CFA 2018 level 3 gostudy CFA l3 cram guide for 2017

GoStudy’s CFA Exam Level ® 2017 Cram Notes www.gostudy.io Powered by GoStudy™ Everything you need to pass & nothing you dont â www.gostudy.io Cram Notes for CFAđ Level 2017 Copyright â 2016 by Go Study LLC.đ All Rights Reserved Published in 2016 The “CFA® and Chartered Financial Analyst® are trademarks owned by CFA Institute CFA Institute does not endorse, promote, review, or warrant the accuracy of the products or services offered by www.gostudy.io Certain materials contained with this text are the copyrighted property of the CFA Institute The following is the copyright disclosure for those materials: “Copyright, 2015, CFA Institute Reproduced and republished from 2015 Learning Outcome Statements, Level III CFA® Program Materials, CFA Institute Standards of Professional Conduct, and CFA Institute’s Global Investment Performance Standards with permission from CFA Institute All rights reserved.” Disclaimer: This cram guide condenses the original CFA Institute study material into 28 pages It is not designed to be comprehensive but to cover key exam topics in order to maximize your time over the last few weeks and days before taking the exam While we believe we cover all of the core concepts accurately we cannot guarantee nor warrant that this is true Use of these notes is not a guarantee of exam success (although we think it will help a lot) and we cannot be held liable for your ultimate exam performance About www.gostudy.io Go Study LLC offers in-depth exam strategies and subject review to help candidates pass the CFA exams In addition to this equation guide we offer full guided notes, a mobile app for on-the-go review with hundreds of notecards, and last-minute cram material such as equation lists and “week before” summary sheets We also highly recommend candidates subscribe to our free newsletter for exclusive offers, access to study tips, tricks, and in-depth discussions of the exam We also periodically provide bonus resources such as mock exams, practice problems, and more to our subscribers If you have any questions regarding this product, the exam, or the company’s future, please contact us via the website or at help@gostudy.io We strive to answer every question a candidate has © www.gostudy.io Contents Ethics Behavioral Finance Human Capital & Financial Capital Private Wealth Management Taxes & Private Wealth Estate Planning Concentrated Positions Managing Institutional Portfolios Capital Market Expectations 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 © www.gostudy.io Ethics Everyone has to comply with the Code and Standards So …does the action uphold the profession? If you were the client would you agree with the course of action? Would a moral person, or leader, follow this course of action? When in doubt err towards the more strict guideline/regulation 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 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 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 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 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 security (prudent investor rule) d Performance and Presentation: Fair, accurate, fact vs opinion Recommend keep records for years e Preservation of Confidentiality: Always for past/present clients unless illegal, required, or for CFA institute investigation Duties to Employers a Loyalty: Employer before you Questions around quitting and taking client info/models often get tested b Additional Compensation Arrangements: Disclose first Written consent from all parties is required c Responsibilities of Supervisors: Reasonable effort to detect/disclose violations 2015 has moved to slightly more proactive duty to educate 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 years 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 Responsibilities as a CFA Institute Member/Candidate a Conduct: Don’t cast negative light on profession or capital markets via your actions © www.gostudy.io Behavioral Finance 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 © www.gostudy.io Cognitive & Emotional Biases Be prepared for reading a passage, identifying biases, & writing what factors caused you to pick it out Cognitive Emotional Belief Perseverance Info Processing CON CON CON REP HIND FAMA     Conservatism Confirmation bias Illusion of control Hindsight Bias  Representativeness     Framing and Anchoring Anchoring & Adjustment Mental Accounting Availability Bias LOSERS      Loss aversion Overconfidence Self-control bias Endowment bias Regret Aversion  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 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 (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 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 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), naïve 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) © www.gostudy.io 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: Foundation: Education/early career Minimal FC, Max HC Accumulation: Mid-career Max earnings period Spending needs high Maintenance: Retirement FC high, HC close to zero 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: Always seek to minimize the correlation between HC and FC Younger investors should invest more in equity-like FC (you have more time to recover from losses) Investors with safer, bond-like income should invest more FC in equity Investors with risky, equity-like income should invest more FC in less risky assets 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: AGE: The younger you are, the more HC you have, the greater your expected demand for life insurance will be 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 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 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 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 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 you need within a 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 © www.gostudy.io Taxes & Private Wealth Basic Principles: The less you trade the more efficient the portfolio, the longer you defer paying taxes the better (tax alpha) 𝑅𝐴𝑅𝑇 = 𝑅 ∗ [1 − 𝑃𝐼 𝑇𝐼 − 𝑃𝐷 𝑇𝐷 − 𝑃𝐶𝐺 𝑇𝐶𝐺 ] Return after realized taxes 𝑇𝐶𝐺 (1−𝑃𝐼 −𝑃𝐷 −𝑃𝐶𝐺 ) (1−𝑃𝐼 𝑇𝐼 −𝑃𝐷 𝑇𝐷 −𝑃𝐶𝐺 𝑇𝐶𝐺 ) Effective capital gains, where the numerator is (1 – all individual proportions of returns) and the denominator is (1 – realized tax rate) Ratio will always be 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 Method Description Investor Effective Tax Rate 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 © www.gostudy.io Estate Value of Gifts vs Bequests Tax free gift relative to a bequest: Taxable gift relative to a bequest: 𝐹𝑉𝑇𝑎𝑥−𝑓𝑟𝑒𝑒 𝑔𝑖𝑓𝑡 𝐹𝑉𝑏𝑒𝑞𝑢𝑒𝑠𝑡 𝐹𝑉𝑇𝑎𝑥𝑎𝑏𝑙𝑒 𝑔𝑖𝑓𝑡 𝐹𝑉𝑏𝑒𝑞𝑢𝑒𝑠𝑡 = = [1+𝑟𝑔 (1−𝑡𝑖𝑔 )]ⁿ [1+𝑟𝑒 (1−𝑡𝑖𝑒 )]ⁿ(1−𝑇𝑒 ) (1−𝑡𝑔 )[1+𝑟𝑔 (1−𝑡𝑖𝑔 )]ⁿ [1+𝑟𝑒 (1−𝑡𝑖𝑒 )]ⁿ(1−𝑇𝑒 ) Taxable gift relative to bequest if donor pays gift taxes: 𝐹𝑉𝑇𝑎𝑥𝑎𝑏𝑙𝑒 𝑔𝑖𝑓𝑡 𝐹𝑉𝑏𝑒𝑞𝑢𝑒𝑠𝑡 = (1−𝑇𝑔 +𝑇𝑔 𝑇𝑒 )[1+𝑟𝑔 (1−𝑡𝑖𝑔 )]ⁿ [1+𝑟𝑒 (1−𝑡𝑖𝑒 )]ⁿ(1−𝑇𝑒 ) : Core Capital Step Step 𝑁 𝑝(𝑠𝑢𝑟𝑣𝑖𝑣𝑎𝑙) = 𝑝(𝐻𝑢𝑠𝑏𝑎𝑛𝑑 𝑠𝑢𝑟𝑣𝑖𝑣𝑒𝑠) + 𝑝(𝑊𝑖𝑓𝑒 𝑠𝑢𝑟𝑣𝑖𝑣𝑒𝑠) − [𝑝(𝐻𝑢𝑠𝑏𝑎𝑛𝑑 𝑆𝑢𝑟𝑣𝑖𝑣𝑒𝑠) 𝑥 𝑝(𝑊𝑖𝑓𝑒 𝑠𝑢𝑟𝑣𝑖𝑣𝑒𝑠] 𝑃𝑉(𝑆𝑝𝑒𝑛𝑑𝑖𝑛𝑔 𝑛𝑒𝑒𝑑) = ∑ 𝑗=1 𝑝(𝑆𝑢𝑟𝑣𝑖𝑣𝑎𝑙𝑗 ) 𝑥 𝑆𝑝𝑒𝑛𝑑𝑖𝑛𝑔𝑗 (1 + 𝑟)𝑡 Generation 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 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 Strategies to Hedge: Sell (max tax penalty), use exchange funds, completion portfolios or other monetization strategies You can 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 Managing Institutional Portfolios © www.gostudy.io 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 = 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: 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 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 + 𝛽1 𝑋1 + 𝛽2 𝑋2 + 𝛽3 𝑋3 … + 𝛽𝑁 𝑋𝑁 + 𝜀 , shrinkage estimators, volatility clustering Survey or Judgement Methods: Survey is exactly what it sounds like and could include panels Judgment is not recommended © www.gostudy.io Returns based style analysis 𝑅𝑃 = 𝑏0 + 𝑏1 𝑆𝐶𝐺 + 𝑏2 𝐿𝐶𝐺 + 𝑏3 𝑆𝐶𝑉 + 𝑏4 𝐿𝐶𝑉 The weight of each beta is non-negative and together they sum to Thus if the SCG beta = 0.8 then 80% of a manager’s returns are due to their small-cap growth orientation R2 is the coefficient of determination, and it shows the percentage of an investor’s returns explained by the style indices 1-R2 is the amount of the returns unexplained by style In other words, 1-R2 shows us the percent of returns due to the manager’s ability to select securities As you should be able to see by the different thickness of the bands, style drift has occurred over time away from large-cap value to mid-cap value: Holdings based style analysis Classify portfolios based on the characteristics of the underlying securities:  Value vs Growth – High P/E = growth, low P/E high dividend = value  Earnings Per Share Growth  Earnings Volatility – Higher earnings volatility = value investor (> cyclical)  Industry Representation –Value = utilities/financials Growth investors in healthcare & technology Equitizing a Market Neutral Long Short Portfolio (EMNLSP): Create long exposure within a long-short portfolio by buying futures contract or market ETF EMNLSP return = Return on long futures + G/L on long/short + RF rate (on cash) Fundamental Law of Active Management; 𝐼𝑅 ≈ 𝐼𝐶 ∗ √𝐼𝐵 Where IR = the information ratio, IC = the information coefficient (depth of knowledge) and IB = investor breadth (# of independent investment decisions) Basically, the > # decisions a manager makes the less depth of knowledge they require Total Active Return True Active Return = Managers total return – Manager’s normal benchmark portfolio Misfit Active Return = Manager’s normal benchmark portfolio return – investor benchmark return 𝑡𝑜𝑡𝑎𝑙 𝑎𝑐𝑡𝑖𝑣𝑒 𝑟𝑖𝑠𝑘 = √(𝑡𝑟𝑢𝑒 𝑎𝑐𝑡𝑖𝑣𝑒 𝑟𝑖𝑠𝑘)2 + (𝑚𝑖𝑠𝑓𝑖𝑡 𝑎𝑐𝑡𝑖𝑣𝑒 𝑟𝑖𝑠𝑘)2 𝐼𝑛𝑓𝑜𝑟𝑚𝑎𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑖𝑜 = 𝑎𝑐𝑡𝑖𝑣𝑒 𝑟𝑒𝑡𝑢𝑟𝑛 𝑅𝑃 − 𝑅𝐵 = 𝑎𝑐𝑡𝑖𝑣𝑒 𝑟𝑖𝑠𝑘 𝜎(𝑃−𝐵) This section on total active return is frequently tested Be able to work