CFA l3 adam runk bullet point list

1 If they give you a cash duration use it Treynor = Beta = Well Diversified Sharpe = Std Dev = Not Well Diversified If a manager ranks highest in Treynor but lowest in Sharpe this indicates they are not well diversified and are taking on nonsystematic risk that is not being captured by Beta “For the pound against the dollar” - The pound is the subject, the pound is the base currency Immunization assumes no default and requires liquid bonds when rebalancing While corporate bonds would theoretically would reduce the cost of immunization due to higher coupons, immunization requires that there is no default and corporate bonds would theoretically increase the cost of rebalance For these reasons corporate bonds would increase the cost of immunization as you would need more in assets (surplus) to invest in corporate bonds FRA Mark to Market ( (Locked in FRA Rate - Current Libor) * Notional * (Loan Day)/360 ) * (1/(1+Current Libor * (Loan Day/360))) * (1/(1+rf)^(FRA Day/365)) FRA Day = Day Underlying Loan Starts - Today Loan Day = Days in underlying loan Symmetric Cash Flow Match = Cash Flow Match + Assumption you borrow short term to fund liability and don’t need perfect matching Immunization Risk Equations = M^2 is immunization risk STDDEV(Tgt) = M^2 * STDDEV(Slope change) * n M^2 = Size of Liability and Dispersion between asset and liability date Confidence Interval = Tgt Return +- (K * STDDEV(Tgt)) n = horizon length Common K Values 1% VAR = 98% Confidence = 2.33 2.5% VAR = 95% Confidence = 5% VAR = 90% Confidence = 1.65 Requirements for Multiple Liability Immunization A PV Asset = PV Liab B Weight Avg Asset Dur = Weight Avg Liab Dur C [ _Liab Dur ] { _Asset Dur _} Asset Dur Range Exceeds Liab Dur Range * Requires constant rebalancing, only immunizes for a small (due to convexity) parralel (if you want paralell must be keyrate/functional duration match or linear program) 10 Stale Price Bias = Serially Correlated Returns = Smoothing Mostly a concern in Direct Real Estate, Distressed Debt and Private Equity Causes correlation to be lower and STDDEV to be lower Makes diversification appear higher Biases Sharpe upward Used to game Sharpe Ratio Not concerning for hedge funds due to monthly reporting 11 Flat and Heavy favorable to interest 12 Wealth tax FVIF = ((1 + R) ( - Tax))^n Tax Drag % > Tax Rate As Time increases tax drag increases As Return increases tax drag DECREASES 13 Tax Drag % = Tax Rate in deferral Value fo Deferral increases as time and return increase 14 Taxable STDDEV = STDDEV (1 - Tax) - therefore all else government absorbs some std dev in taxable acct Also noteworthy is that if you have a period of negative returns you will have a better return in a taxable account due to value of offsetting gains If you have a period of positive returns you will best in a tax exempt/tax deferred account 15 TAE can be lower than Tcg if gains are large & deferred for a long time with little dividends/interest TAE can be larger than Tcg if low basis 16 FVIF(total) = (((1+Rart)^n) - 1) * (1 - Tecg) + - (1 - B) * Tcg Rart = Return (1 - Realized Tax) Realized Tax = Pi * Ti + Pd * Td + Prg * Trg Tecg = ((1 - Realized Tax) / (% Unrealized)) * Tcg B = PV/Cost Basis RAE = FVIF(Total) ^ (1/n) -1 Tax Drag % = r - RAE TAE = - (RAE/r) Tax Drag $ = (FV No Tax - PV) - (FV Tax - PV) % Value of deferral = Tax Drag% Accrual - Tcg 17 Deemed Disposition = Immediate tax on unrealized gains at death or upon leaving country, generally no estate tax, thus its best to gift low basis assets before death 18 Taxable Gift (IF GIVER PAYS) = (1 + aftertaxreturn)^n * (1 - Tg + Tg*Te) Tg*Te represents the reduction in estate tax due to the tax bill being paid by the giver Example: Estate size is 100k Gives 20k gift Estate size is 80k Pays 5k tax on gift, Estate size is now 75k If estate tax is 50% there is a 0.5* 5k = 2.5k reduction in estate tax from the gift giver paying the tax 19 PIE - Three principles of central Bank P = Political Influence - independent of it I = Inflation target to guide expectations E = Economic Control of economy using monetary policy to prevent overheat/cooling 20 Vintage Effect only important if timeframe is less than years 21 Rolling returns show cyclility and consistency 22 Historical VAR and Monte Carlo VAR are nonparamentric (they assume no return distribution) Historical VAR uses simulated returns for options/bonds based upon current characteristics Analytical VAR can be used for non-normal returns but must be supplemented with scenario analysis VAR focuses on Left Tail CVAR focuses on right tail CVAR (credit Var) is hard to estimate and cannot be separated from VAR CVAR is also hard to project as defaults occur infrequently and data is limited 23 Tail VAR = VAR + Avg of Worst X% outcomes Gives insight into magnitude of loss which is a weakness of VAR that can be overcome with TailVAR or Scenario analysis VAR should not be used in isolation because of this 24 Cons of VAR Different methods give different results, generates false sense of security (output only as good as input), ignores upside, ignores magnitude of worst case, does not account for liquidity of positions, historical relationships may not hold, some methods difficult and expensive 25 Pro of Analytical VAR allows modeling of correlations 26 8% expected return, Std dev of 10%, Port Size = 833,333.33 0.08 - * 0.10 = -12% -0.12 * 833,333.33 = 100k 2.5% annual VAR of 100k 97.5% chance loss will be no more than 100k in a year 2.5% chance loss will be at least 100k in a year 27 You can expect a loss of _ for _ months in years (use above info) 0.08/12 = 0.00667 0.10 / (SQRT(12)) = 0.02887 (0.0067 - * 0.02887)*833,333.33 = 42,529.19 0.025 VAR * 12 months in a year * years = 1.5 months You can expect a loss of 42,529.19 for 1.5 monthsin the next years VAR can only be time scaled using SQRT (Periods) if and only if expected return = 0% 28 Special Purpose Vehicle = Enhanced Derivatives Product Company Separately collateralized subsidiary to improve your own counterparty risk If you are trading with someone elses Enhanced Derivatives Product company there will likely be much less credit risk/counterparty risk 29 Herstatt/Settlement/Counterparty Risk can be reduced by: Clearinghouse posting margin netting (noncurrency) continuously-linked-settlement (for currency) and Closeout netting (for