TOPICS IN RETURN MEASUREMENT & Adjustments to Prior Period Returns

Question 1

Active investors have two ways to act on a view on the current value of a security and potentially earn a return:

Answer 1

If the view is that the security is undervalued, purchase it and earn a gain if it goes up in value.
If the view is that the security is overvalued, sell it short and earn a gain if it goes down in value.

Question 2

Define short selling

Answer 2

Short Selling
Short selling is used by investors to profit from a negative view on a stock. Although not all instruments can be sold short and shorting is restricted in some markets, strategies using short selling are of great interest to many investors.

Question 3

The 1st stage of short selling is:

Answer 3

The investor creates an account with a prime broker and deposits $1,000 cash. Prime brokers provide services required to create the short segment of a portfolio. The prime broker facilitates short selling by identifying long owners who are willing to lend their securities. The prime broker may be affiliated with the custodian bank holding the investor’s long securities and cash, or it may be a separate firm

Question 4

The 2nd stage of short selling is:

Answer 4

A portion of the deposited cash—in this case, $900—is used to purchase Stock L, which the investor expects to increase in value. The investor now has a long position in Stock L. The rest of the cash, $100, is held as a liquidity buffer because the prime broker is aware of the investor’s intention to hold a short position. The liquidity buffer or margin is available to cover margin calls if the value of the short securities goes up instead of down. Margin is required because a short position has theoretically unlimited loss potential. As the value of a short security goes up, the prime broker will demand additional cash collateral from the short seller in the form of periodic margin calls.

Question 5

The 3rd stage of short selling is:

Answer 5

The prime broker identifies holders of the securities that the investor wants to sell short and in this case borrows $900 worth of Stock S. The investor now has a short position in Stock S. In this example, Stock S does not pay a dividend while it is held short. If a stock were to pay a dividend while held short, then the short seller would be responsible for paying the dividend to the lender. (In this case the calculation of the return on the short position would account for the cost of reimbursing the dividend to the lender.)

Question 6

The 4th stage of short selling is:

Answer 6

The broker then sells the stocks, with the short sale proceeds going to the lender or the lender’s agent (typically a bank) as collateral. This also motivates the short seller to return the borrowed securities. Long investors who choose to lend their securities do so in order to earn a small incremental return on their long position. When short positions are collateralized with cash, the broker invests the cash collateral. A percentage of the interest earned on the invested collateral is returned to the borrower as a fee rebate. The difference between the income on the cash collateral and the income rebated to the borrower is shared between the lender and the lending agent. When securities, rather than cash, are accepted as collateral, the borrower pays a fee that is split between broker and lender. Collateral is carefully managed, because in exchange for the income from reinvested collateral, the lender and the broker assume the risks of lending securities. Risks to the security lender include (1) that the value of the collateral declines and does not cover the value of the securities and (2) that the borrower does not return the securities.

Question 7

Define margin call and fee rebate?

Answer 7

Margin Call: A request for the short seller to deposit additional funds to bring their balance up to the initial margin.

Fee Rebate: In a short sale, the portion of the income earned on the invested collateral that is returned to the borrower of shares.

Question 8

Any portfolio that uses both long positions and short selling can be called a long–short portfolio, Define Long- short portfolio

Answer 8

A portfolio that contains both long positions in assets expected to rise in value and short positions in assets expected to fall in value.

Question 9

Long–short strategies that match long and short risk exposures are called market-neutral strategies. Define market neutral

Answer 9

They are labeled “market-neutral” because they intend to eliminate exposure to the market and earn gains only by exploiting security- or sector-specific factors. Market-neutral strategy returns are theoretically uncorrelated with the market; in other words, they should have a beta close to zero

Question 10

Another common strategy using short selling is a short extension strategy. Give an example.

Answer 10

A portfolio consisting of a long position of 100 plus x percent and a short position of x percent.

For example, a 130/30 strategy is leveraged on the long side to 130% of the market exposure, and this is offset by short positions worth 30% of the gross portfolio exposure. If the portfolio is worth $100, then there are approximately $130 in long positions and $30 in short positions. This strategy, in effect, generates $160 exposure to the manager’s stock-picking ability with a $100 net market exposure.

