buy from different geographical locations to generate income to pass on to investors in the form of dividends. Need to meet tax status - 95% of assets in real estate and 90% income to passed on to share holders. Therefore not much capital appreciation.
• Returns from REITs are more aligned with equity markets than the underlining real estate therefore not a good hedge against inflation
• Limited diversification

Question 331

R30

Real Estate Benchmarks

Answer 331

• NAREIT > for indirect investment. REIT’s are public companies using financial leverage (therefore assets and liabilities on balance sheet). Use of leverage distorts and makes NARIET less reflective of underlying assets. Cap weighted. Source of valuation are the securities prices for the REITs on the exchange. Index returns calculated after deduction of investment advisory fees.
• NCREIF > for direct investment. Made up of 20 unlevered commercial properties invested into by institutional investors. Smoothed and unsmoothed. Valued by apprasial. However this is not done frequently. This understates volatility, and therefore over estimate risk adjusted returns. This creates a smoothing out bias. Value weighted, published quarterly. Index returns calculated before deduction of investment advisory fees.
• NCREIF unsmoothed > more reflective of current real estate values

Question 332

R30

Hedge Fund: Strategies

Answer 332

• Equity market neutral - identify overvalued and undervalued equity securities while neutralizing the portfolio’s exposure to market risk by combining an equal number of long and short positions. Typically structured to be market, industry, sector, and dollar neutral.
• Convertible arbitrage - buy undervalued convertable bond and short the stock. Benefits if stock volatility increases and credit quality of the issuer improve.
• Fixed-income arbitrage - identify overvalued and undervalued fixed-income securities, primarily on the basis of expectations of changes in the term structure of interest rates or the credit quality of various related issues or market sectors. Fixed-income portfolios are generally neutralized.
• Distressed securities - invest in both the debt and equity of companies that are in or near bankruptcy. Long only position. Very illiquid and difficult to short.
• Merger arbitrage - the opportunity typically involves buying the stock of a target company after a merger announcement and shorting an appropriate amount of the acquiring company’s stock.
• Hedged equity - identify overvalued and undervalued equity securities. Not structured to be market, industry, sector, and dollar neutral, and they may be highly concentrated
• Emerging markets - generally only have long positions.
• Global macro - to take advantage of moves in major financial and non-financial markets through trading in currencies, swaps, futures, and option contracts, although they may also take major positions in traditional equity and bond markets
• Fund of funds - FOF invests in 10–30 hedge funds. Two layers of fees—one to the hedge fund managers and another to the manager of the FOF

Question 333

R30

Hedge Fund Structure

Answer 333

• Management Fee - usually 1-2% AUM
• Non mandatory incentive fee - c.20%
• Highwater mark - prevents double dipping, Prevents recouping previous losses as gains.
• Highwater mark is different for each investor based on their subscription date
• Lock-up periods - often invest in risky / illiquid assets that take time to provide required returns. Often 1-3 years. Often withdrawals will take place at certain times (quarterly) to control the outflow of funds so remaining investors should be insulated against the unfavorable unwinding of positions.

Question 334

R30

Fund of Funds Advantages / disadvantages

Answer 334

• Diversification benefits - made up of 20-30 hedge funds
• More liquidity
• Less survivorship and back fill bias
• Classification and style drift are issues - Investors must use factors to test for “style drift” in generic FOFs
• FOF needs to keep money aside for redemptions - leads to cash drag
• More correlated to equity markets than hedge funds.

Question 335

R30

Hedge Fund Valuation issues (5)

Answer 335

1. HF chase absolute return - how to determine benchmark? Most benchmark assume long only positions but HF use both long and short positions
2. Impact of performance fees, lockup periods, age of the fund and size of funds on valuation. Young funds outperform older funds, larger fund underperform smaller funds.
3. HF returns are calculated monthly as beginning value minus ending value, this is often annualised, but does not consider cash flows. Returns are often smoothed - often use rolling 12 moving average to smooth out variability of returns.
4. HF often use leverage. Assets are often consider without leverage.
5. HF returns are not normally distributed - Sharpe Ratio is not appropriate.

Question 336

R30

Sharpe Ratio limitations

Answer 336

1. Assumes normal distributions - but HF returns not normally distributed.
2. Assumes all asset are all liquid. Illiquidty assets are not valued frequency which underestimates volatility - bias SR upwards.
3. The Sharpe ratio has not been found to have predictive ability for hedge funds in general.
4. The Sharpe ratio is primarily a risk-adjusted performance measure for stand-alone investments and does not take into consideration the correlations with other assets in a portfolio.
5. The Sharpe ratio can be gamed:

• Lengthening the measurement interval. This will result in a lower estimate of volatility;
• Compounding the monthly returns but calculating the standard deviation from the uncompounded monthly returns
• Writing out-of-the-money puts and calls on a portfolio. This strategy can potentially increase the return by collecting the option premium without paying off for several years
• Smoothing returns.
• Getting rid of extreme returns (best and worst monthly returns each year) that increase the standard deviation. Operationally, this strategy entails a total-return swap

Question 337

R30

Hedge Fund Benchmarks

Answer 337

• Hedge Fund Research (HFR) big index for HF
• Issues:

1. Relevance of past data - the past returns of an index reflect the performance of a different set of managers from today’s or tomorrow’s set. may be a more severe problem for value-weighted indexes than for equal-weighted indexes because value-weighted indexes are more heavily weighted in the recent best-performing fund(s)
2. Popularity bias - As top-performing funds grow through new inflows and high returns and poorly performing funds are closed, the top-performing funds represent an increasing share of the index
3. Stale price bias - lack of security trading - measured standard deviation may be higher or lower than it would be if actual prices existed. Not a big issue for HF.
4. Backfill bias - missing past return data for a component of an index are filled in at the discretion of the component
5. Survivorship bias -this bias is in the range of at least 1.5%–3% per year. Minor for event-driven strategies, is higher for hedged equity, and is considerable for currency funds.

Question 338

R30

Commodities General

Answer 338

• Direct - buy physical commodity or derivative on commodity. Low correlation with equity and bonds. May incur carrying costs.
• Indirect - equity in companies specializing in commodity production. Indirect commodity investment—in particular, equity instruments in commodity-linked companies—does not provide effective exposure to commodity price changes. Especially if company is hedge its risk.
• Commodities often have postive correlation with inflation (except agriculture)
• Commodity indices wieghted on world production or worldwide importance of that commodity.

Question 339

R30

Commodities and inflation

Answer 339

Two factors making a commodity a good hedge against unexpected inflation:

1. Storable
2. Demand for commodity is linked economic activity.

Question 340

R30

Determinants of commodity returns (3)

Answer 340

• Business cycle–related supply and demand - supply and demand conditions are determined by different economic fundamentals from those affecting stocks and bonds, commodity prices are expected to be sensitive to the business cycle but to have little or even negative correlation with stocks and bonds. 3 reasons for this:

1. Commodities correlate positively with inflation whereas stocks and bonds are negatively correlated with inflation.
2. Commodity prices and stock/bond prices react differently in different phases of the business cycle. Commodity futures prices are more affected by short-term expectations, whereas stock and bond prices are affected by long-term expectations.
3. Commodity prices tend to decline during periods of weakness in the economy.

• Convenience yield. - At low inventory levels, convenience yields are high, and vice versa. A related implication is that the term structure of forward price volatility generally declines with the time to expiration of the futures contract—a phenomenon known as the Samuelson effect.
• Real options under uncertainty - producers are holding valuable real options—options to produce or not to produce—and will not exercise an option to produce unless spot prices start to climb.

Question 341

R30

Private Equity

Answer 341

• Venture Capital and Buyout Funds
• VC look for smaller start-up companies with limited history.
• Buyout funds look for a public / private company that it is already trading but could be improved. Will take public companies private.
• Direct venture capital investment is typically structured as convertible preferred stock rather than common stock
• Indirect investment is primarily through private equity funds, including VC funds and buyout funds. Private equity funds are usually structured as limited partnerships or limited liability companies (LLCs) with an expected life of 7–10 years and an option to extend the life for another 1–5 years.
• Less of a diversifier and more of a long term return enhancement of a portfolio.

Question 342

R30

Private Equity: Investment Characteristics

Answer 342

• Illiquidity. Private equity investments are generally highly illiquid
• Long-term commitments. Private equity investment generally requires long-term commitments.
• Higher risk than seasoned public equity investment. The returns to private equity investments, on average, show greater dispersion than seasoned public equity investments, although they may be roughly comparable to those of publicly traded microcap shares.49 The risk of complete loss of the investment is also higher. The failure rate for new and young businesses is high.
• High expected IRRs are required. Private equity investors target high rates of return as compensation for the risk and illiquidity of such investments.
• Limited information - especially for Venture Capital

Question 343

R30

VC vs Buyout Fund Return Characteristics

Answer 343

• Buyout funds are usually highly leveraged. In contrast, VC funds use no debt in obtaining their equity interests.
• The cash flows to buyout fund investors come earlier and are often steadier than those to VC fund investors. Because buyout funds purchase established companies, buyout fund investors usually realize returns earlier than VC fund investors, whose investments may still be in the cash-burning stage. The expected pattern of interim returns over the life of a successful venture capital fund has sometimes been described as a J-curve, in which early returns (e.g., over the first five or six years) are negative as the portfolio of companies burns cash but later returns accelerate as companies are exited.
• The returns to VC fund investors are subject to greater measurement error. These valuations are subject to much less uncertainty for buyout funds investing in established companies.