currency) Credit Analysis on counterparty Have minimum credit standards Counterparty issuer limits 30 Performance Netting Risk - Requires multiple managers with an asymetric performance fees (not ad valorem) Risk of one guy doing great and everyone else doing terrible and the company still having pay bases to everyone that sucked and pay base + incentive payments to the good guy The company won’t receive good revenue because most of their revenue arrangements are performance fees which wont be paid as nearly everyone sucked except that one good guy 31 Effective Beta Port End Value + Gain/Loss on Contract = Overall End Value Overall End Value / Begin Value - = % Overall Change % Overall Change / % Index Change = Effective Beta Gain/Loss on Contract = # contracts bought (negative if sold) * (Futures Price Now - Futures Price Begin) * Multiplier if any 32 Put + Straddle = Strip Puts benefit if price goes down and straddle benefits if volatile If a womans clothes go down shit will get volatile Strap is a strip but with a call instead of a put 33 Box Spread = (Strike Spread / (1 + rf)^n) - Net Premium = Arbitrage Profit Bear Put Spread combined with Bull Call Spread used for arbitrage based upon put/call parity relationship 34 Insurance Need Lower Post Death Objectives Better family health history and lower risk aversion Larger FC/Less HC/Aka you’re old More correlated HC is to FC (market) —Since HC is PV of future income and the discount rate is based upon inflation + risk of HC a higher correlation to FC the greater the risk of HC thus a greater discount rate applied to value HC, thus HC will be lower as a result thus refer to the “Larger FC/Less HC” rule 35 Hedge Hedge market but not currency = foreign Rf Hedge currency but not market (assuming perfect hedge) = (1 + Roll Yield) * (1 + local return) - Hedge none = (1 + local return) * (1 + Currency Return) - Hedge both market and currency = Domestic Rf 36 Currency Hedge Foreign Bond Assuming IRP Holds and no change in rates, and same maturity/quality Return = Domestic Rf + (Bond Rate - Local Rf) Thus when comparing hedged foreign bonds, the largest spread between the bond rate and the bonds respective local rf rate will have highest return assuming IRP holds and no changes in rates/credit spreads 37 Source/Territory Conflict Exemption - Pay Source Credit - Pay higher of source or residence Deduction - Pay Source then pay part of residence = Source Rate + (1 - Source Rate) * Residence Rate Deduction only a partial resolution 38 Forward Conversion with Options Buy Put and sell call at same price, identical to a short forward and will earn rf 39 Completeness Port combines port and concentration to minimize correlation with the concentration Uses tax loss harvesting to reduce the concentration which causes rest of port to become low basis Still retains risk of downside due to specific factors Reduces mismatch return? 40 Primary Capital = Personal + Mkt Risk buckets ——basically it is networth excluding concentrations Implied Assets = Human Capital Implied Liabilities = PV future spending needs Excess Capital = PV Assets including implied - PV Liab including Implied Always note that a safety reserve is highly recommended as mortality rates are based upon average figures and to provide a psychological buffer against volatility Use Rf rate to calc PV of spending needs because spending risk is unrelated to the risk of the assets used to fund spending Prob Joint Survival = - Chance they Both Die Chance They Both Die = Prob one dies * Prob other dies As time passes implied liabilities decline as they have a finite lifespan assuming the same annual spending needs (IF THEY ARE PRESENTLY SPENDING) If they are not presently spending and spending is in future their implied liabilities will rise as time passes because they are being discounted less 41 Yardeni - Forward Earnings Yield vs Corp A Debt - (Import of earn * year earn growth) Premise Since D1/(R-G) = P then R - G = D1/P It is assumed that D1 = E1 Thus Yardeni can be compared to R - G where Corp A Debt is R and the (Import of earn * year growth) is G Obvious Con is that Corp A Debt is not a good approximation of the risk of equity Additionally the importance of earnings changes depending upon where the cycle is and is not static 42 Fed - Forward Earnings Yield vs 10 year T Bond Con of Fed is doesn’t consider earnings growth Another Con compares nominal figure (Bond Yield) to real figure (earn yield) TBond Yield not a good approximation fo equity risk Pro - It captures the relationship when rates fall earnings are more valuable which is true as earnings become more real as inflation falls 43 More Frequent Rebalance Pro - Potentially less market impact as the portfolio will require smaller trades to rebalance back to target Con - Higher transaction costs relative to the benefits of rebalancing and more monitoring 44 % of port rebalancing vs Calendar Year % of port - if one is outside of band then rebalance ALL to target Con - Requires more monitoring Pro - related to market activity 45 Bond Equivalent Yield = If given for immunization be sure to compound semi-annually Bond Equivalent Yield = ((1 + Annual Return)^(1/2)-1) * 46 If plan freezes inflation indexed benefits for new retirees, current AND DEFERRED will retain inflation benefits Also it is important to note that even if a plan does not index benefits for inflation there will need to be SOME real bonds in the portfolio to account for the % of salary increases related to inflation Equity = Real salary increases Real Bonds = Benefits indexed for inflation + Inflation part of salary increases Nominal Bonds = Benefits not indexed for inflation 47 Asset Only Approach - Low risk asset is asset with low correlation with other assets In ALM low risk asset is the asset with the highest correlation to the liabilities 48 Tax Efficient = Buy and hold Dont want cash drag = not buy and hold Floor = CPPI or buy and hold risk tolerance increases 20% for every 20% increase in wealth = constant mix Believe moderately increasing to flat market with low volatility = Buy and hold 49 Do nothing if trending, rebalance if expect correction = Discretionary hedge 50 Duration of Call = Dur of underlying * Delta * (Price of Underlying / Price of Option) 51 Port turned over twice a year and cost to trade is 50 bps Cost to trade = 50bps * (1 time bought + time sold) * times