Question 11

The first step in performance measurement is to take portfolio valuations as inputs and then calculate single- and multi-period returns. When short positions are present, we need to consider the following:

Answer 11

Return calculation for long positions in segments and securities (segments are groups of securities within a portfolio—e.g., countries, sectors, or industries)
Return calculation for short positions in segments and securities

Question 12

As you will see, it is important to use a convention for describing performance in the presence of short positions. Our convention is to report

Answer 12

a return on the underlying asset as positive if the asset increases in value, regardless of whether it is held long or short, and
a return on the underlying asset as negative if the asset decreases in value, regardless of whether it is held long or short.

Question 13

The next step is to communicate performance taking into account whether the security is held long or short in the portfolio. Using the previous example, if the portfolio had a long position in the security, then the portfolio enjoyed a positive contribution due to the 10% return in the underlying security asset.

True/False

Answer 13

The next step is to communicate performance taking into account whether the security is held long or short in the portfolio. Using the previous example, if the portfolio had a long position in the security, then the portfolio enjoyed a positive contribution due to the 10% return in the underlying security asset.

Question 14

The presence of short positions means that the calculation of contributions to return requires special consideration:

Answer 14

First, the weights need to be calculated such that they add up to 100%. To do this, we sum the portfolio values—long positions with positive signs and short positions with negative signs.
Then, market values are converted into weights by dividing each position value by the total portfolio market value. Because there are short positions, the long position weights will exceed 100%.
Next, again assuming a convention of negative weights representing short positions and security returns representing the return on the underlying security, contribution to return is calculated as weight times return. The underlying security held short fell in value by −16.7% which, multiplied by the beginning weight of −30%, leads to a positive contribution of 5% at the portfolio level. In this example, the value of the portfolio increased from $100 to $105 over the period, and the entire gain is made up of the positive contribution to return from the short segment.

Question 15

Which of these factors is not a consideration when calculating the return on a portfolio that includes short positions?

a. Securities lending fee rebate
b. The probability of a margin call
c. Interest on the collateral supporting the short positions

Answer 15

B is correct. The probability of a margin call is not considered in the calculation of portfolio return. The securities lending fee rebate is included because any lending fees that are shared by the portfolio count as income over the period. The interest on collateral supporting the short positions is explicitly included in the portfolio return calculation because the interest is income earned on the positions in the portfolio over the period.

Question 16

A portfolio has the following transactions:

a. The portfolio manager purchases 10 shares of Security A at $5.00 per share and 10 shares of Security B at $5.00 per share.
b. The portfolio manager shorts 10 shares of Security C at $1.50 per share and 10 shares of Security D at $1.50 per share.
c. $1 of interest accrues on the cash collateral posted to cover the short positions.

The following are the end-of-period per-share prices:
Security A: $6.00
Security B: $4.00
Security C: $1.60
Security D: $1.30
The portfolio return is closest to:
−2.00%
1.00%.
2.00%.

Answer 16

C is correct. The return is 2% because the total value of the portfolio increased from $100 to $102. There is $30 in collateral to cover $30 in short positions [(10 × 1.50) + (10 × 1.50)]. The beginning value of $100 is calculated using the prices and positions of the four securities plus the collateral: (10 × 5.00) + (10 × 5.00) − (10 × 1.50) − (10 × 1.50) + 30. The ending value of $102 is calculated as (10 × 6.00) + (10 × 4.00) − (10 × 1.60) − (10 × 1.30) + $30 cash + $1 of interest.

Question 17

Which of the following is most accurate regarding a portfolio using a 13030 short extension strategy?

a. The portfolio is market-neutral.
b. The portfolio has a net 130% long exposure to its given market.
c. The strategy allows managers to add value by identifying both assets that are expected to perform well and assets that are expected to perform poorly in a given market.

