CFA 2018 level 3 gostudy CFA l3 cram guide for 2017

The more flexibility with respect to HC ability to delay retirement etc the more risk that can be taken in FC Demand for life insurance depends on certain variables: 1.. RISK TOLERANC

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Cram Notes for CFA® Level 3 – 2017

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Contents

Ethics 3

Behavioral Finance 4

Human Capital & Financial Capital 6

Private Wealth Management 6

Taxes & Private Wealth 7

Estate Planning 7

Concentrated Positions 8

Managing Institutional Portfolios 8

Capital Market Expectations 9

Equity Market Valuation 10

Asset Allocation 11

Fixed Income 12

Bond Portfolio Management 14

Equity Portfolio Management 15

Alternative Investments 17

Risk Management 18

Risk Management with Futures 21

Portfolio Execution 23

Monitoring & Rebalancing 26

Performance Evaluation 27

GIPS 30

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1 Everyone has to comply with the Code and Standards So …does the action uphold the profession?

2 If you were the client would you agree with the course of action?

3 Would a moral person, or leader, follow this course of action?

4 When in doubt err towards the more strict guideline/regulation

5 Differences between requirements and recommended guidelines are frequently tested

Summarizing the Code of Ethics -PEJMAR

Priority - Your client's interests always come first (then your employer, then you)

Encourage - Practice and encourage others to act professionally and ethically to reflect credit on yourself/profession Judgment - Use reasonable care and judgment when performing all professional activities

Maintain - Keep your knowledge up to date and encourage other professionals to do the same

Actions - Employ integrity, competence, diligence, and respect in an ethical manner with everyone

Rules - Promote the integrity of capital markets by following the rules

Standards of Professional Conduct

1 Professionalism

a Knowledge of the Law: Have to know them, comply with stricter of CFA, local, home law

b Independence and Objectivity: Reasonable care, compensation ??s/issuer paid research

c Misrepresentation: Knowingly misrepresenting/omitting information, commit plagiarism

d Misconduct: Fraud, Negative light on profession Distinction btwn personal/professional

2 Integrity of Capital Markets

a Material nonpublic information: Can’t trade on it or cause others too MOSIAC theory

b Market Manipulation: Artificially distort price or volume with intent to deceive

3 Duties to Clients

a Loyalty, prudence, and care: Act for benefit of client above employer/you Fiduciary duty

b Fair Dealing: Fair and objective Disclose different levels of service (OK w/ no negative)

c Suitability: In context of Risk constraints from IPS Evaluate on portfolio level vs risk of just 1

security (prudent investor rule)

d Performance and Presentation: Fair, accurate, fact vs opinion Recommend keep records for 7

years

e Preservation of Confidentiality: Always for past/present clients unless illegal, required, or for

CFA institute investigation

c Responsibilities of Supervisors: Reasonable effort to detect/disclose violations 2015 has moved to

slightly more proactive duty to educate

5 Investment Analysis, Recommendations, and Actions

a Diligence and Reasonable Basis: Cover basis for investment, thorough, disagreeing on a group

recommendation is OK

b Communications with clients/ prospective clients: Would you want to know something if you were

the client? If yes, then disclose it

c Record retention: Electronic OR paper OK Recommendation: Keep records for 7 years

6 Conflicts of Interest

a Disclosure of Conflicts: Disclose anything that would interfere with independence and objectivity

b Priority of Transactions: Clients > Employers > You Treat paying family the same as other

clients

c Referral Fees: Full disclosure so clients can judge potential biases Often in SD context

7 Responsibilities as a CFA Institute Member/Candidate

a Conduct: Don’t cast negative light on profession or capital markets via your actions

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Traditional finance is built on the assumptions of (1) rational Individuals, (2) perfect Information, (3) efficient markets that quickly

absorb new information Leading to the price is right (prices adjust to info instantly) and no free lunch (no arbitrage possible) This is

represented by the CAPM Model = 𝑟𝑒 = 𝑟𝑓 + 𝛽(𝑟𝑚− 𝑟𝑓)

Behavioral finance relaxes assumption of rational markets Individuals can behave differently about risk & reward

