Qual Info

Question 1

Cognitive Errors

Answer 1

-Related to the way the brain functions, processes, and files info, forms memories or makes judgements, and the difficulty of complete mathematical understanding
-9 Types categorized into Belief Perserverance Biases (5) and Info Processing errors (4)

Question 2

Emotional Biases

Answer 2

Related to emotional, motivational, and social influences, or to human needs

Question 3

Belief Perserverance Biases

Answer 3

-A cognitive error category
-Holding on to previous irrational and illogical beliefs
1) Conservatism
2) Confirmation
3) Representativeness
4) Illuision of control
5) Hindsight

Question 4

Information Processing Errors

Answer 4

-A cognitive error category
-Misusing and the irrational/wrongful processing of info in financial decisions
1) Anchoring and adjustment
2) Mental Accounting
3) Framing
4) Availability

Question 5

Cognitive Dissonance

Answer 5

-Closely related to various aspects of Belief Perserverance Bias
-A type of mental discomfort which occurs when new info conflicts with previously held beliefs or information

Question 6

Conservatism Bias

Answer 6

-Belief Perserverance Bias
-Occurs when individuals fail to update perceptions to reflect new info. People assign more weight to previous beliefs and smaller weight to new info

Question 7

Confirmation Bias

Answer 7

-Belief Perserverance Bias
-People notice what confirms their beliefs and ignore (or discount) info that contradicts/could change their beliefs

Question 8

Representative Bias

Answer 8

-Belief Perserverance Bias
-Occurs when people classify new info based on previous experiences
-Ppl attempt a best fir into a existing classification

Question 9

Base-Rate Neglect

Answer 9

-Part of representative bias, which is a belief perseverance bias
-Investors overreact to new info on a company without considering the underlying base probability of an event
-e.g. investors discover info leading them to believe comp is in growth phase when other evidence suggests a low prob of any comp being a growth comp

Question 10

Sample-Size Neglect

Answer 10

-Part of representative bias, which is a belief perseverance bias
-Investors draw a conclusion that the entire population is similar to a very small sample

Question 11

Illusion of Control Bias

Answer 11

-Belief Perserverance Bias
-Occurs when FMPs believe they have more control over a situation than they actually have

Question 12

Anchoring and Adjustment Bias

Answer 12

-Info Processing Error
-Describes how people base their initial forecast on some past experience (anchor) and adjust that estiamte as new info presents itself, but initial anchor dominates the final prediction

Question 13

Mental Accounting Bias

Answer 13

-Info Processing Error
-When investors assign different levels of importance to different “pots” of money

Question 14

Framing Bias

Answer 14

-Info Processing Error
-Exhibit this when they answer the same question differently depending on how it is asked

Question 15

Availability Bias

Answer 15

-Info Processing Error
-Occurs when people overestimate the probability of event occuring based on “availability” of their memory of the event (i.e. how easily the event comes to mind)

Question 16

Emotional Biases

Answer 16

-May be harder to control bc they originate from unconscious influences rather than conscious calculation (as in cognitive errors)
1) Loss Aversion Bias
2) Overconfidence Bias
3) Self-control bias
4)status quo bias
5) Endowment bias
6) Regret-aversion bias

Question 17

Loss Aversion Bias

Answer 17

-Emotional Bias
-Occurs when investors make decisions designed to avoid losses rather than to seek gains

Question 18

Overconfidence Bias

Answer 18

-Emotional Bias
-Occurs when people overestimate their knowledge, abilities, or access to info and consequently have too much faith in their intuition, reasoning, or judgement

Question 19

Self-Control Bias

Answer 19

-Emotional Bias
-Occurs when FMPs fail to support their long-term goals with short-term behavior

Question 20

Status Quo Bias

Answer 20

-Emotional Bias
-Results primarily from inertia rather than conscious choice. Change is often uncomfortable for people and if no problem is apparent they will prefer not to make changes

Question 21

Endowment Bias

Answer 21

-Emotional Bias
-People attach more value to the assets they own/inherit than assets they dont own

Question 22

Regret Aversion Bias

Answer 22

-Emotional Bias
-Investors resist situations that require a decision for fear of a negative outcome

Question 23

5-Way Model (BB&K)

Answer 23

-Classifies indvs based on level of confidence (y-axis) and method of action (x-axis)

Question 24

Adventurer

Answer 24

-5 Way BBK Model (Confident, impetuous)
-Confident in decisions and willing to take changes, makes him reluctant to accept advice

Question 25

Celebrity

Answer 25

-5 Way BBK Model (anxious, impetuous)
-Center of attention who holds some opinions but also knows his limitations

Question 26

Individualist

Answer 26

-5 way BBK model (confident, careful)
-independent and confident by nature

Question 27

Guardian

Answer 27

-5 Way BBK Model (anxious, careful)
-Cautious and concerned about future, meaning other types may become more guardian like as they age

Question 28

Straight Arrow

Answer 28

-5 Way BBK Model (center)
-sensible and secure, willing to accept risk commensurate with a normal return

Question 29

Passive Preservers

Answer 29

-BIT (Conservative style, passive)
-Not sophisticated investors with focus on financial security and wealth preservation
-Primarily emotional biases

Question 30

Friendly Followers

Answer 30

-BIT (Moderate style, Passive)
-May be difficult to advise bc their cognitive biases give them confidence that encourages them to accept greater risk than their regret aversion will actually allow

Question 31

Independent Individualists

Answer 31

-BIT (Growth style, Active)
-Most likely to be contrarian, resist following a financial plan, and are comfortable investing and taking risks
-Primarily cognitive biases

Question 32

Active Accumulators

Answer 32

-BIT (Aggressive style, Active)
-Likely to have concentrated positions and high port turnover rates
-Primarily emotional biases

Question 33

Bayes Formula

Answer 33

P(A|B) = [P(B|A) * P(A)]/[P(B)

Question 34

Financial Crises Types

Answer 34

-Type 1 - A permanent, one-time decline with resumption of the trend rate after initial shock
-Type 2 - No persistent one-time decline but continuing a lower trend rate
-Type 3 - Both a permanent, one-time decline and continuation at a lower trend rate after initial shock

Question 35

Value of Stock Market, GDP

Answer 35

Ve = GDP * (E/GDP) * (P/E) + Div Yield (for total return of stock market)
-Key insight is that corp earnings as a % of GDP and PE multiple cannot continually rise over the long-term
-Only way value of stock mrkt can increase over the long term is through long term GDP growth

Question 36

Real Long Term Trend GDP Growth

Answer 36

=Labor input growth + Labor productivity growth

Question 37

Business Cycles

Answer 37

-Result from short to medium term cycles that cause oscillations around longer term trend growth rate of economy
-Initial recovery -> Early Expansion -> Late Expansion -> Slowdown -> Contraction -> repeat

Question 38

Initial Recovery

Answer 38

-After contraction, before early expansion (a few months)
-Economic features: After low point, output gap is large, inflation is decelerating, stimulative policies remain in place, economy starts to grow
-Captial Market Features: ST and LT govt bond yields likely to be bottoming but may still decrease, stock mrkt may begin to rise quickly as recession fears subside, riskier small cap stocks, HY bonds, and EM secs will do well

Question 39

Early Expansion

Answer 39

-After initial recovery, before late expansion
-Economic Features
–output gap remains negative, but unemployment starts to fall
–consumers start to borrow to spend (housing and consumer durable demand increases)
–businesses step up production (profits begin to expand rapidly)
–central banks remove stimulus
-Capital Market features
–short rate begin to increase (long rates remain stable/increase slightly)
–Flattening yield curve
–stock price trend upwards

Question 40

Late Expansion

Answer 40

-After early expansion, before slowdown
-Economic Features
–Positive output gap and danger of inflation (capacity pressures boost investment spending)
–low unemployment, strong profits, rising wages and prices (inflation)
–debt coverage ratios may deteriorate as business borrows to fund growth
–Monetary policy becomes more restrictive
-Capital Market Features
–private sector borrowing causes rates to rise
–yield curve continues to flatten as short rates rise faster than long rates
–stocks are volatile as investors watch for deceleration
–inflation hedges (e.g. commodities) may begin to OP cyclical assets

Question 41

Slowdown

Answer 41

-After late expansion, before contraction
-Economic Features
–Fewer viable investment projects and overleveraging cause slowing growth (business confidence wavers)
–inflation continues to rise as business pricing attempt to outpace rising input costs
–Economy is vulnerable to shocks
-Capital market features:
–LT bonds may top but ST rates continue to rise/may peak (yield curve may invert)
–credit spread widens, depressing bond prices for lower credit issues
–stocks may fall (utilities and quality stocks likely to OP)

Question 42

Contraction

Answer 42

–After slowdown, before initial recovery
-Economic Features
–Firms cut investment spending, then decrease production (unemployment can rise quickly)
–Profits drop sharply with credit mrkts tightening, accounting transgressions discovered, and bankruptcies
-Capital Market features
–ST and LT rates begin to fall (yield curve steepens)
–credit spreads widen, remains wide until trough
–early phase stock mrkt declining while late phase stock mrkt begins to rise

Question 43

Taylor Rule

Answer 43

i* = r,neutral + pi,e + 0.5(y^,e - y^, trend) + 0.5(pi,e - pi,target)
i: target Policy nominal rate, r,neutral: real policy rate targeted with trend growth and target inflation, (y^,e - y^, trend): expected and trend real GDP growth rates
-When the interest rate given is nominal, do not need to add expected inflation:
i = r,neutral + 0.5(y^,e - y^, trend) + 0.5(pi,e - pi,target)

-if the target rate calculated is greater than the current target rate, econ could grow too fast which would cause tightening of output gap. This is unsustainable and would lead to higher inflation and weaker growth

Question 44

General Business Cycle Effect on Yield Curve

Answer 44

-Yield curve steepens as business cycle bottoms
-Flattens during expansions
-Becomes flat to inverted toward the peak as rates rise
-Re-steepens during contraction

Question 45

Current Account

Answer 45

Reflects exports and imports of goods and services, investment income flows, and unliteral transfers
-Because financial market reacts more quickly to changes than real markets, changes to current account are reflected quickly in the capital account vis ST rates, exchange rates, and financial asset prices
-ST changes in current account are less likely to result in exchange rate changes
-Larger, persistent imbalances must be financed by adjustments to private or public savings

Question 46

Capital Account

Answer 46

Reflects foreign direct investment (FDI), involving productive asset purchases and sales, and portfolio investments (PI), involving financial asset transactions

Question 47

Balance of Payments Equation and Takeaways

Answer 47

(X - M) = (S - I) + (T - G)
-(X-M) = net exports, representing the current account
-(S - I) = Domestic savings - Domestic investment
-(T - G) = Taxes - govt spending
-for a floating rate exchange regime to be in EQ (every buyer has a corresponding seller), current account surplus (positive X-M term), where there are net buyers of a currency. This must be offset by a deficit of the capital account (i.e. investment overseas), where there are net sellers of the currency. This capital required to invest oversees comes from domestic savings (S) in excess of domestic investment (I) or a govt budget surplus where taxes raised (T) are higher than govt spending (G)

Question 48

Conditions of YTM Being Earned

Answer 48

1) Cash flow of bond are received in full and on time
2) Bond is held to maturity
3) Cash flows are reinvested at YTM
-Generally effects of conditions 2 and 3 offset eachother. If horizon is less than port duration , condition 2 will dominate and investor underperforms YTM when rates rise. If horizon is more than port duration, 3 will dominate and investor underperforms YTM when rates fall

Question 49

Building Block Approach

Answer 49

-Breaks the expected return for fixed income security into 4 components:
1) ST nominal default risk free rate
2) Term premium
3) Credit premium
4) Liquidity premium

Question 50

Grinold Kroner Model

Answer 50

-Extends gordon growth model to consider effects of share repos and changes in valuation levels through forecast horizon
-E(R,e) = (D/P) + (%Delta(E) - %Delta(S)) + %Delta(P/E) + Expected Inflation
-D/P = Div yield, %Delta(E) = Nominal earnings growth rate, %Delta(S) = Expected change in shares outstanding

Question 51

Components of Grinold Kroner Model

Answer 51

Model: E(R,e) = (D/P) + (%Delta(E) - %Delta(S)) + %Delta(P/E) + Inflation Expectation
-%Delta(P/E) = growth rate of PE ratio, the “repricing return”
-Income Component of Expected Return = D/P - %Delta(S)
-Expected Capital Gains = %Delta(E) + %Delta(P/E)
-Est. Rate of change in EPS= %Delta(E) - %Delta(S)

Question 52

Singer-Terhaar Method

Answer 52

-EQ Approach
RP,i,sig = P,i,GM * Sig,i * (RP,GM / Sig,GM)
RP,i,Sig = Risk premium of mrkt “i” assuming 100% integration with global mrkts
-P,i,GM = Correl coefficient between i and global mrkt
-(RP,GM / Sig,GM) = Sharpe ratio of global mrkt port

Question 53

Singer-Terhaar Method, Risk Premium in Perfectly Segmented Markets

Answer 53

RP,i,s = Sig,i * Sharpe Ratio,i

Question 54

Singer-Terhaar Method, Risk Premium when Degree of Intergration (row) is A value between 0 and 100%

Answer 54

RP,i = (row)RP,i,G + (1-row)(RP,i,s)

Question 55

Expected Real Estate Return, Cap Rate

Answer 55

E(R,RE) = Cap Rate + g,NOI - %Change(Cap Rate)
Cap rate = NOI / Prop Value

Question 56

Dornbusch Overshooting Mechanism

Answer 56

-Assuming perfect cap mobility, assumes that cap flowing into a higher returning domestic economy will instantly strengthen the currency up to the point where, looking forward, currency is expected to weaken by the return advantage of domestic economy
E(%Delta(S,d/f)) = (r,d - r,f) + (Term,d - Term,f) + (Credit,d - Credit,f) + (ERP,d - ERP,f) + (LIQ,d - LIQ,f)

Question 57

Unsmoothing Appraisal-Based Returns

Answer 57

R,t = (1 - lambda)r,t + (lambda)R,t-1
Lamda = parameter of model taking value between 0 (unsmoothed original data) and 1 (smoothed original data)
-R,t = current observed (smoothed) return
r,t = unobservable true return

Question 58

Estimated Variance of True Return Series, Unsmoothing Appraisal-Based Returns

Answer 58

var(r) = [(1 + lamda) / (1 - lamda)]* var(R)
Lamda = parameter of model taking value between 0 (unsmoothed original data) and 1 (smoothed original data)
var(r) = est. variance of true return series
var(R) = observed variance of smoothed returns
-since lambda is b/t 0 and 1, true variance is always higher than reported smoothed variance

Question 59

Marginal Contribution to Total Risk (MCTR)

Answer 59

=Asset Beta * Port. Std. Dev.

