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CFA Level 3 > Countdown > Flashcards

Countdown Flashcards

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1
Q

Difference between MCS and Deterministic forecasting?

A

DF uses single return assumption.

MCS uses variable inputs to produce a probability distribution.

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2
Q

Slippage costs most likely the result of

A

Commissions

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3
Q

Increase convexity of a bond

A

Buy long calls on long dated bonds

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4
Q

What scenario of interest rate volatility will a bullet under perform a barbell

A

Parallel shift either way Bullet under performs
Flattening - Bullet under performs
More curvature - Bullet under performs
Increased rate volatility - Bullet under performs

You would buy the long and short term bonds in these scenarios

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5
Q

To take advantage of expected curvature?

A

Create a butterfly portfolio

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6
Q

What call option is embedded in a MBS?

How might a manager decrease convexity?

A

A short call.

Decrease convexity by selling calls or buying puts. Ie buying the MBS will be the same as buying a short call if yield curves are expected to be steady.

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7
Q

Conservatism

Confirmation bias

A

Conservatism Rationally forming a view but failing to change that view based on new informaiton.

Confirmation bias is actively seeking new/existing information to support your view.

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8
Q

Self control bias

A

Deviating from long term goals seeking immediate gratification

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9
Q

Mean Variance portfolio. What matters?

A

Only expected return and variance matter.

It is the preferred portfolio for investors with mainly cognitive biases.

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10
Q

Illusion of control

A

Believing you know more simply by acquiring more information.

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11
Q

For futures. If you are increasing the position exposure:
Beta T =
Beta P =
Bt - Bp / Bf x Mv/F x Multiplier

A

Beta T = Beta

Beta P = zero

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12
Q

Modified dietz return =

A

EMV - BMV - CF / BMV + Weight x CF

Weight = no days to end of month / 30

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13
Q

Absolute profit/loss CDS =

A

Absolute profit/loss CDS = ChangeCDS x FSD x Notional

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14
Q

TWRR =

A

TWRR = (1+r)x(1+r)x(1+r) - 1

geometric return

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15
Q

To protect a portfolio based in a foreign ccy. ie BRL/USD (BRL exposure for a USD investor)

A

Either Buy Call on BRL

aka

Buy Put on USD

This will protect against base currency appreciated.

(same thing)

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16
Q

Convertibles arbitrage funds perform best when:

A

Issurance is high (more choice)
Moderate vol levels (not high due to illiquidity)
Left tail risk as hedge funds basically established the liquidity for Convertibles they dont fare well during volatile periods.

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17
Q

Hedge fund types

A

Equity Event relative opportunity for Specialist Multi-Managers
Equity = EMN, LS, DS
Event Driven = Merger arb, Distressed
Relative Value = FI arb, Convertible arb
Opportunistic = Global Macro, Managed futures
Specialist = Vol Trading, Reinsurance
Multi-manager = FoF and Multi-strategy

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18
Q

Conditional linear factor model

A

Provides intrinsic value of a hedge fund and how risk exposures perform in turbulent periods.

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19
Q

Framing bias portfolio

A

Most likely to construct a 1/n portfolio.

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20
Q

Multi manager fund positives

A

No netting of fees

Reallocate capital more quickly and better transparency of underlying managers.

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21
Q

Cross sectional momentum strategies

Time series momentum strategies

A

Will be same asset class (ie bonds) and will create a market neutral position

Time series momentum strategies will be net long or net short looking at asset performance relative to other strategies.

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22
Q

What is the fee structure which most closely aligns interests between managers and investors and is symetrical?

A

Fee equal to base + performance sharing is a symmetrical fee structure which best aligns shareholder and manager interests.
It exposes the manager to both downside and upside risk.

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23
Q

Forward rate payoff equation =

A

Realised gain = V0 x (-End date rate + Start date rate)

Hedged $15m MXN MXN/USD 
15m x (-0.0921 + 0.1098)
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24
Q

Which is more OTM a 40 delta or 10 delta strangle.

If you have negative delta how do you offset this?

At what level of delta is an option OTM?

No calls needed equation.

A

A 40 delta will move more relative to share price and so is less OTM than a 10 delta.

A delta strangle of both where both are OTM would have the same intrinsic value as the strangle of both equal zero.

