Vocab Words

Question 1

Accounting defeasance

Answer 1

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.

Question 2

Accumulation phase

Answer 2

Phase where the government predominantly contributes to a sovereign wealth pension reserve fund

Question 3

Active management for a stable upward sloping yield curve

a changing yield curve?

Answer 3

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.

Question 4

Active return

–> how to calculate it

Answer 4

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

Question 5

Active risk

–> how to calculate

Answer 5

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.

Question 6

Active risk budgeting

Answer 6

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.

Question 7

Active share

–> equation to find it?

Answer 7

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

Question 8

Activist short selling

Answer 8

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.

Question 9

what are the five conclusions of the adaptive markets hypothesis?

Answer 9

(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:

1. The relationship between risk and return is not perfectly stable. It changes over time as the competitive environment changes.
2. Active management of investments can find opportunities to exploit inefficiencies from time to time
3. Adaption and innovation are key to survival
4. Survival is the only objective that matters
5. No strategy will work all the time

Question 10

Agency trade

Answer 10

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.

Question 11

Alpha decay

Answer 11

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

Question 12

Alternative trading systems

Answer 12

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.

Question 13

Anchoring and adjustment (anchoring bias)

–> how to overcome this bias?

Answer 13

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.

Question 14

Anomalies

Answer 14

Apparent deviations from market efficiency.

Question 15

Arithmetic attribution

Answer 15

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.

Question 16

Arrival price

Answer 16

In a trading context, the arrival price is the security price at the time the order was released to the market for execution.

Question 17

Aspirational risk bucket

–> Three tools for addressing a concentrated position in a publicly traded common stock

Answer 17

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.

Question 18

Asset location

Answer 18

The type of account an asset is held within, e.g., taxable or tax deferred.

Question 19

Focus of asset-only asset allocation

Answer 19

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

Question 20

Authorized participants

Answer 20

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.

Question 21

Availability bias

Answer 21

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.

Question 22

Back-fill bias

Answer 22

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.

Question 23

Barbell portfolio and when is this strategy useful?

–> what sort of portfolio works best under a flattening yield curve?

Answer 23

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.

Question 24

Base Currency

Answer 24

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

Question 25

Basis risk | --> how to quantify it?

Answer 25

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.

Question 26

Bayes’ formula

Answer 26

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)

Question 27

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?

Answer 27

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

Question 28

Behavioral biases

Answer 28

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)

Question 29

Behavioral macro-finance

Answer 29

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”

Question 30

Behavioral finance micro

Answer 30

A focus on individual level behavior that examines the behavioral biases that distinguish individual investors from the rational decision makers of traditional finance.

Question 31

Benchmark spread - -> what is usually referenced? - -> issues that can arise?

Answer 31

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.

Question 32

Best-in-class

Answer 32

An ESG implementation approach that seeks to identify the most favorable companies and sectors based on ESG considerations. Also called positive screening.

Question 33

Bid price

Answer 33

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.

Question 34

Bottom-up approach

Answer 34

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.

Question 35

Bounded rationality

Answer 35

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.

Question 36

Breadth

Answer 36

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

Question 37

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?

Answer 37

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)

Question 38

Buffering

Answer 38

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.

Question 39

Bullet

Answer 39

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.

Question 40

Business cycle

Answer 40

Fluctuations in GDP in relation to long-term trend growth, usually lasting 9-11 years.

Question 41

Butterfly spread | --> Max loss and max profit for long and short butterfly spreads

Answer 41

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

Question 42

Calendar spread | --> best time to implement?

Answer 42

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

Question 43

Canadian model

Answer 43

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.

Question 44

Capital market expectations and the process of setting them up (7 steps)

Answer 44

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 1. Specify the set of expectations needed, including the time horizon(s) to which they apply. 2. Research the historical record. 3. Specify the method(s) and/or model(s) to be used and their information requirements. 4. Determine the best sources for information needs. 5. Interpret the current investment environment using the selected data and methods, applying experience and judgment. 6. Provide the set of expectations needed, documenting conclusions. 7. Monitor actual outcomes and compare them with expectations, providing feedback to improve the expectation-setting process.

Question 45

Capital sufficiency analysis | Capital needs analysis

Answer 45

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

Question 46

Capture ratio | --> what does a concave and convex capture ratio look like? (>100% or less?)

Answer 46

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.

Question 47

Carhart model

Answer 47

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.

Question 48

Carry trade

Answer 48

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

Question 49

Cash drag

Answer 49

Tracking error caused by temporarily uninvested cash.

Question 50

Cash flow matching - -> the effects of interest rate movements? - -> drawbacks of this method?

Answer 50

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.)

Question 51

Cash-secured put

Answer 51

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).

Question 52

Representative Sampling

Answer 52

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.

Question 53

Certainty equivalent

Answer 53

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.

Question 54

Civil law

Answer 54

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.

Question 55

Closet indexer vs sector rotator vs diversified stock picker --> active share and active risk styles

Answer 55

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

Question 56

Code of ethics

Answer 56

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.

Question 57

Cognitive dissonance

Answer 57

The mental discomfort that occurs when new information conflicts with previously held beliefs or cognitions.

Question 58

Cognitive errors (9 types and how to address?)

Answer 58

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

Question 59

Collar - -> max profit and loss? - --> investors best case scenario?

Answer 59

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

Question 60

Common law

Answer 60

A legal system which draws abstract rules from specific cases. In common law systems, law is developed primarily through decisions of the courts.

Question 61

Community property regime

Answer 61

A marital property regime under which each spouse has an indivisible one-half interest in property received during marriage.

Question 62

systematic vs non-systematic risk

Answer 62

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.

Question 63

Completion overlay

Answer 63

A type of overlay that addresses an indexed portfolio that has diverged from its proper exposure.

Question 64

Confirmation bias

Answer 64

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

Question 65

Conjunction fallacy

Answer 65

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.

Question 66

Conservatism bias

Answer 66

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.

Question 67

Contingent immunization

Answer 67

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

Question 68

Controlled foreign corporation

Answer 68

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.

Question 69

Convexity | --> how to increase and decrease portfolio convexity?

Answer 69

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.

Question 70

Core capital | --> how to estimate core capital needs?

Answer 70

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

Question 71

Covered call - -> break even price? - -> when is this strategy the least profitable?

Answer 71

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

Question 72

Creation units

Answer 72

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

Question 73

Credit method for tax calculation

Answer 73

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)

Question 74

Credit risk

Answer 74

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.

Question 75

Cross-currency basis swap | --> when are the notional principals of the swap exchanged?

Answer 75

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

Question 76

Cross hedge

Answer 76

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.

Question 77

Cross-sectional consistency

Answer 77

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.

Question 78

Managed futures trends: 1. Cross-sectional momentum 2. Time Series Momentum

Answer 78

1. 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. 2. 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

Question 79

Currency overlay

Answer 79

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.

Question 80

Custom security-based benchmark | --> requirements of a custom benchmark in order for it to be used as a benchmark portfolio?

Answer 80

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.

Question 81

Decision price

Answer 81

In a trading context, the decision price is the security price at the time the investment decision was made.

Question 82

Decision-reversal risk

Answer 82

The risk of reversing a chosen course of action at the point of maximum loss.

Question 83

Decumulation phase

Answer 83

Phase where the government predominantly withdraws from a sovereign wealth pension reserve fund.

Question 84

Dedicated short-selling

Answer 84

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.

Question 85

Deduction method | --> equation to calculate taxes due

Answer 85

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.

Question 86

Deemed dispositions

Answer 86

Tax treatment that assumes property is sold. It is sometimes seen as an alternative to estate or inheritance tax.

Question 87

Deemed distribution

Answer 87

When shareholders of a controlled foreign corporation are taxed as if the earnings were distributed to shareholders, even though no distribution has been made.

Question 88

Deferred annuity

Answer 88

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.

Question 89

Defined benefit vs defined contribution plan

Answer 89

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.

Question 90

Defined contribution | --> who is responsible for ultimate retirement benefit, investment and admin providers?

Answer 90

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

Question 91

Delay cost

Answer 91

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

Question 92

Delta | --> how to calculate the delta of a combined position of L or S stock and L or S calls or puts?

Answer 92

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)

Question 93

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?

Answer 93

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)

Question 94

Demand deposits

Answer 94

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).

Question 95

Diffusion index

Answer 95

An index that measures how many indicators are pointing up and how many are pointing down.

Question 96

Direct market access

Answer 96

(DMA) Access in which market participants can transact orders directly with the order book of an exchange using a broker's exchange connectivity.

Question 97

Disability income insurance

Answer 97

A type of insurance designed to mitigate earnings risk as a result of a disability in which an individual becomes less than fully employed.

Question 98

Discretionary trust

Answer 98

A trust structure in which the trustee determines whether and how much to distribute in the sole discretion of the trustee.

Question 99

Dispersion

Answer 99

- 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%.

Question 100

Disposition effect

Answer 100

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.

Question 101

Dividend capture

Answer 101

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.

Question 102

Domestic-currency return

Answer 102

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

Question 103

Donor-advised fund

Answer 103

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.

Question 104

Double inflection utility function

Answer 104

A utility function that changes based on levels of wealth.

Question 105

Downside capture

Answer 105

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)

Question 106

Drawdown - -> what is maximum drawdown? - -> drawdown duration?

Answer 106

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).

Question 107

Duration matching

Answer 107

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.

Question 108

Dynamic asset allocation

Answer 108

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.

Question 109

Dynamic hedge

Answer 109

A hedge requiring adjustment as the price of the hedged asset changes.

Question 110

Earnings risk

Answer 110

The risk associated with the earning potential of an individual.

Question 111

Three approaches to economic forecasting?

Answer 111

1. 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). 2. 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. 3. 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.

Question 112

Economic balance sheet

Answer 112

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.

Question 113

Economic indicators

Answer 113

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.

Question 114

Economic net worth

Answer 114

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)

Question 115

Effective convexity | --> examples and formula?

Answer 115

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)

Question 116

Effective duration

Answer 116

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.

Question 117

Effective federal funds (FFE) rate

Answer 117

The fed funds rate actually transacted between depository institutions, not the Fed’s target federal funds rate.

Question 118

Emotional biases

Answer 118

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

Question 119

Empirical duration | --> when to use empirical vs effective duration?

Answer 119

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.

Question 120

Endowment bias

Answer 120

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.

Question 121

Endowment model

Answer 121

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)

Question 122

What is the goal of an enhanced indexing strategy?

Answer 122

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.

Question 123

Environmental, social, and corporate governance (ESG)

Answer 123

Also called socially responsible investing , refers to the explicit inclusion of ethical, environmental, or social criteria when selecting a portfolio.

Question 124

forward vs future

Answer 124

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.

Question 125

Estate

Answer 125

All of the property a person owns or controls; may consist of financial assets, tangible personal assets, immovable property, or intellectual property.

Question 126

Estate planning

Answer 126

The process of preparing for the disposition of one’s estate (e.g., the transfer of property) upon death and during one’s lifetime.

Question 127

Estate tax freeze

Answer 127

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.

Question 128

Ethical principles

Answer 128

Beliefs regarding what is good, acceptable, or obligatory behavior and what is bad, unacceptable, or forbidden behavior.

Question 129

Excess capital

Answer 129

An investor’s capital over and above that which is necessary to fund their lifestyle and reserves.

Question 130

Exchange-traded fund

Answer 130

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

Question 131

Execution cost

Answer 131

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

Question 132

Exemption method

Answer 132

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

Question 133

Exhaustive

Answer 133

An index construction strategy that selects every constituent of a universe.

Question 134

Conditional value at risk (CVaR - aka expected tail loss, expected short fall )

Answer 134

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

Question 135

Extended portfolio assets and liabilities

Answer 135

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.

Question 136

Factor-model-based benchmarks

Answer 136

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.

Question 137

Financial buyers

Answer 137

Buyers who lack a strategic motive.

Question 138

Financial capital --> how to find total economic capital

Answer 138

The tangible and intangible assets (excluding human capital) owned by an individual or household. total economic capital = human capital + financial capital

Question 139

Fixed trust

Answer 139

A trust structure in which distributions to beneficiaries are prescribed in the trust document to occur at certain times or in certain amounts.

Question 140

Forward conversion with options

Answer 140

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.

Question 141

Forward rate bias | --> how to capitalize on a forward rate bias

Answer 141

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.

Question 142

Framing bias

Answer 142

An information-processing (cognitive) bias in which a person answers a question differently based on the way in which it is asked (framed)

Question 143

Fulcrum securities

Answer 143

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

Question 144

Full replication approach

Answer 144

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.

Question 145

Fund-of-funds

Answer 145

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.

Question 146

G-spread

Answer 146

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.

Question 147

Gamblers’ fallacy

Answer 147

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.

Question 148

gamma

Answer 148

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

Question 149

General account

Answer 149

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.

Question 150

Goals-based investing (planning) - -> what are the advantages and disadvantages? - -> what are the 3 risk buckets?

Answer 150

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.” 1. 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. 2. 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 3. 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.

Question 151

Grinold–Kroner model

Answer 151

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

Question 152

Hague Conference on Private International Law

Answer 152

An intergovernmental organization working toward the convergence of private international law. Its 69 members consist of countries and regional economic integration organizations.

Question 153

Halo effect

Answer 153

An emotional bias that extends a favorable evaluation of some characteristics to other characteristics.

Question 154

Hard-catalyst event-driven approach

Answer 154

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.

Question 155

Health insurance

Answer 155

A type of insurance used to cover health care and medical costs.

Question 156

Health risk

Answer 156

The risk associated with illness or injury.

Question 157

How to calculate the hedge ratio of futures (how to find the number of futures contracts needed to hedge a cash flow)

Answer 157

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)

Question 158

High-water mark

Answer 158

A specified net asset value level that a fund must exceed before performance fees are paid to the hedge fund manager.

Question 159

Hindsight bias

Answer 159

A bias with selective perception and retention aspects in which people may see past events as having been predictable and reasonable to expect.

Question 160

Holdings-based attribution

Answer 160

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.

Question 161

Holdings-based style analysis

Answer 161

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.

Question 162

Home bias

Answer 162

A preference for securities listed on the exchanges of one’s home country.

Question 163

Horizon matching

Answer 163

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.

Question 164

I-spread

Answer 164

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.

Question 165

Self Control bias

Answer 165

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.

Question 166

Immediate annuity

Answer 166

An annuity that provides a guarantee of specified future monthly payments over a specified period of time.

Question 167

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?

Answer 167

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.

Question 168

Implementation shortfall Execution cost Opportunity cost trading cost

Answer 168

(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)

Question 169

Implied volatility

Answer 169

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.

Question 170

Implied volatility surface

Answer 170

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.

Question 171

Indexing

Answer 171

A common passive approach to investing that involves holding a portfolio of securities designed to replicate the returns on a specified index of securities.

Question 172

Indifference curve analysis

Answer 172

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.

Question 173

Information coefficient

Answer 173

Formally defined as the correlation between forecast return and actual return. In essence, it measures the effectiveness of investment insight.

Question 174

Input uncertainty

Answer 174

Uncertainty concerning whether the inputs are correct.

Question 175

Intertemporal consistency

Answer 175

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.

Question 176

Intestate

Answer 176

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.

Question 177

Intrinsic value of a fx rate

Answer 177

The difference between the spot exchange rate and the strike price of a currency option.

Question 178

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.

Answer 178

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.

Question 179

Investment style

Answer 179

A natural grouping of investment disciplines that has some predictive power in explaining the future dispersion of returns across portfolios.

Question 180

Irrevocable trust | -->why might this be a good idea for a child?

Answer 180

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.

Question 181

Joint ownership with right of survivorship

Answer 181

Jointly owned; assets held in joint ownership with right of survivorship automatically transfer to the surviving joint owner or owners outside the probate process.

Question 182

Key person risk

Answer 182

The risk that results from over-reliance on an individual or individuals whose departure would negatively affect an investment manager.

Question 183

Key rate duration | --> when to use key rate vs effective duration?

Answer 183

- 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.

Question 184

Knock-in/knock-out

Answer 184

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.

Question 185

Leading economic indicators

Answer 185

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.

Question 186

Leveraged recapitalization and what is a staged exit strategy?

Answer 186

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: 1. 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. 2. 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).

Question 187

Liability driven investing (LDI) model | --> main focus?

Answer 187

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.

Question 188

Liability glide path

Answer 188

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.

Question 189

Liability insurance

Answer 189

A type of insurance used to manage liability risk.

Question 190

Liability-relative

Answer 190

With respect to asset allocation, an approach that focuses directly only on funding liabilities as an investment objective.

Question 191

Liability risk

Answer 191

The possibility that an individual or household may be held legally liable for the financial costs associated with property damage or physical injury.

Question 192

Life-cycle finance

Answer 192

A concept in finance that recognizes as an investor ages, the fundamental nature of wealth and risk evolves.

Question 193

Life insurance

Answer 193

A type of insurance that protects against the loss of human capital for those who depend on an individual’s future earnings.

Question 194

Life settlement | ---> what to look for if investing in a life settlement?

Answer 194

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.

Question 195

Lifetime gratuitous transfer

Answer 195

A lifetime gift made during the lifetime of the donor; also known as inter vivos transfers.

Question 196

Limited-life foundations

Answer 196

A type of foundation where founders seek to maintain control of spending while they (or their immediate heirs) are still alive.

Question 197

Liquidity classification schedule

Answer 197

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.

Question 198

Longevity risk

Answer 198

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.

Question 199

Loss severity (loss given default)

Answer 199

The amount of loss if a default occurs. Also called loss given default.

Question 200

Macaulay duration | --> equation to find?

Answer 200

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.

Question 201

Manager peer group | manager universe

Answer 201

A broad group of managers with similar investment disciplines.

Question 202

Matrix pricing

Answer 202

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.

Question 203

Mental accounting bias

Answer 203

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.

Question 204

Micro vs macro attribution

Answer 204

micro attribution: Attribution at the portfolio manager level. Macro attribution: analyzes investment decision at the fund sponsors level

Question 205

Mismatch in character

Answer 205

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.

Question 206

Mission-related investing

Answer 206

Aims to direct a significant portion of assets in excess of annual grants into projects promoting a foundation’s mission.

Question 207

Model uncertainty

Answer 207

Uncertainty as to whether a selected model is correct.

Question 208

Modified duration | --> how to calculate the effect of a 20bp increase in interest rates

Answer 208

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%.

Question 209

Monetize

Answer 209

To access an item’s cash value without transferring ownership of it.

Question 210

Money duration

Answer 210

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

Question 211

Multi-class trading

Answer 211

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.

Question 212

Multi-manager fund

Answer 212

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.

Question 213

Multi-strategy fund

Answer 213

A fund in which teams of portfolio managers trade and invest in multiple different strategies within the same fund.

Question 214

Mutual funds | --> vs ETFs?

Answer 214

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.

Question 215

Negative screening

Answer 215

An ESG implementation approach that excludes certain sectors or companies that deviate from an investor’s accepted standards.

Question 216

Net asset value and how to calculate the expected net asset value at the end of the year?

Answer 216

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)

Question 217

human capital | --> how to estimate?

Answer 217

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!

Question 218

Net worth tax or net wealth tax | -->how to calculate its impact?

Answer 218

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

Question 219

Nonstationarity

Answer 219

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.

Question 220

Norway model | --> advantages and disadvantages?

Answer 220

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.

Question 221

Offer price

Answer 221

The price at which a counterparty is willing to sell one unit of the base currency.

Question 222

Opportunity cost

Answer 222

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)

Question 223

Optional stock dividends

Answer 223

A type of dividend in which shareholders may elect to receive either cash or new shares.

Question 224

Overconfidence bias

Answer 224

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

Question 225

Overlay

Answer 225

A derivative position (or positions) used to adjust a pre-existing portfolio closer to its objectives.

Question 226

Reconstitution

Answer 226

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.

Question 227

Pairs trading

Answer 227

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.

Question 228

Parameter uncertainty

Answer 228

Uncertainty arising because a quantitative model’s parameters are estimated with error.

Question 229

Participant/cohort option

Answer 229

Pools the DC plan member with a cohort that has a similar target retirement date.

Question 230

Participant-switching life-cycle options

Answer 230

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.

Question 231

Passive investment

Answer 231

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.

Question 232

Passive management

Answer 232

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.

Question 233

Permanent life insurance

Answer 233

A type of life insurance that provides lifetime coverage.

Question 234

Portfolio overlay

Answer 234

An array of derivative positions managed separately from the securities portfolio to achieve overall intended portfolio characteristics.

Question 235

Position delta

Answer 235

The overall or portfolio delta. For example, the position delta of a covered call, consisting of long 100 shares and short one at-the-money call, is +50 (= +100 for the shares and -50 for the short ATM call).

Question 236

Positive screening

Answer 236

An ESG implementation approach that seeks to identify the most favorable companies and sectors based on ESG considerations. Also called best-in-class.

Question 237

Premature death risk

Answer 237

The risk of an individual dying earlier than anticipated; sometimes referred to as mortality risk.

Question 238

Premium

Answer 238

Regarding life insurance, the asset paid by the policy holder to an insurer who, in turn, has a contractual obligation to pay death benefit proceeds to the beneficiary named in the policy.

Question 239

Prepaid variable forward

Answer 239

in a prepaid variable forward, the dealer pays the owner now -- equivalent to borrowing. The loan will be repaid by delivering shares at a future date. Delivery of all shares on the repayment date if the price per share drops but delivery of a smaller number of shares in the price rises - -> A variable prepaid forward contract is a strategy used by stockholders to cash in some or all of their shares while deferring the taxes owed on the capital gains. The sale agreement is not immediately finalized but the seller (stockholder) collects the money - -> This strategy is typically used by investors who own a large number of shares in a single company and want to raise cash while postponing taxes. - -> A collar and loan combined within a single instrument.

Question 240

Present value of distribution of cash flows methodology

Answer 240

Method used to address a portfolio’s sensitivity to rate changes along the yield curve, this approach seeks to approximate and match the yield curve risk of an index over discrete time periods.

Question 241

Price value of a basis point

Answer 241

(PVBP) The decrease in a asset or liability's price for a 1% change in yield. Also called basis point value (BPV). --> if yield rates are expected to fall, the bond with the highest PVBP would perform the best how to calculate the Predicted change = Portfolio par amount × Partial PVBP × (–Curve shift)

Question 242

Primary capital

Answer 242

After tax assets held outside a concentrated position that are at least sufficient to provide for the owner’s lifetime spending needs. - -> i.e. would include cash, equity, bond accounts as well as physical assets like a mortgage but you would add the value of a non publicly traded corp that they owned - -> the value of each asset = value - tax on gain in asset i. e. if one hold muni bonds valued at 3k that cost 3150, assuming a 20% tax rate, contribution to net value would be 3030 (3000 - (-150*.2)) i. e. if equities port was worth 3400 with 1650 cost basis, net value after tax would be 3400 - (1750*.2) = 3050

Question 243

Principal trade

Answer 243

A trade in which the market maker or dealer becomes a disclosed counterparty and assumes risk for the trade by transacting the security for their own account. Also called broker risk trades.

Question 244

Profession

Answer 244

An occupational group that has specific education, expert knowledge, and a framework of practice and behavior that underpins community trust, respect, and recognition.

Question 245

Program trading

Answer 245

A strategy of buying or selling many stocks simultaneously.

Question 246

Prospect theory vs expected utility theory

Answer 246

Expected Utility theory assumes individuals will choose the outcome which gives maximum utility given the probability of outcomes (which option rational individuals should choose in a complex situation with an unknown outcome). Prospect theory allows for the fact that individuals may choose a decision which doesn't necessarily maximize utility because they place other considerations above utility. --> utility theory ex: a client exhibits self-control and is able to defer consumption. This client is considering short-term and long-term goals and attempting to maximize the present value of utility. Prospect theory: An alternative to expected utility theory, it assigns value to gains and losses (changes in wealth) rather than to final wealth, and probabilities are replaced by decision weights. In prospect theory, the shape of a decision maker’s value function is assumed to differ between the domain of gains and the domain of losses. - -> This theory describes how individuals make choices in situations in which they must decide between alternatives that involve risk and how they evaluate potential losses and gains. Prospect theory considers how alternatives are perceived based on their framing, how gains and losses are evaluated, and how uncertain outcomes are weighted. - -> Most people reject a gamble with even chances to win and lose unless the possible win is at least twice the size of the possible loss. - -> People are risk-seeking when there is a low probability of gains or a high probability of losses. (i.e. most people would take the bet if faced with choosing between losing $12,000 with 100% certainty (high probability of loss), or accepting a gamble that offers a 50% f of winning $6,000 and a 50% probability of losing $24,000) - -> Deviations in decision making result in overweighting low-probability outcomes.

Question 247

Protective put | --> potential drawbacks?

Answer 247

An option strategy in which a long position in an asset is combined with a long position in a put on that asset. - -> A protective put provides downside protection while retaining the upside potential. - -> There are two potential drawbacks with this hedging strategy. The strategy requires an out-of-pocket expenditure to purchase the put options, which can be significant depending on a number of factors, including the volatility of the stock, the strike price, and maturity. Another potential drawback is the credit risk of the counterparty. Counterparty risk is greater for an over-the-counter (OTC) derivative because the investor incurs the credit risk of a single counterparty. With respect to exchange-traded instruments, because a clearinghouse is the counterparty and guarantees the instrument, the investor incurs significantly less counterparty risk. - -> to buy a protective put in a fx position, if the base currency is USD, and you're trying to hedge again the Chinese Yen, you'd buy a protective put option on the CNY/USD exchange rate

Question 248

Pure indexing vs multi-factor manager

Answer 248

Pure indexing: Method investors use to match an underlying market index in which the investor aims to replicate an existing market index by purchasing all of the constituent securities in the index to minimize tracking risk. Multi-factor: Most multi-factor products are diversified across factors and securities and typically have high active share but have reasonably low active risk (tracking error), often in the range of 3%. Most multi-factor products have a low concentration among securities in order to achieve a balanced exposure to risk factors and minimize idiosyncratic risks (non-market risks).

Question 249

Put spread

Answer 249

A strategy used to reduce the upfront cost of buying a protective put, it involves buying a put option and writing another put option.

Question 250

Quantitative market-neutral

Answer 250

An approach to building market-neutral portfolios in which large numbers of securities are traded and positions are adjusted on a daily or even an hourly basis using algorithm-based models.

Question 251

Rational economic man

Answer 251

A self-interested, risk-averse individual who has the ability to make judgments using all available information in order to maximize his/her expected utility.

Question 252

Re-base

Answer 252

With reference to index construction, to change the time period used as the base of the index.

Question 253

Realized volatility

Answer 253

Historical volatility, the square root of the realized variance of returns, which is a measure of the range of past price outcomes for the underlying asset.

Question 254

Rebalancing overlay

Answer 254

A type of overlay that addresses a portfolio’s need to sell certain constituent securities and buy others.

Question 255

Rebalancing range

Answer 255

A range of values for asset class weights defined by trigger points above and below target weights, such that if the portfolio value passes through a trigger point, rebalancing occurs. Also known as a corridor. In the context of portfolio rebalancing, trigger points are the endpoints of a rebalancing range (corridor). The higher the transaction costs and lower the volatility of the asset class, the wider the optimal corridor. --> asset classes with large standard deviations and small corridors or with small standard deviations and large corridors should be reconsidered for rebalancing band adjustments. The higher the volatility of the rest of the portfolio, excluding the asset class being considered, the more likely a large divergence from the strategic asset allocation becomes, which should point to a narrower optimal corridor, all else being equal. The higher the correlation of an asset class with the rest of the portfolio, the wider the optimal corridor because the portfolio is expected to move in tandem. When asset classes move in sync, further divergence from target weights is less likely.

Question 256

Rebate rate

Answer 256

The portion of the collateral earnings rate that is repaid to the security borrower by the security lender.

Question 257

Reduced-form credit models

Answer 257

Reduced form models builds upon structural models and uses historical trading data based on debt that trades in the firm; it also incorporates macro conditions + company specific conditions. Reduced form models solve for default intensity, or the POD over a specific time period, using observable company-specific variables such as financial ratios and recovery assumptions as well as macroeconomic variables, including economic growth and market volatility measures. – originated to overcome structural models weakness (that company assets trade) - they replace this assumption by assuming SOME OF THE FIRMS DEBT TRADES -called reduced form b/c they impose assumptions on outputs of structural model (probability of default + loss given default) rather than on bal sheet itself. -this gives model tremendous flexibility in matching actual market condition Reduced Form Model Assumptions: 1. arbitrage free markets, where company debt trades 2. risk free rate is stochastic (capturing interest rate risk) 3. state of economy can be described by stochastic variables that represent macro factors 4. firm defaults at random time when economy is in state of X 5. given macro factors X, company default represents idiosyncratic risk (nonsystematic risk) 6. given default, % loss on company debt = 0 < X < 1 - assumptions 4/5/6 are imposed on outputs of structural mode, so we assume we KNOW PROBABILITY OF DEFAULT AND LOSS GIVEN DEFAULT - 4 focuses on where economy is heading, 5 is company specific, 6 is how much debt is worth We can use historical OR implicit methods to estimate model parameters (we can use historical b/c debt does trade + macro factors are observable) Strengths: - we can use historical estimates - credit risk measures changing macro conditions - we don’t need to specific a firms bal sheet structure Weaknesses: - hazard rate estimation – using past to predict future

Question 258

Regret-aversion bias

Answer 258

An emotional bias in which people tend to avoid making decisions that will result in action out of fear that the decision will turn out poorly. - -> error of commission regrets from taking action - -> error of omission results from not taking action - -> clients will tend to naively diversify

Question 259

Relative value volatility arbitrage | --> 4 ways to implement?

