Private Wealth Management SS 4

Question 1

what is situational profiling and the various approaches to situational profiling? pg. 156

Answer 1

situational profiling is the categorization of investors into groups to better understand their basic philosophy and preferences. the three approaches to situational profiling are based on:

1) source of wealth
> active
> passive

2) measure of wealth
> subjective assessment of financial well-being based on perceived wealth
> perception of wealth
> clients who perceive their wealth as small are less willing to take risk

3) stage of life
> foundattion phase
> accumulation phase
> maintenance phase
> distribution phase

Question 2

what is psychological profiling? pg. 159

Answer 2

psychological profiling, sometimes referred to as personality typing, bridges the differences between “traditional finance” (economic analysis of objective financial circumstances) and what has come to be defined as “behavioral finance.”

traditional finance:
> exhibit risk aversion
> hold rational expectations
> practice asset integration

behavioral finance:
> exhibit loss aversion
> hold biased expectations
> practice asset segregation

Question 3

define the two major components within the IPS? pg. 165

Answer 3

objectives and constraints.
objectives include:
1) return
2) risk

constraints include:

1) liquidity
2) time horizon
3) taxes
4) legal and regulatory environment
5) unique circumstances

Question 4

based on investors responses to a questionnaire, individual investors may be classified into what descriptive personality traits (also called the 4-way model)? pg. 164

Answer 4

1) cautious (primarly on feeling, more risk averse)
> higher risk aversion/low risk tolerance
> reluctant to make decision or to consult others
> portfolios tend to have low turnover
2) methodical (primarily on thinking, more risk averse)
> relies on thinking and hard facts
> continually seek new information, database
> unemotional and rarely get attached to their investments
> generally cautious
3) spontaneous (primarily on feeling, less risk averse)
> continually adjust the portfolio based on feels about the market
> fear falling behind or missing trends
> admit they are not experts but dount others’ ability
> portfolios are ofther over-managed with high turnover
4) individualist (primarily on thinking, less risk averse)
independent thinkers and may do their own research
> confident in their ideas
> confident in their ability to achieve their long-term investment objectives

this is based on the Bailard, Biehl, and Kaiser model (without the straight arrow)

Question 5

what are the four steps to asset allocation? pg. 187

Answer 5

step 1) return requirement
step 2) risk tolerance
step 3) constraints
step 4) risk-adjusted performance and diversification evaluation

Question 6

what are the three major sources of government tax revenue? pg. 218

Answer 6

1) taxes on income: salaries, interest, dividents, realized capital gains, unrealized capital gains.
2) wealth-based taxes: property (real estate), transfer of wealth.
3) taxes on consumption: sales tax and value-added taxes.

Question 7

what are the seven classifications of income tax regimes? pg. 222

Answer 7

1) common progressive
2) heavy dividend tax
3) heavy capital gain tax
4) heavy interest tax
5) light capital gain tax
6) flat and light
7) flat and heavy

Question 8

define tax drag? pg. 224

Answer 8

tax drag refers to the negative efffect on taxes on after-tax returns and increases with an increase in horizon and rate of return.

tax drag $= before tax gain - after tax gain

tax drag %= tax drag $ / before tax gain

Question 9

what is the equation to determine the future value of an investment that is tax deferred? pg. 226

Answer 9

FVIFcg=PV [(1+r)^n * (1-tcg) + tcg]
or
FVIFcg=PV + pretax gain*(1-tcg)

Question 10

what is the equation to determine the future value of an investment that is tax deferred and has a cost basis value as a percentage of the current value? pg. 228

Answer 10

FVIFcgb=(1+r)^n * (1-tcg) + tcg*B

Question 11

what is the wealth-based tax equation for which full capital base plus appreciation is taxed on an annual base? pg. 229

Answer 11

FVIFw=[(1+r)(1-tw)]^n

because wealth taxes apply to the capital base, the absolute magnitude of the liability they generate is less sensitive to investment return than taxes based on ruturns. consequently, the proportion of investment growth that it consumes decreases as return increase. viewed differently , a wealth tax consumes a greater proportion of investment growth when returns are low.

Question 12

what is the equation for blended tax return? pg. 231

Answer 12

pi=interest income / total return
pd=dividend return / total return
pcg=capital gain / total return

r=r(1-piti-pdtd-pcg*tcg)

Question 13

what is the equation to determine the effective capital gains tax rate? pg. 232

Answer 13

T=[tcg(1-pi-pd-pcg)]/(1-piti-pdtd-pcg*tcg)

Question 14

what is equation to calculate the future after-tax accumulation for each unit of currency in a taxable portfolio? pg. 233

Answer 14

FVIFtaxable=PV[(1+r)(1-T)+T-(1-B)*tcg]

if cost basis is equal to the market value, theb B=1.

Question 15

what is the equation to determine the accrual equivalent return and accrual equivalent tax rate? pg. 235

Answer 15

PV*(1+Rae)^n = FV

solve for Rae.

r*(1-Tae)=Rae

solve for Tae. the accrual equivalent tax rate can be used to measure the tax efficiency of different asset classes or portfolio management styles.