from given information to perform several calculations to get the IR Corporate Governance (retired): Know about the principal-agent problem (asymmetric information and/or differing incentives) 16 © www.gostudy.io Alternative Investments Common Diversification benefits –low correlation with equities/bonds High due diligence costs, hard to get info Characteristics Low liquidity –So they have a liquidity premium and > E(r) Hard to evaluate performance or value Common issues for individuals: Suitability, taxes, liquidity, concentrated portfolios, complexity of the investments, decision risk Real Estate: Direct = owning residential, commercial, or agricultural land Indirect is via vehicle like REIT Pros of Real Estate Investing Cons of Real Estate Investing  Low correlation with equities  High information costs (due diligence)  Low volatility of returns  High commissions to purchase/sell  Good inflation hedge  Asymmetric information (for direct)  Can support a lot of leverage  Illiquid (especially direct strategy)  Property expenses are tax deductible  Indivisible (geographic/political risk)  Direct control of properties  High operating costs  Geographic diversification is possible  Location risk (idiosyncratic risk) Note, some of these pro/cons apply more to direct real estate (e.g indivisible, illiquid, high purchase costs) and asymmetric info Private Equity: PE investments have low liquidity and are often subject to lock up periods They tend to be higher risk, higher reward than public equity investments, with earlier stage (VC) investing risker than buyout funds Compared to VCs, buyout funds (1) use more leverage, (2) have earlier/steadier CF, (3) have less error/variability in e(r), and (4) suffer fewer investment losses Fees usually involve both AUM and carried interest LPs worried about this use clawback provisions, highwater marks Commodities: Direct via ownership of the physical commodity or derivatives/futures priced on those assets or indirect which involves investing in companies whose main business is tied to commodities With the indirect approach you need to be careful that the firm does not fully hedge its exposure to the underlying asset In general commodities have high liquidity, offer diversification from stocks/bonds (low correlation), and can slightly enhance portfolio returns when they are positively correlated with inflation Note commodities tend to be positively associated with inflation IF they are storable or IF they have a correlation with economic activity But even if including commodities ↓portfolio returns it can still lead to a ↑ Sharpe ratio due to the diversification benefits Commodity Futures Return: Hedge Funds: Strategy Convertible Arbitrage Distressed Securities Emerging Markets Equity-Market Neutral Hedged Equity Fixed Income Arbitrage Global Macro Merger Arbitrage Fund of Funds Definition Buy undervalued convertible securities, short stock Earn interest based on bond yield and short-sale Benefits from greater volatility, upward sloping yield curve Long only Capitalize on inefficiency in distressed marketplace Long only, invest in emerging Uses pairs trading (buy undervalued, short overvalued) to eliminate systematic risk & capitalize on mispricing Similar to equity-market neutral, but manager can keep net exposure long or short depending on view towards market Largest strategy bucket Long/Short fixed positions based on expected changes in yield curve Focus on industries/region vs individual security selection Focus on investing ahead of potential mergers (deal arbitrage), spin-offs, take-overs Diversify investments across multiple managers/strategies Good beginner entry, but extra layer of mngt incurs more fees Can be subject to style drift 17 © www.gostudy.io 𝑆ℎ𝑎𝑟𝑝𝑒𝐻𝐹 𝐴𝑛𝑛𝑢𝑎𝑙𝑖𝑧𝑒𝑑 =     𝐴𝑛𝑛𝑢𝑎𝑙𝑖𝑧𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 − 𝐴𝑛𝑛𝑢𝑎𝑙𝑖𝑧𝑒𝑑 𝑟𝑓 𝑎𝑛𝑛𝑛𝑢𝑎𝑙𝑖𝑧𝑒𝑑 σ Assumes a normal distribution (which HF don’t have) Assumes returns are uncorrelated (if returns trend, standard deviation will be understated) Standalone risk measure that does not factor in diversification The Sharpe ratio is larger for longer holding periods by the square root of time If we use monthly returns, we get the annualized returns by multiplying by 12, but the annual standard deviation is multiplied by √𝟏𝟐…biasing the Sharpe ratio upward by √𝟏𝟐 Sortino Ratio = 𝑅𝑝 − 𝑀𝐴𝑅 𝐷𝑜𝑤𝑛𝑠𝑖𝑑𝑒 𝐷𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 Sortino ratio replaces the risk free rate with MAR, or minimum acceptable return, and it uses downside deviation instead of the annualized standard deviation This lessens concerns around asymmetric returns (fat tails) Note on HF Performance: Younger funds tend to outperform older ones, smaller hedge funds tend to outperform larger ones, & longer lock up period tends to produce higher returns Also remember survivorship bias Managed Futures: Invest in derivative contracts, either systematic rules-based or discretionary Key benefit is diversification potential, sometimes even have negative correlation