 The Concave shape of the risk-averse investor's utility function indicates diminishing marginal utility Thus as the overall wealth

increases, utility begins to increase at a decreasing rate

 The risk-neutral investor acts as if unaware of risk (considers only returns)

 The utility function for the risk-seeking individual is convex, indicating increasing marginal utility Thus each additional unit of

wealth provides more and more utility”

Bounded Rationality: it is impossible for every individual to have perfect information about every possible outcome for every single

decision The result is that people practice satisfice = satisfy + suffice Under satisfice people gather some but not all info, use

heuristics (or rules of thumb) to analyze it, and sometimes struggle to make sense of the info (computational limits)

Types of Behavioral Frameworks:

Consumption & Savings: People feel differently about spending money vs saving Consumption triggers immediate gratification

whereas saving is delayed gratification, i.e marginal propensity to consume is highest Leads to self-control bias, different ways of framing wealth depending on if it is current income, assets, or future savings Marginal propensity to consume highest for income

Behavioral Asset Pricing Model: Adds a sentiment premium to the CAPM: 𝑟𝑒= 𝑟𝑓+ 𝛽(𝑟𝑚− 𝑟𝑓) + 𝑠𝑒𝑛𝑡𝑖𝑚𝑒𝑛𝑡 𝑝𝑟𝑒𝑚𝑖𝑢𝑚

Behavioral Portfolio Theory (BPT): People build their portfolio layer by layer according to their goals They will match the risk of their

investments based on how much they need the money (from least risky for vital stuff on up) The approach is suboptimal b/c it

doesn’t factor in correlation Very similar to mental accounting

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Cognitive & Emotional Biases

Be prepared for reading a passage, identifying biases, & writing what factors caused you to pick it out

 Framing and Anchoring

 Anchoring & Adjustment

 Status Quo bias

Cognitive Biases (Grouped as Belief Perseverance and Information Processing Errors)

Belief Perseverance (Con Con Con Rep Hind)

Conservatism: Emphasize old info/original more than new (common w/ analysts)

Confirmation bias: Seek confirming evidence and discount contradictory evidence

Illusion of control: Thinking you have more influence over an outcome than you do

Hindsight Bias: Selective memory Tend to remember r correct views and forget mistakes

Representativeness: Using overly simple if-then or rule-of-thumb decisions Individuals use heuristics (experience) to classify

information: “IF it looks a certain way THEN it must be in a certain category.” There are two forms representativeness bias can take: Base-rate neglect is where new info is given too much weight and sample-size neglect is assuming small samples represent the

entire population

Information Processing Biases (FAMA)

Framing & Anchoring: View info differently depending on the context/way it was received

Anchoring & Adjustment: Remain anchored to an initial value (expected price, forecast) It’s similar to conservatism bias, so

remember on the exam that Anchoring & Adjustment is ALWAYS related to a SPECIFIC NUMBER

Mental Accounting: People place wealth into different buckets to meet different goals/treat different sources of money differently Availability Bias: Focus on info that is easy to find, or focus on easily remembered past experiences

Emotional Biases (LOSERS)

Loss Aversion: Feeling greater pain for a loss than pleasure for a gain of equal value

Overconfidence: Think you know more than you do (illusion of knowledge/control) Also related to Self-attribution bias where you

take credit for the good and pass blame when bad

Self-control bias Insufficient saving due to tendency for overconsumption (short-run gratification) and over-emphasis on income

versus total return

Endowment bias: See assets you own as worth more than you’d actually be willing to pay to acquire them

Regret Aversion: Tendency to do nothing due to a fear of making the wrong decision Basically making errors of omission instead of

errors of commission

Status quo bias: A tendency to stay with current investments due to apathy (emotional desire to do nothing, think 401(ks), laziness

Analysts/professional investor biases:

Groupthink (Social proof bias), overconfidence, representativeness, illusion of knowledge, and ego-defense mechanisms like hindsight and self-attribution Also the way management of company presents material can influence analysts Gamblers fallacy is thinking

there will be a long-term reversal back to average more often there actually is

Defined Contribution plan investment errors: Include status quo bias (401ks), nạve diversification (all equal), disposition effect (sell

winners, keep losers), home bias (too many assets in home country), mental accounting, gamblers fallacy, and social proof bias