Answer 17

C is correct. The 13030 short extension strategy can go both long and short, enabling the manager to profit from the ability to identify in advance assets that are going to over- or underperform others. A market-neutral strategy would have equal long and short exposures neutralizing its exposure to the underlying market. A 13030 portfolio is in net 100% exposed to the underlying marke

Question 18

Which of the following is most likely a reason for a long–short equity portfolio to establish ready access to cash?

a. To pay for new short positions
b. To reimburse the lender of a security for dividends
c. If the prices of stocks held short go down, the broker may ask for an increase in collateral.

Answer 18

B is correct. Having ready access to cash facilitates the reimbursement of dividends to the lender of a shorted security (ready cash also helps in meeting margin calls if a stock held short goes up in value and the broker asks for additional collateral). The establishment of a short position generates cash: To create the position, the manager borrows securities and then sells the borrowed securities for cash.

Question 19

There are two main classes of derivatives:

Answer 19

forward commitments (futures, forwards, and swaps) and contingent claims (options).

Question 20

Define Forward commitments

Answer 20

Forward commitments are commitments or promises to buy or sell an asset at some specified future date.

Question 21

Define options

Answer 21

Options give the owner the right, but not the obligation, to buy or sell an asset. Derivatives can be traded on an exchange or over the counter (OTC).

Question 22

In studying the treatment of derivatives in performance measurement, the standard formulas for return calculation (time-weighted rate of return, unit price method)3 are still valid. T/F

Answer 22

True
In studying the treatment of derivatives in performance measurement, the standard formulas for return calculation (time-weighted rate of return, unit price method)3 are still valid.

Question 23

Define Notional value

Answer 23

notional market value is the value of the underlying security where changes in the market value of the underlying security would equal changes in the combination of futures and the cash position. The notional market value (also known as notional exposure, or NE) of a futures contract is defined as the value of an underlying security that would cause (approximately) the same change in net realizable value for a given (infinitesimal) change in the price of the underlying security as the change in the combination of futures and the associated cash position

Question 24

The purpose of calculating the notional exposure is to estimate the economic exposure—that is, the risk of the loss that one experiences if one invests in an asset class. Economic exposure is:

Answer 24

The risk of loss from a position in an asset class

Question 25

Define a futures contract

Answer 25

A futures contract is a standardized binding contract traded on an exchange between two parties to exchange a specified asset of standardized quantity and quality for a price agreed today with delivery occurring at a specified future date

Question 26

Valuation approaches for futures contracts are based on a consideration of the cost of carry. Define cost of carry.

Answer 26

The net of the costs and benefits of holding, storing, or “carrying” an asset.

Question 27

Under the assumption that there are no arbitrage opportunities, the investment in the underlying must deliver the same return as the investment in a futures contract and a cash position corresponding to the notional value of the underlying. Thus, the following conceptual relationship holds:

Answer 27

Futures price=Spot price+Cost of financing−Net Income from underlying

(Cost of financing−Net Income from underlying)= cost of carry

Question 28

A more precise expression for the price of a futures contract with delivery date T at t (t < T) is given by

Answer 28

Ft=(Bt−E(1+rfin)t˜−t)(1+rfin)T−t

where

Ft	 = 	Futures price according to the cost-of-carry approach at t
Bi	 = 	Price of the underlying at t
rfin	 = 	Cost of financing on an annual basis
E	 = 	Income of the underlying (e.g., dividends)
t˜	 = 	Date of the cash flow

Question 29

We define the notional exposure of futures contracts as:

Answer 29

NE = Sign×Number of contracts×Contract value multiplier×Price underlying

where Sign equals +1 for long positions and −1 for short positions. Notice that the price of the underlying is used instead of the futures price.

Question 30

Define CTD and when it is used?

Answer 30

CTD is The bond which, based on the then-prevailing price, financing rates, and conversion factor, is the lowest cost to deliver upon expiry of a futures contract.