Question 60

Absolute Contribution to total Risk (ACTR)

Answer 60

=Asset weight * MCTR

Question 61

Ratio of Excess return to MCTR

Answer 61

=(Expected return - risk free rate) / MCTR
-Asset allocation optimal when this ratio is the same for all assets

Question 62

Liability-Relative Asset Allocation

Answer 62

-An asset allocation process with the presence of a clients liabilities within the investment horizon. includes Surplus optimization approach, 2-portfolio Approach, and Integrated Asset-Liability Approach

Question 63

Surplus Optimization Approach

Answer 63

-Liability-Relative Asset Allocation approach
-Uses the traditional MVO approach based on the volatility of the surplus volatility as the measure of risk, Characteristics: Simple, linear correlation, all levels of risk, any funding ratio, single period

Question 64

2-Portfolio Approach (Hedging/Return-Seeking Portfolio Approach)

Answer 64

-Liability-Relative Asset Allocation approach
-Partitions assets into 2 groups: A hedging port managed so that its assets are expected to produce a good hedge to cover req CFs from liabilities, and a return-seeking port that can be treated as an asset only port
-Characteristics: Simple, linear/nonlinear correlation, conservative levels of risk, positive funding ratio for basic approach, single period (S-LN-CPS)

Question 65

Integrated Asset0Liablity Approach

Answer 65

-Liability-Relative Asset Allocation approach
-The most comprehensive of the 3 Liability-Relative Asset Allocation approaches, where decisions regarding the composition of liabilities are made in conjunction with their asset allocation
-Characteristics: complex, linear/nonlinear correlation, all levels of risk, any funding ratio, multiple periods

Question 66

Portfolio Returns and Taxes

Answer 66

r,at = p,d(r,pt)(1-t,d) + p,cg(r,pt)(1-t,cg)
r,at: expected after-tax return, r,pt: expected pre-tax return, p,d: proportion of r,pt attributed to dividend income, p,cg: proportion of r,pt attributed to capital gains

stdDev,at = stdDev,pt(1-t)
–> means expected after tax return std dev is smaller than pre-tax return std dev

Question 67

Put-Call Parity

Answer 67

S,0 + p,0 = c,0 + [X / {(1+r)^T}]
S,0: price of underlying security; p,0 and c,0 are prices of put and call options, both with strike price ‘X’ and expiration ‘T’; [X / {(1+r)^T}]: the PV of a risk free 0 coup bond paying X at option expiration

Question 68

Put-Call Forward Parity

Answer 68

Question 69

Basic Long Option Payoffs

Answer 69

Call Option: MAX[S,T - X, 0] - c,0
Put Option: MAX[X - S,T, 0] - p,0

Question 70

Covered Call Factoids

Answer 70

-A combo of long underlying security position and a short call position
-Investment objectives: Yield enhancement (writting slightly OTM calls in a static mrkt), Reducing overweight position (selling ITM call in static mrkt increases effective sale price), or target price realization

Question 71

Covered Call Equations

Answer 71

-Value of Covered Calls @ Expiration: S,T - MAX[S,T - X, 0]
-P&L: S,T - MAX[S,T - X, 0] + c,0 - S,0
-Max Profit: X - S,0 + c,0
-Max Loss: S,0 - C,0
Breakeven: S,0 - c,0

Question 72

Covered Call Payoff Graph

Answer 72

-Max gain occurs when stock price appreciates to the strike price
-Max loss occurs when stock price falls to 0

Question 73

Protective Put Factoids

Answer 73

-A combo of a long underlying security position and a long put position
-Basically a form of insurance with objective of protective against investment loss. Can think of put premium as cost of insurance
-Major risk is they have a finite term and have to be rolled over periodically (expensive)

Question 74

Protective Put Equations

Answer 74

-Value of Protective Puts @ Expiration: S,T + MAX[X - S,T, 0]
-P&L: S,T + MAX[X - S,T, 0] - S,0 - p,0
-Max Profit: Theoretically unlimited
-Max Loss: S,0 - X + p,0
-Breakeven: S,0 + p,0

Question 75

Protective Put Payoff Graph

Answer 75

-Max gain unlimited as gains on underlying long stock are unbound above
-Max loss occurs when stock price falls to exercise price

Question 76

Delta, Calls and Puts

Answer 76

-Delta = Change(option price)/Change (underlying)
-Long Call Delta: Always positive, between [0,1]. Long ATM call option will have delta = 0.5
-Long Put Delta: Always negative, between [-1,0]. Long ATM put option will have delta = -0.5

Question 77

Bull Spreads

Answer 77

-Objective is to benefit from rising prices with a lower cost than a simple long position or a call option
-Both call and put bull spreads you are long the lower strike option and short the higher strike option

Question 78

Call Bull (Debit) Spread Factoids

Answer 78

-Buying a lower strike price call option (X,L) and selling a higher strike price call option (X,H) with the same expiration date
-As the higher strike call (which you are short on) is less expensive than lower strike call (which you are long on), call bull spread requires a cash outflow (debit spread)
-Risk is that underlying must rise above lower strike price to offset initial costs

Question 79

Put Bull (Credit) Spread Factoids

Answer 79

-Buying a lower strike put option and selling a higher strike put option with the same expiration date
-As the higher strike price (short on) is more expensive, put bull spread generates an initial cash inflow (credit spread)
-Risk is that if stock price falls below high strike price, investor will begin losing initial cash flow

Question 80

Call Bull (Debit) Spread Equations

Answer 80

-Value @ Expiration: MAX[0, (S,T - X,L)] - MAX[0, (S,T - X,H)]
-Profit: MAX[0, (S,T - X,L)] - MAX[0, (S,T - X,H)] - (c,L - c,H)
-Max Profit: X,H - X,L - (c,L - c,H) when S,T > X,H
-Max Loss: (c,L - c,H), when S,T < X,L
-Breakeven Price: X,L + (c,L - C,H)

Question 81

Call Bull (Debit) Spread P&L Graph

Answer 81

-Max profit occurs when S,T > X,H
-Max Loss occurs when S,T < X,L

Question 82

Put Bull (Credit) Spread Equations

Answer 82

-Value @ Expiration: MAX[0, (X,L - S,T)] - MAX[0, (X,H - S,T)]
-Profit: MAX[0, (X,L - S,T)] - MAX[0, (X,H - S,T)] - (p,L - p,H)
-Max Profit: p,H - p,L, when S,T> X,H
-Max Loss: (X,H - X,L) - (p,H - p,L), when S,T < X,L
-Breakeven: X,H - (p,H - p,L)

Question 83

Put Bull (Credit) Spread P&L Graph

Answer 83

-Max profit occurs when S,T > X,H
-Max Loss occurs when S,T < X,L

Question 84

Bear Spread

Answer 84

-Objective is to benefit from falling prices at a lower cost than a simple short position/put option with same expiration date
-Both call and put spreads you are long the higher strike option and short the lower strike option

Question 85

Call Bear (Credit) Spread Factoids

Answer 85

-Investor buys a higher strike call and sells a lower strike call with same expiration date
-As the higher strike call option is less expensive than lower strike call, results in an initial cash inflow (credit spread)
-Risk is that stock price rises above the lower strike price, causing him to loose initial credit spread

Question 86

Put Bear (Debit) Spread Factoids

Answer 86

-Investor buys higher strike put option and writes lower strike put option with same expiration date
-As higher strike put option is more expensive, put bear spread generates initial cash outflow (debit spread)
-Risk is that if stock price does not fall below the high strike price, investor will lose initial cash outflow

Question 87

Call Bear (Credit) Spread Equations

Answer 87

-Value @ Expiration: MAX[0, S,T - X,H] - MAX [0, S,T - X,L]
-P&L: MAX[0, S,T - X,H] - MAX [0, S,T - X,L] - (c,H - c,L)
-Max Profit: Net premium received, c,L - c,H, when S,T < X,L
-Max Loss: (X,H - X,L) - c,L + c,H, when S,T > X,H
-Breakeven: X,L + c,L - c,H

Question 88

Call Bear (Credit) Spread P&L Graph

Answer 88

-Max Profit occurs when S,T < X,L
-Max Loss occurs when S,T > X,H

Question 89

Put Bear (Debit) Spread Equations

Answer 89

-Value @ Expiration: MAX[0, X,H - S,T] - MAX[0, X,L - S,T]
-P&L: MAX[0, X,H - S,T] - MAX[0, X,L - S,T] - (p,H - p,L)
-Max Profit: (X,H - X,L) - (p,H - p,L), when S,T < X,L
-Max Loss: (p,H - p,L)
-Breakeven: X,H - (p,H - p,L)

Question 90

Put Bear (Debit) Spread P&L Graph

Answer 90

-Max Profit occurs when S,T < X,L
-Max Loss occurs when S,T > X,H

Question 91

Straddle

Answer 91

-Objective is to profit from a directional play on volatility, either for decreasing (short straddle) or increasing (long straddle). Both involving going long/short both put/call with same expiration on same asset

Question 92

Long Straddle Factoids

Answer 92

-Profitable when volatility rises above market consensus
-Buy a put and a call with same strike prices and same expiration on same asset

Question 93

Long Straddle Equations

Answer 93

-Value @ Expiration: MAX [0, S,T - X] + MAX[0, X - S,T]
-P&L: MAX [0, S,T - X] + MAX[0, X - S,T] - c,0 - p,0
-Max Profit: X - S,T - c,0 - p,0. Unlimited if S,T > X. Limited to X - c,0 - p,0 if S,T = 0
-Max Loss: c,0 + p,0, when S,T = X
-Breakeven: Upside breakeven (when S,T > X) = X + c,0 + p,o, downside breakeven (when S,T < X) = X - c,0 - p,0

Question 94

Long Straddle P&L Graph

Answer 94

-Max Profit (Upside): Unlimited when S,T > X. Max Profit (downside) limited to X - c,0 - p,0 when S,T = 0
-Max Loss when S,T = X

Question 95

Short Straddle Factoids

Answer 95

-Profitable when volatility declines and there is minimal movement in underlying asset
-Sell a put and a call with same strike prices, same expiration and on same asset

Question 96

Short Straddle Equations

Answer 96

-Same as long straddle but with signs reversed
-Value @ Expiration: -MAX[0, S,T - X] - MAX [0, X - S,T]
-P&L: -MAX[0, S,T - X] - MAX [0, X - S,T] +c,0 + p,0
-Max Profit: c,0 + p,0 when S,T = X
-Max Loss: Unlimited when S,T > X, limited to X - c,0 - p,0 when S,T =0
-Breakeven: Upside Breakeven (when S,T > X) = X + c,0 + p,0, downside breakeven (when S,T < X = X - p,0 - c,0

Question 97

Short Straddle P&L Graph

Answer 97

-Max Profit: When S,T = X
-Max Loss (Upside): Unlimited when S,T > X. Max Loss (downside) limited to X - c,0 - p,0 when S,T = 0

Question 98

Collar Factoids

Answer 98

-Assumes investor owns underlying. Achieves downside protection by buying long put below current market price and reducing this cost of protection by writing covered call exercisable above current market price
-Risk is that it the short call limits upside participation

Question 99

Collar Equations

Answer 99

-Value @ Expiration: S,T + MAX [0, X,L - S,T] - MAX[0, S,T - X,H]
-P&L: S,T + MAX [0, X,L - S,T] - MAX[0, S,T - X,H] - S,0 - p,0 + c,0
-Max Profit: X,H - S,0 - p,0 + c,0 when S,T >/= X,H
-Minimum Profit (potentially a loss) X, L - S,0 - p,0 + c,0, when S,T </= X,L
-Breakeven Price: S,0 + p,0 - c,0 if there is a max loss (when X,L < S,0)

Question 100

Collar P&L Graph

Answer 100

Question 101

Calendar Spread

Answer 101

-Options strategy where investor sells and buys same type of option, but with different expiration dates to take advantage of time decay

Question 102

Long Calendar Spread

Answer 102

-ST option is sold and LT option is purchased
–Investor expects to profit from time passage as ST option falls in value by more than LT option
-Profitable when markets are stable in sort term and longer-term implied volatility rises