turned over = 2% 52 Benchmarks and Validity Check Absolute - Not Investable Broad Index - Only appropriate if semi-active approach vs broad index Mgr Universe - Fail everything except measurable Style - Ambiguous and may not match manager process Factor - Ambiguous and not intuitive Return-Based - SATISFIES - is requires many months to get reliable pattern Custom Security - SATISFIES - Arguably the best but is expensive to construct and maintain and have transparency concerns 53 Type Error - Keeping bad manager 54 Inputs to Maco Attribution Policy Allocation, Bench Returns, Fund Returns/Cash Flows/Valuations 55 Macro Steps Net Contributions - No Impact Rf Rate Category @ Neutral - Passive Return in excess of rf Style @ Neutral - Misfit Return Fund @ Neutral - Active Return excluding Tactical Asset Allocation Fund @ Actual Weight - Tactical Asset Allocation + rf + Passive + Misfit + Active excl TAA + TAA = Total Return 56 Assumptions of Quality Control - VAN V - Volatility of Alpha Constant (doesn’t change styles) A - Alpha independent N - No Skill is null 57 GIPS - Bring over past performance from new firm Must have same decision makers, same process, and have records to support performance that you obviously didn’t steal or take from your previous employer without permission FOR NON GIPS Must disclose your role in the performance (co-manager, etc) or just disclose the performance you were responsible Again you can’t find the shit in your computer from your previous employer and use it without permission 58 Within Sector (SELECTION) Bench Sector Weight * (Port Sector Return - Bench Sector Return) Pure Sector Allocation =(Port Sector Weight - Bench Sector Weight) * (Bench Sector Return - Bench Return) Interaction = (Port Sector Weight - Bench Sector Weight) * (Port Sector Return - Bench Sector Return) 59 Short Collar = Risk Reversal Short Seagull Spread = Collar + Sale of OTM Put = Put Spread + Sale of OTM Call Short Seagull Spread = Short Risk Reversal + Sale of OTM Call Long Seagull Spread = Call Spread + Sale of OTM Put Short Butterfly Spread = Sandwich Spread Bear Put Spread + Bull Call Spread = Box Spread Money Spread = Spread with more options on one side than other Time Spread = Spread with differing maturities on one side than other 60 Core GIPS Principles Adhere to Law Properly Define Firm Provide Compliant presentations to all prospects Ensure not false or misleading Common Pros and Cons Including microcaps increase completeness and decrease investability Floating Bond increases cash flow risk and decreases market risk Cash Flow Matching has no immunization risk but requires more cash to fund as there is rarely perfect matching and need to assume conservative rates for cash balances which can be large sometimes OTC Derivatives more customized/useful for currency but are more difficult to exit as difficult to find offsetting so may have to negotiate early termination fee Thus not as liquid as exchange traded Calendar Year Rebalancing is simple, provides discipline, and requires less monitoring, but is unrelated to market activity Using Min Var Ratio (Beta) for a proxy hedge decreases basis risk/tracking error but is very unstable and requires constant montioring and rebalancing Buyout funds are more stable, have earlier cash flows, higher avg returns, and less failures BUT have less upside potential than Venture Capital Integration causes more liquidity and lower risk but at the tradeoff of lower return and less diversification benefits Optimization (vs Strat Sampling) minimizes tracking error but at the cost of higher turnover Also risk of overfitting/sampling error Ad Valorem (AUM) Fee is simple & predictable but does not align port mgr interests as well as a performance fee Pooled Accts have lower mgmt costs for small funds that cant afford dedicated mgr but may hold excess cash to provide liquidity and it is difficult to differentiate pooled performance Stock Index futures have lower transaction costs and can leave underlying manager underdisturbed to facilitate risk mgmt transactions but must be rolled over and have uptick rule that only allows sales at a price higher than last trans cost for shorts Holdings analysis captures changes in style more quickly and can tell you what a manager holds but it cannot detect style drift like Returns based analysis can and it also is more complicated than returns based analysis Implementation shortfall algorithm has less opportunity cost but more market impact than VWAP algorithm If you are risk averse and consider MVO or are doing portfolio trades or believe in an uptrending market if buying and a downtrending market if selling you will want implementation shortfall as it frontloads trades on in day and considers missed trade opp cost 61 Min Var Ratio = Cov (Asset, Hedge) / VAR (Hedge) Similar to Beta except Var of Mkt = Var of Hedge This is only used for a proxy hedge due to basis risk 62 European Call has Jump to Default Risk (AKA Current Credit Risk) but has potential credit risk equal to the price of the option (NOT THE OPTION PAYOFF) 63 American Call option has current credit risk equal to the price of the option (NOT THE OPTION PAYOFF) 64 Measure the potential credit risk of a currency forward: A Current Spot * ((1 + rf domestic)^n / (1 + rf foreign)^n) = New Forward Rate B ((New Forward Rate - Locked In Forward Rate at purchase) * Foreign Notional) / (1 + rf domestic)^n = PV Domestic Gain to the LONG PV Domestic Gain to the Long = -PV Domestic Gain to the short SPOT = Domestic/Foreign 65 Info Ratio = Info Coeff * SQRT (Breadth) 66 (Asset MV * Asset Dur - Liab MV * Liab Dur) / Equity MV = Equity Dur 67 Spread over mean / STDDEV Spread = Highest will exhibit fastest mean reversion 68 Utility = Port Return - 0.5 * K * VAR (Asset) 69 Last Years Expenses - check and see if you need to increase for inflation 70 Friedman Savage Double Inflection Utility Function: People must be paid a premium to take moderate risks People maximize expected wealth subject to a safety constraint Low income/wealth individuals either chose no or low risk with current wealth (buy insurance) or a high risk with a low probability payout to acquire future wealth (gambling/lottery) High Income /wealth individuals are risk averse with current assets Middle Income/individuals prefer small more fair gambles? Traditional Finance assumes Risk Averse