CFA® Level III Formula Sheet – 2023 Syllabus ECONOMICS ECONOMICS CAPITAL MARKET EXPECTATIONS: CAPITAL MARKET FRAMEWORK ANDEXPECTATIONS: MACRO FRAMEWORK AND MACRO CONSIDERATIONS CONSIDERATIONS A Decomposition of GDP Analysis to CME - One commonly used framework decomposes a country’s aggregate trend growth rate into two parts: labor inputs and labor productivity. - The components of the labor input are: o Growth in potential labor force size. o Growth in actual labor force participation. - The components of labor productivity are: o Growth from increasing capital inputs. o Growth in total factor productivity (TFP). Anchoring Asset Returns to Trend Growth The trend GDP growth rate is linked to equity prices, as captured by the following formula: ππ = πΊπΊπΊπΊπΊπΊ × ππ × ππππ where - V: aggregate value of equity - GDP: level of nominal GDP - S: share of earnings relative to the overall economy - PE: market price-to-earnings ratio Monetary Policy Taylor Rule To determine where the policy rate should be set, central banks can use the Taylor rule: ππ ∗ = π π " + πΌπΌ# + .0.52πΊπΊπΊπΊππ# − πΊπΊπΊπΊππ$ 4 + 0.52πΌπΌ# − πΌπΌ$ 45 where - ππ ∗ : optimal nominal policy rate - π π " : neutral real policy rate - πΊπΊπΊπΊππ# : expected GDP growth rate - πΊπΊπΊπΊππ$ : long-term trend GDP growth rate - πΌπΌ# : expected inflation - πΌπΌ$ : inflation target Macroeconomic Linkages The link between current and capital accounts is expressed as follows: (ππ − ππ) = (ππ − πΌπΌ) + (ππ − πΊπΊ) where - X: exports - M: imports - S: domestic savings - I: domestic investment - T: taxation - G: government spending CAPITAL EXPECTATIONS: CAPITAL MARKET MARKET EXPECTATIONS: FORECASTING ASSET CLASS RETURNS FORECASTING ASSET CLASS RETURNS The Building Block Approach to Fixed-Income Returns The building block model breaks a bond’s YTM into the components that compensate investors for various risks. www.saltsolutions.com Component Compensation for One-period default risk-free rate Interest rate risk + Credit premium Credit/Default risk + Term premium + Liquidity premium Duration risk Illiquidity DCF Approach to Equity Returns Gordon Growth Model π·π·& πΈπΈ(ππ% ) = + ππ ππ' Grinold-Kroner Model π·π·& πΈπΈ(ππ% ) ≈ − % π₯π₯π₯π₯ + %π₯π₯π₯π₯π₯π₯ + %π₯π₯π₯π₯ ππ' where - %π₯π₯π₯π₯: nominal rate of earnings growth - %π₯π₯π₯π₯π₯π₯: change in the P/E ratio - % π₯π₯π₯π₯: change in the number of shares outstanding The Singer-Terhaar Model - The model estimates risk premiums for assets (or asset classes) based on their degree of integration with the global market portfolio. - Risk premium assuming full integration: π π ππ( = ππ(,* ππ( × ππππππππππππ ππβππππππππ π π π π π π π π π π - Risk premium assuming complete segmentation: π π ππ( = ππ( × ππππππππππππ ππβππππππππ π π π π π π π π π π - The Singer-Terhaar asset risk premium is simply the weighted average of the fully-integrated and completely segmented risk premiums. Forecasting Real Estate Returns ππππππ πΆπΆπΆπΆπΆπΆ ππππππππ = ππππππππππ πΈπΈ(π π +% ) = πΆπΆπΆπΆπΆπΆ ππππππππ + %π₯π₯π₯π₯π₯π₯π₯π₯ For finite time periods: πΈπΈ(π π +% ) = πΆπΆπΆπΆπΆπΆ ππππππππ + %π₯π₯π₯π₯π₯π₯π₯π₯ − %π₯π₯π₯π₯π₯π₯π₯π₯ ππππππππ Estimating Volatility from Smoothed Returns π π $ = (1 − ππ)ππ$ + πππ π $,& 1 + ππ ππππππ(ππ) = O P ππππππ(π π ) > ππππππ(π π ) 1 − ππ Time-Varying Volatility: ARCH Models - ) + π½π½(ππ$- − ππ$,& ππ$- = πΎπΎ + (πΌπΌ + π½π½)ππ$,& where - ππ$- : variance of a single asset - πΎπΎ: a constant - ) - π½π½: the effect of a “shock” (ππ$- − ππ$,& - πΌπΌ + π½π½: mean reversion DERIVATIVES DERIVATIVES OPTION STRATEGIES OPTION STRATEGIES Put-Call Parity ππ' + ππ' = ππ' + ππ (1 + ππ). ππ' − ππ' = ππ' − ππ (1 + ππ). Synthetic Positions Forward Call ππ' = ππ' − Put ππ' = ππ + ππ' (1 + ππ). ππ − ππ' + ππ' (1 + ππ). where - ππ' : time-0 stock price - ππ' : time-0 put price - ππ' : time-0 call price - / (&2+)! : strike price ππ, discounted at risk-free rate ππ for a period of ππ years Useful Greeks Delta πΆπΆβππππππππ ππππ π£π£π£π£π£π£π£π£π£π£ ππππ ππππππππππππ β≈ πΆπΆβππππππππ ππππ π£π£π£π£π£π£π£π£π£π£ ππππ π’π’π’π’π’π’π’π’π’π’π’π’π’π’π’π’π’π’π’π’ Gamma πΆπΆβππππππππ ππππ π£π£π£π£π£π£π£π£π£π£ ππππ ππππππππππ π€π€ ≈ πΆπΆβππππππππ ππππ π£π£π£π£π£π£π£π£π£π£ ππππ π’π’π’π’π’π’π’π’π’π’π’π’π’π’π’π’π’π’π’π’ Vega πΆπΆβππππππππ ππππ π£π£π£π£π£π£π£π£π£π£ ππππ ππππππππππππ π£π£ ≈ πΆπΆβππππππππ ππππ π£π£π£π£π£π£π£π£π£π£ ππππ π£π£π£π£π£π£π£π£π£π£π£π£π£π£π£π£π£π£π£π£ Theta (Θ) Indicator of an option price’s sensitivity to the passage of time (usually negative). Covered Call Covered call = Written call + Long stock πΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈ π£π£π£π£π£π£π£π£π£π£ = ππ. − ππππππ[(ππ. − ππ), 0] ππππππππππππ ππππ ππππππππππππ = ππ. − ππππππ[(ππ. − ππ), 0] + ππ' − ππ' Investment objectives: - Yield enhancement - Reducing a position at a favourable price - Target price realization Protective Put Protective Put = Long put + Long stock πΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈ π£π£π£π£π£π£π£π£π£π£ = ππ. + ππππππ[(ππ − ππ. ), 0] ππππππππππππ ππππ ππππππππππππ = ππ. + ππππππ[(ππ − ππ. ), 0] − ππ' − ππ' Investment objectives: - Protects against losses in the underlying asset Copyright © 2023 Salt Solutions. All Rights Reserved. Personal copies permitted. Resale or distribution is prohibited. 