You BUY calls (or options with positive delta)

Options with delta less than 0.50 are OTM.
Stock total delta / option delta = no calls needed

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25
Q

More likely to follow a passive currency management?

A

A short time horizon.
High risk aversion
Significant foreign bond exposure.
Client who doubts the benefit of discretionary management.

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26
Q

CAD fund has US assets. Assuming negative correlaiton between CAD and US corporate profits, what is the minimum variance hedge ratio to reduce volatilty of CAD?

A

Negative correlation of CAD ccy and USD profits mean positive correlation of USD and USD profits.
Rdc increases, Rfx and Rfc are correlated.
Therefore you need to overhedge.

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27
Q

Jane Simms manages a German portfolio denominated in the EUR and decides to use an option collar to reduce her downside risk exposure to the Mexican peso (MXP) while retaining some potential upside. Which of the following strategies will accomplish her objective?

A

Buy an OTM call on the EUR and sell an OTM put on the EUR.

The collar Simms describes requires buying OTM puts and selling OTM calls on the MXP.

aka BUY an OTM Put on MXP and sell and OTM Call on MXP.

Same thing but careful how questions are phrased.

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28
Q

Foundation return target

A

a REAL return ahead of inflation plus management fees of 0.2%

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29
Q

what is a duration neutral bond trade?

When is it most profitable?

A

short the 2 year bond and long 10 year bond with matched durations.
Most profitable when yield curve inverts.

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30
Q

What is bounded rationality?

A

Any argument which highlights a decision is not completely rational. Ie switching to 50% equity allocation cause you read somewhere you’re supposed to.

Make argument for why a decision was not completely rational.

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31
Q

What happens if credit spreads and interest rate chanes?

A

The bond price will be added up for both the change in spreads and the change credit spreads to combine.

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32
Q

What is emperical duration?

A

CREDIT RATINGS create different empirical duration. Empirical duration is the calculation of a bond’s duration based on historical data rather than a preset formula. Often found by running a regression of its price returns on changes in benchmark interest rates.

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33
Q

If you have a flat inverted yield curve and want to protect and probably add convexity to your bond portfolio as you expect interest rates to rise, what strategy is best?

A

Buy calls, Buy Puts = increase convexity.

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34
Q

What type of rolldown yield would you get from an inverted yield curve?

A

You can expect negative rolldown return.

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35
Q

What is tail risk?

A

Concern an asset will decline.

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36
Q

A sign of a portfolio using discretionary approach?

A

Small number of stocks

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37
Q

Tracking error aka

A

Active risk

If you have a tracking error budget of 10% then you should target active risk to be less than 10%

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38
Q

Where does an EMN get its beta eexposure?

A

EMN get beta from its derivative position.

Its long and short positions are both targeting alpha in the same way as a long extension fund.

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39
Q

Net worth =

Net wealth =

A

Net worth economic balance sheet = (PV Human capital + assets) - (PV future consumption - liabilities)
Net wealth financial balance sheet = (assets) - (liabilities)

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40
Q

Should cash be included in the MVO process?

What is the two fund approach?

A

It CAN be.

Under the two-fund approach cash is excldued from MVO.

41
Q

smoothing of commercial real estate returns is evidenced how?

A

By a high serial correlation reading.

42
Q

Vested pension benefits
Unvested pension benefits

Financial capital or human capital?

A

Vested pension benefits can be considered components of financial capital
Unvested pension benefits are contingent on future work and are thus considered part of human capital

43
Q

Net worth

Economic net worth

A

Net worth = assets - liabilities

Economic net worth = Net worth from traditional balance sheet + (PV of future earnings + unvested pension benefits) - (PV of future consumption + PV of bequests)

44
Q

Universal insurance

A

More options and remains in force until death

45
Q

How should an advisor help quantify a clients goals?

A

Capital sufficiency analysis can be used to determine the likelihood of meeting goals.

46
Q

Scheduled algorithm. POV TWAP and VWAP.

A

Suitable when you have smaller trades 5% to 10% of ADV.

Only suitable for trades which have a longer time horizon to release the trade.

47
Q

Trade relancing

Wider corridors when:

Narrower corridors when:

A

Wider corridors if assets have HIGHER correlations (ie equities and bonds increase in correlation). you can have wider ranges as divergence becomes less likely.
After tax less volatile so can manage wider corridors.