(groupthink)

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IPS & Behaviorally Modified Strategies

Behaviorally Modified Asset Allocation: Try to get as close to efficient as possible…humor emotional biases, educate out of cognitive

(> Wealth = > Ability to tolerate sub-optimal (i.e standard of living risk) Idea is to more easily weather ups and downs of market

Goal Based Investing: Similar to BPT, portfolio built in layers to meet different goals

Classification Schema

Barnewell 2-way model: Active/Passive investors Active=entrepreneurs, risked money Passive=inheritors/steady income=less risk BB&K 5-way model: Individualist, Adventurer, Guardian, Celebrity, Straight Arrow

Pompian: Passive preserver, friendly follower, independent individualist, active accumulator

Human Capital & Financial Capital

Four Stages of Wealth Accumulation:

1 Foundation: Education/early career Minimal FC, Max HC

2 Accumulation: Mid-career Max earnings period Spending

needs high

3 Maintenance: Retirement FC high, HC close to zero

4 Distribution: Death, bequests, estate transfers

HC is different for each individual depending on their specific

earnings risk, longevity risk, and mortality risk

Balancing HC vs FC:

1 Always seek to minimize the correlation between HC and FC

2 Younger investors should invest more in equity-like FC (you have more time to recover from losses)

3 Investors with safer, bond-like income should invest more FC

in equity

4 Investors with risky, equity-like income should invest more FC

in less risky assets

5 The more flexibility with respect to HC (ability to delay

retirement etc) the more risk that can be taken in FC

Demand for life insurance depends on certain variables:

1 AGE: The younger you are, the more HC you have, the greater your expected demand for life insurance will be

2 DESIRE TO LEAVE BEQUEST: Life insurance is also dependent on your desire/need to leave assets after death If you have a strong desire or need for post-death

objectives, your demand for life insurance will be higher than if you don’t care about leaving anything to heirs

3 RISK TOLERANCE: Lower risk-tolerance leads to bond-like investments (more conservative allocation) and greater demand for life insurance The opposite is also true

You can also think about it this way—if you have a high risk tolerance you don’t want to “waste” your money buying life insurance when you could invest it instead

4 AMOUNT OF FINANCIAL CAPITAL: More FC means less demand for life insurance This can be because the more FC you have the less you may need a substitute in

case of loss of HC Alternatively, the more FC you have, the lower the % of HC in your total wealth and the less demand you have for life insurance in general

5 SUBJECTIVE PROBABILITY OF SURVIVAL: The more likely you think you are to die, the higher your demand for life insurance

Retirement risks:

Financial risks (market fluctuations), savings risks (didn’t save

enough), longevity risk (outliving savings)

Hedging options: Fixed rate annuities (same nominal amount),

Variable rate annuities adjust based on performance (riskier but adjusts for inflation)

Private Wealth Management

IPS = RR-TTLLU : Risk, Return and the 5 constraints: Time, Taxes, Legal, Liquidity, & Unique

Risk Tolerance: Willingness (psychological) vs Ability (wealth, time, & goals) Always err towards conservative style

Risk - Above average, average, below average tolerance

Return - Calculation based on investor goals, pre or post tax, solve using financial calculator (have PV, FV)

Time -Multi-stage time horizons based on life events, positive relationship with risk,

Taxes - May factor into return calculation, watch out for long term holdings as constraint

Liquidity - How much cash do you need within a 1 year period Inverse relationship to risk Inflation may matter

Legal - Less important for individuals, state they may need to consult legal professionals

Unique - Catch-all bucket

Solving for required return

Are you solving for pre or post tax return? Real or nominal? If nominal, include expected inflation

List the client objectives

Quantify their current assets This is their PV

Calculate the time horizon This is n

Calculate what they will need on an annual basis This is their PMT This is sometimes a predictable annual payment (like a

mortgage) or the sum of their total living expenses (think time value) NET of their income (so total inflow vs outflow) Make sure you apply nominal/real and pre/post tax to these inputs as well