Question 103

Short Calendar Spread

Answer 103

-ST option is bought and LT option is sold
-Investor expects to profit from time passage as LT option falls in value by more than ST option
-Profitable when markets are volatile in ST with falling LT implied volatility

Question 104

Volatility Smile

Answer 104

-Occurs when OTM puts and calls exhibit greater implied volatility than ATM options
-Can become a volatility skew in times of market stress as more ppl are interested in buying port protection in the form of puts, driving up prices and implied vol

Question 105

Options Strategies Given Investment Objectives

Answer 105

Question 106

Notional Size of Swap Required to Adjust Duration of Fixed Income Portfolio

Answer 106

N,s = [(MDUR,T - MDUR,P) / MDUR,S] * MV,P
MDUR,S = MD of receive-fixed Swap

Question 107

Principal Invoice Amount, Futures

Answer 107

=(Future Settlement Price 100) x CF x Contract size

Question 108

Profit/Loss From Delivering Deliverable Bond, Futures

Answer 108

=Principal Invoice Amount - Cost of purchasing bond

Question 109

Basis Point Values (BPVs)

Answer 109

-Measures the absolute change in value of a portfolio for a 1 bp change in yields
BPV,P = MV,P x MDUR,p x 0.01%

Question 110

of Futures Required to Change Portfolio Duration, BPV

Answer 110

N,f = [(BPV,T - BPV,p) /( BPV,f / CF)

Question 111

Futures Price and CTD Bond, BPV

Answer 111

BPV,f = BPV,CTD / CF
-Fair futures prices are inversely related to the CF of the CTD bond

Question 112

of Futures Required to Adjust Beta Exposure of Equity Portfolio

Answer 112

N,F = (S/F) * [(B,T - B,S) / B,F]
=(S/F) * (-B,S / B,F)
S = mrkt value of equity portfolio
F = value per futures contract (price x multiplier)
B,S = Equity portfolio beta

-When doing a 2-piece trade (i.e. buying one future, selling another), B,s = 0 for the buy side and B,T = 0 for the sell side. S = Target allocation, or what you are working with

Question 113

VIX Term Structure

Answer 113

-Flat shape shows vol is expected to remain stable over near to LT
-Downward slope shows decreasing vol expectations over time, making prices higher for ST contracts (backwardation). If VIX is in backwardation and vol expectations are expected to remain constant, VIX prices will increase as contract approaches maturity
-Upward slope shows increasing vol expectations overtime, making prices lower for ST contracts (contango). If VIX is in contango and vol expectations are expected to remain unchanged, VIX prices will decrease overtime

Question 114

Variance Swap

Answer 114

-Allows investors to take directional bets on implied vs realized vol to speculate/hedge portfolios
-The payoff at expiration of long variance swap will be positive when realized variance is greater than strike variance
-Only exchange cash at settlement

Question 115

Notional Variance, Variance Swap

Answer 115

N,Variance = N,Vega / (2 x Strike Price)
-Ignore decimals/%’s, make all numbers whole numbers

Question 116

Settlement Amount Paid to Long Swap Position, Variance Swap

Answer 116

Settlement Amt, T = N,Vega * [ (var - X^2) / (2 * Strike Price)
=N,variance * (Var - X^2)
–Ignore decimals/%’s, make all numbers whole numbers

Question 117

Value of Variance Swap, T

Answer 117

-Ignore decimals/%’s, make all numbers whole numbers

Question 118

Forward Premium/Discount, Currenices

Answer 118

F, FC/DC - S, FC/DC = S, FC/DC * {[(i,FC - i,DC) * (Act/360)] / [1 + (i,DC * (act / 360))]}
-If forward rate is higher than spot rate, base currency (domestic currency) is said to be trading at a forward premium and is expected to appreciate in the future

Question 119

Forward Rate, Currencies

Answer 119

=S,FC/DC * {[1 + (i,FC x act/360)] / [1 + (i,DC x act/360)]}

Question 120

Return on Global Assets, Domestic Currency

Answer 120

R,DC = [w1 * (1 + R,FC1)(1 + R,FX1) + w2 * (1 + R,FC2) (1 + R,FX2)] - 1

-Make sure return terms are stated with domestic currency in numerator

Question 121

Variance of Domestic Return

Answer 121

Var(R,DC) = var(R,FC) + var(R,FX) + [2 * stdDev(R,FC) x stdDev(R,FX) x p(R,FC , R,FX)]
-make sure return terms are stated with domestic currency in numerator

Question 122

Effective Duration

Answer 122

= [(PV-) - (PV+)] / [2(Delta(curve))(PV,0)]

Question 123

Effective Convexity

Answer 123

=[(PV-) + (PV+) - 2(PV,0)] / [(Delta(curve)^2)(PV,0)]
-Bonds with greater convexity enjoy greater price increase when yields fall and smaller price decline when yields rise
-Bonds with longer maturity tend to have greater convexity than shorter maturity bonds

Question 124

Components of Fixed Income Return

Answer 124

-E(r) = Coupon income + rolldown return + E((delta(P)) due to yield change and spread) + E(currency gains/losses)
-Coupon income = Coupon income + reinvestment interest relative to bonds price (if no reinvestment income, coup inc = Bonds annual current yield)
-Roll-Down Return = (B,1 - B,0) / B,0
-Rolling Yield = yield income + roll-down return
-E((delta(P)) due to yield change and spread) = (-D * Delta(Y)) + [0.5 x CX x (delta(Y)^2)]

Question 125

Portfolio Return, Leverage

Answer 125

r,P = Leveraged return / Portfolio equity = {[r,i x (V,E + V,B)] - (r,B x V,B)} / V,E
=(return to Equity + return to borrowed) / Portfolio equity = [r,i(V,E) + V,B(r,i - r,B)] / V,E
=Return on equity capital + return on borrowed capital = r,i + (V,B / V,E)(r,i - r,B)

r,i: Asset return, V,E: Invested equity, V,B: Borrowed equity capital, r,B: Cost of borrowed capital

Question 126

Futures Leverage

Answer 126

Leverage = (Notional Value - Margin) / Margin

Question 127

Repo Rate

Answer 127

=(Selling price - Repurchase price) / Selling price

Question 128

Repo Price

Answer 128

Principal (initial selling price) + interest = Principal x [1 + r,R(Term/360)]
r,R = repo rate

Question 129

Rebate Rate, Securities Lending

Answer 129

=Collateral earnings rate - security lending rate

Question 130

Liability Driven Investing (LDI) Strategy

Answer 130

-A form of Asset-liability mgmt (ALM) that takes the liabilities as given and builds the asset portfolio in accordance with the interest rate characteristics of the liabilities

Question 131

Classification of Liabilities

Answer 131

-I: Traditional fixed rate bonds with no embedded options
II: Bonds with embedded options, term life insurance policy
III: Floating rate notes/inflation protected security
IV: property and casualty insurance payouts

Question 132

Yield Curve Dynamics

Answer 132

-Changes in yield levels: Occur when yield curve changes by same number of bps at each maturity (AKA Parallel shift)
-Changes in yield curve slope: Can be quantified as the difference between yields for long maturities less yields for short maturities (when spread widens, curve is said to steepen and when it narrows, curve is said to flatten)
-Changes in yield curve shape (curvature) - Can be quantified by the Butterfly Spread

Question 133

Butterfly Spread

Answer 133

-Can be used to quantify the yield curve shape (curvature)
-Butterfly Spread = 2YTM10 - (YTM2 + YTM30)
-Generally positive, increases as curve becomes more concave (humped) and would likely be negative for a convex (U-shaped) curve

Question 134

Price Change in Bond
(AKA Price-Yield Return)

Answer 134

%Delta(V, Full price) = -MD,P x Delta(Y) + 0.5(C,P)(Delta(Y)^2)

-Use Effective Duration when available
-Use end of horizon measurements when available

Question 135

Strategies to Increase Duration - Purchase Bullet

Answer 135

-Buy bond with duration greater than benchmark
-Excess return: Price appreciation as YTM declines
-Risks: Yields increase rather than decrease

Question 136

Strategies to Increase Duration - Receive Fixed Swap

Answer 136

-Fixed rate receiver
-Excess return: Swap MTM gain as yield falls plus carry (fixed less floating rate) and less margin cost
-Risks: Higher floating rate/higher swap yield level

Question 137

Strategies to Increase Duration - Long Futures

Answer 137

-Buy contract for forward delivery
-Excess return: Futures MTM gain less margin cost
-Risks: Yields increase/funding costs increase

Question 138

Strategies for Yield Curve Changes General

Answer 138

-Bull scenarios generally denote falling rates while bear scenarios denote rising rates
-Duration neutral strategies apply when port mgmt has no view on which end of the curve may change more than the other (no net change in duration between long and short end)
-Steepening scenarios suggest long end will increase in yield relative to short end
-Flattening scenarios suggest long end will decrease in yield relative to short end

Question 139

Strategies for Yield Curve Changes - Duration-Netural, Steepening

Answer 139

-Net 0 duration
-Excess return: Gain from slope increase
-Risks: Yield curve flattens

Question 140

Strategies for Yield Curve Changes - Duration-Netural, Flattening

Answer 140

-Net 0 duration
-Excess return: Gain from slop decrease
-Risks: Yield curve steepens

Question 141

Strategies for Yield Curve Changes - Bull Steepening

Answer 141

-Net long duration
-Excess Return: Gain from slop increase / lower yields
-Risks: Yield curve flattens or higher yields

Question 142

Strategies for Yield Curve Changes - Bear Steepening

Answer 142

-Net short duration
-Excess return: Gain from slope increase / higher yields
-Risks: Yield curve flattens or lower yields

Question 143

Strategies for Yield Curve Changes - Bull Flattening

Answer 143

-Net long duration
-Excess return: Gain from slope decrease / lower yields
-Risks: Yield curve steepens or higher yields

Question 144

Strategies for Yield Curve Changes - Bear Flattening

Answer 144

-Net short duration
-Excess return: Gain from slope decrease / higher yields
-Risks: Yield curve steepens or lower yields

Question 145

Credit Risk

Answer 145

-Identifies risk that a debt issuer will fail to make a promised interest/principal payment, and includes Default risk (probability that debt issuer will fail to make the payment) and Loss severity (amt of loss if default occurs)

Question 146

Loss Given Default (LGD)

Answer 146

=EE * (1 - RR)
EE = expected exposure (bond value)

Question 147

Expected Loss (EL)

Answer 147

=LGD * POD

Question 148

Yield Spread

Answer 148

-Difference between bond YTM and similar-maturity govt bond
-Advantages: simple to calculate, widely understood
-Disadvantages: Maturity mismatch, curve slope bias, inconsistent over time

Question 149

G-Spread

Answer 149

-Spread over interpolated govt bond
-Advantages: Transparent, maturity matching default risk free govt bond
-Disadvantages: Subject to changes in govt bond demand

Question 150

I-Spread

Answer 150

Yield spread over swap rate of same maturity
-Advantages: Spread vs mrkt based (MRR) measure often used as hedge or for carry trade
-Disadvantages: Point estimate of term structure and not useful for option bonds

Question 151

ASW (Asset Swap) Spread

Answer 151

-Spread over MRR of fixed bond coupon
-Advantages: Transparent, traded spread that converts current bond coupon to MRR plus a spread
-Disadvantages: Market-based spread rather than cash flow absed spread and now useful for option bonds

Question 152

Z-Spread

Answer 152

-Constant yield spread over a govt (or swap) spot curve
-Advantages: Reflects term structure of govt or swap zero rates
-Disadvantages: More complex calculation and not useful for option bonds

Question 153

CDS Basis Spread

Answer 153

-Difference between yield spread and CDS spread of same maturity
-Advantages: Transparent, interpolated CDS spread vs Z spread
-Disadvantages: Market based spread rather than cash flow based spread and not useful for option bonds

Question 154

OAS Spread

Answer 154

-Yield spread using Z spread including bond option volatility
-Advantages: Allows comparison of option free risk bonds with option bonds
-Disadvantages: Complex calculation based on volatility and, with MBS, prepayment assumptions. Bonds with embedded options unlikely to earn OAS over time

Question 155

Credit Strategy - Bottom Up Approach

Answer 155

-Portfolio management selects the best relative value securities from bonds in the same country, industry, or other category
-First segment the potential universe of credit issues into similar credit risks, then use credit relative value analysis to find most attractive in that credit segment . Then applies a weighting method.