Answer 259

A volatility trading strategy that aims to source and buy cheap volatility and sell more expensive volatility while netting out the time decay aspects normally associated with options portfolios. Ways to implement: 1. simple exchange-traded options. The maturity of such options typically extends to no more than two years. In terms of expiry, the longer-dated options will have more absolute exposure to volatility levels than shorter-dated options, but the shorter-dated options will exhibit more delta sensitivity to price changes. 2. implement the volatility trading strategy using OTC options. In this case, the tenor and strike prices of the options can be customized. The tenor of expiry dates can then be extended beyond what is available with exchange-traded options. 3. use VIX futures or options on VIX futures as a way to more explicitly express a pure volatility view without the need for constant delta hedging of an equity put or call for isolating the volatility exposure. 4. purchase an OTC volatility swap or a variance swap from a creditworthy counterparty. A volatility swap is a forward contract on future realized price volatility. Similarly, a variance swap is a forward contract on future realized price variance, where variance is the square of volatility. Both volatility and variance swaps provide “pure” exposure to volatility alone, unlike standardized options in which the volatility exposure depends on the price of the underlying asset and must be isolated and extracted via delta hedging. --> for an expected increase in equity market volatility, buy an ATM call on volatility (VIX) futures and sell an OTM put on VIX futures

Question 260

Repurchase agreements vs reverse repos?

Answer 260

(repos) In a repurchase agreement, a security owner agrees to sell a security for a specific cash amount, while simultaneously agreeing to repurchase the security at a specified future date (typically one day later) and price. - -> The interest rate on a repurchase agreement is called the repo rate A reverse repo is a repurchase agreement from the standpoint of the lender.

Question 261

Request for quote

Answer 261

(RFQ) A non-binding quote provided by a market maker or dealer to a potential buyer or seller upon request. Commonly used in fixed income markets these quotes are only valid at the time they are provided.

Question 262

Reserve portfolio

Answer 262

The component of an insurer’s general account that is subject to specific regulatory requirements and is intended to ensure the company’s ability to meet its policy liabilities. The assets in the reserve portfolio are managed conservatively and must be highly liquid and low risk.

Question 263

Residence jurisdiction | --> three potential double taxation conflicts>

Answer 263

A framework used by a country to determine the basis for taxing income, based on residency. Residence–residence conflict: If he were a resident of both countries, Country A and B would both claim residence of Mr. Lloyd, subjecting his worldwide income to taxation by both countries. Source–source conflict: Both Country A and B may claim source jurisdiction of the same investment properties as income from the investments that are in Country A, but managed from Country B. Residence–source conflict: Because Lloyd lives in Country B, but has investment properties in Country A, he may be subject to a combination of two taxation jurisdictions. As a resident of Country B he could be taxed on worldwide income; and if Country A exercises source jurisdiction on his assets, he will be taxed on these as well. In this case, the source country (Country A) is commonly viewed to have primary jurisdiction to tax income within its borders and the residence country (Country B) is expected to provide double taxation relief.

Question 264

Resistance levels

Answer 264

Price points on dealers’ order boards where one would expect to see a clustering of offers.

Question 265

Returns-based benchmarks

Answer 265

Benchmarks constructed by examining a portfolio’s sensitivity to a set of factors, such as the returns for various style indexes (e.g., small-cap value, small-cap growth, large-cap value, and large-cap growth).

Question 266

Returns-based style analysis

Answer 266

A top-down style analysis that involves estimating the sensitivities of a portfolio to security market indexes. --> Drawbacks or limitations associated with the use of a returns-based style analysis relative to a holdings-based analysis include (either would be acceptable): • Returns-based analyses are generally less accurate than holdings-based or transaction based analyses because they do not utilize actual portfolio holdings. • Most returns-based models impose unnecessary constraints that make it difficult to detect more aggressive positions such as deep value or micro-cap. - -> An adviser would find style analysis most useful, whether it be returns-based (RBSA) or holdings-based (HBSA), when applied to strategies that hold publicly-traded securities where pricing is frequent. 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. - -> In addition, 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.

Question 267

Revocable trust

Answer 267

A trust arrangement wherein the settlor (who originally transfers assets to fund the trust) retains the right to rescind the trust relationship and regain title to the trust assets.

Question 268

Definition of: - risk aversion - risk capacity - risk perception - risk tolerance - risk budgeting - risk premium - risk attribution --> which ones can a wealth manager influence?

Answer 268

Risk Aversion: The degree of an investor’s unwillingness to take risk; the inverse of risk tolerance. How the individual behaves when faced with negative outcomes. Risk Capacity: The ability to accept financial risk. It is determined by the client’s net worth, income, investment time horizon, liquidity needs, and so on. Risk Perception: The subjective assessment of the risk involved in the outcome of an investment decision. A wealth manager can help shape a client’s risk perception. Risk Tolerance: The capacity to accept risk, attitude towards risk; the level of risk an investor (or organization) is willing and able to bear. An individual’s overall risk tolerance is relatively stable and is not likely to vary due to a wealth managers influence or with changing financial market conditions. Also, a client’s risk tolerance for individual goals may vary; they may have a low risk tolerance for near-term goals but a higher risk tolerance for longer-term goals. Risk budgeting: The establishment of objectives for individuals, groups, or divisions of an organization that takes into account the allocation of an acceptable level of risk. Risk premium: An extra return expected by investors for bearing some specified risk. Risk attribution: The analysis of the sources of risk.

Question 269

Risk budgeting

Answer 269

The establishment of objectives for individuals, groups, or divisions of an organization that takes into account the allocation of an acceptable level of risk.

Question 270

Risk reversal

Answer 270

A strategy used to profit from the existence of an implied volatility skew and from changes in its shape over time. A combination of long (short) calls and short (long) puts on the same underlying with the same expiration is a long (short) risk reversal. --> short risk reversal strategy: If the put-implied volatility is too high relative to call-implied volatility, you would devise a long risk-reversal strategy by shorting OTM Put + going long OTM Call: This is equivalent to a synthetic LONG position, since the risk-reward profile is similar to that of a long stock position. Known as a bullish risk reversal, the strategy is profitable if the stock rises appreciably, and is unprofitable if it declines sharply. --> long risk reversal strategy: short OTM Call + long OTM Put: This is equivalent to a synthetic SHORT position, as the risk-reward profile is similar to that of a short stock position. This bearish risk reversal strategy is profitable if the stock declines sharply, and is unprofitable if it appreciates significantly.

Question 271

Sale and leaseback

Answer 271

A transaction wherein the owner of a property sells that property and then immediately leases it back from the buyer at a rate and term acceptable to the new owner and on financial terms consistent with the marketplace.

Question 272

Scenario analysis

Answer 272

A risk assessment technique involving the examination of the performance of a portfolio under specified situations. --> Hypothetical scenario analysis allows for examination of portfolio performance under envisioned situations that have not occurred in the past but might cause large changes in security prices. Tail risk is, by definition, poorly measured by risk models that seek to extrapolate past behavior. Although historical scenario analysis tests a portfolio’s performance under unusual circumstances, such tests are limited to circumstances that have actually occurred previously. Therefore, hypothetical scenario analysis is a superior tail risk assessment approach for risks with no historical precedent.

Question 273

Seagull spread

Answer 273

An extension of the risk reversal foreign exchange option strategy that limits downside risk. A seagull option is a three-legged currency options trading strategy to minimize risk. It is implemented using two puts and a call or vice versa. The long position is the body of the seagull. It is often an ATM put to provide downside protection. The two wings are sold (written) and are OTM (Out of The Money) they should be a call above and a put below the current spot price. These partially offset the cost of the hedge. ex: stock at $60 - 58P /+60P/ -62C

Question 274

Selective

Answer 274

An index construction methodology that targets only those securities with certain characteristics.

Question 275

Self-attribution bias

Answer 275

A bias in which people take personal credit for successes and attribute failures to external factors outside the individual’s control. - -> self enhancing bias is when individuals take all the credit for their success - -> self-protecting bias is when a person places all the blame for their failures on someone or something else

Question 276

Separate accounts

Answer 276

Accounts holding assets to fund future liabilities from variable life insurance and variable annuities, the products in which customers make investment decisions from a menu of options and themselves bear investment risk.

Question 277

Separate property regime

Answer 277

A marital property regime under which each spouse is able to own and control property as an individual.

Question 278

Sharpe ratio vs sortino ratio

Answer 278

Sharpe ratio: The average return in excess of the risk-free rate divided by the standard deviation of return; a measure of the average excess return earned per unit of standard deviation of return. Also known as the reward-to-variability ratio. sharpe ratio = (Asset Return - Risk Free Return) / s.d. --> You're sharpe to consider both the up and downside --> to find the sharpe ratio of a portfolio combined iwth a risk free asset, you take the %portion of the risky asset x risky asset sd (i.e. if risky asset is 40% of portfolio with a sd of 18.69, the combined s.d. of portfolio is 18.69 x 0.4 = 7.47%) Sortino ratio: For hedge fund strategies with large negative events, the Sortino ratio is a more appropriate measure of risk-adjusted return than the Sharpe ratio. The Sharpe ratio measures risk-adjusted performance, where risk is defined as standard deviation, so it penalizes both upside and downside variability. The Sortino ratio measures risk-adjusted performance, where risk is defined as downside deviation (better for the goal of preserving capital), so it penalizes only downside variability below a minimum target return and more accurately assesses performance when retrun distributions are not summetrical sortino ratio = (asset return - target return) / s.d. of negative returns only (aka target semi deviation) - -> Sortino ratios use investor-specific preferences, rather than market conditions and is better equip to address an investors goal of preserving capital (Sortino penalizes managers who don't meet a min acceptable return) - -> The Sortino ratio offers the ability to more accurately assess performance when return distributions are not symmetrical. The Sharpe ratio assumes symmetrical returns.

Question 279

Short-biased

Answer 279

A hedge fund strategy in which the manager uses a less extreme version of dedicated short-selling. It involves searching for opportunities to sell expensively priced equities, but short exposure may be balanced with some modest value-oriented, or index-oriented, long exposure.

Question 280

Short sale against the box

Answer 280

Shorting a security that is held long. - -> defers capital gains, is riskless - -> dividends will pass through to the borrower of the shares in the short against the box strategy and thus not available to lender

Question 281

Shortfall probability

Answer 281

The probability of failing to meet a specific liability or goal.

Question 282

Shrinkage estimation

Answer 282

Estimation that involves taking a weighted average of a historical estimate of a parameter and some other parameter estimate, where the weights reflect the analyst’s relative belief in the estimates.

Question 283

Single-manager fund

Answer 283

A fund in which one portfolio manager or team of portfolio managers invests in one strategy or style.

Question 284

Situational influences

Answer 284

External factors, such as environmental or cultural elements, that shape our behavior.

Question 285

Smart beta

Answer 285

Involves the use of simple, transparent, rules-based strategies as a basis for investment decisions.

Question 286

Smart order routers

Answer 286

(SOR) Smart systems used to electronically route small orders to the best markets for execution based on order type and prevailing market conditions.

Question 287

Soft-catalyst event-driven approach

Answer 287

An event-driven approach in which investments are made proactively in anticipation of a corporate event (mergers and acquisitions, bankruptcies, share issuances, buybacks, capital restructurings, re-organizations, accounting changes) that has yet to occur.

Question 288

Source jurisdiction

Answer 288

A framework used by a country to determine the basis for taxing income or transfers. A country that taxes income as a source within its borders imposes source jurisdiction.

Question 289

Special dividends

Answer 289

A dividend paid by a company that does not pay dividends on a regular schedule, or a dividend that supplements regular cash dividends with an extra payment.

Question 290

Spread curve

Answer 290

The fitted curve of credit spreads for each bond of an issuer plotted against either the maturity or duration of each of those bonds.

Question 291

Spread duration | --> equation to calculate

Answer 291

A measure used in determining a portfolio’s sensitivity to changes in credit spreads (credit spread is the difference in yield between bonds of a similar maturity but with different credit quality). This is the m.d. of a portfolio less the impact of treasuries (treasuries have 0 spread above treasuries) - -> the bond with the lowest credit rating will have the lowest spread duration (high yield is least reactive to changes in risk free interest rates). - ->Credit spreads tend to be negatively correlated with risk-free interest rates. - -> As a result, the price behavior of bonds with high credit risk often more closely resembles that of equities rather than fixed income. For example, you have a portfolio with: $1,000,000 market value of 9-year Treasury Notes, with a modified duration of 7 years $2,000,000 market value of a 7-year corporate bond with a modified duration of 5 years $3,000,000 market value of a 2-year corporate with a modified duration of 1.8 years The spread duration of the portfolio is: ($1,000,000/$6,000,000) × 0 years + ($2,000,000/$6,000,000) × 5 years + ($3,000,000/$6,000,000) × 1.8 years = 2.57 years. For comparison, the modified duration of the portfolio is: ($1,000,000/$6,000,000) × 7 years + ($2,000,000/$6,000,000) × 5 years + ($3,000,000/$6,000,000) × 1.8 years = 3.73 years. --> The approximate percentage price change resulting from a 20bp increase in spread would be = (-SpreadDur) x .002 (Note: you would calculate a change in gov bonds yields by calculating ModDus x change in treasury

Question 292

Standards of conduct

Answer 292

Behaviors required by a group; established benchmarks that clarify or enhance a group’s code of ethics.

Question 293

Static hedge

Answer 293

A hedge that is not sensitive to changes in the price of the asset hedged.

Question 294

Status quo bias

Answer 294

An emotional bias in which people do nothing (i.e., maintain the “status quo”) instead of making a change. - -> individuals tendency to stay in their current investments and not explore other options - -> Status quo bias reflects the tendency for forecasts to perpetuate recent observations and for managers to then avoid making changes. Status quo bias can be mitigated by a disciplined effort to avoid anchoring on the status quo. - -> Overcome this bias by educating the client about the return-enhancing and risk-reducing benefits of a portfolio approach.

Question 295

Stop-losses

Answer 295

A trading order that sets a selling price below the current market price with a goal of protecting profits or preventing further losses. Stop-loss orders involve leaving bids or offers away from the current market price to be filled if the market reaches those levels.

Question 296

Straddle - -> when to implement this strategy? - -> when is it most valuable?

Answer 296

A long straddle is a combination of a long call option and a long put option, both with the same strike price and expiration date. In contrast to this long straddle, if someone writes both options, it is a short straddle (short put and short call at same price and exp). Investors tend to employ a straddle when they anticipate a significant move in a stock's price but are unsure about whether the price will move up or down. straddles are directionally neutral (value jumps whether stock goes up or down). The long straddle strategy is based on expectations of volatility in the underlying stock being higher than the market consensus, and a short straddle should be implemented when expected vol is lower than market expectation - -> The difference between a straddle and a strangle is that the strangle has two different strike prices (you can save money if you have a hint on which way the stock will move and pay less for say downside protection), while the straddle has a common strike price. - -> a long straddle has potentially unlimited upside and a short straddle has potentially unlimited downside - -> a short straddle is most valuable when a stock doesn't move at all and you can collect both premiums - in this case, the max profit is the sum received for writing both options - -> a long straddle is most proftable when the stock moves in either direction in more than the premiums paid (i.e. if 65 strike price and $5 in premiums paid, the trade is profitable below 60 or above 70) Ex: The straddle strategy consists of simultaneously buying a call option and buying a put option at the same strike price. The market price for the $67.50 call option is $1.99, and the market price for the $67.50 put option is $2.26, for an initial net cost of $4.25 per share. Thus, this straddle position requires a move greater than $4.25 in either direction from the strike price of $67.50 to become profitable. So, the straddle becomes profitable at $67.50 – $4.26 = $63.24 or lower, or $67.50 + $4.26 = $71.76 or higher.

Question 297

What is a strangle and when is it appropriate?

Answer 297

A variation on a straddle in which the put and call have different exercise prices; if the put and call are held long, it is a long strangle; if they are held short, it is a short strangle. - -> a short strangle is appropriate when you expect low volatility, and a long strangle is appropriate when you expect high volatility - -> While a straddle has no directional bias, a strangle is used when the investor believes the stock has a better chance of moving in a certain direction, but would still like to be protected in the case of a negative move. For example, let's say you believe a company's results will be positive, meaning you require less downside protection. Instead of buying the put option with the strike price of $15 for $1, maybe you look at buying the $12.50 strike that has a price of $0.25. This trade would cost less than the straddle and also require less of an upward move for you to break even.

Question 298

Strategic asset allocation

Answer 298

1) The process of allocating money to IPS-permissible asset classes that integrates the investor’s return objectives, risk tolerance, and investment constraints with long-run capital market expectations. 2) The result of the above process, also known as the policy portfolio. - -> risk factor-based approaches to asset allocation can be applied to develop more robust asset allocations. - -> mean–variance optimization typically overallocates to the private alternative asset classes, partly because of underestimated risk due to stale pricing and the assumption that returns are normally distributed - -> if somebody would like to introduce a currency overlay to a portfolio that did not previously allow for one, the manager should structure the currency overlay so that it is as uncorrelated as possible with other asset or alpha-generation programs in the portfolio. 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. - -> The SAA provides the long-term asset allocation, and the Tactical AA provides the ability to add some value from short-term opportunities, but without exposing the portfolio to undue risk.

Question 299

Strategic buyers

Answer 299

Buyers who have a strategic motive (e.g., realization of synergies) for seeking to buy a company.

Question 300

Stratified sampling (stratification) vs optimization

Answer 300

A sampling method that guarantees that subpopulations of interest are represented in the sample. Also called representative sampling or cell approach. Stratified sampling does NOT account for covariances. --> In equity indexing, stratified sampling methods are most frequently used when the portfolio manager wants to track indexes that have a large number of constituents or when dealing with a relatively low level of assets under management optimization typically involves maximizing a desirable characteristic or minimizing an undesirable characteristic, subject to one or more constraints. --> optimization process accounts explicitly for the covariances in the portfolio constituents and results in lowering tracking error when compared with stratified sampling alone

Question 301

Structural credit models - strengths, weaknesses and assumptions

Answer 301

Structural is akin to an option analogy (and assumes that a company's assets trade like a stock). Structural is more theory based/missing key components (but it gives you a basic understanding of what you're looking for). vs Reduced form models builds upon this and uses historical trading data based on debt that trades in the firm; it also incorporates macro conditions + company specific conditions. - Structural credit models use market-based variables to estimate the market value of an issuer’s assets and the volatility of asset value. The likelihood of default is defined as the probability of the asset value falling below that of liabilities. - Equity holders have limited liabilities to extent of company assets - firm is like a call option; owning a firms equity is like owning a call option on firm’s assets (key point to structural model) - Debt holders get either PAR or COMPANY ASSETS at expiration: a) probability of default depends if company assets fall below par b) loss given default = PAR – COMPANY ASSETS at expiration - it’s like a call with face value of debt as strike; worthless if you don’t hit it Structural Model assumptions (same as option pricing) 1. firms assets trade arbitrage free – no transaction costs, high liquidity, no bid-ask spreads 2. risk free rate is constant (no interest rate risk in model) 3. firms assets have a lognormal distribution with a mean/variance 4. volatility assumption of SD per year Inputs: Cannot use historical inputs (company’s assets don’t actually trade) so we must use implicit rates Strengths: 1. provides option analogy to understand firms default probability + recovery rate 2. it can be estimated using only current market prices (black schools) Weaknesses: 1. default probability and recovery rate depend on BS, and BS are complex 2. can only be estimated with CALIBRATION (implied rates from market prices of firm equity) 3. biased bc we can only use implicit inputs 4. ignores business cycle

Question 302

Structural risk

Answer 302

Risk that arises from portfolio design, particularly the choice of the portfolio allocations.

Question 303

Stub trading

Answer 303

An equity market-neutral strategy that capitalizes on misalignment in prices and entails buying and selling stock of a parent company and its subsidiaries, typically weighted by the percentage ownership of the parent company in the subsidiaries. --> A stub is a security created after spinning off a subsidiary from a parent company or as the result of a bankruptcy or restructuring. Stub stocks generally trade at a lower price and valuation as compared to their parent company.

Question 304

Support levels

Answer 304

Price points on dealers’ order boards where one would expect to see a clustering of bids.

Question 305

Surplus

Answer 305

The difference between the value of assets and the present value of liabilities. With respect to an insurance company, the net difference between the total assets and total liabilities (equivalent to policyholders’ surplus for a mutual insurance company and stockholders’ equity for a stock company). --> surplus capital is capital that is in excess of primary capital.

Question 306

Surplus portfolio

Answer 306

The component of an insurer’s general account that is intended to realize higher expected returns than the reserve portfolio and so can assume some liquidity risk. Surplus portfolio assets are often managed aggressively with exposure to alternative assets.

Question 307

Survival probability

Answer 307

The probability an individual survives in a given year; used to determine expected cash flow required in retirement.

Question 308

Survivorship bias

Answer 308

Bias that arises in a data series when managers with poor track records exit the business and are dropped from the database whereas managers with good records remain; when a data series of a given date reflects only entitites that have survived to that date.

Question 309

Synthetic long forward position

Answer 309

The combination of a long call and a short put with identical strike price and expiration, traded at the same time on the same underlying. --> shorting a call and going long a put is a synthetic short i.e. stock trading at $91 and you buy a 90C and sell a 90P - if the stock price declines to $80, your call 90C will expire worthless and somebody will put the stock to you at 90 - creating a loss when the stock price declines and a gain when the stock price rises.

Question 310

Synthetic short position

Answer 310

The combination of a short call and a long put at the same strike price and maturity (traded at the same time on the same underlying). --> The combination of a long call and a short put with identical strike price and expiration, traded at the same time on the same underlying is a synthetic long i.e. stock trading at $91 and you sell a 90C and buy a 90P - if the stock price declines to $80, your 90C will expire worthless but you can put the stock to somebody at 90 - creating a gain when the stock price declines and a loss when it rises.

Question 311

Tactical asset allocation

Answer 311

Asset allocation that involves making short-term adjustments to asset class weights based on short-term predictions of relative performance among asset classes. - -> when comparing to the "Strategic asset allocation" you compare the TAA to the policy weights - -> The Sharpe ratio is suitable for measuring the success of TAA relative to SAA. Specifically, the success of TAA decisions can be evaluated by comparing the Sharpe ratio realized under the TAA with the Sharpe ratio that would have been realized under the SAA.

Question 312

Tail risk

Answer 312

The risk that there are more actual events in the tail of a probability distribution than would be predicted by probability models. --> Tail risk events are difficult to model and virtually impossible to predict in advance. Such events do occur in credit markets and often result in unexpectedly large negative and positive portfolio returns. --> Tail risk can be assessed by using scenario analysis. Scenario analysis is a risk assessment technique that examines portfolio performance under specific situations. The primary purpose of scenario analysis is to test the portfolio’s performance under plausible but unusual circumstances. Scenario analysis in credit portfolios often involves projecting portfolio returns when there are large moves in corporate bond prices (because small price changes are not unusual) or large changes in spreads, and it may include scenarios based on actual historical or hypothetical events. Past periods when security prices demonstrated unusual behavior are good candidates for historical scenario analysis. Because tail risk is ultimately the risk of extremely unusual events, one useful approach is envisioning events that have not occurred but might cause large moves in security prices via hypothetical scenarios involving large moves in interest rates, exchange rates, credit spreads, or commodity prices.

Question 313

Tax avoidance vs tax evasion

Answer 313

Tax avoidance: developing strategies that minimize tax, while conforming to both the spirit and the letter of the tax codes of jurisdictions with taxing authority. Tax evasion: The practice of circumventing tax obligations by illegal means such as misreporting or not reporting relevant information to tax authorities.

Question 314

Taylor rule

Answer 314

A rule linking a central bank’s target short-term interest rate to the rate of growth of the economy and inflation. target nominal policy rate = (neutral real fed funds rate) + [0.5 (expected real GDP g − trend REAL GDP g)] + [0.5 ( expected inflation rate − target inflation rate)] The formula for the Taylor rule requires: 1. Neutral Fed Funds Rate = (The real policy rate that would be targeted if growth is expected to be at trend) + (expected inflation rate) aka nominal fed funds rate 2. The expected and target inflation rates 3. The expected and trend REAL (not inflation adjusted nominal) GDP growth rates.

Question 315

Temporary life insurance

Answer 315

A type of life insurance that covers a certain period of time, specified at purchase. Commonly referred to as “term” life insurance.

Question 316

Term deposits

Answer 316

Interest-bearing accounts that have a specified maturity date. This category includes savings accounts and certificates of deposit (CDs).

Question 317

Term structure of volatility

Answer 317

The term structure of volatility is the curve depicting the differing implied volatilities of options with the same strike price but different maturities. Intuitively, it reflects the market expectation on the future implied volatility. The plot of implied volatility (y-axis) against option maturity (x-axis) for options with the same strike price on the same underlying. Typically, implied volatility is not constant across different maturities – rather, it is often in contango, meaning that the implied volatilities for longer-term options are higher than for near-term ones. --> Contango is when the futures price is above the expected future spot price

Question 318

Territorial tax system

Answer 318

A framework used by a country to determine the basis for taxing income or transfers. A country that taxes income as a source within its borders imposes source jurisdiction.

Question 319

Testamentary gratuitous transfer

Answer 319

The bequeathing or transfer of assets upon one’s death. From a recipient’s perspective, it is called an inheritance.

Question 320

Testator

Answer 320

A person who makes a will.

Question 321

Thematic investing Impact Investing Production-orientated investing

Answer 321

Thematic investing: An investment approach that focuses on companies within a specific sector or following a specific theme, such as energy efficiency or climate change. Impact investing: Investment approach that seeks to achieve targeted social or environmental objectives along with measurable financial returns through engagement with a company or by direct investment in projects or companies. Production-oriented approach: Groups companies that manufacture similar products or use similar inputs in their manufacturing processes.

Question 322

Theta - -> how to calculate - -> what would a theta of -0.5 mean?

Answer 322

The daily change in an option’s price, all else equal. Theta measures the sensitivity of the option’s price to the passage of time, known as time decay. --> theta of stock is 0 Theta of a long option positions is +1 and theta of a short option position is -1 x the given theta --> i.e. the theta of a long call position with given -0.50 theta is +1 x -0.50 = -0.50, insinuating that the option is exposed to time decay. The theta of a short put position with a given theta of -0.47 is -1x-0.47 = +0.47 which is positive and benefits from time decay

Question 323

Time-series estimation

Answer 323

Estimators that are based on lagged values of the variable being forecast; often consist of lagged values of other selected variables.

Question 324

Time-to-cash table

Answer 324

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.

Question 325

Time value

Answer 325

The difference between the market price of an option and its intrinsic value, determined by the uncertainty of the underlying over the remaining life of the option.

Question 326

Top-down approach

Answer 326

The top-down approach involves the investor formulating a view on major macroeconomic trends, such as economic growth and corporate default rates, and then selecting the bonds that the investor expects to perform best in a given environment. Advantage: The main advantage of a top-down approach is that a sizable portion of credit returns can be attributed to macro factors. Limitation: A top-down approach may be difficult to implement since the expectations for interest rates, economic cycles and other macro influences are closely examined by market participants and, in many cases, reasonably reflected in current credit market prices. As a result, it can be difficult for an investor to gain an informational advantage in a top-down approach.

Question 327

Total factor productivity

Answer 327

A variable which accounts for that part of Y not directly accounted for by the levels of the production factors (K and L).