Question 344

R30

Issues formulating a strategy for private equity investment

Answer 344

• Ability to achieve sufficient diversification.
• Liquidity of the position. Direct private equity investments are inherently illiquid. Consequently, private equity funds are also illiquid. Investors in funds must be prepared to have the capital tied up for 7–10 years
• Provision for capital commitment. The cash is advanced over a period of time known as the commitment period, which is typically five years
• Appropriate diversification strategy. Can be by Industry Sector, Stage of Company, Geographical Location

Question 345

R30

VC stages

Answer 345

• Early Stage > Seed
• Early Stage > Start-Up -supports product development and initial marketing
• Early Stage > First Stage - supports such activities as initial manufacturing and sales
• Later Stage > Second Stage - supports the initial expansion of a company already producing and selling a product
• Later Stage > Third stage - rovides capital for major expansion
• Pre-IPO > Mezzaine - provides capital to prepare for the IPO—often a mix of debt and equity

Question 346

R30

Private Equity Exit Strategy

Answer 346

• merger with another company;
• acquisition by another company (including a private equity fund specializing in this process); or
• an IPO, whereby the company becomes publicly traded.
• Buyout funds only - dividend recapitalization - A method by which a buyout fund can realize the value of a holding; involves the issuance of debt by the holding to finance a special dividend to owners.

Question 347

R30

Private Equity Fees

Answer 347

• The compensation to the fund manager of a private equity fund consists of a management fee plus an incentive fee
• Management fee is usually a percentage of limited partner commitments to the fund
• Often in the 1.5%–2.5% range and often scale down in the later years of a partnership to reflect a reduced workload or the return of capital from exiting investments.
• Carried Interest - A private equity fund manager’s incentive fee; the share of the private equity fund’s profits that the fund manager is due once the fund has returned the outside investors’ capital.

Question 348

R30

Private Equity Indices Issues

Answer 348

• Infrequent market pricing poses a major challenge to index construction. Lack of observable market prices for private equity, short-term return and correlation data may be subject to the smoothing effects of stale prices
• Vintage Year Effects - the influence that economic conditions and market opportunities associated with a given vintage year may have on various funds’ probabilities of success.
• Fund manager’s appraisals (usually supplied on a quarterly basis) represent estimates, not market prices.

Question 349

R30

Managed Futures

Answer 349

• Pooled investment vehicles, frequently structured as limited partnerships, that invest in futures and options on futures and other instruments.
• Structured in a similar manner to hedge funds
• Provide unique returns and diversification benefits
• Trade only in derivatives markets
• More of a macro focus e.g. Interest rates, currencies
• Managed futures are often classified into subgroups on the basis of investment style (e.g., systematic or discretionary), markets traded (e.g., currency or financial), or trading strategy (e.g., trend following or contrarian).

Question 350

R30

Distressed Securities

Answer 350

• Can be debt or equity
• Companies at or near bankruptcy
• Hedge fund structure. This is the dominant type. Investors generally enjoy more liquidity (that is, they can withdraw capital more easily) than with other structures.
• Private equity fund structure. Private equity funds have a fixed term (i.e., a mandated dissolution date) and are closed end (they close after the offering period has closed). This structure has advantages in cases where the assets are highly illiquid or difficult to value

Question 351

R30

3 types of Distressed Investing

Answer 351

• Long-Only Value Investing. Involves investing in perceived undervalued distressed securities in the expectation that they will rise in value as other investors see the distressed company’s prospects improve. When the distressed securities are public debt, this approach is high-yield investing. When the securities are orphan equities, this approach is orphan equities investing.
• Distressed Debt Arbitrage Involves purchasing the traded bonds of bankrupt companies and selling the common equity short. If the company’s prospects worsen, the value of the company’s debt and equity should decline, but the hope is that the equity, in which the fund has a short position, will decline to a greater degree. If the company’s prospects improve, the portfolio manager hopes that the debt will appreciate at a higher rate than the equity because the initial benefits to a credit improvement accrue to bonds as the senior claim in the capital structure.
• Private Equity - Private equity has also been called an “active” approach because it involves corporate activism. The investor becomes a major creditor of the target company to obtain influence on the board of directors or, if the company is already in reorganization or liquidation, on the creditor committee. The investor buys the debt at deep discounts, then influences and assists in the recovery or reorganization process’

Question 352

R30

Distressed securities risks (4)

Answer 352

• Event risk. Any number of unexpected company-specific or situation-specific risks may affect the prospects for a distressed securities investment.
• Market liquidity risk. Market liquidity in distressed securities is significantly less than in other securities.
• Market risk. The economy, interest rates, and the state of equity markets are not as important as the liquidity risks.
• J factor risk. The judge’s involvement in the proceedings and the judgments will decide the outcome of investing in bankruptcy. It is also an important variable in determining which securities, debt or equity, of a Chapter 11–protected company to invest in.