Narrow corridors when: mean reversion is likely therefore divergence from target weights would be less likely.
Lower transaction costs allow for a narrower range due to it being cheaper when you do rebalance.
Pretax narrower as more likely to move outside during volatile periods

48
Q

What does a ‘return seeking / hedging’ portfolio look like with £8bn liabilities and £10bn assets?

A

£8bn would be in the hedging portfolio. £2bn would be in the return seeking portfolio.

Asset allocation
80% index linked gilts
20% Equity investments.

49
Q

when given different modules to meet a return target. Which one do you pick. What value do you use to discount?

A

You pick the module with the highest Minimum expected return and that is your discount rate. You ignore Er.

Ie go to columns 75% of success. Pick the highest figure. Use that as the I/Y in the calculator and discount the future value to PV.

50
Q

What do you need to look for when immunizing a single cash flow liability?

A

You need to MATCH the liability with the portfolio being used.
You need to MATCH the Macaulay duration with the portfolio being used.
(slightly different when you have multiple liabilities where you need convexity to slightly exceed.

51
Q

Which portfolio would you pick if the yield curve is FLATTENING?

A

You would pick the BARBELL.

You can weight the modified duration if you’re told the percentage held in each bond to find the actual change. Otherwise barbell is trying go to.

52
Q

Return objective
Inflation 4%
Er 4.5 %
Tax 25%

A

4% + 4.5% = 8.5%

8.5% / 0.75 = 11.3%

53
Q

Two standard deviation approach with a 14% limit
Er 12.8%
SD 13.2%

A

12.8% - (2 x 13.2%) = -13.6%

This is within the drawdown limit.

54
Q

Life insurance Benefits

A

Death benefit is paid directly to beneficiaries tax exempt

Premiums paid to an insurance premium no longer form part of your estate.

55
Q

Foundation
Low ability to take risk

High ability to take risk

A

Low:
Sole source of funding is the portfolio.
No contributions expected.

High:
Long horizon gives longer time TO RECOVER LOSSES.
Small difference in the maximum and the minimum expected return vs costs and inflation relative to the 5% distribution requirement.

56
Q

Why do passives have lower taxes?

A

Passives have LOWER turnover and therefore lower taxable gains from trades within the fund.

57
Q 
Surplus optimisation
vs
Two Portfolio approach (aka Hedging / return seeking portfolio)
vs
Integrated asset-liability approach
vs 
Goals based approach
A

Surplus optimisation = extension to MVO with efficient frontier based on the surplus with its volatility as its measure of risk.

Two Portfolio approach (aka Hedging / return seeking portfolio) = separates portfolio in two, one to hedge usually in bonds and the other to seek returns.

Integrated asset-liability approach = integrates both assets and liabilities in a constant feedback loop. Banks and insurers often make decisions jointly as banks stress tests would effect both.

Goals based approach for individual investors with numerous conflicting goals.

58
Q

Justify

A

Pick one and reject the others with a quick reason.

59
Q

Full replication

vs

Optimisation

vs

vs stratified sampling

A

Full replication = only useful for very large cap indexes which are liquid where you don’t want to sue sophisticated models

Optimisation = uses mean variance optimisation to minimize tracking error. It can be used alongside stratified sampling. It is however more costly and complex.

Stratified sampling = will increase tracking error but is a happy medium for more complex indexes. Takes a strata and matches risk exposures. Lower cost.

60
Q

Signs of a discretionary approach

A

Small number of stocks and use of NON-financial information such as ESG and management quality.

61
Q

signs of high active risk and high active share

A

high active risk due to many active weights

active share would be shown by a low number of stocks.

Index has low active share and low active risk. Concentrated portfolio has high active share and high active risk.

62
Q

Effect of high correlation of a companies performance with plan assets

A

Lowers the pensions ability to take risk. As company performs poorly the plan must become more defensive.

63
Q

Return objective of a foundation

A

Maintain purchasing power in perpetuity with a reasonable level of risk.

64
Q

Would a small team utilize the endowment model with high allocation to alternatives?

A

No they would not have the necessary resources to do so.
Unable to access top managers.
Inexperience with the asset class.

