Lecture 4

Question 1

IPS Investment Objectives

Answer 1

Information needed in order to:

• Determine the clients goals and set objectives (typically risk adjusted returns)
• Determine risk tolerance (qualitative and quantitative approach). Changes over time. Questionnaires, interviews, review of past decisions
• Determine constraints: liquidity needs, clients legal and tax position, and any unique circumstances

Question 2

Developing, implementing, reviewing client objectives

Answer 2

1. Client info gathering to understand clients needs & market intelligence used as input to develop solutions
2. Development and/or revision of IPS
3. Portfolio construction and management-decisions on security selection and timing
4. Portfolio monitoring and review
5. Portfolio evaluation and measurement

Question 3

IPS should contain information on

Answer 3

• Investment objectives
• Reporting requirements
• Portfolio revision guidelines
• Manager fees
• Investment strategy
• The preferred investment style of the investment manager
• Details of benchmark selected for performance measurement and attribution

IPS designed to inform the client and guide the wealth manager

Question 4

Investment objectives

Answer 4

= clients desired outcomes expressed in terms of risk and return
- stability of principle (most conservative and risk averse)
- income
- growth of income
- capital appreciation

May be accompanied by less important secondary objectives (relating to tax free opportunities, liquidity requirements as well as other constraints )

Question 5

Risk

Answer 5

Risk tolerance: ability and willingness to take risk

Risk apetite
- Ability (determined by financial circumstances, lifestyle, financial goals)
- Willingness ( assessed via responses to different investment outcomes)

Increasing regulatory requirements in terms of documenting clients risk appetite and advising on suitable investments

Risk profiling: questionnaire. Responses converted into a numerical scale, evaluated and used to assign a risk aversion coefficient to the individual

Risk aversion = 1 / Risk Tolerance
Could be also measured in terms of
- standard deviation of returns
- tracking error = relative risk vs benchmark (extent to which portfolio return drifts from benchmark)
- VAR which assess the likelihood of loss beyond a specified threshold level over time

Question 6

Clients circumstances includes

Answer 6

Financial Understanding
- positive relationship between sophistication and risk tolerance

Socio economic characteristics
- women more risk averse & save more
- marital status, couples & families to save more
- life cycle stage: older ppl tend to be more risk averse
- income, occupation- greater risk preference amongst managerial and professional occupations

Human Capital

Question 7

Life cycle stages

Answer 7

Foundation
Longest time horizons, start to build wealth

Accumulation
Earnings accelerate, investable assets accumulate

Maintenance
Focus shifts to maintaining desired lifestyle and financial security

Distribution
Wealth now considered for distribution

Question 8

Measuring risk

Answer 8

Market or systemetic risk
Liquidity risk
Credit risk
Inflation risk
Interest rate risk
Exchange rate risk
Default risk

Systematic risk -non diversifiable

Non systematic risk - diversifiable

Question 9

Methods of quantifying risk

Answer 9

Forward looking forecasts and probabilities: Assess the likelihood of each possible state of the world occurring and estimate the returns and values arising given that particular outcome

Backward looking analyses - study historically observed returns and associated frequencies on the assumption that this past data will he representative of the future