Because the price of an interest rate futures contract is closely linked to the price of the cheapest-to-deliver (CTD) bond, choosing this specific bond provides another option for the mapping. From a basket of deliverable bonds, the CTD bond is the one that—based on the then-prevailing price, the level of short-term financing rates, and the pre-specified conversion factor—has the lowest cost to deliver upon expiry of the contract. The bond expected to be cheapest to deliver may vary frequently over the life of the futures contract.

Question 31

Assume the portfolio manager wishes to increase the duration of the portfolio and does so by purchasing 10 Euro Bund futures contracts, which have maturities of 8-10 years. The futures price is 105% and the contract multiplier is 100,000.19 For practical reasons, the notional exposure is calculated using the futures price rather than the price of the underlying.20 The notional exposure is then given by

Answer 31

NE = Sign×Number of contracts×Contract value multiplier×Futures price
= 1×10×100,000×€(105100)
= €1.05m

Question 32

Define a forward contract

Answer 32

forward contract (or forward) is a non-standardized (and non-exchange-traded) contract between two parties to buy or sell an asset at a specified future time at a price agreed upon today.

Question 33

The value of a (long) forward investment at time t1 with forward contract maturity T and price change between t0 and t1 is23

Answer 33

(Ft1−Ft0)1(1+rfin)(T−t1)

Question 34

A call option behaves very differently depending on its moneyness. Define moneyness

Answer 34

The relationship between the option exercise price and the underlying price.

Question 35

The price relationship between the option and the underlying can be approximately expressed by the option delta, which is a change in the value of the call for a unit change in the value of the underlying. Define the option delta

Answer 35

The delta is the change in call option value relative to a change in the value of the underlying.

Question 36

For a deep in-the-money call option, the delta (d) is close to 1, which means that a change in the underlying will cause a change in option price of the same magnitude. The delta of a deeply out-of-the-money call option is close to zero, which means that a change in the price of the underlying will have almost no effect on the option price. When the stock price is near the strike price of the option, delta is typically close to 0.5. T/F

Answer 36

For a deep in-the-money call option, the delta (d) is close to 1, which means that a change in the underlying will cause a change in option price of the same magnitude. The delta of a deeply out-of-the-money call option is close to zero, which means that a change in the price of the underlying will have almost no effect on the option price. When the stock price is near the strike price of the option, delta is typically close to 0.5.

Question 37

The relevant economic exposures can be determined using a method similar to the procedure for futures. The notional exposure assumes the following form:

Answer 37

NE = Sign × δ ×
Number of contracts × Contract value multiplier × Price of underlying

The sign is +1 for a long position in the underlying and −1 for a short position in the underlying.

Question 38

Define a swap contract

Answer 38

A swap is an instrument in which counterparties exchange cash flows; the cash flows of one party’s financial instrument are exchanged for the cash flows of the other party’s financial instrument.

Question 39

The respective exposures can thus be directly derived from the market values of the individual instruments:

Answer 39

Exposure to Instrument 1 = Market value of Instrument 1

Exposure to Instrument 2 = −Market value of Instrument 2

Question 40

A portfolio consists of US$-denominated bonds with maturities between zero and six years and a cash position. The net asset value of the portfolio equals US$38.5m. The portfolio manager enters a swap agreement in which he agrees to pay six months Libor in exchange for receiving an annual payment of 3% fixed on a notional value of US$10m. The swap has a remaining life of two years. If the value of the fixed instrument equals US$10.25m and that of the floating instrument equals US$9.88m, the exposures are:

Answer 40

Exposure in the fixed-rate position with the two-year maturity: +US$10.25m
Exposure in the floating-rate position: −US$9.88m

Question 41

Assume that the net income derived from an underlying stock index is less than the cost of financing the spot purchase. If one uses the futures price in the calculation of the notional exposure from the index future, then one would:

a. overestimate the exposure.
b. underestimate the exposure.
c. estimate the exposure accurately.

Answer 41

A is correct. With the net income from the underlying stock index being less than the cost of financing, the futures price is higher than the underlying stock index price. The use of the futures price, rather than the price of the underlying, in the calculation of the notional exposure would overestimate the exposure

Question 42

All else being equal, the notional return of a forward contract is most likely different from the futures contract notional return because:

a. forwards are usually traded on margin.
b. futures are not traded on a stock exchange.
c. cash flows of the forward occur at contract maturity.