65
Q

A classic convertible bond

arbitrage strategy

A

A classic convertible bond
arbitrage strategy is to buy the relatively undervalued convertible bond and take a short position in the relatively overvalued stock.

66
Q

What is a conditional linnear factor model?

A

A conditional model can show whether hedge
fund risk exposures to equities that are insignificant during calm periods
become significant during turbulent market periods. During normal periods
when equities are rising, the desired exposure to equities (S&P 500 Index)
should be long (positive)

67
Q

Asset liability management
Liability driven investing
Asset driven investing

A

Asset liability management - when both assets and liabilities change with interest rates .BANKS
Liability driven investing - takes liabilities as a given and uses assets to meet future liabilities. NOT useful for perpetual time horizons
Asset driven investing - takes assets as a given and manages liabilities according to those assets.

68
Q

Large parallel increase and decrease in yield curve effect on assets vs liabilities?

A

Future value of assets will exceed future value of liabilities

69
Q

Increase duration and convexity of a bond with options

A

Buy calls, buy puts

70
Q

A MBS more value in rising or lowering volatility?

A

There is an embedded call option from the mortgage borrowers which becomes more valuable as interest rate volatility increases.. HOWEVER, this is effectively a short position for the MBS SECURITY. In which case it will perform better as interest rate volatility DECREASES.

71
Q

Econometric model

Leading indicator approach

A

Econometric model: Structural models specify functional relationships among variables based on ECONOMIC THEORY.
+ discipline and consistency among variables based on economic theory
- complex and time consuming to formulate.

Leading indicator approach: Economic indicators are economic statistics published by official agencies and/or private organizations. Diffusion Index
+Simple to consturct
-Can provide false signals

72
Q

Macro attribution

Micro attribution

A 
Macro = fund sponsor decisions eg the actual pension funds decision to swap PE funds for FI funds
Micro = portfolio manager decisions to overweight telcos
73
Q

Do you buy/sell the short/long term CDS on expected yield curve steepening and economy improvements?

A

In the late expansion stage, the credit spread curve is expected to steepen (upward-sloping for both IG and HY). That is due to the probability of default falling in the near term, causing short-term CDS spreads to fall by more than longer-term CDS spreads. In order to profit from this view, Angeles should sell protection in the 3-year CDX HY index and buy protection in the 10-year CDX HY index. James’s CDS positions are not consistent with this view since she has sold protection in the 10-year index and bought protection in the 3-year index.

Long end more likely to be riskier so you’d buy long dated. Short end would be safer so you could sell.

74
Q

Netting risk

A

FoF ONLY. Fees paid to outperforming managers cannot be offset like they can in a Multi-strat fund.

75
Q

Scheduled algo

Liquidity seeking algo

Arrival price algo

Dark strategy

SORs

Closing price benchmark

A

Scheduled algo POV, TWAP, VWAP - less than 10% ADV low urgency small orders, minimal market impact

Liquidity seeking algo - large orders less liquid market

Arrival price algo (high urgency, moderate size less than 15% - small orders in liquid markets where manager beleives price will move against them.

Dark strategy - large orders, ILLIQUID market where other strategies would lead to high market impact. For investors concerned with posting in lit markets.

SORs (smart order routers through lit or dark markets)

The closing price benchmark is typically used by index managers and mutual funds that
wish to execute transactions at the closing price for the day. Minimizes potential tracking error.

76
Q

CDS Spreads rise profit when
Seller of protection
Buyer of protection

Economic recovery expected

Economic slowdown

A

Seller of protection profit when CDS spread falls and CDP price rises
Buyer of protection profits when CDS spreads rise and CDS price falls.

Economic recovery you’d Sell HY protection and Buy IG protection.

Economic slowdown. Buy HY protection. Sell IG protection.

77
Q

Liability driven model

Endowment model

A

Liability driven is not useful for perpetual investment horizons

Endowment commonly used by universities with perpetual time horizons. Makes use of external managers in alternatives and equities. Higher value add but also higher cost than a Norway model.

78
Q

Free float vs fundamental index

A

Free-float weighted indices operate based on the validity of the efficient market
hypothesis, whereas fundamental weighting operates to exploit possible inefficiencies in
market pricing.

79
Q

Equity index must be

A
  1. Rules-based,
  2. Transparent, and
  3. Investable.
80
Q

BPV or convexity match for immunisation?