Question 156

Credit Relative Value Analysis

Answer 156

-Used in Bottom Up Approach
-Looks at the spread for similar securities with the idea that, all else equal, mgmt would prefer greater yield for the same risk. For non-similar securities, mgmt would determine whether excess return sufficiently compensates for the risk imparted by the nonsimilar factors
-E[Excess Spread] = Spread,0 - (EffSpread Dur x Delta(Spread)) - (POD x LGD)

Question 157

Spread Curve

Answer 157

-Shows the spread of the fitted curve for each issuers securities of different maturity or duration. Higher spread curve indicates wider spread over benchmark and thus greater perceived risk
-Recent issues by well known issuers have narrower spreads compared to older issues by infrequent issuers. Spreads widen as issues age

Question 158

Spread Duration and Weighting

Answer 158

-The % change in price for a given % change in yield spread
-W,MV, Sdc = W,MV,Index x [D,S,index / D,S,sector]
-Spread duration weighting structures the portfolio to provide the same % change in price from each position given a 1% change in spread

Question 159

Credit Strategy - Top-Down Approach

Answer 159

-Mgmt first broadly defines appropriate sectors, then selects sectors expected to benefit from perceived macro trends, the over/underweights the sectors

Question 160

Spread Sensitivity

Answer 160

-A secondary credit market measure of liquidity
-The % change in spread over a reference rate for a % change in outflows from mutual funds or credit market

Question 161

CDS Price

Answer 161

P,CDS = (Fixed CDS Coupon - CDS Spread) x EffSpreadDur,CDS
-If spread is greater than fixed coupon, P,CDS < 0 and buyer pays seller
-Fixed coupon is determined the the Intl Swaps and Derivatives Association: IG issuers usually carry 1% fixed coupon and HY issuers carry 5%

Question 162

Passively Managed Equity Portfolio - Replication Strategies

Answer 162

-Full replication should result in negligible tracking error but requires a large enough mandate size and liquid index constituents. This is preferred when the index has a relatively small number of constituents (less than 1k) and when the index is market cap weighted
-Stratified sampling is used when the benchmark index contains large number of securities / mandate size is small.
-Optimization is a middle ground

Question 163

Active Return

Answer 163

R,A = nSUMi=1 [w,i - W,i)r,i]
w,i = portfolio weight of asset i
W,i = benchmark weight of asset i

R,A = SUM[(B,pk - B,bk)F,k + (a + e)
B,pk = Portfolio sensitivity to each reward factor k
B,bk = benchmark sensitivity to each reward factor k
F,k = rewarded factor return
a = return due to mgmt skill at security selection and timing
e = idiosyncratic return

Question 164

Breadth of Expertise

Answer 164

E(R,A) = IC x RAD(BR)stdDev(R,A)(TC)
IC = expected information coefficient (correlation between forecast and actual active return)
BR = breadth (# of independent, uncorrelated mgmt decisions)
TC = transfer coefficient (the degree to which port insights translate to investment decisions)

Question 165

Building Blocks for Systematic Approach Types

Answer 165

Top-Down: Macro factors, factor timing, diversified.

Bottom-up: Security specific factors, no factor timing, diversified

Question 166

Building Blocks for Discretionary Approach Types

Answer 166

Top-Down: Macro factors, factor timing, diversified/concentrated

Bottom-up: Firm-specific factors, potential factor timing, diversified/concentrated

Question 167

Active Share

Answer 167

-Measurement of portfolio weights differences from benchmark weights
-Active Share = 1/2 x SUM[|w,i - W,i|]

-Value of 0 = mgmt fully matching benchmark
-Value of 1 = mgmt holds no benchmark constituents in portfolio

Question 168

Hedge Fund Strategies - Equity

Answer 168

-Long/Short Equity
-Dedicated Short Bias
-Equity market neutral

Question 169

Hedge Fund Strategies - Event-Driven

Answer 169

-Merger Arbitrage
-Distressed securities
-Soft-Catalyst Approach: Mgmt could attempt to profit from forecasting the event
-Hard-Catalyst Approach: Mgmt attempts to profil from price movements after an event has been publicly announced (tend to involve lower vol than soft catalyst)

Question 170

Hedge Fund Strategies - Relative Value

Answer 170

-Fixed income arbitrage
-Convertible Bond arbitrage

Question 171

Hedge Fund Strategies - Opportunistic

Answer 171

-Global Macro
-Managed Futures
-These have the broadest mandates of all HF strategies

Question 172

Hedge Fund Strategies - Specialist

Answer 172

-Volatility strategies
-Reinsurance strategies

Question 173

Hedge Fund Strategies - Multi-Manager

Answer 173

-Multi-strategy
-Fund of funds

Question 174

HF: Long/Short Equity

Answer 174

-Equity Category of HF
-Attempt to derive alpha by taking long positions in undervalued secs and short positions in overvalued secs
-Can be generalists (cover diverse universe of industries) or sector specific
-Management is typically fundamental in nature, with investments based on high conviction ideas derived from intimate knowledge of the business conditions affecting the investment
-Leverage levels can vary significantly between management. Higher leverage typically used by more quant mgmt
-Relatively liquid strategy that can be employed in both LPs and MF vehicles

Question 175

HF: Dedicated Short-Bias

Answer 175

-Equity category of HF
-Short bias (30-60% net short position in fund), and mgmt will take long positions
-Dedicated Short Selling (maintain only short positions, 60-120% short)
-Liquidity is relatively high
-Returns are too volatile to permit/require use of leverage
-Due to operational complexities of short selling, best operated in an LP rather than an MF

Question 176

HF: Equity Market Neutral

Answer 176

-Equity category of HF
-Take long and short positions in similar or related securities with overall fund objective of keeping major risk factor exposure (stock mrkt beta, size, value) close to 0
-As market related risks have been eliminated, these strategies often employ large amounts of leverage. This large leverage makes them unsuitable for MFs but good for LPs
-Generally have net equity exposures of 0
-Good for periods of non-trending/declining markets

Question 177

HF: Merger-Arbitrage

Answer 177

-Event-Driven category of HF
-In a cash for stock deal, merger arb mgmt will purchase shares of target company aiming to profit as its value rises once acquisition is completed. In a stock for stock deal, merger arb mgmt will purchase shares of target company and short sell shares of acquirer in same ratio as the offer
-Earns relatively small risk premium when acquisitions are successful, faces steep loses if they fall through (risk/return profile similar to writing insurance on deal going through)
-Relatively liquid, but face significant tail risk
-Due to moderate/high use of leverage, better suited to LPs though some MFs exist

Question 178

HF: Distressed Securities

Answer 178

-Event-Driven category of HF
-Focus on securities of companies that are in financial distress, facing potential bankruptcy, or have already entered bankruptcy proceedings
-Strategies include liquidation (buying positions in debt securities trading below expected recovery values in liquidation, reorganization (long positions in securities deemed to be significantly undervalued relative to a likely reorg outcome) and Capital Structure Arbitrage
-Low liquidity and long lockuptimes, redemption gates, etc make them good for LPs
-Leverage levels not excessive due to high volatility of assets involved
-risk and return at higher end of even driven category

Question 179

HF: Fixed Income Arbitrage

Answer 179

-Relative Value category of HF
-Involves buying undervalued debt securities and short selling overvalued with aim of profiting when valuations revert to normal levels
-Strategies include yield curve trading, carry trades, L/S credit trading, and differences in vol expectations for securities with embedded options
-Involves high levels of leverage to magnify relatively small gains expected
-Liquidity is good for strategies involving sovereign debt but could be poor for corporate and muni markets

Question 180

HF: Convertible Bond Arbitrage

Answer 180

-Relative value category of HF
-Involves buying convertible bond and hedging the market risk of call option through taking delta-adjusted short position in issuers shares. Gains when volatility of share price underlying convertible is greater than volatility implied by the conversion option, net of hedging costs
-High use of leverage to extract gains from small profits

Question 181

HF: Global Macro

Answer 181

-Opportunistic category of HF
-Have one of the broadest mandates of all HF strategies
-Use global securities and derivatives to express their top down view on relative economic health of different countries and markets. They tend to be anticipatory and not trend following, often taking contrarian positions
-Generally employe high leverage through implicit gearing of derivatives

Question 182

HF: Managed Futures

Answer 182

-Opportunistic category of HF
-Also have very broad mandate allowing investment in virtually any type of global asset class, primarily through derivatives
-While global macro aim to anticipate trends using discretionary techniques and fundamental data, this aims to follow trends using systematic techniques and technical data
-As futures markets are among the most actively traded in the world, strategy is liquid
-Exhibit low correlations with traditional asset classes, therefore attractive for diversification

Question 183

HF: Volatility Trading

Answer 183

-Specialist Strategy of HF Category
-Overall goal is to purchase volatility when its undervalued and sell it when its overvalued
-Liquidity is good for exchange traded options and VIX futures, but could be low for OTC options and vol/var swaps
-Leverage could be high due to derivatives use

Question 184

HF: Reinsurance

Answer 184

-Specialist category of HF
-HFs offer high value to policyholders for their life insurance contracts, with them aiming to earn return from paying remaining premiums on contracts and receiving a payout when original insured dies. Similar strategy employed for catastrophe risk

Question 185

HF: Fund of Funds

Answer 185

-Mutli Manager category of HF
-role of FoF mgmt is to perform due dilligence and monitor risk mgmt of underlying portfolio mgmt
-Can be desirable for reporting purposes, pooling capital, greater access to underlying funds
-Extra layer of mgmt adds additional fees and may result in lower transparency into indv mgmt process
-Experiences the problem of “netting risk” where superior underlying mgmt will charge performance fees to FoF regardless of whether FoF generates positive returns in aggregate

Question 186

HF: Multi-Strategy Hedge Funds

Answer 186

-Multi manager category of HF
-Combine several strategies, and are run by different teams of mgmt under a single fund structure
-Allows fuller transparency, eliminates most netting of risk, but exposes investors to higher operational risk of fund failure vs FoFs

Question 187

Size and Timing of Contributions to Private Funds

Answer 187

C,t = RC,t x (CC - PIC,t)
C,t: Capital contribution in year t
RC,t: Rate of contribution (%) in year t
CC: Capital commitment
PIC,t: Paid-in-Capital (i.e. capital paid in prior to year t)

Question 188

Distributions and NAV of Private Funds

Answer 188

D,t = RD,t[NAV,t-1 x (1 + G)]
NAV,t = [NAV,t-1 x (1 + G)] + C,t - D,t

D,t = dollar distributions in Year t
RD,t = rate of distributions (%) in year t
G = growth rate in NAV

Question 189

IPS Components

Answer 189

-Background and IOs
-Investment parameters
-Portfolio Asset allocation
-Portfolio management
-Duties and Responsibilities
-IPS appendix

Question 190

IPS - Background and IOs

Answer 190

-Details clients relevant details and investment needs
-Background info likely to include mrkt values of client assets, tax status, expected cash flows

Question 191

IPS - Investment Parameters

Answer 191

-Builds the framework in which the clients investment plan should be build, outlines key investment preferences
-Risk tolerance, time horizon, asset class preference, other investment preferences, liquidity preferences and constraints (RATLOC)

Question 192

IPS - Portfolio Asset Allocation and Management

Answer 192

-Details the target asset allocation for client based on their IOs and parameters
-Subsections include discretionary authority, rebalancing framework, tactical changes, and implementation
(DR TIT)

Question 193

IPS - Duties and Responsibilities

Answer 193

-Outlines the responsibilities of those implementing the investment plan

Question 194

Different Tax Systems

Answer 194

-Tax Havens: Very low or 0 tax rates for foreign investors
-Territorial Tax Systems: Tax locally generated returns
-Worldwide Tax Systems: Tax all income of residents regardless of where in the world its earned

Question 195

Pre and Post-Tax holding period return

Answer 195

pre-tax HPR, R = [(Value - Value,0) + Income] / Vallue,0
Post-Tax HPR, R’ = R - (Tax / Value,0)
Tax Efficiency Ratio (TER) = R’ / R (higher ratio indicates more tax efficient mgmt or investment)

Question 196

Modified Dietz Method, After-tax HPR

Answer 196

R’ = R - [Tax / (Value,0 + SUM{C,j(N - j) / N}]
C,j = cash flow on day j
N = Number of days in calendar month
N - j = Number of days from cash flow to the end of month

Question 197

After-Tax Post-Liquidation Returns, R,PL

Answer 197

-Assumes that portfolio investments are sold at the end of an evaluation period, and all capital gains taxes become due (a liquidation tax). Used to capture impact of unrealized capital gains.
-Liquidation Tax = (Final Value - Tax basis) x Capital gains tax rate
R,PL = {[(1 + R’,1) (1 + R’,2) … (1 + R’,n) - (Liquidation tax / Final value)] ^ (1/n) } - 1

Question 198

After-Tax Excess Returns and Tax Alpha

Answer 198

-Pre-Tax Excess Return, x = R - B
-After-Tax Excess Return, x’ = R’ - B
-Tax Alpha, a,tax = x’ - x
-this represents excess return generated/lost due to tax mgmt decisions made by portfolio management

Question 199

Future Value, Different Tax Accounts

Answer 199

-Tax-Exempt Account: FV, Tax-Exempt = (1 + R)^n
-Taxable Account: FV, Taxable = (1 + R’)^n
-Tax-Deferred Account: FV, Tax-deferred = (1 + R)^n (1-t)

Question 200

Relative Value, Tax-Free Gifts

Answer 200

RV, Tax-Free Gift = FV,Gift / FV,Bequest
={[1 + r,g(1 - t,g)]^n} / {[1 + r,e(1 - t,e)]^n x (1 - T,e)}
r,g = pre-tax returns to beneficiary
t,g = tax rate on returns in beneficiary portfolio
r,e = pre-tax returns to donors estate
t,e = tax-rate on returns in donors estate
T,e = estate tax rate

-If RV,Tax Free Gift > 1, more efficient to gift today rather than to wait and bequeath at death

Question 201

Relative Value, Taxable Gifts

Answer 201

RV, Taxable Gift = FV,Gift / FV,Bequest
= {[1 + r,g(1 - t,g)]^n x (1 - T,g)} / {[1 + r,e(1 - t,e)]^n x (1 - T,e)}
T,g = gift tax rate

-RV, Taxable Gift = RV,Tax Free Gift x (1 - T,g)

r,g = pre-tax returns to beneficiary
t,g = tax rate on returns in beneficiary portfolio
r,e = pre-tax returns to donors estate
t,e = tax-rate on returns in donors estate
T,e = estate tax rate