Question 353

R30

Distressed Investing Terms

Answer 353

• Prepackaged Bankruptcy - A bankruptcy in which the debtor seeks agreement from creditors on the terms of a reorganization before the reorganization filing.
• Orphan Equity - The newly issued equity of a company emerging from reorganization.
• Fallen Angels - Debt that has crossed the threshold from investment grade to high yield.
• High-yield investing. - A distressed securities investment discipline that involves investment in high-yield bonds perceived to be undervalued.
• Distressed debt arbitrage - A distressed securities investment discipline that involves purchasing the traded bonds of bankrupt companies and selling the common equity short.

Question 354

R30

Commodities and inflation

Answer 354

Two factors making a commodity a good hedge against unexpected inflation:

1. Storable
2. Demand for commodity is linked economic activity.

Question 355

R16

How CME fits into investment process

Answer 355

• Step 1 - Construct IPS
• Step 2 - Formulate CME - Macro (inflation, interest rates, asset classes etc) and Micro expectations (concerning individual assets)
• Step 3 - Asset Allocations (SAA)

Question 356

R16

7 Step Framework for CME

Answer 356

1. Specify the final set of expectations that are needed, including the time horizon to which they apply.
2. Research the historical record - what are drivers of past performance?
3. Specify the method(s) and/or model(s) that will be used and their information requirements.
4. Determine the best sources for information needs.
5. Interpret the current investment environment using the selected data and methods, applying experience and judgment.
6. Provide the set of expectations that are needed, documenting conclusions (answers step 1)
7. Monitor actual outcomes and compare them to expectations, providing feedback to improve the expectations-setting process

Question 357

R16

Problems of forecasting - 1

Limitations of Economic Data

Answer 357

1. Limitations of Economic Data:

• Time lag between collection of data and when it is distributed
• Data can be revised - but revisions are not made at the time they are distributed
• Data definitions and methodologies change over time.
• Data indices are rebased over time - meaning that the specific time period used as the base of the index is changed

Question 358

R16

Problems of forecasting - 2

Data Measurement Errors and Biases

Answer 358

• Data Measurement Errors and Biases:

1. Transcription errors. These are errors in gathering and recording data. Such errors are most serious if they reflect a bias.
2. Survivorship bias.
3. Appraisal (smoothed) data - Appraised values tend to be less volatile than market-determined values for the identical asset would be. The consequences are 1) the calculated correlations with other assets tend to be smaller in absolute value than the true correlations, and 2) the true standard deviation of the asset is biased downward

Question 359

R16

Problems of forecasting - 3

The Limitations of Historical Estimates

Answer 359

• The Limitations of Historical Estimates:

1. Regime changes - Changes in the technological, political, legal, and regulatory environments, as well as disruptions such as wars and other calamities, can alter risk–return relationships. Gives rise to the statistical problem of nonstationarity (meaning, informally, that different parts of a data series reflect different underlying statistical properties)
2. A long data series may be a statistical necessity BUT :

The risk that the data cover multiple regimes increases.

Time series of the required length may not be available.

In order to get data series of the required length, the temptation is to use high-frequency data (weekly or even daily). Data of high frequency are more sensitive to asynchronism across variables. As a result, high-frequency data tend to produce lower correlation estimates.

Question 360

R16

Problems of forecasting - 4

Ex Post Risk Can Be a Biased Measure of Ex Ante Risk

Answer 360

• Ex Post Risk Can Be a Biased Measure of Ex Ante Risk

Understates risk and overstate returns

Question 361

R16

Problems of forecasting - 5

Biases in Analysts’ Methods

Answer 361

• Biases in Analysts’ Methods:

1. Data-mining bias - introduced by repeatedly “drilling” or searching a dataset until the analyst finds some statistically significant pattern. Such patterns cannot be expected to be of predictive value
2. Time-period bias - Research findings are often found to be sensitive to the selection of starting and/or ending dates

Question 362

R16

Problems of forecasting - 6

The Failure to Account for Conditioning Information

Answer 362

• The Failure to Account for Conditioning Information:

1. Prospective returns and risk for an asset as of today are conditional on the specific characteristics of the current marketplace and prospects looking forward
2. We should not ignore any relevant information or analysis in formulating expectations. Indeed, the use of unconditional expectations can lead to misperceptions of risk, return, and risk-adjusted return.

Question 363

R16

Problems of forecasting - 7

Misinterpretation of Correlations

Answer 363

• Misinterpretation of Correlations

1. Assumes a linear relationship between variables
2. Without the investigation and modeling of underlying linkages, relationships of correlation cannot be used in a predictive model

Question 364

R16

Problems of forecasting - 8

Psychological Traps (6)

[Applies to forecasters]

