Vocab Words Flashcards
Accounting defeasance
Also called in-substance defeasance, defeasance is a provision in a contract that voids a bond or loan on a balance sheet when the borrower sets aside cash or bonds sufficient enough to service the debt.
(defeasance: the action or process of rendering something null and void)
- -> In-substance defeasance occurs when a firm irrevocably deposits cash or other assets Into a trust for the sole purpose of making principal and interest payments on debt as the payments become due.
Accumulation phase
Phase where the government predominantly contributes to a sovereign wealth pension reserve fund
Active management for a stable upward sloping yield curve
a changing yield curve?
Active management for a stable upward sloping yield curve
- buy and hold: extend duration to get higher yield
- roll down the yield curve: portfolio weighting highest for securities at the long end of the steepest yield curve segments, maximize gains on securities from declines in yield as time passes
- sell convexity to increase yield(higher yield bonds have less convexity)
- carry trade: borrow at a lower rate to purchase securities with higher rates
Active management for a changing yield curve
- increase portfolio duration if rates are expected to decrease, decrease duration if rates are expected to increase
- increase portfolio exposure to key rate durations where relative decreases in key rates are expected. Decrease portfolio exposure to key rate duration where relative increases in key rates are expected (The key rate is the interest rate at which banks can borrow when they fall short of their required reserves. )
- long option positions are a more effective way to add convexity. Short option positions reduce convexity.
Active return
–> how to calculate it
The portfolio’s return in excess of the return on the portfolio’s benchmark.
Exp. Active return =
info. coefficient x square root of breadth x s.d. of active return x transfer coefficient
- info coef: The information coefficient shows how closely the analyst’s financial forecasts match actual financial results. The IC can range from 1.0 to -1.0, with -1 indicating the analyst’s forecasts bear no relation to the actual results, and 1 indicating that the analyst’s forecasts perfectly matched actual results.
- Breadth: The number of truly independent decisions made each year.
- -> if a manager selects ten stocks every month, his breadth is 10 x 12 = 120. If a manager makes a selection every quarter, his breadth is 4
- s.d. of active return: the difference between the benchmark and the actual return aka the active risk
- transfer coef: defined as the correlation between the risk-adjusted alphas and active weights. The TC is an objective measure of how much of the alphas’ information is transferred into a portfolio and is a measure of portfolio construction efficiency
Active risk
–> how to calculate
Active risk aka tracking error is a type of risk that a fund or managed portfolio creates as it attempts to beat the returns of the benchmark against which it is compared. Active risk is the difference between the managed portfolio’s return less the benchmark return over some time period. Actively-managed funds will have risk characteristics that vary from their benchmark. Generally, passively-managed funds seek to have limited or no active risk in comparison to the benchmark they seek to replicate.
–> a pm can completely control active share (weightings) but not active risk. If a manager switches out a pair trade with a less correlated pair trade, the active risk will increase (i.e. Fund 3 held active positions in two automobile stocks—one was overweight by 1 percentage point (pp), and the other was underweight by 1pp. Fund 3 trades back to benchmark weights on those two stocks and then selects two different stocks, one energy stock and one financial stock. Fund 3 overweights the energy stock by 1pp and underweighted the financial stock by 1pp increasing the funds active risk but leaving active share unchanged)
active risk =
square root of [ (year 1 port return - year 1 benchmark return)^2 + (year 2 port return - year 2 benchmark return)^2… etc / (n-1)]
–> The level of active risk will rise with an increase in idiosyncratic (individual) volatility.
I.e you could benchmark to a sector and neutralize that factor exposure (lowering the active share) but take concentrated bets within a factor which increases your active risk
–> The active risk attributed to Active Share will be smaller in more diversified portfolios.
–> combining a fund with high covariance to a portfolio will lower active risk of the overall portfolio (high covariance = lower the tracking error)
–> All portfolios have risk, but systematic and residual risk are out of the hands of a portfolio manager, while active risk directly arises from active management itself. (sector bets are an example of active risk)
–> In a single-factor model, if the factor exposure is neutralized, the active risk will be entirely attributable to the Active Share—a consequence of the manager deviating from benchmark weights.
Active risk budgeting
Risk budgeting addresses the question of which types of risks to take and how much of each to take. Active risk budgeting addresses the question of how much benchmark-relative risk an investor is willing to take. At the level of the overall asset allocation, active risk can be defined relative to the strategic asset allocation benchmark. At the level of individual asset classes, active risk can be defined relative to the benchmark proxy.
Active share
–> equation to find it?
A measure, ranging from 0% to 100%, of how similar a portfolio is to its benchmark. The measure is based on the differences in a portfolio’s holdings and weights relative to its benchmark’s holdings and their weights. A manager who precisely replicates the benchmark will have an active share of zero; a manager with no holdings in common with the benchmark will have an active share of one.
active share = .5 (sum of all (absolute value of weight of security i in the portfolio - weight in benchmark))
- -> High Active Share indicates that a manager’s holdings differ substantially from the benchmark, and low active risk indicates low idiosyncratic risk resulting from diversification: This combination indicates that the manager most likely follows a diversified stock picking strategy.
- -> Active share changes only if the total of the absolute values of the portfolio’s active weights changes. i.e. for two trades, if both the initial position and the new position involved two stocks such that one was 1pp underweighted and the other was 1pp over weighted. Although the active weights of particular securities did change between the initial position and the new position, the total absolute active weights did not change. Therefore, the portfolio’s active share would not change
Activist short selling
A hedge fund strategy in which the manager takes a short position in a given security and then publicly presents his/her research backing the short thesis.
what are the five conclusions of the adaptive markets hypothesis?
(AMH) A hypothesis that applies principles of evolution—such as competition, adaptation, and natural selection—to financial markets in an attempt to reconcile efficient market theories (EMH assumes that market prices reflect all available information) with behavioral alternatives.
–> The AMH theory assumes that successful investors apply heuristics or mental rules of thumb until they no longer work
The AMH leads to these five conclusions:
- The relationship between risk and return is not perfectly stable. It changes over time as the competitive environment changes.
- Active management of investments can find opportunities to exploit inefficiencies from time to time
- Adaption and innovation are key to survival
- Survival is the only objective that matters
- No strategy will work all the time
Agency trade
A trade in which the broker is engaged to find the other side of the trade, acting as an agent. In doing so, the broker does not assume any risk for the trade.
Alpha decay
In a trading context, alpha decay is the erosion or deterioration in short term alpha after the investment decision has been made.
–> ALPHA DECAY is the phenomenon whereby a particular investment methodology deteriorates in performance over time. Initially well suited to the original market conditions at the time of inception. Trades are more valuable when under-discovered, and as the trade becomes crowded, the potential alpha decays
Alternative trading systems
An alternative trading system (ATS) is one that is not regulated as an exchange but is a venue to match the buy and sell orders of its subscribers. (ATS brings together buyers and sellers to find transaction counterparties outside of a regulated exchange - i.e. dark pools.)
- -> Also called multilateral trading facilities (MTF).
- -> Regardless of the trading venue, transactions and quantities are always reported.
- -> Dark pools provide anonymity because no pre-trade transparency exists. Exchanges are known as lit markets (as opposed to dark markets) because they provide pre-trade transparency—namely, limit orders that reflect trader intentions for trade side (buy or sell), price, and size. However, with a dark pool, there is less certainty of execution as compared to an exchange.
Anchoring and adjustment (anchoring bias)
–> how to overcome this bias?
An information-processing bias in which the use of a psychological heuristic influences the way people estimate probabilities - i.e. when a person starts out with an initial idea and adjusts their beliefs based on this starting point.
–> fixating on a target number once an investor has it in mind
–>The anchoring bias is the tendency of the mind to give disproportionate weight to the first information it receives on a topic: initial impressions, estimates, or data, anchor subsequent thoughts and judgments.
–> Despite setbacks and new information, an investor may not appropriately adjust his view due to perceiving new information through a warped lens and thus, the decision making may deviate from rational reasoning.
–> To overcome anchoring bias, the manager should consciously ask questions that may reveal an anchoring and adjustment bias: “Am I holding on to this stock based on rational analysis, or am I trying to attain a price that I am anchored to, such as the purchase price or a high water mark?”
Ex: an analyst should look at the basis for his decision to hold ABC to determine if it is anchored to a price target (a new 52-week high) or based on an objective, rational view of the company’s fundamentals. Gerber should have periodically reviewed his decision-making process to determine if his analysis of ABC’s prospects was appropriate, focusing more on the company’s fundamentals rather than the price target.
Anomalies
Apparent deviations from market efficiency.
Arithmetic attribution
An attribution approach which explains the arithmetic difference between the portfolio return and its benchmark return. The single-period attribution effects sum to the uity eturn, however, when combining multiple periods, the sub-period attribution effects will not sum to the excess return.
Arrival price
In a trading context, the arrival price is the security price at the time the order was released to the market for execution.
Aspirational risk bucket
–> Three tools for addressing a concentrated position in a publicly traded common stock
In goal-based portfolio planning, that part of wealth allocated to investments that have the potential to increase a client’s wealth substantially.
- -> includes assets such as a privately owned business, commercial and investment real estate, and concentrated stock positions.
- -> Three tools for addressing a concentrated position in a publicly traded common stock include outright sale, monetization, and hedging.
Asset location
The type of account an asset is held within, e.g., taxable or tax deferred.
Focus of asset-only asset allocation
With respect to asset allocation, an approach that focuses directly on the characteristics of the assets without explicitly modeling the liabilities.
–> focuses on asset return and standard deviation
Authorized participants
An authorized participant is an organization that has the right to create and redeem shares of an exchange traded fund (ETF).
–> Broker/dealers who enter into an agreement with the distributor of the fund.
Availability bias
A cognitive error where people let predicted future probabilities be impacted by memorable past events (information processing bias - product of faulty reasoning and analysis)
- -> the human tendency to think that examples of things that come readily to mind are more representative than is actually the case
- -> As a result of availability bias, investors may choose an investment based on advertising rather than on a thorough analysis of the options.
- -> Investors who exhibit availability bias may limit their investment opportunity set, may choose an investment without doing a thorough analysis of the stock, may fail to diversify, and may not achieve an appropriate asset allocation.
- -> An investor could overcome this bias by developing an appropriate investment policy strategy, with a focus on appropriate goals (short- and long-term), and having a disciplined approach to investment decision making. An investment policy statement would help provide discipline and would alert the investor that he really has only considered investments that he is familiar with. Further, an investor should consider the asset allocation within the portfolio.
Back-fill bias
The distortion in index or peer group data which results when returns are reported to a database only after they are known to be good returns.
Barbell portfolio and when is this strategy useful?
–> what sort of portfolio works best under a flattening yield curve?
The barbell strategy is used to take advantage of the best aspects of short-term and long-term bonds. In this strategy only very short-term and extremely long-term bonds are purchased. Longer dated bonds typically offer higher interest yields, while short-term bonds provide more flexibility.
The short-term bonds give an investor the liquidity to adjust potential investments every few months or years. If interest rates start to rise, the shorter maturities allow an investor to reinvest principal in bonds that will realize higher returns than if that money was tied up in a long-term bond.
The long-term bonds give an investor a steady flow of higher-yield income over the term of the bond. However, by not having all of your capital in long-term bonds, this limits the downside effects if interest rates were to rise in that bond period.
- -> Under a flattening yield curve, a barbell portfolio will outperform bullet portfolios or laddered portfolios
- -> if the curve steepens, a bullet position will outperform the barbell portfolio. In a steepening, the short- and intermediate-term bonds will maintain/gain value from flat/lower rates while long-maturity bonds will lose value from rising rates
- -> The higher-convexity barbell portfolio will likely outperform the bullet portfolio if there is an instantaneous downward parallel shift in the yield curve because of the barbell portfolio’s greater sensitivity to the expected decline in yields. Portfolios with higher convexity are most often characterized by lower yields (they are more exposed to int rate movements vs CP credit). Investors will be willing to pay for increased convexity when they expect yields to change by more than enough to cover the give-up in yield.
–>The optimal time for bond investors to implement the barbell strategy is when there are large gaps between short- and long-term bond yields.
Base Currency
With respect to a foreign exchange quotation of the price of one unit of a currency, the currency referred to in “one unit of a currency.”
- -> i.e. CAD/USD - CAD is the base and USD is the quote currency
- -> If U.S. dollars (USD) are used to buy GBP, the exchange rate is for the GBP/USD pair.