1 Bull Spreads and Bear Spreads Buy Sell Call Bull Spread Put Bull Spread Low-strike call Low-strike put High-strike call High-strike put Expiration Value for Call Bull Spread = ππππππ[(ππ. − ππ4 ), 0] − ππππππ[(ππ. − ππ5 ), 0] Profit Call Bull Spread = ππππππ[(ππ. − ππ4 ), 0] − ππππππ[(ππ. − ππ5 ), 0] − (ππ4 − ππ5 ) where - ππ. : time-T stock price - ππ4 : lower strike price - ππ5 : higher strike price - ππ4 : call premium with lower strike price - ππ5 : call premium with higher strike price Buy Sell Call Bear Spread Put Bear Spread High-strike call High-strike put Low-strike call Low-strike put Expiration Value for Put Bear Spread = ππππππ[(ππ5 − ππ. ), 0] − ππππππ[(ππ4 − ππ. ), 0] Profit Put Bear Spread = ππππππ[(ππ5 − ππ. ), 0] − ππππππ[(ππ4 − ππ. ), 0] −(ππ5 − ππ4 ) where - ππ. : time-T stock price - ππ4 : lower strike price - ππ5 : higher strike price - ππ4 : put premium with lower strike price - ππ5 : put premium with higher strike price Straddle Straddle = Long call + Long put (same strike) Expiration Value for Straddle = ππππππ[(ππ. − ππ), 0] + ππππππ[(ππ − ππ. ), 0] Profit of Straddle = ππππππ[(ππ. − ππ), 0] + ππππππ[(ππ − ππ. ), 0] − ππ' − ππ' Collar (on Existing Holding) Collar = Long put + Short call + Underlying asset Expiration Value for Collar (ππ& > ππ- ) = ππ. + ππππππ[(ππ& − ππ. ), 0] − ππππππ[(ππ. − ππ-), 0] Profit of Collar (ππ& > ππ-) = ππ. + ππππππ[(ππ& − ππ. ), 0] − ππππππ[(ππ. − ππ- ), 0] − ππ' − ππ' + ππ' Calendar Spread Combination of options with same strike prices but different expiration times. Long calendar spread: - Buy longer-term call, sell shorter-term call - Buy longer-term put, sell shorter-term put www.saltsolutions.com Volatility Conversion ππ:"";(8 ππ*<"$=89 = ππ6(789 = √252 √21 Futures Hedge Other Key Terms: - Implied volatility: derived from option pricing model - Realized volatility: historical observed volatility - Volatility smile: u-shaped volatility curve - Volatility skew: implied volatility increases for OTM puts but decreases for OTM calls - Risk-reversal: long call and short put on same underlying with same time to expiration - Term structure of volatility: implied volatility according to different maturities of option - Implied volatility surface: 3D plot of days to expiration, option strike prices, and implied volatilities Identifying Appropriate Strategies For implied volatility and underlying asset: Volatility Bearish Decrease Write calls Buy puts + Write calls Same Increase Buy puts Neutral Write straddle Calendar spread Buy straddle SWAPS, FORWARDS, SWAPS, FORWARDS,AND ANDFUTURES STRATEGIES FUTURES STRATEGIES Bullish Write puts Buy calls + Write puts Buy calls Interest Rate Swaps Notional value of Swap ππππππππ. − ππππππππ? ππ> = O P ππππ? ππππππππ> where - ππππππππ? : portfolio’s modified duration - ππππππππ> : modified duration of the swap - ππππππππ. : portfolio’s targeted modified duration - ππππ? : portfolio’s market value Fixed-Income Futures Principal Invoice Amount for CTD Bond @;$;+%A >%$$8%B%"$ ?+7C% =f g × πΆπΆπΆπΆ × πΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆ ππππππππ &'' where - CF: Conversion factor of CTD bond βππ P × πΆπΆπΆπΆ βπΆπΆπΆπΆπΆπΆ π΅π΅π΅π΅π΅π΅. − π΅π΅π΅π΅π΅π΅? ππ# = O P × πΆπΆπΆπΆ π΅π΅π΅π΅π΅π΅D.6 π»π»π»π»π»π»π»π»π»π» π π π π π π π π π π = O where - π΅π΅π΅π΅π΅π΅. is targeted basis point value for the bond portfolio - π΅π΅π΅π΅π΅π΅? is the bon portfolio’s current basis point value - π΅π΅π΅π΅π΅π΅D.6 is the basis point value of the CTD bonds in the futures contract ππππππππ. − ππππππππE ππ ππ# = O P O P × πΆπΆπΆπΆ πΉπΉ ππππππππD.6 where - πππππππ π . : portfolio’s targeted modified duration - ππππππππE : bond portfolio’s current modified duration - ππππππππD.6 : modified duration of the CTD bond - P: market value of the bond portfolio - F: market value of the futures contract as product of future contract’s size and the price of the CTD bond per 100 par Equity Forwards and Futures π½π½. − π½π½> ππ ππ# = l mO P πΉπΉ π½π½# where - π½π½. is the target beta - π½π½> is the equity portfolio’s current beta - π½π½# is the beta of the futures contract - ππ is the value of the equity portfolio - πΉπΉ is the value of the futures contract as a product of the contract price and multiplier Derivatives on Volatility Variance swaps ππππππππππππππππ ππππππππππππππππ = O ππππππππ πππππ‘π‘π‘π‘π‘π‘π‘π‘π‘π‘π‘π‘ P 2 × ππππππππππππ ππππππππππππππππππππ π΄π΄π΄π΄π΄π΄π΄π΄π΄π΄π΄π΄. = (ππππππππππππππππ ππππππππππππππππ)(π π π π π π π π π π π π π π π π π£π£π£π£π£π£π£π£π£π£π£π£π£π£π£π£ − ππππππππππππππππ π π π π π π π π π π π π ) ππππππππππππππ$ = ππππππππππππππππ ππππππππππππππππ × ππππ$ (ππ) π‘π‘ × O × [π π π π π π π π π π π π π π π π ππππππ(0, π‘π‘)]ππ ππ − π‘π‘ + ππ × [πΌπΌπΌπΌπΌπΌπΌπΌπΌπΌπΌπΌπΌπΌ ππππππ(π‘π‘, ππ)]− ππππππππππππ - P where - ππππ$ (T) is the value of $1 at time π‘π‘ which will mature at time ππ - π π π π π π π π π π π π π π π π ππππππ(0, π‘π‘) is the realized volatility from time 0 to time π‘π‘ - πΌπΌπΌπΌπΌπΌπΌπΌπΌπΌπΌπΌππ ππππππ(π‘π‘, ππ) is the implied volatility remaining in the period (ππ − π‘π‘) Copyright © 2023 Salt Solutions. All Rights Reserved. Personal copies permitted. Resale or distribution is prohibited. 2 CURRENCY MANAGEMENT: CURRENCY MANAGEMENT: AN INTRODUCTION AN INTRODUCTION Domestic Currency Return π π 6D = (1 + π π @D )(1 + π π @/ ) − 1 where - π π 6D is the domestic-currency return (in percent) - π π @D is the foreign-currency return (in percent) - π π @/ is the percentage change in the foreign currency against the domestic currency Approximations: π π 6D ≈ π π @D + π π @/ - - - ππ (π π 6D ) ≈ ππ (π π @D ) + ππ (π π @/ ) + 2ππ(π π @D ) β ππ(π π @/ ) β ππ(π π @D , π π @/ ) Uncovered Interest Rate Parity %βππ5/4 ≈ ππ5 − ππ4 - %βππ5/4 is percentage change in the ππ5/4 spot exchange rate (low-yield currency is base currency) - ππ5 is interest rate on high-yield currency - ππ4 is the interest rate on low-yield currency Minimum-Variance Hedge Ratio ππ9 πΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆ (π¦π¦, π₯π₯) = ππ9,G O P ππππππππππππππππ(π₯π₯) ππG FIXED INCOME FIXED INCOME OVERVIEW OF FIXED-INCOME OVERVIEW OF FIXED-INCOMEPORTFOLIO MANAGEMENT PORTFOLIO MANAGEMENT Roles of Fixed-Income Securities in Portfolios - Diversification Benefits - Benefits of Regular Cash Flows - Inflation Hedging Potential Fixed-Income Mandates Liability-Based Mandates - Cash flow matching - Duration matching - Contingent immunization - Horizon matching Total Return Mandates - Pure indexing - Enhanced indexing - Active management Effective Duration and Effective Convexity ππππ, − ππππ2 πΈπΈπΈπΈπΈπΈ6;+ = 2 ⋅ π₯π₯π₯π₯π₯π₯π₯π₯π₯π₯π₯π₯ ⋅ ππππ' ππππ, + ππππ2 − 2 ⋅ ππππ' πΈπΈπΈπΈπΈπΈD<" = (π₯π₯π₯π₯π₯π₯π₯π₯π₯π₯π₯π₯)- ⋅ ππππ' www.saltsolutions.com Decomposition of Expected Returns πΈπΈ[π π ] ≈ πΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆ ππππππππππππ ± π π π π π π π π π π π π π π π π ππππππππππππ ± πΈπΈ[ππππππππππ β ππππππππ ππππππππβππππππππ π¦π¦π¦π¦π¦π¦π¦π¦π¦π¦π¦π¦ ] ± πΈπΈ[ππππππππππ β ππππππππ π¦π¦π¦π¦π¦π¦π¦π¦π¦π¦ π π π π π π π π π π π π π π ] ± πΈπΈ[ππππππππππ β ππππππππ ππππππππππππππππ π£π£π£π£π£π£π£π£π£π£ ππβππππππππππ] π΄π΄π΄π΄π΄π΄π΄π΄π΄π΄π΄π΄ ππππππππππππ ππππππππππππππ πΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆ ππππππππππππ = πΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆ ππππππππ ππππππππππ π π π π π π π π π π π π π π π π ππππππππππππ π΅π΅π΅π΅π΅π΅π΅π΅ ππππππππππH"I − π΅π΅π΅π΅π΅π΅π΅π΅ ππππππππππE%J7""7"J = π΅π΅π΅π΅π΅π΅π΅π΅ ππππππππππE%J7""7"J πΈπΈ[ππππππππππ β ππππππππ ππππππππβππππππππ π¦π¦ππππππππππ ] = −ππππ(βππππππππππ) 1 + (πΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆ)(βππππππππππ)2 where - MD: modified duration Leveraged Portfolio Return ππππππππππππππππππ ππππππππππππ ππK (ππH + ππE ) − ππE ππE ππ? = = ππππππππππππππππππ ππππππππππππ ππH ππE = ππK + (ππK − ππE ) ππH where - ππK : return on invested funds - ππE : borrowing rate Futures Leverage πΏπΏπΏπΏπΏπΏπΏπΏπΏπΏπΏπΏπΏπΏπΏπΏ@;$;+%A = ππππππππππππππππ π£π£π£π£π£π£π£π£π£π£ − ππππππππππππ ππππππππππππ Dollar Interest in Repurchase Agreement π·π·π·π·π·π·π·π·π·π·π·π· ππππππππππππππππ = ππππππππππππππππππ ππππππππππππ × π π π π ππππ ππππππππ × (ππππππππ ππππ ππππππππ ππππ ππππππππ /360) Rebate Rate in Securities Lending π π π π π π π π π π π π ππππππππ = πΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆ ππππππππππππππππ ππππππππ − ππππππππππππππππ ππππππππππππ ππππππππ LIABILITY-DRIVEN AND & INDEX-BASED LIABILITY-DRIVEN STRATEGIES INDEX-BASED STRATEGIES Convexity πΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆ (ππππππππππππππππ ππππππ. )- + ππππππππππππππππ ππππππ. +π·π·π·π·π·π·π·π·π·π·π·π·π·π·π·π·π·π·π·π· = (1 + πΆπΆππππβ ππππππππ π¦π¦π¦π¦π¦π¦π¦π¦π¦π¦ )Duration ππππππππππ ππππππππππππππππ = ππππππππππππππππ ππππππππππππππππ × ππππππππππππ ππππππππππ ππππππππππππππππ ππππππππππππππππ = ππππππππππππππππ ππππππππππππππππ ππ 1+ ππ # Futures Contracts (for Immunization) πΏπΏπΏπΏπΏπΏπΏπΏπΏπΏπΏπΏπΏπΏπΏπΏπΏπΏ ππππππππππππππππππ π΅π΅π΅π΅π΅π΅ = π΄π΄π΄π΄π΄π΄π΄π΄π΄π΄ ππππππππππππππππππ π΅π΅π΅π΅π΅π΅ + 2ππ# × πΉπΉπΉπΉπΉπΉπΉπΉπΉπΉπΉπΉπΉπΉ π΅π΅π΅π΅π΅π΅4 where: E?L"!# - πΉπΉπΉπΉπΉπΉπΉπΉπΉπΉπΉπΉπΉπΉ π΅π΅π΅π΅π΅π΅ ≈ D@"!# - πΆπΆπΆπΆD.6 : conversion factor for the CTD security - A positive ππ# implies buying futures contracts - A negative ππ# implies selling futures contracts Accumulated & Projected Benefit Obligation 1 ππ × πΊπΊ × ππ' 1 ~ ×} − π΄π΄π΄π΄π΄π΄ = (1 + ππ). ππ ππ × (1 + ππ)M ππππππ = ππ × πΊπΊ × ππ' × (1 + π€π€). (1 + ππ). 1 1 ~ ×} − ππ ππ × (1 + ππ)M where: - ππ: percentage of final salary - πΊπΊ: number of years worked - ππ' : current salary - π€π€: wage growth - ππ: discount rate on high-quality corporate bonds - ππ: years until retirement - ππ: years after retirement Swap Notional Principal to Close Duration Gap ππππππππ π΅π΅π΅π΅π΅π΅ ~ πΏπΏπΏπΏπΏπΏπΏπΏπΏπΏπΏπΏπΏπΏπΏπΏπΏπΏ π΅π΅π΅π΅π΅π΅ = π΄π΄π΄π΄π΄π΄π΄π΄π΄π΄ π΅π΅π΅π΅π΅π΅ + }ππππ × 100 Full Interest Rate Hedging (π΄π΄π΄π΄π΄π΄π΄π΄π΄π΄ π΅π΅π΅π΅π΅π΅) × (βπ΄π΄π΄π΄π΄π΄π΄π΄π΄π΄ π¦π¦π¦π¦π¦π¦π¦π¦π¦π¦π¦π¦) + (π»π»π»π»π»π»π»π»π»π» π΅π΅π΅π΅π΅π΅) × (βπ»π»π»π»π»π»π»π»π»π» π¦π¦π¦π¦π¦π¦π¦π¦ππππ) ≈ (πΏπΏπΏπΏπΏπΏπΏπΏπΏπΏπΏπΏπΏπΏπΏπΏπΏπΏ π΅π΅π΅π΅π΅π΅) × (βπΏπΏπΏπΏπΏπΏπΏπΏπΏπΏπΏπΏπΏπΏπΏπΏπΏπΏ π¦π¦π¦π¦π¦π¦π¦π¦π¦π¦π¦π¦) YIELD CURVE CURVE STRATEGIES STRATEGIES YIELD Butterfly spread = −Short-term yield +2 Mediumterm yield −Long-term yield Duration Approximation 1 × πΆπΆ × (βππ)2 Sensitivity of a Bond Futures to Changes in Yield π΅π΅π΅π΅π΅π΅D.6 πΉπΉπΉπΉπΉπΉπΉπΉπΉπΉπΉπΉπΉπΉ π΅π΅π΅π΅π΅π΅ ≈ πΆπΆπΆπΆD.6 Sensitivity of a Swap to Changes in Yield ππππππππ ππππππππππππππππ ππππππππ π΅π΅π΅π΅π΅π΅ ≈ ππππππππππππ>N(O × 10,000 %π₯π₯ππππ @;88 ≈ −π·π· × βππ + where - ππ is the annualized cash flow yield - ππ is the compounding periods per year Copyright © 2023 Salt Solutions. All Rights Reserved. Personal copies permitted. Resale or distribution is prohibited. 3 FIXED FIXED INCOME INCOME ACTIVE ACTIVE MANAGEMENT: MANAGEMENT: CREDIT STRATEGIES CREDIT STRATEGIES Credit Risk A borrower's credit risk is determined by default risk and loss severity. - Default risk: Measured by the probability of default (POD) - Loss severity: Measured by the loss given default (LGD). It can be calculated as LGD = 1 – RR, where RR is the recovery rate Over a single period, a bond's credit spread can be approximated as ππππππππππππ ≈ ππππππ × πΏπΏπΏπΏπΏπΏ. Fixed-Rate Bond Credit Spread Measures - Benchmark spread (yield spread): The difference between the yields on a risky bond and an onthe-run government bond with a similar maturity. - G-spread (government spread): The difference between a bond's yield and an interpolated government bond yield. - I-spread (interpolated spread): The difference between a bond's yield and a swap rate, or market reference rate (MRR), rather than the government yield. This measure relies on a single point on the curve and it can only be used for option-free bonds. - Asset swap spread (ASW): The difference between a bond's coupon rate and the MRR on a swap of the same maturity. - Z-spread (zero-volatility spread): The constant spread that is added to each point on the government spot curve to force the present value of a bond's future cash flows to equal its current market value. This can only be used for bonds without embedded options. - CDS basis: The difference between a bond's Zspread and the spread on credit default swaps (CDS) of the same (or interpolated) maturity for the issuer - Option-adjusted spread (OAS): This is very similar to the Z-spread but it also works for bonds with embedded options. This measure is highly dependent on assumptions about interest rate volatility and prepayment speed. Floating-Rate Note Credit Spread Measures Floating-rate notes (FRNs) make payments based on a variable MRR. - Coupon rate: Determined by taking the sum of the MRR and a quoted margin (QM) - Discount rate: Determined by taking the sum of the MRR and discount margin (DM) ππππ = (ππππππ + ππππ)(πΉπΉπΉπΉ) ππ (πππ π π π + π·π·π·π·) & O1 + P ππ (ππππππ + ππππ)(πΉπΉπΉπΉ) ππ + +β― (ππππππ + π·π·π·π·) O1 + P ππ (ππππππ + ππππ)(πΉπΉπΉπΉ) + πΉπΉπΉπΉ ππ + (ππππππ + π·π·π·π·) P P O1 + ππ www.saltsolutions.com Duration Times Spread (DTS) π·π·π·π·π·π· ≈ πΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈ × ππππππππππππ Excess Spread Return πΈπΈ[πΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈ] ≈ ππππππππππππ' − πΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈ × π₯π₯π₯π₯π₯π₯π₯π₯π₯π₯π₯π₯π₯π₯ − ππππππ × πΏπΏπΏπΏπΏπΏ Credit Default Swap (CDS) The amount of the upfront payment can be approximated as: ππππππππππππππ πΆπΆπΆπΆπΆπΆ ππππππππππππππ ≈ (πΆπΆπΆπΆπΆπΆ ππππππππππππ − πΉπΉπΉπΉπΉπΉπΉπΉπΉπΉ πΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆ) × πΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπππΆπΆπΆπΆπΆπΆ The CDS price per unit of par value can be calculated as: πΆπΆπΆπΆπΆπΆ ππππππππππ ≈ 1 − (πΆπΆπΆπΆπΆπΆ ππππππππππππ − πΉπΉπΉπΉπΉπΉπΉπΉπΉπΉ πΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆ) × πΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈππD6> The change in a CDS' price can be approximated as: %π₯π₯ πΆπΆπΆπΆπΆπΆ ππππππππππ ≈ −π₯π₯π₯π₯π₯π₯π₯π₯ ππππππππππππ × πΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈππD6> EQUITY INVESTMENTS EQUITY INVESTMENTS PASSIVE EQUITY INVESTING PASSIVE EQUITY INVESTING Index Concentration - The Herfindahl-Hirshaman Index (HHI) can be used to measure stock concentration risk in a portfolio. The HHI is the sum of the constituent weightings squared: " π»π»π»π»π»π» = É π€π€77T& - The effective number of stocks represents the number of stocks required in an equally-weighted portfolio that would have the same HHI: 1 πΈπΈπΈπΈπΈπΈππππππππππππ ππππππππππππ ππππ π π π π π π π π π π π π = π»π»π»π»π»π» Approaches to Passive Equity Investing - Pooled Investments: Mutual funds and exchange-traded funds, are easy to purchase, hold, and sell. - Derivatives-Based Approaches: Options, swaps, and futures contracts can be used to gain index performance. - Separately Managed Equity Index-Based Portfolios: An indexed portfolio can be built by purchasing the constituent securities of the index. Portfolio Construction - Full Replication: Hold all the securities in an index in proportion with the index weightings. - Stratified Sampling: Index constituents are first divided into strata or subgroups. Securities are chosen for the portfolio so the portfolio weights by strata will match the index weights by strata. - Optimization: Minimize the tracking error subject to specified constraints. - Blended Approach: A blend of the three approaches can be used to track a particular index. Tracking Error Management - The excess return is the difference between the portfolio returns and the benchmark returns. πΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈ ππππππππππππO = π π O − π π U - Tracking error measures how closely the portfolio return matches the benchmark return. ππππππππππππππππ ππππππππππO = ÑππππππππππππππππV$,V% ACTIVE EQUITY INVESTING ACTIVE EQUITY INVESTING Active Return Active return is the sum of the security returns times the weight differences between the portfolio and benchmark: P π π : = É π₯π₯ππ7 π π 7 π₯π₯ππ7 = π₯π₯ππ?7 − π₯π₯ππE7 7T& Expected Active Return The expected active portfolio return can be determined as follows: πΈπΈ[π π : ] = πΌπΌπΌπΌ × √π΅π΅π΅π΅ × ππV& × ππππ where - IC: Expected information coefficient of the manager, which is how much the manager’s forecasted active returns correspond to the manager’s realized active returns - BR: Breadth, which is the number of independent decisions made each year - TC: Transfer coefficient, which is the ability to convert portfolio insights into investment decisions; an unconstrained portfolio has a transfer coefficient of 1 Active Share and Active Risk - Active share measures how the size positions in a manager’s portfolio differs from the benchmark: π΄π΄π΄π΄π΄π΄π΄π΄π΄π΄π΄π΄ ππβππππππ = " 1 ÉÖππO<+$,7 − ππU%"C=B(+W,7 Ö 2 7T& - Active risk can be measured using realized historical numbers or using predicted estimates of correlations and variances: " π΄π΄π΄π΄π΄π΄π΄π΄π΄π΄π΄π΄ π π π π π π π π = Üππ - áÉ.π½π½OW − π½π½UW 5πΉπΉW à + ππ%WT& Causes and Sources of Absolute Risk The total portfolio variance (ππO ) and contribution of each asset to portfolio variance (πΆπΆπΆπΆππ ) can be calculated with the following formulas: " " ππO = É É π₯π₯7 π₯π₯Y πΆπΆ7Y 7T& YT& " πΆπΆπΆπΆ7 = É π₯π₯7 π₯π₯Y πΆπΆ7Y = π₯π₯7 πΆπΆ7O YT& where - π₯π₯Y : the asset’s weight in the portfolio - πΆπΆ7Y : the covariance of returns between asset i and asset j - πΆπΆ7O : the covariance of returns between asset i and the portfolio Copyright © 2023 Salt Solutions. All Rights Reserved. Personal copies permitted. Resale or distribution is prohibited. 4 Causes and Sources of Relative/Active Risk The variance of the portfolio’s active return %π΄π΄π΄π΄ππ & can be used to measure relative risk. " " π΄π΄π΄π΄O = É É(π₯π₯7 − ππ7 )2π₯π₯Y − ππY 4π π πΆπΆ7Y 7T& YT& where - π₯π₯7 : asset’s weight in the portfolio - ππ7 : benchmark weight in asset i - π π πΆπΆ7Y : covariance of relative returns between asset i and asset j ALTERNATIVE INVESTMENTS ALTERNATIVE INVESTMENTS HEDGE STRATEGIES HEDGE FUND FUN STRATEGIES Classification of Hedge Funds and Strategies Hedge Fund Characteristics - Legal/ Regulatory Overview - Flexible Mandates - Large Investment Universe - Aggressive Investment Styles - High Leverage - Liquidity Constraints - High Fees Equity Strategies - Long/Short Equity: Buy undervalued stocks and sell overvalued stocks short. - Dedicated Short-Selling and Short-Biased: Take short-only positions in equities but may vary the short positions by holding cash. - Equity Market-Neutral: Use offsetting long and short positions to establish an overall portfolio with near zero net exposure to equity market risk (beta). Event-Driven Strategies - Merger Arbitrage: Take positions based on their expectations about merger activity. - Distressed Securities: Focus on firms that