w equities Private managed futures outperform public ones Distressed Securities: Buying up high-risk assets that are either in or near bankruptcy Very inefficient market that most investors not enter Hence it is high-risk, high-reward, and generally requires active management: Characteristics  High Event Risk: Huge company-specific or situation-specific risk that is uncorrelated to the markets  Low Liquidity, Cyclical Demand: Demand is cyclical…so you have a risk of not being able to sell  Market Risk: Basic macro factors, common to all assets, less important for distressed securities  J-Factor Risk: Judicial or legal risk is high, especially for assets already in bankruptcy Can include long-only value, private equity, or distressed debt arbitrage With the latter, you go long debt and short equity of same security If the company deteriorates, the equity value will decline by more than the debt If the company’s positon improves the debt has greater priority over dividends so the bond will increase in value Note, constructing a hedge fund benchmark is very difficult Some alternative approaches to measuring performance include 𝑉 −𝑉 measuring daily returns: 𝑟𝑖 = , creating an absolute return target, analyzing style between managers, using the Sharpe or 𝑉0 Sortino ratio, or value-added return (sum of the individual long and short positions), or finally a customized long/short separated benchmark Risk Management Enterprise risk management (ERM) focuses on firm-wide policies and procedures Value at risk (VAR) is more about the given probability of loss on a portfolio basis Decentralized Risk Management ERM - Centralized Risk Management  Manage risk by business line  Gives a better birds-eye view of firm risk  Puts responsibility for risk management to  Responsibility closer to senior managers those closest to the risk factors  Has economies of scale    Financial Risks Market Risk (ALM framework) Credit Risk Liquidity Risk       Non-Financial Risks Operational (Tech/Human) Settlement risk Model risk Sovereign risk Regulatory risk Accounting/legal/contract risk 18 © www.gostudy.io Value at Risk (VAR): Measuring the probability that a portfolio’s return will fall below a certain level over a specific period of time The key drawback of VAR is that it doesn’t talk about how much worse the loss could get VAR says nothing about magnitude of loss Equation Formula VAR – Analytical Method +Easy to calculate, model correlation, apply to diff time periods -Assumes normal distribution, hard to compute 𝑉𝐴𝑅 = [Ȓ𝑝 − (𝑧)( 𝛿)] 𝑉𝑝 Ȓ𝑝 = Expected return of portfolio z = z-value at desired level of significance (will be given on exam OR…5% VAR = 1.65, 1% VAR = 2.33) 𝛿 = standard deviation of returns, 𝑉𝑝 = Value of portfolio VAR – Historical Method +Easy to calculate, does not assume normal distribution -Assumes historical pattern will repeat VAR – Monte Carlo Rank historical returns from highest to lowest Calculate the lowest 5% of returns and use the highest value of that lowest 5% to set the 5% VAR for that time period (usually daily) So if you have 40 observations, the lowest 5% of observations would be the lowest (0.05*40) returns We take the higher of those observations and multiply it by the portfolio value to get the dollar VAR Computationally intensive but can model different assumptions Does not assume normal distribution, can lead to false sense of confidence Also expensive to run Extensions to VAR: I-Var, CF at risk, Earnings at risk, T-VAR (uses left tail) or credit VAR which focuses on upper tail Managing Market Risk: Risk budgeting, Position limits, liquidity limits, performance stop-outs, individual risk factor limits, leverage limits, minimum credit standards, creating and using special purpose vehicles Managing Credit Risk: Limiting exposure, Marking-to-market, using collateral Risk Adjusted-Performance Metrics Sharpe Rati𝑜 = 𝑅𝑝 − 𝑅𝑓 𝜎𝑝 Risk-adjusted return on invested capital (RAROC), and the information ratio Sortino Ratio to measure excess return to risk = ROMAD (return over maximum drawdown) = 𝑅𝑝 −𝑀𝐴𝑅 𝐷𝑜𝑤𝑛𝑠𝑖𝑑𝑒 𝐷𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 𝑅𝑝 𝑀𝑎𝑥 𝐷𝑟𝑎𝑤𝑑𝑜𝑤𝑛 19 © www.gostudy.io Currency Risk Management: Returns on an international investment have two components: the return on the assets in its local currency (RFC) and the currency return (RFX) that results as a function of the relative performance between an investor’s domestic currency (DC) and the foreign currency (FC) Types of currency hedging -Do nothing -Passive Hedging – Matches the same currency exposure of a benchmark in order to eliminate any currency risk relative to the benchmark -Active approach: Treats currency risk independently of the benchmark’s exposure and could be discretionary (allowing modest deviation) or fullblown The goal with an active approach is to earn currency alpha to exploit short term inefficiencies It is also possible an investor would use different managers to oversee currency in a currency overlay Key Points        Shorter time horizons = more likely to hedge Risk averse clients = more likely to hedge Greater liquidity requirements = more likely to hedge Greater Allocation to foreign fixed income = more likely to hedge Lower transaction costs to build a hedge = more likely to hedge Greater volatility in financial markets = more likely to hedge Skepticism of inefficiencies in currency market = more likely to hedge (because there is less chance to earn currency alpha) Tactical Currency Management Economic fundamentals – Assumes PPP holds in long term and short-term deviations can be exploited Technical analysis Carry trade - When you borrow in a lower interest rate currency and invest the money you borrowed in a higher interest rate currency Works best in periods of low volatility but can lead to high losses during flights to safety Volatility trades Minimum Variance Hedge: Regression analysis used to determine sensitivity of underlying to changes in a variable Hedge ratio = the beta or slope coefficient of that analysis 𝑅𝐷,𝑈 = ∝ +h(𝑅𝐹𝑢𝑡 ) Emerging market hedging risk factors:  Higher bid-ask spreads and trading costs  Greater event risk (extreme market events)  High potential for severe illiquidity during times of crisis  Tendency for currencies to correlate during crisis (which reduces effectiveness of any hedge)  Risk of an emerging country’s government manipulating its currencies Hedging Exchange Rate Risk with Forwards and Futures (if receiving or paying in foreign currency in the future) Transaction Exposure or future foreign currency payment a If you receive payment, hedge by selling forward b If you are paying, hedge by buying it forward Economic exposure indirect risk to foreign currency even if you aren’t transacting directly in FC (suppliers etc) Translation exposure relates to balance sheet/accounting risk rather than cash flows (not vital for L3) 20 © www.gostudy.io Risk Management with Futures Equation Formula 𝐵𝑇 − 𝐵𝑃 𝑉𝑃 # 𝑐𝑜𝑛𝑡𝑟𝑎𝑐𝑡𝑠 𝑡𝑜 𝑏𝑢𝑦 𝑜𝑟 𝑠𝑒𝑙𝑙 = ( )( 𝐵𝑓 (𝑃𝑓 ∗ 𝑚𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟) Adjusting Equity Portfolio Duration Adjusting Bond Portfolio Duration   To INCREASE a portfolio’s beta BUY futures contracts To DECREASE a portfolio’s beta SELL futures contracts Where: 𝐵𝑇 = Target or desired beta 𝑉𝑃 = Current value of portfolio 𝐵𝑃 = Portfolio beta 𝑃𝑓 = Futures price 𝐵𝑓 = Beta of futures contract multiplier = # indicating index value per contract 𝑀𝐷𝑇 − 𝑀𝐷𝑃 𝑉𝑃 # 𝑐𝑜𝑛𝑡𝑟𝑎𝑐𝑡𝑠 𝑡𝑜 𝑏𝑢𝑦 𝑜𝑟 𝑠𝑒𝑙𝑙 = (𝑦𝑖𝑒𝑙𝑑 𝑏𝑒𝑡𝑎)( )( ) 𝑀𝐷𝑓 (𝑃𝑓 ∗ 𝑚𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟) Determine the # of futures contracts necessary Note the numerator is the FV of the T-bill position…its saying you will go long more equity futures contracts than you would if your money wasn't growing at the risk-free rate # futures necessary = Build a Synthetic Equity Position (𝑇𝐻𝑒𝑙𝑑 )(1 + 𝑅𝑓 )𝑡 (𝑃𝑓 )(𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟) Round the value to the nearest whole number Next calculate the PV of the cash you will need to settle your futures contract when it comes due: 𝑇𝐸𝑞𝑢𝑖𝑡𝑖𝑧𝑒𝑑 = (# 𝑐𝑜𝑛𝑡𝑟𝑎𝑐𝑡𝑠𝑅𝑜𝑢𝑛𝑑𝑒𝑑 )(𝑃𝑓 )(𝑚𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟) (1 + 𝑅𝑓 )𝑡 Then calculate the effective # of equity units purchased (if needed) = Build a Synthetic Cash Position (# 𝑐𝑜𝑛𝑡𝑟𝑎𝑐𝑡𝑠𝑅𝑜𝑢𝑛𝑑𝑒𝑑 )(𝑚𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟) (1 + 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑦𝑖𝑒𝑙𝑑) # 𝑒𝑞𝑢𝑖𝑡𝑦 𝑐𝑜𝑛𝑡𝑟𝑎𝑐𝑡𝑠 𝑡𝑜 𝑠𝑒𝑙𝑙 = −[ 𝑉𝑃 (1+𝑅𝑓 )𝑇 (𝑃𝑓 )𝑚𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟) where VP = the value of the portfolio Note the negative sign ] So to reallocate from bonds to equities: Adjusting Portfolio Between Equity & Debt Remove all duration (MD=0) by shorting bond futures Add systemic risk to the position (𝛽 > 0) by buying stock index futures And to reallocate from equities to bonds: Remove all systematic risk (𝛽 = 0) by shorting the stock index futures Go long/buy bond futures (MD > 0) to add the correct level of duration 21 © www.gostudy.io Options Strategies Covered Call – Sell call on a stock you own (capped upside, earn income, decrease cost casis) Protective Put – Buy a put on a stock you own (Hedge downside by giving you right to sell, pay premium) Bull Spread – Moderately bullish Buy low strike call and sell higher strike call (profit if stock goes up, starts with net deficit) Bear Spread – Moderately bearish Buy a call with a high strike price and short a lower strike call option Butterfly Spread – Bet that the stock remains near current price Buy low and high strike calls, sell two in between Straddles – Betting on volatility Long straddle is buying put/call with same strike price & short straddle is reverse Box Spread – Lock in risk free rate using bull call and bear put Long Call/Short Put w/ low exercise price Short call/long put w/ higher strike price Option Collars – Lock in a portfolio value by combining protective puts and covered calls Zero cost collar if premiums are equal Delta 𝐺𝑎𝑚𝑚𝑎 = ∆𝑜𝑝𝑡𝑖𝑜𝑛 𝑝𝑟𝑖𝑐𝑒 𝑂𝑝𝑡𝑖𝑜𝑛 𝐷𝑒𝑙𝑡𝑎 = ⁄∆𝑢𝑛𝑑𝑒𝑟𝑙𝑦𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒 Sell