- -> you buy the base at the bid, sell the base at the ask
Basis risk
–> how to quantify it?
The risk resulting from using a hedging instrument that is imperfectly matched to the investment being hedged; in general, the risk that the basis will change in an unpredictable way. (prices won’t move in exactly offsetting and predictable ways) Basis risk can arise when the underlying securities pay dividends, because the futures contract tracks only the price of the underlying index. Stock splits do not affect investment performance comparisons.
–> To quantify the amount of the basis risk, an investor simply needs to take the current market price of the asset being hedged and subtract the futures price of the contract. For example, if the price of oil is $55 per barrel and the future contract being used to hedge this position is priced at $54.98, the basis is $0.02.
Bayes’ formula
A mathematical rule explaining how existing probability beliefs should be changed given new information; it is essentially an application of conditional probabilities.
P(A|B) = P(A) P(B|A)P(B)
Which tells us: how often A happens given that B happens, written P(A|B),
When we know: how often B happens given that A happens, written P(B|A)
and how likely A is on its own, written P(A)
and how likely B is on its own, written P(B)
Bear spread
- -> Max loss, profit and breakeven point for a bear put spread and a bear call spread
- -> pros and cons?
Bull Spread
- -> Max loss, profit and breakeven point for a bull put spread and a bull call spread
- -> pros and cons?
Bear spread: An option strategy that becomes more valuable when the price of the underlying asset declines, so requires buying one option and writing another with a lower exercise price. (long higher strike and short lower strike)
Bull Spread: An option strategy that becomes more valuable when the price of the underlying asset increases, so requires buying one option and writing another with a higher exercise price. (long lower strike and short higher strike)
PROS:
- limit losses, reduces the costs of option
CONS:
- limits gains, risk of short call buyer exercising option (bull call spread)
Put Spread:
Break even point = higher strike - net premiums and commissions
Call Spread:
Break even point = lower strike + net premiums and commissions
Max profit of a bear put spread = max loss of a bull put spread = (higher - lower) - net premiums and commissions
max loss of a bear put spread = max profit of a bull put spread
= net premiums and commissions
Max profit of a bear call spread = max loss of a bull call spread
= net premiums and commissions
max loss of a bear call spread = max profit of a bull call spread
= (higher - lower) - net premiums and commissions
Behavioral biases
A tendency to behave in a way that is not strictly rational.
- -> Behavioral biases can be
1. cognitive - result from incomplete information or inability to analyze - i.e. belief perseverance biases (representativeness, illusion of control, conservatism, confirmation and hindsight bias) and Information processing biases (Framing bias, anchoring and adjustment, mental accounting, availability) (R.I.C.C.H.F.A.M.A)
2. emotional - spontaneous reactions that affect how individuals see information - i.e. loss aversion bias, overconfidence bias, self control bias, status quo bias, endowment bias, regret-aversion bias) (L.O.S.S.E.R)
Behavioral macro-finance
A focus on market level behavior that considers market anomalies that distinguish markets from the efficient markets of traditional finance.
–> defined as the field that “detects and describes anomalies in the efficient market hypothesis that behavioral models may explain”
Behavioral finance micro
A focus on individual level behavior that examines the behavioral biases that distinguish individual investors from the rational decision makers of traditional finance.
Benchmark spread
- -> what is usually referenced?
- -> issues that can arise?
The yield on a credit security over the yield on a security with little or no credit risk (benchmark bond is almost always a gov bond) and with a similar duration (does not have to be exactly the same duration).
- -> A bond may be considered under-valued or over-priced based on its yield spread above a relevant benchmark yield.
- -> The benchmark spread is a simple way to calculate a credit spread; it subtracts the yield on a recently issued benchmark-sized security with little or no credit risk (benchmark bond) of a particular maturity from the yield on a credit security. Typically, the benchmark bond is an on-the-run government bond.
- -> A problem with benchmark spread is the potential maturity mismatch between the credit security and the benchmark bond. Unless the benchmark yield curve is perfectly flat, using different benchmark bonds will produce different measures of credit spread.
Best-in-class
An ESG implementation approach that seeks to identify the most favorable companies and sectors based on ESG considerations. Also called positive screening.
Bid price
In a price quotation, the price at which the party making the quotation is willing to buy a specified quantity of an asset or security.
Bottom-up approach
the top-down approach goes from the general to the specific, and the bottom-up approach begins at the specific and moves to the general.
Generally, the bottom-up approach focuses its analysis on specific characteristics and micro attributes of an individual stock. In bottom-up investing concentration is on business-by-business or sector-by-sector fundamentals. This analysis seeks to identify profitable opportunities through the idiosyncrasies of a company’s attributes and its valuations in comparison to the market.
- Bottom-up investing begins its research at the company level but does not stop there. These analyses weigh company fundamentals heavily but also look at the sector, and microeconomic factors as well. As such, bottom-up investing can be somewhat broad across an entire industry or laser-focused on identifying key attributes.
–> A credit strategy approach that involves selecting the individual bonds or issuers that the investor views as having the best relative value from among a set of bonds or issuers with similar features.
Bounded rationality
The notion that people have informational and cognitive limitations when making decisions and do not necessarily optimize when arriving at their decisions. People are not fully rational when making decisions and do not necessarily optimize but rather satisfice when arriving at their decisions. People have informational, intellectual, and computational limitations. Bounded rationality describes the phenomenon whereby people gather some (but not all) available information, use heuristics to make the process of analyzing the information tractable, and stop when they have arrived at a satisfactory, but not necessarily optimal, decision.
Breadth
The number of truly independent decisions made each year.
–> if a manager selects ten stocks every month, his breadth is 10 x 12 =f 120. If a manager makes a selection every quarter, his breadth is 4
Brinson hood bowler (BHB) model vs Brinson Fachler (BF) Model
- -> how to use and find the BHB vs BF allocation effect of a subsection of the portfolio?
- -> how to find the selection effect
- -> how to find the interaction term?
The approach to return attribution established in various papers co-authored by Gary Brinson. Can be used to find the attribution of a certain sector or region to an overall portfolio. The value added by the portfolio manager is decomposed in allocation, selection, and interaction effects.
ALLOCATION EFFECT: refers to the portfolio managers decision to over or underweight specific sector weighting vs the benchmark.
To find the allocation effect of a certain portion of a portfolio when compared to a benchmark using the BF Model: this should be your default
= (weight of sector in port - weight in benchmark) x (benchmark sector return - total benchmark return)
To find the allocation effect using the BHB Model - This model is not used to find attribution effect on overall portfolio.
= (weight of sector in port - weight in benchmark) x ( benchmark sector return)
The BHB model rewards investors who overweight positively performing sectors, while the BF only does so if the sector outperforms the benchmark.
ex: let’s assume the following:
Sector 1 Portfolio Weight: 50% Sector 1 Benchmark Weight: 30% Sector 1 Portfolio Return: 6.5% Sector 1 Benchmark Return: 6.5% Benchmark Return: 9.2%
BF Allocation = (50% - 30%) * (6.5% - 9.2%) = -.54%
BHB Allocation = (50% - 30%) * (6.5%) = 1.3%
In this example, it’s clear that the manager allocated excess funds to a sector that dramatically underperfoms the overall benchmark…so it’s not reasonable to give the manager credit for doing so.
SELECTION EFFECT: the portfolio managers value added by selecting individual securities within the sector and weighting the portfolio differently compared to the benchmarks weightings
= weight in benchmark x (sector portfolio return - sector benchmark return)
The interaction term is the combination of the allocation and selection effects:
= (weight of sector in port - weight in benchmark) × (fund sector return - benchmark sector return)
Buffering
Establishing ranges around breakpoints that define whether a stock belongs in one index or another.
–> As long as stocks remain within the buffer zone, they stay in the current index, and as a result, the holdings of the fund may exceed the holdings of the index.
Bullet
A fixed income portfolio made up of securities targeting a single segment of the curve.
A bullet bond portfolio only invests in intermediate term bonds
–> When an upward-sloping yield curve becomes less curved in the way expected by the minority of analysts (the intermediate-term yields decline while other rates remain unchanged), a more bullet-like portfolio will outperform a more laddered portfolio and a more barbell-like portfolio. This will occur because the bullet portfolio is concentrated in intermediate-term bonds whose values rise as yields fall while the other bonds’ values remain the same.
–> a bullet performs well when the yield curve is expected to steepen
–> convexity and dispersion ranking:
bullet (least) < laddered < barbell (most)
–> Lower convexity and dispersion are desirable aspects in liquidity management. A barbell portfolio has higher convexity (would respond more dramatically to changes in interest rates), and would see a reduction in cash flow reinvestment risk with the reduction of convexity.
Business cycle
Fluctuations in GDP in relation to long-term trend growth, usually lasting 9-11 years.
Butterfly spread
–> Max loss and max profit for long and short butterfly spreads
Butterfly spreads use four option contracts with the same expiration but three different strike prices. A higher strike price, an at-the-money strike price (traded 2x), and a lower strike price (3 different strike prices). The options with the higher and lower strike prices are the same distance from the at-the-money options. If the at-the-money options have a strike price of $60, the upper and lower options should have strike prices equal dollar amounts above and below $60. At $55 and $65, for example, as these strikes are both $5 away from $60.
–> unlike straddles and strangles, potential risk is limited
ex: long call butterfly spread: An investor shorts two call options on Verizon at a strike price of $60, and also buys two additional calls at $55 and $65.
+55C/ -60C/ -60C/ +65C
- Long butterfly spreads are long the wings, short the body (2 options contracts) and profit from time decay when the price at exp is at the strike price of the middle (ATM) options
- Short butterfly spreads are short the wings and long the body
max profit for a long put spread = max loss for a short put spread:
= (higher strike price) - (ATM strike price) - (any premiums paid or received)
max profit for a long CALL spread = max loss for a short CALL spread
= (ATM Strike price) - (lower strike price) - (any premiums paid or received)
max loss of a long call butterfly spread = max profit of a short call butterfly spread
= commissions paid
max loss of a long put spread = max gain of a short put spread
= commissions paid
Calendar spread
–> best time to implement?
A strategy in which one sells an option and buys the same type of option but with different expiration dates, on the same underlying asset and with the same strike. When the investor buys the more distant (near-term) call and sells the near-term (more distant) call, it is a long (short) calendar spread.
- -> you go long the longer dated option if you think the underlying asset or volatility will increase and you go short the longer dated asset if you think the asset or volatility will decrease
- -> implement this strategy when vol is low in order to profit from the passage of time
Canadian model
Characterized by a high allocation to alternatives. The Canada model relies more on internally managed (not outsourced) assets than the endowment model. The innovative features of the Canada model are the:
a) reference portfolio
b) total portfolio approach
c) active management.
Capital market expectations and the process of setting them up (7 steps)
Capital market expectations define the conclusions investment analysts arrive at regarding the potential risks and returns of entire classes of investments. The ultimate objective is a set of projections with which to make informed investment decisions, specifically asset allocation decisions.
Achieving long-term investment objectives - ensure portfolios are internally consistent
- > Cross-sectional consistency: consistency across asset classes regarding portfolio risk/return characteristics
- > Intertemporal consistency: consistency over various investment horizons regarding portfolio decisions over time
- Specify the set of expectations needed, including the time horizon(s) to which they apply.
- Research the historical record.
- Specify the method(s) and/or model(s) to be used and their information requirements.
- Determine the best sources for information needs.
- Interpret the current investment environment using the selected data and methods, applying experience and judgment.
- Provide the set of expectations needed, documenting conclusions.
- Monitor actual outcomes and compare them with expectations, providing feedback to improve the expectation-setting process.
Capital sufficiency analysis
Capital needs analysis
The process by which a wealth manager determines whether a client has, or is likely to accumulate, sufficient financial resources to meet his or her objectives
Capture ratio
–> what does a concave and convex capture ratio look like? (>100% or less?)
The capture ratio (CR) is the upside capture divided by downside capture. It measures the asymmetry of return.
- -> A capture ratio greater than 1 indicates positive asymmetry, or a convex return profile, whereas a capture ratio less than 1 indicates negative asymmetry, or a concave return profile. A capture ratio equal to 1 would describe a symmetric return profile, whereas a ratio greater than or less than 1 indicates an asymmetric profile.
- -> A capture ratio less than one indicates the downside capture is greater than upside capture and reflects greater participation in falling markets than in rising markets.
- -> determines the managers relative performance when markets are up or down.