Question 202

Irrevocable vs Revocable Trusts

Answer 202

-Irrevocable Trusts - Cannot be changed by the grantor, and trustee files tax-related documents and pays relevant tax from tax assets. Provide better protection from legal claims against grantor
-Revocable Trust - Can be dissolved by grantor and assets returns, but grantor, rather than trustee, will be responsible for documents and paying taxes

Question 203

Fixed vs Discretionary Trusts

Answer 203

-Fixed Trusts - Distribute assets to beneficiaries according to a specified fixed schedule or formula
-Discretionary Trusts - Allow trustees discretion as to the timing and size of distributions to beneficiaries. These are seen as less of a legal right to beneficiary and therefore creditors to beneficiary are less likely to be able to make claims against this kind of trust

Question 204

Trusts

Answer 204

-A structure in which a trustee holds and manages assets donated by the grantor (or settlor) for the benefit of beneficiaries
-Allow control, asset protection, and some favorable tax treatment

Question 205

Foundations

Answer 205

-Legal structure set up for a certain spending purpose, like trusts can be set up to outlive the donor
-Usually donations to foundation are tax deductible, and returns are taxed favorable with assets in the foundation not subject to estate taxes
-Likely required to distribute 5% of assets annually to its programs

Question 206

Controlled Foreign Corporation (CFC)

Answer 206

-A company located in a tax jurisdication different from controlling taxpayers home jurisdiction
-Typically established in jurisdictions with low/no corporate income tax, allowing taxation to be deferred until profits are distributed from corporation back to owner

Question 207

Human vs Financial Capital

Answer 207

-Human Capital - The PV of of the individuals future expected labor income
-Financial Capital - Consists of bank accounts, individual securities, pooled funds, and any other assets owned by individual that are not considered human capital
-Best to diversify financial capital from human capital

Question 208

Methods of Risk Management (4)

Answer 208

-Risk Avoidance: Not engaging in risky activity
-Risk Reduction: Lowering the likelihood that a risk will occur or decreasing the severity of the loss
-Risk Transfer: Through the purchase of insurance or annuities
-Risk Retention (Self-Insuring): Keeping the risk and setting aside money to cover potential loses

Question 209

Financial Stages of Life - Education Phase

Answer 209

-First Stage
-Investing in knowledge through formal education/skill development
-Characteristics: Financially dependent on parents, very little financial capital, almost no focus on savings or risk mgmt

Question 210

Financial Stages of Life - Early Career

Answer 210

-Second Stage
-Completes education and enters workforce, age 18-20s / early 30s
-Gets married, has children, buys home
-FA can help with Life insurance can supplement lack of sufficient financial and human capital

Question 211

Financial Stages of Life - Career Development

Answer 211

-Third Stage
-Specific skill development with a given field, ages 35-50
-Accumulation for childrens college education, large purchases such as vacation home, travel
-FA can help with retirement savings

Question 212

Financial Stages of Life - Peak Accumulation

Answer 212

-Fourth Stage
-Moving towards max earnings and greatest opportunity for wealth accumulation, age 51-60
-Retirement planning and travel, high career risk as high paying job may not be replaced
-FA can help with reducing investment risk, developing retirement income strategies

Question 213

Financial Stages of Life - Pre-Retirement

Answer 213

-Fifth Stage
-A few years before retirement age
-Income often at career highs
-FA can help with decreasing investment risk, tax planning for retirement distributions

Question 214

Financial Stages of Life - Early Retirement

Answer 214

-Sixth Stage
-Period of comfortable income and enough assets to cover living expenses, at least first 10 yrs of retirement
-Use savings for enjoyment, most active period of retirement, less likely to suffer from cognitive/mobility impairments
-FA can help with the still existent need for asset growth as this phase could last 20 years

Question 215

Financial Stages of Life - Late Retirement

Answer 215

-Unknown duration
-Physical activity declines, cognitive/physical problems may deplete savings, may need LT health care
-FA can help with annuities to reduce/eliminate longevity risk

Question 216

Risk Management Techniques

Answer 216

Question 217

DB Pension Plan

Answer 217

-Benefits: Contracted lifetime pension payments generally based on salary
-Contributions: Employer contributions based primarily on investment performance of underlying assets; employee may also contribute
-Investment Decision Making: Determined by pension fund in meeting plan objectives
-Investment Risk: Borne by employer
-Mortality/Longevity Risk: Borne by pool of employees

Question 218

DC Pension Plan

Answer 218

-Benefits: Based on underlying investments
-Contributions: Employee is primary contributor, employer may also contribute
-Investment Decision Making: Determined by employee
-Investment Risk: Borne by employee
-Mortality/Longevity Risk: Borne by employee

Question 219

Sovereign Wealth Funds (SWFs)

Answer 219

-State owned investment funds/entities that look to invest funds from budget surpluses to meet various IOs. Many SWFs are a hybrid of 2/more of these
-Budget Stabilization Funds
-Development Funds
-Pension Reserve Funds
-Reserve Funds
-Savings Funds

Question 220

Budget Stabilization Fund

Answer 220

-SWF
-Main objective is to insulate the budget and economy from commodity price volatility (esp oil) and external shocks
-Liabilities and Time Horizons: Short term, liabilities uncertain - to fund budget shortfalls in event of revenue falls from cyclical/volatile industries
-Liquidity Needs: government spending needs may spike during periods of negative price shocks, which would require the fund to maintain high levels of liquidity
-Asset Allocation: Dominated by fixed income, risk averse due to need for counter-cyclical assets and mgmt by CB or finance ministry (which tend to be more risk averse)

Question 221

Development Funds

Answer 221

-SWF
-Main objective is to fund priority socioeconomic projects
-Liabilities and Time Horizons: Medium to long term, liabilities uncertain
-Liquidity Needs: Will depend on the economic development initiatives that the fund was created to support
-Asset Allocation: Depends on time horizon

Question 222

Pension Reserve Funds

Answer 222

-SWF
-Main Objective is to fund pension-like liabilities of the government
-Liabilities and Time Horizon: Long term, liabilities are more certain pension-related funding and less certain healthcare funding
-Liquidity Needs: Likely to have an accumulation phase (where surpluses are being used to build the fund) which would have low liq needs and a decumulation phase which would have high liq needs
-Asset Allocation: tilted towards EQs and Alts, typically follow the endowment model but may also follow Canada reference portfolio model

Question 223

Reserve Funds

Answer 223

-SWF
-Main objective is to aim to increase returns (or reduce negative carrying costs) of government reserves
-Liabilities and Time Horizon: Very long, liabilities are no real claim on the fund as it is the investment of excess FX reserves - used to help fund the cost of carry on CB balance sheet
-Liquidity Needs: Likely low to moderate
-Asset Allocation: Titled towards EQs

Question 224

Savings Funds

Answer 224

-SWF
-Main objective is to share wealth across generations, with the wealth usually related to high revenues from nonrenewable assets
-Liabilities and Time Horizon: Long term, liabilities uncertain - used to fund intergenerational wealth transfer
-Liquidity Needs: Low due to LT nature of fund, but savings funded by natural resources may have liq needs change once natural resource begins to burn out
-Asset Allocation: Tilted towards EQs and Alts, typically follow endowment model

Question 225

Institutional Investment Approaches - Norway Model

Answer 225

-A largely passive managed portfolio with a mix of public equities and FI securities only (little, if any alternatives)
-Useful for institutional investors seeking low cost and transparent investment management
-Disadvantages are limited value adding potential

Question 226

Institutional Investment Approaches - Endowment Model

Answer 226

-High allocation to alts, actively managed through external asset management
-Useful for those with low liq needs with a moderate levels of assets
-Disadvantages is that its expensive and can be difficult to implement

Question 227

Institutional Investment Approaches - Canada Model

Answer 227

-High allocation to alts, internally managed
-Incorporates a reference portfolio that drives asset and risk allocations
-Useful for those with low liq needs and resources to manage investments

Question 228

Institutional Investment Approaches - Liability Driven Investing (LDI) Model

Answer 228

-High allocation to FI securities (long duration for DB pension plans, SWFs, endowments, and foundations to match liability durations; shorter durations for banks and insurers)
-Can incorporate a hedging portfolio of bonds and derivatives and a return generating portfolio

Question 229

Modified Duration of Banks Equity Capital

Answer 229

-DE = [(A/E) * DA] - [((A/E) - 1) * D*L x (Delta(i) / Delta(y))]

Question 230

Trading Alpha

Answer 230

-Short-Term Alpha: Represents investment price movement over the period between investment decision and trade execution
-Alpha Decay: The erosion of ST alpha until the trade is executed or abandoned, the rate of this affects trade urgency

Question 231

Implementation Shortfall (IS)

Answer 231

-Measures total cost of executing the trade above a decision price
-IS = r,paper - r,actual
-IS = SUM[s,j(p,j)] - SUM[s,j(P,d)] + {S - SUM[S,j]}(p,n - P,d) + Fees

-IS,bps = {IS / [S x p,d]} x 10,000

s,j, p,j: Number of shares executed and prices of the jth trade. USE NEGATIVE SHARE NUMBERS FOR SELL ORDERS
P,d: Price when trade decision is made (arrival price)
S: total number of shares ordered
P,n: Current share price (Closing share price)
-First 2 terms are the execution costs and second 2 terms are the opportunity costs
-IS Minimization strategy is app when there is a need for formal control, like when mgmt is switching

Question 232

IS: r,paper

Answer 232

r,paper = S(P,n - P,d) = S(P,n) - S(p,d)

S: total number of shares ordered
P,n: Current share price
P,d: Price when trade decision is made

Question 233

IS: r,actual

Answer 233

r,actual = SUM(s,j)(P,n) - SUM[s,j(P,j)] - Fees

s,j and p,j = number of shares executed and the prices of the jth trade
SUM(s,j) = Total number of shares executed
Fees = commissions, exchange fees, and taxes

Question 234

Trade Cost Calculations

Answer 234

-Positive values indicate additional cost and underperformance relative to benchmark

-Cost/share = Side x (P,bar - P!)
-Total cost = Side x (P,bar - P!) x # shares
-Arrival Cost in bps = Side x [(P,bar - P!) / P!] x 10,000

Buy Side = +1, Sell Side = -1
P,bar = Weighted average execution price of order
P! = Arrival/Reference price (Price when order is released for market execution)

Question 235

Market Adjusted Cost

Answer 235

-Index cost (bps) = Side x [(Index VWAP - Index arrival price) / Index arrival price] x 10,000
-Market-Adjusted Cost (bps) = Arrival cost bps - B(Index cost (bps))

Question 236

Returns-Based Attribution

Answer 236

-Uses only total returns to establish sources of return and risk.
-Most appropriate when underlying portfolio return info is not available
-Approach is easiest to implement, but least informative and most subject to data manipulation

Question 237

Holdings-Based Attribution

Answer 237

-Relates return and risk to holdings at the beginning of period
-Holdings based returns will not equal actual portfolio return, and the difference can be attributed to a timing/trading effect
-Appropriate for passive strategies
-Better when using data with shorter time span as longer time periods will be subject to trading effects which this does not capture

Question 238

Transactions-Based Attribution

Answer 238

-Uses the weights and returns of all transactions, including their transaction costs
-All excess returns can be calculated and accurately explained but its the most difficult and time consuming
-Most accurate attribution

Question 239

The Brinson-Hood-Beebower (BHB) Approach

Answer 239

-An equity return attribution approach
-Considers that portfolio and benchmark returns for a period are each the sum of asset-weighted individual sectors

Question 240

Allocation Effects

Answer 240

-Occur when portfolio management adds or loses value by having portfolio sector weights different from benchmark sector weights
-A,i,BHB = (w,i - W,i)B,i

w,i = Portfolio sector weight
W,i = Benchmark sector weight
B,i = Benchmark sector return

Question 241

Selection (Security) Effects

Answer 241

-Occurs when management creates a different return from his selection within a sector than occurred in the benchmark, which results from different security weights within a sector
-This is the same for both BHB and BF model

S,i = W,i(R,i - B,i)

W,i = Benchmark sector weight
R,i = Portfolio sector return
B,i = Benchmark sector return

Question 242

Interaction Effect

Answer 242

-Describes the portion of return that results from both differences in portfolio weights and differences in securities
-This is the same for both BHB and BF model

I,i = (w,i - W,i)(R,i - B,i)

w,i = Portfolio sector weights
W,i = Benchmark sector weights
R,i = Portfolio sector returns
B,i = Benchmark sector returns

Question 243

Exposure Decomposition

Answer 243

-Fixed income return attribution approach that is duration based
-Involves working through a hierarchy of portfolio positions from the top down to explain active management of a portfolio relative to its benchmark
-Has duration effects (relate specifically to return attributable to shifts in the yield curve across all duration buckets) and duration bucket effects (relate to yield curve shift effects, curve effects, sector allocation effects, and bond selection effects within the same duration bucket

Question 244

Yield Curve Decomposition

Answer 244

-Fixed income attribution approach
-Breaks active return contributions into time effects, yield curve effects, and spread effects. Can be bottom up or top down
-Duration Based Yield Curve Decomposition: Uses active return calculated using negative duration multiplied by specific type of yield change. As it uses duration it is subject to estimation errors
-Full Repricing Yield Curve Decomposition - Rather than duration based repricing, this uses 0-coupon spot rates to calculat individual bond price changes that result from yield changes in each yield curve attribution category. Better aligned with how portfolio management view the instruments, but more costly, difficult, and hard to explain