Question 328

Total return equity swap

Answer 328

A total return swap (TRS) is an over-the-counter portfolio derivative strategy that combines elements of interest rate swaps and credit derivatives. There is an exchange of cash flows (the total return on a specified asset or equity index in return for specified fixed or floating rate payments) between the two parties over the tenure of the contract, based on a reference obligation that is an underlying equity, commodity, or bond index (you can't swap one index for another). - -> i.e.i f a CEO wanted to sell 10% of a $3B position in his company to invest in a floating interest rate instrument, he would pay the return on 300k worth of his stock and receive a return based on a floating interest rate investment of 300M - -> you can use swaps to gain or reduce exposure to a segment of the market by receiving or paying the return on an index vs a market reference rate. (i.e. if a manager wants to gain exposure internationally and reduce exposure domestically, they could pay the return on a domestic corporate bond index and receive the returns on a foreign equity index with the other side of each swap the reference rate)

Question 329

Total return payer vs receiver

Answer 329

In a total return swap, one party makes payments according to a set rate, while another party makes payments based on the rate of an underlying or reference asset. A total return swap allows the party receiving the total return to gain exposure and benefit from a reference asset without actually owning it. These swaps are popular with hedge funds because they provide the benefit of a large exposure to an asset with a minimal cash outlay. The two parties involved in a total return swap are known as the total return payer (pays based on moves in underlying asset - if asset declines, they receive that depreciation) and the total return receiver (pays fixed in exchange for pnl on underlying asset). --> Equity swaps that have a single stock as underlying can be cash settled or physically settled. If the swap is cash settled, on the termination date of the contract, the equity swap payer will pay the appreciation or receive the depreciation in cash. If an analyst believes a stock may temporarily decline in price, he would want to hedge the position by receiving any depreciation in price and buy a one year total return payer swap. If the swap is physically settled, on the termination date, the equity swap receiver will receive the quantity of the single stock specified in the contract and pay the notional amount Party responsible for paying the reference obligation cash flows and return to the receiver, but will also be compensated by the receiver for any depreciation in the index or default losses incurred on the portfolio. - -> The receiver assumes systematic and credit risks, whereas the payer assumes no performance risk but takes on the credit exposure the receiver may be subject to. - -> Total return swaps permit the party receiving the total return to benefit from the reference asset without owning it. - -> the total return payer pays the interest and returns of an underlying asset (i.e. 1M invested in s&p) in exchange for the fixed cash flow at a reference rate + spread (i.e. LIBOR +2)

Question 330

Total return swap

Answer 330

A swap in which one party agrees to pay the total return on a security. Often used as a credit derivative, in which the underlying is a bond.

Question 331

Trade urgency

Answer 331

A reference to how quickly or slowly an order is executed over the trading time horizon.

Question 332

Transactions-based attribution

Answer 332

``` An attribution approach that captures the impact of intra-day trades and exogenous events such as a significant class action settlement. --> captures both the holdings and the transactions (purchases/sales) completed within the defined period, which would allow the entire excess return to be quantified and explained. ```

Question 333

Transfer coefficient

Answer 333

The ability to translate portfolio insights into investment decisions without constraint. --> how limited you are in your security selection. if you are unconstrained, TC=1. if you are limited to long only securities, you TC will be less than 1

Question 334

Unsmoothing

Answer 334

An adjustment to the reported return series if serial correlation is detected. Various approaches are available to unsmooth a return series.

Question 335

Upside capture ratio

Answer 335

A measure of capture when the benchmark return is positive in a given period; upside capture greater (less) than 100% generally suggests out (under) performance relative to the benchmark.

Question 336

Utility theory

Answer 336

Utility is the level of relative satisfaction received from the consumption of goods and services. Utility theory is the thought that people maximize the present value of utility subject to a present value budget constraint.

Question 337

Vega

Answer 337

The change in an option’s price for a change in volatility of the underlying, all else equal. --> if you are long an option, your vega is the given vega, but if you are short, the option vega is opposite - i.e. if you are short a put with a vega of 0.216 (benefits from volatility), the vega of the position is -0.216 and therefore the position would benefit from reduced volatility.

Question 338

Variance vs Vega notional and how to find PnL on a variance swap

Answer 338

Variance swaps are based on variance (sd^2) vs volatility (sd). There is no initial exchange of notional principal, no interim settlement periods and a single payment at the expiration of the swap based on the difference between actual and implied variance over the life of the swap -->The P&L of a variance swap is often expressed in terms of vega notional. The vega optional is the approximate gain or loss for a 1% change in volatilty for a variance swap For a vega notional of €100k, a gain of €500k is expressed as a profit of 5 vegas (i.e. 5 times the vega notional). Variance notional is the notional amount of a variance swap - the expected pay off at maturity; variance notional = (vega notional) / [(2 × volatility strike price)] --> i.e. if variance notional strike price is given = 400 then vol strike price (s.d.) = 20 Vega notional is the trade size for a variance swap, which represents the average profit and loss of the variance swap for a 1% change in volatility from the strike. Profit or loss = notional variance x (variance - variance strike) - -> variance = realized volatility = standard deviation^2 - -> implied vol^2 = variance strike - vol is stated in sd so you must square - -> if the realized vol is greater than the strike vol, buyer (long) makes a profit. If the realized vol is less, buyer takes a loss ex: The notional is specified in volatility terms which means $100K per vega. The variance units is approximate Vega Notional divided by 2 x Volatility strike. Because of this, you have already converted the Variance Notional from Vega Notional. In this case, the variance notional is $100K/(2x20) = $2,500. where: Variance =400 (k=square root of 400 = 20) therefore, Volatility is =√400 which is 20. This is consistent to the formula. (Don’t look at it in percentage and convert it to 0.2, otherwise you will be confused)

Question 339

Vesting

Answer 339

A term indicating that employees only become eligible to receive a pension after meeting certain criteria, typically a minimum number of years of service.

Question 340

Volatility clustering

Answer 340

The tendency for large (small) swings in prices to be followed by large (small) swings of random direction.

Question 341

Volatility skew

Answer 341

The volatility skew is the difference in implied volatility (IV) between out-of-the-money options, at-the-money options, and in-the-money options. The volatility skew, which is affected by sentiment and the supply and demand relationship of particular options in the market, provides information on whether fund managers prefer to write calls or puts. IV is the prevalent market view of the chance that the underlying asset will reach a given price. - -> Let’s look at why there’s a difference between put and call prices. When investors consider hedging their bullish stock positions, they commonly do so with options by buying puts or selling calls. This drives the price of puts up and calls down, respectively. This difference in pricing among options is called the skew and under normal circumstances, puts trade at higher volatility (traders willing to pay more for downside protection = higher price = higher vol) than calls for exactly that reason—investors are offsetting some of the bullishness of their stock positions. - -> investors view downside protection as more valuable, so puts are more valuable, and their price changes more dramatically with changes in the underlying - -> Implied volatility for out-of-the-money (OTM) put options is higher than for at-the-money (ATM) put options and increases as the strike price moves further away from the current stock price. Implied volatilities for OTM call options are lower than for ATM call options and decrease as strike prices rise above the current stock price.

Question 342

Volatility smile

Answer 342

- When options with the same expiration date and the same underlying asset, but with different strike prices, are graphed for implied volatility, the tendency is for that graph to show a smile when implied volatility is plotted against strike price. - The more an option is ITM or OTM, the greater its implied volatility becomes. Implied volatility tends to be lowest with ATM options. The volatility smile’s existence shows that ITM and OTM options tend to be more in demand than ATM options. Demand drives prices, which affects implied volatility. —> volatility smirk is when OTM puts have higher implied vol but OTM calls have lower implied volatility

Question 343

Will

Answer 343

A document associated with estate planning that outlines the rights others will have over one’s property after death. Also called testament.

Question 344

Z-spread | --> Characteristics that may contribute to a higher z-spread

Answer 344

The Zero-volatility spread (Z-spread) is the constant spread that makes the price of a security equal to the present value of its cash flows when added to the yield at each point on the spot rate Treasury curve where cash flow is received. Characteristics that may contribute to a higher z-spread: - lower liquidity bonds i.e. bonds that have not been issued recently or with smaller issue sizes may be less frequently traded and held by a smaller number of market participants. Relatively illiquid bonds often carry greater spreads to compensate investors for this disadvantage. - Bond structure - subordinated debt normally offers greater credit spreads than senior debt.

Question 345

Market Adjusted Cost?

Answer 345

Market adjusted cost is used to remove the impact of market improvements on trade cost which insures that the trader is not penalized or rewarded for general market improvements over the trade horizon Market Adj. Cost (bps) = Arrival Cost (bps) - (beta x index cost (bps)) Arrival Cost = Side × [(avg price - arrival price) / arrival price] index cost = side* x [(index VWAP - Index Arrival Price) / Index Arrival Price] side* = +1 for buy order, -1 for sell order --> a negative result would indicate a savings due to buying in a downward market

Question 346

Equitization | --> when is this often used?

Answer 346

To minimize cash drag on a portfolio, or fund underperformance from holding uninvested cash in a rising market, PMs may use a strategy known as equitization. Equitization refers to temporarily investing cash using futures or ETFs to gain the desired equity exposure before investing in the underlying securities longer term. --> Equitization may be required if large inflows into a portfolio are hindered by lack of liquidity in the underlying securities. So, if a Fund’s large inflow cannot be invested immediately, the PM can equitize the cash using equity futures or ETFs and then gradually trade into the underlying positions and trade out of the futures/ETF position.

Question 347

sortino ratio vs target semideviation vs semideviation

Answer 347

Sortino Ratio = (Avg. Port. Return - min acceptable return) / downside std deviation --> sharpe ratio is (Avg. Port. Return - min acceptable return) / std deviation Target Semideviation = (Avg Port Return - Min Acceptable Return) / Sortino Ratio semideviation = square root of [ (1/n) x (sum of all average - value)^2)] --> Semi-deviation will reveal the worst-case performance to be expected from a risky investment. Semi-deviation is a method of measuring the below-mean fluctuations in the returns on investment. Semi-deviation is an alternative to the standard deviation for measuring an asset's degree of risk. Semi-deviation measures only the below-mean, or negative, fluctuations in an asset's price. This measurement tool is most often used to evaluate risky investments.

Question 348

contrast Type I and Type II errors in manager hiring and continuation decisions

Answer 348

The determination of whether a manager is skillful typically starts with the null hypothesis (the hypothesis assumed to be true until demonstrated otherwise) that the manager is not skillful. As a result, there are two types of potential error: Type I: Hiring or retaining a manager who subsequently underperforms expectations. Rejecting the null hypothesis of no skill when it is correct. - -> more easily measured and may be linked to comp of the decision maker - -> errors of commission (error in acting or doing something) Type II: Not hiring or firing a manager who subsequently outperforms, or performs in line with, expectations. Not rejecting the null hypothesis when it is incorrect. --> error of omission (error in not acting or doing something

Question 349

Three tools that can be used to diversify a concentrated position

Answer 349

1. An outright sale - owners can sell the concentrated position, which gives them funds to meet a spending need or reinvest. An outright sale typically results in significant tax liabilities. 2. Equity monetization: strategies provide the owners with funds to spend or reinvest without triggering a taxable event. A loan against the value of a concentrated position is an example of a monetization strategy. 3. Hedging: The owner of a concentrated position can hedge the value of the concentrated position with derivatives. A long put position is an example of a hedge. (options can be costly depending on volatility of underlying, strike price and duration. If one is forced to enter a derivative contract OTC, counterparty risk is higher due to the investor incurring the credit risk of a single counterparty) --> ways to hedge: A. short sale against the box: short stock you already own. Gains = losses B. Equity forward sale contract: sell the stock forward at a known price C. Forward conversion with options: selling calls and buying puts with the same strike price used to establish a hedged ending value of the concentrated positions. The options in a forward conversion usually have identical strike price with the goal of creating a riskless position that can be borrowed against. D. Total return equity swap: the investor enters a swap to pay the total return on a stock and receives LIBOR

Question 350

Indemnity pan vs preferred provider organization vs Health maintenance organization plan

Answer 350

indemnity plan: allows the insured to go to essentially any medical service provider, but the insured must pay a specified percentage of the “reasonable and customary” fees. preferred provider organization (PPO): is a large network of physicians and other medical service providers that charge lower prices to individuals within the plan than to individuals who obtain care on their own. health maintenance organization (HMO): allows office visits at no, or very little, cost to encourage individuals to seek help for small medical problems before they become more serious.

Question 351

The number of futures contracts needed to fully remove the duration gap between the asset and liability portfolios

Answer 351

``` # contracts = (basis point value liability - basis point value asset) / basis point value of futures contract --> a positive number would indicate you should take a long position and a negative number would indicate you take a short position ``` - -> Duration gap is a measure of the sensitivity of the value of the balance sheet assets and liabilities to changes in market interest rates - -> BPV is how much an asset or liability decreases for every 1% increase in interest rates (if liability BPV is smaller than asset BPV, and interest rates increase by 1%, the value of your assets is declining faster than the value of your liabilities and you are hurt by increasing interest rates) - -> a minus sign indicates a short position or selling of N futures contracts (i.e. -328.891/1,000 = sell 329 contract). A short futures position hedges against rising interest rates (asset values declining faster than liabilities in a rising interest rate environment). If the PM decided to purchase only, say, 254 contracts, then the portfolio would be underhedged, and you can conclude that the pension fund is left to be hurt by rising interest rates (reinvestment risk) and helped by falling interest rates; therefore, he must believe interest rates will fall. - -> if a PM thought that interest rates were going to rise, he would over hedge

Question 352

What are the 4 types of liabilities that exist? | --> which yield statistics can be used?

Answer 352

Type 1: Known future amounts and payouts --> Only Type I clients can use a yield statistics, such as Macaulay, modified duration, money durations, and the present value of a basis point (PVBP), when implementing immunization strategies. Type 2: Known future amounts, uncertain payout dates Type 3: Uncertain future amounts, certain payout dates Type 4: Uncertain future amounts, uncertain payout dates. --> With Type II, III, and IV liabilities, a curve duration statistic known as effective duration is needed to estimate interest rate sensitivity. This statistic is calculated using a model for the uncertain amount and/or timing of the cash flows and an initial assumption about the yield curve.

Question 353

Rolling Yield

Answer 353

Rolling Yield = Yield Income + Rolldown Return Yield Income = avg. annual coupon payment $ / current bond price $ --> i.e. 1.86% coupon on 100 par = 1.86/100 = 1.86% Rolldown Return = (Bond Price @ End of period - Bond price @ Beg) / Bond Price @ Beg

Question 354

How to find the return of a leveraged portfolio

Answer 354

= return on invested funds + [ (Debt/Assets) x (Return - borrowing rate) ]

Question 355

How to create a synthetic short position using options | breakeven, max profit and loss?

Answer 355

The synthetic short stock options strategy consists of simultaneously selling a call option and buying the same number of put options at the same strike price and expiration date. Breakeven Price: strike price +/- fees Maximum Profit Potential: breakeven price x 100 = (stock price at $0) Maximum Loss Potential: Unlimited (just like with shorting a stock)

Question 356

non-deliverable forwards (NDFs)

Answer 356

A non-deliverable forward (NDF) is a cash-settled, and usually short-term, forward contract. The notional amount is never exchanged, hence the name "non-deliverable." Two parties agree to take opposite sides of a transaction for a set amount of money—at a contracted rate, in the case of a currency NDF. This means that counterparties settle the difference between contracted NDF price and the prevailing spot price. The profit or loss is calculated on the notional amount of the agreement by taking the difference between the agreed-upon rate and the spot rate at the time of settlement. - -> Forward contracts that are cash settled (in the non-controlled currency of the currency pair) rather than physically settled (the controlled currency is neither delivered nor received). - -> the pricing of NDFs may differ from what is expected under arbitrage conditions - -> The credit risk underlying an NDF is lower than an outright forward contract since the notional size of the contract is not exchanged at settlement, but only the non-controlled currency amount by which the notional size of the controlled currency has changed over the life of the contract—that is, the change in the controlled currency times the notional size converted to the non-controlled currency at the spot rate on the settlement date. - -> The credit risk does not relate to the central bank of the developing country but, rather, the counterparty risk faced in the contract.

Question 357

How to create a synthetic long put

Answer 357

short stock + ATM long call A synthetic put is an options strategy that combines a short stock position with an ATM long call option on that same stock to mimic a long put option. This action is taken to protect against appreciation in the stock's price. A synthetic put is also known as a married call or protective call. --> good as insurance for a short stock appreciating --> volatility is beneficial to this strategy and time decay would impact it negatively

Question 358

Option-Adjusted Spread (OAS)

Answer 358

The constant spread that, when added to all the one-period forward rates on the interest rate tree, makes the arbitrage-free value of the bond equal to its market price. Option-adjusted spread equals zero-volatility spread minus the value of call option as stated in basis points. It is the appropriate yield measure for a callable bond: Option-Adjusted Spread (OAS) = Z-Spread − Option Value - -> if the OAS does not equal the Z spread, the bond is likely callable - -> The most appropriate measure for a portfolio-level spread is the OAS because it is challenging to apply the G-spread, I-spread, or Z-spread to a diversified portfolio of credit securities because none of these spread measures would reflect optionality in the relevant bonds

Question 359

How to find the total return (expected return for the horizon aka horizon return or yield) of a bond over a given time period?

Answer 359

horizon return = (yield income + roll down yield) + expected change in price based on yield view + Expected change in price based on credit spread + FX return - credit losses -->rolling yield = yield income + roll down yield yield income = coupon / market price roll down return = (sell price - market price) / market price OR (Bond Price @ End of period - Bond price @ Beg) / Bond Price @ Beg expected change in price based on yield view = [–MD** × ΔYield] + [0.5 × Convexity × (ΔYield)^2] expected change in price based on spread view = [–MD** × ΔSpread] + [0.5 × Convexity × (ΔSpread)^2] * fx return and credit losses would be given * * if MD is expected to change, use the expected effective duration for portfolio at the horizon. Duration can be swapped out for MD - -> note for change in yield - a .55% in this equation is .0055

Question 360

What does "riding the yield curve" mean? How does it differ from buy and hold strategies?

Answer 360

Riding the yield curve is a strategy based on the premise that, as a bond ages, it will decline in yield (increase in price) if the yield curve is upward sloping. This is known as “roll down”; that is, the bond rolls down the (static) curve. Riding the yield curve differs from buy and hold in that the manager is expecting to add to returns by selling the security at a lower yield (higher price) at the horizon. This strategy may be particularly effective if the portfolio manager targets portions of the yield curve that are relatively steep and where price appreciation resulting from the bond’s migration to maturity can be significant. i.e. a pm elects to position their portfolio at the steepest part of the yield curve, with the expectation of selling bonds in one year --> Riding the yield curve enables the PM to benefit from coupon income as well as capital gains over a particular horizon. This strategy pays off in an upward-sloping, static yield curve scenario. As time passes, bonds in the portfolio will roll down and can be sold at a lower yield (higher price) than when they were purchased

Question 361

Condor Spread

Answer 361

similar to a butterfly spread but instead of three strikes, has four strikes (i.e. the long or short body instead of being +60c + 60c will be +60c, +62C) A condor spread is a non-directional options strategy that limits both gains and losses while seeking to profit from either low or high volatility. There are two types of condor spreads. A long condor seeks to profit from low volatility and little to no movement in the underlying asset. A short condor seeks to profit from high volatility and a sizable move in the underlying asset in either direction. ex: Long condor spread: +55C/ -60C/ -62C /+67C ex: short condor spread: -55C/ +60C/ +62C /-67C - -> profit from a decrease in yield curve curvature Max Profit for long condor = Strike Price of Lower Strike Short Call - Strike Price of Lower Strike Long Call - Net Premium Paid - Commissions Paid i. e 60-55 - net premiums and comm - -> Max Profit Achieved When Price of Underlying is in between the Strike Prices of the 2 Short Calls Max loss long condor spread: commissions and premiums paid --> this is the max profit for a short condor Max loss for short condor = Strike Price of Lower Strike long Call - Strike Price of Lower Strike short Call - Net Premium Paid - Commissions Paid 60-55 - net premiums and comm --> Max Loss Occurs When Price of Underlying is in between the Strike Prices of the 2 Long Calls Upper Breakeven Point = Strike Price of Highest Strike Long Call - Net Premium Received Lower Breakeven Point = Strike Price of Lowest Strike Long Call + Net Premium Received Ex: To determine the positions, we take the maximum allowance of 30-year bonds of $17 million and determine money duration. Money duration is equal to market value x modified duration divided by 100. 30-year bond money duration = $17 million × 19.69 (given) = $334.73 million. The market values of the other positions are: 1-year bond: $334.73 million/0.99* = $338.11 million or $338 million 5-year bond: $334.73 million/4.74* = $70.62 million or $71 million 10-year bond: $334.73 million/8.82* = $37.95 million or $38 million --> *mod dur given

Question 362

Sarah Ko, a private wealth adviser in Singapore, is developing a short-term interest rate forecast for her private wealth clients who have holdings in the US fixed-income markets. Ko needs to understand current market expectations for possible upcoming central bank (i.e., US Federal Reserve Board) rate actions. The current price for the fed funds futures contract expiring after the next FOMC meeting is 97.175. The current federal funds rate target range is set between 2.50% and 2.75%. Q: Explain how Ko can use this information to understand potential movements in the current federal funds rate.

Answer 362

(implied rate - current mid point) / (new mid point - current mid point) First, Ko knows that the Federal Fund Effective (FFE) rate implied by the futures contract price of 97.175 is 2.825% (= 100 – 97.175). This is the rate that market participants expect to be the average federal funds rate for that month. Second, Ko should determine the probability of a rate change. She knows the 2.825% FFE rate implied by the futures signals a fairly high chance that the FOMC will increase rates by 25 bps from its current target range of 2.50%–2.75% to the new target range of 2.75%–3.00%. She calculates the probability of a rate hike as follows: (2.825%−2.625%) / (2.875%−2.625%) =0.80, or 80% --> 2.625 is mid point, 2.825 is implied rate, 2.875 new mid point Ko can now incorporate this probability of a Fed rate hike into her forecast of short-term US interest rates.

Question 363

forms of trading costs associated with an internally-managed 100% foreign-currency hedged currency management strategy?

Answer 363

- Trading requires dealing on the bid/offer spread offered by dealers. Dealer profit margin is based on these spreads. Maintaining a 100% hedge will require frequent rebalancing of minor changes in currency movements and could prove to be expensive. “Churning” the hedge portfolio would progressively add to hedging costs and reduce the hedge’s benefits. - A long position in currency options involves an upfront payment. If the options expire out-of-the-money, this is an unrecoverable cost. - Forward contracts have a maturity date and need to be “rolled” forward with an FX swap transaction to maintain the hedge. Rolling hedges typically generate cash inflows and outflows, based on movements in the spot rate as well as roll yield. Cash may have to be raised to settle the hedging transactions (increases the volatility in the organization’s cash accounts). The management of these cash flow costs can accumulate and become a large portion of the portfolio’s value, and they become more expensive for cash outflows as interest rates increase. - Hedging requires maintaining the necessary administrative infrastructure for trading (personnel and technology systems). These overhead costs can become a significant portion of the overall costs of currency trading. --> Optimal hedging decisions require balancing the benefits of hedging against the costs of hedging. Hedging costs come mainly in two forms: trading costs and opportunity costs. The opportunity cost of a 100% hedge strategy is the forgone opportunity of benefiting from favorable currency rate movements. Accepting some currency risk has the potential to enhance portfolio return. A complete hedge eliminates this possibility.

Question 364

How to find the domestic-currency return

Answer 364

RDC = (1 + RFC)(1 + RFX) – 1

Question 365

How to find the excess return of a bond in order to compare them?

Answer 365

Used in various senses appropriate to context: 1) The difference between the portfolio return and the benchmark return; 2) The return in excess of the risk-free rate. Calculate the excess return of each individual bond: = (spread X holding period) - (ΔSpread X spread duration*) - (holding period X credit loss rate**) - -> *spread duration = duration x spread / current OAS spread - -> **expected annual credit loss rate = probability of default x loss severity (loss severity is aka loss given default) - -> the one with the greatest value is best - -> spread: current OAS and Z spread can be used interchangeably - the OAS effectively adjusts the Z-spread to include the value of the embedded option. - -> holding period in fractions of years (6 mos = 0.5) - -> Note: spread "narrowing by 30bps" translate to -0.30% change in z-spread -- calculated expected OAS at end of period (i.e. 1.8) - beg of period (i.e. 1.5) To find excess return of a bond portfolio: apply individual allocation weights to each respective excess return and sum them all up i.e. Portfolio EXR ≈ (70% × 0.05%) + (15% × 0.04%) + (10% × 0.10%) + (5% × 0.23%) = 0.06%

Question 366

list the differences between credit markets in emerging market countries and developed countries.

Answer 366

Concentration in commodities and banking - Commodity producers and banks represent a much higher proportion of emerging market indexes than of developed market indexes. Because loan portfolios of emerging market banks are often highly exposed to the commodity sector, the effect of commodities, either directly or indirectly, on emerging markets can be even more pronounced. Government ownership - Many emerging market bond issuers are government owned or have a controlling or partial stake owned by their local government and therefore have implicit or explicit gov support. When a government owns or controls a company, a primary advantage for credit investors is the potential for explicit or implicit support in the event of a perilous financial situation for the company. A primary disadvantage for credit investors is uncertainty in the contractual rights and interests of non-domestic bondholders as part of a debt restructuring. Credit quality - Compared with that of developed markets, the emerging market credit universe has a high concentration in both the lower portion of the investment-grade rating spectrum and the upper portion of high yield. This concentration of credit ratings largely reflects the sovereign ratings of emerging markets. Rating agencies typically apply a “sovereign ceiling” to corporate issuers globally, implying that a company is normally rated no higher than the sovereign credit rating of its domicile. - Across emerging markets, a relatively small number of bonds trade regularly. - Nearly all countries globally have complex bankruptcy laws, and in some less developed markets, creditors must sometimes face legal systems that are influenced by government officials and equity holders.

Question 367

Identify one drawback for each of the tail risk management strategies.

Answer 367

1. Portfolio diversification : An investor may find it difficult to identify attractively valued investment opportunities that can protect against every tail risk that the investor foresees. The use of portfolio diversification as tail risk protection may not fully achieve an investor’s objectives. --> example would include going long a sector that would benefit from a price devaluation in another (i.e. long car companies vs falling metal prices) 2. Tail risk hedging involving derivatives: Tail risk hedging, like insurance, typically has a cost and therefore lowers portfolio returns if the tail risk event does not occur. Some investors cannot use derivatives and therefore may be unable to hedge certain tail risks via derivatives.

Question 368

Equation to find Beta | --> equation to find sd?

Answer 368

beta = covariance / market variance - -> variance = s.d.^2 = s. d = (expected asset return - risk free return)/Sharpe ratio * * note that Beta references variance of the BROAD MARKET - if given the s.d. of a sector, note that this is not the s.d. to be plugged into the formula. The s.d. of the market portfolio should be used to calculate variance.

Question 369

Standard Deviation vs Variance how to reduce a portfolio's absolute risk (variance)?

Answer 369

standard deviation^2 = variance s.d. = σ = square root of (sum of all( value - mean / n-1)) where mean = sum of all data points/n --> There are two potential changes that can be made to reduce the total portfolio variance (either would be acceptable): • Kibble could add a new fund to the US equity portfolio that has a lower covariance with the portfolio than the existing funds in the portfolio. • Kibble could replace one of the existing funds in the US equity portfolio with another fund that has a lower covariance with the portfolio than the fund being replaced.

Question 370

How to find the estimated return for an asset using the Singer–Terhaar approach to the international extension of the CAPM

Answer 370

Step 1: Find the fully segmented risk premium = s.d. x sharpe ratio Step 2: find the fully integrated risk premium (the industry risk premium) = s.d. x sharpe ratio x correlation Step 3: Combine the two, considering the degree of integration = fully integrated risk premium x integration portion + fully segmented risk premium x non integrated portion --> non integrated portion = 1 - fully integrated portion Step 4: add the risk free rate and any other given premiums (i.e. if given an illiquidity premium, add that) note: sharpe ratio = return vs risk = Expected risk premium for overall portfolio / Expected standard deviation for the portfolio --> the portfolio or industry with the highest estimated return would be the most attractive (expected return reflects compensation for systematic risk) --> In integrated financial markets, domestic investors can buy foreign assets and foreign investors can buy domestic assets --> All else being equal, the Singer–Terhaar model implies that when a market becomes more globally integrated (segmented), its required return should decline (rise) as a reflection of its risk. As prices adjust to a lower (higher) required return, the market should deliver an even higher (lower) return than was previously expected or required by the market. Therefore, the allocation to markets that are moving toward integration should be increased. If a market is moving toward integration, its increased allocation will come at the expense of markets that are already highly integrated. This will typically entail a shift from developed markets to emerging markets.

Question 371

Impact of deflation on real estate and equities

Answer 371

In deflation, real estate experiences downward pricing pressure (negative) and bonds benefit from improving purchasing power (positive). Unexpectedly low inflation (or deflation) will put downward pressure on expected rental income and property values, especially for less-than-prime properties, which may have to cut rents sharply to avoid rising vacancies. In equilibrium, inflation at or below expectations is a positive for equities. When inflation returns to the expected level, equities are likely to perform well.

Question 372

Fed Funds target nominal policy rate

Answer 372

use the Taylor rule to find the fed funds target nominal policy rate= Neutral fed funds rate + [0.5 x (forecast GDP growth rate - trend GDP growth rate)] + [0.5 x (forecast inflation rate - target inflation rate) the Taylor rule links a central bank’s target short-term interest rate to the rate of growth of the economy and inflation. --> expected GDP or inflation is the forecasted rate

Question 373

Prudence Bias (prudence trap)

Answer 373

The prudence bias is the tendency to temper forecasts so that they do not appear extreme or the tendency to be overly cautious in forecasting.

Question 374

Representative Bias - what are the two types?