Calculate their FV This is often equal to the PV adjusted for inflation over the time horizon, i.e goal = maintain purchasing power Calculate the % return needed This will be using your financial calculator

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Basic Principles: The less you trade the more efficient the portfolio, the longer you defer paying taxes the better (tax alpha)

𝑅𝐴𝑅𝑇 = 𝑅 ∗ [1 − 𝑃𝐼𝑇𝐼− 𝑃𝐷𝑇𝐷− 𝑃𝐶𝐺𝑇𝐶𝐺] Return after realized taxes

Annual government taxation reduces risk of the account by = σ ∗ (1 − tax) If not taxed annually this doesn’t apply

𝑭𝑽𝑰𝑭 = Future Value Interest Factors (future accumulation equations)

Deferred Capital Gains (the lower the B the

more you pay in taxes)

𝐹𝑉𝐼𝐹𝐶𝐺𝐵 = [(1 + 𝑟)ⁿ(1 − 𝑡𝑐𝑔)] + 𝑡𝑐𝑔𝐵

Where B = Cost Basis/Market Value

Tying it all together… 𝐹𝑉𝐼𝐹𝑇 = [(1 + 𝑅𝐴𝑅𝑇)ⁿ(1 − 𝑇𝐸𝐶𝐺 )] + 𝑇𝐸𝐶𝐺 − (1 − 𝐵)𝑇𝐶𝐺

Tax drag = The return without taxes (1+r)N compared to the total gain after taxes That difference (gain with no taxes – gain with

taxes) is the tax drag stated in dollars The tax drag % is then equal to the tax drag $ value / total gain without taxes

Tax Deferred Account (traditional IRA), contribute with pre-tax dollars, 𝐹𝑉𝐼𝐹𝑇𝐷𝐴= (1 + 𝑅)ⁿ (1 − 𝑇𝑛)

Tax Exempt Account (Roth IRA), contribute with post-tax dollars, 𝐹𝑉𝐼𝐹𝑇𝐸𝐴= (1 + 𝑅)ⁿ

If you think rates will be higher in the future, invest in a tax-exempt account If you think they will be lower in the future, invest in a tax deferred account If rates will be the same, since $ contributions are capped, TEA > TDA

Tax Loss Harvesting: Offset gains/losses for tax purposes & create TVM Sell losers at end of year, winners at beginning of next year

HIFO: Highest in, First Out accounting means selling highest cost-basis stock first to minimize capital gains

Double Taxation & Jurisdictional Issues

Source country: Taxes ALL income generated within borders Residence country: Taxes income of citizens no matter where they are

Credit Residence country gives credit for taxes paid to Source country = Max(Tresidence, Tsource)

Exemption Residence country exempts income earned in Source country = Tsource

Deduction Residence country allows deduction for taxes paid to Source country = Tresidence + Tsource(1 − Tresidence)

Estate Planning

Forced Heirship Rules mandate that children (and often spouses) are entitled to some minimum percentage of an estate If they are

already receiving more than this minimum in the will then the forced heirship rules would be moot Community Property Regimes

mandate that a spouse is entitled to half the portion of the estate that was built up during the marriage

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Estate Value of Gifts vs Bequests

Tax free gift relative to a bequest: 𝐹𝑉𝑇𝑎𝑥−𝑓𝑟𝑒𝑒 𝑔𝑖𝑓𝑡𝐹𝑉

𝑗=1Generation skipping will increase the value of the estate by a factor of 1

(1 − 𝑡)

⁄ where t is the applicable estate tax Other tax minimizing strategies include valuation discounts (e.g family businesses), charitable gifts, life insurance, and spousal exemptions

Concentrated Positions

A concentrated position (>25% total assets) exposes an investor to significant specific risk or systematic risk that cannot be

diversified away This flies in the face of portfolio theory and the benefits of diversification which L3 stresses so much Concentrated positions can arise because of entrepreneurial activity, real estate, or option grants as an executive Selling a position can be

complicated either because of a lack of desire to sell or the tax complications of doing so