have concave utility curves and convex indifference curve It assumes individuals maximize utility subject to a budget constraint 71 Ways to reduce turnover/transaction costs for indexes: Overlap between categories, buffering rules, less index breadth, multiple variables to measure style, clear and transparent rules that allow indexes to anticipate changes 72 Y = TFP + ALPHA * K + (1 - ALPHA) * L Incentivizing Savings increases K and may increase TFP One time changes don’t affect long term growth More Wealth Redistribution = Lower TFP due to inefficiencies in asset prices Regulations cause one time change More technology = Higher TFP 73 Contingent Immun PV Asset * (1 + (Min or Safety Return / 2))(^n*2) = Required Terminal Required Terminal / (1 + Available Immun / 2)^(n*2) = PV Liab PV Asset - PV Liab = Cushion Spread 74 Traders should not monitor risk it should be independent group that reports to CEO/Board 75 Don’t add two VARs together as there is a diversification benefit 76 Mkt Val Asset / Replace Val Asset = Tobin Q Mkt Val Asset - Mkt Val Liab / (Replace Val Asset - Mkt/Replace Val Liab) = Equity Q B Written IPS which documents compliance with fiduciary standards, adequate invest option selection process IPS is a governing set of principals not an individual IPS C Provide educational resources to assist participants in selecting their own investment objectives and constraints *There are no limits on employer stock in DC plan only a defined benefit plan (which is 10%) *Particpants bear investment risk, employer contributions more stable *Portability of plan and no risk if employer goes bankrupt and participants can choose their investments based upon what works best for them 358 Cash Balance Plan = Defined Benefit Plan only difference is that this used to introduce the concept of investment risk but the accounts value is purely hypothetical 359 High board turnover causing short term focus should be put in unique section of foundation Also if a foundation/endowment has a small amount of trained staff this will probably exempt them from using complicated investments such as alternatives Also remember that minimums on private are typically 5M and you need to be diversified Thus you need a minimum 25M investment in private equity If the endowment is only 50M this will be innappropriate due to huge illiquidity from alt Good rule of thumb is endowment/foundation needs to be at least 250M in size if not 500M 360 Independent foundation - 5% in excess of expenses - Family/Individual Company Sponsor - 5% in excess of expenses - Corp Sponsor - tied to company Operating - 3.33% or 85% of income in excess of expenses - Family/Individual - Has board of Dir and is used to fund research/organization Community - no spend requirement - General Public funds - fund social/education/religions and has board of dir 361 Underwriting cycle - most pronounced for nonlife (aka causality) where competition causes desire for higher returns Portfolios take on more risk and acheive higher returns which leads to cutting of premiums to better compete These cuts to premium usually make the premiums income insufficent to pay for claims which causes reliance on port liquidations to satisfy claims Non-Life are taxable investors and they switch between nontaxable and taxable bonds depending upon where they are in the profitability (underwriting) cycle Growth of surplus is important to maintain competitve stance It’s also extremely important for liquidity due to shift of tax to nontax bonds and due to liquidiations of port to satisfy claims Generally they maintain a T-Bill reserve, are more subject to inflation risk than life insurance as they insure replacement value They have uncertain timing and uncertain cash flow size wheras life insurance just has uncertain timing They can have geographic concentrations which should be noted in unique and rely heavily on income generated by port “Long Tail” describes the payoff to claimants which typically takes years Portion of income relating to actuarial assumed rate to meet claims is generally not taxed Generally short term liabilities They are heavily regulated but not as much as life insurance 362 Prepaid variable forward is a collar + a loan in one security It is not considered a sale for tax purposes and is exempt from US margin rules 363 Joint Ownership, Rights of survivorship, trusts, retirement plans and life insurance all avoid probate 364 Secular Changes in Bonds - there are less put/call features and less long term bonds (so these both command premiums in market) Aggregate duration has decreased (due to less long term bonds) Increased use of credit based derivatives and more non-government international bonds Interm term bullets most popular 365 Long term bullets have most convexity Sinking funds are a series of partial calls which are more convex than a puttable/callable bond when rates rise and have more upside if rates fall IF PURCHASED AT A DISCOUNT 366 As maturity increases credit risk exponentially increases 367 Structure Trade Motivations - From viewpoint of a bond buyer: Puts well for high volatility and rising/flat rates Calls well for low volatility and rising/flat rates Bullets are best for falling rates 368 Motivation for trading on the run is liquidity Curve adjustment is curve position/duration 369 More issuance actually tightens spreads as it provides price confirmation and decreases price uncertainty 370 OAS is used to assess relative value across MBS/Callable/bullet Its main weakness is that it excludes default risk when valuing the option and thus can’t be used for high yield or emerging market debt Less option adjusted issuance has diminished use Another is that it does not account for the volatility of credit spreads For example a year corp bond with an OAS of 100 does not have the same credit risk as a 10 year bond with an OAS of 100 due to higher volatility of spreads the longer the maturity is 371 Credit Default Swap spreads are used for high yield and emerging debt 372 Interest rate swap spreads are not used for high yield/emerging debt They require homogenity (aka vanilla bullet) Used mainly in europe allow comparison of fixed with float debt another benefit is not based on treasury rates 373 Liquidity premium constantly varies but is decreasing over the long term 374 Repo is legally a sale and repurchase wheras prepaid variable