are either already in the bankruptcy process or that are currently experiencing financial distress and are expected to file for bankruptcy in the near future. Relative Value Strategies - Fixed-Income Arbitrage: Seek to profit from relative mispricing. o Yield curve trades involve taking long and short positions based on expected changes in the shape of the yield curve in response to macroeconomic conditions. o Carry trades are executed by shorting low-yielding bonds and purchasing higher-yielding bonds. - Convertible Bond Arbitrage: Seek to take advantage of discrepancies between the prices of an issuer’s convertible bonds and their straight bonds. Opportunistic Strategies - Global Macro Strategies: Generally hold views on macro-level economic activity based on top-down analysis and express views by taking positions in a variety of asset classes and instruments. - Managed Futures: A highly technical and systematic strategy that is executed using primarily futures and options on futures. www.saltsolutions.com Specialist Strategies - Volatility Trading: Relative value volatility arbitrageurs can take advantage of differences in implied volatility for the same product across time zones (time-zone arbitrage) or markets (cross-asset volatility trading). - Reinsurance/Life Settlements: The sale of a life insurance policy to a party other than its originator is called a life settlement. Third-party brokers will then package the individual policies that they have acquired into pools to be resold to hedge funds. Multi-Manager Strategies - Fund-of-Funds: The FoF manager will make allocations to a diverse group of funds. - Multi-Strategy Hedge Funds: Multiple teams pursuing distinct strategies within the same organization. Conditional Factor Risk Model - A conditional risk-factor model goes a step further to account for the possibility that factor exposures can change under different market conditions. - Using the example of a managed futures with exposure to equity and commodity risks, the conditional factor model is: ππ=# = πΌπΌ + π½π½H π π H + π½π½D π π D + π·π·π½π½H π π H + π·π·π½π½D π π D where o π·π·: Dummy variable with a value of 0 under normal market conditions and 1 during crises o π·π·π½π½H π π H : Incremental exposure to equity risk during periods of market stress ASSET ALLOCATION ASSET ALLOCATIONTO TOALTERNATIVE ALTERNATIVE INVESTMENTS INVESTMENTS Achieving and Maintaining the Strategic Asset Allocation - In private partnerships, GPs have broad discretion over decisions related to capital calls and distributions. - The net asset value of a private fund with a drawdown structure at time t is: ππππππ$ = ππππππ$,&(1 + ππ) + πΆπΆ$ − π·π·$ where: o ππππππ$,& : fund’s net asset value at the end of the previous period o g: growth rate o πΆπΆ$ : amount of new contributions (capital calls) during period t o π·π·$ : the amount of distributions made during period t - One particular model for forecasting contributions uses the following formula: πΆπΆ$ = π π πΆπΆ$ × (πΆπΆπΆπΆ − πππππΆπΆ$ ) where: o π π πΆπΆ$ : rate of contributions during period t o πΆπΆπΆπΆ: capital commitment o πππππΆπΆ$ : amount paid-in-capital prior to period t - The formula for forecasting distributions uses a variable for the rate of distributions: π·π·$ = π π π·π·$ × ππππππ$,& (1 + ππ) PORTFOLIO MANAGEMENT (PART I) PORTFOLIO MANAGEMENT (PART I) THE BEHAVIORAL BIASES OF INDIVIDUALS THE BEHAVIORAL BIASES OF INDIVIDUALS Cognitive vs. Emotional - Cognitive errors are statistical, information-processing, or memory errors. Can be moderated through better information and education. - Emotional biases stem from attitudes or feelings. Must often be adapted to because it is very difficult to reduce or eliminate them. Cognitive Errors Belief Perseverance Biases - Conservatism Bias: Maintain prior views by inadequately incorporating new information. Tend to overweight initial beliefs and underreact to new information. - Confirmation Bias: Tend to only notice what confirms their beliefs. - Representativeness Bias: Tend to use past classifications for new information, even if it does not fit into the category. - Illusion of Control Bias: Believe they can control outcomes that they cannot. - Hindsight Bias: Look at past events and think they would have been predictable. Information-Processing Biases - Anchoring and Adjustment Bias: When people estimate an unknown value or probability, they often start by adjusting from an “anchor” value. - Mental Accounting Bias: Put money in separate mental buckets and treat them differently. - Framing Bias: Answer the same question differently just based on how the question is framed. - Availability Bias: Use heuristics (mental shortcuts) when making decisions. Emotional Biases - Loss-Aversion Bias: Prefer avoiding losses more than achieving gains. - Overconfidence Bias: o Overestimate their own abilities. o Can come from the illusion of superior knowledge or consistently attributing success to skill and failure to external factor. o Self-enhancing and self-protecting biases are the two sides of the self-attribution bias. - Self-Control Bias: Fail to make decisions that are best for their long-term goals because of a lack of self discipline. - Status Quo Bias: Inclined to do nothing rather than change. - Endowment Bias: Value an asset more when they hold the rights to it. - Regret-Aversion Bias: Avoid decisions that could turn out badly. Copyright © 2023 Salt Solutions. All Rights Reserved. Personal copies permitted. Resale or distribution is prohibited. 