calls = short underlying = buy shares to hedge Sell puts = long underlying = sell shares to hedge ∆𝐷𝑒𝑙𝑡𝑎 ∆𝑆𝑡𝑜𝑐𝑘 Delta hedging creates position where portfolio value doesn’t change in response to change in prices Gamma is highest when a stock is at the money because Interest Rate Options Strategy Used when Purpose Exercised If: Payoff Long an Interest Rate Call Will be borrowing at a floating rate Hedge against an increase in rates LIBOR > Strike Price NP*[max(0, LIBOR-Strike Rate)](D/360) Long an Interest Rate Put Will be lending at a floating rate Hedge against a drop in interest rates LIBOR < Strike Price NP*[max(0, Strike Rate- LIBOR-)](D/360) 22 © www.gostudy.io Interest Rate Swaps 𝐷𝑆𝑤𝑎𝑝 = 𝐷𝑎𝑠𝑠𝑒𝑡 − 𝐷𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑦 Duration of Swap Position 𝐷𝑝𝑎𝑦 𝑓𝑙𝑜𝑎𝑡𝑖𝑛𝑔 = 𝐷𝑓𝑖𝑥𝑒𝑑 − 𝐷𝑓𝑙𝑜𝑎𝑡𝑖𝑛𝑔 Pay-floating position Will be a positive number 𝐷𝑝𝑎𝑦 𝑓𝑖𝑥𝑒𝑑 = 𝐷𝑓𝑙𝑜𝑎𝑡𝑖𝑛𝑔 − 𝐷𝑓𝑖𝑥𝑒𝑑 Pay-fixed position Will be a negative number Note the duration of the floating position will usually be 0.25 It is just (Time to PMT/2) Equation Formula Changing Duration of a Swap 𝑀𝐷𝑡 − 𝑀𝐷𝑝 𝑁𝑃 = 𝑉𝑃 ( ) 𝑀𝐷𝑠𝑤𝑎𝑝 1) Converting Foreign CF 2) into Domestic CF 3) 4) Divide foreign cash flow by the foreign interest rate to obtain the foreign NP (MAKE SURE to divide the annual interest rate given by the # of periods first) Convert the foreign NP into the domestic NP at the current exchange rate Enter a swap with the domestic NP Pay the foreign CF, receive the domestic payment (calculated using the domestic interest rate and NP…again make sure that the annual interest rate is divided by the # of periods) Currency Swaps: There are two notional principals, one in each currency Unlike with interest rate swaps the counterparties EXCHANGE the principals at both the beginning and end of the swap Throughout the life of the swap the period payments are usually not settled on a net basis To solve a currency swap: 1) Divide the foreign cash flow by the foreign interest rate to obtain the foreign NP  MAKE SURE to divide the annual interest rate given in the problem by the # of periods first 2) Convert the foreign NP into the domestic NP at the current exchange rate 3) Enter a swap with the domestic NP 4) Pay the foreign CF, receive the domestic payment (calculated using the domestic interest rate and NP…again make sure that the annual interest rate is divided by the # of periods) Swaptions 1) 2) A payer swaption  The buyer has the right to be the fixed-rate payer in an interest rate swap A receiver swaption  The buyer has the right to the fixed-rate receiver in an interest rate swap A payer swaption used to convert a future floating-rate loan into a fixed-rate loan and the receiver swaption would convert a future fixed-rate loan into a floating rate loan A swaption can also be used to terminate an existing swap In this instance a manager would enter a swaption with the same characteristics as the original swap, but take the opposite position Portfolio Execution What How executed Main Advantage Main Disadvantage Market Order Immediate execution at best available price Start at lowest price, fill as much of the order as possible, then move to 2nd lowest price etc Guarantees execution (speed) Price uncertainty Limit Order Trade at best available price up to a limit defined by trader Same procedure, but only up to the specified limit Guarantees a min/max price Execution uncertainty 𝐵𝑢𝑦 𝑜𝑟𝑑𝑒𝑟 𝑒𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑠𝑝𝑟𝑒𝑎𝑑 = (𝑒𝑥𝑒𝑐𝑢𝑡𝑖𝑜𝑛 𝑝𝑟𝑖𝑐𝑒 − 𝑚𝑖𝑑𝑞𝑢𝑜𝑡𝑒) ∗ 𝑆𝑒𝑙𝑙 𝑜𝑟𝑑𝑒𝑟 𝑒𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑠𝑝𝑟𝑒𝑎𝑑 = (𝑚𝑖𝑑𝑞𝑢𝑜𝑡𝑒 − 𝑒𝑥𝑒𝑐𝑢𝑡𝑖𝑜𝑛 𝑝𝑟𝑖𝑐𝑒) ∗ Bid  Is the price a dealer will BUY (and you can sell) Ask  Is the price a dealer will SELL (and you can buy) If the effective spread is LESS than the Market Bid-Ask spread that is a sign of a good trade and high market liquidity 23 © www.gostudy.io Types of Markets Market Type Quote driven (dealer market) Order driven Order driven (Electronic Crossing Networks) Automated Auctions (Electronic limit order market) Pros Guaranteed execution Market-makers provide liquidity Transparent Allows for price discovery Automatic rules match counterparties Allows for anonymous trades Can accommodate large orders Does not have a market impact Price discovery Allows for anonymous trades Fairly liquid Cons Not transparent Order may not be executed (price over liquidity) No price discovery Partial order fills Can have poor liquidity Gaining popularity because of a perceived lack of disadvantages Signs of an efficient market Measuring Market Quality Liquidity Transparency Assurance of trade completion  Small bid-ask spreads  Pre-trade information is  High confidence that both readily available for sides of a trade will uphold  Market depth (large trade orders don’t reasonable cost and time their side of the agreement affect price) (i.e pay or deliver as  Post trade information is  Resilient (price stays close to intrinsic promised…hence the also provided value) existence of  Large # buyers/sellers with diverse clearinghouses) characteristics  Convenient platform to trade which is fair for all Execution Costs Explicit costs - Readily discernable, include things like taxes, commissions, stamp duties, and fees Implicit costs - Harder to measure, and include the bid-ask spread, market/price costs, opportunity costs, and delay or slippage costs Volume Weighted Average Price: A measure of the average price of a transaction when you purchase portions of the stock at different prices Basically VWAP gives you the true overall price of a transaction VWAP is easy to understand and is most useful for small transactions in non-trending markets Implementation Shortfall: Another trade execution measure that breaks costs down into components Less susceptible to gaming and more explicit about measuring implicit costs  Explicit Costs  Market impact costs: Any cost resulting from an order being executed at a price outside of the current bidask  Missed trade opportunity costs (MTOC): This is the gain (or loss you avoid) if your order does not get filled or is only partially filled  Delay/Slippage costs: Slippage measures the trading costs caused by time delay in executing a transaction due to lack of liquidity  Realized profit/loss: The difference between the execution price and the closing price on the day before divided by the % of the order that gets filled 24 © www.gostudy.io VWAP vs Implementation Shortfall Comparison VWAP Implementation Shortfall -Easily understood -Can see total cost of implementation -Computationally simple -Visualizes trade-off between quick execution & price PROS -Can be applied quickly -Decomposes trade into different costs -Best for small trades in non-trending -Not subject to gaming markets -Can be gamed -Not informative if trade is large % of daily volume -Unfamiliar to traders CONS -Does not evaluate delayed/unfulfilled -Computationally intense orders -Does not account for market moves Types of Traders 1) Information-motivated traders: Motivated to trade now because they possess time sensitive information Demand liquidity and will use market-orders This incurs higher costs than other types of traders 2) Value motivated traders: Looking to capitalize on intrinsic mispricing on securities (i.e a deep value investor) Because price is all important and the speed of execution isn’t as vital they are patient and will use limit orders 3) Liquidity motivated traders: Essentially the counterparty to info-motivated and value-motivated traders and will freely disclose their motivations Think of them as a broker mixing and matching buy-sell orders and taking the spread as their profit 4) Passive traders: Similar to liquidity-motivated traders but are more focused on cost reduction and low commission, low impact trades They favor limit orders and trade on crossing networks Trading tactics 1) Liquidity-at-any cost: Often used to transact a large block quickly, usually by an info-motivated trader or mutual fund seeking liquidity Quick and certain execution means higher costs and information leakage 2) Costs-are-not-important: Belief that markets are efficient (so paying attention to execution price is pointless Trading average costs & quicker execution for loss of control over costs 3) Need-trustworthy-agent: Employ a broker to execute trades on a thinly traded security The broker’s job is both to obtain a good price within a reasonable time period and to prevent information leakage on trade intent By using and trusting an agent you cede control and incur high commission costs 4) Advertise-to-draw-liquidity: Most common example is an IPO This is NOT an info-motivated trade Its main strength is low trading costs and its main disadvantage is high administrative costs 5) Low-cost-whatever-the-liquidity: Its strength is low costs, with weaknesses around uncertainty of execution and most importantly the danger that if you only seek low costs you will trade into a downward trending/weak market Algorithmic Trading Quantitative, computer controlled automated trading, designed to hide trades, reduce risk, and minimize costs They tend to perform better in trending markets There are a few different types Logical participation strategies: Trade with market flow to escape notice Strategies include tying to VWAP, TWAP, or % volume These tend to be slower in terms of execution relative to our next category Implementation Shortfall (arrival) strategies: Complete a trade while attempting to minimize trading costs as defined by our implementation shortfall equation (so it factors in both implicit and explicit costs) As a consequence, trades tend to be front-loaded and occur earlier in the day Market Volume Low High Low Low Market Conditions and Algorithmic Trading Strategies Bid-ask spread Trade urgency Ideal Strategy Simple participation Low Low (VWAP) High High Broker/ECN NOT Algo Opportunistic Low Low participation Implementation Low High Shortfall Why? Reduce market impact by spreading out trade Highly customized Low urgency, lots of