Managing Institutional Portfolios

Strategies to Hedge: Sell (max tax penalty), use exchange funds, completion portfolios or other monetization strategies You can do this with equity swaps, options, or futures contracts Risks: Cross-hedging risk, basis risk, a

perfect hedge might be considered a constructive sale

and trigger taxes

Reasons to sell: Diversification, generate liquidity, optimize

tax efficiency, (Sometimes) maintain control of company Exit

values: IPO, Sell to PE, management buyout, recap, Monetize

by borrowing against business or sale & leaseback for real

estate

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IPS for Pension Fund: The required return calculation is usually a mandatory minimum actuarial rate plus inflation and management

fees This excess return requirement is acceptable only if a plan is fully funded or has a surplus, but may not be realistic if the plan is

underfunded and cannot take on more risk to drive returns higher

Pension Fund Risk: Ability is average to below average and depends on: Plan surplus (+), financial status/profitability of firm (+),

correlation between company performance and pension fund and the company (-), liquidity features in the plan (-, lump-sum agreements, amount of sponsor contributions), and workforce characteristics (retirement age and ratio of active-to-retired

workers) Time is infinite unless shutting down, can have sub-portfolios for retired/active

Foundations & Endowments: Foundations are grant-making entities, usually begun through a wealthy contributor (e.g the Gates Foundation) Endowments are long-term funds set aside to support non-profits (e.g a college endowment)

Return for foundations/endowments: =spending rate +

inflation + management fees In general the CFA now uses

the multiplicative method (1+Spending rate) X (1+inflation)

x (1+fees) but the additive approach is OK too

Risk: Can take more risk than pension funds since no legally

binding obligations Risk ability up with low annual spending requirements or when using spending rules

Time: Usually indefinite Liquidity: Foundations have

spend-down provisions usual min = 5% (see table) If expect more income or uses smoothing rule = lower liquidity requirement

Unique: Size of the fund A small fund and team may make

high due diligence investments like hedge funds inappropriate

Spending Rules: 3 year simple avg, Geometric, or simple

Life Insurance & Non-life insurance: Return equal to actuarial minimum return Life insurance have conservative to below-avg risk

tolerance Life insurance companies face uncertainty about timing of payment but amount is defined Non-life (P&C) insurers have greater uncertainty about both amount and timing of payment Duration for life insurance usually 20-40 years, non-life much shorter (b/c duration of liabilities shorter) ALM techniques commonly employed to manage risk/liquidity Unique includes geography

Banks: Most conservative of the institutions, will use ALM to hedge Return goal is to earn a positive interest rate spread above cost

of funds Time horizon is matched by the liabilities and is usually less than 10 years Banks face ongoing liquidity needs to meet

withdrawals, loans, etc Highly regulated with capital requirements Unique: Geographic concentration, type of loan, can’t divest

ALM vs.AO

Institutions with fewer constraints on their liabilities can employ an asset only (AO) approach With AO, the goal is to maximize total

return, and the market risk of any liabilities is not considered Asset Liability management (ALM) explicitly considers the risks of

liabilities and seeks to construct a portfolio that minimizes chances of shortfall risk ALM does this by selecting assets that have a

high correlation with liabilities If liabilities increase, assets should too, thereby ensuring there is always sufficient cash on hand DB Pension funds, insurance companies, and banks often use ALM Foundations, Endowments, and DC plans do not In a pension fund, ALM has three buckets to match liabilities depending on active or retired Inactive participants are hedged with nominal bonds

(sometimes inflation-indexed), the same for the already accrued benefits of active lives, and future benefits hedged with equities

Capital Market Expectations

Forecasting issues: Limits to using economic data, data measurement error or bias, limits to historical estimates, use of ex post data, the fact that patterns may not repeat, failing to account for conditional info, or misinterpreting correlation, model & input

uncertainty, or behavioral biases

Forecasting Tools:

Statistical tools: Multifactor (linear) regression 𝑌 = 𝑎 + 𝛽1𝑋1+ 𝛽2𝑋2+ 𝛽3𝑋3… + 𝛽𝑁𝑋𝑁+ 𝜀 , shrinkage estimators, volatility clustering