Question 16

describe the three types of investment accounts? pg. 237

Answer 16

1) taxable account
2) tax-deferred account (IRA)
3) tax-exempt account (Roth)

Question 17

regarding the objectives and constraints, elaborate on the objectives? pg. 166

Answer 17

objectives include:

1) return
> required (focus on exam) vs desired
> quantify investable asset base
> pay close attention to directions
> regarding pre- or after-tax and real or nominal (in which case, must include inflation)
> inflation rate should be adjusted upward by portfolio’s averate tax rate
> could be a TVM or IRR calculation (pg. 166)
2) risk
> ability and willingness
> conclusion is generally the more conservative of the two

Question 18

regarding the objectives and constraints, elaborate on the constraints? pg. 166

Answer 18

constraints include:

1) liquidity
> difference between portfolio cash inflow and outflow
> one-time positive or negative liquidity events
> ease of selling illiquid assets
> ongoing expenses
> emergency reserve
2) time horizon
> single-stage and multi-stage
> as a general rule, more then 15 years is long term, less then 3 years is short term
> shorter time hoizons reduce abilit to bear risk
3) taxes
4) legal and regulatory environment
> generally, few for individuals
> the code and standards apply
> in trust situation, the manager generally takes on fiduciary duty
> in complex situations, state the need to seek qualified advise
5) unique circumstances
> socially responsible investing
> charitable gifts
> concentrated holding of company stock

Question 19

compare and contract monte carlo vs deterministic approaches? pg. 190

Answer 19

deterministic approaches:
> allows for the calculation for mean variance optimization

monte carlo approach:
> probabilistic approach
> provides a better indication or the risk/return tradeoff
> shows the trade-off between short-term and long-term goals
> incorporates the impact of taxes
> can model path dependency and multiplicative effects over time periods

Question 20

a settlor that transfers gifts during his lifetime to an irrovacable trust is known as? pg. 263

Answer 20

inter vivos gift.

Question 21

a decedent without a valid will or with a will that does not dispose of their property is condered to have died as what? pg. 2643

Answer 21

intestate.

Question 22

is the legal concept of a trust unique to the common law? pg. 264

Answer 22

yes.

Question 23

when childred have the right to a fixed share of a parent’s estate whether or not the child is estranged or conceived outside a marriage is know as what? pg. 264

Answer 23

forced heirship rules. wealthy individual may attempt to move assets into an offshore trust governed by a different domicile to circumvent forced heirship rules, however, “clawback” provision bring such lifetime gifts back into the estate to calculate the child’s share.

Question 24

what is the capital required to fund spending of an investor to maintain a given lifestyle, their goals, and provide adequate reserves to unxpected commitment? pg. 268

Answer 24

core capital?

Question 25

define excess capital? pg. 268

Answer 25

an investor with more assets than liabilities on the life balance sheet and has more capital than is necessary to fund their lifestyle and reserves.

Question 26

what is the equation to calculate the survival probability? pg. 269

Answer 26

p(survival)=p(husband survives)+p(wife survives) - p(husband survives) x p(wife survives)

Question 27

what is the equation to calculate the present value of spending needs for a couple? pg. 270

Answer 27

pv(spending need | core capital) = {summation} [ (p(survival) x spending)/(1+r)^j]

Question 28

what is the difference between a fixed trust and discretionary trust? pg. 288

Answer 28

a fixed trust indicates the amount of distribution which the trustee must follow. a discretionary trust, the grantor can make his wishes know to the trustee through language in the trust document and through a non-binding letter of wishes, hence, the distributions are discretionary.

Question 29

what are the two types of tax jurisdictions, explain each one? pg. 293

Answer 29

source jursidiction, a country that taxes income as a source within its borders.

residence jurisdiction, a country that imposes taxes based on residency, whereby all income (domestic or foreign sourced) is subject to taxation.

Question 30

explain the three forms of double taxation conflicts? pg. 294

Answer 30

residence-residence conflict: two countires may claim residence of the same individual.

source-source conflict: two countries my claim source jurisdiction of the same asset. this conflict can arise on income from a company situationin country A but managed from country B.

residence-source conflict: most common form of a conflict.

Question 31

what are the three forms of foreign tax credit provisions? pg. 295

Answer 31

credit method: T=Max[Tresidence, Tsource]

exemption method: T=Tsource

deduction method: T=Tresidence+Tsource(1-Tresidence)

Question 32

list the three stages of life? pg. 324

Answer 32

1) education stage
2) working stage
3) retirement stage

Question 33

state the two terms the desribe the risk of dying too early and living too long? pg. 325

Answer 33

1) mortality risk: premature death

2) longevity risk: living too long

Question 34

describe the three risk factors associated with human capital that investors need to manage? pg. 328

Answer 34

1) wage earnings risk
a) volatility
b) correlation with other assets

2) mortality risk

3) longevity risk
a) financial market risk: market drops early in retirement
b) risk of outliving portfolio

Question 35

describe human capital and identify a financial asset with behaviors that mimic it? pg. 333

Answer 35

human capital is treated like any other asset class; it has its own risk and turn properties and its own correlations with other financial asset classes. human capital is similar to an inflation-adjusted, real-return bond.