A

First of get the closest BPV of asset vs liability.

Secondly get a convexity which slightly exceeds

81
Q

dividend capture

A

Trying to trade the ex-div date. Doesn’t always work in practice due to:
Tax considerations
Stock movements on the ex-div date.

82
Q

List four objectives or constraints when aligning the

portfolio to IPS

A 
- Risk objective;
• Return objective;
• Liquidity requirement;
• Time horizon;
• Tax concern;
• Legal and regulatory factors; or
83
Q

Time Horizon

A

Assume university is at age 18 for 4 years tuition
State approximate life expectancy
State retirement age
Plus other goals.

84
Q

Liquidity preferences

A
  • Excessive current liquid assets at €1 million
    • Current salary exceeds expenditures
    • Need to cover lake house expenses starting 1 year
    from now
    • Education expenses as they come due
85
Q

Return Objective

A

Growth oriented—no need for current investment
income
• 3% inflation to be added to real asset growth
• Tax efficiency important given marginal rates
• €200,000 retirement goal

86
Q

Other Investment
Preferences/
Constraints

A
  • Retain investment real estate (lake house) for
    personal use
  • Receive family business proceeds in 6 months
  • Lauren, at this time, does not plan to work
87
Q

PPP currency with the lower inflation will:

Current account surplus:

Stronger GDP Growth:

A

Relative purchasing power parity predicts that the country with the lower expected inflation should see its currency strengthen by the difference in expected inflation rates.

Current account surplus: strengthening ccy

Stronger GDP Growth: stronger ccy.

88
Q

immunisation

the most restrictive form?

A

aim is to match asset and liability macaulay duration

cash flow matching is the most restrictive form of immunization. Usually requires buying low yielding safer assets which increases initial investment.

89
Q

receiver swaption effect on duration and convexity?

A

receive fixed rate. Increase duration. Increase convexity

90
Q

Rising short and long term rates relative to mid term rates?

Therefore long position in 2yr and 30 yr suggests

A

Positive butterfly view and fall in butterfly spread. Long bullet. Short barbell.

This positions suggests a negative butterfly view and fall in butterfly spread.

91
Q

Effective duration

A

Effective duration is used to measure interest rate risk for when future cash flows are uncertain because they are contingent on future interest rates. Hence it is used for bonds with embedded options.

92
Q

forward rate bias

A

Forward rate bias occurs when high interest rate currencies do not actually depreciate as much as interest parity theory suggests (i.e., uncovered interest rate parity does not hold). That implies that the managers would earn a better exchange rate if they left foreign currency unhedged and remained exposed to changes in spot rates, rather than hedging and locking in the forward discounts. Divergence from interest rate parity where investors seek to benefit by borrowing in low yield currency and investing in high yield currency.

93
Q

Illusion of control shown by what, mitigated by what?

Illusion of control shown by what, mitigated by what?

A

Illusion of control is show by frequent changes to TAA. Remedy by beginning with CAPM

Illusion of control also shown by frequent changes to the TAA. Mitigated by starting with goals based investing.

94
Q

Foundations or Endowments need to pass on all donations in year they are received?

A

Foundations must spend all donations in the year the donation was received known as flow through.

95
Q

RBSA Vs HBSA which is susceptible to window dressing.

A

HBSA is susceptible to window dressing. NOT useful for high portfolio turnover due using a point in time value.

RBSA most useful for liquid markets with regular pricing. Lack of pricing may understate risk exposure.

96
Q

Scheduled algo
Arrival price algo
Dark aggregator

A

Scheduled algo < 10% ADV POV TWAP VWAP
Arrival price algo 10% - 15% ADV (high urgency)
Dark aggregator > 15% Larger illiquid orders.

97
Q

Higher retired lives

Higher employer turnover

A

Higher retired lives = lower risk tolerance. Greater liquidity needs.
Higher employee turnover = lower probability benefits will become vested. Low PV of liabilities.

Higher expected returns will only lower the PV of the liability if it also increases the discount rate applied to the liability.

98
Q

Economic recovery

A

HY spread expectef to fall relative to IG.
Sell protection on HY, Buy protection on IG.

HY credit curve steepens.
SELL short term HY, BUY long dated HY.

CDS SELL SHORT RECOVERY

CFA Level 3 (12 decks)

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