Survey or Judgement Methods: Survey is exactly what it sounds like and could include panels Judgment is not recommended

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Discounted cash flow Analysis: Gordon growth model 𝑃0= 𝐷𝑖𝑣0 (1+𝑔)

𝑅𝑖−𝑔 (always remember Div1 vs Div0)

Grinold Kroner Model

𝑅𝑖= (𝐷𝑖𝑣1

𝑃0 ) + 𝑖 + 𝑔 − ∆𝑆 + ∆(

𝑃

𝐸) Treat the change in share count appropriately and remember g

in the equation is the real earnings growth NOT the nominal

Nominal earnings growth: 𝑖 + 𝑔 The re-pricing return: ∆(𝑃

𝐸) Expected income return from the current yield: (𝐷𝑖𝑣1

𝑃0 ) − ∆𝑆

Risk Premium Approach:

RB= rf+ inflation risk premium + default risk premium

+ liquidity risk premium + maturity risk premium

+ tax premium

ICAPM:

𝑟𝑒= 𝑟𝑓+ 𝛽(𝑟𝑔𝑖𝑚− 𝑟𝑓)

The only difference from CAPM is that Rgim is the return on the

global investable market (gim) This means the iCAPM beta

represents the sensitivity of the asset to returns on the world market portfolio

The ERP = (𝑟𝑔𝑖𝑚− 𝑟𝑓) or we can think of any asset’s risk premium as equal to:

(Sharpe ratio of global portfolio) x (Asset’s own volatility) x (assets correlation with global portfolio)

Reviewing Beta (which you may need to solve for ERP)

Taylor Rule

𝑟𝑡𝑎𝑟𝑔𝑒𝑡= 𝑟𝑛𝑒𝑢𝑡𝑟𝑎𝑙+ [0.5(𝐺𝐷𝑃𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑− 𝐺𝐷𝑃𝑡𝑟𝑒𝑛𝑑) + 0.5(𝑖𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑− 𝑖𝑡𝑎𝑟𝑔𝑒𝑡)]

If expected GDP < GDPtrend then the central bank should cut rates to stimulate the economy If expected inflation > target inflation then the central bank would raise rates to minimize inflation Of course you should plug in the values to determine the ultimate outcome—the GDP and inflation numbers can offset each other There are a few ways that the exam could try to trick you when asking about the Taylor rule They might give you the current Central Bank rate but the equation asks you to use the NEUTRAL rate

They could ask you for the adjustment needed in the rate and not what the new target rate should be In this case you need to solve the equation but then relate it back to the current rate which would be given but which you would not plug into the Taylor equation

Equity Market Valuation

Cobb Douglas: 𝑌 = 𝐴𝐾α𝐿𝑏 where K = capital stock,L = quantity of labor, A = total factor productivity (TFP), α is the output elasticity

of capital and β is the output elasticity of labor Both are between 0 and 1 and α + β = 1 Conceptually, TFP represents technology, change in laws, or natural resources etc Factors to increase GDP include > savings, higher retirement age, growth in labor force, > production efficiency Things that reduce GDP include taxes and environmental regulations

Other testable concepts include the business/inventory cycle, economic growth trends, and government policy, and international economic linkages including evaluating emerging economies

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If S&P Earnings Yield is greater (less) than the treasury

yield then equities are undervalued (overvalued) So

Ratio > 1, Equities undervalued; Ratio < 1, equities

overvalued; ratio = 1 then equities are fairly valued

3 Flaws of Fed Model:

1 It ignores the equity risk premium

2 It ignores earnings growth

3 It compares a real variable, the S&P Earnings Yield, to a nominal variable, the treasury yield

𝑀𝑉𝐷𝑒𝑏𝑡 + 𝑀𝑉𝐸𝑞𝑢𝑖𝑡𝑦𝑡𝑜𝑡𝑎𝑙 𝑟𝑒𝑝𝑙𝑎𝑐𝑒𝑚𝑒𝑛𝑡 𝑐𝑜𝑠𝑡

Both Ratios are mean reverting

If ratio > 1, overvalued, stock should go down in value

Since it is difficult to estimate replacement costs both Tobins Q and Equity Qs tend to persist over time