Answer 42

C is correct. Because the cash flow occurs at maturity, it needs to be discounted in the valuation. Therefore, returns will in general be different. Forwards do not usually require margin, and futures are traded on exchanges

Question 43

Assume that a portfolio manager sold five contracts of EURO STOXX 50 Index Futures. The contract value multiplier for such instruments is 10. On 6 February, the index had a price of €3,393. The portfolio has a position in the underlying European stocks of €170,000. The portfolio manager in trading these futures in regard to the overall position in European stocks is most likely intending to:

a. increase exposure.
b. create a neutral portfolio position.
c. create a short position in terms of economic exposure.

Answer 43

B is correct. The notional exposure created by the short position in the futures is given by NE = −1 × 5 × 10 × €3,393 = −€169,650. Thus, the net economic exposure in the European stock segment is given by €350 (€170,000 − €169,650), which is close to zero. The net equity position is approximately neutral

Question 44

Consider a long position in 10 DAX futures contracts. The contract value multiplier of the DAX futures is 25. The following are the values at close:

31 Dec. 31 Jan.

DAX 9,805 10,694
DAX Futures 9,986 10,708
Given a return on an associated cash position of 0.04%, the notional return of the futures contract position is closest to:

a. 7.36%.
b. 7.40%.
c. 9.11%.

Answer 44

B is correct. The initial notional exposure of this position is NE = 10 × 25 × €9,805 = €2,451,250. The notional income is €2,451,250 × 0.04% = €980.5. Thus the notional return is

10×25×(10,708−9,986)+980.52,451,250=7.40%
Response A omits the interest on the cash position. Response C uses the change in the price of the underlying instead of that for the futures prices.

Question 45

A portfolio manager buys 10 call options on the EURO STOXX 50 to obtain a long position on European equities. On that day, the underlying index has a value of €3,404. The strike price of the option is €3,500 and the contract multiplier is 5. If the delta of the option is 0.4 and the price of the option is €80, the notional exposure of this position is closest to:

a. €1,600.
b. €68,080.
c. €170,200.

Answer 45

B is correct: NE = 5 × 10 × €3,404 × 0.4 = €68,080

Question 46

Define domestic ccy.

Answer 46

The currency an investor uses for consumption purposes (e.g., Canadian dollars are the domestic currency for a Canadian investor). Also called base currency or home currency.

Question 47

Define Spot exchange rate

Answer 47

The rate at which one currency can be exchanged for immediate delivery of another currency.

Question 48

Define Currency spot return:

Answer 48

The percent change in an exchange rate over a specified time period.

Question 49

The returns in the base currency can be calculated as follows for each month:

Answer 49

[(End-of-month market value converted to the base currency at the rate in effect at the end of the month)/(Beginning-of-month market value converted to the base currency at the rate in effect at the beginning of the month)] − 1.

Question 50

Define Forward currency contracts

Answer 50

Contracts between two parties for the exchange of a specified amount of currency at a fixed exchange rate at a future date.

Question 51

he potential for this covered interest arbitrage results in a relationship known as covered interest rate parity, which states that the forward rate will be a function of the spot rate and relative interest rates in the two countries. Define Interest rate parity

Answer 51

Relationship which states that the forward rate will be a function of the spot rate and relative interest rates in the two countries.

F0=S01+rFC1+rDC

Question 52

he return on a forward currency contract is not the same as the spot currency return (unless the interest rates of both currencies are identical). The return on the forward currency contract is known as the forward currency return (or simply the forward return or currency surprise).34

The currency forward return for period t is

Answer 52

St+1Ft−1

where

St+1 = spot exchange rate at time t + 1

Ft = forward exchange rate at time t for conversion at time t + 1

Question 53

British pounds at a higher rate of interest than can then be reinvested in US dollars. This is called the cost of hedging. Ex ante, this cost may be accepted by risk-averse investors to reduce their currency exposure.