Carhart model
Carhart model is Fama-French w/price momentum as the 4th factor. Fama french was able to explain ~90% of a stocks performance, with the attribution of the last 10% being due to the ideas “winners keep winning, losers keep losing” FOMO
Carhart model = Fama French + Momentum
Expected return =
risk free rate + (factor coefficient) Market risk premium+ (factor coef) SMB + (factor coef) HML + (factor coef) momentum
market risk premium: expected return - risk free return
SMB: Smll minus large cap - excess return of small cap stocks
HML: high minus low - excess return of value stocks
WML: winners minus losers (momentum)
ex:
a 1.1 beta market risk premium, means that the portfolio is tracking close to the equity risk premium, which is normal for an all equity-based fund
a SMB loading is -0.5, which means that the portfolio is predominantly large-cap.
HML loading is -0.3, which means the portfolio holds a portfolio of mostly growth stocks.
Carry trade
A trading strategy that involves buying a security and financing it at a rate that is lower than the yield on that security (going long a higher-yielding security and shorting a lower-yielding security) with the expectation of receiving the positive carry and of profiting on long and short sides of the trade when the temporary relative mispricing reverts to normal.
- -> Carry trades may or may not involve maturity mis-matches. Intra-market (same market) carry trades typically do involve different maturities, but inter-market (two diff markets) carry trades frequently do not (but sometimes do), especially if the currency is not hedged. In addition, if two curves are involved they need not have different slopes provided there is a difference in the level of yields between markets (one market yielding 1.5% and the other yielding 0.4%).
- -> Inter-market (two markets) carry trades do not, in general, break even if each yield curve goes to its forward rates. Intra-market (same market) trades will break even if the curve goes to the forward rates because, by construction of the forward rates, all points on the curve will earn the “first-period” rate (that is, the rate for the holding period being considered). Inter-market trades need not break even unless the “first-period” rate is the same in the two markets. If the currency exposure is not hedged, then breaking even also requires that there be no change in the currency exchange rate.
- ->A classic example of a fixed-income arbitrage trade involves buying lower-liquidity (due to some bonds being held and therefore not in the available purchase pool), off-the-run government securities and selling higher-liquidity, duration-matched, on-the-run (most recently issued) government securities. Interest rate and credit risks are hedged because long and short positions have the same duration and credit exposure. So, the key concern is liquidity risk. Under normal conditions, as time passes, the more (less) expensive on-the-run (off-the-run) securities will decrease (increase) in price as the current on-the-runs are replaced by a more liquid issue of new on-the-run bonds that then become off-the-run bonds
Cash drag
Tracking error caused by temporarily uninvested cash.
Cash flow matching
- -> the effects of interest rate movements?
- -> drawbacks of this method?
Immunization approach that attempts to ensure that all future liability payouts are matched precisely by cash flows from bonds or fixed-income derivatives, such as interest rate futures, options, or swaps.
- -> Cash flow matching entails building a dedicated portfolio of zero-coupon or fixed-income bonds to ensure there are sufficient cash inflows to pay the scheduled cash outflows. However, such a strategy is impractical and can lead to large cash flow holdings between payment dates, resulting in reinvestment risk and forgone returns on cash holdings.
- -> Cash flow matching has no yield curve or interest rate assumptions. With this immunization approach, cash flows come from coupon and principal repayments that are expected to match and offset liability cash flows. Because bond cash inflows are scheduled to coincide with liability cash payouts, there is no need for reinvestment of cash flows. Thus, cash flow matching is not affected by interest rate movements. (Cash flows coming from coupons and liquidating bond portfolio positions is a key feature of a duration-matching approach.)
Cash-secured put
An option strategy involving the writing of a put option and simultaneously depositing an amount of money equal to the exercise price into a designated account (this strategy is also called a fiduciary put).
Representative Sampling
A representative sample is a subset of a population that seeks to accurately reflect the characteristics of the larger group. For example, a classroom of 30 students with 15 males and 15 females could generate a representative sample that might include six students: three males and three females
–> A sampling method that guarantees that subpopulations of interest are represented in the sample. Also called cell approach.
Certainty equivalent
The maximum sum of money a person would pay to participate or the minimum sum of money a person would accept to not participate in an opportunity.
Civil law
A legal system derived from Roman law, in which judges apply general, abstract rules or concepts to particular cases. In civil systems, law is developed primarily through legislative statutes or executive action.
Closet indexer vs sector rotator vs diversified stock picker
–> active share and active risk styles
a closet indexer is a fund that advertises itself as being actively managed but is substantially similar to an index fund in its exposures.
–> A closet index would exhibit both low Active Share and low active risk, because such funds make few active bets.
A sector rotator typically has high active risk, high tolerance for sector deviations and could have either high or low Active Share, depending on whether a concentrated or diversified portfolio approach was followed.
Diversified stock picker: High Active Share indicates that a manager’s holdings differ substantially from the benchmark, and low active risk indicates low idiosyncratic risk resulting from diversification
Code of ethics
An established guide that communicates an organization’s values and overall expectations regarding member behavior. A code of ethics serves as a general guide for how community members should act.
Cognitive dissonance
The mental discomfort that occurs when new information conflicts with previously held beliefs or cognitions.
Cognitive errors (9 types and how to address?)
Behavioral biases resulting from faulty reasoning; cognitive errors stem from basic statistical, information processing, or memory errors. The individual may be attempting to follow a rational decision-making process but fails to do so because of cognitive errors.
- -> remember RICCH (belief perseverance biases) FAMA (information processing biases)- rich families sometimes think they know best :)
- REPRESENTATIVENESS BIAS (base rate neglect or sample size neglect- cognitive bias in which people tend to classify new information based on past experiences and classifications. If-then stereotype heuristic used to classify new information)
- ILLUSION OF CONTROL BIAS (the tendency to overestimate one’s control over events)
- CONSERVATISM BIAS (where people emphasize original, pre-existing information over new data. This can make decision-makers slow to react to new, critical information and place too much weight on base rates.)
- CONFIRMATION BIAS (looking for what confirms one’s beliefs)
- HINDSIGHT BIAS - selective memory of past events, remember correct views and forget errors
- FRAMING BIAS - viewing info differently depending on how it is received
- ANCHORING AND ADJUSTMENT (the tendency to reach a decision by making adjustments from an initial position, or “anchor”)
- MENTAL ACCOUNTING BIAS - each goal is considered separately
- AVAILABILITY (the probability of events is influenced by the ease with which examples of the event can be recalled)
- -> Cognitive errors should be moderated, whereas emotional biases should be adapted to. Because cognitive errors stem from faulty reasoning, they can often be corrected through better information, education, and advice (i.e. giving sharpe ratios, etc). Because emotions can be more difficult to control, it may be possible only to recognize an emotional error and “adapt” to it.
- -> it is likely that with education these biases can be reduced or even eliminated. The result will be a portfolio that is similar to the mean–variance portfolio.
- -> risk tolerance questionnaires are generally effective for cognitive-based individuals (but work best for institutional investors) and less effective for those with emotional biases
Collar
- -> max profit and loss?
- –> investors best case scenario?
An option position in which the investor is long shares of stock and then buys a put with an exercise price below the current stock price (protective put) and shorts a call with an exercise price above the current stock price (covered call). Collars allow a shareholder to acquire downside protection through a protective put but reduce the cash outlay by writing a covered call.
- -> An investor’s best-case scenario is when the underlying stock price is equal to the strike price of the written call option at expiry.
- -> collar does carry market risk within a range of the stock’s trading price.
Maximum Profit = Call option strike price - Stock purchase price - Net of premiums
Maximum Loss = Stock purchase price - Put option strike price - Net of premiums
Common law
A legal system which draws abstract rules from specific cases. In common law systems, law is developed primarily through decisions of the courts.
Community property regime
A marital property regime under which each spouse has an indivisible one-half interest in property received during marriage.
systematic vs non-systematic risk
Systematic: the component of risk that cannot be eliminated by holding a well-diversified portfolio. Systematic risk includes macroeconomic factors such as unexpected changes in the level of real business activity and unexpected changes in the inflation rate. Systematic risk-factor approaches typically explain most or all of the risk and return patterns of public assets but far less of those patterns for private assets. This is due to the widespread use of appraisal-based valuation for private assets and the idiosyncratic risks (non-market risks) present in individual funds.
Non-systematic: company specific or idiosyncratic risk specific to a particular company’s operations, reputation, and business environment.
Completion overlay
A type of overlay that addresses an indexed portfolio that has diverged from its proper exposure.
Confirmation bias
A belief perseverance bias in which people tend to look for and notice what confirms their beliefs, to ignore or undervalue what contradicts their beliefs, and to misinterpret information as support for their beliefs.
–> this is an example of a cognitive (incomplete info or inability to analyze) error and a belief perseverance bias
Conjunction fallacy
An inappropriate combining of probabilities of independent events to support a belief. In fact, the probability of two independent events occurring in conjunction is never greater than the probability of either event occurring alone; the probability of two independent events occurring together is equal to the multiplication of the probabilities of the independent events.
Conservatism bias
Conservatism bias is a belief perseverance bias in which people maintain their prior views or forecasts by inadequately incorporating new information.
- -> A cognitive error emphasizing information used in original forecasts over new data
- -> ex would be ignoring or inadequately considering information that is contrary to your original analysis
Note: confirmation bias is slightly different. Given new information - only absorb what matches your belief, discard everything else. (so something gets taken in… provided it matches what is already believed). In conservatism - entire new info is discarded.
Contingent immunization
Contingent immunization is an investment approach where a fund manager switches to a defensive strategy if the portfolio return drops below a predetermined point. Contingent immunization typically refers to a contingency plan used in some fixed-income portfolios. It is a strategy where a fund manager uses an active management approach to individually select securities in hopes of outperforming a benchmark. However, a contingency plan is triggered once certain predetermined losses have accumulated. The idea is that the contingency plan will immunize assets against further losses.
–> alter the duration of the asset portfolio if manager has strong views on future interest rate changes
Controlled foreign corporation
A company located outside a taxpayer’s home country and in which the taxpayer has a controlling interest as defined under the home country law.
Convexity
–> how to increase and decrease portfolio convexity?
Convexity builds on the concept of duration (how long a bonds cash flows would pay back the investor) by measuring the sensitivity of the duration of a bond as yields change. Portfolio managers will use convexity as a risk-management tool, to measure and manage the portfolio’s exposure to interest rate risk.
- a bond with higher convexity will always have a higher price (lower yield) then that of lower, regardless of whether interest rates rise or fall because a 5% coupon bond is more sensitive to interest rate changes than a 10% coupon bond.
- typically, the higher the coupon rate, the lower the convexity or market risk (higher coupon = shorter duration = lower risk)
- if a person is unsure of direction of interest rates, its a good move to increase convexity - and because of this, generally, more (positive) convexity is desired by fixed-income investors.
- -> The exception to this is if the investor wants to keep it closer to a 0 coupon bond, then they’d want lower convexity. i.e. if an investor has a set liability in a set time frame, and the goal is to minimize the dispersion of cash flows around the Macaulay duration (liability due date) and make the portfolio more like the zero-coupon liability it is attempting to immunize, you’d select the portfolio with the lowest convexity because minimizing the portfolio convexity (i.e., the dispersion of cash flows around the Macaulay duration) makes the portfolio closer to the zero-coupon bond that would provide perfect immunization. )
- In a stable yield curve environment, holding bonds with higher convexity (lower yields) negatively affects portfolio performance (you’re taking on the extra risk for no reason). Higher convexity bonds have lower yields than bonds with lower convexity, all else being equal.
- Convexity is a better measure of interest rate risk, concerning bond duration. Where duration assumes that interest rates and bond prices have a linear relationship, convexity allows for other factors and produces a slope. Portfolios with higher convexity have higher structural risk because the delta between the bonds that construct the portfolio are very spread out, exposing the portfolio to a lot of interest rate risk when it comes to reinvesting
- -> If a bond’s duration increases as yields increase, the bond is said to have negative convexity. In other words, the bond price will decline by a greater rate with a rise in yields than if yields had fallen. As interest rates rise, and the opposite is true.
ex: convexity of MBS: Generally, when interest rates fall, bond prices rise. But a bond with negative convexity loses value when interest rates fall. This is often the case for mortgage-backed securities (MBS) because they rely on underlying mortgage loans, which are typically refinanced (and thus paid off early) when interest rates fall - ->If a bond’s duration increases and yields fall, the bond is said to have positive convexity. In other words, as yields fall, bond prices rise by a greater rate—or duration—than if yields rose. Positive convexity leads to greater increases in bond prices. If a bond has positive convexity, it would typically experience larger price increases as yields fall, compared to price decreases when yields increase.