Question 245

Risk Attribution

Answer 245

-Identifies sources of volatility for portfolios managed to absolute return mandates and sources of tracking risk for portfolios managed to benchmark-relative mandates

Question 246

Liability-Based Benchmarks

Answer 246

-Appropriate when the fund sponsor must defease a specific liability (should focus on cash flows that must be generated to defease the liability)
-For a fully funded plan, benchmarks should focus on asset performance relative to change in plan liabilities. For unfunded/overfunded plans, benchmark should help sponsor track progress toward full funding of pension liability

Question 247

Sortino Ratio

Answer 247

SR = (R - B) / DD

R = Portfolio return (expected return for ex-ante SR)
B = Benchmark (target) return. As it uses a target return it cannot be compared across investors like the sharpe ratio
DD = downside deviation

=(avg. Port Return - Minimum Acceptable Return (MAR)) / Target semideviation

-Risk-adjustment metric used to determine additional return for each unit of downside risk. High SR is preferred as it indicates investor will earn higher return for each unit of downside risk
-App for opportunistic hedge funds or other strategies with non-normal distribution and leverage, option writing and commodity derivatives

Question 248

Appraisal Ratio

Answer 248

-Compares annualized Jensen’s alpha (active mgmt return) to the std deviation of the error term (unsystematic, security specific, risk)
-Higer ratio is desired as it shows more units of active return per unit of unsystematic risk

Question 249

Capture Ratio

Answer 249

-Represents managements success in capturing the benchmark return

Capture = R,t / B,t
Upside Capture if B,t >/= 0, Downside Capture if B,t < 0

UC > 1 = outperformance
DC < 1 = outperformance

Question 250

Upside/Downside Capture Ratios (UDCRs) AKA Capture Ratio

Answer 250

-Measures upside capture relative to downside Capture

CR = UC / DC

> 1 = convex (positive asymmetry): Returns from these strategies increase at an increasing rate with the magnitude of benchmark returns (ideal in most cases)
< 1 = concave (negative asymmetry): Returns increase at a decreasing rate with the magnitude of benchmark returns

-Suffer from measurement base bias

Question 251

Type I and II Errors - Management Selection

Answer 251

-Type I Errors: Rejecting the correct null hypothesis that the mgmt has no skill and subsequently hiring/retaining a manager who underperforms. More common for investors to be concerned with this as they create explicit costs. These are errors of commission (errors due to action)
-Type II Errors: Failing to reject an incorrect null hypothesis and subsequently not hiring/firing a manager who achieves or exceeds expectations, create opportunity costs. These are errors of ommission (due to lack of action)

Question 252

Returns-Based Style Analysis (RBSA)

Answer 252

-A top-down approach that estimates the portfolios sensitivity to common risk factors, usually by regressing actual portfolio returns vs security market indices representing the risk factors
-Advantages: Low data reqs, can be applied to complex strategies, objective, unaffected by window dressing
-Disadvantages: Backward looking, understate exposures for illiquid portfolios with smoothed returns, does not look at individual holdings

Question 253

Holdings Based Style Analysis (HBSA)

Answer 253

-Bottom up approach that estimates risk exposures based on portfolio securities at a specific time
-Advantages: Looks at current, not historic risk factors, likely to capture changes in style quicker, looks at individual holdings
-Disadvantages: Subject to window dressing, can get complex, high data reqs, also understates exposures for illiquid ports with smoothed returns

Question 254

Active Share and Tracking Risk

Answer 254

Question 255

Leverage Adjusted Duration Gap

Answer 255

=D,A - K(D,L)
-K = Leverage = L/A
-Positive Gap = Assets fall more than liabilities in rising rates
-Negative gap = Liabilities fall more than assets in rising rates

Question 256

DB Pension Plans and Risk Tolerance

Answer 256

-Early Retirment Provisions (-)
-Average age of employees (-)
-Ratio of retired to active lives (-)
-Funded Status (+)
-D/E ratio (-) as it indicates the business exposure to financial risk. lower DE means they have lower leverage and more able to contribute to fund in times of poor business performance

Question 257

Different Bond Portfolios and Yield Curve Assumptions

Answer 257

-Bullet portfolio will OP when yield curve steepens / becomes less curved due to less sensitivity to LT rates (which will relatively increase under both of these scenarios)
-Barbell portfolio will OP when yield curve flattens / becomes more curved due to greater sensitivity to LT rates (which are expected to fall)

Question 258

Butterfly Spreads and Strategy

Answer 258

-Butterfly spread is an inverse volatility strategy that profits when volatility is falling
-If curve is steepening/becoming less curved, create butterfly spread by going long intermediate bullet portfolio and short a barbell portfolio in short and long duration securities
-If curve is flattening/becoming more curved, create spread by going short intermediate bullet portfolio and long a barbell portfolio in short and long duration securities

Question 259

Change in Fixed Income Portfolio Value Given Key-Rate Duration

Answer 259

Delta(V,P) = V,P x - (MDUR / 10,000) x Shift,bps

Question 260

Change in Fixed Income Portfolio Value Given Key-Rate Duration

Answer 260

Delta(V,P) = V,P x - (MDUR / 10,000) x Shift,bps
V,p = Par value of portfolio

Question 261

Features of Independent Variables used in a Returns-Based Style Analysis

Answer 261

-Mutually Exclusive: One company is not included in 2 different independent variables
-Exhaustive: The independent variables cover the fully market cap and style range of the portfolio being analyzed
-Represent Distinct Sources of Risk: The independent variables each generate different types of investment returns

Question 262

R^2

Answer 262

-In a Returns-based style analysis this represents the proportion of the variation in fund returns coming from passive techniques
-High R^2 means the model used is a good fit for describing the factors that affect the variance in port returns
-High R^2 in a factor analysis suggests factor selection is very important

Question 263

Factors Expected in Value Oriented Equity Funds

Answer 263

-Consistent growth in dividends
-High dividend cover
-High cash flow generation
-High ROE

Question 264

Contribution of Market Factor/Asset Class to Total Portfolio Variance

Answer 264

CV, Asset Class i = nSUMj=1[w,i(w,j)Cov(i,j)]

CV, Factor i = nSUMj=1 [B,Fi(B,Fj)Cov(Fi,Fj)

Question 265

Minimum Variance Hedge Ratio, Currencies

Answer 265

-Will increase as the exchange rate correlation with foreign returns increases from -1 to +1
h = p(R,DC, R,DC/FC) x [Std.Dev(R,DC) / Std.Dev(R,DC/FC)]

Question 266

Fixed Income Portfolio Immunization

Answer 266

-Portfolio is immunized when the PV and Macaulay duration of the assets = PV and Macaulay duration of liabilities
-PV of a portfolio of bonds is the sum of the market value of all bonds
-Duration of assets is calculated as the cash-weighted (from market values) Macaulay duration of the bonds in portfolio
-When mrkt values of assets and liabilities differ, matching the money duration or BPV becomes more important

Question 267

Contingent Immunization

Answer 267

-A liability-based framework
-Active management of surplus funds can be performed when the current market value of assets is greater than the PV of the liability

Question 268

Float Adjusted Weighting Method

Answer 268

-Allocates weight to constituents relative to the mrkt value of outstanding shares freely traded
-Leads to less frequent rebalancing than equal-weighting and results in lower turnover cost
-May overweight overvalued companies and extremely large cap companies. (equal weighting will overweight the effects of small companies)

Question 269

Portable Alpha

Answer 269

-Achieved by removing the beta of the manager by shorting futures with the same systematic risk as the manager. Can then add the desired systematic risk by adding a relevant futures contract

Question 270

Information Ratio

Answer 270

IR = IC(RAD(BR))TC

Question 271

Goals-Based Approach

Answer 271

-A strategic asset allocation approach that uses the behavioral finance insight that investors ted to think of their funds in “buckets” earmarked for specific purposes

Question 272

Active Management Strategy - Factor Based

Answer 272

-Analyst determines what characteristics the mrkts reward with return and selects secs with those characteristics
-Usually implemented in a hedged portfolio approach, which ranks indv secs by expected performance given factor forecast and then groups then into quintiles/deciles. Mgmt goes long best expected quantile and shorts worst.
-Hedged portfolio approach generates a dollar neutral portfolio (dollar value of long positions = dollar value of short positions)

Question 273

Early Expansion - Abbreviation

Answer 273

Econ:
S(timulative policies removed)
O(utput gap negative)
C(onsumers start to borrow to spend. Durables, housing demand up)
U(nemployment falls)
P(roduction up)
P(rofits up)

Capital Markets:
M(arket trending up)
F(lattening yield curve)
S(hort term rates up)

Question 274

Contraction - Abbreviation

Answer 274

Econ:
D(own): Profits, production, investment
U(nemployment up)
C(redit markets tighten)
E(rrors discovered)

Capital Markets:
S(teepening yield curve)
W(idening spreads)
E(arly market phase down)
R(ates, long and short, down)
L(ate market phase up)

Question 275

Initial Recovery - Abbreviation

Answer 275

Econ:
S(tim policies remain)
O(utput gap large)
I(nflation slowing)
E(con starts to grow)

Capital Markets:
R(ates bottom)
M(arket trends up)
R(isky assets OP)

Question 276

Slow Down - Abbreviation

Answer 276

Econ:
V(ulnerable to shocks)
I(nvest opps down)
S(lowing growth)
I(nflation up)
O(overleveraging)

Capital Markets:
T(opping LT rates)
W(idening credit spreads)
I(nversion potential for YC)
R(ising ST rates)
D(ownward market potential)
D(efensive stocks OP)

Question 277

Late Expansion - Abbreviation

Answer 277

Econ:
O(utput gap positive)
D(ebt coverage ratios falling)
I(nflation danger)
R(estrictive monetary policy)
U(nemployment low)
U(p): investment , prices, wages, production

Capital Markets:
I(nflation hedges OP)
M(arkets volatile)
F(lattening yield curve)
P(rivate borrowing leads to rising rates)

Question 278

Hedging Ratios and Duration Gap

Answer 278

-Hedging ratio (HR) is the % of the duration gap that is closed with derivatives. HR = 0 implies no hedging while HR = 100% implies immunization and completely removes interest rate risk

Question 279

Pension Funds and Hedging

Answer 279

-Bc of pension funds negative duration gap (asset BPV is less than liability BPV), typical plan suffers when rates fall and could become underfunded
-To fix: Receive-fixed swaps (preferred when rates are expected to be low). Swaption collar (preferred if rates are expected to go up). Purchased receiver swaption (preferred if rates are projected to reach a certain threshold that depends on the option costs and strike rates)

Question 280

Types of Return

Answer 280

-True Active return = mgmt port reutrn less normal (i.e. benchmark) port retun
-Style return = Benchmark return less market index return
-Excess return = Port return less market index return

Question 281

Modified Dietz Method of Returns

Answer 281

Question 282

Immunization Strategies - Duration Matching

Answer 282

-Portfolio is managed in order to match the interest rate sensitivity of a liability portfolio.
-Accounts for parallel shifts in yield curve but not nonparallel (twists)

Question 283

Immunization Strategies - Cash Flow Matching

Answer 283

-Portfolio is managed in order to match the cash flows of a liability portfolio
-Portfolio will have no exposure to the level or shape of the yield curve
-Can still benefit from rebalancing if market conditions change (new cheapest to hold bond) or if characteristics of holdings change (i.e. callable bonds)

Question 284

Immunization Strategies - Derivatives Overlay

Answer 284

-Portfolio is managed by using futures to provide key portfolio characteristics such as duration level
-This can reduce transactional and liquidity costs

Question 285

Attribution vs Appraisal

Answer 285

-Attribution decomposes risk and return into its sources
-Appraisal establishes mgmt skill vs risk and return from uncontrollable sources. Appraisal can be used to inform and improve the port mgmt process

Question 286

Risks to Swaptions

Answer 286

1) Credit risk if swaption is not collateralized
2) collateral exhaustion risk if it is collateralized
3) Spread risk between swap fixed rates and the corporations cost of funds

Question 287

Income Return

Answer 287

= Coupon / Current price

Question 288

Roll-Down Return

Answer 288

-The expected price appreciation/depreciation of the bond based on current yield curve over the next 12 months
-Longer-maturity portion of yield curve is flatter and will result in less roll yield each period. So ports OW in LT securities would experience lower alpha due to roll yield

Question 289

Hedged Currency Management Program

Answer 289

-All else equal, investor would have stronger desire to hedge when
-higher allocation to fixed income
-Shorter time horizon
-High vol expectations

Question 290

Different Bond Portfolios and Risk

Answer 290

-Laddered portfolio helps diversify CFs against structural yield curve changes by balancing bond price risk and reinvestment risk. These are better for liquidity management
-Bullet portfolio has significant bond price risk but little reinvestment risk
-Barbell portfolio has significant reinvestment risk in the short end and significant bond price risk in the long end

Question 291

Hedge Fund Correlation and Market Beta

Answer 291

-Have relatively high correlation (indicates statistically strong directional relationship)
-Have relatively low market bets (results in a milder rise/fall than public equities)

Question 292

Leverage and Arithmetic vs Geometric Returns

Answer 292

-Ignoring funding costs
-Leverage will increase expected single period (arithmetic) returns/standard deviation of portfolio to [Leverage factor x unlevered port return/standard deviation]
–Extra vol will lower long-term geometric compounded returns as large falls will require larger proportional gains to revover.
-Expected Geometric Return of Port: R,g = R,A - (StdDev^2/2) where R,A and StdDev are the arithmetic return/std dev to the levered portfolio