Answer 53

cost of hedging is in the case of currency forward contracts, the condition where using the forward rate results in a lower return than the current spot rate.

Question 54

In this case, there is a benefit of hedging. The investor benefits from reduced currency risk and a forward premium. Benefits of hedging are:

Answer 54

In the case of currency forward contracts, the condition where using the forward rate results in a higher return than the current spot rate.

Question 55

Define Ccy overlay

Answer 55

The case where a portfolio’s currency exposures are managed separately from the management of the portfolio itself.

Question 56

The overlay return is then added to the underlying portfolio’s return in the base currency (here, GBP) to arrive at the hedged return. T/F define hedged return

Answer 56

When using currency forward contracts, the return that reflects the foreign asset return in local currency terms and the forward discount or premium.

Question 57

There are two types of overlay strategies:

Answer 57

Those designed to reduce (or hedge) existing currency exposures
Those designed to generate excess return from active currency management

Question 58

lthough this index is described as 60% partially hedged into USD, the actual currency exposure to USD is greater than 60% because there is USD exposure in the unhedged part of the index, which arises from the index’s 40% exposure to US securities. The actual USD exposure can be derived from the following equation:

Answer 58

h × 100% + (1 − h) × w$

where

h = the partial hedge rate (or hedge ratio)

w$ = the weight of USD exposure in the unhedged index

Question 59

The start value of a portfolio in Australian dollars (AUD) is AUD135m, and the end value is AUD160m. The currency spot exchange rate is 2.0 AUD/GBP at the start of the period and 1.8 AUD/GBP at the end of the period. The base currency return of the portfolio in British pounds (GBP) is closest to:

a. 6.67%.
b. 29.63%.
c. 31.69%.

Answer 59

C is correct:160/1.8135/2.0−1=88.8967.5−1=31.69%

Question 60

Which of the following types of returns are not achievable for investors in a different reporting currency?

a. Base
b. Local
c. Hedged

Answer 60

B is correct. Local returns (returns denominated in the local currency) are unachievable for investors with a different reporting or base currency. Hedged and base currency returns are achievable.

Question 61

The return on a forward currency contract is known as the:

a. local return.
b. currency surprise.
c. spot currency return.

Answer 61

B is correct. The return on a forward contract is known as the forward return or currency surprise because it is the element of the return that is unknown.

Question 62

Assume a current spot rate of 0.8 EUR/USD

Assume an annual rate of interest in USD of 1%

Assume an annual rate of interest in EUR of 3%

The one-month forward rate of USD against the EUR is closest to:

a. 0.7987.
b. 0.8013.
c. 0.8158.

Answer 62

B is correct. At the current spot rate, EUR100 would buy EUR100 × 1.25 = USD125. Borrowing EUR100 at an annualized interest rate of 3% for one month would cost 100 × 100×(1.03)1/12=100.2466.

Investing USD125 at an annualized rate of 1% for one month would yield 125 × 125×(1.01)1/12=125.1037.

The forward value of USD against the EUR in one month’s time is, therefore, USD125.1037 = EUR100.2466;

USD1=100.2466125.1037=0.8013

Question 63

Which of the following statements is incorrect? Currency overlay:

a. portfolio values can be positive or negative.
b. portfolio returns must be linked geometrically.
c. portfolios can be used to generate excess return from active currency management.

Answer 63

B is correct. Currency overlay is not an asset; you cannot invest in a currency overlay portfolio and receive returns that are geometrically linked over time.

Question 64

In an international benchmark, hedged index returns are:

a. lower than local returns.
b. higher than local returns.
c. can be either lower or higher than local returns.

Answer 64

C is correct. The difference between the local and hedged index returns represents the interest rate differential between the two currencies concerned, which could result in either a “cost” or “benefit” of hedging.

Question 65

A single futures contract can be broken into two pieces:

Answer 65

a long notional exposure to the underlying and a short “financing instrument” representing the (theoretical) amount borrowed to finance the position. By isolating the components and calculating a return on each, the analyst can calculate returns reflecting the intended use of the derivative in the portfolio.