5 BEHAVIORAL BEHAVIORAL FINANCE FINANCEAND INVESTMENT PROCESSES AND INVESTMENT PROCESSES Bailard, Biehl, and Kaiser Five-Way Model - Adventurer: Confident and willing to take chances, so often hold undiversified portfolio - Celebrity: Like to be center of attention, but recognizes weaknesses so may seek investment advice - Individualist: Independent and confident; make decisions after careful analysis - Guardian: Cautious and concerned about the future; common for older people approaching retirement - Straight Arrow: Sensible and secure; willing to take on some risk for extra return Description of the Four Behavioral Investor Types - Passive Preservers want to preserve wealth rather than take risk to generate more wealth. - Friendly Followers are passive investors that follow the investment advice of others, such as friends or advisers. - An Independent Individualist is an active investor that is typically strong-willed and independent. - Active Accumulators are aggressive, confident and strong-willed. How Behavioral Factors Affect Portfolio Construction - Inertia and Default - Naïve Diversification - Investing in the Familiar Stocks o Familiarity and overconfidence o Naïve extrapolation of past returns o Framing and status quo o Loyalty o Financial incentives - Excessive Trading - Home Bias Behavioral Finance and Analyst Forecasts Overconfidence in Forecasting Skills - Investment analysts are often overconfident in their abilities and information, which is referred to as the illusion of knowledge bias. - Analysts also exhibit self-attribution bias, in which they take credit for success and assign responsibility for failure. - Availability bias causes the analysts to give too much weight to accessible and readily recalled information. - Hindsight bias inclines the analyst to think past events are predictable. Influence of Company’s Management on Analysis - Company management can present information in such a way to exploit biases. - Framing, anchoring and adjustment, and availability are all cognitive biases that can play a role. www.saltsolutions.com Analyst Biases in Conducting Research - Collecting too much information can lead to the illusion of control and representativeness. - Stories can be weaved that are created to fit the data. - Confirmation bias can lead analysts to become entrenched in their prior beliefs. - The gamblers’ fallacy is another cognitive bias that can affect analysts. It is a wrong belief that probabilities must revert to a long-term mean. - Endowment bias and confirmation bias can lead to analysts recommending financially sound companies even if the current stock price does not justify the investment. How Behavioral Factors Affect Committee Decision Making - Social proof is a bias in which individuals tend to follow the group beliefs. - Group discussions can lead to an overconfidence bias. - Committees often perform poorly because they are usually composed of individuals with similar backgrounds who have debates to arrive at a consensus. How Behavioral Finance Influences Market Behavior Momentum - Most markets exhibit short-term positive correlation and long term negative correlation. - Availability bias could also explain why investors rely so much on recent information. - Regret aversion could drive investors to purchase mutual funds that have performed well in the previous year to avoid regretting again not owning it the next year. - The disposition effect encourages investors to hold onto losers just to avoid recognizing the loss. Bubbles and Crashes - Overconfidence leads to overtrading, underestimation of risk, and lack of diversification. - Bubbles can be linked to confirmation, self-attribution, and hindsight bias. Value and Growth - Value stocks outperform growth stocks. - Overconfidence can affect growth rate predictions. Emotional investors may be attracted to growth. TOPICS IN WEALTH MANAGEMENT MANAGEMENT TOPICS IN PRIVATE PRIVATE WEALTH After-Tax Returns - A pre-tax holding period return is calculated as follows: ππ. − ππ' + πΌπΌπΌπΌπΌπΌπΌπΌπΌπΌπΌπΌ π π = ππ' - An after-tax holding period return is a pre-tax return adjusted for tax payments: ππ. − ππ' + πΌπΌπΌπΌπΌπΌπΌπΌπΌπΌπΌπΌ − ππππππ π π ′ = ππ' - The Modified Dietz formula can be used to better estimate returns when tax payments have been made within the period: ππππππ π π [ = π π − πΆπΆY (ππ − ππ) ππ' + ∑ ππ - The after-tax post-liquidation return is calculated as the geometrically linked sub-period returns less the embedded tax liability that would be due if accumulated unrealized gains were realized upon liquidation: & πΏπΏπΏπΏπΏπΏ. ππππππ " ~ −1 πΉπΉπΉπΉπΉπΉπΉπΉπΉπΉ ππππππππππ πΏπΏπΏπΏπΏπΏ. ππππππ = (πΉπΉπΉπΉπΉπΉπΉπΉπΉπΉ π£π£π£π£π£π£π£π£π£π£ − ππππππ ππππππππππ) × πΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆ ππππππππ π‘π‘π‘π‘π‘π‘ ππππππππ = πΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈπΈ ππππππππππππππ ππππππππ × πΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆ ππππππππ π‘π‘π‘π‘π‘π‘ ππππππππ - Tax alpha is simply the pre-tax excess return (relative to a benchmark) less the after-tax excess return. - The tax efficiency ratio (TER) is a portfolio’s after-tax return as a percentage of its pre-tax return. π π ?4 = }(1 + π π &[) … (1 + π π "[ ) − Capital Accumulation - The future value of an investment held in a taxexempt account is: πΉπΉππ.(G,%G%BO$ = (1 + ππ)" - If the same investment were held in a taxable account, its future value would be: πΉπΉππ.(G(U8% = [1 + ππ(1 − π‘π‘)]" - Holding an investment in a tax-deferred account allows it to accumulate gains that are untaxed until they are realized: πΉπΉππ.(G,I%#%++%I = (1 + ππ)" (1 − π‘π‘) Potential Capital Gain Exposure (PCGE) ππππππππ πΊπΊπΊπΊπΊπΊπΊπΊπΊπΊ − πΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆπΆ πΊπΊπΊπΊπΊπΊπΊπΊπΊπΊ π·π·π·π·π·π·π·π·π·π·π·π·π·π·π·π·π·π·π·π·π·π·π·π·π·π· − πΏπΏπΏπΏπΏπΏπΏπΏπΏπΏπΏπΏ = ππππππππππ ππππππ π΄π΄π΄π΄π΄π΄π΄π΄π΄π΄π΄π΄ Estate Planning - The relative value of transferring assets as gifts during the donor's lifetime rather than as bequests can be calculated using the following formula: " .1 + ππJ 21 − π‘π‘J 45 (1 − ππJ ) πΉπΉππ\7#$ = πΉπΉππE%];%A$ [1 + ππ% (1 − π‘π‘% )]" (1 − ππ% ) - If annual returns are taxed at the same rate for the recipient and donor and the assets can be transferred as tax-free gifts, the relative value is formula shown above simplifies to: 1 1 − ππ% π π π π = Copyright © 2023 Salt Solutions. All Rights Reserved. Personal copies permitted. Resale or distribution is prohibited. 