Answer 374

A belief perseverance bias in which people tend to classify new information based on past experiences and classifications. Representative bias is just the idea that the past will persist and new information is based on past experience - -> placing an emphasis on short term performance results is a consequence of representativeness bias (the investor may think that the market will continue to grow at a rapid rate or holds a losing position because its rallied back in the past) - -> Return chasing is a common result of this bias, and it results in overweighting asset classes with strong recent performance. 2 types: - base rate neglect: too little consideration given to the initial classification being correct (probability of the categorization is not adequately considered.) - sample size neglect: inferring too much from a small new sample of information or incorrectly assume that small sample sizes are representative of populations (or “real” data)

Question 375

Loss Aversion bias | —> how to overcome this bias?

Answer 375

Placing more "value" on losses than on a gain of the same magnitude. A bias in which people tend to strongly prefer avoiding losses as opposed to achieving gains. - -> Overcome this bias by adopting a disciplined approach, using fundamental analysis, to understand the benefits of diversification and tax-loss harvesting. - -> myopic loss aversion: if individuals systematically avoid equity to avoid potential short run declines in value (loss aversion), equity prices will be biased downward (and future returns biased upwards)

Question 376

Behavioral biases in DC plan participants

Answer 376

- status quo bias: investors make no change to their initial asset allocation - naïve diversification: 1/n allocation - disposition effect: sell winners, hold losers - home bias: placing a high proportion of assets in stocks of firm in their own country - mental accounting: each goal is considered separately - gamblers fallacy: wrongly predicting reversal to the mean - social proof bias: following the beliefs of a group

Question 377

Data Mining Bias and the solution to address it?

Answer 377

data-mining bias arises from repeatedly searching a data set until a statistically significant pattern emerges. Such a pattern will almost inevitably occur, but the statistical relationship cannot be expected to have predictive value. As a result, the modeling results are unreliable. Irrelevant variables are often included in the forecasting model. --> As a solution, the analyst should scrutinize the variables selected and provide an economic rationale for each variable selected in the forecasting model. A further test is to examine the forecasting relationship out of sample.

Question 378

the implications for the following for an economy entering the late expansion phase of the business cycle: i. Bond yields ii. Equity returns iii. Short-term interest rates

Answer 378

Bond yields: In the late expansion phase of the business cycle, bond yields are usually rising but more slowly than short-term interest rates are, so the yield curve flattens. Private sector borrowing puts upward pressure on rates while fiscal balances typically improve. Equity returns: In the late expansion phase of the business cycle, stocks typically rise but are subject to high volatility as investors become nervous about the restrictive monetary policy and signs of a looming economic slowdown. Cyclical assets may underperform while inflation hedges, such as commodities, outperform. Short-term interest rates: In the late expansion phase of the business cycle, short-term interest rates are typically rising as monetary policy becomes restrictive because the economy is increasingly in danger of overheating. The central bank may aim for a soft landing.

Question 379

The implications on cash, bonds, equities and real estate returns assuming a forecasted economic contraction and lower inflation

Answer 379

Cash: With the economy contracting and inflation falling, short-term rates will likely be in a sharp decline. Cash, or short-term interest-bearing instruments, are unattractive in such an environment. However, deflation may make cash particularly attractive if a “zero lower bound” is binding on the nominal interest rate. Otherwise, deflation is simply a component of the required short-term real rate. Bonds: The fund’s holdings of high-quality bonds will benefit from falling inflation or deflation. Falling inflation results in capital gains as the expected inflation component of bond yields falls. Persistent deflation benefits the highest-quality bonds because it increases the purchasing power of their cash flows. It will, however, impair the creditworthiness of lower-quality debt. Equities: The fund’s holdings of asset-intensive and commodity-producing firms will be negatively affected by falling inflation or deflation. Within the equity market, higher inflation benefits firms with the ability to pass along rising costs. Real Estate: The fund’s real estate holdings will be negatively affected by falling inflation or deflation. Falling inflation or deflation will put downward pressure on expected rental income and property values. Especially negatively affected will be sub-prime properties that may have to cut rents sharply to avoid rising vacancies

Question 380

Monetary policy throughout the business cycle - | initial recovery, early expansion, late expansion, slowdown and contraction

Answer 380

Monetary policy is the action of central banks to control the availability of cash (i.e. adjusting interest rates or buying/selling bonds) vs fiscal policy is taxes initial recovery: Stimulative stance. Transitioning to tightening mode. early expansion: Withdrawing stimulus late expansion: Becoming restrictive slowdown: Tight. Tax revenues may surge as accumulated capital gains are realized. contraction: Progressively more stimulative. Aiming to counteract downward momentum.

Question 381

Money market rates throughout the business cycle - | initial recovery, early expansion, late expansion, slowdown and contraction

Answer 381

initial recovery: Low/bottoming. Increases expected over progressively shorter horizons. early expansion: Moving up. Pace may be expected to accelerate. late expansion: Above average and rising. Expectations tempered by eventual peak/decline. slowdown: Approaching/reaching peak contraction: Declining.

Question 382

bond yields and yield curve throughout the business cycle - | initial recovery, early expansion, late expansion, slowdown and contraction

Answer 382

initial recovery: Long rates bottoming. Shortest yields begin to rise first. Curve is steep. early expansion: Yields rising. Possibly stable at longest maturities. Front section of yield curve steepening, back half likely flattening. late expansion: Rising. Pace slows. Curve flattening from longest maturities inward. slowdown: Peak. May then decline sharply. Curve flat to inverted. contraction: Declining. near term curve steepening. Likely steepest on cusp of Initial Recovery phase.

Question 383

Model, spread and liquidity risk

Answer 383

Model risk refers to making incorrect assumptions regarding future liabilities or approximations being inaccurate. Model risk arises whenever assumptions are made about future events and approximations are used to measure key parameters. Liquidity risk is associated with exhausting available collateral funds to meet margin calls on derivative positions or to pay benefits. Spread risks are not associated with contractual guarantees but rather originate from the intersection of interest rates, credit ratings and opportunity cost. There are really two types of spread risk, although they are not mutually exclusive. (note that if it comes down to a discrepancy in rates used and asked if its model or spread risk, they want you to say spread risk) The first kind, true spread risk, represents the likelihood the market value of a contract or a specific instrument is reduced based on the actions of the counterparty. If the issuer of a bond does not default on its bond obligations, but makes other financial mistakes that lower the issuer's credit rating, the value of the bonds likely drops. This risk is assumed by the investor. The second type of spread risk comes from credit spreads. Credit spreads are the difference between yields of various debt instruments. The lower the default risk, the lower the required interest rate; higher default risks come with higher interest rates (cost of accepting lower default risk is lower interest income.) --> credit rating migration can cause spread risk to become realized

Question 384

payer and receiver swaptions

Answer 384

A swaption, also known as a swap option, refers to an option to enter into an interest rate swap or some other type of swap. In exchange for an options premium, the buyer gains the right but not the obligation to enter into a specified swap agreement with the issuer on a specified future date. Swaptions come in two main types: a payer swaption and a receiver swaption. - In a payer swaption, the purchaser has the right but not the obligation to enter into a swap contract where they become the fixed-rate payer and the floating-rate receiver. - A receiver swaption is the opposite i.e. the purchaser has the option to enter into a swap contract where they will receive the fixed rate and pay the floating rate. Swaptions are over-the-counter contracts and are not standardized, like equity options or futures contracts. Thus, the buyer and seller need to both agree to the price of the swaption, the time until expiration of the swaption, the notional amount and the fixed/floating rates.

Question 385

three ways to analyze retirement goals?

Answer 385

1. Annuity pricing: Stresses the importance of achieving their lifetime income goal of maintaining their inflation-adjusted current standard of living throughout retirement. Analyzing this goal by pricing a joint life annuity is the best method to insure that this goal will be achieved. Annuities provide a series of fixed payments, either for life or for a specified period, in exchange for a lump sum payment. The calculated price of an annuity equals the present value of a series of future fixed outflows during retirement. - ->A relatively simple way for a wealth manager to calculate the present value of his desired retirement spending is by pricing an annuity. 2. Mortality table: A mortality table allows for estimating the present value of retirement spending needs by associating each outflow with a probability based on life expectancy. A wealth manager uses a mortality table to determine the probability that he will live to a certain age. This information allows him to predict his anticipated inflation-adjusted retirement spending according to the probability that he will be living in a given year. A mortality table illustrates an individual’s life expectancy at any given age. A wealth manager can use a mortality table to estimate the present value of a client’s retirement spending needs by assigning associated probabilities to annual expected cash outflows. --> A potential problem with using mortality tables as the sole method to analyze a retirement goal is the probability that either one or both clients live to an age that exceeds the life expectancy of the general population. Thus, they run the risk of outliving their assets and may need to reduce their annual income (spending) goal at some point. 3. Monte Carlo simulation: yields an overall probability of meeting retirement needs by aggregating the results of many trials of probability-based estimates of key variables. It is a flexible approach for exploring different retirement scenarios. Although the Monte Carlo output gives the probability of meeting a goal, it would not guarantee that their goal is achieved, nor would it necessarily measure the “shortfall magnitude” to achieving their goal. Thus, a client runs the risk of outliving their assets and may need to reduce their annual income (spending) goal at some point. This simulation models the uncertainty of the key variables and the uncertainty or variability in the future outcome. A Monte Carlo simulation uses assumptions of probability distributions for the key variables and then runs a large number of independent trials that generate many random outcomes. --> An advantage of Monte Carlo simulation for retirement planning is its flexibility in modeling and exploring different scenarios. Typically, retirement goals are more complex than a fixed, annual cash flow need. For instance, if a wealth manager wishes to determine the effect of a significant purchase/gift or large unforeseen expenses, he can model these scenarios with a Monte Carlo simulation.

Question 386

Deterministic vs. Monte Carlo Model

Answer 386

Deterministic forecasting is used to determine if a private client is going to meet their retirement goals by using simple variable inputs to create a linear model that helps determine success. There is a multitude of different variables (portfolio value, investment horizon, age, return assumptions, cash flows, taxes, inflation, etc…) that can be thrown in to make the analysis more specific but typically it just picks a rate and assumes assets will grow at that rate annually (incorrectly assumes future asset performance = past asset performance). Deterministic forecasting is interchangeable with Monte Carlo simulation (which is better but more complex). Monte Carlo involves simulating your portfolio's performance thousands of times to determine probable outcomes given different assumptions about important variables. - -> An advantage of the Monte Carlo model is that it can be customized to include input data for such variables as inflation expectations and management fees and KNOWN simple tax implications to aid in determining the probability of success, but cannot measure the magnitude of investment shortfalls. The deterministic model does not have the capability to include tax assumptions and is not as well suited to assess multiperiod effects. The monte carlo simulation will give you an idea of best and worst scenario as well as the likelihood of those things occurring. - -> Monte Carlo simulation can accommodate many future possible scenarios, such as portfolio rebalancing costs and non-normal distributions. Unfortunately, neither model is able to take into account the impact of taxes on investment returns.

Question 387

How to find the after tax gain on a 250k investment earning 8% annually and taxed 10% annually for 25 years

Answer 387

Ignoring taxes = $250,000 × [1 + 0.08]^25 $1,712,119 Including taxes = $250,000 × [1 + 0.08 ×(1 − 0.10)]^25 1,421,706 Amount consumed by taxes = $290,413 Investment gain $1,712,119 − $250,000 = $1,462,119 Investment gain consumed by taxes $290,413/$1,462,119 = 19.9%

Question 388

How to calculate the accrual equivalent after tax annual return for 1) turning a larger period into a smaller period 2) when given an accrual equivalent return, what is the accrual equivalent tax rate?

Answer 388

monthly Accrual Equivalent Annual Return over a year (12 months) = 100% × [(Ending Value/Beginning Value)^1/12 − 1] can be used for deferred capital gains: FV of CG = account value x [ (1+return)^n) x (1 - tax rate) +tax rate - (1 - B) x tax rate] B = cost basis / current balance of account i.e if cost basis = account balance than B = 1 and if cost basis is 50k/100k then B = 0.5 Then calculate (Future Value/Current Value)^1/n to find the accrual equivalent ``` If given a gross return and accrual equivalent, the accrual equivalent tax rate = Return x (1-Accrual equivalent tax rate) = after tax accrual equivalent Return ```

Question 389

Information needed in advising private wealth clients (there are 10 bullet points)

Answer 389

- current employment - experience with market volatility - interest in meeting specific goals rather than a particular return objective - liquidity needs - investment preferences based on his environmental and social concerns. - Family situation: Marital status, children and grandchildren, ages of family members - Identification: Copy of driver’s license or passport - Additional career information: Future aspirations for career, business, and retirement - Investment background - More details on financial goals and risk tolerance

Question 390

Four different types of HF strategies: 1. Dedicated Short Bias 2. Event Driven 3. Convertible Bond Arbitrage 4. Global Macro

Answer 390

Dedicated short bias: A dedicated short bias hedge fund strategy is an example of an equity hedge fund strategy, not an event-driven or relative value strategy. Equity hedge fund strategies focus primarily on the equity markets, and the majority of their risk profiles contain equity-oriented risk. Dedicated short bias managers look for possible short selling targets among companies that are overvalued, that are experiencing declining revenues and/or earnings, or that have internal management conflicts, weak corporate governance, or even potential accounting frauds. --> Short-biased strategies are expected to provide some measure of alpha in addition to lowering a portfolio’s overall equity beta Event Driven: A merger arbitrage hedge fund strategy is an example of an event-driven strategy. Event-driven hedge fund strategies focus on corporate events, such as governance events, mergers and acquisitions, bankruptcy, and other key events for corporations. Merger arbitrage involves simultaneously purchasing and selling the stocks of two merging companies to create “riskless” profits. Event-driven strategies, such as merger arbitrage, tend to be exposed to some natural equity market beta risk. Overall market risk can potentially disrupt a merger’s consummation (though hedging may be possible). To the extent that deals are more likely to fail in market stress periods, event-driven merger arbitrage strategies have market sensitivity and left-tail risk attributes. Also, while event-driven strategies may have less beta exposure than simple, long-only beta allocations, the higher hedge fund fees effectively result in a particularly expensive form of embedded beta. --> merger arbitrage is a good source of uncorrelated alpha and a relatively liquid strategy Convertible bond arbitrage: A convertible bond arbitrage hedge fund strategy is an example of a relative value strategy. Relative value hedge fund strategies focus on the relative valuation between two or more securities. Relative value strategies are often exposed to credit and liquidity risks because the valuation differences from which these strategies seek to benefit are often due to differences in credit quality and/or liquidity across different securities. A classic convertible bond arbitrage strategy is to buy the relatively undervalued convertible bond and take a short position in the relatively overvalued underlying stock. --> convertible arbitrage strategy performs best when there is modest volatility. Heightened volatility would suggest a period of illiquidity and widening credit spreads. Global macro: A global macro hedge fund strategy is an example of an opportunistic hedge fund strategy, not an event-driven or relative value strategy. Opportunistic hedge fund strategies take a top-down approach, focus on a multi-asset opportunity set, and include global macro strategies. Global macro managers use both fundamental and technical analysis to value markets as well as discretionary and systematic modes of implementation.

Question 391

How to use a conditional linear factor model to uncover and analyze the hedge fund’s risk exposures

Answer 391

A linear factor model can provide insights into the intrinsic characteristics and risks in a hedge fund investment. Since hedge fund strategies are dynamic, a conditional model allows for the analysis in a specific market environment to determine whether hedge fund strategies are exposed to certain risks under abnormal market conditions. A conditional model can show whether hedge fund risk exposures to equities that are insignificant during calm periods become significant during turbulent market periods. During normal periods when equities are rising, the desired exposure to equities (S&P 500 Index) should be long (positive) to benefit from higher expected returns. However, during crisis periods when equities are falling sharply, the desired exposure to equities should be short (negative). A simple conditional linear factor model applied to a hedge fund strategy’s returns can be represented as: (Return on HFi)t = (intercept of HF A) + βi,1(Factor 1)t + βi,2(Factor 2)t + … + βi,K(Factor K)t + Dtβi,1(Factor 1)t + Dtβi,2(Factor 2)t + … + Dtβi,K(Factor K)t + (error)i,t where: (Return on HFi)t is the return of hedge fund i in period t; βi,1(Factor 1)t represents the exposure to risk factor 1 (up to risk factor K) for hedge fund i in period t during normal times; Dtβi,1(Factor 1)t represents the incremental exposure to risk factor 1 (up to risk factor K) for hedge fund i in period t during financial crisis periods, where Dt is a dummy variable that equals 1 during financial crisis periods (i.e., June 2007 to February 2009) and 0 otherwise; (error)i,t is random error with zero mean and standard deviation of σi.

Question 392

Equity Market Neutral Equity Strategy | --> 2 signs of a good pair trade?

Answer 392

Overall, EMN managers are more useful for portfolio allocation during periods of non-trending or declining markets. EMN hedge fund strategies take opposite (long and short) positions in similar or related equities whose prices are out of historical alignment and are expected to experience mean reversion, while attempting to maintain a near net zero portfolio exposure to the market. EMN managers neutralize market risk by constructing their portfolios such that the expected portfolio beta is approximately equal to zero. Moreover, EMN managers often choose to set the betas for sectors or industries as well as for common risk factors (e.g., market size, price-to-earnings ratio, and book-to-market ratio) equal to zero. Since these portfolios do not take beta risk and attempt to neutralize many other factor risks, they typically must apply leverage to the long and short positions to achieve a meaningful return profile from their individual stock selections. - -> Two stocks make for an ideal pairs trade if (1) the current price ratio differs from its long-term average and shows historical mean reversion and (2) the two stocks’ returns are highly correlated. - -> equity market–neutral managers are likely to have high levels of diversification and turnover ratios. EMN strategies typically deliver return profiles that are steadier and less volatile than those of many other hedge strategy areas. Over time, their conservative and constrained approach typically results in a less dynamic overall return profile than those of managers who accept beta exposure. Despite the use of substantial leverage and because of their more standard and overall steady risk/return profiles, equity market-neutral managers are often a preferred replacement for fixed-income managers during periods when fixed-income returns are unattractively low.

Question 393

How to calculate the payoffs of the merger arbitrage under the following two scenarios: 1. The merger is successfully completed. 2. The merger fails.

Answer 393

1. successful: net of the long/short positions: purchase price of stock A x # shares (you'd receive the spread) 2. unsuccessful: the prices would revert back to pre merger commentary prices and you'd cover your short position there and sell your long position - the G/L would be the purchase price - the sale price i. e. ABC stock is currently trading at $60 and XYZ stock is currently trading at $18. The offer ratio is 1 share of ABC in exchange for 2 shares of XYZ. Soon after the announcement, XYZ’s share price jumps to $22 while ABC’s falls to $55 in anticipation of the merger receiving required approvals and the deal closing successfully. At the current share prices of $55 for ABC and $22 for XYZ, Patel attempts to profit from the merger announcement. He buys 40,000 shares of XYZ and sells short 20,000 shares of ABC. (at the end you're exchanging the value of ABC shares for XYZ shares) 1. success: You would receive $1,100,000 from short selling 20,000 shares of ABC and would pay $880,000 to buy 40,000 shares of XYZ. This provides a net spread of $220,000 if the merger is successfully completed. 2. failure: (ABC: $1,100,000 – $1,200,000 = –$100,000) + (XYZ: –$880,000 + $720,000 = –$160,000).

Question 394

Benefits of multi strategy funds vs fund of funds

Answer 394

Multi-strategy managers can reallocate capital into different strategy areas more quickly and efficiently than would be possible by a fund-of-funds (FoF) manager. The multi-strategy manager has full transparency and a better picture of the interactions of the different teams’ portfolio risks than would ever be possible for FoF managers to achieve. Consequently, the multi-strategy manager can react faster to different real-time market impacts—for example, by rapidly increasing or decreasing leverage within different strategies depending upon the perceived riskiness of available opportunities. The fees paid by investors in a multi-strategy fund can be structured in a number of ways, some of which can be very attractive when compared to the FoFs’ added fee layering and netting risk attributes. Conceptually, FoF investors always face netting risk, whereby they are responsible for paying performance fees due to winning underlying funds while suffering return drag from the performance of losing underlying funds. Even if the FoF’s overall performance is flat or down, FoF investors must still pay incentive fees due to the managers of winning funds. Risk Profile and Liquidity - FoF and multi-strategy funds are designed to offer steady, low-volatility returns via their strategy diversification. Multi-strategy funds have generally outperformed FoFs but with more variance and occasional large losses often related to their higher leverage. Multi-strategy funds offer potentially faster tactical asset allocation and improved fee structure (netting risk handled at strategy level) but with higher manager-specific operational risks. FoFs offer a potentially more diverse strategy mix but with less transparency and slower tactical reaction time. Both groups typically have similar initial lock-up and redemption periods, but multi-strategy funds also often impose investor-level or fund-level gates on maximum redemptions allowed per quarter. Leverage Usage - Multi-strategy funds tend to use significantly more leverage than most FoFs, which gravitate to modest leverage usage. Thus, multi-strategy funds are somewhat more prone to left-tail blow-up risk in stress periods. Still, better strategy transparency and shorter tactical reaction time make multi-strategy funds overall more resilient than FoFs in preserving capital. Benchmarking - FoFs can be tracked using such sub-indexes as HFRX and HFRI Fund of Funds Composite Indices; Lipper/TASS Fund-of-Funds Index; CISDM Fund-of-Funds Multi-Strategy Index; and the broad Credit Suisse Hedge Fund Index as a general proxy for a diversified pool of managers. Multi-strategy managers can be tracked via HFRX and HFRI Multi-Strategy Indices; Lipper/TASS Multi-Strategy Index; CISDM Multi-Strategy Index; and CS Multi-Strategy Hedge Fund Index.

Question 395

Roll Down Return

Answer 395

The roll down return is equal to the bond’s percentage price change assuming an unchanged yield curve over the strategy horizon. The roll down return results from the bond “rolling down” the yield curve as the time to maturity decreases. As time passes, a bond’s price typically moves closer to par. --> The benefit of roll down comes from riding the yield curve in a stable interest rate environment with an upward-sloping yield curve. As bonds mature, they have shorter maturities and, therefore, lower required yields. As the required yields decrease, the value of the bonds increase. If the portfolio’s holdings are concentrated at the steeper parts of the yield curve, the roll down benefit is increased.

Question 396

Opportunistic HF strategy

Answer 396

Opportunistic strategies have risk exposure to market directionality, also called trendiness. These are directional strategies aiming to “take a view” (often a leveraged one) on market trends, currencies, or other market-based opportunities. Opportunistic strategies include Global Macro, Equity Hedge (Long/Short Equity), Managed Futures (or CTA), and Emerging Markets strategies. Generally, the key source of returns in global macro strategies revolves around correctly discerning and capitalizing on trends in global markets. For example, global macro managers typically hold views on trends in inflation (among other things). Global macro strategies are typically top down and use a range of macroeconomic and fundamental models to express a view regarding the direction or relative value of an asset or asset class. If the hedge fund manager is making a directional bet, then directional models will use fundamental data regarding a specific market or asset to determine whether it is undervalued or overvalued relative to history and the expected macro trend.

Question 397

Herfindahl–Hirschman Index (HHI)

Answer 397

The HHI measures stock concentration risk in a portfolio. It is calculated by squaring the market share of each firm competing in a market and then summing the resulting numbers. It can range from close to zero to 10,000. The number of effective stocks in a portfolio is 1/HHI i.e. if there was only one firm in the market, its market cap would be 100% of the market share so 100^2 = HHI of 10,000 vs if there were 3 firms, with firm 1 being 5% of the market share, firm 2 being 60% of the market share and firm 3 being 35% of the market share, the HHI would be .05^2 + .60^2 + .35^2 = .4850 and the effective number of stocks is 2.06 - -> regulators reference this when considering mergers etc (high score = more concentration in the market and mergers and acquisitions might be considered bad for the consumer due to concentration of firm power and influence) - -> Using the HHI, one can estimate the effective number of stocks, held in equal weights, that would mimic the concentration level of the respective index. The effective number of stocks for a portfolio is calculated as the reciprocal of the HHI. The HHI is 0.0286; the reciprocal (1/0.0286) is 34.97. Therefore, the effective number of stocks to mimic the US large-cap benchmark is approximately 35.

Question 398

How to find the domestic currency return of a portfolio of foreign assets How to find the domestic currency value of a foreign portfolio

Answer 398

domestic return = weight of currency 1 in portfolio x (1 + (ending balance / beginning balance ) x (ending spot rate/beginning spot rate) + weight of currency 2 in portfolio x (1 + (ending balance / beginning balance ) x (ending spot rate/beginning spot rate) +... etc domestic return = weight of EUR in portfolio ( end EUR/beg EUR) x (end EUR fx rate/beg EUR fx rate) + weight of CHF in portfolio ( end CHF/beg CHF) x (end CHF fx rate/beg CHF fx rate) + etc...

Question 399

Assume an American investor wants to acquire 200k shares of a Spanish company at 90EUR and decides to fully hedge the position with a six-month USD(base)/EUR(quote) forward contract. 6 mo forward contract px at initiation: -19/-18.3 3 m fwd contract at initiation: -8.1/-7.6 (3 mo later: -21.6/-21) spot rate USD(base)/EUR(quote) at initiation: 1.3935(bid)/1.3893(ask) 3 months later:1.4106/1.4210 Three months later, the shares have increased to EUR100 and the investor would like to close out the position. What is the cash outflow (in US dollars) required to close out the forward contract? USD Libor 1.266% EUR Libor 1.814%

Answer 399

The initial foreign asset position was EUR18 million: 200,000 shares × EUR90/share. The six-month forward contract would have been sold using the bid of the base currency (euro) at an all-in forward rate of 1.3935 – 19/10,000 = 1.3916 USD/EUR. (you sell it short at the price people are willing to pay for it) If the position had been closed in three months, a three-month forward contract would have to be purchased (to complete the span of the 6 month forward contract) at the offer of the base currency at an all-in forward rate of 1.4210 – 21/10,000 = 1.4189 USD/EUR. (you purchase at rate people are asking The cash outflow at settlement (in 3 months) would have been: amount hedge x (cost to cover - cost to hedge) EUR18 million × (1.4189 – 1.3916) USD/EUR = USD491,400. This amount needs to be discounted by three months at the US dollar Libor rate: 491,400/(1 + 0.01266^(90/360)) = USD489,850.

Question 400

valuation hierarchy

Answer 400

1. Observable quoted market prices for similar investments in active markets 2. Quoted prices for similar investments in markets that are not active 3. Market-based inputs other than quoted prices that are not observable for the investment 4. When no quotes or other market inputs are available, estimates based on quantitative models and assumptions

Question 401

5 way to add leverage to an unlevered portfolio

Answer 401

1. futures contracts 2. swap agreements 3. structured financial instruments 4. repurchase agreements 5. securities lending --> adding bonds of highly leveraged companies does not involve the use of leverage

Question 402

The Wealth Manager's 3 Roles

Answer 402

1. Goal quantification. Sometimes clients do not have specific, quantifiable goals that wealth managers can analyze. For example, a young client may be unable to estimate her future retirement lifestyle needs, while another client’s well-articulated retirement needs may not be realistic in the private manager’s assessment. In both cases, the wealth manager has an opportunity to formulate specific client goals. The wealth manager can help the client quantify each goal and plan accordingly. 2. Goal prioritization. Private clients tend to have multiple, sometimes competing, goals. For example, ensuring a more secure retirement may mean less funding for the education of a client’s grandchildren. When clients have competing priorities, wealth managers have an opportunity to help them decide what matters most. Goal prioritization depends on what is most important to the client, not necessarily which needs occur sooner in the client’s investment horizon. 3. Goal changes. Individual investors’ circumstances may change for a variety of reasons. When these changes occur, wealth managers sometimes must help clients re-prioritize their financial goals and reassess their investment strategy. Identifying client goals is not a one-time task but rather a part of an ongoing dialogue between wealth manager and client.

Question 403

Identify risks faced by investors in emerging market equities over and above those that are faced by fixed income investors in such markets.

Answer 403

In addition to the economic, political and legal risks faced by fixed income investors, equity investors in emerging markets face corporate governance risks. Their ownership claims may be expropriated by corporate insiders, dominant shareholders or the government. Interested parties may misuse the companies’ assets. Weak disclosure and accounting standards may result in limited transparency that favors insiders. Weak checks and balances on governmental actions may bring about regulatory uncertainty, seizure of property or nationalization.

Question 404

Describe the main issues that arise when conducting historical analysis of real estate returns.

Answer 404

Properties trade infrequently so there is no data on simultaneous periodic transaction prices for a selection of properties. Analysis therefore relies on appraisals. Secondly, each property is different, it is said to be heterogenous. The returns calculated from appraisals represent weighted averages of unobservable returns. Published return series are too smooth and a sample volatility understates the true volatility of returns. It also distorts estimates of correlations.