- > positiive convexity: rates increase = duration falls or duration rises as yields fall
- -> Under a stable yield curve, portfolio convexity can be reduced by selling options, either puts or calls. A PM can sell convexity by selling a call on the bonds he owns or selling a put on bonds he would like to own. The option premium received would augment the yield of the portfolio (options would decrease in value as they matured). The selling lowers convexity in the portfolio, which is acceptable if he expects future volatility to be lower than that reflected in current option prices (If volatility is lower than the level priced into the options, the portfolio will still benefit from selling options). Buying MBSs also provides an option-writing opportunity, in this case selling a prepayment option to homeowners. Purchasing an MBS would decrease convexity
- -> In the case of an instantaneous downward parallel shift in the yield curve, a portfolio with added convexity resulting from the purchase of a near-the-money option on Treasury bond futures would increase in value more than a portfolio without the call option.
- -> if the yield curve changes to some extent—the portfolio will still benefit from reducing convexity by selling options to the extent volatility is lower than the expectations priced into the option premiums received.
Core capital
–> how to estimate core capital needs?
The amount of capital required to fund spending to maintain a given lifestyle, fund goals, and provide adequate reserves for unexpected commitments.
core capital needs in N years =
Probability of survival x spending needs / (1+ real risk free rate)^n
Covered call
- -> break even price?
- -> when is this strategy the least profitable?
An option strategy in which a long position in an asset is combined with a short position in a call on that asset.
- -> a yield enhancement strategy: establish a liquidation value at which he would be willing to sell x% of his position
- -> There are two potential drawbacks with this strategy: The investor retains full downside exposure to the shares (to the extent the share price decreases by more than the premium received), and the upside potential is limited (the call strike price plus the premium received).
- -> The breakeven share price for a covered call is the share price minus the call premium received
- -> any price below the break even price incurs a loss, any price above the break even is a gain
- -> max profit = call price - strike price + premium received
Creation units
Large blocks of ETF shares often traded against a basket of underlying securities.
- -> this transaction typically occurs between the ETF distributor and a broker/dealer. Entering into a creation unit transaction is done to facilitate trading but does not establish a passive bond position.
- -> Authorized participants create ETF shares in large increments—known as creation units—by assembling the underlying securities of the fund in their appropriate weightings to reach creation unit size, which is typically 50,000 ETF shares. The AP then delivers those securities to the ETF sponsor
Credit method for tax calculation
When the residence country reduces its taxpayers’ domestic tax liability by the amount of taxes paid to a foreign country that exercises source jurisdiction.
TCredit Method = Max(TSource, TResidence)
i.e. if the clients residence country has a 15% tax rate and the country in which they derive their income has a 20% tax rate, to calculate the tax it would just be net income or capital gains x 20% (the higher of the two)
Credit risk
The risk of loss caused by a counterparty’s or debtor’s failure to make a timely payment or by the change in value of a financial instrument based on changes in default risk. Also called default risk.
Cross-currency basis swap
–> when are the notional principals of the swap exchanged?
A cross currency basis swap involves the exchange of the principal and interest payments in one currency for the principal and interest payments in another currency
- -> The cross-currency basis swap will convert the lump sum that the bank borrowed in euro into a lump sum in dollars. When the term of the borrowing is complete it will convert the principal back from dollars to euro at exactly the same fixed currency rate that is agreed up front.
- -> The notional principals on the swap are most likely exchanged at both inception and at maturity
Cross hedge
A hedge involving a hedging instrument that is imperfectly correlated with the asset being hedged; an example is hedging a bond investment with futures on a non-identical bond.
Cross-sectional consistency
A feature of expectations setting which means that estimates for all classes reflect the same underlying assumptions and are generated with methodologies that reflect or preserve important relationships among the asset classes, such as strong correlations. It is the internal consistency across asset classes.
Managed futures trends:
- Cross-sectional momentum
- Time Series Momentum
- Cross sectional momentum: A managed futures trend following strategy implemented with a cross-section of assets (within an asset class) by going long those that are rising in price the most and by shorting those that are falling the most. This approach generally results in holding a net zero (market-neutral) position and works well when a market’s out- or underperformance is a reliable predictor of its future performance. Such an approach is generally implemented with securities in the same asset class (i.e. corporate bonds). The strategy is to take long positions in contracts for bonds that have risen the most in value relative to the others (the bonds with the narrowing spreads) and short positions in contracts for bonds that have fallen the most in value relative to the others (the bonds with the widening spreads). In contrast, positions for assets in time-series momentum strategies are determined in isolation, independent of the performance of the other assets in the strategy and can be net long or net short depending on the current price trend of an asset.
- time-series momentum: A managed futures trend following strategy in which managers go long assets that are rising in price and go short assets that are falling in price. The manager trades on an absolute basis, so be net long or net short depending on the current price trend of an asset. This approach works best when an asset’s own past returns are a good predictor of its future returns.
–> The only difference between the two approaches: positions for assets in time-series momentum strategies are determined in isolation, independent of the performance of the other assets in the strategy and can be net long or net short depending on the current price trend of an asset. Cross-sectional momentum strategies take positions based on relative value
Currency overlay
A type of overlay that helps hedge the returns of securities held in foreign currency back to the home country’s currency.
–> a currency overlay program will add value to the portfolio only if the currency alpha has a low correlation with other asset classes in the portfolio (i.e., Brazilian equities and corporate bonds). By introducing foreign currencies as a separate asset class, the more currency overlay is expected to generate alpha that is uncorrelated with the other programs in the portfolio, the more likely it is to be allowed in terms of strategic portfolio positioning
–> if internal resources for active management are lacking, the fund manager would outsource currency exposure management to a sub-advisor that specializes in foreign exchange management. This approach would allow the fund manager to separate the currency hedging function (currency beta), which can be done effectively internally, and the active currency management function (currency alpha) which can be managed externally by a foreign currency specialist.
Custom security-based benchmark
–> requirements of a custom benchmark in order for it to be used as a benchmark portfolio?
Benchmark that is custom built to accurately reflect the investment discipline of a particular investment manager. Also called a strategy benchmark because it reflects a manager’s particular strategy.
- -> The use of an index as a widely accepted benchmark requires
1. clear, transparent rules for security inclusion and weighting
2. investability
3. daily valuation
4. availability of past returns, and turnover.
Decision price
In a trading context, the decision price is the security price at the time the investment decision was made.
Decision-reversal risk
The risk of reversing a chosen course of action at the point of maximum loss.
Decumulation phase
Phase where the government predominantly withdraws from a sovereign wealth pension reserve fund.
Dedicated short-selling
A hedge fund strategy in which the manager takes short-only positions in equities deemed to be expensively priced versus their deteriorating fundamental situations. Short exposures may vary only in terms of portfolio sizing by, at times, holding higher levels of cash.
Deduction method
–> equation to calculate taxes due
When the residence country allows taxpayers to reduce their taxable income by the amount of taxes paid to foreign governments in respect of foreign-source income.
TDeduction Method = TSource + TResidence(1 − TSource)
i.e. 10% tax in resident country and 15.5% tax in country where the residents income is derived
= 10.0% + [15.5% x (1-10%)]
= 24.0%
- -> Source tax system: A jurisdiction that imposes tax on an individual’s income that is sourced in the jurisdiction.
- -> Residence tax system: A jurisdiction that imposes a tax on an individual’s income based on residency whereby all income (domestic and foreign sourced) is subject to taxation.
Deemed dispositions
Tax treatment that assumes property is sold. It is sometimes seen as an alternative to estate or inheritance tax.
Deemed distribution
When shareholders of a controlled foreign corporation are taxed as if the earnings were distributed to shareholders, even though no distribution has been made.
Deferred annuity
An annuity that enables an individual to purchase an income stream that will begin at a later date.
–> Most deferred variable annuities offer a diversified menu of potential investment options, whereas a fixed annuity locks the annuitant into a portfolio of bond-like assets at whatever rate of return exists at the time of purchase.
Defined benefit vs defined contribution plan
defined benefit: A retirement plan in which a plan sponsor commits to paying a specified retirement benefit.
Defined Contribution: A retirement plan in which contributions are defined but the ultimate retirement benefit is not specified or guaranteed by the plan sponsor.
–> for a DC plan, the shortfall risk falls on the employee. For a DB plan, that employer has promised a payment until end of life.
–> The DB plan pools mortality risk such that those in the pool who die prematurely leave assets that help fund benefit payments for those who live longer than expected. The employee bears the risk of outliving her savings with the DC plan.
Defined contribution
–> who is responsible for ultimate retirement benefit, investment and admin providers?
A retirement plan in which contributions are defined but the ultimate retirement benefit is not specified or guaranteed by the plan sponsor.
–> For a defined contribution plan, the sponsor is responsible to ensure:
• Appropriate investment of plan assets
• Suitable investment options
• Selecting administrative providers
Delay cost
The (trading related) cost associated with not submitting the order to the market in a timely manner. The price movement in between the time in which the analyst communicates the investment to the trader and when the trader releases the order to the market
= (decision price - arrival price) x actual shares traded
- decision price = price when manager decides to make the investment and communicates to trader
- arrival price = price when the order is placed by the trader
Delta
–> how to calculate the delta of a combined position of L or S stock and L or S calls or puts?
The change in an option’s price in response to a change in price of the underlying, all else equal.
- -> the delta of a short position is - N shares shorted - i.e. if you’re short 500 shares of ABC, the delta of that position is -500
- -> the delta of a long option position is the number of shares shorted x the given delta, the delta of a short option position is number of shares short (contract number x 100)
- -> the delta of a combined position - i.e. short 500 shares and long 5 calls with a delta of .439 would be -500 + (500*.439) = 219.5 OR short 500 shares and short 5 puts with a delta of -.399 is -500 - (500 x -.399) = -300.5 (in this situation, the put combo is more bearish)
Delta hedging
ec: if you own a put with a .25 delta - how many shares do you need to own of ABC to delta hedge your put?
Delta hedging is an options trading strategy that aims to reduce, or hedge, the directional risk associated with price movements in the underlying asset. The approach uses options to offset the risk to either a single option holding or an entire portfolio of holdings. The investor tries to reach a delta neutral state and not have a directional bias on the hedge
ec: if you own a put with a .25 delta - you will need to own 25 shares of ABC to delta hedge your put (100 shares per contract x .25 = 25)
Demand deposits
Accounts that can be drawn upon regularly and without notice. This category includes checking accounts and certain savings accounts that are often accessible through online banks or automated teller machines (ATMs).
Diffusion index
An index that measures how many indicators are pointing up and how many are pointing down.
Direct market access
(DMA) Access in which market participants can transact orders directly with the order book of an exchange using a broker’s exchange connectivity.
Disability income insurance
A type of insurance designed to mitigate earnings risk as a result of a disability in which an individual becomes less than fully employed.
Discretionary trust
A trust structure in which the trustee determines whether and how much to distribute in the sole discretion of the trustee.
Dispersion
- Dispersion refers to the range of potential outcomes of investments based on historical volatility or returns.
- Generally speaking, the higher the dispersion, the riskier an investment is, and vice versa.
- Dispersion can be measured using alpha and beta, which measure risk-adjusted returns and returns relative to a benchmark index, respectively.
- -> The primary risk measurement statistic, beta, measures the dispersion of a security’s return relative to a particular benchmark or market index, most frequently the U.S. S&P 500 index. A beta measure of 1.0 indicates the investment moves in unison with the benchmark. A beta >1 indicates the security is likely to experience moves greater than the market as a whole—a stock with a beta of 1.3 could be expected to experience moves that are 1.3x the market, meaning if the market is up 10%, the beta stock of 1.3 climbs 13%.
Disposition effect
As a result of loss aversion, an emotional bias whereby investors are reluctant to dispose of losers. This results in an inefficient and gradual adjustment to deterioration in fundamental value.
–> a behavior consistent with the emotional bias of loss aversion, exhibits itself when investors tend to sell winners too quickly and hold on to losers too long.
Dividend capture
A trading strategy whereby an equity portfolio manager purchases stocks just before their ex-dividend dates, holds these stocks through the ex-dividend date to earn the right to receive the dividend, and subsequently sells the shares.