6 RISK RISK MANAGEMENT MANAGEMENT FOR FORINDIVIDUALS INDIVIDUALS Economic Balance Sheet - The assets on an individual's economic (holistic) balance sheet include both their human capital and their financial capitalγ - Human capital is the present value of expected future employment income. - Financial capital includes both personal assets and investment assets, which can be classified based on marketability and whether they are publicly traded. PORTFOLIO PORTFOLIOMANAGEMENT MANAGEMENTFOR FOR INSTITUTIONAL INVESTORS INSTITUTIONAL INVESTORS Common Characteristics Institutions tend to share the following characteristics that distinguish this class of investors from individuals: - Large Scale - Long Investment Horizons and Low Liquidity Needs - Regulatory Framework - Formal Governance Framework - Principal-Agent Problems DB Pension Liabilities Benefit payments are determined by a formula based on inputs such as tenure and final salary. Estimates of future payments must account for unknowns such as mortality and inflation. Stakeholders The primary stakeholders are participants, sponsors, and governments. Investment Objectives Primarily to meet obligations to participants. Secondary objectives may include limiting surplus volatility or minimizing the sponsor's need to make additional contributions. Legal/Regulatory Constraints Governments tend to establish high regulatory requirements for pensions, often based on the principles of prudential supervision, capital adequacy, market integrity, and consumer protection. Trustees may be held personally liable if they fail to meet their fiduciary duty to participants. Tax Constraints DB pension plans are typically tax-exempt investors. Risk Considerations - Investment Horizon: Typically long-term for plans that remain open to new participants. Workforce characteristics, such as a higher average age of participants, will shorten a plan's investment horizon. - Liquidity Needs: Funds are required to make benefit payments. Plan features, such as options to accept lump-sum payments, will increase liquidity needs. - Other Risk Considerations: A DB pension plan's risk tolerance may be limited by factors such as common risk exposure with the sponsor, underfunded status, and the sponsor's financial status. www.saltsolutions.com Asset Allocation Pension plans have traditionally held large fixedincome allocations with some equities as a source of growth. Recently, alternative assets have become more common in pension portfolios, although asset allocations can be subject to regulatory requirements and limitations. DC Pensions Liabilities Plan sponsors are only liable for their promised contributions and the plans themselves have no liabilities beyond allowing participants to access the assets in their accounts. Stakeholders Plan participants are the primary stakeholders. Investment Objectives Individual participants have their own specific objectives. The investment firms and insurance companies that manage DC plans will want to show that their portfolio options perform well. Legal/Regulatory Constraints Plan sponsors are typically required to provide regular financial education courses for participants. Other legal requirements may include offering a glide path fund as a default option. Tax Constraints Assets held in DC pension plan accounts are allowed to accumulate tax-free until they are withdrawn, after which they are taxed at the participant's applicable rate. Risk Considerations - Investment Horizon: DC plans must provide a range of investment options that account for differences in the time horizons of individual participants. All else equal, older participants and larger balances are associated with shorter investment horizons. - Liquidity Needs: DC plans receive regular contributions from participants, but must maintain sufficient liquidity to meet withdrawals. Asset Allocation While each participant has their own allocation preferences, the aggregate scale of DC plans may give them access to asset classes that would otherwise be unavailable to them. Plans must offer participants a menu of different allocations. Sovereign Wealth Funds SWFs - Budget Stabilization Funds - Typically created by governments that rely heavily on natural resource revenues to provide fiscal support if commodity prices fall. - The primary objective is to preserve the real value of assets and liabilities are relatively unpredictable, so risk tolerance is relatively low with large allocations to highly-liquid, low-risk debt securities. SWFs - Development Funds - Given a broad mandate to spur economic growth, these funds invest in a variety of opportunities — from infrastructure projects to venture capital investments in emerging sectors. - Liabilities are ill-defined and it is difficult to generalize about asset allocations for these types of funds. However, they tend to be longterm investors with low liquidity needs and an objective to earn a real return in excess of GDP or productivity growth. SWFs - Savings Funds - The purpose of these funds is to transfer wealth to future generations. - Liquidity needs are relatively low, typically determined by a fixed spending rate. - An objective to achieving intergenerational equity produces a very long-term time horizon with a correspondingly high level of risk tolerance. - Portfolio allocations are dominated by equities and alternatives, with relatively few fixedincome assets. SWFs - Reserve Funds - These funds are used by export-intensive economies to absorb their local currency while accumulating excess foreign currency reserves as assets. - The return objective is a rate in excess of the yield on the monetary stabilization bonds issued by the central bank. - A very long-term time horizon allows for high allocations to equity-like alternatives, but some liquid fixed-income securities are also held in order to meet relatively unpredictable liquidity needs. SWFs - Pension Reserve Funds - Used to pre-fund future pension and health care costs, these funds are supported by government budget surpluses. - Liquidity needs are minimal during an initial accumulation phase, allowing for