Question 405

A client has asked his adviser to explain the key considerations in forecasting exchange rates. The adviser’s firm uses two broad complementary approaches when setting expectations for exchange rate movements, namely focus on trade in goods and services and, secondly, focus on capital flows. Identify the main considerations that the adviser should explain to the client under the two approaches

Answer 405

two approaches to forecasting exchange rates: 1. Analysts can focus on flows of export and imports to establish what the net trade flows are and how large they are relative to the economy and other, potentially larger financing and investment flows. The approach also considers differences between domestic and foreign inflation rates that relate to the concept of purchasing power parity. Under PPP, the expected percentage change in the exchange rate should equal the difference between inflation rates. The approach also considers the sustainability of current account imbalances, reflecting the difference between national saving and investment. 2. Under a second approach the analysis focuses on capital flows and the degree of capital mobility. It assumes that capital seeks the highest risk-adjusted return. The expected changes in the exchange rate will reflect the differences in the respective countries’ assets’ characteristics such as relative short-term interest rates, term, credit, equity and liquidity premiums. The approach also considers how money flows and the fact that exchange rates provide an across the board mechanism for adjusting the relative sizes of each country’s portfolio of assets.

Question 406

signs of a strengthening currency with regards to: - inflation - short term rates - gdp growth - laws on international investments - credit account surpluses and deficits

Answer 406

- lower expected inflation - increasing short term gov rates - higher GDP growth - laws that allow international investment - credit account surpluses

Question 407

Characteristics of REITs vs equities

Answer 407

traded REIT securities are more highly correlated with direct real estate and less highly correlated with equities over multi-year horizons. Thus, although REITs tend to act like stocks in the short run, they act like real estate in the longer run. Traded REIT securities have relatively high correlations with equity securities over short time horizons, such as one year. The higher correlations suggest that traded REIT securities will not act as a good diversifier for an equity portfolio over a one-year period.

Question 408

how to find the long-run expected or required return for commercial real estate? For a finite period of time?

Answer 408

An estimate of the LONG RUN expected or required return for commercial real estate = = Cap Rate + NOI Growth Rate --> Capitalization rate is a real estate valuation measure used to compare different real estate investments. Where: Cap rate = NOI / Property Value NOI growth rate = NOI growth rate (real) + inflation expectation If expected to calculate for a finite period of time (i.e. 1 year), the expected return for real estate can be estimated = = Cap Rate + NOI Growth Rate - % change in the cap rate --> An approximation of the steady-state NOI growth rate for commercial real estate is equal to the growth rate in GDP.

Question 409

things to consider when evaluating emerging market bonds

Answer 409

The analyst should examine the health of the macroeconomy in some detail. A few indicative guidelines can be helpful. If there is one ratio that is most closely watched, it is the ratio of the fiscal deficit to GDP. Most emerging countries have deficits and perpetually struggle to reduce them. A persistent ratio above 4% is likely a cause for concern. other things to consider: - A debt-to-GDP ratio exceeding 70%–80% is perhaps of only mild concern for a developed market, but is a sign of vulnerability for an emerging market. - A persistent annual real growth rate less than 4% suggests that an emerging market is catching up with more advanced economies only slowly, if at all, and per capita income might even be falling—a potential source of political stress. - Persistent current account deficits (imports > exports) greater than 4% of GDP probably indicate lack of competitiveness. - Foreign debt greater than 50% of GDP or greater than 200% of current account receipts is also a sign of danger. - Finally, foreign exchange reserves less than 100% of short-term debt is risky, whereas a ratio greater than 200% is ample. It must be emphasized that the numbers given here are merely suggestive of levels that may indicate a need for further scrutiny.

Question 410

When to make a: 1. Modest asset allocation change (± 5% to 10% maximum per asset class) 2. Stronger asset allocation change (± 10% to 15% maximum per asset class) 3. Close to the rational asset allocation (± 0% to 3% maximum per asset class)

Answer 410

Modest: this approach would be most appropriate for either investors with a low wealth level/low standard of living who are exhibiting emotional biases, or for investors with a high wealth level/high standard of living that are exhibiting cognitive biases. Stronger: best for investors exhibiting emotional biases, specifically overconfidence and regret aversion. This combination suggests that a stronger asset allocation change may be warranted. Small (modest): this approach would be most appropriate for investors with a low wealth level/standard of living and who are exhibiting cognitive biases.

Question 411

Yield Curve Trade vs l/s credit trade

Answer 411

For yield curve trades, the prevalent calendar spread strategy involves taking long and short positions at different points on the yield curve where the relative mispricing of securities offers the best opportunities, such as in a curve flattening or steepening, to profit. Perceptions and forecasts of macroeconomic conditions are the backdrop for these types of trades. The positions can be in fixed-income securities of the same issuer; in that case, most credit and liquidity risks would likely be hedged, making interest rate risk the main concern. Alternatively, longs and shorts can be taken in the securities of different issuers—but typically ones operating in the same industry or sector. In this case, differences in credit quality, liquidity, volatility, and issue-specific characteristics would likely drive the relative mispricing. In either case, the hedge fund manager aims to profit as the mispricing reverses (mean reversion occurs) and the longs rise and shorts fall in value within the targeted time frame. In a long/short credit trade, valuation differences result from differences in credit quality—for example, investment-grade versus non-investment-grade securities. It involves the relative credit risks across different security issuers and tends to be naturally more volatile than the exploitation of small pricing differences within sovereign debt alone.

Question 412

3 types of benchmarking methods

Answer 412

1. A manager universe—or manager peer group—is a broad group of managers with similar investment disciplines. Although not a benchmark, per se, a manager universe allows investors to make comparisons with the performance of other managers following similar investment disciplines. 2. Factor-model-based benchmarks are constructed by regressing the portfolio’s return against the factors believed to influence returns. 3. An absolute return benchmark is a minimum target return that the manager is expected to beat. It will not determine how the manager performed relative to other managers.

Question 413

How to find a funds return due to manager style?

Answer 413

The return due to manager style is = return on the benchmark portfolio - return on the appropriate market index

Question 414

Of the 4 different types of behavioral investor types, list the behavioral biases prevalent (emotional and cognitive) and level of risk aversion of a passive preserver

Answer 414

passive preserver (aka guardian): primarily emotional -- - low risk tolerance and conservative investment style. More passive. Does better with big picture information - emotional biases: endowment, loss aversion, status quo, regret aversion - cognitive biases: mental accounting and anchoring and adjustment

Question 415

how to find a portfolio's levered return

Answer 415

levered return = | return on investment + [(debt borrowed/portfolio equity) x (return on investment - borrow rate)]

Question 416

Things to include in portfolio reporting to clients (9 items)

Answer 416

Typically, a portfolio report answers several questions, including: - A portfolio asset allocation report, which may reflect strategic asset allocation targets - A performance summary report for the current (often year-to-date) period - A detailed performance report, which may include asset class and/or individual security performance (including interest, dividends and capital appreciation) - A historical performance report covering the period since the inception of the client’s investment strategy - A contribution and withdrawal report for the current period - A purchase and sale report for the current period - A currency exposure report detailing the effects of exchange rate fluctuations - A benchmark report that shows the performance of Patel’s equity and bond portfolios relative to their respective benchmarks and the overall portfolio performance relative to a blended benchmark (based on weights that are appropriate for Patel’s holdings) - An accompanying letter that provides market commentary, investment context, education, and other advice

Question 417

Different client segment and advisor types

Answer 417

1. Mass affluent segment (250k-1M): The mass affluent segment is generally focused on building their investment portfolio and may have financial planning needs (e.g., education funding, cash flow or budget management, and risk management). Risk management needs may relate to future sources of income and may result in the need for various forms of insurance. Older clients in this segment tend to have a focus on retirement planning and investing for a secure retirement. - more clients per wealth manager which leads to less customization and more robo advisors - robo advisors are typically advised for smaller account <250K and private client relationships for those up to 1M 2. High-Net-Worth Segment (1-10M) Wealth managers that focus on the high-net-worth segment typically have a lower client-to-manager ratio than those that focus on the mass affluent segment. Also, wealth managers of high-net-worth clients tend to focus on customized investment management, tax planning, and wealth transfer issues (i.e., estate planning). Wealth transfer issues may lead to a longer investment time horizon and greater risk capacity (though not necessarily greater risk tolerance). The higher wealth levels of this segment may also lead to investment in less liquid asset classes and more sophisticated portfolios that require stronger product knowledge on the part of the wealth manager. 3. Ultra-High-Net-Worth Segment The ultra-high-net-worth segment tends to have multi-generational time horizons, highly complex tax and estate-planning considerations, and a wider range of service needs. As a result, firms that represent this segment have relatively few clients per wealth manager. Additional services may be provided to this segment, such as bill payment services, concierge services, travel planning, and advice on acquiring assets such as artwork or aircraft. Wealth managers focused on this segment often manage accounts for multiple family members and therefore also deal with family governance issues, such as preparing the client’s heirs for the inheritance of substantial wealth. Wealth managers in this segment may assemble teams of service providers with specialized and complementary skills. For instance, firms may include specialized tax advisors, legal advisors, investment specialists, and a relationship manager (RM) as members of a client relationship team. Some ultra-high-net-worth individuals choose to hire these specialized experts to work exclusively for themselves and their family members. This arrangement is referred to as a “family office.”

Question 418

Portfolio Construction—Traditional Approach | --> what are the six steps?

Answer 418

Constructing portfolios per the traditional approach for private clients involves several key steps: 1. Identify asset classes. - -> The wealth manager identifies the asset classes that may be appropriate for the client’s portfolio. 2. Develop capital market expectations. - -->The wealth manager considers the expected returns, standard deviations, and correlations of asset classes in relation to the client’s investment horizon. Wealth managers typically update their capital market expectations according to changes in the financial market environment. 3. Determine portfolio allocations. - -> Wealth managers sometimes use mean–variance optimization to identify possible portfolio allocations that meet the client’s return requirement and risk tolerance. Mean–variance optimization provides a framework for determining how much to allocate to each asset to maximize the expected return for an expected level of risk. The “optimal” portfolio for a given client is the portfolio that maximizes expected return given the client’s degree of risk tolerance. Note that a client’s optimal portfolio may contain allocations to certain asset classes that may be impractical or difficult for the client to maintain. Therefore, wealth managers generally apply asset class constraints in the optimization process. For example, the minimum and maximum thresholds for a given asset class might be 0% and 20%, respectively. - -> MVO typically over-allocates to the private alternative asset classes, partly because of underestimated risk due to stale pricing and the assumption that returns are normally distributed. MVO also tends to result in asset allocations that are concentrated in a subset of the available asset classes (i.e. only US equities and bonds) 4. Assess constraints. - ->Private clients often face certain constraints. For instance, suppose a client has a €5 million investment portfolio, with €2 million of the total portfolio invested in 14 individual stocks in Germany that have appreciated in value considerably. Selling these securities may be prohibitive due to potential taxes on any capital gains in the client’s country of domicile. In this situation, the client’s wealth manager may specify a minimum threshold for German equities to reflect the embedded capital gains. Another example of a constraint applies when a client owns a considerable amount of residential real estate. In this case, the client’s wealth manager may limit the allocation to real estate investment trusts (REITs) in the client’s investment portfolio. 5. Implement the portfolio. - -> At this stage, the wealth manager faces several decisions. One decision is the choice of active management or passive management (e.g., indexing) for each asset class. Once that decision is made, manager selection becomes an important consideration. Another decision for the wealth manager is which factors to recommend within a given asset class. Such factors may include “value” (value stocks over growth stocks) and “size” (small-capitalization stocks over large-capitalization stocks). Implementation also involves a decision to utilize individual securities or pooled vehicles, such as mutual funds and ETFs. Finally, the decision to apply currency hedging can be another important implementation decision. 6. Determine asset location (tax vs tax defferred). - --> When a client’s portfolio comprises multiple accounts, the wealth manager must determine where to allocate the various asset classes and securities. This allocation decision is called asset location. Generally, tax considerations are a critical factor for asset location. If certain accounts offer unique tax benefits (e.g., tax deferral), the wealth manager will generally allocate to these accounts those investments that will likely produce a meaningful level of taxable income. --> easier to understand, better for clients with less understanding and easier to implement for those who are concerned with costs

Question 419

How to find the portion of performance unexplained by rewarded factors (alpha)

Answer 419

alpha = fund return in excess of the risk free rate - [(beta x factor performance) + (beta x factor performance) + ...]

Question 420

The manager of the Western Fund focuses on smaller companies in the Russell 1000 Value Index and uses the following constraints: Size: The capitalization of the average company is $1.8 billion. On average, companies of this size trade 0.90% of their capitalization every day. Liquidity: Positions can be no larger than 7% of average daily trading volume. Allocation: Positions can be no larger than 1.75% of total assets under management. Diversification: The portfolio must contain at least 60 securities. If the manager of the Western Fund is hired by Epsilon, she will have $100 million of Epsilon’s funds to manage. Which constraint is most restrictive with respect to average position size

Answer 420

The most restrictive constraint on position size for the Western Fund manager is the liquidity constraint. It arises from the restriction on average daily trading volume: The average position size cannot exceed $1.13 million. Average daily trading for the representative company size: 0.90% × $1.8 billion = $16.2 million. Restriction on trading volume: 7% × Average daily trading = 7% × $16.2 million = $1.13 million. Restriction on allocation: 1.75% × $100 million = $1.75 million. Restriction on diversification: $100 million/60 securities = $1.67 million. Position size is restricted by trading volume, and the fund could hold up to $100 million/$1.13 million = 89 securities.

Question 421

How to find the portion of a portfolios variance contributed by one country when given a covariance matrix? ways to reduce absolute risk of a portfolio?

Answer 421

1. The contribution of Country A to total portfolio (3 countries) variance is calculated as follows: ``` Weight A × Weight A × cov(A,A) = + Weight A × Weight B × cov(A,B) = + Weight A × Weight C × cov(A,C) = ``` Country A’s contribution to total portfolio variance = is the sum of the above 2. The portfolio variance = (Std. dev.)^2 = 3. The proportion of total portfolio variance contributed by Country A’s contribution to total portfolio variance ÷ The portfolio variance --> Alternatively, if given, Country A’s contribution to total portfolio variance = Weight A × cov(A,Pprtfolio) The portion of total portfolio risk explained by the market factor is calculated in two steps. 1. The first step is to calculate the contribution of the market factor to total portfolio variance as follows: factor A covariance= (factor A coefficient x Fact A coef x Factor A variance) + (factor A coefficient x Fact B coef x Factor B variance) + (factor A coefficient x Fact C coef x Factor C variance) 2. The second step is to divide the resulting variance attributed to the market factor by the portfolio variance of returns = Factor A cov / portfolio variance --> portfolio variance = standard deviation of returns^2 ways to reduce absolute risk: 1. add a new fund with lower covariance than the existing funds in the portfolio 2. replace one of the funds with another fund that has a lower covariance with the portfolio than the fund being replaced

Question 422

Quantitative vs Fundamental approach to active equity management strategy --> the steps to creating a quantitative active strategy approach?

Answer 422

Fundamental approaches stress the use of human judgment in arriving at an investment decision, whereas quantitative approaches stress the use of rules-based, quantitative models to arrive at a decision. - -> The fundamental approach is a subjective investment process that uses discretion in making decisions. It emphasizes forecasting future prospects, including the future earnings and cash flows of a company. - -> examples of quantitative approaches: Determining a security’s exposure to selected variables that predict its return, using a portfolio optimizer to control the risk in the construction of a portfolio - -> Portfolios managed using a quantitative approach are usually rebalanced at regular intervals, such as monthly or quarterly. In contrast, portfolios managed using a fundamental approach usually monitor the portfolio’s holdings continuously and may increase, decrease, or eliminate positions at any time. - -> The focus of a quantitative approach is on factors across a potentially large group of stocks, whereas fundamental strategies focus on a relatively small group of stocks. Consequently, a quantitative fund will likely hold a larger number of stocks than an equity fund. - -> Managers following a fundamental approach typically select stocks by performing extensive research on individual companies; thus, fundamental investors see risk at the company level. In contrast, with a quantitative approach, the risk is that factor returns will not perform as expected. Because the quantitative approach invests in baskets of stocks, the risks lie at the portfolio level rather than at the level of specific stocks (company level). - -> Steps in creating a quantitative, active strategy: 1. Define the market opportunity or investment thesis 2. Acquire relevant data, process, and transform into a usable format. 3. Back-test the strategy, which involves identifying the factors to include as well as their weights. 4. Evaluate strategy performance using an out-of-sample back-test.

Question 423

Assuming investment account of 250k earning 7.5% annually for 15 years in a country that taxes realized cap gains at 10% How much after tax wealth would a person accumulate assuming that 50% of all capital gains were recognized each year?

Answer 423

after tax perf for cap gains at end of period = A = performance * ( 1 - 50%)(tax rate) return (r) = 0.075(1 – (0.5)(0.10)) = 0.075(1 – 0.05) = 0.07125 marginal tax rate = B = tax rate* [(1 - 50%) / (1-50% x tax rate) tax rate (t) = 0.10[(1 – 0.5)/(1 – 0.5 × 0.10)] = 0.052632 = $account x [ (1 + r)^n ( 1 - t ) + t ] FV = €250,000 × [(1 + 0.07125)^15(1 – 0.052632) + 0.052632] = €678,158

Question 424

How does the GIPS standards define actual direct trading expenses?

Answer 424

The GIPS Glossary defines trading expenses as “the actual costs of buying or selling investments” and states, “These costs typically take the form of brokerage commissions, exchange fees and/ or taxes, and/ or bid-offer spreads from either internal or external brokers. Custodial fees charged per transaction should be considered custody fees and not trading expenses.”

Question 425

how to use the human life value method for determining life insurance needs to calculate the additional amount of life insurance that somebody requires to be adequately covered

Answer 425

The calculations assume (1) client works for exactly 15 years and (2) his family needs the proceeds of the life insurance immediately upon his death. Step 1: Calculate the pretax income needed to be replaced Bradley’s annual income = $175,000 Less: income and payroll taxes at 30% (-52,500) = Annual income (after taxes) $122,500 Less: family expenses attributable to client -$20,000 = Net annual income after expenses $102,500 Plus: non-taxable employer contribution to defined-contribution retirement plan ($175,000 × 5%) = 8,750 = Net after-tax income needed to be replaced for Bradley 111,250 Amount of pretax income needed to replace the net after-tax income assuming 20% tax on life insurance benefits received = [($111,250/(1 − 0.20)] = ($111,250/0.80) = $139,063 Step 2: Adjust the discount rate to account for the projected growth rate of earnings and expenses - Discount rate: 4% - Projected annual salary and expense increase for Bradley: 3% Calculate the adjusted rate (i): i = [(1 + Discount rate)/(1 + Growth rate)] − 1 = [(1 + 0.04)/(1 + 0.03)] − 1 = 0.97% Step 3: Determine the total amount of life insurance needed by calculating the present value of an annuity due in advance $139,063 × PVAADV(15 years, 0.97%) = $1,951,345 [Inputs on financial calculator (HP-12C): Mode: BEG; n: 15; i: 0.97; PMT: 139,063; FV: 0; calc PV] Step 4: Less Bradley’s current life insurance coverage (from Exhibit 1) (250,000) Step 5: Additional life insurance required for Bradley $1,701,345

Question 426

What is the expected future accumulation in 15 years assuming these parameters hold for that time period Portfolio size: 1M Pretax annual return: 6% Hypothetical Tax Profile and Example Interest (i) - 20% (Tax rate: 35%) Dividends (d) - 30% (Tax rate: 15%) Capital gain (cg) 40% Tax rate: 25%

Answer 426

1. Calculate annual return after taxes = pretax annual return x [(portion of income from interest x interest tax rate) - (portion of income from divs x div tax rate) - (portion of income from cap gains x cap gain tax rate)] = 0.06*[1 – (0.30)(0.15) – (0.20)(0.35) – (0.40)(0.25)] = 0.0471 or 4.71 percent 2. Calculate the effective capital gains tax rate = [cap gains tax rate x (1 – portion of inc from div – portion of inc from int – portion of inc from cap gains)] / [1 – (0.30)(0.15) – (0.20)(0.35) – (0.40)(0.25)] = [cap gains tax rate x (1 – 0.30 – 0.20 – 0.40)] / [1 – (0.30)(0.15)] – (0.20)(0.35) – (0.40)(0.25)] = 0.0318 FVIFTaxable = portfolio value [(1+ after tax annual return)^n x (1- effective cap gains tax rate) + effective Cap gains tax rate x [(1- (cost basis/portfolio value) x cap gains tax rate) = £1,000,000[(1 + 0.0471)^15(1 – 0.0318) + 0.0318] = £1,962,776 Assuming the cost basis is 700K: B = £700,000/£1,000,000 = 0.70 = £1,000,000[(1 + 0.0471)^15 x (1 – 0.0318) + 0.0318 – (0.25)(1 – 0.70)] = £1,887,776

Question 427

Traditional approach vs risk-based approach for defining a investment opportunity set --> limitations and advantages of the traditional approach?

Answer 427

The traditional approach simply looks at asset allocations (FI, equity, etc) and does not consider the difference in risk between a 3% allocation in government bonds vs high yield bonds, etc. The primary limitations of traditional approaches are that they overestimate the portfolio diversification and obscure the primary drivers of risk The primary advantages are that its easier to explain and implement which means it doesn't require costly in house resources, which would likely be necessary with a risk-based approach

Question 428

How to calculate the change in convexity given a change in bond allocations

Answer 428

Step 1) Assuming the new portfolio has to be duration matched, find the combination of the bonds which matches the duration of the current portfolio Dur current = bond A dur (weight) + Bond B dur (1-weight) Step 2. Now that you have the weights of the new portfolio that is duration matched, find the difference in convexity : Gain in convexity = (Weight of new bond A) × (Convexity of bond A) + (Weight of new bond B) × (Convexity of bond B) – (Weight of the original bond) × (Convexity of original bond)

Question 429

Elements of a liquidity analysis

Answer 429

to find how liquid a portfolio is - take the % of portfolio allocated to the different liquidity buckets and see if they fall in range of the requirements. If there is more room for illiquid investments that add higher return (i.e. private equity), add them

Question 430

How to find the implied forward rate

Answer 430

implied forward rate = | [(1+YTM)^n / 1+ 1 year YTM] - 1

Question 431

ways to implement an inter-market trades

Answer 431

Inter-market carry trades may or may not involve a duration mismatch. Among the ways to implement an inter-market carry trade subject to currency exposure are the following: (a) Borrow from a bank in the lower interest rate currency, convert the proceeds to the higher interest rate currency, and invest in a bond denominated in that currency; (b) borrow in the higher rate currency, invest the proceeds in an instrument denominated in that currency, and convert the financing to the lower rate currency via the FX forward market; and (c) enter into a currency swap, receiving payments in the higher rate currency and making payments in the lower rate currency. Inter-market carry trades can be implemented without currency risk by (a) receiving fixed/paying floating in the steeper market and paying fixed/receiving floating in the flatter market or (b) taking a long position in bond (or note) futures in the steeper market and a short futures position in the flatter market. - Inter-market trades should be assessed on the basis of returns hedged into a common currency. Doing so ensures that they are comparable. Neither local currency returns nor unhedged returns are comparable across markets because they involve different currency exposures/risks. - The primary driver of inter-market trades is anticipated changes in yield differentials. Over horizons most relevant for active bond management, the capital gains/losses arising from yield movements generally dominate the income component of return (i.e., carry) and rolling down the curve. Hence, expectations with respect to yield movements are the primary driver of inter-market trade decisions. - Due to covered interest arbitrage, the relative attractiveness of bonds does not depend on the currency into which they are hedged for comparison. Hence, the ranking of bonds does not depend on the base currency of the portfolio.

Question 432

Modified Dietz formula

Answer 432

The modified Dietz method is a measure of the ex post performance of an investment portfolio in the presence of external flows. modified dietz = (port value at end of period - port value at beg of period - the sum of each cash flow) / port value at beg of period + (the sum of all cash flows multiplied by their weight) - -> you can apply this formula to an entire composite (beg of all the portfolios, all of the cash flows, sum of all ending balances etc) - -> you can find the weighted return of a portfolio at the end of a period (after mid term cash flows) by taking the beg period bal + (the CF x the CF weighting factor) etc to find the new denominator and then calculate the same

Question 433

Morningstar vs Thomson Reuters Lipper style classification

Answer 433

Morningstar calculates a score for value and growth on a scale of 0 to 100 using five proxy measures for each. The value score is subtracted from the growth score. A strongly positive net score leads to a growth classification, and a strongly negative score leads to a value classification. A score relatively close to zero indicates a core classification. To achieve a blend classification, the portfolio must have a balanced exposure to stocks classified as value and growth, a dominant exposure to stocks classified as core, or a combination of both. Both Morningstar and Lipper classify individual stocks in a specific style category. Neither assumes a security can belong to several styles in specific proportion. The Lipper methodology does have a core classification. It sums the Z-score of six portfolio characteristics over several years to determine an overall Z-score that determines either a value, core, or growth classification.

Question 434

The purpose of back testing a strategy

Answer 434

The purpose of back-testing is to identify correlations between the current period’s factor scores, FS(t), and the next period’s holding period strategy returns, SR(t + 1).

Question 435

A European bond portfolio manager wants to increase the modified duration of his €30 million portfolio from 3 to 5. She would most likely enter a receive-fixed interest rate swap that has principal notional of €20 million and and modified duration of?

Answer 435

(Portolfio value x MD) + (portfolio value x MD) = ending port value x MD €30,000,000(3) + (NS × MDURS) = €30,000,000(5) Given the swap’s notional (NS) of €20,000,000, its required modified duration can be obtained as: MDURS = [(5 – 3)€30,000,000]/€20,000,000 = 3.

Question 436

The CIO of a Canadian private equity company wants to lock in the interest on a three-month “bridge” loan his firm will take out in six months to complete an LBO deal. He sells the relevant interest rate futures contracts at 98.05. In six-months’ time, he initiates the loan at 2.70% and unwinds the hedge at 97.30. The effective interest rate on the loan is?

Answer 436

The CIO sells the relevant interest rate future contracts at 98.05. After six months, the CIO initiates the bridge loan at a rate of 2.70%, but he unwinds the hedge at the lower futures price of 97.30, thus gaining 75 bps (= 98.05 – 97.30). The effective interest rate on the loan is 1.95% (= 2.70% – 0.75%).

Question 437

How to find the allocation that has the highest probability of meeting the target return

Answer 437

the portfolio that generates the highest value for the following is the one most likely to hit the target (expected annual return – target return)/return volatility

Question 438

How to calculate the return of a foreign currency given the domestic and relative return currency

Answer 438

return of domestic currency = (1 + return of foreign currency) x (1 + change of foreign currency relative to domestic currency) - 1 i.e. if foreign currency account appreciated 4% and the fx currency appreciated 2% vs USD - the return of the foreign held account would be (1+.04) x (1+.02) - 1 = 6.08%

Question 439

How to find a composites investment multiple (TVPI)

Answer 439

The GIPS Glossary defines the TVPI (real estate and private equity) as “total value divided by since inception paid-in capital.” The GIPS Glossary defines Total Value (real estate and private equity) as “residual value plus distributions”. The simplest way to find TVPI is to add Ratio of Residual Value to Paid in Capital (RVPI) and Realization Multiple (DPI - the since inception distributions divided by since inception paid-in capital). - -> Alternately, one can multiply the monetary amount of paid-in capital by RVPI to determine the residual value, add it to cumulative distributions, and divide the sum by paid-in capital. i. e. if paid in capital is 20M and RVPI is .99, distributions are 2.5M, then the calculation is [(20 × 0.99) + 2.5]/20 = 1.12

Question 440

PIC Multiple

Answer 440

The GIPS Glossary defines the PIC Multiple (real estate and private equity) as: since inception paid-in capital (PIC) divided by cumulative committed capital ---> given paid-in capital of $20 million and a PIC multiple of 0.80, committed capital is $20/0.80 = $25.0

Question 441

How does GIPS define an "advertisement" ?

Answer 441

The following definition of “advertisement” is provided in the GIPS Advertising Guidelines: “For the purposes of these guidelines, an advertisement includes any materials that are distributed to or designed for use in newspapers, magazines, firm brochures, letters, media, or any other written or electronic material addressed to more than one prospective client. Any written material, other than one-on-one presentations and individual client reporting, distributed to maintain existing clients or solicit new clients for a firm is considered an advertisement.”

Question 442

How to find the modified duration of a bank's equity capital after restructuring: ex: Meura Bancorp, a US bank, has an equity capital ratio for financial assets of 12%. Meura’s strategic plans include the incorporation of additional debt in order to leverage earnings since the current capital structure is relatively conservative. The bank plans to restructure the balance sheet so that the equity capitalization ratio drops to 10% and the modified duration of liabilities is 1.90. The bank also plans to rebalance its investment portfolio to achieve a modified duration of assets of 2.10. Given small changes in interest rates, the yield on liabilities is expected to move by 65 bps for every 100 bps of yield change in the asset portfolio.

Answer 442

Equity MD= (Mod Dur of equity leveraged) - (Mod Dur of liabilites x change in liab) = [(A/E)x Asset MD] − [(A/E − 1 ) x Liability MD x (Δinterest rates)] =[ (1/0.10)×2.10 ] − [(1/0.10−1)×1.90×0.65] = 9.89 years --> Equity Capital Ratio means the ratio of Bank's and each other Banking Subsidiary's Equity Capital to Bank's and each other Banking Subsidiary's total assets (10% = 10% of total ownership is cash and the remaining is financed - 1/.1 = 10. The remaining financed if 10% of asset worth 10 is equity, is 9 )

Question 443

Compare the efficiency of the ETF and total return swap TAA implementation alternatives from the perspectives of capital commitment, liquidity, and tracking error.