RASPOC

Answer 364

Psychological Traps

1. Anchoring trap - The tendency of the mind to give disproportionate weight to the first information it receives on a topic. The analyst can try to address this trap by consciously attempting to avoid premature conclusions.
2. Status quo trap - The tendency for forecasts to perpetuate recent observations—that is, to predict no change from the recent past. The status quo trap may be overcome with rational analysis used within a decision-making process.
3. Confirming evidence trap - The bias that leads individuals to give greater weight to information that supports an existing or preferred point of view than to evidence that contradicts it.
4. Overconfidence trap - The tendency of individuals to overestimate the accuracy of their forecasts. To overcome: Examine all evidence with equal rigor. Enlist an independent-minded person to argue against your preferred conclusion or decision. Be honest about your motives. To prevent this trap from undermining the forecasting endeavor is to widen the range of possibilities around the primary target forecast.
5. Prudence trap - The tendency to temper forecasts so that they do not appear extreme; the tendency to be overly cautious in forecasting. To avoid the prudence trap, an analyst is again wise to widen the range of possibilities around the target forecast
6. Recallability trap - The tendency of forecasts to be overly influenced by events that have left a strong impression on a person’s memory. To minimize the distortions of the recallability trap, analysts should ground their conclusions on objective data and procedures rather than on personal emotions and memories.

Question 365

R16

Problems of forecasting - 9

Model Uncertainty

Answer 365

• Model Uncertainty:

1. Model uncertainty - Uncertainty concerning whether a selected model is correct.
2. Input uncertainty - Uncertainty concerning whether the inputs are correct.

• Input uncertainty and model uncertainty in particular often make it hard to confirm the existence of capital market anomalies (inefficiencies)

Question 366

R16

Tools for formulating CME (5)

Answer 366

1. Statistical Tools
2. DCF Models
3. Risk Premium Model
4. Financial Equilibrium Models
5. Survey and Panel Methods

Question 367

R16

Statistical Tools for CME

Answer 367

1. Use arthmetic average for single periods, but geometric average for mutliple periods
2. Shrinkage Estimator - Estimation that involves taking a weighted average of a historical estimate of a parameter and some other parameter estimate, where the weights reflect the analyst’s relative belief in the estimates. Uses a target covariance matrix - A component of shrinkage estimation; allows the analyst to model factors that are believed to influence the data over periods longer than observed in the historical sample. Used when data set is very small. Reduces the incidence of historical outliers. Can be used for both covariance and mean returns forecasting.
3. Time series model - forecasting a variable on the basis of lagged values of the variable being forecast and often lagged values of other selected variables. Useful in developing particularly short-term forecasts for financial and economic variables. Notably applied to estimating near-term volatility
4. Volatility Clustering - will high or low volaility persist in short term.
5. Multifactor models - When the factors are well chosen, a multifactor model approach may filter out noise. This structure has been found useful for modeling asset returns and covariances among asset returns

Question 368

R16

DCF Models for CME

Answer 368

• Gordon Growth model
• Have the advantage of being forward-looking.
• They do not address short-run factors such as current supply-and-demand conditions, so practitioners view them as more appropriate for setting long-term rather than short-term expectations
• DCF models can be used for Fixed Income and equity but for fixed income we should use YTM. The YTM calculation makes the strong assumption that as interest payments are received, they can be reinvested at an interest rate that always equals the YTM

Question 369

R16

DCF Models for CME - Gronold-Kroner

Answer 369

E(R_e ) ≈ D/P −(ΔS) + i +g + ΔP/E

• Expected income return: D/P − ΔS.
• Expected dividend yield D/P
• Repurchase yield: − ΔS.
• Expected nominal earnings growth return: i + g.
• Expected repricing return: ΔP/E
• Compounded Annual growth rate or expected rate of return on equity: E(R_e)

Question 370

R16

Risk Premium Approach for CME

Answer 370

E(R_i) = RF + (Riskpremium)^₁ + (Riskpremium)₂ +…+ (Riskpremium)_K

• Real risk-free interest rate
• Inflation premium - The sum of the real risk-free interest rate and the inflation premium is the nominal risk-free interest rate, often represented by a governmental Treasury bill YTM
• Default risk premium
• Illiquidity premium
• Maturity premium
• Tax premium
• Equity risk premium:

E(R_e) = YTM on a long-term government bond + Equity risk premium

Question 371

R16

Financial Market Equilibrium Models for CME

Answer 371

• The GIM acts as a proxy for the world market portfolio and is made up of both traditional and alternative asset classes which have enough capacity to absorb all meaningful investments
• Singer–Terhaar Full Integration

RP_i = σ_iρ_i,M (RP_M/σ_M)

• Singer–Terhaar Segmented Markets

RP_i = σ_i (RP_M / σ_M)

• Possible addition of illquidity premium
• Steps to calculate:

1. Estimate the perfectly integrated and the completely segmented risk premiums for the asset class using the ICAPM.
2. Add the applicable illiquidity premium, if any, to the estimates from the prior step.
3. Estimate the degree to which the asset market is perfectly integrated.
4. Take a weighted average of the perfectly integrated and the completely segmented risk premiums using the estimate of market integration from the prior step

