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CFA Level III > R17 - Asset Allocation > Flashcards

R17 - Asset Allocation Flashcards

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1
Q

Tactical asset allocation (TAA) vs Strategic asset allocation (SAA)?

A 
SAA - based on long run capital market expectations by asset class
TAA - short term expectations; add value through mispriced securities and other idiosyncratic things
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2
Q

Asset-liability management approach (ALM) vs asset-only approach?

A

ALM focuses on change in surplus

Asset-only - purely focused on assets and returns, not thinking about liabilities

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3
Q

Dynamic asset allocation vs static asset allocation?

A

Dynamic - considers links between returns in multiple periods
Static - ignores link

ALM typically uses dynamic approach

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4
Q

Return objective default view on principal and what must return cover?

A 
Default: principal to be maintained
Return must cover:
-spending needs
-expected inflation
-management fees
---that's common for foundations and endowments
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5
Q

Risk objective: how to set it and formula for mean variance based approach to select between two portfolios?

A
  • could use mean variance based approach
  • –based on interviews or questionnaires, for example
  • –higher risk RA is 6-8
  • –lower is 1-2

Formula:
Risk adjusted utility of a portfolio (Up)

Up = R - 0.005(A)(variance)

R = expected return
A = risk aversion score of investor
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6
Q

Downside measures of risk:

A

Shortfall risk - exceeding max acceptable dollar loss
Semivariance - variance only of returns below expected return
Target semivariance - SV below some minimum return

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7
Q

Downside measures of risk: Roy’s safety first measure

A

RSF = Rp - Rmar / (portfolio std dev)

Rp = portfolio expected return
Rmar = minimum acceptable return
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8
Q

Checklist for specifying asset class:

A
  1. Assets homogenous and positive correlation
  2. Classes are Mutually exclusive (asset is not in two classes)
  3. Assets are diversifying with low correlation
  4. Class includes most of world’s investable assets (e.g. Not just domestic equity)
  5. Sufficiently liquid
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9
Q

When to add an asset class: shortcut formula?

A 
Add new asset class if:
Sharpe(new asset) > Sharpe (existing portfolio) x correlation (of asset and current portfolio)
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10
Q

What lessens impact of currency risk when investing in foreign markets?

A
  • low correlation of assets and currency return
  • low correlation of currencies in the portfolio
  • passage of time as currency risk diminishes
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11
Q

Why is currency vol more important to consider in bond portfolios investing in foreign markets?

A

Currency vol tends to be higher than bond vol

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12
Q

What political risks exist when investing in foreign markets?

A
  • discriminatory taxation
  • nationalize the asset
  • suspend capital movement
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13
Q

What can cause investing in foreign markets to be more expensive than domestic investments?

A
  • assets may be less liquid so higher transaction costs
  • free-float issues
  • lack of info
  • higher management fees
  • lack of market investment infrastructure (clearing / custody fees, other)
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14
Q

What are two benefits of international investing?

A
  • better returns than mature markets

- bond markets accross different countries tend to be less correlated than equity markets

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15
Q

What is contagion?

A

correlation of asset classes tend to converge toward 1 in market crises

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16
Q

Conditional correlation approach:

A

two correlation matrices:

  1. for normal conditions
  2. for market crises
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17
Q

What is a fully segment market?

A

capital cannot flow freely between markets. risk reflected is standalone risk of that market

18
Q

Integrated market?

A

capital can flow freely. Risk reflected is standalone risk and correlation with global market.

19
Q

What happens in short and long run as market transitions from segmented to integrated?

A

short term: capital inflows bid up equity prices and raise returns

long term: expected future returns decrease because of higher prices. Also, lower vol because economy more mature, info more efficient, political stability

20
Q

What happens to differsification benefits and cost of capital when an economy has become fully integrated?

A

correlation increases so diversificaiton benefits lower

lower stnd dev of market

cost of capital lower facilitating economic growth

21
Q

Steps to establish asset allocation:

A
  • specify permissible classes
  • formulate cap market expectations
  • assess the client
  • determine optimization approach to use
22
Q

what are the six asset allocation optimization approaches?