Question 36

what are the four key theoretical asset allocation implications when considering both human capital and financial capital? pg. 334

Answer 36

1) youger investors invest more in stocks than older investors
2) investors with safe labor income (thus safe human capital) invest more of their financial portfolio in stocks
3) investors with labor income that is highly correlated with the stock markets invest their financial assets in less risky assets
4) the ability to adjust labor supply increases an investor’s allocation to stock

Question 37

what is the equation to calculate the PV of human capital? pg. 336

Answer 37

HC(x) = sum [E(ht)] / [1+r+v]^(t-x)

E(ht) is expected earnings in year t
r is inflation-adjusted risk-free rate
v is the discount rate (which should be adjusted to the risk level of the person’s labor income)

Question 38

true of false: the optimal insurance demand increases with risk aversion? pg. 351

Answer 38

true, conservative investors should invest more in risk-free assets and buy more life insurance than aggressive investors should.

Question 39

true or falst: the optimal insurance demand decreases as teh correlation between human capital and financial capital increases? pg. 353

Answer 39

true, life insurance is purchased to protect human capital from the family and loved ones. as the correlation between the risky asset and the income flow increases, the ex ante value of human capital to surviving family decreases. this lower valuation on human capital induces a lower demand for insurance. also, less money spent on life insurance indirectly increases the amount of financial wealth the investor can invest, so the invest can invest more in risk-free assets to reduce the risk associated with her total wealth.

Question 40

what are the three risk individuals face during retirement? pg. 354

Answer 40

1) financial market risk: if the market drops or corrections occur early during retirement, the individual’s portfolio may not be able to weather the stress of subsequent systematic withdrawls. financial risk can be mitigated by using modern portfolio theory.
2) longevity risk: can be hedged away with insurnace products (annuities)
3) risk of spending uncertainty: this is primarily a behavioral issue.

Question 41

describe the main difference between a fixed-payout annuity and a variable-payout annuity? pg. 360

Answer 41

a fixed annuity pays out a fixed amount in regular intervals whereas a variable annuity pays out a fixed number of fund units.

Question 42

an individual is worth $800K in a community property regime which includes $200K retained as seperate property. he is married with 2 children. he wishes to bequeath $300K to his surviving mother before passing away. how much is his wife, children, and mother entitled to recieve? pg. 265

Answer 42

1) his wife is entitled to the greater of her share under community property or forced heirship rules. under community property, she is entitiled to receive one-half of the community property, or 0.5($800K-$200K)=$300K. under forced heirship rules, she is entitled to one-third of the total estate, 1/3*$800K=$266,667.
2) the children are collectively entitled to receive one-thrid of the total estate equal to $266,667.
3) his is able to freely dispose of the remainder to his mother, $800K-$300K-$266.667=$233.33K

Question 43

what is the equation to determine 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? pg. 278

Answer 43

RV=FVgift/FVbequest

RV=[1+rg(1-tig))]^n / [[1+re(1-tie)]^n * (1-Te)]

Question 44

what is the equation to determine the relative value of a taxable gift made during one’s lifetime compared to a bequest that is transferred as part of a taxable estate? pg. 279

Answer 44

RV=FVgift/FVbequest

RV=[[1+rg(1-tig))]^n * (1-Tg)] / [[1+re(1-tie)]^n * (1-Te)]

Question 45

what is the equation to determine the relative after-tax value of a gift when the donor pays the gift tax and when the recipient’s estate will not be taxable? pg. 282

Answer 45

RV=FVgift/FVbequest

RV=[[1+rg(1-tig))]^n * (1-Tg+TgTe)] / [[1+re(1-tie)]^n * (1-Te)]

Question 46

what is the relative after-tax future value over n years of a charitable gift compared to a taxable bequest? pg. 286

Answer 46

RV=FVgift/FVbequest

RV=[(1+rg)^n+Toi[1+re(1-tie)]^n(1-Te)] / [[1+re(1-tie)]^n(1-Te)]

Question 47

low-basis holdings in individual portfolios arise through a number of circumstances, but the three principal events typically lead to the situation are? pg. 308

Answer 47

1) entreprenuerial success
2) executive success
3) investment success

Question 48

what are the 3 (4) type of risks associated with concentrated positions and methods to diversify? pg. 309

Answer 48

1) market risk
2) specific risk
3) residual risk
a) counterpary risk
b) regulatory risk

Question 49

what are the four different methods (not including the charitable strategy) for diversifying concentrated positions? pg. 313

Answer 49

1) outright sale

2) exchange funds
a) public exchange funds
b) private exchange funds

3) completion portfolios
a) single-asset class completion portfolio
b) multi-asset class completion portfolio

4) hedging strategies
a) equity collars
b) monetization of the position
c) variable pre-paid forwards
d) relative attractiveness of hedging transactions