Question 372

R16

Survey and Panel methods for CME

Answer 372

• Survey - A method of capital market expectations setting that involves surveying experts.
• Panel - A method of capital market expectations setting that involves using the viewpoints of a panel of experts. The group queried and providing responses must be fairly stable.
• Judgement - The expectations-setting process nevertheless can give wide scope to applying judgment. Other investors who rely on judgment in setting capital market expectations may discipline the process by the use of devices such as checklist

Question 373

R16

Business Cycle

Answer 373

1. Initial recovery. Inflation still declining Stimulatory fiscal policies Confidence starts to rebound Short rates low or declining; bond yields bottoming; stock prices strongly rising
2. Early upswing. Healthy economic growth; inflation remains low Increasing confidence. Short rates moving up; bond yields stable to up slightly; stock prices trending upward
3. Late upswing. Inflation gradually picks up Policy becomes restrictive Boom mentality Short rates rising; bond yields rising; stocks topping out, often volatile
4. Slowdown. Inflation continues to accelerate; inventory correction begins Confidence drops Short-term interest rates peaking; bond yields topping out and starting to decline; stocks declining
5. Recession. Production declines; inflation peaks Confidence weak Short rates declining; bond yields dropping; stocks bottoming and then starting to rise

Question 374

R16

Taylor Rule

Answer 374

R_optimal = R_neutral + [0.5×(GDP_gforecast − GDP_gtrend) + 0.5×(I_forecast − I_target)]

• The Taylor rule gives the optimal short-term interest rate as the neutral rate plus an amount that is positively related to the excess of the forecasts of GDP and inflation growth rates above their trend or target values.
• The belief is that when GDP forecast growth is below trend, lowering the interest rate will stimulate output by lowering corporations’ cost of capital. When forecast inflation is below target, lowering the interest rate is expected to help the inflation rate return to target through its stimulative effect on the money supply.

Question 375

R16

Economic Growth Trends

Answer 375

• LT trend growth determined by:

1. Population growth
2. Business investment
3. Exogenous Shocks

• The trend growth in GDP is approximately the sum of the following:

growth from labor inputs, comprising:

• growth in potential labor force size and*
• growth in actual labor force participation, plus*

growth from labor productivity, comprising

growth from capital inputs and

TFP growth (i.e., growth from increase in the productivity in using capital inputs).

Question 376

R16

Permanent income hypothesis

Answer 376

• The hypothesis that consumers’ spending behavior is largely determined by their long-run income expectations.
• Temporary or unexpected (or one-time) events such as benefiting from an inheritance might temporarily increase an individual’s demand for items that might not ordinarily be purchased, but overall spending patterns remain largely determined by long-run expectations. However, if an unexpected event (e.g., winning the lottery) produced an ongoing series of incoming cash flows, it would be expected to permanently alter an individual’s spending patterns since the flows would be ongoing and could be depended upon over the long term.
• Only when income disruptions occur over the long term may individuals capitulate and reduce their consumption—out of necessity

Question 377

R16

Government Structural Policies

Answer 377

• To help facilitate long term economic growth:

1. Fiscal policy is sound.
2. The public sector intrudes minimally on the private sector. The most damaging regulations for business tend to be labor market rules (e.g., restricting hiring and firing) because such regulations tend to raise the structural level of unemployment
3. Competition within the private sector is encouraged.
4. Infrastructure and human capital development are supported
5. Tax policies are sound. According to economic theory, taxes distort economic activity by reducing the equilibrium quantities of goods and services exchanged

Question 378

R16

Exogenous Shocks

Answer 378

• Can spread to other economies - contagion. Diversification is lost in times of contagion.
• Oil Shocks
• Financial Crises - more dangerous in a low interest rate environment.

Question 379

R16

Country Risk Analysis

Answer 379

1. How sound is fiscal and monetary policy? Fiscal deficit to GDP A persistent ratio above 4 percent is regarded with concern.
2. What are the economic growth prospects for the economy? Annual growth rates of less than 4 percent generally mean that the country is catching up with the industrial countries slowly
3. Is the currency competitive, and are the external accounts under control? Current account deficit is > 4% potentially damaging. 1–3% of GDP is probably sustainable, provided that the economy is growing.
4. Is external debt under control? Ratio of foreign debt to GDP > 50% is dangerous territory, while 25–50% is the ambiguous area. Or use debt to current account receipts > 200% for this ratio puts the country into the danger zone, while a reading below 100% does not.
5. Is liquidity plentiful? Reserves divided by short-term debt Safe level is over 200% while a risky level is under 100%
6. Is the political situation supportive of the required policies?

Question 380

R16

Economic Forecasting

Answer 380

1. Econometric models, the most formal and mathematical approach to economic forecasting. Uses ordinary lease squared regression.
2. Leading indicators: variables that have been found to lead (precede) turns in the economy.
3. Checklists, requiring the subjective integration of the answers to a set of relevant questions.