Answer 443

Capital Commitment: From a cash ‘usage’ perspective, a ETF would be less efficient (requiring a larger cash outlay) than a total return swap replicating the ETF. The capital commitment of an unlevered ETF equals the full notional value. In contrast, a total return swap generates a similar economic exposure to ETFs with much lower capital. The cash-efficient nature of derivatives, such as total return swaps, makes them desirable tools for gaining incremental exposure to a particular asset class. Liquidity: From a liquidity perspective, a ETF would be more efficient than the total return swap. As exchange-traded standardized products, ETFs enjoy liquid trading and narrow bid–ask spreads. In contrast, total return swaps are over-the-counter contracts (not exchange traded) that are negotiated and customizable on such features as maturity, leverage, and cost. Tracking Error: (aka active risk) From a tracking error perspective, ETFs would be less efficient than the total return swap. i.e. a Russell 1000 Growth ETF would have associated tracking error, which may result from premiums and discounts to net asset value, cash drag, or regulatory diversification requirements. In contrast, for total return swaps, the replication is exact. A Foundation would receive the total index return without incurring any tracking error to the benchmark index because the swap counterparty is obligated to provide the index return. This would, however, expose the Foundation to counterparty credit risk and introduce additional complexities in managing net exposure over the duration of the contract.

Question 444

How to calculate the contribution of foreign currency to an accounts total return

Answer 444

to estimate: take the total return of the portfolio - return of the equity portion (if given) i.e. if portfolio is 50% USD and asset return is 10% (fx return of 0) , 25% Euro and asset return is 5% (fx return of 2%) and 25% JPY and asset return is -3% (fx return of 4%), given the overall return of 7% you can estimate fx return contributed: 7% - [(.5 x .1) + (.25 x .05) + (.25 x -0.03)] = 7% - (5% -1.25% -.75%) = 1.5% remaining that can be explained via fx to find exact: Find the weighted currency return = (0.50 × 0.0%) + (0.25 × 2.0%) + (0.25 × 4.0%) = 1.5%. Then , calculate the weighted cross-product: [0.50 × (10.0% × 0.0%)] + [0.25 × (5.0% × 2.0%)] + [0.25 × (–3.0% × 4.0%)] = –0.005%. the contribution of foreign currency to the total return can be calculated as the sum of the weighted currency return of 1.5% and the weighted cross-product of –0.005%: = 1.495%

Question 445

When should a client implement active currency management vs passive hedging vs hedging vs currency overlay?

Answer 445

Portfolios should be biased towards a more-fully hedged currency management program the more: - short term the investment objectives of the portfolio - risk averse the beneficial owners of the portfolio are (and impervious to ex post regret over missed opportunities) - immediate the income and/or liquidity needs of the portfolio - fixed-income assets are held in a foreign-currency portfolio (FI portfolios tend to have closer to a 100% hedge) - cheaply a hedging program can be implemented - volatile (i.e., risky) financial markets are - skeptical the beneficial owners and/or management oversight committee are of the expected benefits of active currency management. Active currency management vs discretionary hedging: The portfolio manager is supposed to take currency risks and manage them for profit with the primary goal of adding alpha to the portfolio through successful trading. This primary goal differs from the discretionary hedging approach in which the manager’s primary duty is to protect the portfolio from currency risk and secondarily seek alpha within limited bounds. While the difference between active currency management and discretionary hedging is one of emphasis more than degree, the bounded discretion that a client grants has can suggest weather the manager is expected to take currency risk and seek alpha with priority over portfolio protection from currency risk. (large bands means active and flexible to take advantage of arbitrage opportunities, small bands means priority is to hedge) Passive hedging: the goal is to keep the portfolio’s currency exposures close, if not equal to, those of a benchmark portfolio used to evaluate performance. Passive hedging is a rules-based approach that removes all discretion from the portfolio manager, regardless of the manager’s market opinion on future movements in exchange rates and aims to eliminate currency risk relative to a benchmark Currency Overlay: currency overlay programs are often conducted by external, FX-specialized sub-advisers to a portfolio (not generalist managing a variety of portfolios across asset classes.) Currency overlay allows for taking directional views on future currency movements (slightly larger bands), to take advantage of convictions in market movements

Question 446

Rivera’s reporting currency is the euro, and he is concerned about his US dollar exposure. His portfolio IPS requires monthly rebalancing, at a minimum. The portfolio’s market value is USD2.5 million. Given Rivera’s risk aversion, Delgado is considering a monthly hedge using either a one-month forward contract or one-month futures contract. Assume Rivera’s portfolio was perfectly hedged. It is now time to rebalance the portfolio and roll the currency hedge forward one month. The relevant data for rebalancing are provided: One month ago: portfolio value: 2.5M USD/EUR spot rate (bid–offer) 0.8913/0.8914 One-month forward points (bid–offer) 25/30 Today: portfolio value: 2.65M USD/EUR spot rate (bid–offer) 0.8875/0.8876 One-month forward points (bid–offer) 20/25 Q. Calculate the net cash flow (in euros) to maintain the desired hedge.

Answer 446

To calculate the net cash flow (in euros) to maintain the desired hedge, the following steps are necessary: 1. Buy USD2,500,000 at the spot rate. Buying US dollars against the euro means selling euros, which is the base currency in the USD/EUR spot rate. Therefore, the bid side of the market must be used to calculate the outflow in euros. USD2,500,000 × 0.8875 = EUR2,218,750. 2. Sell USD2,650,000 at the spot rate adjusted for the one-month forward points (all-in forward rate). Selling the US dollar against the euro means buying euros, which is the base currency in the USD/EUR spot rate. Therefore, the offer side of the market must be used to calculate the inflow in euros. All-in forward rate = 0.8876 + (25/10,000) = 0.8901. USD2,650,000 × 0.8901 = EUR2,358,765. 3. Therefore, the net cash flow is equal to EUR2,358,765 – EUR2,218,750, which is equal to EUR140,015.

Question 447

How to calculate which portfolio has the highest likelihood of reaching a goal given a return and sharpe ratio?

Answer 447

first - figure out what the goal is. i.e. if the clients goal is to be able to withdraw 50k out of a 1M portfolio without touching the principal. The goal is 50k/1M return (5%) Then, take all the portfolios and select the one with the largest value when calculated: (exp return on portfolio - required return threshold) / standard deviation of portfolio

Question 448

Black-Litterman model vs MVO and reverse optimization for asset allocation

Answer 448

``` the BL model uses an index to start and the accompanying weights/returns/covariances, and the investor adjusts these weights and returns by incorporating their own subjective views on each asset class and their confidence in those views --> Black–Litterman starts with the excess returns produced from reverse optimization, which commonly uses the observed market-capitalization value of the assets or asset classes of the global opportunity set and then the analyst adjusts the output from reverse optimization with his expectations of the market before he continues to retrieve asset weights. ``` Reverse optimization takes as its inputs a set of asset allocation weights that are assumed to be optimal (The starting weights are commonly the observed market-capitalization value of the assets or asset classes of the global opportunity set) and, with covariances and the risk aversion coefficient, solves for expected returns. The asset allocation using reverse optimization would not take into account the investor’s own views. - In contrast to MVO, the reverse optimization method results in a higher allocation to global bonds, US bonds, and global equities as well as a lower allocation to cash and US equities. - -> MVO is simply starting the asset allocation process with the analysts expected returns/covariances for each asset class and constructing the efficient frontier. - For the reverse optimization approach, the expected returns of asset classes are the outputs of optimization with the market capitalization weights, covariances, and the risk aversion coefficient used as inputs. In contrast, for the MVO approach, the expected returns of asset classes are inputs to the optimization, with the expected returns generally estimated using historical data. - -> both tend to be more diversified than what a mean variance optimization model may produce (MVO will concentrate exposures in a subset - i.e. in the US). The asset allocation weights for the MVO method are outputs of the optimization with the expected returns, covariances, and a risk aversion coefficient used as inputs` - -> another common criticism of MVO is that the model outputs, the asset allocations, tend to be highly sensitive to changes in the model. MVO Portfolios are based on market risk only and are more sensitive to measurement errors in the expected return than to measurement errors in correlation and risk.

Question 449

Fama French Model

Answer 449

The Fama-French Three-factor Model is an extension of the Capital Asset Pricing Model (CAPM). The Fama-French model aims to describe stock returns through three factors: (1) market risk, (2) the outperformance of small-cap companies relative to large-cap companies, and (3) the outperformance of high book-to-market value companies versus low book-to-market value companies. The rationale behind the model is that high value and small-cap companies tend to regularly outperform the overall market. Expected ROR = risk free rate + (factor coefficient) Market risk premium+ (factor coef) SMB + (factor coef) HML where: - Market risk premium: return market - risk free - SMB (Small Minus Big) = Historic excess returns of small-cap companies over large-cap companies - --> positive value indicates small cap tilt, negative would indicate large cap tilt - HML (High Minus Low) = Historic excess returns of value stocks (high book-to-price ratio) over growth stocks (low book-to-price ratio) - -> positive value would indicate value tilt, negative value would indicate a growth tilt

Question 450

Ways to monitor credit market liquidity risk?

Answer 450

Trading volume It is important for individuals to properly understand the liquidity environment in credit markets, as well as its implications. As broker/dealers have reduced their corporate bond holdings, trading volume in credit markets has declined following the 2008–09 global financial crisis. Spread sensitivity to fund outflows Another measure used to evaluate liquidity is spread sensitivity to large withdrawals by investors from credit funds. A large withdrawal is likely to require a fund to sell assets. Bid–ask spreads Bid–ask spreads can also be used to assess liquidity in credit markets. Generally speaking, bid–ask data should be analyzed cautiously because such information is stable only when markets, in turn, are stable. More volatile market conditions often have a negative effect on bid–ask spreads. This effect is often temporary and suggests that bid–ask levels tend to stabilize after a brief period of volatility.

Question 451

How to assess the tail risk of a fixed-income portfolio.

Answer 451

Tail risk events are difficult to model and virtually impossible to predict in advance. Such events do occur in credit markets and often result in unexpectedly large negative and positive portfolio returns. Tail risk can be assessed by using scenario analysis. The primary purpose of scenario analysis is to test the portfolio’s performance under plausible but unusual circumstances. Because tail risk is ultimately the risk of extremely unusual events, one useful approach is envisioning events that have not occurred but might cause large moves in security prices via hypothetical scenarios involving large moves in interest rates, exchange rates, credit spreads, or commodity prices. --> Scenario analysis in credit portfolios often involves projecting portfolio returns when there are large moves in corporate bond prices (because small price changes are not unusual) or large changes in spreads, and it may include scenarios based on actual historical or hypothetical events. Past periods when security prices demonstrated unusual behavior are good candidates for historical scenario analysis.

Question 452

Ways to manage liquidity risk in a bond portfolio?

Answer 452

holding cash; managing position sizes; holding liquid, non-benchmark bonds; and making use of credit default swap (CDS) index derivatives and exchange-traded funds (ETFs). - Holding cash As the most liquid asset, cash is an important consideration in liquidity management among credit portfolio managers. - Managing position sizes Position sizes are selected in the context of liquidity. Typically, more liquid credit securities are given greater portfolio weight, all else being equal. Holding greater weights of liquid credit securities and cash may decrease expected credit portfolio returns, but the liquid nature of these assets may be an increasingly important consideration among portfolio managers. - Holding non-benchmark bonds Liquid credit securities that are outside portfolio managers’ benchmarks may also be used as cash surrogates. Such positions typically provide some incremental yield over cash and can be liquidated relatively easily to raise cash for portfolio management needs. -Making use of CDS index derivatives and ETFs Portfolio managers may manage liquidity risk using CDS index derivatives. The market for CDS derivatives is relatively more active than credit markets. ETFs offer another alternative for portfolio managers to manage liquidity risk. Credit ETFs enable investors to more quickly obtain diversified exposure in the credit markets, although at the expense of reduced ability to actively select individual credit securities. -> Hedging with derivatives, such as credit default swaps, is effective but costly.

Question 453

Identify an appropriate structured financial instrument for each of the below objectives. Justify each response. Objective: - Exposure to consumer credit - Levered exposure to credit - Lower-risk exposure to the financial sector

Answer 453

Exposure to consumer credit: ABS Several types of non-mortgage assets are used as collateral for ABS, including auto loans and lease receivables, credit card receivables, student (or other personal) loans, bank loans, and accounts receivable. ABS may thus provide a way for investors to express views on consumer credit. Levered exposure to credit: CDO or CLO Mezzanine and equity tranches of CLOs and CDOs provide a mechanism for investors to gain additional return if the underlying collateral has strong returns. Conversely, these tranches also face heightened risk of losses in an adverse credit environment. This risk–return trade-off of mezzanine and equity tranches of CLOs and CDOs thus provides leveraged exposure to the underlying collateral (e.g., loans and bonds). --> CLO vs CDO: CLO is a purchase of a group of loans that could cover multiple sectors and is less risky. CDOs is the collection of the cash generating assets in a certain sector and is more risky and more complex Lower-risk exposure to the financial sector: Covered bonds A covered bond is a debt obligation usually issued by a bank and backed by a segregated pool of assets called a “cover pool”. This dual recourse protection for creditors in the event of default against both the issuer and the cover pool lowers the credit risk of covered bonds relative to otherwise similar corporate bonds or ABS. Investors typically view covered bonds as a lower-risk alternative to financial sector bonds. An investor who wants to reduce his portfolio’s risk to the financial sector may sell corporate debt issued by banks and buy covered bonds instead.

Question 454

For goal planning: what is a change in constraints vs goals vs beliefs?

Answer 454

Constraints: A change in constraints relates to material changes in constraints, such as time horizon, liquidity needs, asset size, and regulatory or other external constraints. i.e.: considering accepting an offer of retiring five years sooner than originally anticipated. Goals: A change in an investor’s personal circumstances that may alter her risk appetite or risk capacity is considered to be a change in goals. Beliefs: A change in the investment beliefs or principles guiding an investor’s investment activities is considered to be a change in beliefs.

Question 455

When estate planning, how to avoid : A. Probate B. Forced heirship

Answer 455

Probate:The legal process to confirm the validity of a will so that executors, heirs, and other interested parties can rely on its authenticity. In some instances, probate can be avoided or its impact limited by holding assets in joint ownership (e.g., joint tenancy with right of survivorship), living trusts, retirement plans, or life insurance strategies. Through these structures, ownership transfers without the need for a will, and hence the probate process can be avoided. Forced heirship: Legal ownership principles whereby children have the right to a fixed share of a parent’s estate. Under civil law, ownership is a precise concept that is tempered by statutes that place certain limitations on the free disposition of one’s assets. Under forced heirship rules, for example, children have the right to a fixed share of a parent’s estate. This right may exist whether or not the child is estranged or conceived outside of marriage. Forced heirship in civil law countries may reduce or eliminate the need for a will. Wealthy individuals may attempt to move assets into an offshore trust governed by a different domicile to circumvent forced heirship rules. Spouses typically have similar guaranteed inheritance rights under civil law forced heirship regimes. In addition, spouses have marital property rights, which depend on the marital property regime that applies to their marriage. Individuals can attempt to reduce or avoid forced heirship by: - moving assets into an offshore trust governed by a different jurisdiction; - gifting or donating assets to others during their lifetime to reduce the value of the final estate upon death; or - purchasing life insurance, which can move assets outside of realm of forced heirship provisions. Such strategies, however, may be subject to “clawback” provisions that provide a basis for heirs to challenge these solutions in court.

Question 456

How to compare different tax strategies for the transfer of assets associated with estate planning 1. tax free gift 2. Bequest

Answer 456

FV of a tax-free gift = PV x [1+pretax return if held by recipient (1-recipents tax rate)^n] FV if bequest at grantors death: = PV [ (1+return) x (1-tax on return in grantors portfolio)^n] (1-extate tax) RV of a taxable gift = FV gift/ FV of bequest FV if gifted: = [(1+return) x (1- current tax rate of recipeint)^n] x (1-transfer tax at end of period) i.e. if a grandparent is considering transferring their estate to their grandchild who currently is in a 25% income tax bracket now vs bequesting it in 5 years. The local tax jurisdiction imposes 30% transfer tax and the assets in question are currently earning 10% annually = [1+0.10(1−0.25)]^5 / [1+0.10(1−0.30)]^5 - 1.0049/.9818 = 1.02 - -> if gifted now, 2 percent more wealth will be created in five years than if the portfolio had remained in the estate and been taxed at 30 percent annually.

Question 457

three potential double taxation conflicts

Answer 457

1. Residence–source conflict When tax jurisdiction is claimed by an individual’s country of residence and the country where some of their assets are sourced; the most common source of double taxation. 2. Source–source conflict When two countries claim source jurisdiction of the same asset; both countries may claim that the income is derived from their jurisdiction. 3. Residence–residence conflict When two countries claim residence of the same individual, subjecting the individual’s income to taxation by both countries.

Question 458

Term vs whole vs universal life insurance

Answer 458

Term life insurance: Temporary life insurance provides insurance for a certain period of time specified at purchase. If the individual survives until the end of the period (e.g., 20 years), the policy will terminate unless it can be automatically renewed. Generally, premiums for term life insurance either remain level over the insured period (e.g., 20 years) or increase over the period as mortality risk increases. The cost of term insurance is less than that of permanent insurance, and the cost per year is less for shorter insured periods (e.g., 10 years versus 20 years), again because of increasing mortality risk. Whole life insurance: Whole life insurance remains in force for an insured’s entire life (hence the name). Whole life insurance generally requires regular, ongoing fixed premiums, which are typically paid annually, although monthly, quarterly, and semiannual payment options also exist. Failure to pay premiums can result in the lapse of the insurance policy. There is generally a cash value associated with a whole life insurance policy that may be accessed if the insured chooses to do so. The non-cancelability of whole life insurance can make this type of policy appealing to purchase at younger ages, when an individual is typically healthier. Whole life insurance policies can be participating or non-participating. Participating life insurance policies allow potential growth at a higher rate than the guaranteed value, based on the profits of the insurance company. A non-participating policy is one with fixed values: The benefits will not change based on the profits and experience of the insurance company. Universal life insurance: Constructed to provide more flexibility than whole life insurance. The policy owner, generally the insured, has the ability to pay higher or lower premium payments and often has more options for investing the cash value. The insurance will stay in force as long as the premiums paid or the cash value is enough to cover the policy expenses of the provider. --> Whole life insurance offers consistency, with fixed premiums and guaranteed cash value accumulation. Universal life insurance gives consumers flexibility in the premium payments, death benefits, and the savings element of their policies.

Question 459

Risks involved when implementing a carry trade

Answer 459

--> i.e. The carry trade is a trading strategy of borrowing in low-yield currencies and investing in highyield currencies. Borrow in USD at 2.211% Invest in China at 5.667% Profit = 5.667% – 2.211% = 3.456% --> Risks involved in carry trades: Risks involved in carry trade (include at least two): 1. High-yielding currencies are typically from high-risk countries. 2. In times of global financial crisis, there is a rapid movement from high-risk currencies to low-risk currencies, resulting in unwinding of carry trades. 3. Large-scale losses can be incurred quickly due to the large amount of leverage involved with a carry trade.

Question 460

Monetary vs fiscal policy

Answer 460

Monetary policy refers to central bank activities that are directed toward influencing the quantity of money and credit in an economy via management of interest rates and the total supply of money in circulation. --> expansionary = lower interest rates (which leads to depreciation of that countries currency) By contrast, fiscal policy refers to the government's decisions about taxation and spending (supply of t-bill bonds). Both monetary and fiscal policies are used to regulate economic activity over time. --> expansionary = lower taxes - -> persistently loose fiscal policy (large tax deficits) paired with loose monetary policy (inflation) leads to high nominal rates because the domestic private sector must be induced to save - -> persistently tight fiscal policy paired with tight monetary policy leads to low nominal rates because it generally results in lower inflation - -> a combo of the two could result in either higher or lower nominal rates aka mid nominal rates

Question 461

potential drawbacks of the following strategy: The strategy creates a hedged long/short portfolio focused on the Quality factor. It ranks Russell 1000 constituents from best to worst, based on this factor, and divides them into decile portfolios. The top decile portfolio is then purchased, while the bottom decile portfolio is shorted.

Answer 461

There are several potential drawbacks to the “hedged portfolio” approach (any two would be acceptable): • The hedged portfolio is not a “pure” factor portfolio because it has significant exposures to other risk factors (e.g., Size, Value, Momentum, Growth, etc.). • The information contained in the middle deciles of the ranked universe (i.e., the Russell 1000) are not utilized, only the information contained in the top and bottom deciles. • This hedged-portfolio approach assumes the relationship between future stock returns and the factor (i.e., Quality) are linear, which may not be the case. • Portfolios using this approach tend to be concentrated. If many managers adopt a similar strategy, the resulting portfolios will be highly concentrated in specific stocks, increasing overall risk to the strategy. • Shorting might be prohibitively expensive for certain stocks, or not possible altogether in certain markets (although this is less of an issue for a universe as deep and liquid as the Russell 1000 Index).

Question 462

The time-weighted average price (TWAP) | --> what are the advantages?

Answer 462

The time-weighted average price (TWAP) trading strategy can be used to avoid volume uncertainties and outliers and should achieve a fair and reasonable price for liquidating shares over a set time period without market impact. TWAP will slice the order into smaller amounts to send to the market following an equal-weighted time schedule. TWAP will send the same number of shares and the same percentage of the order to be traded in each time period. The advantages of using TWAP trading strategy are • TWAP excludes potential trade price outliers. (vs VWAP would be impacted) • TWAP should achieve fair and reasonable prices over the trading period.

Question 463

Free Float vs Fundamental Weighting`

Answer 463

Free-float weighting is a form of capitalization weighting. A cap-weighted index can be thought of as a liquidity-weighted index because the largest-cap stocks tend to have the highest liquidity and the greatest capacity to handle investor flows at a manageable cost. --> Rather than using all of the shares (both active and inactive shares), as is the case with the full-market capitalization method, the free-float method excludes locked-in shares, such as those held by insiders, promoters, and governments Fundamental weighting intends to exploit possible inefficiencies in market pricing caused by the overuse of cap-weighted approaches. --> Fundamentally weighted indexes can base their construction on a range of fundamental metrics, such as revenue, dividend rates, earnings, or book value. Fundamentally weighted indexes provide a benchmark for passively managed funds offered to investors seeking exposure to stocks based on fundamental characteristics.

Question 464

the 5 BB&K Client Classifications

Answer 464

Individualists – They are confident and careful. They generally do not go to a consultant to manage their investments but do it by themselves. Individualists are unlikely to easily take advice without doing their own analysis but are pleasant to work with because they process information rationaly Adventurers – Adventurers generally go for only big bets and end up with concentrated portfolios. They have the resources to do so and are willing to take risks. The investment made by this type of investors are generally focused and not diversified. They are difficult to work with. Celebrities – Celebrities are those that are swayed too much by the trend and do not have any expertise or opinion about investments. However, not having the expertise and the confidence required to manage the portfolio on their own, they approach investment managers frequently. --> celebrities hold opinions about some things but may be willing to take advice about investing. They only recognize their investment limitations to a certain extent. Guardians – Guardians are both anxious and careful. Lacking confidence in themselves, they approach investment counsels. They generally emphasize on safety of the capital while making the investments and a significant proportion of their investments is generally devoted to government securities and guaranteed return investments. People tend to become guardians as they age. Straight arrows – The average investor. These are halfway between complete confidence and anxiety, and extreme carefulness and impetuousness. Straight arrows are sensible and secure. They fall near the center of the graph. They are willing to take on some risk in the expectation of earning a commensurate return.

Question 465

Describe how each of the following circumstances can create concerns for a convertible bond arbitrage (relative value) hedge fund strategy: 1. Short selling 2. Credit issues 3. Time decay of call option 4. Extreme market volatility

Answer 465

1. Short selling Since Hedge Fund 1 employs a convertible arbitrage strategy, the fund buys the convertible bond and takes a short position in the underlying security. When short selling, shares must be located and borrowed; as a result, the stock owner may want his/her shares returned at a potentially inopportune time, such as during stock price run-ups or when supply for the stock is low or demand for the stock is high. This situation, particularly a short squeeze, can lead to substantial losses and a suddenly unbalanced exposure if borrowing the underlying equity shares becomes too difficult or too costly for the arbitrageur. 2. Credit issues Credit issues may complicate valuation since bonds have exposure to credit risk. When credit spreads widen or narrow, there would be a mismatch in the values of the stock and convertible bond positions that the convertible manager may or may not have attempted to hedge away. 3. Time decay of call option The convertible bond arbitrage strategy can lose money due to time decay of the convertible bond’s embedded call option during periods of reduced realized equity volatility and/or due to a general compression of market implied volatility levels. 4. Extreme market volatility Convertible arbitrage strategies have performed best when convertible issuance is high (implying a wider choice among convertible securities as well as downward price pressure and cheaper prices), general market volatility levels are moderate, and the liquidity to trade and adjust positions is sufficient. Extreme market volatility typically implies heightened credit risks. Convertibles are naturally less-liquid securities, so convertible managers generally do not fare well during such periods. Because hedge funds have become the natural market makers for convertibles and typically face significant redemption pressures from investors during crises, the strategy may have further unattractive left-tail risk attributes during periods of market stress.

Question 466

Information Ratio

Answer 466

Active return / active risk --> basically the ultimate factor in how good a PM is. can also be calculated: IR = ( portfolio return - benchmark return ) / tracking error * tracking error = standard deviation of difference between portfolio and benchmark returns

Question 467

How to use ruin probabilities

Answer 467

i.e. Jacobs asks to determine how much he could withdraw annually from a balanced portfolio if he wants to be at least 94% certain that the portfolio will last for the remainder of his life the hazard rate is the % of failure - i.e. 0.8 means that there is a 0.8% chance that Jacob may run out of money. If Jacob can handle up to a 6% chance of failure, find the spending rate that is closest to 6% - i.e. if a 4$/100$ saved has a hazard rate of 6.3% and Jacob has 2M saved, he can safely withdraw ($4/$100) x 2M = $80k annually

Question 468

Active share vs active risk

Answer 468

Active Share and active risk do not always move in tandem. A manager can pursue a higher Active Share without necessarily increasing active risk (and vice versa). Active Share measures the degree to which the number and sizing of the positions in a manager’s portfolio are different from those of a benchmark. Active Share takes a value between 0 (replicates benchmark) and 1 (has no similarity) --> Investors are more likely to be willing to pay higher fees for higher Active Share as an indicator of greater active management Active risk, also called tracking error, is the standard deviation of active returns (portfolio returns minus benchmark returns). Active risk is affected by the degree of cross-correlation between securities, whereas Active Share is not. A portfolio manager can completely control Active Share because they control the weights of the securities in the portfolio. However, a manager cannot completely control active risk because predicted active risk depends on estimations of correlations and variances of securities that may be different from those actually realized.

Question 469

active share and active risk profile of: 1. pure indexing 2. factor neutral 3. factor diversified 4. concentrated factor bets 5. concentrated stock picker

Answer 469

1. pure indexing - no active positions, zero active shares and zero active risk 2. factor neutral - no active factor bets - idiosyncratic risk (non-market risks) low if diversified, low active risk, low active shares (if diversified) 3. factor diversified - balanced exposure to risk factors and minimized idiosyncratic risk through high number of securities in portfolio - Reasonably low active risk and high Active Share from large amount of securities used that are unlikely to be in the benchmark 4. concentrated factor bets - targeted factor bets - idiosyncratic risk likely to be high - high active shares and high active risk 5. concentrated stock picker - targeted individual stock bets - highest active share and highest active risk --> 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

Question 470

GIPS standards for private equity disclosures - -> 4 ratio disclosures? - -> valuation frequency? - -> composite construction?

Answer 470

- GIPS requires the disclosure of (1) total value to since-inception paid-in capital (2) since-inception distributions to since-inception paid-in capital (3) since-inception paid-in capital to cumulative committed capital (4) residual value to since-inception paid-in capital - GIPS standards require that valuations be prepared at least annually - GIPS standards require the separation of composites by strategy as well as vintage year. Under the Standards, there is no minimum or maximum number of portfolios that a composite may include. The Standards require that firms disclose the number of portfolios in each composite as of the end of each annual period presented, unless there are five or fewer portfolios

Question 471

when to implement each of the below risk management techniques: A. Risk retention B. Risk reduction C. Risk transfer

Answer 471

A. Risk retention -A risk with the loss characteristics of low frequency of occurrence and low severity of loss is best managed through risk retention --such as not purchasing an extended warranty on an infrequently used and relatively inexpensive item. B. Risk reduction - A risk with the loss characteristics of high frequency of occurrence and low severity of loss, such as dental cavities, is best managed through risk reduction —for example, through proper dental hygiene. C. Risk transfer - A risk with the loss characteristics of low frequency of occurrence and high severity of loss, such as an earthquake that destroys your home, is best managed through risk transfer

Question 472

signs of a risk efficient strategy - what metric is the most important?

Answer 472

- low active risk (indicates active return contributions of a lower dispersion than the benchmark and competing funds) - fewer securities - -> lower fees for higher active share can support a decision - -> when presented which sharpe ratio and active risk, the MORE relevant metric is the active risk measurement

Question 473

what disclosures are required in order for performance materials to be GIPS compliant?

Answer 473

1. The currency used to express performance 2. Whether any fees other than trading expenses are deducted from gross-of-fees returns 3. Whether any fees other than trading expenses and management fees are deducted from net-of-fees returns 4. The fee schedule 5. A measure of internal dispersion 6. Firms must only disclose the presence, use, and extent of leverage, derivatives, and short positions if it is material, including a description of the frequency of use and characteristics of the instruments sufficient to identify risks (no negative statement is required) 7. Firms must only disclose if the presentation conforms to laws or regulations that conflict with the requirements of the GIPS standards; no negative statement is required. 8. The availability of a list of composite descriptions should be disclosed 9. The availability of policies for valuing portfolios, calculating performance, and preparing compliant presentations should be disclosed 10. If the firm has included non-fee-paying portfolios in its composite, the percentage of the composite assets represented by non-fee-paying portfolios must be disclosed as of the end of each annual period (I.5.A.6). 11. The composite creation date must be disclosed 12. If the composite represents a global investment strategy, the presentation must include information about the treatment of withholding taxes on dividends, interest income, and capital gains, if material 13. the a composite description and benchmark description must be disclosed 14. For periods beginning on or after 1 January 2001, portfolios must be valued at least monthly. For periods beginning on or after 1 January 2010, portfolios must be valued on the date of all large cash flows. 15. The GIPS standards state that accrual accounting must be used for fixed-income securities and all other investments that earn interest income (no cash basis accounting) 16. If a composite includes portfolios with bundled fees, the firm must present the percentage of composite assets represented by portfolios with bundled fees as of each annual period end - For each composite presented to be GIPS compliant, the Standards require that firms show at least 5 years of annual performance (less if the firm or composite has been in existence for a shorter period) and then the performance record must be extended each year until 10 years of results have been presented. - Returns should be net and gross of fees and not annualize quarterly returns - Firms are required to show a measure of internal dispersion when more than 5 portfolios are in the composite

Question 474

Formulate the investment objectives section of the investment policy statement for the Endowment. The Prometheo University Scholarship Endowment (the Endowment) was established in 1950 and supports scholarships for students attending Prometheo University. The Endowment’s assets under management are relatively small, and it has an annual spending policy of 6% of the five-year rolling asset value.

Answer 474

The mission of the Prometheo University Scholarship Endowment is to provide scholarships for students attending the university. In order to achieve this mission, the Endowment must maintain the purchasing power of the assets in perpetuity while achieving investment returns sufficient to sustain the level of spending necessary to support the scholarship budget. Therefore, the investment objective of the endowment should be to achieve a total real rate of return (after inflation) of at least 6% with a reasonable level of risk.

Question 475

equity fund diversification using: Private equity Private real estate Absolute return hedge fund

Answer 475

- An absolute return hedge fund has the greatest potential to diversify a fund’s dominant public equity risk (vs private equity or private real estate.) Absolute return hedge funds exhibit an equity beta that is often less than that of private equity or private real estate. Also, absolute return hedge funds tend to exhibit a high potential to diversify public equities, whereas equity long/short hedge funds exhibit a moderate potential to fulfill this role. - Private equity provides moderate diversification against public equity. The primary advantage of private equity is capital growth. - Private real estate provides only moderate diversification against public equity. The primary advantage of private real estate is income generation.

Question 476

Qualitative risks to consider when monitoring a fund investment

Answer 476

- key person risk - alignment of interests - changes in complexity of the organization, structure of management fees, compensation of the investment professionals, growth in assets under management (AUM), and the amount of capital the key professionals have committed to the funds that they are managing - style drift - risk management - client/asset turnover - could be a sign of a problem - client profile - long term or quick to redeem? - service providers - reputable?

Question 477

FOF vs UCITS vs SMA

Answer 477

An FOF would allows a smaller investor to co-invest with other investors in alternative investment opportunities for which they might otherwise be too small to participate. • An in-house team would not be necessary to review and maintain an FOF, which uses an outside manager. • SMA have high minimum investments and may require enhanced in-house investment resources. • UCITS have a less attractive risk/return profile for a relatively small-sized portfolio but offer the best liquidity - UCITS have regulatory restrictions that can make them more difficult for a fund manager to implement the desired investment strategy.

Question 478

growth rate in the aggregate market value of equity

Answer 478

equity return forecast = (growth rate of nominal GDP) + (the change in the share of profits in GDP) + (the change in P/E) + (dividend yield) growth rate of nominal GDP = growth of real GDP + inflation growth rate of real GDP = growth rate in the labor input + growth rate in labor productivity

Question 479

Currently, Eastland’s currency is fixed relative to the currency of the country of Northland, and Eastland maintains policies that allow unrestricted capital flows. An analyst examines the relationship between interest rates and exchange rates. He considers three possible scenarios for the Eastland economy: Scenario 1 Shift in policy restricting capital flows Scenario 2 Shift in policy allowing the currency to float Scenario 3 Shift in investor belief toward a lack of full credibility that the exchange rate will be fixed forever Q: Discuss how interest rate and exchange rate linkages between Eastland and Northland might change under each scenario

Answer 479

Scenario 1 Eastland currently has a fixed exchange rate with unrestricted capital flows. It is unable to pursue an independent monetary policy, and interest rates will be equal to those in Northland. By restricting capital flows along with a fixed exchange rate, Eastland will be able to run an independent monetary policy with the central bank setting the policy rate. Thus, interest rates can be different in the two countries. Scenario 2 Eastland currently has a fixed exchange rate pegged to Northland with unrestricted capital flows. Eastland is unable to pursue an independent monetary policy with interest rates in Eastland equal to the interest rates prevailing in Northland (the country to which the currency is pegged). If Eastland allows the exchange rate to float, it will now be able to run an independent monetary policy with interest rates determined in its domestic market. The link between interest rates and exchange rates will now be largely expectational and will depend on the expected future path of the exchange rate. To equalize risk-adjusted returns across countries, interest rates must generally be higher (lower) in the country whose currency is expected to depreciate (appreciate). This dynamic often leads to a situation where the currency overshoots in one direction or the other. Scenario 3 Eastland and Northland (with currencies pegged to each other) will share the same yield curve if two conditions are met. First, unrestricted capital mobility must occur between them to ensure that risk-adjusted expected returns will be equalized. Second, the exchange rate between the currencies must be credibly fixed forever. Thus, as long as investors believe that there is no risk in the future of a possible currency appreciation or depreciation, Eastland and Northland will share the same yield curve. A shift in investors’ belief in the credibility of the fixed exchange rate will likely cause risk and yield differentials to emerge. This situation will cause the (default-free) yield curve to differ between Eastland and Northland.

Question 480

How to calculate the change in convexity given the sale of one bond in exchange for the purchase of another?

Answer 480

1) find the mixture of new bonds which matches the duration of the bond being replaced. I.e. say you are replacing 10 year bonds with a mixture of 3 year and LT bonds duration 10 = (duration 3 X weight) + duration LT X (1-weight) weight = allocation to 3 year bonds 2) after you have the duration matching weights, the G/L in convexity is calculated: Gain in convexity = (Weight of the 3-year) × (Convexity of the 3-year) + (Weight of the long-term bond) × (Convexity of the long-term bond) – (Weight of the 10-year) × (Convexity of the 10-year)

Question 481

How to calculate the equivalent value $ one should allocate from one bond to another in order to maintain a duration neutral position

Answer 481

in order to maintain a neutral duration position 1. find the money duration of the bond being exchanged out = $value / PVBP 2. exchange that money duration value / PBVP of the bond to be switched in - -> assuming PVBP is given in millions, divide the value of the bond position by 1M to make sure you are comparing apples to apples ``` i.e. if you are exchanging 150M LT bonds with a PVBP ($million) of 1,960 for an unknown value of 2 year bonds with a PVBP of 197 math = 150M/1M = 150 150 x 1960 = 294,000 294,000/197 = 1,492.39 1492.39 x 1M = $1.492M ```

Question 482

Probability ratio equation

Answer 482

used to find the best portfolio choice given expected return and standard deviation - = (expected return - required return) / s.d. of the portfolio

Question 483

resampling

Answer 483

resampling combines mean–variance optimization (MVO) with Monte Carlo simulation, leading to more diversified asset allocations. Resampling, like other asset allocation models, is subject to criticisms, including that riskier asset allocations tend to be over-diversified and the asset allocations inherit the estimation errors in the original inputs. --> Resampling is a methodology of economically using a data sample to improve the accuracy and quantify the uncertainty of a population parameter.

Question 484

how to determine the inflation adjusted annual cash flow generated by a sub portfolio

Answer 484

inflation adjusted annual cash flow generated by a sub portfolio = [ amount invested x (minimum expected return - inflation) ] / [ 1 - [ (1+inflation)/(1+expected return) ]^n ] x (1+expected return) --> minimum adjusted return should be the rate expected at the appropriate horizon and probability of success (you will be given multiple)

Question 485

Risk Parity asset allocation | —> how to calculate the risk attributable from each asset?

Answer 485

A risk parity asset allocation is based on the notion that each asset class should contribute equally to the total risk of the portfolio. The equal contribution of each asset class is calculated as: (weight of asset i x covariance of asset i with the portfolio) = (variance of the portfolio / number of assets)

Question 486

math to find optimal return for reverse optimization

Answer 486

reverse optimization returns = CAPM = | risk free rate x (beta x market risk premium)

Question 487

1. how to determine the value needed to invest given the desire to buy a 5M house in 5 years earning 4.4% annually 2. investment needed to keep up with current annual expenditures of $100,000 for the next 10 years, assuming annual inflation of 3% from Year 2 onward and 2.2% earned annually

Answer 487

how to determine the value needed to invest given the desire to buy a 5M house in 5 years earning 4.4% annually N=5 i=4.4 PMT = 0 FV=-5,000,000 cpt PV ``` PV= $100,000/(1.022) + [ ($100,000(1.03)^1) / (1.022^2) ] + [($100,000(1.03)^2) / (1.02^3)] + etc PV = $1,013,670 (or $1.01 million) ```

Question 488

Perrin selects a policy and asks Blanc to calculate the net payment cost index (per $1,000 of face value, per year), using a life expectancy of 20 years and a discount rate of 5%. Table 1 provides information about Perrin’s policy. Face value: $500,000 Annual premium (paid at beginning of the year): $12,000 Policy dividends anticipated per year (paid at end of the year): $2,000 Cash value projected at the end of 20 years: $47,000

Answer 488

The net payment cost index assumes that the policy will stay in force and estimates how much $1,000 worth of coverage will cost you per year (your net premium). This will tell you how much the life insurance policy costs per year on average. According to this method, the lower the index, the better the price The net payment cost index assumes that the insured will die at the end of a specified period—in this case, the given life expectancy of 20 years. Calculating the net payment cost index includes the following steps. 1. Future value of premiums (annuity due, 5%, 20 years) $416,631.02 Financial calculator operations: N = 20, I = 5, PV = 0, PMT = −12,000, mode = begin (because paid at beg of year): FV → 416,631.02 -> To switch between begin and end mode, 2ND > PMT > 2ND > ENTER until the correct mode is selected > 2ND > CPT to select 2. Future value of dividends (ordinary annuity, 5%, 20 years) ($66,131.91) N = 20, I = 5, PV = 0, PMT = 2,000, mode = end: FV → −66,131.91 3. 20-Year insurance cost = FV of premiums + FV of dividends = $350,499.11 Annual payments for insurance cost (annuity due, 5%, 20 years) = ($10,095.24) N = 20, I = 5, PV = 0, FV = 350,499.11, mode = begin: PMT → −10,095.24 4. Net payment cost index ($10,095.24/500) - -> 500 = # of thousand dollars of face value

Question 489

how to calculate the ROR for a portfolio given large cash flows

Answer 489

just geometrically link the smaller periods. I.e. if calculating for january Jan 1 portfolio balance: 100k Jan 15 cash flow: +15K, ending 118k balance Jan 31 balance: 130k Jan 1-15: [(118-15k)-100k]/100k = 3% Jan 15-31: (120-118)/118 = 1.69% link: [ (1.03)x(1.0169) ] - 1 = 4.75%

Question 490

Emerging market risk guidelines

Answer 490

- Fiscal deficit/GDP should be less than 4.00% - Debt/GDP should be less than 70.00% - Current account deficit should be less than 4.00% of GDP - Foreign exchange reserves should be at least 100.00% of short-term debt

Question 491

Steps to developing a fundamental active investment process

Answer 491

1. Define the investment universe and the market opportunity—the perceived opportunity to earn a positive risk-adjusted return to active investing, net of costs—in accordance with the investment mandate. The market opportunity is also known as the investment thesis. 2. Prescreen the investment universe to obtain a manageable set of securities for further, more detailed analysis. 3. Understand the industry and business for this screened set by performing industry and competitive analysis and analyzing financial reports. 4. Forecast company performance, most commonly in terms of cash flows or earnings. 5. Convert forecasts to valuations and identify ex ante profitable investments. 6. Construct a portfolio of these investments with the desired risk profile. 7. Rebalance the portfolio with buy and sell disciplines. --> Managers using an active fundamental investment process usually monitor the portfolio’s holdings continuously and may rebalance at any time. In contrast, portfolios using a quantitative approach are usually rebalanced at regular intervals, such as monthly or quarterly, or in response to updated output from optimization models

Question 492

In its quarterly policy and performance review, the investment team for the Peralandra University endowment identified a tactical allocation opportunity in international developed equities. The team also decided to implement a passive 1% overweight ($5 million notional value) position in the asset class. Implementation will occur by either using an MISC EAFE Index ETF in the cash market or the equivalent futures contract in the derivatives market. The team determined that the unlevered cost of implementation is 27 basis points in the cash market (ETF) and 32 bps in the derivatives market (futures). This modest cost differential prompted a comparison of costs on a levered basis to preserve liquidity for upcoming capital commitments in the fund’s alternative investment asset classes. For the related analysis, the team’s assumptions are as follows: Investment policy compliant at 3 times leverage Investment horizon of one year 3-month Libor of 1.8% ETF borrowing cost of 3-month Libor plus 35 bps Q. Recommend the most cost-effective strategy. Justify your response with calculations of the total levered cost of each implementation option.

Answer 492

Solution As the lower cost alternative, the endowment’s investment team should implement the 1% overweight position using futures. The additional cost of obtaining leverage for each option is as follows: = [ notional value of investment x (1 - (1/leverage ratio) x ETF Borrowing rate ] / notional value of investment --> for both, if you are given an unlevered cost of implementation, add that to the cost of obtaining the leverage and compare ETF: ($5 million × 0.6667 × 2.15%) / $5 million = 1.43% (or 143 bps) and Futures: ($5 million × 0.6667 × 1.80%) / $5 million = 1.20% (or 120 bps), where the inputs are derived as follows: 0. 6667 reflects the 3 times leverage factor - 66.67% borrowed and 33.33% cash usage (1-1/leverage ratio) 2. 15% reflects the ETF borrowing rate (3-month Libor of 1.80% + 35 bps), and 1. 80% reflects the absence of investment income offset (at 3-month Libor) versus the unlevered cost of futures implementation. The total levered cost of each option is the sum of the unlevered cost plus the additional cost of obtaining leverage: ETF: 27 bps + 143 bps = 170 bps and Futures: 32 bps + 120 bps = 152 bps. This 18 bps cost advantage would make futures the appropriate choice for the endowment’s investment team.

Question 493

Ethical and Professional Standards - Professionalism | what are the underlying values?

Answer 493