Domestic-currency return
A rate of return stated in domestic currency terms from the perspective of the investor; reflects both the foreign-currency return on an asset as well as percentage movement in the spot exchange rate between the domestic and foreign currencies.
domestic currency return =
(1+ foreign Currency asset return)(1+the percentage change of the foreign currency against the domestic currency) -1
Donor-advised fund
A fund administered by a tax-exempt entity in which the donor advises on where to grant the money that he or she has donated.
Double inflection utility function
A utility function that changes based on levels of wealth.
Downside capture
A measure of capture when the benchmark return is negative in a given period; downside capture less (greater) than 100% generally suggests out (under) performance relative to the benchmark.
=(sum of all of the down month portfolio returns/n periods) / (sum of all of the downside benchmark returns/n periods)
–> (upside capture would be sum of all the up months/n) / (sum of all the up months/n)
Drawdown
- -> what is maximum drawdown?
- -> drawdown duration?
Defined as the percentage peek-to-trough decline for a portfolio.
–> Maximum drawdown is the cumulative peak-to-trough loss during a continuous period. Drawdown duration is the total time from the start of the drawdown until the cumulative drawdown recovers to zero, which can be segmented into the drawdown phase (start to trough) and the recovery phase (trough to zero cumulative return).
Duration matching
Immunization approach based on the duration of assets and liabilities. Ideally, the liabilities being matched (the liability portfolio) and the portfolio of assets (the bond portfolio) should be affected similarly by a change in interest rates.
- -> Cash flows coming from coupons and liquidating bond portfolio positions is a key feature of a duration-matching approach.
- -> duration matching requires present value of assets = present value of liabilities (there are exceptions when the asset and liability discount rates differ). The goal should be to minimize portfolio convexity, but make asset (portfolio) convexity greater than that of the liabilities. (assets should be less volatile)
- -> nonparallel yield curves can be a problem because the value of some assets and liabilities will respond differently based of the time horizon they come due
- –>Portfolio and liability basis point values match (BPV = BPVL).
- -> Asset dispersion of cash flows and convexity (lower convexity = higher yield = lower value) exceed those of the liabilities. (But not by too much, in order to minimize structural risk exposure to curve reshaping).
- -> Regularly rebalance the portfolio to maintain the BPV match of A and L as time and yields change.
Dynamic asset allocation
A strategy incorporating deviations from the strategic asset allocation that are motivated by longer-term valuation signals or economic views than usually associated with tactical asset allocation.
Dynamic hedge
A hedge requiring adjustment as the price of the hedged asset changes.
Earnings risk
The risk associated with the earning potential of an individual.
Three approaches to economic forecasting?
- economic indicators approach: The simplest forecasting approach because it requires following only a limited number of variables. Leading economic indicators may provide information about upcoming changes in economic activity, inflation, interest rates and security prices.
- ->In the economic indicators approach, for example, the composite of leading economic indicators is based on an analysis of its forecasting usefulness in past cycles. The indicators are intuitive, simple to construct, require only a limited number of variables, and third-party versions are also available.
Strengths:
• The leading indicator–based approach is simple since it requires following a limited number of economic/financial variables.
• Can focus on individual or composite variables that are readily available and easy to track.
• Focuses on identifying/forecasting turning points in the business cycle.
Weaknesses:
• Data subject to frequent revisions resulting in “look-ahead” bias.
• “Current” data not reliable as input for historical analysis.
• Overfitted in sample. Likely overstates forecast accuracy.
• Can provide false signals on the economic outlook.
• May provide little more than binary directional guidance (no/yes).
- Checklist approach: highly subjective and time-consuming because they require looking at the widest possible range of data and may require subjective judgment.
- -> Two strengths of the checklist approach are its flexibility and limited complexity, although one weakness is that it imposes no consistency of analysis across items or at different points in time. - Economic (econometric) modeling: the relationships between variables are likely to change. In practice, model-based forecasts rarely forecast recessions well, although they have a better record of anticipating upturns.
Strengths:
• Econometric models can be quite robust and can examine impact of many potential variables.
• New data may be collected and consistently used within models to quickly generate output.
• Models are useful for simulating effects of changes in exogenous variables.
• Imposes discipline and consistency on the forecaster and challenges modeler to reassess prior view based on model results.
Weaknesses:
• Models are complex and time consuming to formulate.
• Requires future forecasts for the exogenous variables, which increases the estimation error for the model.
• Model may be mis-specified, and relationships among variables may change over time.
• Models may give false sense of precision.
• Models perform badly at forecasting turning points.
Economic balance sheet
A balance sheet that provides an individual’s total wealth portfolio, supplementing traditional balance sheet assets with human capital (PV of future earnings) and pension wealth, and expanding liabilities to include consumption and bequest goals. Also known as holistic balance sheet.
Economic indicators
Economic statistics provided by government and established private organizations that contain information on an economy’s recent past activity or its current or future position in the business cycle.
Economic net worth
The difference between an individual’s assets and liabilities; extends traditional financial assets and liabilities to include human capital and future consumption needs.
Economic net worth = Net worth from the traditional balance sheet + (Present value of future earnings + Present value of unvested pension benefits) – (Present value of consumption goals + Present value of bequests)
Effective convexity
–> examples and formula?
A second-order effect that describes how a bond’s interest rate sensitivity changes with changes in yield. Effective convexity is used when the bond has cash flows that change when yields change (as in the case of callable bonds or mortgage-backed securities). Similarly, we use the effective convexity to measure the change in price resulting from a change in the benchmark yield curve for securities with uncertain cash flows.
Effective convexity =
[Price if yield curve declines + Price if yield curve increases - (2 x initial bond price) ]
/
(ΔCurve^2 x initial bond price)
Effective duration
Duration adjusted to account for embedded options (parallel shifts in the yield curve.) For option free bonds, this is the modified duration.
–> As a measure of interest rate sensitivity for high-yield bonds, empirical duration is superior to effective duration (because of the inverse relationship between interest rates and credit risk)
For all credit ratings, empirical duration (Empirical Duration is the calculation of a bond’s duration based on historical data rather than a preset formula) is smaller than the theoretically based effective duration because credit spreads tend to be negatively correlated with risk-free interest rates. One important reason for this phenomenon is that key macro factors, such as economic growth, default rates, and monetary policy, usually have opposite effects on risk-free rates and spreads. As a result of the typically negative correlation between risk-free rates and credit spreads, changes in risk-free rates tend to generate smaller changes in corporate bond yields than theoretical measures of duration suggest. This reduced effect is even more pronounced for securities with high credit risk and large credit spreads.
Therefore, the difference between effective and empirical duration is largest for the high-yield categories (bonds rated Ba, B, and Caa). Notably, Ba rated and B rated bonds have almost no empirical sensitivity to interest rate changes, and Caa rated bonds actually have negative empirical durations. Effective duration, in contrast, would tend to overestimate the effects of the same changes.
Effective federal funds (FFE) rate
The fed funds rate actually transacted between depository institutions, not the Fed’s target federal funds rate.
Emotional biases
Behavioral biases resulting from reasoning influenced by feelings; emotional biases stem from impulse or intuition.
- -> Cognitive errors should be moderated, whereas emotional biases should be adapted to. Because cognitive errors stem from faulty reasoning, they can often be corrected through better information, education, and advice. Thus, most cognitive biases can be “moderated.” Because emotions can be more difficult to control, it may be possible only to recognize an emotional error and “adapt” to it.
- -> When advising emotionally biased investors, advisers should focus on explaining how the investment program being created affects such issues as financial security, retirement, or future generations rather than focusing on quantitative details
–> “Don’t be such an EMOTIONAL L.O.S.S.E.R!”
L oss-Aversion
O verconfidence and familiarity (illusion of knowledge)
S tatus Quo (preference for no change)
S elf-control
E ndowment (a tendency to ask for much more money to sell something than one would be willing to pay to buy it)
R egret aversion
Empirical duration
–> when to use empirical vs effective duration?
A measure of interest rate sensitivity that is determined from actual market data (vs effective duration references an equation). Empirical data, since it observes actual historical price changes, better captures the interplay between interest rate risk and credit risk while effective duration would only incorporate the price impact of interest rate risk.
–> For all credit ratings, empirical duration (Empirical Duration is the calculation of a bond’s duration based on historical data rather than a preset formula) is smaller than the theoretically based effective duration because credit spreads tend to be negatively correlated with risk-free interest rates.
–> A bond’s empirical duration is often estimated by running a regression of its price returns on changes in a benchmark interest rate. Sometimes the price of a bond doesn’t change by the amount you would expect when the benchmark YTM changes. You use the actual price change to compute the empirical duration.
–> As a measure of interest rate sensitivity for high-yield bonds, empirical duration is superior to effective duration. As a result of the typically negative correlation between risk-free rates and credit spreads, changes in risk-free rates tend to generate smaller changes in corporate bond yields than theoretical measures of duration suggest. This reduced effect is even more pronounced for securities with high credit risk and large credit spreads.
Therefore, the difference between effective and empirical duration is largest for the high-yield categories (bonds rated poorly at Ba, B, and Caa). Notably, Ba rated and B rated bonds have almost no empirical sensitivity to interest rate changes, and Caa rated bonds actually have negative empirical durations. Effective duration, in contrast, would tend to overestimate the effects of the same changes.
Endowment bias
An emotional bias in which people value an asset already held higher than if it were not already held
–> Overcome this bias by explaining to Moylan that her parents left her the portfolio’s overall capital and the benefits from which may be derived, and not the specific investments. Start by making small changes over time to redeploy existing portfolio assets into investments possessing greater diversification benefits and growth to offset inflation effects.
Endowment model
Characterized by a high allocation to alternative investments (private investments and hedge funds), significant active management, and externally managed assets (which distinguishes it from the Canadian model, an approach that relies more on internally managed assets).
- -> The primary advantage of using the endowment model is a higher potential for value-added, above-market returns.
- –> Disadvantages include that the endowment model can be difficult to implement for small institutional investors because they might not be able to access high-quality managers. The endowment model may also be difficult to implement for a very large institutional investor because of the institutional investor’s very large footprint. Furthermore, relative to the Norway model, the endowment model is more expensive in terms of costs/fees.
- -> the endowment model is not good for somebody with a short time horizon, because it seeks to capture a illiquidity premium of alternative investments
- -> good for HNW clients with long time horizons, high risk tolerances, relatively small liquidity needs and those comfortable with outside managers
- -> The Yale model emphasizes investing in alternative assets (such as hedge funds, private equity, and real estate) as opposed to investing in traditional asset classes (such as stock and bonds)
What is the goal of an enhanced indexing strategy?
Method investors use to match an underlying market index in which the investor purchases fewer securities than the full set of index constituents but matches primary risk factors reflected in the index.
–> This strategy replicates the index performance under different market scenarios more efficiently than the full replication of a pure indexing approach.
Environmental, social, and corporate governance (ESG)
Also called socially responsible investing , refers to the explicit inclusion of ethical, environmental, or social criteria when selecting a portfolio.
forward vs future
A futures contract has standardized terms and is traded on an exchange (centrally cleared), where prices are settled on a daily basis until the end of the contract. Futures contracts embed significant leverage (more risky) because they permit the counterparties to gain exposure to a large quantity of the underlying asset without having to actually transact in the asset.
A forward contract is a private (higher default risk) and customizable agreement for the forward sale of a position that settles at the end of the agreement and is traded over-the-counter.
–> forward contracts are not subject to mark-to-market margin adjustments and are more liquid for large transactions
In comparison to a futures contract, a forward contract is:
- more flexible in terms of currency pair, settlement date, and transaction amount.
- less expensive
- simpler than futures contracts from an administrative standpoint owing to the absence of margin requirements, reducing portfolio management expense.
- forwards are more liquid than futures for trading in large sizes because the daily trade volume for OTC currency forward contracts dwarfs those for exchange-traded futures contracts.
Estate
All of the property a person owns or controls; may consist of financial assets, tangible personal assets, immovable property, or intellectual property.
Estate planning
The process of preparing for the disposition of one’s estate (e.g., the transfer of property) upon death and during one’s lifetime.
Estate tax freeze
A plan usually involving a corporation, partnership, or limited liability company with the goal to transfer future appreciation to the next generation at little or no gift or estate tax cost.
Ethical principles
Beliefs regarding what is good, acceptable, or obligatory behavior and what is bad, unacceptable, or forbidden behavior.
Excess capital
An investor’s capital over and above that which is necessary to fund their lifestyle and reserves.