Question 381

R16

Econometric models

Answer 381

Econometric models

• Rarely forecast recessions well, although they have a better record in anticipating upturns.
• Can be complex and time consuming to construct
• May require interpretation of results

Question 382

R16

Economic Indicators

Answer 382

• Leading
• Lagging
• Coincident
• Advantages:

1. Simple and easy to understand
2. Data often available from 3rd parties
3. Can be taylored to individuals needs
4. 3rd Party literature available

• Disadvantages

1. Results have been inconsistant
2. Have given false signals

Question 383

R16

Checklist Approach

Answer 383

• Subjective
• Less complex and very flexible
• Time consuming
• Limited complexity

Question 384

R16

Forecasting Asset Class Returns

Answer 384

• Cash and equivalents - Managers lengthen or shorten maturities according to their expectations of where interest rates will go next.
• Nominal Default-Free Bonds - For investors buying and selling long-term bonds over a shorter time period, the emphasis is on how bond yields will respond to developments in the business cycle and changes in short-term interest rates
• Defaultable Debt - During a business cycle, spreads tend to rise during a recession because companies are under stress from both weak business conditions and, typically, higher interest rates. Default rates typically rise during recessions.
• Emerging Market Bonds - Higher default risk. Often in terms of non-domestic currency
• Inflation-Indexed Bonds - Real Yields rise as real economy expands. Real yields fall as inflation rises. Real yield falls as investor demand grows. There are considered a seperate asset class.
• Emerging Market Stocks - often positively correlated with business cycle in developed world.
• Real Estate - growth in consumption, real interest rates, the term structure of interest rates, and unexpected inflation as systematic determinants of real estate returns.

Question 385

R16

Exchange Rate Forecasting (5)

Answer 385

1. Relative PPP - The theory that movements in an exchange rate should offset any difference in the inflation rates between two countries. PPP is often not a useful guide to the direction of exchange rates in the short or even medium run (up to three years or so). PPP in broad terms does seem to be useful in the long run—say, over periods of five years or longer
2. Relative economic strength forecasting approach - Better for short term rather than long term.An exchange rate forecasting approach that suggests that a strong pace of economic growth in a country creates attractive investment opportunities, increasing the demand for the country’s currency and causing it to appreciate. Focuses on investment flows rather than trade flow. The relative strength approach indicates the response to news on the economy but does not tell us anything about the level of exchange rates. The PPP approach indicates what level of the exchange rate can be regarded as a long-term equilibrium. By combining the two, we can generate a more complete theory.
3. Capital flows forecasting approach - An exchange rate forecasting approach that focuses on expected capital flows, particularly long-term flows such as equity investment and foreign direct investment. Inflows of FDI into a country increase the demand for the country’s currency, all else being equal.
4. Savings–investment imbalances forecasting approach - An exchange rate forecasting approach that explains currency movements in terms of the effects of domestic savings–investment imbalances on the exchange rate. Not really used for forecasting exchange rates, but it could be. If the economy becomes weak enough and domestic investments no longer exceed domestic savings, then the currency will weaken.
5. Government Intervention - economists and the markets have been skeptical about whether governments really can control exchange rates with market intervention alone because of three factors: First, the total value of foreign exchange trading, in excess of US$1 trillion daily, is large relative to the total foreign exchange reserves of the major central banks combined. Second, many people believe that market prices are determined by fundamentals and that government authorities are just another player. Third, experience with trying to control foreign exchange trends is not encouraging in the absence of capital controls. Unless governments are prepared to move interest rates and other policies, they cannot expect to succeed.

Question 386

R5

Asset Management Industry Trends (3)

Answer 386

1. Growth of Passive Investing

• Management fees for index (or other passive) funds are often a fraction of those for active strategies
• Many active asset managers face in generating ex ante alpha, especially in somewhat more-efficiently priced markets, such as large-cap US equitie

1. Big data

• Social media data. -can aid key market sentiment indicators and indicate potential specific user trends related to products and services
• Imagery and sensor data - relevant to economic considerations (e.g., weather conditions, cargo ship traffic patterns) and company-specific considerations (e.g., retailer parking capacity/usage, tracking of retail customers).

1. Robo advisors

• Growing demand from “mass affluent” and younger investors
• Lower fees
• New entrants. Lower barrier to entry

Question 387

R5

Smart Beta

Answer 387

• Involves the use of simple, transparent, rules-based strategies as a basis for investment decisions.
• Feature higher management fees and higher portfolio turnover relative to passive market-cap weighted strategies

Question 388

R5

What tasks does effective governance perform?