Question 293

US DoL Fiduciary Rule

Answer 293

-Would expand the definition of fiduciary to all professionals providing advice for retirement plans and IRAs

Question 294

FATCA Rule

Answer 294

-Requires non US financial institutions to report info about financial accounts held by US taxpayers or by non US entities in which US taxpayers hold substantial ownership interest

Question 295

SEC Best Interest Rule

Answer 295

-Would require dealers and brokers to act in the best interest of clients and restrict the usage of the term adviser or advisor

Question 296

Interest Rate Swap

Answer 296

-No notional is exchanged and the payments are netted

Question 297

Cross Currency Swap

Answer 297

-Notionals are exchanged at the beginning and at the ending of the swap. Payments typically are not netted

Question 298

Notional Principal Needed to Close Duration Gap, Swaps

Answer 298

BPV,Asset + [NP x (Swap BPV / 100)] = BPV,Liability

-Solving for NP above would produce the NP of a receive-fixed interest rate swap for a 100% hedging ratio

Question 299

Barbell Strategy

Answer 299

-Exposure to short and long end of maturity spectrum
-Beneficial when yields are expected to flatten while being volatile (want more exposure to the long-end)

Question 300

Bullet Strategy

Answer 300

-Exposure to the middle portion of the maturity spectrum
-Benefits from a normal and stable yield curve
-Low convexity (good when yields are not expected to provided added price gains from yield volatility (i.e. stable yield curve))

Question 301

Pairs Trading

Answer 301

-Can use either qualitative or quant methods to determine firms with correlation in price movement
-Short OP sec (idea is it will return to correlation with a lower price), long UP sec

Question 302

Leverage given Debt-to-Asset Ratio

Answer 302

Leverage = Assets / Equity (A/E)
A/E = 1 / (E/A)
E/A = 1 - (D/A)
Therefore A/E = 1 / (1 - D/A)

Question 303

Stub Trading

Answer 303

a version of pairs trading that invests 100% of a long or short position in parent company and invests the other way in the subsidiaries based on the proportion owned by parent

Question 304

Strategic Asset Allocation (SAA)

Answer 304

-Uses mean-variance optimization in asset allocation

Question 305

Discretionary Tactical Asset Allocation (TAA)

Answer 305

-Considers market sentiment indicators such as margin borrowing, short interest, and the vol index

Question 306

Systematic Tactical Asset Allocation

Answer 306

-Uses risk factors such as value and momentum to capture short-term returns

Question 307

Equity Style Classifications

Answer 307

-Do not require that attribute pairs be mutually exclusive
-Used to assess mgmt performance relative to a style benchmark
-Used to determine risk and return profiles from specific sets of security attributes

Question 308

Different Types of Transfers

Answer 308

-Will: Activates at the death of the testator, which subjects it to additional expense and exposure to public in the probate process
-Inter vivos Trust: Established prior to grantors death, thus avoiding probate
-Joint Tenancy with Survivorship: Creates automatic transfer from a decedent to the other members of the joint tenancy, also avoiding probate

Question 309

Risk Measures and Client Types

Answer 309

-SWFs may use probability of loss as well as traditional volatility measures
-Volatility of surplus is most likely to be used by a DB pension plan
-Conditional Value at risk is a common risk measure for banks and insurers

Question 310

Traditional Portfolio Construction Approach

Answer 310

-Based on identifying return and risk objectives and divsersifying across asset classes as to maximize returns given a risk tolerance level . Looking at overall asset allocation rather than account by account

Question 311

Liquidity Method of Classifying Assets - Marketable/Liquid

Answer 311

-Equity and Equity Like: Public equity, Long-short equity, hedge funds
-Fixed Income and Fixed Income Like: Fixed income, cash
-Real Estate: Public real estate, commodities

Question 312

Liquidity Method of Classifying Assets - Private/Illiquid

Answer 312

-Equity and Equity Like: Private equity
-Fixed Income and Fixed Income Like: Private credit
-Real Estate: Private real estate, private real assets

Question 313

Portfolio Returns and Fees

Answer 313

Portfolio returns - Trading costs = Gross-of-Fee Returns
Gross of fee returns - Management fees = net of fee returns
Net of fee returns - Admin expenses = Client returns

Question 314

Volatility Skew

Answer 314

-Result of increasing implied vols for OTM puts and decreasing implied vols for OTM calls
-Typically more common than Vol Smile bc investors are more interested in port protection through OTM puts, driving up those option prices through increased implied vol

Question 315

Economic Forecasting Approaches

Answer 315

-Checklist approach: Monitors a wide variety of economic data but developed estimates for model inputs based on subjective judgement
-Economic Indicators and Econometric methods both use inputs derived without subjective judgement in the data, though the selection of data types may require substantial judgement

Question 316

Strategies for Managing Concentrated Positions in Public Equities - Completion Portfolio

Answer 316

-Reinvests the proceeds of sales of the concentrated position in a diversified port which is designed to offset the specific risk of the concentrated position
-Use gain deferral and opportunistic tax-loss harvesting to offset tax liabilities of the concentrated position
-Completion port eventually becomes an index-tracking port once the concentrated position has been significantly reduced in size

Question 317

Strategies for Managing Concentrated Positions in Public Equities - Staged Diversification Strategy

Answer 317

Spreads the sale of the concentrated position over several years, investing the proceeds in a diversified portfolio of stocks (exposure to concentrated position is longer)

Question 318

Strategies for Managing Concentrated Positions in Public Equities - Equity Monetization

Answer 318

-Appropriate for investors with concentrated positions wishing to raise liquidity without selling the position
-Involves 1) Hedging the risk of the concentrated position and 2) Borrow funds, using the hedged position as collateral, and invest in a diversified portfolio

Question 319

Strategies for Managing Concentrated Positions in Public Equities - Exchange Fund

Answer 319

-A partnership which allows investors to contribute their low-basis stock position in exchange for a share in the fund. Since the exchange itself isnt a taxable event, investor can defer cap gains on the disposal of the concentrated position until they redeem investment in exchange fund
-In US exchange fund has minimum investment period of 7 years

Question 320

Different Currency Management Programs: Unhedged

Answer 320

Not likely to have any currency management, with currency transactions taking place according to fund transactional needs

Question 321

Different Currency Management Programs: Passive Hedge

Answer 321

-Likely to hedge all exposures back to domestic currency.
-Likely to utilize currency forward derivatives to ensure domestic investors receive the performance of the underlying securities in their local currencies

Question 322

Different Currency Management Programs: Discretionary Hedge

Answer 322

-Likely to hedge most exposures back to domestic currency.
-Mgmt may maintain exposures to some currencies if its expected to add to overall performance in domestic currency

Question 323

Different Currency Management Programs: Fully Active Hedge

Answer 323

-Does not consider the currency exposures of the portfolio, but instead seeks additional performance from taking currency exposures

Question 324

Proxies While Waiting for Capital Calls for Private Investments

Answer 324

-Public equities for private equities
-Public debt for private credit
-Energy stocks/commodity futures for private real assets
-REITs for private real estate

Question 325

Correlation

Answer 325

Correlation (A,B) = (Covariance(A,B)) / [Std.Dev,A x Std.Dev,B]

Question 326

2-Asset Portfolio Variance

Answer 326

Sig^2, R = w1^2(Var,1) + w2^2(Var,2) + 2(w1)(w2)(StdDev1)(StdDev2)(P,1,2)

Question 327

Carry Trade

Answer 327

-To execute, go long the currency that is at a discount and short the currency that is at a premium in forward market
-If the exchange rate quote is higher than what is implied by the forward points in the duration of the forward contract, mgmt will make a profit

Question 328

Box Spread

Answer 328

-Constructed by:
-Low Strike: taking a synthetic long exposure (long call + short put)
-High Strike: synthetic short position (short call long put)

Question 329

Forward Curve and Yield Curve Assumptions

Answer 329

-If the yield curve in the future = the current implied forward curve at that time then the 1 Yr return from a bond regardless of maturity will = the return of a 1 year bond
-If the yield curve in the future is less than the current implied forward curve at that time then the 1 year return will be greater than the return of a 1 yr bond
-If the yield curve in the future is greater than the current implied forward curve at that time then the 1 year return will be less than the return of a 1 yr bond

Question 330

Self-Attribution Bias

Answer 330

-Emotional bias where they claim credit for the successes (self-enhancing bias) and blame others for failures (self-protecting bias).
-To correct, maintain an accurate recording of all investment decisions and their reasonings, which would provide a clearer picture on the performance attribution
-This is a form of overconfidence

Question 331

Groupthink/Social Proof

Answer 331

-Can occur when a group is made up of indvs with similar backgrounds. What will occur is the indvs will moderate their own viewpoints toward the consensus viewpoint.
-Can be mitigated through better diversification within the group - meaning to include members of different backgrounds and ways of thinking

Question 332

Risk Aversion and Behavior Types

Answer 332

-Those who exhibit individualism (make their own decisions), self-confidence in those decisions, or spontaneity around making decisions will be less risk averse

Question 333

Grinold-Kroner Model and Long Term Assumptions

Answer 333

-Assumption that corp earnings grow at a premium to economic growth for long run not plausible. It implies either an ever rising ratio of economy wide earnings to GDP or earnings accuring to domestic business not included in the index (e.g. private firms) continually shrinking relative to GDP. Neither are likely
-Perpetual share repos would eventually eliminate all shares
-Perpetually rising PE would lead to arbitrarily high P/E

Question 334

Immunization and Rebalancing

Answer 334

-Liabilities that are immunized with a bond portfolio must be rebalanced regularly as the Mac Dur changes over time and as yields change. Otherwise, duration gap will increase and the undefeased liability will experience greater variability
-Must weigh the trade-off between allowing some duration gap vs rebalancing transaction costs. To reduce transaction costs, could use derivatives to manage duration

Question 335

Creating an Accounting Defeasance

Answer 335

-An immunization strategy whereby a certain amount is set aside in cash or high quality (govt) bonds to match required liability cash flows to effectively remove the liability from the balance sheet
-Basically prepays without a prepayment penalty

Question 336

Convexity and Immunization

Answer 336

-Convexity is a measure of the variability of cash flows around the duration of the portfolio.
-Lower CX means less variation in realized return over time, with no CX reflecting a 0 coupon bond. Good when their are no cash flows associated with the liability
-CX greater than the liablities CX is required bc the liabilities will have dispersed cash flows. Otherwise, for large rate changes the value change of the liabilities may be greater than value change for assets

Question 337

Net Equity Exposure and Beta

Answer 337

-Net equity exposure = Absolute long equity positions - absolute short equity positions
-If fund beta is greater than net equity exposure, it implies that on average the stocks in the fund have betas that are greater than 1.0
-If fund beta is less than net equity exposure, implies that on average the stocks in the fund have bets that are less than 1.0

Question 338

Traditional vs Risk-Based Asset Allocation

Answer 338

-Traditional forecasts returns, volatility, and correlations of the asset classes
-Risk-Based estimates each assets exposure to targeted risk factors
Advantages (Risk vs Traditional):
-Allows port mgmt to more accurately target specific desired exposures
-Leads to development of multi-dimensional framework compared to a traditional allocation
Disadvantages
-Sensitive to the observation period and may change over time
-Complex to understand
-Can be difficult to translate risk-factor targets to actual asset classes in the portfolio

Question 339

Var vs CVar

Answer 339

-VaR is the minimum amount you can expect to lose on any given day x% of the time
-CVaR is the average amount you will lose on any given day x% of the time, conditional on exceeding the VaR cutoff

Question 340

Return Attributable to Asset Categories

Answer 340

R,Asset Category X = [Ending value / (Beginning value + contributions)] - 1
Return From Asset Categories = nSUMi=1[w,i(R,i)] - r,f

Question 341

Normal Benchmark, True Active Return, and Misfit Active Return

Answer 341

-Normal Benchmark represents the managers typical positions in his investment universe.
-True active return is active return against a normal benchmark
-Misfit active return is active return against an unsuited benchmark

Question 342

Inverted Yield Curve and Strategies

Answer 342

-The fall in LT YTMs will lead to price appreciation under a Buy and hold strategy
-Higher ST yields would enable mgmt to reinvest bond coupon at a higher rate in a yield rolldown strategy
-Mgmt would face negative carry when financing a bond purchase in the repo market

Question 343

Bond Options and YTM

Answer 343

-Value of call options is negatively related to YTM (decrease in YTM increases value of call option)
-Value of put options positively related to YTM (decrease in YTM decreases value of put option)

Question 344

Bull Flattening

Answer 344

-When the shape of the yield curve flattens from LT rates falling faster than ST rates

Question 345

Bear Flattening

Answer 345

-Shape of yield curve flattens from ST rates rising faster than LT rates

Question 346

Bull Steepening

Answer 346

-Yield curve steepens from ST rates falling faster than LT rates

Question 347

Bear Steepening

Answer 347

-Yield curve steepens from LT rates rising faster than ST rates

Question 348

Liability Types and Model Inputs for Value Estimate

Answer 348

-Liabilities that have less certainty around size and timing of cash flows are likely to use curve duration stats in estimating value
-Liabilities with high certainty around the size and timing of payments will generally be modeled using yield duration stats