Exchange-traded fund
Exchange-traded Funds or ETFs are hybrid investment products with many features of mutual funds combined with the trading features of common stocks or bonds. Essentially, ETFs are typically portfolios of stocks or bonds or commodities that trade throughout the day like common stocks.
- -> ETFs have smaller taxable events than mutual funds because of the in-kind transfer of securities between an authorized participant and the mutual fund when redemptions occur
- -> Disadvantages of using ETFs vs mutual finds include the need to buy at the offer and sell at the bid price, paying commissions, and possibly facing illiquid markets at either purchase or sale.
- -> Unlike mutual funds, ETFs can be shorted and bought on margin
Execution cost
The difference between the (trading related) cost of the real portfolio and the paper portfolio, based on shares and prices transacted.
= actual price paid for position - (qty x share price when trade is ordered)
OR execution cost = delay costs + trading costs
Exemption method
When the residence country imposes no tax on foreign-source income by providing taxpayers with an exemption, in effect having only one jurisdiction impose tax.
–> if country A is the source country and they live in country B, the person only pays taxes in country A at country A’s tax rate
Exhaustive
An index construction strategy that selects every constituent of a universe.
Conditional value at risk (CVaR - aka expected tail loss, expected short fall )
While VaR represents a worst-case loss associated with a probability and a time horizon, CVaR is the expected loss if that worst-case threshold is ever crossed
- -> good for addressing concerns about left tail risk (the risk of permanent capital loss) and assessing portfolios with asset classes and investment strategies with negative skewness and long tails
- –> provides a more in depth and nuanced view of risk than mean variance optimization because MVO can’t easily accommodate the characteristics of more alternative investments (MVO simply uses s.d. to assess risk which assume normal distribution of returns) and typically over-allocates to alternative asset classes because the risk is underestimated due to stale pricing and the assumption that returns are normally distributed
Extended portfolio assets and liabilities
Assets and liabilities beyond those shown on a conventional balance sheet that are relevant in making asset allocation decisions; an example of an extended asset is human capital.
Factor-model-based benchmarks
Benchmarks constructed by examining a portfolio’s sensitivity to a set of factors, such as the return for a broad market index, company earnings growth, industry, or financial leverage.
Financial buyers
Buyers who lack a strategic motive.
Financial capital
–> how to find total economic capital
The tangible and intangible assets (excluding human capital) owned by an individual or household.
total economic capital = human capital + financial capital
Fixed trust
A trust structure in which distributions to beneficiaries are prescribed in the trust document to occur at certain times or in certain amounts.
Forward conversion with options
The construction of a synthetic short forward position against the asset held long.
–> The forward conversion is a monetization strategy , usually put into place when the investor has a high portfolio concentration in a single security that cannot be sold. The goal here is to be able to borrow against the hedged position and invest the proceeds in a diversified portfolio. A better hedge means more of the value of the concentrated position can be borrowed against (think of the hedged position as collateral). You could hedge and monetize a position with a collar, but the collar does not eliminate all downside risk so the Loan to Value ratio would be less than if you bought the put and sold the call at he current stock price because with the collar the collateral is of lower quality.
Forward rate bias
–> how to capitalize on a forward rate bias
Persistent violation of uncovered interest rate parity that is exploited by the carry trade.
Two ways to earn a positive roll yield:
1. Implement a carry trade: Buy (invest in) the high-yield currency and sell (borrow) the low-yield currency.
2. Trade the forward rate bias: Buy (invest in) the forward discount currency and sell (borrow) the forward premium currency.
–> Given that the base currency (i.e. the US dollar) is trading at a forward premium, the hedge requires the sale of US dollar forward, resulting in a positive roll yield. The concept of roll yield is very similar to forward rate bias and the carry trade.
Framing bias
An information-processing (cognitive) bias in which a person answers a question differently based on the way in which it is asked (framed)
Fulcrum securities
Partially-in-the-money claims (not expected to be repaid in full) whose holders end up owning the reorganized company in a corporate reorganization situation.
–> the security is most likely to convert into equity in a reorganized company after it emerges from bankruptcy
Full replication approach
When every issue in an index is represented in the portfolio, and each portfolio position has approximately the same weight in the fund as in the index.
Fund-of-funds
A fund of hedge funds in which the fund-of-funds manager allocates capital to separate, underlying hedge funds (e.g., single manager and/or multi-manager funds) that themselves run a range of different strategies.
G-spread
G-spread, which uses a linear interpolation of the yields of two on-the-run government bonds as the benchmark rate, weighted so that their weighted average duration matches the duration of the credit security.
G-spread (also called nominal spread) is the difference between yield on Treasury Bonds and yield on corporate bonds of same maturity. Because Treasury Bonds can be assumed to have zero default risk, the difference between yield on corporate bonds and Treasury bonds represent the default risk.
G-Spread = Yc − Yg
Where Yc is the yield on non-treasury bond and Yg is the yield on government bond of the same maturity.
–> A benefit of the G-spread is that when the maturity of the credit security differs from that of the benchmark bond, the yields of two government bonds can be weighted so that their weighted average maturity matches the credit security’s maturity.
Gamblers’ fallacy
The gambler’s fallacy is a cognitive behavioral bias in which an analyst wrongly projects a reversal to a long-term trend. This reflects a faulty understanding about the behavior of random events. The analyst expects a pattern that has diverged from the long term average to reverse within a specific period of time.
–> This bias is caused by a faulty understanding of random events and expecting patterns to repeat.
gamma
While delta changes based on the underlying asset price, gamma is a constant that represents the rate of change of delta
–> an option with the largest gamma is the one with the strike price closest to the current price or near expiration when the deltas can move quickly toward 1.0 or 0.0
—> negative gamma = short option position
General account
Account holding assets to fund future liabilities from traditional life insurance and fixed annuities, the products in which the insurer bears all the risks—particularly mortality risk and longevity risk.
Goals-based investing (planning)
- -> what are the advantages and disadvantages?
- -> what are the 3 risk buckets?
With respect to asset allocation or investing, an approach that focuses on achieving an investor’s goals (for example, related to supporting lifestyle needs or aspirations) based typically on constructing sub-portfolios aligned with those goals.
Goals based investing allows a financial advisor to break out asset allocations to different risk buckets which may make it easier for clients with concentrated positions to see where they are lacking. The manager then performs mean–variance optimization for each goal “portfolio” rather than at the overall portfolio level. Goal portfolios are optimized either to a stated maximum level of volatility or to a specified probability of success. Therefore, with goals-based investing, the allocation of the overall portfolio is a function of the respective allocations of the individual goal portfolios.
Goal-based planning allows the adviser to incorporate psychological considerations into the asset allocation and portfolio construction process. This approach highlights the consequences of selecting an asset allocation that is riskier than is appropriate for a particular investor. A goals-based methodology extends the Markowitz framework of diversifying market risk by incorporating several notional “risk buckets.”
- The first bucket is the personal risk bucket, which includes assets such as a personal residence, certificates of deposit, treasury securities, and other safe investments. The goal of this bucket is protection from poverty or a decrease in lifestyle. The desire is to achieve almost certainty of protection. Allocations to this bucket limit loss but yield below-market rates of return.
- The second bucket is the market risk bucket, which includes assets such as stocks and bonds. The goal of this bucket is to maintain the current standard of living. Allocations to this bucket provide average risk-adjusted market returns
- The third bucket is the aspirational risk bucket and includes assets such as a privately owned business, commercial and investment real estate, and concentrated stock positions. The goal of this bucket is the opportunity to increase wealth substantially. Allocations to this bucket are expected to yield above-market returns but with substantial risk of loss of capital.
- ->This type of risk allocation framework would give an advisor a basis to sit down with a client and identify the significant risk they face from things like a concentrated position and highlight that their allocations to the personal risk and market risk buckets are inadequate.
- -> An advantage of the goals-based investing approach is that it may be easier for clients to express their risk tolerance on a goal-specific basis rather than at the overall portfolio level. A disadvantage is that the combination of goal portfolio allocations may not lead to optimal mean–variance efficiency for the entire portfolio. In other words, the aggregation of each goals-based portfolio allocation may not produce a total portfolio allocation that lies along the client’s efficient frontier.
It should be noted that the remaining steps of the portfolio construction process discussed previously—identifying asset classes, implementing the portfolio, and determining asset location—are the same for both the goals-based investing approach and the traditional approach.
Grinold–Kroner model
The Grinold and Kroner Model is used to calculate expected returns for a stock, stock index or the market as whole
= (dividend yield - change in shares outstanding) + Earnings Growth + %ΔP/E Multiplier
- -> expected income return = dividend yield - change in shares outstanding
- *make sure to consider whether shares are being reduced - i.e. if reducing by 1% you would add dividend yield + 1%
- -> Earnings growth rate = expected inflation + expected real total corporate earnings growth rate
- -> %ΔP/E Multiplier = expected repricing return
- -> dividend yield = dividend / price
Hague Conference on Private International Law
An intergovernmental organization working toward the convergence of private international law. Its 69 members consist of countries and regional economic integration organizations.
Halo effect
An emotional bias that extends a favorable evaluation of some characteristics to other characteristics.
Hard-catalyst event-driven approach
An event-driven approach in which investments are made in reaction to an already announced corporate event (mergers and acquisitions, bankruptcies, share issuances, buybacks, capital restructurings, re-organizations, accounting changes) in which security prices related to the event have yet to fully converge.
Health insurance
A type of insurance used to cover health care and medical costs.
Health risk
The risk associated with illness or injury.
How to calculate the hedge ratio of futures (how to find the number of futures contracts needed to hedge a cash flow)
The hedge ratio is the relationship of the quantity of an asset being hedged to the quantity of the derivative used for hedging.
–> hedge ratio of futures = amount of currency to be exchanged / futures contract size
–> futures contract size = (futures price x multiplier)
High-water mark
A specified net asset value level that a fund must exceed before performance fees are paid to the hedge fund manager.
Hindsight bias
A bias with selective perception and retention aspects in which people may see past events as having been predictable and reasonable to expect.
Holdings-based attribution
A “buy and hold” attribution approach which calculates the return of portfolio and benchmark components based upon the price and foreign exchange rate changes applied to daily snapshots of portfolio holdings.
Holdings-based style analysis
A bottom-up style analysis that estimates the risk exposures from the actual securities held in the portfolio at a point in time.
–> Style analysis, whether returns-based or holdings-based, must be meaningful, accurate, consistent, and timely in order to be useful. Accordingly, style analysis would be most useful in understanding equities and bonds. However, it would be less meaningful for evaluating venture capital assets since they are not traded and are thus illiquid. It can be applied to other strategies (hedge funds and private equity, for example), but the insights drawn from a style analysis of such strategies are more likely to be used for designing additional lines of inquiry in the course of due diligence rather than for confirmation of the investment process.
Home bias
A preference for securities listed on the exchanges of one’s home country.
Horizon matching
Horizon matching is a hybrid approach to liability-based mandates that combines cash flow matching and duration matching. Cash flow matching intends to match a short- to medium-term liability stream (charity donations for the first five years) to a stream of bond portfolio cash inflows. Duration matching further considers that the bond portfolio’s reinvestment risk and market price risk offset each other as it relates to the charity donations during Years 6 through 10.
–> Under this approach, liabilities are categorized as short-and long-term liabilities.
I-spread
I-spread stands for interpolated spread. It is the difference between yield on a bond and the swap rate, i.e. the interest rate applicable to the fixed leg in the floating-for-fixed interest rate swap. The difference between yield on a bond and a benchmark curve such as LIBOR is useful in assessing credit risk of different bonds. Higher i-spread means higher credit risk. I-spread is typically lower than the G-spread.
Self Control bias
A bias in which people tend to believe that they can control or influence outcomes when, in fact, they cannot.
–> A bias in which people fail to act in pursuit of their long-term, overarching goals because of a lack of self-discipline (i.e. not saving because you’re not thinking long term, and then being really risky to make up for it later in life). The consequences of self-control bias include accepting too much risk in the portfolio and asset allocation imbalance problems as you attempt to generate higher returns.
Immediate annuity
An annuity that provides a guarantee of specified future monthly payments over a specified period of time.
Immunization
- -> when is a portfolio considered “immunized”?
- -> what are the structural risks to immunization?
- -> what are the two requirements to achieve immunization?
- -> effect of price and coupon reinvestment risk in the case of an upward shift in the yield curve for an immunized liability?