forward is not a sale Bank custody is a cheap alternative to physically deliverying a repo collateral 375 Pure indexing is rarely implemented for bonds due to the difficulty and cost of replicating the index due to large number of bonds, illiquidity of some bonds, limited issuance of some bonds, heterogenous nature of bonds, and constantly changing composition of the index 376 Bums Problem - Is related to fixed income indexes that are weighted based upon issuance size The bums who borrow the most have the highest weight which increases the credit risk of the index Equal weighting can reduce this problem but then you have the issue of more illiquidity in the index There are liquid versions of indexes that should be used as benchmarks as most bond indexes are not investable 377 Income/Reinvestment Risk = Decreases if rates rise Market Risk = Duration Risk = Interest Rate Risk = can eliminate by matching duration and convexity (easier to match convexity by matching bond sectors such as MBS and % in callable debt) Issuer Exposure = Event Risk —as a result of default/downgrade Contingent Claim/prepay risk = from callable/MBS debt Yield curve risk —Match key rate duration Spread Risk —-match port spread duration 378 Shifts in the LEVEL of interest rates represent 90% of the changes in the yield curve 379 Compare what credit spreads are baked into the price using arbitrage agreements and forward rates of corporates with forecast 380 inputs for total return analysis A Investment horizon B Expected reinvestment rate C Change in price given interest rate forecast 381 Spread Duration = Duration - Contribution to duration from treasury securities 382 Discount liabilities using implied yield curve of port securities (AKA IRR) Using the treasury spot curve is very conservative way to it 383 Investment Impediments/Restricitions AKA “Segmentation” create relative value opportunities 384 Bottom up = credit plus, Top down = sovereign plus Crossover sectors = BBB and BB credit quality 385 Combination Matching = Horizon Matching = Cash flow match first years then immunized classically afterward 386 Management fees are most important for fixed income where alpha is pretty much nonexistant over the long term 387 Adding an additional manager may be useful if their active return has a low correlation to port active return 388 Cash flow matching starts with last bond/liability and works backward It does not require rebalancing 389 major sources of hedging error: Incorrect duration calc, inaccurate projected basis values, inaccurate yield beta estimate 390 Factor exposures (beta/duration) are calculated as of DATE THE HEDGE IS LIFTED 391 If downside deviation uses average annual return as the threshold return it is called semivariance Con is uses half the dataset and is hard to compute Another Con - Most bonds/options have skewed returns and characteristics that change over time Therefore you cannot solely use either analytical VAR or semivariance for these types of investments as it relies on std dev Historical VAR or monte Carlo VAR are both non parametric It says that shortfall risk is also nonparamentric but I’m really not sure how that’s accurate as in every IPS problem I’ve seen its expected return - * std dev Shortfall risk is also unfamiliar to clients Both Shortfall Risk and VAR approaches not account for magnitude of worst returns wheras semivariance does 392 Risk management is about setting appropriate levels of risk given firms expertise not eliminating risk 393 Market oriented can be the result of an unfocused process Growth risk is that forecasted growth won’t materialize Value risk is that prices are low for a reason 394 Total Return swaps avoid foreign dividend tax 395 Static Hedge - buy and hold to expiry This obviously is a poorer hedge but has lower transaction costs than dynamic hedging Larger the risk aversion, the more dynamic the hedge If holding a foreign asset and the foreign currency is expected to weaken by less than the negative roll yield a risk NEUTRAL investor will not hedge However a risk AVERSE investor will still hedge due to the risk of the forecast being wrong 396 (Spread at Maturity - Strike Spread) * Notional * Risk Factor = Payoff from credit spread option 397 If there are capital controls covered interest rate parity will not hold Thus Forward will not equal Spot * (1 + rf dom) / (1 + rf for) 398 Trade the foward rate bias = carry trade = a bet that UNCOVERED interest rate parity will not hold and you will capture all/part of the interest rate differential between the two countries without much currency movement offsetting gains 399 If hedging a foreign asset with a higher rf rate you will want to sell forward the base foreign currency to receive the price domestic currency Since Spot = (Domestic / Foreign), Forward Rate = Spot * (1 + domestic rf) / (1 + foreign rf) Thus forward rate will be at a discount to spot Rule: If selling at a discount or buying at a premium you will have a negative roll yield approximately equal to the differentials between the rf rates If selling at a premium and buying at a discount you will have a positive roll yield approximately equal to the differential between rf rates Always ask yourself questions A Am I hedging a foreign liability or a foreign asset? If a foreign asset you will want to sell forward the foreign currency Your goal will be to lock in a rate you can convert that foreign asset back to your domestic currency If you have a foreign liability you will want to sell forward your domestic currency Your goal will be to lock in a rate you can convert your domestic dollars to foreign money in order to pay off your foreign liability Selling forward Foreign = Buying Forward Domestic Selling forward domestic = Buying Forward Foreign B What is the base currency? The base currency will always be the subject of the sentence unless otherwise stated On the test they should tell you which one it should be “For pound vs the euro” The pound will be the base currency C What is the forward rate? Based upon A and B you should have all the info you will need to calculate the forward rate Forward Rate = SPOT (P/B) * (1 + rf P) / (1 + rf B) Calculate the foward rate then apply the rule 400 A 5% change in EUR/USD is not the same as a 5% change in USD/EUR When calcuating the domestic return of a foreign asset the equation = Domestic Return = (1 + Local Return) * (1 + currency return) Currency Return = New Spot (Domestic / Foreign) / Old Spot (Domestic / Foreign) - 401 Passive Currency Hedge Goal = minimize tracking error - requires frequent monitoring/rebalance Discretionary Currency Hedge Goal = small mismatches but goal is to reduce risk and make up for costs Active Currency Hedge Goal = outperformance Overlay Currency = Anything outsourced to another manager 402 Qualities that are more likely to make someone want to hedge currency: Short term View Short term liquidity need more risk averse unconcerned with opportunity cost believe in active management positive correlation between Rfx and Rfc Using Bonds (as currency volatility makes up a large portion of a bonds overall volatility and Rfx and Rfc are correlated as interest rates will affect both) *In equities there are little long term effects from hedging in a well diversified portfolio 403 Socially Responsible Investing (SRI) Should be noted in unique and causes a bias to small caps and growth that may require either a custom bench or tilts to correct 404 Reasons Shorts can Outperform Longs A Mgmt more likely to be too optimistic because they own shares/options of their own stock B Barriers to shorting exist (segmentation) C More likely to have buy recommendations than sell recommendations (as don’t want to tick off mgmt or large shareholders) 405 Long Short Mkt Neutral - Earns alpha, symmetric opportunity set and thus more breadth thus higher info ratio, portable, efficient, systematic risk eliminated 406 Pro of equitized market neutral —-Return = Alpha + Beta + Collateral Yield A Suitable for highly efficient markets B Better idea of alpha cost C Can change beta leaving alpha manager undisturbed Con - Alpha and beta not coordinated so less efficient 407 Forecast for good healthcare sector so buy healthcare stocks Breadth = not 408 Semi-active stock based is relative bench weights, has more breadth and higher info ratio than derivative based (which earns alpha via collateral managment) 409 uses of market indexes = market proxy, basis for etfs, instructions for manager/consultant 410 ETFs Pro vs index funds = trades all day, no fund level shareholder accounting, more tax efficient as selling ETF shares to another investor is not a taxable event for the ETF Con - has higher index licensing fees 411 Equity is a better hedge against inflation than bonds but in certain industries where there is strong competitino not all of cost is passed on to consumer 412 Performance Evaluation purpose is feedback and exhaustive quality control check that helps focus attention on poor processes 413 Goal of ERM = comprehensive and optimally allocate risk to most profitable areas whle considering diversification/correlation of risks Place Responsibility on senior management, risk takers seperate from risk reporters, well trained staff, appropriate tech and timely reporting to decision makers, important to anticipate divergence of risk takers incentive with firm 414 Capital allocation has dual objective of capital preservation and profit maximization Nominal limits are easy to understand and calc but shouldn’t be used on a standalone basis VAR Limit - can be supplement or alternative to nominal Allocates based upon exposure Only as accurate as VAR Difficult to calculate and understand Max Loss Limit - always crucial to have this in supplement to any process Internal Capital Requirements - Uses 1% VAR, takes into account VAR diversification Used firmwide for liquidity purposes Regulator Requirements - have to use 415 Mega Cap Buyout - takes public company private Middle Market Buyout - buys private then exits 416 Private Equity typically LP or LLC for limited liability benefit - 10 years with option to extend for High illiquidity and must maintain cash for capital calls Used as a return enhancer not a diversifier as returns linked to IPOs which are linked to market prices LLC is best if you have a small knowledgable group of investors because it allows them to have more control Add Value in ways - restructure operations/improve mgmt, buy company at discount to intrinsic value, increase/restructure leverage Raised money via private placement to wealth investors only which are likely to be pensions, endowments, foundation, family office Have high due dilligence costs TVPI = RVIP + DPI Composite Market Value = PIC * RVPI % of PIC returned to investors = DPI Committed Capital = PIC / PIC Multiple Use Since Inception IRR to compare PE Performance (vintage year matters if performance < years) 417 AUM weighting of hedge fund index will cause index to take on characteristics of best performers as their values will increase and they will become higher weights Also new money chases past performance causing AUM to increase as well Can use equal weight to correct this bias but it comes at a cost of investability 418.Survivorship bias largest for currency / hedged equity hedge funds This can be reduced via due dilligence or by using a FOF (but will get additional fee layer with FOF) 419 PE Distressed Debt has - Market Risk, J-Factor Risk (Judge), Liquidity Risk, Event Risk If you have a high risk tolerance & long term horizon there is relatively low risk in long run with good opportunity for positive active returns due to segmentation (restrictions other investors have) and due to small sell side coverage Large negative Skew and Excess Kurtosis Long Reorganized Equity = Orphan Equity Long the bond short the stock = Distressed Debt Arbitrage Does well if goes bankrupt as the stock will decline to but bond will be worth something Does well if doesn’t go into bankruptcy as there will still be little chance stock will earn a profit anytime soon but bond will improve in price as there won’t be any default or partial default 420 Seed Stage / Startup Stage and Stage are forming the idea, forming the product and starting production Typically entered into by a VC or Angel investor Called the “Formative Stage” Stage and Mezzanine typically done with VC or Strategic Partners (large corporations who engage in corporate venturing) 421 Factors to consider with clients for alternatives - Tax issues, suitability, illiquidity, decision risk (risk they will panic and want to sell at worst time), communication with client, concentration in other stocks 422 50 Delta Option = ATM Call -50 Delta Option = ATM Put 25 Delta