Answer 388

• Effective governance models perform the following tasks:

1. Articulate long- and short-term objectives of the investment program
2. Allocate decision-making rights and responsibilities among the functional units in the governance hierarchy while considering their knowledge, capacity, time, and position in the hierarchy
3. Specify processes for developing and approving the IPS
4. Specify processes for developing and approving the investment program’s strategic asset allocation
5. Establish a reporting framework to monitor the investment program’s progress toward the agreed-upon goals and objectives
6. Undertake periodic governance audits

Question 389

R5

Reporting Framework

Answer 389

• Benchmarking is necessary for performance measurement, attribution, and evaluation.
• Management reporting to understand which parts of the portfolio are performing ahead of or behind the plan, and why as well as whether assets are being managed in accordance with investment guidelines.
• Governance reporting, which addresses strengths and weaknesses in program execution

Question 390

R5

Asset manager focus - individual vs Institutional

Answer 390

Asset managers who focus on individual investors typically package investment strategies through highly regulated pooled vehicles (e.g., mutual funds or exchange-traded funds). Institutional-focused managers typically package their investment strategies in less regulated and more customizable product structures (e.g., separately managed accounts and limited partnerships).

Question 391

R5

What must portfolio management process reconcile?

Answer 391

The portfolio management process must reconcile (balance):

1. Asset owner objectives
2. The possibilities offered by the investment opportunity set

Question 392

R5

Explain the importance of the IPS.

Answer 392

The investment policy statement (IPS) is the foundation of an effective investment program.

• A well-designed IPS serves as the foundation and guidance to investment managers/advisors for ongoing management of scheme assets.
• A well designed IPS assures stakeholders that program assets are managed with the appropriate care and diligence.

Question 393

R5

Six typical key elements of an IPS

Answer 393

1. An introduction that describes the purpose and scope of the document itself and describes the asset owner. The description of the asset owner should allow the reader of the IPS to understand the context within which the investment program exists.
2. A statement of investment objectives, which describes the target investment returns and willingness to endure risk to achieve these returns.
3. A section discussing the investment constraints within which the investment program must operate to include liquidity requirements time horizons tax concerns, legal and regulatory factors, and unique circumstances
4. A statement of duties and responsibilities outlining the allocation of decision rights and responsibilities among the investment committee, investment staff and any third-party service providers.
5. An explanation of the investment guidelines to be followed in implementation and on specific types of assets excluded from investment, if any.
6. A section specifying the frequency and nature of reporting to the investment committee and to the board of directors.

Question 394

R6

Trade Bodies vs Professionalism

Answer 394

These standards distinguish professions from the craft guilds and trade bodies that were established in many countries. In particular, the requirement for members of professions to uphold high ethical standards is one clear difference. Another difference is that trade bodies do not normally have a mission to serve society or to set and enforce professional conduct rules for practitioners.

Question 395

R6

How professions establish trust

Answer 395

1. Professions normalize practitioner behavior.
2. Professions provide a service to society.
3. Professions are client focused.
4. Professions have high entry standards.
5. Professions possess a body of expert knowledge.
6. Professions encourage and facilitate continuing education.
7. Professions monitor professional conduct.
8. Professions are collegial.
9. Professions are recognized overseeing bodies.
10. Professions encourage the engagement of members.

Question 396

R6

Trust in Investment Management

Answer 396

• The investment management profession meets most, but currently not all, of the expectations of a profession
• The investment management profession and investment firms must be interdependent to maintain trust. Employers and regulators have their own standards and practices that may differ from regulations and standards set by professional bodies. The investment management professional bodies typically direct professionals in how to resolve these differences.

Question 397

R6

CFA Institute as an Investment Management Professional Body

Answer 397

• The mission of CFA Institute is “to lead the investment profession globally, by promoting the highest standards of ethics, education, and professional excellence for the ultimate benefit of society
• The CFA Institute Global Body of Investment Knowledge (GBIK) and Candidate Body of Knowledge (CBOK) are updated on an ongoing basis through a process known as practice analysis
• Members of CFA Institute and CFA Program candidates are required to adhere to the Code and Standards and to sign annually a statement attesting to that continued adherence

Question 398

R6

Expectations of Investment Management Professionals

Answer 398

Characteristics and behavior expected of all professionals include honesty, integrity, altruism, continuous improvement, excellence, loyalty, and respect for colleagues, employers, and clients. Extremely high standards, but not perfection, are expected, including behavior in public. Professionals should, through their actions, uphold the reputation of their profession and be responsible, accountable, and reliable in their work. Professionals should reflect regularly about the cycle of self-improvement, starting with a self-assessment, identification of knowledge gaps, compiling a program of continuing professional development to fill those gaps, putting the new learning into practice, and then evaluating the results in order to inform the next cycle. Key duties of professionals are to provide independent advice, avoid or disclose conflicts of interest, and respect client information, objectivity, transparency, and confidentiality.

Question 399

R6

Challenges for Investment Management Professionals

Answer 399

• New trends are reshaping professions and expectations of professionals.
• Transparency has made it easier for consumers to compare the prices of services.
• Regulation has become increasingly commonplace across the world
• Globalization has driven more common practice around the world. Globalization could prove adverse for the investment management profession if large global firms, through consolidation, wish to establish their own standards and practices that conflict with the codes of individual professional bodies
• The greatest challenge for the investment management profession comes from technology. Digital systems may be able to replace or enhance many of the functions of an investment professional.