An investor having an investment horizon equal to the bond’s Macaulay duration is effectively protected, or immunized, from the first change in interest rates. The interest rate risk has been immunized when portfolio’s weighted average Macaulay duration approximately matches the time horizon of the liability and can be calculated as follows:
[(Portfolio weightBond 1 × DurationBond 1) + (Portfolio weightBond 2 × DurationBond 2) + (Portfolio weightBond 3 × DurationBond 3)]
- -> immunization is AKA zero replication
- -> Immunization is the process of structuring and managing a fixed-income portfolio to minimize the variance in the realized rate of return and to lock in the cash flow yield (internal rate of return) on the portfolio
- -> Structural risk to immunization arises from twists and non-parallel shifts in the yield curve. Structural risk is reduced by minimizing the dispersion of cash flows in the portfolio, which can be accomplished by minimizing the convexity for a given cash flow duration level.
- -> The two requirements to achieve immunization for multiple liabilities are for 1) the money duration (value of bond x Mod Dur aka BPV) of the asset and liability to match and for 2) the asset convexity to exceed the convexity of the liability (i.e. if the asset convexity is less than the liabilities as interest rates increase, they will underperform - you want the asset portion to be less volatile)
- -> The price effect and the coupon reinvestment effect cancel each other in the case of an upward shift in the yield curve for an immunized liability.
Implementation shortfall
Execution cost
Opportunity cost
trading cost
(IS) The difference between the return for a notional or paper portfolio, where all transactions are assumed to take place at the manager’s decision price, and the portfolio’s actual return, which reflects realized transactions, including all fees and costs.
–> note that if the trade takes more than a day, the decision price moves from the original decision price to the PBD EOD price because at that point you have to decide to put the trade back out again
IS = paper return - actual return
IS in bps = (Execution Cost + Opportunity Cost + Fees) / (Total Order Shares x decision price)
–> total shares = executed + those left remaining
–> convert into bp
exec. cost = actual sale profit - (shares traded x decision price)
OR = delay cost + trading cost
op. Cost = shares remaining unexecuted x (closing price - decision price)
Decision price: when the manager decides to buy or sell
Arrival price: price when the order is placed by trader
trading cost: due to market impact of executing the trade
trading cost = shares executed x (avg px - arrival price)
Implied volatility
Implied volatility (IV) refers to the degree of volatility of the price of a given security as expected by investors. It is essentially a forecast that investors can use as a metric while making investment-related decisions.
Investors can use IV to discern future fluctuations in the price of a security, and as a proxy to the market risk associated with that security. When the market is bearish, implied volatility increases because investors expect the prices of equity to decline in the future. Similarly, in a bullish market, investors expect the prices to rise over time, which means that implied volatility decreases.
Implied volatility surface
A three-dimensional plot, for put and call options on the same underlying asset, of days to expiration (x-axis), option strike prices (y-axis), and implied volatilities (z-axis). It simultaneously shows the volatility skew (or smile) and the term structure of implied volatility.
Indexing
A common passive approach to investing that involves holding a portfolio of securities designed to replicate the returns on a specified index of securities.
Indifference curve analysis
A decision-making approach whereby curves of consumption bundles, among which the decision-maker is indifferent, are constructed to identify and choose the curve within budget constraints that generates the highest utility.
Information coefficient
Formally defined as the correlation between forecast return and actual return. In essence, it measures the effectiveness of investment insight.
Input uncertainty
Uncertainty concerning whether the inputs are correct.
Intertemporal consistency
A feature of expectations setting which means that estimates for an asset class over different horizons reflect the same assumptions with respect to the potential paths of returns over time. It is the internal consistency over various time horizons.
Intestate
Having made no valid will; a decedent without a valid will or with a will that does not dispose of their property is considered to have died intestate.
Intrinsic value of a fx rate
The difference between the spot exchange rate and the strike price of a currency option.
Investment policy statement
Sharfepto Zik, a private wealth manager, is meeting with a client, Garbanzo Patel, in order to create an investment policy statement (IPS) for Patel’s upcoming retirement. Patel estimates that he will require €200,000 per year, with annual increases for inflation, during retirement. Patel’s primary spending goals during retirement are to provide for his family’s needs and maintain his retirement lifestyle. His secondary goals are to fund his philanthropic activities and leave a significant inheritance to his children.
During his retirement, Patel will receive union pension payments of €50,000 per year with annual increases for inflation. In his spare time, Patel runs a small business that provides him with an annual income of €120,000 and is valued at €1 million. He will continue running his business during retirement.
Patel holds a portfolio of securities valued at approximately €4 million. The portfolio primarily contains dividend-paying stocks and interest-bearing bonds. Patel has reinvested all these distributions back into his portfolio but anticipates that after retirement he may need to use some of the distributions to fund his expenses.
Patel plans to buy a vacation home in three years. His budget for the vacation home is approximately €1.4 million. Patel has not decided yet how he will fund this purchase.
A written planning document that describes a client’s investment objectives and risk tolerance over a relevant time horizon, along with the constraints that apply to the client’s portfolio.
Invesment objective section ex:
- Purpose: Support Patel’s lifestyle in retirement (higher priority), provide for family’s needs (higher priority), fund philanthropic activities (lower priority), provide inheritance for children (lower priority)
- Anticipated annual need: €200,000, with annual increases for inflation
- Annual need met with: Income from small business (approx. €120,000), pension (€50,000 with annual inflation increases), portfolio distributions
- Intent to purchase of €1.4 million vacation home in three years
- Manager should assist in quantifying philanthropic and bequest goals and determining how to fund large purchases or cash flows
The purpose of this portfolio is to support Garbanzo Patel’s lifestyle in retirement, to provide for his family’s needs, to fund his philanthropic activities, and to provide an inheritance for his children. Patel’s primary objective is to provide for his family’s needs and support his lifestyle during his retirement. The philanthropic and bequest objectives are lower priorities.
To meet all his objectives, Patel anticipates needing €200,000 per year, with annual increases for inflation. His cash needs will be primarily satisfied through income from his small business of approximately €120,000 per year and his union pension payments of €50,000 per year. The pension payments will increase annually for inflation. Any remaining cash needs will be satisfied by taking distributions from his portfolio.
Patel also intends to purchase a vacation home in three years and plans to pay approximately €1.4 million.
Patel has not articulated specific amounts for his philanthropic activities or his children’s inheritances. Zik should work with Patel to quantify his philanthropic and bequest goals and to decide on the best way to fund the purchase of his vacation home.
Investment style
A natural grouping of investment disciplines that has some predictive power in explaining the future dispersion of returns across portfolios.
Irrevocable trust
–>why might this be a good idea for a child?
A trust arrangement wherein the settlor has no ability to revoke the trust relationship.
–> reasons to elect for a trust:
• If the beneficiaries are minors and cannot receive the life insurance proceeds directly at this time.
• A trust permits grantor to nominate a trustee of his choosing, rather than one appointed by a government authority, to manage the insurance benefit while the children are underage.
•Grantor can designate the age(s) and circumstance(s) under which each child will receive trust distributions.
• The trustee may be given discretionary powers to alter the timing and/or amount of payments as well as the ability to treat the beneficiaries unequally if the children’s needs are unequal or change over time.
• There is the possibility of professional investment management of the proceeds.
• The trust may add a degree of privacy for the receipt and distribution of the insurance payouts to the children.
• There may be asset protection features that place the insurance proceeds beyond the reach of Serensen’s creditors or the creditors of his estate.
Joint ownership with right of survivorship
Jointly owned; assets held in joint ownership with right of survivorship automatically transfer to the surviving joint owner or owners outside the probate process.
Key person risk
The risk that results from over-reliance on an individual or individuals whose departure would negatively affect an investment manager.
Key rate duration
–> when to use key rate vs effective duration?
- The key rate duration calculates the change in a bond’s price in relation to a 100-basis-point (1%) change in the yield for a given maturity.
- When a yield curve has a parallel shift, you can use effective duration, but key rate duration must be used when the yield curve moves in a non-parallel manner, to estimate portfolio value changes.
- Duration measures tell you the price risk involved in holding fixed income securities given a change in interest rates
- -> For instance, say you’re comparing two bonds that share a coupon rate of five percent. In looking more closely at each one, you notice the first bond has a duration of 4.8 years while the second bond has a duration of 9.2 years. This means if interest rates rise to six percent, the first bond’s price will fall by only about 4.8 percent while the second bond’s price will fall by nearly double that, or about 9.2 percent. In this sense, duration gives investors a key measure of volatility when comparing multiple bond investments. Controlling for other factors, a bond with shorter duration will suffer less volatility than a bond with longer duration.
Knock-in/knock-out
Features of a vanilla option that is created (or ceases to exist) when the spot exchange rate touches a pre-specified level.
–> Knock-in options come into existence when the price of the underlying asset reaches or breaches a specific price level, while knock-out options cease to exist (i.e. they are knocked out) when the asset price reaches or breaches a price level.
Leading economic indicators
A set of economic variables whose values vary with the business cycle but at a fairly consistent time interval before a turn in the business cycle.
Leveraged recapitalization and what is a staged exit strategy?
Recapitalization is when the owner restructures the company balance sheet and directs the company to take actions beneficial to the owner, such as paying a large dividend or buying some of the owner’s shares
A leveraged recapitalization is a strategy that involves retooling a company’s balance sheet in partnership with a private equity firm. A recapitalization strategy is a “staged” exit strategy. The private equity firm generally invests equity capital and arranges debt with senior or subordinated lenders. The owner transfers his/her stock for cash and an ownership interest in the newly capitalized entity. This allows the owner to monetize a significant portion of his/her business equity (typically 60% to 80%) and retain significant upside potential with the remaining ownership (typically 20% to 40%). The after-tax proceeds the investor receives could be deployed into other asset classes to help build a diversified portfolio. Additionally, the retained stake motivates the owner to grow the business.
From a tax perspective, the owner is taxed currently on the cash received and typically receives a tax deferral on the stock rolled over into the new entity. This strategy would be appealing to a business owner considering selling a private business in the near future and residing in a jurisdiction where tax rates are scheduled to increase.
There are two potential disadvantages to employing a leveraged recapitalization strategy:
- Private equity firms are financial buyers and, as such, they typically will not pay as high a price as strategic buyers because they do not have the same opportunity as strategic buyers to take advantage of financial and operating synergies.
- the owner relinquishes control of the company.
–> a “staged” exit strategy allows the owner to have two liquidity events, one up-front and a second typically within a 3 to 5 year timeframe, when the private equity firm cashes out of the investment (sale or monetization of the remainder of their ownership).
Liability driven investing (LDI) model
–> main focus?
In the LDI model, the primary investment objective is to generate returns sufficient to cover liabilities, with a focus on maximizing expected surplus return (excess return of assets over liabilities) and managing surplus volatility.
- -> focuses on growth of the surplus and standard deviation
- -> i.e. if the goal is to fund retirement, LDI is appropriate to use
- -> Liability-driven investing (LDI) is a form of asset/liability management (ALM). All ALM strategies require the manager to incorporate the interest rate sensitivity of both the assets and the liabilities in the portfolio management process. The amount and timing of cash outlays may be sensitive to changes in interest rates if decisions are based on other savings or salaries change with market interest rates (i.e. decision to retire). Further, the value of the liability portfolio would change with changes in interest rates because of a discount rate effect, even if the amount or timing of the payments do not change.
- -> Liability-based mandates are investments that take an investor’s future obligations into consideration. Liability-based mandates are managed to match expected liability payments with future projected cash inflows. These types of mandates are structured in a way to ensure that a liability or a stream of liabilities can be covered and that any risk of shortfalls or deficient cash inflows for a company is minimized.
Liability glide path
the objective of the liability glide path is to increase the funded status by reducing surplus risk over time. The glide path blueprints de-risk as funded status increases by re-allocating funds out of the growth assets and into the liability hedge. In normal market environments, such a shift will reduce plan surplus risk but also reduce expected returns so contributions will be more likely to occur.
–> A specification of desired proportions of liability-hedging assets and return-seeking assets and the duration of the liability hedge as funded status changes and contributions are made.
Liability insurance
A type of insurance used to manage liability risk.
Liability-relative
With respect to asset allocation, an approach that focuses directly only on funding liabilities as an investment objective.
Liability risk
The possibility that an individual or household may be held legally liable for the financial costs associated with property damage or physical injury.
Life-cycle finance
A concept in finance that recognizes as an investor ages, the fundamental nature of wealth and risk evolves.