Option = OTM Call -25 Delta Option = OTM Put 75 Delta Option = ITM Call -75 Delta Option = ITM Put 423 Use currency swaps to take advantage of fact that domestic banks give domestic borrowers better rates because they are more familiar with them 424 Dual currency bond = principal in domestic currency, coupon payments in foreign currency Useful if corp generates enough foreign revenue to be able to pay coupons but not to pay the principal Equivalent to domestic bond + swap with no notional exchange 425 Structured notes are created to help investors get around constraints Are bonds that are linked to equity indexes or are levered 426 Discretionary Trust = Creditor Protection Fixed Trust = No creditor protection 427 Foreign Banks became QIS to protect non-us customer confidentiality 428 If rainfall is correlated with corn prices: Rainfall may influence corn prices but corn prices obviously not influence rainfall If looking at factors that influence rainfall corn prices would be considered exogenous 429 If an investor perceives their wealth to be large relative to their needs they will have more risk willingness 430 Only asset manager firms can claim compliance with GIPS 431 Differences of Private Equity vs Public Equitiy - Deal structure negotiated with manager and investors, can access internal projections, board participation by investors 432 Cram Down - when a judge overrules a dissenting class of creditors invalidating the priority rule The objecting creditors must receive property of equal value OR anyone below them (junior) gets nothing 433 New Value Exception - Retain equity interest in banktruptcy by new capital contribution 434 Due Dilligence for Alternatives - Opportunity, Process, Org, People, Terms/Structure, Service Providers, Documents, Write up GIPS CHART - MUST HAVE Port Return (include ITD if less than years, if have 11 years performance must include 10 years, cannot annualize anything less than a year) Bench Return Annualized ex post year stddev (start 2011) % Firm Assets or both Composite assets and total firm assets # of Ports in composite (if greater than 5) Internal Dispersion Figures (if greater than 5) GIPS CHART - MAY NEED IF % non fee pay (if non fee pay) % carveouts (if any 2006 - 2009) % bundled/wrap fee (if used) GIPS DISCLOSE - MUST HAVE Composite Description, creation date (NOT BOILERPLATE) Benchmark Description Firm Description Availability of Full composite list, valuation policies, policy for calc return, policy for prep compliant report Fee Schedule Currency Gross/Net Fees Internal Dispersion Metric Used GIPS DISCLOSE - MAY NEED Composite Redefinition, date and reason 10 Firm Redefinition, date and reason 11 If valuation used unobservable input or differed from GIPS heirarchy 12 Cash allocation policy (if carveouts used) 13 Signficant employee turnover (if applicable) 14 If believe ex post stddev is not adequate why u feel that way also include second ex post risk metric IN ADDITION NOT REPLACING 15 If Subadvisor use what their expertise is and periods you used them 16 Components of bundled fee (if any) 17 Details of withholding tax (if a global equity strategy) 18 Extent and use of leverage if material and KEY risk factors that would help investor understand NOT BOILERPLATE 19 If the Composite name changed (don’t need reason) 20 If laws conflict the nature of the conflict (must comply with the local law) 21 Availability of verification report (if verified) 22 If significant cash flow policy, then what it is GIPS NOTES Must be asset weighted composites (begin of month or method that incorp cash flows) valued at least monthly after 2010 or on date of large external cash flows Definition of large is per composite 2001 - 2010 was just monthly Cannot link simulated (but can provide as supplementary info) Must keep records to back calcs Custody Fee = Mgmt expense Gross of fees must be after actual trading expenses if you can’t get the actual ones then gross must be net the bundled portion that includes the actual Cannot use estimated Additionally if gross is net of anything other than actual trading expenses must disclose Can link pre 2000 noncompliant but must disclose Trade Date Accounting (not settlement) Accrual Accounting for bonds (not cash) Fair Value to value (not market) If large external cash flow comes in can either separate subaccount or exclude account from composite on month end PRIOR TO INFLOW and put back in a timely manner (as defined by policy) Nondiscretionary included in total firm assets but not in any composite Discretionary fee paying must be in at least composite and should be in every composite for which they meet the definition of 10 Cannot say in a general presentation calculated in accordance with GIPS unless reporting individual performance in one on one meeting to client 11 No partial verification cannot just verify a composite 12 Must include cash in total returns no matter what 13 Definition of discretion in policy and consistent application 14 Must obey firms policy 15 No carveout after Jan 2010 16 Discontinued composites kept for years 17 Cannot remove historical performance from a composite Can only change prospectively 18 Non-Fee paying discretionary MAY be included in composite but must disclose % 19 Core GIPS Principle: A Adhere to law, B Properly Define Firm, C Provide compliant presentation to all prospects D Ensure not false or misleading 20 If you get the call that client has died on July 11th and instructed to stop trading, must show performance through end of June (last full period) 21 Definition of firm is ultimately determined by how the firm holds itself out to clients Must have autonomous processes and decision makers 22 Policies - discretion definition, error correction policies, methods for valuing investments, definition of large cash flow, firm definition, inclusion of new acct policies, significant cash flow policies, etc GIPS Reccomended: Should be veriried Adopt broadest meaning of firm provide presentations to clients for any composite client is included in annually Value port on all cash flows regardles sof size 3rd party valuations (dont change just to look better) accrue mgmt fees for net of fees Accrue reclaimable withholding Disclose if composite contains proprietary asset New cash flows in temporary account preferred 10 not present a composite that has a minimum value if you know client