liquidity=price High trade urgency 25 © www.gostudy.io Monitoring & Rebalancing Calendar Rebalancing: Rebalances a portfolio at regular timed intervals irrespective of market activity A portfolio with higher volatility would probably be rebalanced more often than one with lower volatility Calendar rebalancing mandates a disciplined approach (which is its primary benefit), but it does not account for any significant variation that can occur between periods Percentage of Portfolio Rebalancing: Rebalanced whenever any asset class moves away from their optimal weights In other words it is triggered by changes in relative asset values which are set by tolerance bands Tolerance bands strike a balance between the costs of rebalancing frequently and the risk of letting allocations stray too far Optimal corridor width: Mathematically we express the width of an optimal corridor as: 𝑇𝑜𝑙𝑒𝑟𝑎𝑛𝑐𝑒 𝐵𝑎𝑛𝑑𝑠 = 𝑇 ± (𝑃 ∗ 𝑇) Where T = target allocation and P = the %∆ maximum allowable deviation Factor Higher Transaction Costs Higher risk tolerance High correlation w/ portfolio High volatility of asset High volatility of portfolio Optimal Corridor Wider Wider Wider Narrower Narrower Why Less rebalancing reduces costs Can tolerate more risk Less risk of more deviation Prevent sudden moves Prevent sudden moves Rebalancing strategies (CPPI, Constant Mix, Buy & Hold) Type of Market Bull Market (up) Oscillating (flat) Market Down Market Shape of Curve Risk tolerance Performs best when… Dynamic Rebalancing Strategies & Market Performance Buy & Hold Constant Mix Outperform (but less Underperform than CPPI) Middle-of-the-pack Middle-of-the-pack Middle-of-the-pack Outperform Linear Passively related to wealth Zero below floor M=1 N/A Concave Absolute tolerance varies proportionally w/ wealth Relatively risk is constant No floor value : SM Measures the value-add or lost relative to the market if the portfolio has the same TOTAL risk as the market Excess return per unit of total excess risk Similar to Sharpe ratio, but compares excess risk/return Positive alpha if IR is positive number Quality control charts The chart, which plots cumulative value added return against time, makes three critical assumptions: (1) The null hypothesis, H0, is that value-added returns = 0, so e(r) = benchmark return, (2) the value added returns are independent & normally distributed, and (3) the investment process is consistent…meaning the variability of value-added returns is as well Quality Control Chart Manager Continuation Policy: A Type I error is keeping a bad manager and a type II error is firing a good manager If you remember the two hypotheses, then remember the expression true null horn Where the H0 = H0 = null, and the ‘RN’ = reject null If that doesn’t help, try “Type keep a pisser.” 29 © www.gostudy.io GIPS We think the most likely GIPS questions would ask you to examine a GIPS return report and talk about factors presented or omitted that violate the GIPS requirements Years Composite return Benchmark # Portfolios Internal Dispersion Measure Amount of composite assets Total Firm Assets or % of Total Along with that information here’s the total summary of the items you need in a GIPS-compliant presentation: 1) 2) 3) 4) 5) 6) 7) 8) 9) 10) 11) Correct GIPS compliance statement Definition of the firm Description of the composite Composite creation date and complete list of composites (available upon request) Policies for valuing portfolios, calculating performance, and preparing presentations (upon request) Currency used Description of benchmarks (or why there is none) Minimum of years of returns and going up to 10 ID whether net or gross fees Management fee schedule (upon request) year ex-post standard deviation or another measure of internal dispersion and explanation Real Estate GIPS Calculations Equation Formula 𝑛 Capital Employed 𝐶𝐸 = 𝐶0 + ∑(𝐶𝐹𝑖 ∗ 𝑊𝑖 ) 𝑖=1 Capital Return 𝑅𝐶 = 𝑉1 − 𝑉0 − 𝐸𝐶 + 𝑆 𝐶𝐸 The Capital Return (RC) gives us the change in market value of a property (V) AFTER considering any capital improvement expenses (EC) and sale proceeds (S) Investment Return 𝑌𝐴 − 𝐸𝑅 − 𝐼𝐷 − 𝑇𝑃 𝐶𝐸 Where: 𝑌𝐴 = gross investment income 𝐸𝑅 = nonrecoverable expenses 𝐼𝐷 = Debt or interest payments 𝑇𝑃 = property taxes 𝐶𝐸 = capital employed 𝑅𝐼 = 𝑂𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝐷𝑖𝑒𝑡𝑧 = 𝐸𝑀𝑉 − 𝐵𝑀𝑉 − 𝐶𝐹 𝐵𝑀𝑉 + 0.5𝐶𝐹 𝑀𝑜𝑑𝑖𝑓𝑖𝑒𝑑 𝐷𝑖𝑒𝑡𝑧 = 𝐸𝑀𝑉−𝐵𝑀𝑉−𝐶𝐹 𝐵𝑀𝑉+∑(𝑊𝑖 ∗𝐶𝐹) where the weight, 𝑊𝑖 = 𝐷𝑎𝑦𝑠 𝑖𝑛 𝑃𝑒𝑟𝑖𝑜𝑑 (𝐶𝐷)−𝐷𝑎𝑦 𝐶𝐹 𝑟𝑒𝑐𝑖𝑒𝑣𝑒𝑑 (𝐷𝑖 ) 𝐷𝑎𝑦𝑠 𝑖𝑛 𝑃𝑒𝑟𝑖𝑜𝑑 (𝐶𝐷) Thanks and good luck! Note access the full version of the notes and the study app at www.gostudy.io 30 ... www .gostudy. io Cram Notes for CFA Level – 2017 Copyright â 2016 by Go Study LLC.đ All Rights Reserved Published in 2016 The CFA and Chartered Financial Analyst® are trademarks owned by CFA. .. Materials, CFA Institute Standards of Professional Conduct, and CFA Institute’s Global Investment Performance Standards with permission from CFA Institute All rights reserved.” Disclaimer: This cram guide. .. Equation Formula Changing Duration of a Swap