Question 66

For a variety of reasons, there are often exceptions discovered between what the money manager believes the portfolio looks like and what the custodian shows. There can be a variety of reasons for this, including:

Answer 66

Missed trades. Perhaps a trade was processed against the wrong account or wasn’t correctly registered on either system.
Mishandling of corporate actions. On occasion, a corporate action may have been missed completely or simply not processed correctly.
Missed cash flows. Perhaps the client added or withdrew funds from the account; while the custodian may have recorded these actions, the manager may not have been aware of them and therefore didn’t record them on the portfolio accounting system.
Pricing problems. This is especially a problem for securities that aren’t actively traded or for which market prices aren’t available. We may have overridden a price, only to learn later that our manually applied price was incorrect. Pricing inconsistencies can lead to erroneous rates of return being reported. This is especially problematic when the problems are related to capital flows.
Exchange rates. Differences in the sources for exchange can also cause differences. Sometimes huge differences.

Question 67

Unfortunately, the story doesn’t end here. On occasion, we will learn of problems that occurred in a prior period, after the reconciliation has been done, which may cause us to reconsider the accuracy of previously reported rates of return. What can cause these problems? Well, they are often similar to the problems we identify during the reconciliation process:

Answer 67

Failed trades. Perhaps a trade that was booked wasn’t able to settle, necessitating the trade being cancelled.
Incorrectly processed trades. Trades may have been recorded and reconciled but later found to be in error.
Problems with corporate actions. Often, all the details necessary to properly process a corporate action may not be available for several weeks, possibly months following the announcement. For example, with a spin-off, there may be shares plus cash issued, but the specifics may not be known for some time. Once they are known, backdated adjustments may be needed.
Pricing problems. Perhaps as a result of misapplied corporate actions or trade problems, we may also have pricing problems.

Question 68

How Firms Handle Retroactive Adjustments?

Answer 68

Ascertain the materiality of the correction. In order to do this, we must calculate the return after the correction is made and compare it with the previously reported number(s). Firms will often establish (perhaps not formally) some cut-off, below which nothing will be done. Criteria such as the change relative to the published return or how far back the change would have to be made will be considered.

Freezing of time periods. Many firms will “freeze” a time period, after which no change will be applied.2 While we can understand the reasoning behind this, depending on how recent the freezing may be applied, we may be creating some problems. For example, if our policy is to freeze any returns reported prior to the last quarter, we’re not allowing much of a window for adjustments. Freezing may be applied to the previous calendar year with a lagging period of six months (after verification). (If a material return error does not wash out over time, then the firm has no choice but to recalculate. Investment advisors cannot knowingly report incorrect returns.)

Question 69

What are the Proposed Approaches used on handling prior period adjustments and that these policies should be strictly adhered to:

Answer 69

Written Policies and Procedures

Definition of Materiality: Two possibilities: absolute and relative. While our table shows the changes in absolute terms, we might want to consider materiality based upon relative magnitude as well.

Freezing Time Periods

Question 70

The policy should state when time periods are “frozen” and what would be done if a very large change had to be applied.

The Process

Answer 70

Step 1. Recalculate the returns.

Step 2. Compare degree of correction to the materiality table. If the magnitude warrants action, provide to a responsible party (individual or committee) for review. This may also go through the firm’s legal or compliance department for review.

Step 3. Decide on what action to take. Document the original number, the corrected figure, and the action taken.

Question 71

Regarding handling corrections, we propose some fairly basic standards, which we feel the industry should follow. As you’ll see, they are rather brief:

Answer 71

1. Develop and maintain a written policy: All firms (who are subject to as-of adjustments, (and who isn’t?)) should develop and maintain written policies and procedures that outline what steps they take in the event of changes to prior period returns. Any as-of changes (whether or not action is taken) should be documented (the change, the reason for the change, the action(s) taken).
   This is in line with GIPS, which now mandates the development of policies and procedures. This is just one of those policies which a firm should have.
2. Make available upon request: Written policies must be made available to clients and prospects, upon request.