Life insurance
A type of insurance that protects against the loss of human capital for those who depend on an individual’s future earnings.
Life settlement
—> what to look for if investing in a life settlement?
The sale of a life insurance contract to a third party. The valuation of a life settlement typically requires detailed biometric analysis of the individual policyholder and an understanding of actuarial analysis.
- -> hedge funds look for policies in which
1. the ongoing premium payments to keep the policy active are relatively low
2. the surrender value offered to the insured individual is also relatively low
3. the probability that the designated insured person is likely to die earlier than predicted by standard actuarial methods is relatively high.
Lifetime gratuitous transfer
A lifetime gift made during the lifetime of the donor; also known as inter vivos transfers.
Limited-life foundations
A type of foundation where founders seek to maintain control of spending while they (or their immediate heirs) are still alive.
Liquidity classification schedule
A liquidity management classification (or table) that defines portfolio liquidity “buckets” or categories based on the estimated time it would take to convert assets in that particular category into cash.
Longevity risk
The risk associated with living to an advanced age in retirement, including the uncertainty surrounding how long retirement will last; the risk of outliving one’s financial resources.
Loss severity (loss given default)
The amount of loss if a default occurs. Also called loss given default.
Macaulay duration
–> equation to find?
Macaulay duration measures the weighted average time an investor must hold a bond until the present value of the bond’s cash flows is equal to the amount paid for the bond, it is often used by bond managers looking to manage bond portfolio risk with immunization strategies.
Macaulay Duration = Modified Duration x [ 1 + (yield/annual frequency) ]
–> An investor having an investment horizon equal to the bond’s Macaulay duration is effectively protected, or immunized, from the first change in interest rates, because price and coupon reinvestment effects offset for either higher or lower rates.
–> macaulay vs modified duration: The modified duration figure indicates the percentage change in the bond’s value given an X% interest rate change. Unlike the Macaulay duration, modified duration is measured in percentages.
Manager peer group
manager universe
A broad group of managers with similar investment disciplines.
Matrix pricing
An approach for estimating the prices of thinly traded securities based on the prices of securities with similar attributions, such as similar credit rating, maturity, or economic sector. Also called evaluated pricing.
Mental accounting bias
An information-processing bias in which people treat one sum of money differently from another equal-sized sum based on which mental account the money is assigned to.
- -> each goal and corresponding wealth is considered seperately. these investors may prefer a portfolio made up of multiple assets with different risk characteristics vs a portfolio of a single asset with the same sharpe and roverall risk profile.
- -> Overcome this bias by showing the correlations and risks between investments within the portfolio, instead of segregating individual investments within the portfolio.
Micro vs macro attribution
micro attribution: Attribution at the portfolio manager level.
Macro attribution: analyzes investment decision at the fund sponsors level
Mismatch in character
Occurs when the gain or loss in the concentrated position and the offsetting loss or gain in hedge are subject to different tax treatments
The potential tax inefficiency that can result if the instrument being hedged, and the tool that is being used to hedge it, produce income and loss of a different character.
Mission-related investing
Aims to direct a significant portion of assets in excess of annual grants into projects promoting a foundation’s mission.
Model uncertainty
Uncertainty as to whether a selected model is correct.
Modified duration
–> how to calculate the effect of a 20bp increase in interest rates
Modified duration identifies how much the duration changes for each percentage change in the yield while measuring how much a change in the interest rates impact the price of a bond. Thus, the modified duration can provide a risk measure to bond investors by approximating how much the price of a bond could decline with an increase in interest rates. It’s important to note that bond prices and interest rates have an inverse relationship with each other.
—> The Macaulay duration calculates the weighted average time before a bondholder would receive the bond’s cash flows. Conversely, the modified duration measures the price sensitivity of a bond when there is a change in the yield to maturity.
Modified duration =
macaulay duration / [ 1 + (YTM/n) ]
–> the effect of a 20bp increase in interest rates would be (-ModDur) x .0020
–> Modified durations’ edge over Macaulay duration is it is more accurate to capture the price changes of the instrument and more appropriate for some immunization techniques
EX:
The modified duration for a bond, with a yield to maturity of 8% for one coupon period, and a Macaulay Duration of 4.99 years is: (4.99 / (1 + 0.08 / 1) = 4.62 years. Therefore, if the yield to maturity increases from 8% to 9%, the DURATION of the bond will decrease by 0.37 years (4.99 - 4.62).
The formula to calculate the percentage change in the PRICE of the bond is the change in yield multiplied by the negative value of the modified duration multiplied by 100%. This resulting percentage change in the bond, for an interest rate increase from 8% to 9%, is calculated to be -4.62% (0.01* - 4.62* 100%).
Therefore, if interest rates rise 1% overnight, the PRICE of the bond is expected to drop 4.62%.
Monetize
To access an item’s cash value without transferring ownership of it.
Money duration
A measure of the price change in units of the currency in which the bond is denominated given a change in its yield-to-maturity.
Money Duration = Market Value x modified Duration
- -> Macaulay duration measures the weighted average time an investor must hold a bond until the present value of the bond’s cash flows is equal to the amount paid for the bond
- -> Mod Dur is the % change of the bond in response to a 1% change in yields
Ex:
A life insurance co holds a USD 1M (par value) position in a bond that has a mod dur of 6.38. the full price of the bond is 102.32 per 100 face value.
Money Duration = 1M x 102.32 x 6.38 = $6,528,000
—> Using the money duration, estimate the loss for each 10 bps increase in the yield to maturity
10bps = .0010 so for each increase in the YTM, the loss is estimated to be $6.258M x .0010 = $6,528.02
Multi-class trading
An equity market-neutral strategy that capitalizes on misalignment in prices and involves buying and selling different classes of shares of the same company, such as voting and non-voting shares.
Multi-manager fund
Can be of two types—one is a multi-strategy fund in which teams of portfolio managers trade and invest in multiple different strategies within the same fund; the second type is a fund of hedge funds (or fund-of-funds) in which the manager allocates capital to separate, underlying hedge funds that themselves run a range of different strategies.
Multi-strategy fund
A fund in which teams of portfolio managers trade and invest in multiple different strategies within the same fund.
Mutual funds
–> vs ETFs?
A professionally managed investment pool in which investors in the fund typically each have a pro-rata claim on the income and value of the fund.
–> mutual funds can not be bought on margin and have larger taxable events than ETFs because of the in-kind transfer of securities between an authorized participant and the fund when redemptions occur.
Negative screening
An ESG implementation approach that excludes certain sectors or companies that deviate from an investor’s accepted standards.
Net asset value and how to calculate the expected net asset value at the end of the year?
Value established at the end of each trading day based on the fund’s valuation of all existing assets minus liabilities, divided by the total number of shares outstanding.
Expected NAV = [Prior-year NAV × (1 + Growth rate) + Capital contributions – Distributions)] × (1 + Growth rate)
Expected distribution = [Prior-year NAV × (1 + Growth rate)] × (Distribution rate)
Capital contributions in period t = percentage to be called in period x (committed capital - capital previously called)
human capital
–> how to estimate?
An implied asset; the net present value of an investor’s future expected labor income weighted by the probability of surviving to each future age. Also called net employment capital.
–> Holding all else equal, a reduction in the nominal risk-free rate, rf, would decrease the total discount rate, thus increasing the present value of human capital.
= wages x (1+g)(chance of survival in mortality table) / (1+rf rate + any other risk premiums given)^n
n= years to retirement
ex:
Alex Hamilton is 62 and expected to retire in 3 years. His current annual wage is 100,000 and expected to increase 4% per year. The risk-free discount rate is 3%, and his continued employment is considered very risky. A 10% risk premium is assumed. Using this information and the survival probabilities in the table, calculate his HC.
Answer: Increase earnings by 4% per year for the 3 years of employment, probability weight the earnings, and discount to the present value (PV) at 13% per year. 13% is the risk-free rate plus the risk premium.
HC = 248,825
13% is the rf rate + the risk premium
For year 1:
His wage is (100 * 1.04) = 104k
From the mortality table, he has a 98% chance of surviving the cold winter
104k(0.98) = 101.92k
To get the PV, bring it back 1 year using the discount rate (13%): 101.92/1.13 = 90.195k
Do the same for years 2 and 3, sum up the PVs and you have your Human Capital!
Net worth tax or net wealth tax
–>how to calculate its impact?
A tax based on a person’s assets, less liabilities.
–> i,e, if a portfolio is expected to earn 5% annually but the resident country imposes a .5 wealth tax annually assuming no other taxes, what is the ending value of a 500k account after 20 years?
= FV = €500,000[(1.05)(1 – 0.005)]^20 = €1,200,100
Nonstationarity
A characteristic of series of data whose properties, such as mean and variance, are not constant through time. When analyzing historical data it means that different parts of a data series reflect different underlying statistical properties.
Norway model
–> advantages and disadvantages?
Characterized by an almost exclusive reliance on public equities and fixed income (the traditional 60/40 equity/bond model falls under the Norway model) (sometimes subject to environmental, social, and governance concerns). Largely passively managed assets, TIGHT tracking error limits and with very little to no allocation to alternative investments.
- -> Advantages of using the Norway model are that investment costs/fees are low, investments are transparent, manager risk is low, and there is little complexity for a governing board (the model is easy to understand).
- -> The disadvantage of using the Norway model is that there is limited potential for value-added (i.e., alpha from security selection skills), above-market returns.
Offer price
The price at which a counterparty is willing to sell one unit of the base currency.
Opportunity cost
The (trading related) cost associated with not being able to transact the entire order at the decision price.
= shares remaining in order x (EOD price per share - decision price)
Optional stock dividends
A type of dividend in which shareholders may elect to receive either cash or new shares.
Overconfidence bias
A bias in which people demonstrate unwarranted faith in their own intuitive reasoning, judgments, and/or cognitive abilities.
- -> Overconfidence bias is a emotional error and is therefore difficult to correct.
- -> Overconfidence and excessive trading are linked to confirmation bias, illusion of knowledge and self-attribution bias (as well as hindsight bias and the illusion of knowledge.)
- -> In asset bubbles, investors often exhibit symptoms of overconfidence: prediction overconfidence leads to setting confidence intervals too narrow leading to overtrading, under-estimation of risks, failure to diversify, and rejection of contradictory information. With overconfidence, investors are more active and trading volume increases, thus lowering their expected profits.
- -> prediction overconfidence: leads to setting confidence intervals too narrow
- -> certainty overconfidence: overstated probability of success
Overlay
A derivative position (or positions) used to adjust a pre-existing portfolio closer to its objectives.
Reconstitution
Reconstitution (aka packeting) :process of removing/replacing stocks that no longer fit the desired market exposure of the index
-> ex. small cap stock’s capitalization increases and stock becomes mid cap
Practices used to reduce trading costs caused by reconstitution:
1) Buffering: establishing a threshold level for change in firms market cap rank that must be met before moving it from one index to another
2) Packeting: only move part of portfolio on first reconstitution date; if stock still meets criteria on next, move the rest of the positionSplitting stock positions into multiple parts.
Pairs trading
An equity market-neutral strategy that capitalizes on the misalignment in prices of pairs of similar under- and overvalued equities. The expectation is the differential valuations or trading relationships will revert to their long-term mean values or their fundamentally-correct trading relationships, with the long position rising and the short position declining in value.
–> largest risk in pairs trading is that the observed price divergence is not temporary and could be due to structural reasons. Frequent use of stop-loss rules, which are set to exit trades when a loss limit is reached, addresses this risk.
Parameter uncertainty
Uncertainty arising because a quantitative model’s parameters are estimated with error.
Participant/cohort option
Pools the DC plan member with a cohort that has a similar target retirement date.
Participant-switching life-cycle options
Automatically switch DC plan members into a more conservative asset mix as their age increases. There may be several automatic de-risking switches at different age targets.
Passive investment
Investment that seeks to mimic the prevailing characteristics of the overall investments available in terms of credit quality, type of borrower, maturity, and duration rather than express a specific market view.
–> Passive strategies seek to earn risk premiums, which are defined as the return in excess of a minimal risk (“risk-free”) rate of return that accrues to bearing a risk that is not easily diversified away—so-called systematic risk. Active strategies, in contrast, assume markets are sufficiently inefficient that security mispricings can be identified and exploited.
Passive management
A buy-and-hold approach to investing in which an investor does not make portfolio changes based upon short-term expectations of changing market or security performance.