Question 349

VC - Seed Stage

Answer 349

-Ventures are still in the idea phase and conducting market research

Question 350

VC - Start Up Stage

Answer 350

-Ventures are developing the product and conducting initial marketing

Question 351

VC - First Stage

Answer 351

-Ventures are producing the producing and selling

Question 352

of Futures Given Value Target

Answer 352

N,F = [V* (1 + r,f)^t] / F,q

F,q = Futures price x Multiplier

Question 353

Straddle vs Strangle

Answer 353

-Both involve buying/selling a put and call option, but a strangle involves using options with different exercise prices

-Strangle Break Even: Upside: High Strike + Net premium
Downside: Low strike - net premium

Question 354

Effective Spread

Answer 354

=Side x 2 x (Trade price - [b+a]/2)
-Effective Spread Transaction Cost = Side x Trade size x (Trade price - [b+a]/2)
-For Volume weighted effective spread, multiply effective spread by the weight of each order relative to total volume of shares orders

Question 355

Sharpe Ratio

Answer 355

=[R,p - R,f] / StdDev,P

Question 356

Estimated Return of Portfolio, Global Market

Answer 356

E(R,p) = R,f + (SR,GM x StdDev,p x Corr(P,GM))

Question 357

Intrinsic Value of Developing Countries Equity Market

Answer 357

V,0 = [D,0 / (r - g,L)] x {(1 + g,L) + (N / 2)(g,s - g,L)}

r = req. return
g,L = long-term normal growth rate
g,S = short-term (current) growth rate
N = # of years to full development

-To get justified forward PE multiple from this, divide V,0 by earnings

Question 358

Fund Raises from Real Estate

Answer 358

-Sale and Leaseback: under this, 100% of the value of the property can be raised if tax loss carryforwards are great enough
-Mortgage Refinancing: Requires a high LTV to refinance a large % of the value of the property

Question 359

Deterministic Forecasting

Answer 359

-Used to determine if a private client is going to meet retirement goals by using simple variable inputs to create a linear model
-Generally simple and unrealistic

Question 360

Insurance Value and Time Passage

Answer 360

-As time passes throughout insureds life, cash value of the policy increases related to the investment performance of underlying assets while insurance value decreases

Question 361

Post-Tax Rebalancing

Answer 361

R,at = R,bt / (1 - t)

Question 362

Estimating Returns for a Tactical Asset Allocation

Answer 362

-First, estimate the VCV matrix using app sample data (NOT Singer-Terhaar approach)
-Then can incorporate VCV matrix into Singer-Terhaar approach to estimate equilibrium asset returns
-Macroeconomic estimates can then by employed into Grinold-Kroner model to estimate equity market returns

Question 363

HHI Index

Answer 363

-Measures the degree of stock concentration in an index
-Effective number of stocks, held in equl weights, that would replicate the degree of concentration of an index = 1/HHI

Question 364

Different Duration Measures

Answer 364

-Key-Rate Duration: Help ID “shaping risk” of a bond, a bonds sensitivity to curvature changes in yield curve
-Effective Duration: Effective for determining bond price changes when cash flows change due to yield level
-Modified Duration: Effective for determining bond price changes when yield levels change by same amt at all maturities

Question 365

Capacity of a Strategy

Answer 365

-Depends on sufficiency, repeatability, and sustainability

Question 366

Intestate

Answer 366

-A decedent without a valid will/a will that doesnt dispose of his property is legally considered to have died intestate

Question 367

Transfers and Taxes

Answer 367

-Gift taxes generally apply when a donor transfers funds during their lifetime (lifetime gratuitous transfer)
-Inheritance taxes arise as the result of a testamentary gratuitous transfer (i.e. as the result of a will)

Question 368

Carhart 4 Factor Model

Answer 368

R,p - R,f = a,p + B,1(RMRF) + B,2(SMB) + B,3(HML) + B,4(WML) + e,p
-Positive alpha will result if the sum of factor returns and risk free rate are less than port return. Therefore, alpha must equal the sum of factor tilt benefits and security selection benefits

Question 369

Objective Function, Mean-Variance Optimization

Answer 369

U,M = E(R,M) - 0.5(lamda)(Var,M)

U,M = Investors utility for asset allocation M
R,M = return for asset allocation M
Lambda = Investors risk aversion coefficient
Var,M = Expected variance of allocation M

Question 370

Methods to Generate Additional Income

Answer 370

-Implement securities lending program: Receive fee on stock loan + return on reinvestment of any cash collateral
-Writing options contracts on securities held: Covered calls/cash-covered puts. Puts on names theyre comfrotable with buying at a given strike
-Dividend capture strategy

Question 371

Methods to Lower Costs without Reducing without Changing Mgmt and Performance Fees

Answer 371

-Reduce admin fees (find cheaper custodian)
-Reduce marketing and distribution costs
-Reduce trading costs (find better broker for lower explicit/implicit costs)
-Change investment approach to more of a buy and hold strategy to reduce frequency of trading

Question 372

Pitfalls in Evaluating back-tested results

Answer 372

-Survivorship bias: Ignoring stocks that have left investment universe due to adverse developments (leads to overly optimistic results)
-Look-Ahead Bias: Using info that was unknown/unavailable at the time an investment decision was made
-Data Mining & Overfitting: Data mining can lead to overfitting
-Transactions Costs
-Constraints on Turnover
-Availability of positions

Question 373

Calculating Delta of Options Strategy

Answer 373

-Simply add the deltas of all positions involved in the strategy

Question 374

MBS and Convexity

Answer 374

-An MBS is a bond with an embedded short call position
-Short call option has negative convexity
-Adding MBS allocation would therefore decrease portfolio convexity and result in smaller benefit from large changes in rates

Question 375

of Options Contracts to Buy Given Notional

Answer 375

=Notional / (strike price x contract size)

Question 376

Delta Hedges

Answer 376

-ATM options provide the best choice to delta hedge any existing positions
-This is difficult to maintain as gamma tends to be largest for ATM options

Question 377

Myopic Loss Aversion

Answer 377

-Concerning oneself more with ST losses than with the big picture of a LT planning strategy
-Makes investors more conservative than their risk profile would warrant
-Can be mitigated by providing longer term compound return data

Question 378

E{Excess Return/Spread)

Answer 378

=Spread,0/Periods per year - (EffSpreadDur x Change(spread) - (LGD x POD)

Question 379

Brinson-Fachler Model Allocation Effect

Answer 379

=(W,p - W,b) x (R,b - B)

-W,p = Portfolio weight
W,b = Benchmark weight
R,b = Benchmark return
B = Overall benchmark return

Question 380

Indices and Arbitrage

Answer 380

-To arbitrage an index, they must be reconstituted
-Reconstitution based on objective criteria increases arbitrage opps as it makes it easier to ID in advance which secs will be exiting/entering the index. This is more difficult when a committee makes the final decision

Question 381

Heuristic Constraints

Answer 381

-Limits imposed upon the construction of the port that are not scientifically proven to be optimal but are generally acknowledged as good practice

Question 382

Self Financing Factor

Answer 382

-One in which the underperforming factor (e.g. LC) could be sold short to purchase the OP facts (e.g. SC)

Question 383

Gamblers Fallacy

Answer 383

-A cognitive behavioral bias where they wrongly predict a reversal to a LT trend

Question 384

Growth Rate in Aggregate Market Value of Equity

Answer 384

=g,N.GDP + %Change(E/GDP) + %Change(P/E) + D/P

Question 385

Economic Balance Sheet

Answer 385

-Includes conventional financial assets and liabilities, as well as extended portfolio assets and liabilities

Question 386

Non-Forfeiture Clause

Answer 386

-Whole life insurance policy feature whereby there is the option to receive some portion of the benefits if premium payments are missed

Question 387

Delay Cost

Answer 387

=SUM(S,j)P,0 - SUM(S,j)(P,d)

Question 388

Execution Risk

Answer 388

-The risk of an adverse price movement occurring over the trading horizon owing to a change in the fundamental value of the security or bc of trading-induced volatility
-This is often proxied by price vol (secs with higher price vol have higher execution risk)

Question 389

Portfolio Alpha, Error Term, and Appraisal Ratio

Answer 389

Alpha,p =R - [r,f - Beta(B - r,f)]
-Var(Error Term) = R^2 - Beta^2(B^2)
-AR = Alpha,p / Std.Dev(Error term)

R = Portfolio return
B = Benchmark return

Question 390

Reserve (Undisclosed) Order

Answer 390

-Used for large orders where only part of the full order is shown

Question 391

Calculating Return Objective

Answer 391

=[(1 +Ann. Distribution Rate) x (1 + Inflation rate) x (1 + management fee)] - 1

Question 392

Rebalancing To Money Duration Target

Answer 392

-Money Duration = MD x Market Value x 0.01
-Rebalancing Ratio = Desired Money duration / Current Money duration
-Cash Requirement = (Rebalancing Ratio - 1) x MV,P

Question 393

Currency Quotes and Options/Forwards

Answer 393

-In general, given a quote of DC/FC, a derivatives contract would be long the FC.

-Call option on DC/FC: Buying FC, selling DC (long FC)
-Put option on DC/FC: Selling FC, buying DC (short FC)
-Futures contract on DC/FC: Long FC

Question 394

Riding the Yield Curve

Answer 394

-Involves buying LT bond and selling it before it matures as to profit from the declining yield that occurs over the life of a bond. Relies on a reasonably static and upward-sloping yield curve
-Works better for steeper yield curves

Question 395

Matrix Pricing, YTM

Answer 395

-Given 2 bonds YTM that are dated longer (H) and shorter (L) the bond you are trying to solve for:

YTM,N = YTM,L + {[(N - N,L) / (N,H - N,L)] x (YTM,H - YTM,L)}

Question 396

PV Factor (PV,t(T))

Answer 396

= 1 / [1 + (r x t/T)]

Question 397

Mean Reversion Strategy

Answer 397

-Relies on the assumption that historical means are significant . -Bonds with extreme deviations from their means (spreads wider by 2-3 std devs) in SR tend to return to their means in LR, therefore appreciating in price

-Best performer: (Current spread - Historical Spread) / Std.Dev of Spread
Pick one with highest number

Question 398

Tracking Error of Portfolio

Answer 398

=RAD(Var,R(Portfolio return - Benchmark return))

Question 399

Calculating Net Payment Cot Index, Insurance

Answer 399

1) Calculate FV of an annuity with given premium and discount rate (N = life expectancy)
2) Calculate FV of an annuity with diven dividend payouts (if any) and discount rate
3) Insurance cost = #1 - #2
4) Calculate Payment of annuity with FV = Insurance cost (#3). This is the interest-adjusted cost per period
5) Divide #4 by the face value of policy (death benefit). This is the net payment cost index

-Note that the type of annuity (normal or annuity due) in Steps 1,3, and 4 depends on when premiums are paid/dividends are received. If Premiums are paid at beginning of period, Steps 1 and 4 would be annuity dues.

Question 400

Items important in Determining Cost of Life Insruance

Answer 400

-Mortality expectations
-The loading that enables an insurance firm to cover expenses and make a profit
-The discount rate used by the insurance company

Question 401

Seagull Spread

Answer 401

-A protective put partially financed by selling an OTM put and call
-Can be viewed as a put spread plus a short OTM call

Question 402

The Bums Problem

Answer 402

-The least credit-worthy constituents in an index tend to increase their debt burden over time, so the bums that have the most debt (and their sector) will tend to be over weighted in importance in a value-weighted index
-Problem that leads to poor index construction

Question 403

Issues with Historical Analysis of Real Estate Returns

Answer 403

-As properties trade infrequently, analysis relies on appraisals
-Since each property is different, the data is heterogeneous
-Published return and vol data is smoothed, understating true vol and distorting correlation estimates

Question 404

Purchasing Power Parity and Exchange Rates

Answer 404

-According to PPP, if Country X has higher inflation than other countries, X domestic currency should depreciate against the other currencies by approx. the difference between X inflation and that in other countries

Question 405

Traded REITs and Correlations

Answer 405

-Traded REITs have relatively high correlations with EQs over ST horizons suggesting they are not good diversifiers over ST
-Traded REITs are more highly correlated with direct RE and less highly correlated with EQs over multi-year horizons

Question 406

Emerging Market Investing Guidelines

Answer 406

Question 407

Dividend Capture Strategy

Answer 407

-Buy a stock just before its ex-dividend date and sell it on/after the date to capture cash dividends
-PM earns alpha when price decrease on ex-div date is less than the size of the cash dividend

Question 408

Shareholder Activism

Answer 408

-Studies show activism at a comp typically leads to improved price momentum and higher DE ratios
-Typically positive excess returns for the shares of comps engaged in activism, both one month before the event date and on the event date itself

Question 409

Microstructure Based Trades

Answer 409

Involve exploiting supply and demand imbalances in the NYSE Trade and Quote (TAQ) Book or other data source, observing positions in the limit book, or other anomalies that may be available for only milliseconds

Question 410

Positive vs Negative Butterfly

Answer 410

-Positive butterfly is a non-parallel yield curve shift that occurs when ST and LT rates shift upwards by more than medium term rates. The shift effectively decreases overall curvature of the yield curve
-Negative butterfly is a non-parallel shift that occurs when ST rates and LT rates shift downwards by more than medium term rates. The shift effectively increases overall curvature of the yield curve

Question 411

Percent Capital Gain Exposure (PCGE)

Answer 411

-An estimate of the % of a funds assets that represent gains
-Measures how much the funds assets have appreciate
-Can be used to gauge the amount of tax liability embedded in a fund, and can be an indicator of possible future capital gain distributions

PCGE = Net gains (losses) / Total Net Assets
-Negative PCGE implies the fund is more likely to be tax efficient going forward