``` I. Professionalism A. Knowledge of the law B. Independence and Objectivity C. Misrepresentation D. Misconduct ```

Question 494

Ethical and Professional Standards - Integrity of Capital Markets what are the underlying values?

Answer 494

II. Integrity of Capital Markets A. Material Nonpublic Information B. Market Manipulation

Question 495

Ethical and Professional Standards - Duties to Clients | what are the underlying values?

Answer 495

``` III. Duties to Clients A. Loyalty, Prudence and Care B. Fair Dealing C. Suitability D. Performance Presentation E. Preservation of Confidentiality ```

Question 496

Ethical and Professional Standards - Duties to Employers | what are the underlying values?

Answer 496

IV. Duties to Employers A. Loyalty B. Additional Compensation C. Responsibilities of Supervisors

Question 497

Ethical and Professional Standards - Investment Analysis, Recommendations and Action what are the underlying values?

Answer 497

V. Investment Analysis, Recommendations and Action A. Diligence and Reasonable Basis B. Communication with Clients and Prospective Clients C. Record Retention

Question 498

Ethical and Professional Standards - Conflicts of Interest | what are the underlying values?

Answer 498

VI. Conflicts of Interest A. Disclosure of conflicts B. Priority of Transactions C. Referral Fees

Question 499

Ethical and Professional Standards - Responsibilities as a CFA Institute Member or CFA Candidate what are the underlying values?

Answer 499

VII. Responsibilities as a CFA Institute Member or CFA Candidate A. Conduct in the CFA Program B. Reference to CFA institute, CFA Designation, and CFA Program

Question 500

Market Anomalies

Answer 500

1. Momentum Effect - return pattern caused by investors following others lead (herding- When a group of investors trade on the same side of the market in the same securities, or when investors ignore their own private information and act as other investors do.) 2. Financial Bubbles and crashes - unusual returns caused by irrational buying or selling 3. Value vs Growth stocks: value tends to outperform growth and the market in general

Question 501

Long Term Economic Growth Rate

Answer 501

long term economic growth rate = population growth + labor force participation + new cap spending + total factor productivity --> each input is stated in terms of growth (percentage change)

Question 502

Risk Premium Approach to expected bond return

Answer 502

expected bond return = | risk-free rate + term premium + credit premium + liquidity premium

Question 503

Weighted Average Risk Premium given degree of integration and segmentation

Answer 503

Use Singer Terhaar approach - weighted average risk premium = [(degree of integration of A) x (expected risk premium assuming full integration)] + [(degree of segmentation of A) x (expected risk premium assuming full segmentation)]

Question 504

Defining features of asset classes

Answer 504

1. Assets within a class are similar and don't fit in more than one class 2. Classes have low correlation to other asset classes, cover all investable assets and are liquid - -> asset classes should be diversifying - note that low pairwise correlations with other asset classes is not sufficient. An asset class may be highly correlated with some linear combination of the other asset classes even when pairwise correlations are not high. - -> asset classes can sometimes overlap risk

Question 505

how to calculate the notional principal of an interest rate swap to increase (or reduce) portfolio duration (target duration)?

Answer 505

The notional principal of an interest rate swap to increase (or reduce) portfolio duration (target duration) can be calculated: notional swap principal = [(target mod dur - current portfolio mod dur)/ (mod dur of swap)] x market value of portfolio

Question 506

How to calculate the number of short treasury futures required to hedge interest rate risk?

Answer 506

of SHORT futures required to hedge interest rate risk = (-BPV of portfolio/ BPV of treasury futures) x conversion factor BPV of Portfolio = Mod Dur of Portfolio x .0001 x Market Value of Portfolio BPV of treasuries = Mod Dur of Tres. futures x .0001 x Market Value of Futures Market Value of Futures = (Contract price / 100) x $100,000

Question 507

Number of futures contracts needed to achieve a target duration

Answer 507

``` # of contracts needed to achieve target duration = [(BPV target portfolio - BPV current portfolio)/ BPV of futures contract] x conversion factor ``` - BPV target = Mod Dur of target x .0001 x market value of target - BPV of Portfolio = Mod Dur of Portfolio x .0001 x Market Value of Portfolio - BPV of treasuries = Mod Dur of Tres. futures x .0001 x Market Value of Futures - Market Value of Futures = (Contract price / 100) x $100,000

Question 508

Number of futures required to to achieve a target portfolio beta?

Answer 508

Number of futures required to to achieve a target portfolio beta = [(target portfolio beta - current portfolio beta)/ beta of stock index] x (market value of portfolio / futures contract value) Futures contract value = futures price x multiplier --> note that to fully hedge the portfolio from market risk, target beta should be 0. To hedge that risk into a seperate portfolio (i.e. hedge euro exposure to US PY exposure, target beta would be 1 for SPY and 0 for starting portfolio beta) example: you want to hedge 10M FTSE exposure to 8M SPY exposure. UK FTSE beta to spy is 1.1, S&P 500 E-Mini Futures One-Month Contract Price is US$3,000 w/ $50 multiplier and FTSE IDX One-Month Futures Contract Price is £7,300 with $10 multiplier number of futures to short FTSE = ( (0-1.1)/1 ) x (8M / (7.3k x 10)) = -121 Number of SPY futures to buy = ((1-0)/1) x (10M / (3k x 50))

Question 509

Mark to market example of a 1 year variance swap where 3 months have elapsed since inception

Answer 509

Step 1. Compute the expected variance at maturity = [annualized REALIZED volatility from initiation to valuation date (i.e. standard deviation) squared x (3months/1 year) ] + [annualized IMPLIED volatility from valuation date to swap maturity squared x (9 months remaining/1 year\)] Step 2. Compute the expected payoff at maturity variance notional = (vega notional) / [(2 × strike price x strike volatility)] expected payoff at maturity = variance to maturity ("found in step 1") - strike vol squared x variance notional --> s.d. squared = variance Step 3. Discount expected payoff at maturity (found in step 2) to valuation date (discount by 9 months)

Question 510

Domestic Currency Variance

Answer 510

variance of domestic currency = variance(foreign asset return) + variance(fx currency return) + (2 x std.dev.) x (foreign asset return) x (std. dev. x fx return) x (std.dev x foreign asset return x fx return) If the asset is risk free: std. dev of domestic currency = std dev of fx returns x (1 + return of asset) i.e. a US investor has a portfolio domiciled in EUR that returns 5 % (asset return) and the EUR appreciated 5% against USD (fx return)

Question 511

long short equity strategies and the disadvantage vs advantages of implementing this strategy? --> what's a long extension portfolio?

Answer 511

there are bias long, bias short long short strategies meaning that the PM is both long and short equities based on their convictions. Long extension portfolios guarantee investors 100% net exposure with a specified short exposure. A typical 130/30 fund will have 130% long and 30% short positions. Market neutral portfolios aim to remove market exposure through offsetting long and short positions. Pairs trading is a common technique in building market-neutral portfolios, with quantitative pair trading referred to as statistical arbitrage. With this strategy, alpha occurs through mean reversion. Benefits of long/short strategies: the ability to better express negative views, the ability to gear into high conviction long positions, the removal of market risk to diversify and the ability to better control risk factor exposures. Drawbacks: potential large losses since share prices are not bounded above, negative exposures to risk premiums, potentially high leverage for market neutral funds, and the costs of borrowing securities and collateral demands from prime brokers. Being subject to a short squeeze on short positions is also a risk.

Question 512

Strategies in managing a private business position

Answer 512

1. Strategic buyer: takes a buy and hold perspective 2. Financial buyer or financial sponsor: restructures the business, add value, and resell the business 3. Recapitalization: Owner structures 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 owner's shares 4. Sale to other management or key employees (management buyout - MBO) 5. Divestiture, sale or disposition of noncore business assets. 6. sale or gift to family members 7. Personal line of credit secured by company shares (owner borrows from the company) 8. IPO 9. Employee stock ownership plan (ESOP). The owner sells stock to the ESOP

Question 513

Strategies in managing a single investment in real estate

Answer 513

1. mortgage financing: a nonrecourse loan would allow the owner to default without risk to other assets 2. Donor-advised fund or charitable trust: providing a tax deduction for and with conditions that meet other objectives of the owner 3. sale and lease back

Question 514

Trade Costs

Answer 514

trade costs represents costs relative to the benchmark, a positive value represents UNDERperformance ``` trade costs (bps) = side x [(execution cost - benchmark price) / benchmark price] x 10,000 ``` where: side= +1 for buy and -1 for sell order

Question 515

Added value trade cost analysis

Answer 515

Added value is a trade cost analysis comparing the arrival cost of the trade with the estimated pre-trade cost ``` added value (bps) = arrival cost (bps) - estimated pre-trade cost absolute cost ($) = side × (execution price − benchmark price) × shares executed ``` --> a negative cost is a benefit - the trader has added value through their trading decisions

Question 516

Treynor Ratio

Answer 516

The Treynor ratio, also known as the reward-to-volatility ratio, is a performance metric for determining how much excess return was generated for each unit of risk taken on by a portfolio (higher is better). T = (portfolio return - risk free rate) / portfolio beta Excess return in this sense refers to the return earned above the return that could have been earned in a risk-free investment. Although there is no true risk-free investment, treasury bills are often used to represent the risk-free return in the Treynor ratio. Risk in the Treynor ratio refers to systematic risk as measured by a portfolio's beta. Beta measures the tendency of a portfolio's return to change in response to changes in return for the overall market.

Question 517

Appraisal Ratio

Answer 517

An appraisal ratio is a ratio used to measure the quality of a fund manager's investment-picking ability. AR = alpha / s.d. of the residual/unsystematic risk s.d. of the residual/unsystematic risk = the standard error of regression

Question 518

Compare the three approaches to evaluate Credit Risk

Answer 518

Three approaches to evaluate Credit Risk = ratings, structural models, reduced form models - ratings least accurate (lag issue in ratings change, downplays macro factors - reduced form are best b/c they can use historical estimates + consider macro factors better (plus more realistic assumption than structural)

Question 519

Factors that shift the strategic decision toward a benchmark neutral or fully hedged strategy

Answer 519

- shorter time horizon for portfolio objectives - high risk aversion - little weight given to the opportunity costs of missing positive currency returns - high short term income and liquidity needs - significant foreign currency bond exposure - clients who doubt the benefit of discretionary managements

Question 520

Increases in currency values are associated with?

Answer 520

Increases in currency values are associated with? 1. currencies that are undervalued relative to their fundamental value 2. currencies that have the greatest rate of increase in fundamental value 3. with higher real or nominal interest rates 4. with lower inflation relative to other countries 5. of countries with decreasing risk premiums

Question 521

How to transfer exposure from one index to another using futures when given a target allocation and beta?

Answer 521

of equity futures to buy or sell to reach a target beta = (target beta - portfolio beta / futures beta) x (value of portfolio to be transitioned / futures price) --> target beta is 0 for cash unless stated otherwise --> value of portfolio to be transitioned: i.e. if currently 70% of a 200M portfolio is large cap and wants to target 40% - value of portfolio to transition is .3x200M = 60M to decrease a equity beta exposure: i.e. say portfolio target beta is .85 and currently 1.15 = (target beta - portfolio beta / futures beta) x ($ of portfolio being adjusted / futures price) --> i.e. if they want the exposure to this index to be 40% of overall 200M portfolio = (.85-1.15/1.02) x (80M / futures price) - -> you'd sum the two if asked to address allocation shift and beta or report separately if asked to address separately - -> negative number would be sell futures, positive would indicate to purchase

Question 522

strategy for duration and convexity for the below predicted interest rate changes: • Investor believes that interest rates will rise sharply • Investor is quite certain that interest rates will remain unchanged • Investor feels strongly that interest rates will change considerably, but has no idea what direction they’ll move • Investor knows in her heart that interest rates will decline substantially

Answer 522

Rise sharply: decrease duration, increase convexity, buy put options Interest rates remain unchanged: leave duration alone, decrease convexity and SELL calls or puts --> In a stable yield curve environment, holding bonds with higher convexity 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. unsure of direction: leave duration alone, increase convexity, BUY calls and puts fall sharply: increase duration, increase convexity and buy call options --> If a bond has positive convexity, it would typically experience larger price increases as yields fall, compared to price decreases when yields increase. Risk to reward trade off is favorable

Question 523

risks of carry trades:

Answer 523

Risks involved in carry trade (include at least two): 1. High-yielding currencies are typically from high-risk countries. 2. In times of global financial crisis, there is a rapid movement from high-risk currencies to low-risk currencies, resulting in unwinding of carry trades. 3. Large-scale losses can be incurred quickly due to the large amount of leverage involved with a carry trade.

Question 524

Russel 1000 vs 2000? | Dow Jones Select Dividend Index?

Answer 524

2000 is smaller cap, 1000 is larger cap | Dow Jones Select Dividend Index is high dividend paying stocks

Question 525

4 ways to address slippage as a fund grows:

Answer 525

* The fund could limit its AUM by not accepting any new funds. This could include returning some capital to existing investors. * The fund could increase the number of portfolio holdings from the current 40, thus limiting the market impact of trading by reducing the number of days it takes to build a full position. * The fund could reduce turnover from the current 70%, which will result in a decrease in trading volume and the associated related implicit costs. * The manager could devise a trading strategy to mitigate market impact costs.