can’t meet the minimum 11 list other firms within parent company 12 disclose key assumptions used to value port, any changes to processes/calc methods 13 Key differences between strategy and bench disclosed 14 gross and net of fees should not be reduced for admin expenses (firm cant control this?) 15 Present cumulative composite returns for all periods as well as annualized 16 present equal weighted mean and median returns 17 Update composites quarterly 18 Present additional post risk measures 19 present compliant returns for all periods 20 Rotate appraisers - years Exclusion from Real Estate REIT, MBS, Private Debt/Comm Loans/Resid Loans (with no equity participation) Exclusion from Private Equity Open ended/evergreen funds Real estate Required Valued quarter end External value every year or at least every years if client agrees by pro appraiser Gross return after all transaction costs Separate income and capital return show components description of discretion Methods and frequency of valuation Period of noncompliance SI-IRR using quarterly cash flows disclose frequency 10 Composite vintage year and vintage definition (year of first draw or year when commit capital closed) 11 Liquidation date and net of fees SI IRR through liquidation date 12 SI IRR of bench which must have same vintage year 13 Present Cum Committ capital 14 RVPI, DPI, TVPI, PIC Multiple, SI distributions, SI PIC Private Equity valued annually at fair value SI-IRR daily cash flows (all real estate crap) frequency of cash flows prior to 2011 Indexes used in calculating public market equiv bench gross and net SI IRR through liquidation PE Fund of Funds (closed end) must provide SI IRR of underly funds aggregated by vintage year PE Fund of Funds (closed end) must give % in direct investments and % in fund vehicles SMA Not applicable to UMA, supplement ordinary GIPS Include all SMAs for same mandate cant split out by manager Must present performance net of entire wrap fee (your own + SMA fee) Cannot just show a managers GIPS to clients/prospects because then it wont be net of the entire wrap fee If you are the SMA manager and are giving it to investment firm using you you must write “ONLY FOR USE OF NAMED SPONSOR” on the report so it can’t be given to clients/prospects Must disclose contingent fees GIPS ADVERTISING If going to more than one relationship then advertising Must include the following things: X Claims compliance with Global Investment Performance Standards Info on how to obtain compliant presentation and composite list Definition of Firm IF ALSO INCLUDING PERFORMANCE THEN YOU MUST ALSO INCLUDE: composite description Gross/net Currency Period of noncompliance Benchmark description Benchmark performance for matching periods Leverage/derivatives/short use if material Everything must match compliant presntation Either: 1, 3, yr annualized through most recent period OR YTD, 1Yr, 3yr, 5yr OR YTD + calendar years If less than years then also ITD performance VERIFICATION DOES NOT GUARANTEE ACCURACY IT IS ONLY USED TO BOLSTER CREDIBILITY OF CLAIM OF COMPLIANCE MUST VERIFY WHOLE FIRM MINIMUM VERIFICATION PERIOD OF YEAR CANT STATE YOU ARE VERIFIED UNLESS A REPORT HAS BEEN ISSUED VERIFIER SHOULDN”T ISSUE A REPORT IF THEY KNOW YOU ARE NOT IN COMPLIANCE THEY USE A SAMPLING OF ACCOUNTS TO ASSESS DISCRETIONARY, COMPOSITE INCLUSION, AND APPLYING POLICY CONSISTENTLY ASSET MANAGER CODE (THINGS THAT ARE IN ADDITION TO NORMAL CODE AND STANDARDS) Required: Compliance officer Have policies and procedures that uphold code Keep records (generic) Arrange a 3rd party (independent) review of port info to ensure accuracy (compliance counts) Hire qualified staff to make and monitor decisions Establish continuity plan (generic) based upon size and scale Firmwide risk management process (generic) that measures and manages risk You are liable for any outsourced work but you can outsource work per the code Must disclose the following: A Disciplinary actions/warnings (regulators or current employer) B Conflicts of interest C Invest Process (lock up, risk factors, leverage/derivatives) D Mgmt fee, components, fee schedule E Amount of soft dollars & how they benefit client F regular and timely performance (generic) G Valuation methods H Proxy vote and trade allocation policies I Audit results J Personell changes K Risk mgmt policies Recommended Asset manager Code Quarterly performance within 30 days of quarter end Keep records years in absence of regulations Update IPS annually or if circumstances dictate sooner (role and responsibilites of manager and bench included in IPS) Disclose estimated fee & Details along with average actual fees & other contingent fees charged to existing clients Gift/Entertainment policy where gifts over a certain value are refused Can temporarily deviate from mandate but client msut agree to flexibility in advance AND must disclose event to client during normal reporting Consider clients outside assets Preapproval process for IPO/Private participation Provide written acknowledgment that client directed trades may limit best execution 10 Any permanent change in style or change in investment process must be adequately disclosed to client IN ADVANCE OF CHANGE 11 Privacy policy for client info 12 No short term performance comp arrangements 13 Continously challeng risk models and describe to clients 14 Disclose valuation methods in a meaningful way 15 Regular disclosure of specific risk info regarding strategies and what metrics they can expect to receive at a product level 16 Disclosures on how client can obtain info on how their proxy vote was cast, systems to monitor outsourcing of proxy voting, guidance on whether additional action warranted if company management is voted against Guidelines for regular reviews of proxy issues ... Point Adjust the forward point based upon number of decimals in quotes Spot = 1.42 Forward points = Forward rate will equal 1.42 + 9/100 = 1.51 Spot = 1.423 Forward Points = 20 Forward rate will... SIDE Forward Point If changing the notional in step A and step C for whatever reason then: Spot transaction will be the SIDE SPOT Forward Rate will be SIDE Spot + Adjusted SIDE Forward Point Adjust... liquid, more cost effective, and easier to short vs cash market 151 Max Drawdown = LARGEST (High point - subsequent low) 152 Act of God/terrorism/input errors = Operational Risk Use wrong model