A
  1. mean-variance
  2. resampled efficient frontier
  3. black-litterman
  4. monte carlo simulation
  5. asset-liability management
  6. experience-based
23
Q

Steps in mean variance optimization approach?

A

Estimate: return, std dev, correlation by asset class

use computer to solve for combo of assets with lowest variance at each level of expected return

24
Q

Instability of MVO efficient frontier?

A

inputs only estimates
changes may be statisticaly insignificant
following changing asset allocation would increase transaction costs

25
Q

Steps in resampled efficient frontier?

A
  1. monte carlo takes random sample of E(R), std dev, corr. from original efficient frontier and makes a resampled efficient frontier
  2. repeat process many times to get “cloud” of possible values
  3. Optimal asset allocation is the average of the allocations of this “cloud”
26
Q

Black-Litterman model of optimal asset allocation?

A

take existing global asset class weights and covariances and find plug implied return necessary to generate those figures

manager adjusts these figures afterward

27
Q

strengths and weaknesses of monte carlo simulation for finding optimal asset allocation?

A

pros:

  • not static
  • distribution of outcomes and probabilities

cons:

  • complex
  • expensive
  • reliant on inputs
28
Q

How to use ALM to find optimal asset allocation:

A

efficient frontier generated on expected surplus versus volatility of surplus

29
Q

pros and cons of ALM for asset allocation?

A

pros:

  • considers liabilities
  • assess prob of meetin liabilities

cons:

  • estimation bias
  • needs another approach (like Monte Carlo) to address multi-period concerns
30
Q

Pros and cons of experience based techniques for asset allocation?

A

pros:

  • generally consistent with conclusions of more sophisticated techniques
  • easy to understand and inexpensive

cons:

  • not sound theory
  • maybe too simplistic for portfolio situations
31
Q

Corner portfolios?

A

where one asset class meets another on plot of MV allocation results.

Allocation is weight required to get desired expected return between two corner portfolio returns.

weighting is applied to allocations and std dev of each portfolio to get weighted average of each measure

32
Q

What is the capital allocation line (CAL)?

A

the tangent portfolio at a certain risk free rate

33
Q

How could you approximate the CAL?

A

choose portfolio from EF with highest sharpe ratio

34
Q

How you achieve portfolio return target when allocating between tangent portfolio and risk free asset?

A

do weighted average of E(R) for tangent port and risk free asset that gets return target.

Will likely be negative weight for risk free asset, meaning borrow at risk free rate.

allocate the weights for each asset class in the tangent portfolio based on weight calculated in step 1.

35
Q

how to calculate standard deviation of portfolio when using tangent portfolio and risk free asset?

A

use the weighted average for tangent and RF that you calculated when doing portfolio E(R) and apply to stnd dev.

stnd dev for risk free asset is 0

36
Q

What to consider when doing SAA for individual investors?

A
  • current/future needs
  • after-tax returns focus
  • personality type and risk aversion
  • total wealth
  • correlation betw HC and FC
  • –diversify equity/bond like HC with bond/equity financial assets
  • mortality risk (dying before FC is accumulated)
  • –hedge with life insurance
  • Longevity risk (outliving FC)
  • –hedge with annuities
37
Q

SAA objective for defined benefit pension plans?

A

meet plan liabilities and retirement obligations of plan beneficiaries

38
Q

SAA objective for foundations and endowments?

A

meet spending requirements and preserve real value of principal

39
Q

Bank’s investment portfolio is a residual use of funds to:

A
  • manage BS interest rate risk by adj asset duration in relation to liability duration
  • provide liquidity
  • generat eincome and return
  • adj. credit risk
40
Q

Three approaches to TAA?

A
  1. Use current prices to project returns
  2. Relative expected risk/return - risk/return seems high now, but economy improving so can increase allocation
  3. Markets mean revert

CFA Level III (17 decks)

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