Question 526

How to best implement a minimum-variance hedge vs another currency

Answer 526

The minimum variance hedge ratio, also known as the optimal hedge ratio, is a formula to evaluate the correlation between the variance in the value of an asset or liability and that of the hedging instrument that is meant to protect it. minimum variance hedge = portfolio value x [correlation x (s.d. of domestic currency/ s.d. of foreign currency)]

Question 527

Asset-Liability Management

Answer 527

Asset/liability management is the process of managing the use of assets and cash flows to reduce the firm’s risk of loss from not paying a liability on time. Well-managed assets and liabilities increase business profits. The asset/liability management process is typically applied to bank loan portfolios and pension plans. - -> Liability-driven investing (LDI) or liability-based investing takes the liabilities (i.e. pension payments) as a given and manages the assets (i.e. bond purchases) to meet those future liability values - -> Asset-driven investing (ADI) takes the assets as a given and manages or adjusts the liabilities in relation to those assets. In case of ADL, we structure our liabilities to match our assets and not the other way round. i.e. a leasing company knows their income (rental income received) so they can match their liabilities accordingly

Question 528

Capital Structure Arbitrage

Answer 528

capital structure arbitrage involves taking long and short positions in the debt and equity of individual companies to extract misvaluations. --> This generally falls under distressed security strategies.

Question 529

Mean-variance analysis

Answer 529

Mean-variance analysis is the process of weighing risk, expressed as variance, against expected return. Investors use mean-variance analysis to make investment decisions. Investors weigh how much risk they are willing to take on in exchange for different levels of reward. Mean-variance analysis allows investors to find the biggest reward at a given level of risk or the least risk at a given level of return. --> Mean-variance asset allocation approach is an asset only approach that does not consider liabilities.

Question 530

When is a risk tolerance questionnaire useful? | --> what sort of investors are questionnaires most relevant for?

Answer 530

Rsk tolerance questionnaires are generally effective for cognitive-based individuals (but work best for institutional investors) and less effective for those with emotional biases - -> Because risk analysis is a cognitive process, the risk tolerance questionnaire may fail investors with an emotional bias—those who are likely to view risk as an emotional process rather than a cognitive process. Risk tolerance questionnaires will likely work better for investors with a cognitive bias because they are likely to think about risk more logically. - -> Questionnaires are a good fit for active growth and passive moderate investor types - investor's who's primary biases are cognitive - -> questionnaires would not work for investors with emotional biases like active aggressive investor types

Question 531

How to calculate the relative value of a foreign held account given beginning and ending balances in the FX and beginning and ending FX rates?

Answer 531

return to the investor in the investors domestic currency is found by weighting the investments and then finding the return of each investment in the DC and combining them. RDC = Weight of investment x (1+port return in FX) x (1+FX return) + Weight of investment 2 x (1+port return in FX) x (1+FX return) where: - weight of investment is found by calculating value of the different portfolios at the beginning of the portfolio / sum of all portfolios (i.e. if invested in 2M equivalent USD in EUR equities and 3M equivalent US in GBP equities - weight 1 = .4 and w2 = .6) - Portfolio return is found by ending EUR bal / Beg EUR bal - i.e. if EUR portfolio goes from 6M to 7M - portfolio return is 16% - FX return is found the same way if giving beginning and ending fx values - i.e. if in 2014 exchange rate was 3.8729 and in 2015 exchange rate is 4.1025 then FX return is 5.92%

Question 532

appraisal data bias impact on correlations and volatility

Answer 532

- calculated correlations with other assets tend to be understated - appraisal values tend to be less volatile than market determined values for identical assets and therefore measured volatilities are biased downward.

Question 533

For funds pursuing a growth at a reasonable price strategy - what is the most important multiple?

Answer 533

P/E-to-growth (PEG) ratio - | where p/e is found: price/12 month forward EPS

Question 534

What sort of bonds provide protection against inflation?

Answer 534

floating coupon bonds and inflation linked bonds

Question 535

Standard VI(C) Referral Fees - Disclosure requirements

Answer 535

Standard VI(C) states that members must disclose the nature of the consideration or benefit—for example, whether on a flat fee or percentage basis; a one-time or continuing benefit; or based on performance—together with the estimated monetary value.

Question 536

Equation for calculating portfolio values with deferred capital gains

Answer 536

FV of CG = account value x [ (1+return)^n) x (1 - tax rate) +tax rate - (1 - B) x tax rate] B = cost basis / current balance of account i.e if cost basis = account balance than B = 1 and if cost basis is 50k/100k then B = 0.5

Question 537

How to find probability of joint survival

Answer 537

p(Joint survival)=p(Greg survives)+p(Christine survives)−p(Greg survives)p(Christine survives)

Question 538

three criteria for immunizing a single future outflow (liability), given that the cash flow yields are sufficiently close in value:

Answer 538

1. Portfolio initial market value must exceed the outflow’s present value of the liability 2. Macaulay Duration must match closely - -> 1&2 = Money duration (mkt value x MD) 3. lower convexity is more preferred as long as it is above the liabilities convexity (The immunizing portfolio needs to be greater than the convexity (and dispersion) of the outflow portfolio. But, the convexity of the immunizing portfolio should be minimized in order to minimize dispersion and reduce structural risk.) This will minimize the effect of non-parallel shifts in the yield curve.

Question 539

steps to a quantitative active investment process

Answer 539

1. The first step in creating a quantitative, active strategy is to define the market opportunity or investment thesis. 2. Then, relevant data is acquired, processed, and transformed into a usable format. 3. This step is followed by back-testing the strategy, which involves identifying the factors to include as well as their weights. 4. Finally, the strategy performance should be evaluated using an out-of-sample back-test. - -> The purpose of back-testing is to identify correlations between the current period’s factor scores, FS(t), and the next period’s holding period strategy returns, SR(t + 1).

Question 540

Incremental VaR

Answer 540

The incremental value at risk measures how the additional portfolio position would change the overall portfolio’s VaR measure.

Question 541

An investor is considering the portfolio impact of a new 12-year corporate bond position with a $75M face value, a 3.25% coupon, current YTM of 2.85, modified duration of 9.887 and a price of 104.0175 per 100 of face value What is the approximate VaR for the bond position at a 99% confidence interval (equal to 2.33 standard deviations) for one month (with 21 trading days) if daily yield volatility is 1.50% and returns are normally distributed?

Answer 541

The expected change in yield based on a 99% confidence interval for the bond and a 1.50% yield volatility over 21 trading days equals 16 bps = (1.50% × 2.33 standard deviations × √21). = .015 x 2.33 x .0458 We can quantify the bond’s market value change by multiplying the familiar (–ModDur × ∆Yield) expression by bond price to get $1,234,105 = $75 million × 1.040175 ⨯ (–9.887 × .0016). bond price = 75M x (107.0175/100) change in yield = (–9.887 × .0016)

Question 542

percent capital gain exposure (PCGE)

Answer 542

PCGE is an estimate of the percentage of a fund’s assets that represent gains and measures how much the fund’s assets have appreciated. It can be an indicator of possible future capital gain distributions. PCGE can be used to gauge the amount of tax liability embedded in a mutual fund. PCGE = Net gains (losses)/Total net assets.

Question 543

How to find the annualized after-tax post-liquidation return Yoonim next asks Chen to evaluate Mutual Fund D, which has an embedded gain of 5% of the ending portfolio value. Yoonim asks Chen to calculate a post-liquidation return over the most recent three-year period. Mutual Fund D exhibited after-tax returns of 7.0% in Year 1, 3.3% in Year 2, and 7.5% in Year 3, and capital gains are taxed at a 20% rate.

Answer 543

The annualized after-tax post-liquidation return is calculated as follows. First, calculate the ending portfolio value. Given Fund D’s after-tax returns over the past three years, the ending portfolio value is calculated as Final after-tax portfolio value = (1 + 0.070) × (1 + 0.033) × (1 + 0.075) = 1.1882. The after-tax returns compounded in this way account for the tax on distributions and realized capital gains but do not account for any unrealized capital gains. The assumed tax liability from capital gains at liquidation is 1.0% of the final value, which is the product of the 5% embedded gain and the 20% capital gains tax rate. The portfolio value net of the unrealized gains tax liability is given by subtracting the assumed tax liability from capital gains at liquidation from the final after-tax portfolio value: Portfolio value net of the unrealized gains tax liability = 1.1882 − 0.01 = 1.1782. Second, calculate the annualized post-liquidation return as follows: 1.1782(^1/3)−1=5.62%.

Question 544

marginal contribution to total risk (MCTR) vs actual contribution to total risk (ACTR)

Answer 544

= beta x portfolio standard deviation marginal contribution to total risk (MCTR) is the beta relative to the portfolio multiplied by the standard deviation of the portfolio ACTR = weight in portfolio x MCTR --> for a portfolio as a whole (vs a segment found above) the MCTR is the s.d. of the portfolio return

Question 545

ways a currency overlay manager can use technical skills to improve a strategy

Answer 545

In forming a market view on such turning points in future exchange rate movements (e.g., peaking in the US dollar) or timing-related position entry and exit points, market technicians follow three principles: (1) Historical price data can be helpful in projecting future movements (2) historical price patterns have a tendency to repeat and identify profitable trade opportunities (3) technical analysis attempts to determine not where market prices should trade but where they will trade. i.e.: when devising a volatility strategy, a manager can use their technical skills to time entry and exit points of positions. She can identify patterns in the historical price data on the US dollar, such as when it was overbought or oversold, meaning it has trended too far in one direction and is vulnerable to a trend reversal. One could appropriately position US dollar trades to maximize potential returns from volatility shifts that could be associated with US dollar exchange rate movements.

Question 546

Risks of regime change

Answer 546

The suggestion by a manager to extend the data series back increases the risk of the data representing more than one regime. A change in regime is a shift in the technological, political, legal, economic, or regulatory environments. --> Regime change alters the risk–return relationship since the asset’s risk and return characteristics vary with economic and market environments. Analysts can apply statistical techniques that account for the regime change or simply use only part of the whole data series.

Question 547

The Barksdales’ human capital is valued at $2.9 million and estimated to be 35% equity-like. A manager determines that an overall target allocation of 40% equity is appropriate for the Barksdales’ total assets on the economic balance sheet. Capital Available Cash and investments 900,000 Adrian: Life insurance 100,000 Total capital available 1,000,000 meeting the Barksdales’ target equity allocation for total economic wealth, the financial capital equity allocation should be?

Answer 547

The equity allocation of the Barksdale’s financial capital is calculated as follows: Total economic wealth = Human capital + Financial capital = $2,900,000 + $900,000 = $3,800,000 Target equity allocation of total economic wealth = $3,800,000 × 40% = $1,520,000 Human capital equity allocation = $2,900,000 × 35% = $1,015,000 Financial capital equity allocation = $1,520,000 − $1,015,000 = $505,000 --> reason to exclude the life insurance: THE CASH VALUE OF INSURANCE IS TREATED AS NON MARKETABLE FINANCIAL CAPITAL. % Financial capital equity allocation = Financial equity allocation/Total financial capital = $505,000/$900,000 = 0.5611, or 56.1%

Question 548

Charitable Remainder Trust

Answer 548

With a charitable remainder trust, the client would make an irrevocable donation of his shares to a trust and receive a tax deduction for the gift. They would no longer have ownership of the shares. Within the trust, the shares could be sold and reinvested in a diversified portfolio without incurring a capital gains tax—since the charitable trust is exempt from taxes. The trust would provide income for the life of its named beneficiaries (the beneficiaries would owe income tax on this income). When the last-named beneficiary dies, any assets remaining in the trust would be distributed to the charity named in the trust.

Question 549

How to find a bonds instantaneous holding period return?

Answer 549

The instantaneous holding period return equals = | ( - Effective Spread Dur) × ∆Spread

Question 550

Qualitative and quantitative manager selection components

Answer 550

Qualitative: Process and People: Evaluating the manager’s investment process, including the manager’s philosophy, process, people, and portfolio. This consideration is broadly described as part of “investment due diligence.” Operational due diligence: Evaluating the manager’s infrastructure and firm, including the accuracy of the manager’s track record and whether the record fully reflects risks; the back office processes and procedures; the terms and if they are acceptable and appropriate for the strategy and vehicle; and the firm’s profitability, its culture, and if it’s likely to remain in business. This and the following bulleted considerations as a whole are broadly described as part of “operational due diligence”: • Investment vehicle: Is the investment vehicle suitable for the portfolio need? • Terms: Are the terms acceptable and appropriate for the strategy and vehicle? • Monitoring: Does the manager continue to be the “best” fit for the portfolio need? Quantitative: Attribution and appraisal: To assess if the manager has displayed skill in investing. The capture ratio: How has the manager performed in “up” versus “down” markets? Drawdown: Does the return distribution exhibit large drawdowns?

Question 551

Things to consider ahead of considering hiring an investment manager?

Answer 551

the content of the adviser’s checklist related to manager selection: the client, with their adviser, should ensure the following tasks were performed prior to manager selection: - Decide that outside support is necessary. - Complete an investment policy statement (IPS). - Determine the appropriate asset allocation.. --> Short of these key actions, the client will be unable to identify the managers who fits her needs, confirm that the managers are suitable for her IPS, and be confident that they will act upon the appropriate asset allocation.

Question 552

Performance Attribution

Answer 552

Performance attribution helps explain how performance was achieved; it breaks apart the return or risk into different explanatory components. Effective performance attribution must account for all of the portfolio’s return or risk exposure, reflect the investment decision-making process, quantify the active decisions of the portfolio manager, and provide a complete understanding of the excess return/risk of the portfolio. --> Performance attribution alone does NOT draw conclusions regarding the quality of a portfolio manager’s investment decisions.

Question 553

How to find the notional value (in US dollar millions) of the interest rate swap necessary to match the duration profile of a given liability?

Answer 553

notional value of swap = (mod dur of liability - mod duration of assets / mod dur of the swap) x plan assets --> keep in mind when calculating the mod dur of the assets that this should only consider the FI portion - i.e. if a plans assets are worth 100M with a mod dur of 7 but only holds 60M in FI and the rest in equities, the mod duration of assets is found 7 x 60% = 4.2

Question 554

Performance appraisal vs performance attribution vs performance measurement

Answer 554

Performance appraisal indicates whether the portfolio’s performance was achieved through manager skill or through luck. Performance attribution analyzes the impact of active investment decisions on returns and the risk consequences of those decisions. Performance measurement provides an overall indication of the portfolio’s performance, usually relative to a benchmark.

Question 555

open end vs closed end funds

Answer 555

closed end funds and ETFs are more liquid than open end funds. Closed end funds are listed securities, they can be bought and sold intra-day, and the price received will depend on the trading volume and depth of the fund. The obvious advantage of these funds is ease of trading, although there can be some price uncertainty for less liquid funds, particularly when trying to buy or sell a large number of shares. Open-end funds are slightly less liquid, providing daily liquidity but also price certainty; shares are bought and sold at the end-of-day NAV. ---> open end funds typically have an incentive fee attached which motivates them to work harder and discourages closet indexing.

Question 556

How to find the excess return due to active factor weighting (note: BHB and BF find total return) --> aka active effect

Answer 556

1. find the return contribution of the factor in the portfolio (portfolio sector weight x portfolio sector return) 2. find the benchmark sector contribution (benchmark sector weight x benchmark sector return) 3. subtract value one (portfolio rector attribution) - value two (benchmark sector attribution) 4. repeat this for all of the factors where there is a difference in sector weighting between the portfolio and then benchmark and sum them up to find total excess return

Question 557

How to find the probability of a rate change given current fed funds rate and the fed futures contract pricing? i.e. PM prefers to infer the likely move from the market pricing of Fed funds futures. The current federal funds rate is 1.88%, and the Fed futures contract is priced at 98.33.

Answer 557

(Effective federal funds rate implied by futures contract−Current federal funds rate) / (Federal funds rate assuming a rate cut−Current federal funds rate) = (1.67−1.88) / (1.63−1.88)=0.86 A: 86% probability of a 25 bp cut in the federal funds rate at the next meeting.

Question 558

Bull vs Bear Flattening scenario

Answer 558

Bear flattening: shorter term yields rise due to investors fleeing riskier assets and buying bonds in a flight to quality. Bull flattening: A bull flattening is a decrease in the yield spread between long- and short-term maturities driven by lower long-term yields-to-maturity

Question 559

When to use a POV algorithm vs an arrival price algo vs a liquidity seeking algo

Answer 559

Liquidity-seeking algorithms are appropriate for large orders that the portfolio manager or trader would like to execute quickly without having a substantial impact on the security price. i.e. a sell order for XYZ shares is for 20% of the expected volume and therefore is a large order. Liquidity-seeking algorithms are also used when displaying sizable liquidity via limit orders could lead to unwanted information leakage and adverse security price movement. In these cases, the priority is to minimize information leakage associated with order execution and avoid signaling to the market the trading intentions of the portfolio manager or trader. POV algorithms (also known as participation algorithms) send orders following a volume participation schedule. As trading volume increases in the market, these algorithms will trade more shares, and as volume decreases, these algorithms will trade fewer shares. Arrival price algorithms are used for orders in which the portfolio manager or trader believes prices are likely to move unfavorably and wishes to trade more aggressively to capture alpha, they are used when the security is relatively liquid or the order is not outsized (size less than 15% of the expected volume).

Question 560

How to find the change in portfolio value given an effective duration and change in yield?

Answer 560

change in portfolio value = (−EffDur × ΔYield) - -> when reviewing a portfolio, remember that the sum of the key rate durations equals the effective portfolio duration. (There are 11 maturities along the Treasury spot rate curve, and a key rate duration is calculated for each. The sum of the key rate durations along a portfolio yield curve is equal to the effective duration of the portfolio.) - -> Key rate duration is not the same as effective duration. Effective duration is an estimate of a security's sensitivity to a parallel shift in interest rates, meaning that it assumes that interest rates change by the same degree for, say, one-year bonds, five-year bonds, 10-year bonds, and 30-year bonds. That's not often the case in the real world, which is why key rate duration is useful -- it measures a security's price sensitivity to shifts at 'key' points along the yield curve. Key duration rates are especially useful for securities with embedded options such as call options or prepayment options. ---> i.e. if the sum of all of portfolio's holding key rates add up up 6.115 and you expect a yield change of 50bps - the portfolio value would decrease by -6.115 x 0.005 = -0.030575 or 3.06%

Question 561

How to calculate the number of futures contracts needed to replace a cash portfolio with exposure to an emerging market valued with a different currency via futures contracts due to a favorable forecast- i.e. you have a 10M USD portfolio that you'd like to invest in a Brazilian equity index, which historically has had a 1.15 beta to the broader EM, compared with his 1.0 target EM beta. Bennett gathers data for the BOVESPA futures contract, whose underlying is the BOVESPA Index. The contract price is R$104,465, with a multiplier of 1 and a USD/BRL spot rate of 4.20.

Answer 561

Calculate the number of futures contracts needed on EM exposure of US$10 million, which at a USD/BRL exchange rate of 4.20 is equal to US$42 million. Adjust brazilian index exposure for beta of 1.15: ``` # futures required = (index target beta / beta of futures contract) x fx adj value of portfolio/ futures contract price ) --> futures contract price = quoted price of futures contract x contract multiplier ``` =(1.0/1.15) x (42,000,000/104,456) = 0.8 = 349.78 ≈350

Question 562

Asset Swap Spread

Answer 562

ASW is the difference between the bond’s fixed coupon rate and the fixed rate on an interest rate swap versus the market reference rate, which matches the coupon dates for the remaining life of the bond.

Question 563

An active portfolio manager seeking to purchase single-name CDS protection observes a 1.75% 10-year market credit spread for a private investment-grade issuer. The effective spread duration is 8.75 and CDS basis is close to zero. What should the protection buyer expect to pay or receive to enter a new 10-year CDS contract?

Answer 563

standard fixed CDS coupon rates are 1% for investment-grade issuers and 5% for high-yield issuers. CD price = ((Fixed Coupon − CDS Spread) × EffSpreadDurCDS) = (1.75-1%) x 8.75 = 6.5625% --> The fixed notional amount upon contract initiation; the initial CDS price is therefore 93.4375 per 100 of notional with a CDS spread of 175 bps.

Question 564

How to calculate the gain on a variance swap: Regan next suggests that Monatize could alternatively hedge Portfolio B using variance swaps. Monatize’s CFO asks Regan to calculate what the gain would be in five months on a purchase of $1,000,000 vega notional of a one-year variance swap on the S&P 500 at a strike of 15% (quoted as annual volatility), assuming the following: Over the next five months, the S&P 500 experiences a realized volatility of 20%; At the end of the five-month period, the fair strike of a new seven-month variance swap on the S&P 500 will be 18%; and The annual interest rate is 1.50%.

Answer 564

The gain on the variance swap is calculated as: =Variance Notional × PVt(T) × {tT × [RealizedVol(0,t)]^2 + ((T−t)/T) × [ImpliedVol(t,T)]^2 − Strike^2} Values for the inputs are as follows: Volatility strike on existing swap = 15 Variance strike on existing swap = 15^2 = 225 ``` Variance Notional = (Vega Notional/2×Strike) = $1,000,000/ 2×15=$33,333.33 RealizedVol(0,t)2 = 20^2 = 400 ImpliedVol(t,T)2= 18^2 = 324 t = 5months T = 12 months ``` PVt(T) = 1/ [1+[1.50%(7/12)] = 0.991326, which is the present value interest factor after five months (i.e., discounting for seven remaining months, from t to T), where the annual interest rate is 1.50%. Thus, the value of the swap in five months is calculated as follows: VarSwapt=$33,333.33×0.991326 × {(5/12)× 400 + ((12−5)/12) × 324 − 225}=$4,317,774.59 Given that Monatize would be long the swap, the mark-to-market value would be positive (i.e., a gain) for Monatize, equal to $4,317,775.

Question 565

Canawacta Tioga is the CFO for Wyalusing Corporation, a multinational manufacturing company based in Canada. One year ago, Wyalusing issued fixed-rate coupon bonds in Canada. Tioga now expects Canadian interest rates to fall and remain low for three years. During this three-year period, Tioga wants to use a par interest rate swap to effectively convert the fixed-rate bond coupon payments into floating-rate payments. Question Q. Explain how to construct the swap that Tioga wants to use with regard to the swap:

Answer 565

1. The swap tenor will be three years, consistent with the length of time for which Tioga expects interest rates to remain low. 2. Tioga will establish an interest rate swap in which Wyalusing will make payments based on a floating reference rate and will receive payments based on a fixed rate. The source of the reference rate and the value of the fixed rate will be set at the time of the swap’s inception. The net effect for Wyalusing of the combination of making fixed payments on its coupon bond, receiving fixed payments on the swap, and making floating payments on the swap is to convert the fixed obligations of its bond coupon payments into floating-rate-based obligations. This scenario will allow Wyalusing to benefit if Tioga’s expectation of low interest rates is realized. 3. The notional value of the swap should be set such that the fixed payments that Wyalusing receives will equal the fixed coupon payments that Wyalusing must make on its fixed-rate bond obligations. 4. Swap settlement dates should be set on the same days as the fixed-rate bond’s coupon payment dates.

Question 566

Apple will soon be building a new manufacturing plant in the United States. To fund construction of the plant, the company will borrow in its home currency of CAD because of favorable interest rates. Steve plans to use a cross-currency basis swap so that Wyalusing will borrow in CAD but make interest payments in USD. Q. Describe how the swap will function, from the perspective of Apple

Answer 566

1. At inception, Apple will pay the notional principal of CAD and will receive an amount of USD according to the USD/CAD exchange rate, agreed to at inception. 2. At each swap payment date, Apple will receive interest in CAD and will pay interest in USD. Both payments are based on floating reference rates for their respective currencies. The CAD rate will also include a basis rate that is quoted separately. On each settlement date, Apple will receive an amount of CAD based on the CAD floating rate minus the basis rate applied to the swap notional value, and it will pay an amount of USD based on the USD floating rate and the USD/CAD exchange rate that was set at inception. 3. At maturity, Apple will receive the notional principal of CAD and will pay an amount of USD according to the USD/CAD exchange rate that was set at inception, applied to the CAD notional principal. The cash flows at maturity are the inverses of the cash flows at inception.

Question 567

Generally speaking, the strategic currency positioning of a portfolio, should be biased toward a more-fully hedged currency management program the more?

Answer 567

short term the investment objectives of the portfolio; risk averse the beneficial owners of the portfolio are (and impervious to ex post regret over missed opportunities); immediate the income and/or liquidity needs of the portfolio; significant portion of fixed-income assets are held in a foreign-currency portfolio; cheaply a hedging program can be implemented; little weight given to the opportunity costs of missing positive currency returns volatile (i.e., risky) financial markets are skeptical the beneficial owners and/or management oversight committee are of the expected benefits of active currency management.

Question 568

how to read an fx rate - i.e $XX USD/CAD

Answer 568

If the USD/CAD currency pair is 1.33, that means it costs 1.33 Canadian dollars for 1 U.S. dollar. In USD/CAD, the first currency listed (USD) always stands for one unit of that currency; the exchange rate shows how much of the second currency (CAD) is needed to purchase that one unit of the first (USD).

Question 569

Coverage Ratio

Answer 569

The coverage ratio measures cash flow available to service debt, with a higher ratio indicating a lower probability of financial distress.

Question 570

Of the 4 different types of behavioral investor types, list the behavioral biases prevalent (emotional and cognitive) and level of risk aversion of a friendly follower

Answer 570

friendly follower: primarily cognitive (responsive to data and new information and will tend to follow the advice of their adviser - aka passive moderate) - low to moderate risk tolerance. More Passive. They often want to be in the latest, most popular investments without regard to suitability for long-term goals. - emotional biases: regret aversion, status quo - cognitive biases: availability, hindsight, framing bias. A friendly follower will typically respond to data backed investment advice

Question 571

Of the 4 different types of behavioral investor types, list the behavioral biases prevalent (emotional and cognitive) and level of risk aversion of a independent individualist

Answer 571

independent individualist - primarily cognitive - wiling to take on slightly more risk with a growth investment style. More active investor (aka active growth) - emotional biases: overconfidence and self attribution - cognitive biases: conservatism, availability, confirmation, representative bias The independent individualist is most difficult to understand, they are independent risk taker, they should not have conservatism bias

Question 572

Of the 4 different types of behavioral investor types, list the behavioral biases prevalent (emotional and cognitive) and level of risk aversion of a active accumulator

Answer 572

active accumulator (aka active aggressive): primarily emotional - high risk tolerance and aggressive investment style. More active investor leads to higher turnover. Typically high net worth. - emotional biases: overconfidence, self control - cognitive biases: illusion of control

Question 573

equation to find nominal interest rate

Answer 573

nominal interest rate = real interest rate + inflation --> a real interest rate is one that has been adjusted to remove the effects of inflation

Question 574

how to calculate the real rate of return

Answer 574

real rate of return = (1+nominal rate / 1+inflation) -1 --> a real return rate is one that has been adjusted to remove the effects of inflation

Question 575

how to find the duration of equity

Answer 575

duration of equity = ModDur of assets x (A/E) - ModDur of liability x (1-A/E) x (estimated change in yield of liabilities relative to 1% change in assets --> assets - liability = equity

Question 576

how to find the risk adjusted utility

Answer 576

U = expected return - (.0005 * A * Variance) | A is the risk aversion score (given)

Question 577

how to calculate current account

Answer 577

current account (i.e. net exports) = (domestic savings - domestic investments) + (taxation - corp spending)

Question 578

advantages and disadvantaged of implementation shortfall vs VWAP to measure transaction costs

Answer 578

IS measures the total impact of portfolio performance attributable to implementation costs. IS compares actual portfolio performance to a hypothetical portfolio based on the value of positions when a decision is reached. advantages: it can be used to evaluate the total portfolio effect of a transaction implementation and analyze the different components of implementation costs disadvantages: it requires more extensive transaction data to evaluate transactions and can potentially use unfamiliar framework to evaluate trades VWAP is simply the average price at which a security trades during any given day advantages: VWAP is simple to compute and easy to understand. It is most useful for evaluating small trades. disadvantages: It can result in gaming by delaying trade placement when market prices to not compare favorably to the VWAP and ignores opportunity costs if orders are not filed

Question 579

Technical and non technical skills of a wealth advisor

Answer 579

Technical: quantitative, technological, language fluency, capital market proficiency, portfolio construction ability and financial planning knowledge Non technical: social skills, communication skills, education and coaching skills and business development and sales skills

Question 580

Challenges faced by institutional investors when planning for liquidity for a private equity portfolio

Answer 580

1. Achieving and maintaining the desired allocation 2. Handling capital calls 3. Planning for the unexpected

Question 581

What are the four reference price benchmarks?

Answer 581

1. Pre trade benchmarks: reference price is known pre execution (I.e. decision price, arrival price, previous close and opening price 2. Intraday benchmarks - I.e. TWAP or VWAP 3. Post trade benchmarks - reference price determined at the end of the trading day or after the trade is completed. Most common example is the closing price 4. Price target benchmarks- a reference price that represents a more favorable price than the market price. An example would be the perceived fair value.