Downside Risk & Roys Safety First Criteria: 𝑅𝑆𝐹 = 𝑅𝑃 −𝑀𝐴𝑅

𝜎 𝑃 The higher RSF is the better

Utility Adjusted Return: 𝑈𝑃 = 𝑅𝑃− 0.005(𝐴)(𝜎𝑃2) Make sure you express variance in non-decimal terms

Correctly Specifying Asset Classes: Homogenous (descriptive/statistical), Diversifying (low correlation), exclusive, exhaustive, liquid

Adding an Investment to a Portfolio: If this equation holds true 𝐸(𝑅𝑛𝑒𝑤)−𝑅𝑓

𝜎 𝑛𝑒𝑤 > [𝐸(𝑅𝑃)−𝑅𝑓

𝜎 𝑃 ] 𝐶𝑜𝑟𝑟(𝑅𝑁𝑒𝑤, 𝑅𝑃)

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Bond Risk and Benchmarks:> Duration = > Market value risk An investor with greater risk aversion would seek a shorter duration portfolio > Maturity = Longer & more certain income streams: An investor wanting stable cash flow goes for longer duration

Dollar Duration: 𝐷𝑜𝑙𝑙𝑎𝑟 𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛 = −(𝑒𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑑𝑢𝑟𝑎𝑡𝑖𝑜𝑛)(0.01)(𝑃𝑟𝑖𝑐𝑒) The rebalancing ratio is equal to = 𝑂𝑙𝑑 𝐷𝐷

𝑁𝑒𝑤 𝐷𝐷 Steps to solve calculation: (1) Calculate the new DD of the portfolio, (2) Calculate the rebalancing ratio to determine the required percentage change (cash needed) to restore the value of the portfolio, (3) If needed, multiply the % change needed (rebalancing ratio – 1) by the market value of the portfolio to calculate the necessary increase/decrease in dollar value

Bond Risk Factors

Risk Factor What it Measures How its Measured

Spread Changes in spread Spread Duration (OAS)

Credit Change in credit

exposure

Duration contribution

by credit rating

Spread duration measures the change in a bond or

sector’s market value for a 1% parallel shift in its spread above that of a risk-free treasury bond Measures include the nominal spread, zero-volatility spread, and option-adjusted spread

A manager would overweight a sector whose spreads are predicted to narrow relative to treasuries or underweight

a sector where spreads are forecast to widen Can also

be used with mean reversion analysis (compare to avg)

Immunization

Price risk: The decrease (or increase) in bond prices caused by a rise (fall) in interest rates The longer the duration of a bond the

greater its price volatility A change in interest rates has a greater effect on the price of a longer duration bond than a shorter one

Reinvestment risk refers to the increase (decrease) in cash flow or investment income caused by a rise (fall) in interest rates If

interest rates go up, any new money you invest in a bond will have a higher coupon or cash payment Price risk and reinvestment

risk are inversely related

Classical immunization protects a bond portfolio from fluctuations in interest rates by matching the durations of assets and liabilities

such that the portfolio earns a predetermined rate of return over a period of time If interest rates decrease, the gain in the portfolio

is ≥ the loss in reinvestment income If interest rates increase, the loss in the portfolio is ≤ the gain in reinvestment income

Some risk remains because most changes in interest rates do not cause a parallel shift in the yield curve, To minimize this risk,

concentrate your cash flows as close to the end of the investment time horizon as possible (minimize dispersion)

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Immunizing Multiple Liabilities

 PV(Assets) = PV(Liabilities)

 Assets and Liabilities must have the same aggregate durations (which was also true before)

 The distribution of durations of the assets in the portfolio must be ≥ than the distribution of durations of the liabilities

Contingent Immunization: Seek higher returns through active management as long as the portfolio value

is above a certain safety net return If the portfolio goes below this specified value then immunization is

triggered to lock in a return

Cash Flow Matching: Because only cash flows that occur prior to the liability can be used to fund a liability cash flow matching is

more stringent than immunization If you don’t get cash, you can’t pay cash Relative to multiple liability immunization:

 Cash flow matching Is more dependent on reinvesting cash flow (so reinvestment rates are vital)

 Is safer, easier to understand, more restrictive, and higher cost

Combination matching: Uses cash flow matching in the short run and immunization in the long run This ensures liquidity in the

short run, minimizes SR rebalancing needs, and reduces costs relative to pure CF matching

Reasons for Secondary Market Trading Constraints Against Buying/Selling in Secondary Markets

 Yield/spread pickup trades

 Credit upside trades

 Credit defense trades

 Sector rotation trades

 New issue swaps (liquidity)

 Yield curve adjustment trades

 Structure trades

 Cash flow reinvestment trades

 Portfolio constraints – quality mandates

 Story disagreements

 Buy-&-Hold

 Seasonality

Bond structures Bullet bonds dominant Long-term & bonds with embedded

options command a premium as a result Barbell / Bullet strategies may show up (barbell = short+long term holdings)

With a MBS, If rates are high: Prepayments decrease, Duration increases, and MBS Price decreases less than a non-callable bond If Rates are low:

Prepayment increases (the option is in the money), duration decreases, and the MBS Price increases less than a non-callable bond

Beware a compare/contrast morning question

Callable bonds exhibit negative

convexity

Negative convexity means that as market yields decrease, duration decreases as well Visually, this means the shape of the yield curve will be concave (downward sloping) for the yields/price where the bond is in the money When call out-of-the-money behaves like a normal bond

𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑎 𝑐𝑎𝑙𝑙𝑎𝑏𝑙𝑒 𝑏𝑜𝑛𝑑

= −(𝐶𝑎𝑙𝑙 𝑜𝑝𝑡𝑖𝑜𝑛)+ 𝐵𝑜𝑛𝑑 𝑃𝑟𝑖𝑐𝑒 Callable bonds will underperform when interest rates fall relative to the coupon rate, and will outperform in a period of rising interest rates

Very similar behavior to a backed security (MBS) see below

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Return on Levered Investment Duration of a Leveraged Portfolio

𝐸

Repurchase agreements:

𝐷𝑜𝑙𝑙𝑎𝑟 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 = 𝑎𝑚𝑜𝑢𝑛𝑡 𝑏𝑜𝑟𝑟𝑜𝑤𝑒𝑑 ∗ 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 (𝑇𝑖𝑚𝑒 360 ⁄ )

Factors impacting credit risk of seller Factors influencing the Repo Rate

 Taking physical delivery of the collateral (Expensive to do

but is lowest risk and has lowest rate)

 Deposit of collateral with a custodian

 Electronic transfer of the asset

 No delivery required (highest risk, highest interest rate)

 Credit risk of borrower (+)

 Quality of collateral (-)

 Length of term (+)

 Method of delivery (physical delivery lowers repo

rate, no delivery increases it)

 Scarcity of collateral (if collateral is scarce and the

lender wants it, that will decrease repo rate)

 Federal funds rate (+)

Hedging formula using duration (see also derivatives/futures section)

# 𝑜𝑓 𝑐𝑜𝑛𝑡𝑟𝑎𝑐𝑡𝑠 = (𝐷𝑇− 𝐷𝑃)𝑃𝑃

𝐷𝐶𝑇𝐷𝑃𝐶𝑇𝐷 (𝐶𝑇𝐷 𝑐𝑜𝑛𝑣𝑒𝑟𝑠𝑖𝑜𝑛 𝑓𝑎𝑐𝑡𝑜𝑟)(𝑦𝑖𝑒𝑙𝑑 𝑏𝑒𝑡𝑎)

If we want to increase DD we BUY FUTURES

If we want to decrease DD we SELL FUTURES

Derivatives & Risk

Three main risks to hedge:

 Default Risk: The risk that the issuer will not pay the

obligations when due

 Credit Spread Risk: The risk of an increase in the yield

spread on the bond

 Downgrade Risk: Risk of a downgrade by a credit

rating agency

Tools to hedge – credit options

 Binary credit options (specific negative credit event)

 Credit spread options (pay-off if spread goes above strike)

 Credit spread forwards (just like any forward)

 Credit swaps (basically pure insurance)

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