very high allocations to equities and illiquid alternatives such as infrastructure, real assets, and hedge funds. - In the subsequent decumulation phase, the investment horizon shortens and funds are allocated to more fixed-income assets to help meet growing liquidity needs. Foundations Liabilities Foundations are typically required to give out a certain percentage of assets as grants every year. Stakeholders A private foundation's primary stakeholders are the individual benefactor (or founding family) and the groups that receive grants. Tensions may exist between increasing current grants and preserving assets for future grants. Investment Objectives Foundations with infinite lives typically seek to maintain the real value of their assets by setting a return target equal to the sum of the spending rate, expected inflation, and any management fees. Copyright © 2023 Salt Solutions. All Rights Reserved. Personal copies permitted. Resale or distribution is prohibited. 7 Legal/Regulatory Constraints Foundation directors are typically required to exercise a fiduciary standard of care and adhere to the principles of modern portfolio theory when making investment decisions. Tax Constraints Foundations are tax-exempt investors, provided that they meet minimum annual spending requirements. Risk Considerations - Investment Horizon: Most foundations expect to continue operating in perpetuity. However, limited life foundations are given a specific date by which they must distribute their assets and cease operating. - Liquidity Needs: Foundations have relatively low liquidity needs. They are not required to make any payments in excess of the minimum threshold to maintain tax-exempt status. However, foundations may be subject to flowthrough rules requiring them to spend donations during the year in which they are received. Asset Allocation - Small allocations to cash and highly liquid securities are maintained in order to meet immediate spending needs, but long investment horizons and low liquidity needs allow for high allocations to equities and alternatives (particularly for larger foundations). - Limited life foundations hold increasingly large allocations of low-risk liquid assets as they move toward winding down their operations. Endowments Liabilities - Endowments do not have specific, legally enforceable liabilities. - An endowment’s liabilities are the informal spending commitments that have been made to future students. - When an endowment uses a fixed spending rate, the amount of its spending in the upcoming year (Year 1) can be calculated based on the spending rate (S), inflation (i), the amount of spending in the previous year (Year 0), and the average value of assets under management (AUM): ππππππππ 1 π π π π π π π π π π π π π π π π = [π€π€ × ππππππππ 0 π π π π π π π π π π π π π π π π × (1 + ππ)] +[(1 − π€π€) × ππ × π΄π΄π΄π΄π΄π΄] o Market value rule: Set w to 0. o Constant growth rule: Set w to 1. o Hybrid rule (a.k.a. Yale spending rule): Set w between 0 and 1. Stakeholders The two most important stakeholder groups for university endowments are current and future students. www.saltsolutions.com Investment Objectives - A university endowment’s main investment objective is to achieve intergenerational equity between current and future students. - The primary component of an endowment’s return objective is the spending rate. Other components of a return target that is sufficient to maintain purchasing power include inflation and management fees. Legal/Regulatory Constraints Investment committees of endowments are often required to invest on a total return basis and achieve sufficient diversification. Tax Constraints - Endowments are typically tax-exempt investors. - Unlike foundations, endowments tend not to be subject to minimum spending requirements in order to maintain this status. Risk Considerations - Investment Horizon: Because university endowments are continually accounting for the interests of future students, their investment horizon is perpetual. - Liquidity Needs: Have lower liquidity needs than foundations. - When assessing an endowment’s ability to tolerate investment risk, consider the degree to which the university depends on its contributions. Asset Allocation - Small allocations to cash and highly liquid securities are maintained in order to meet immediate spending needs. - Larger endowments have relatively high allocations to illiquid alternative assets. - The share of alternatives in endowment portfolios has been increasing over time at the expense of equities and fixed income securities. Banks Liabilities - Demand deposits have effectively zero duration as they can be withdrawn at any moment. - Time (term) deposits, such as savings accounts and certificates of deposit, have slightly longer duration because funds cannot be withdrawn without advance notice. - Banks can also access short-term wholesale funding, but this is a higher cost source of funds than deposits, which are perceived as more stable. Stakeholders - The primary stakeholders of banks are the customers who deposit their funds and the borrowers who receive loans. - Counterparties to derivative contracts and shareholders also have a strong interest in the ongoing operations of banks. Investment Objectives Banks typically use their investment portfolios to manage their exposure to interest rate risk. Insurers Liabilities - Life Insurer: o Due to the long-term nature of their liabilities, life insurers have traditionally had investment horizons of 20 to 40 years. However, this has changed as insurers have diversified into new product lines. o For certain products (e.g., term life insurance, fixed annuities), the insurer bears the investment risk. o Certain life insurance liabilities are highly sensitive to interest rates. - Property and Casualty Insurers: o P&C insurers have shorter duration, more volatile liabilities. As a result, P&C insurers tend to allocate a higher proportion of their portfolios to cash and short-term fixedincome instruments. - Regulators typically require insurers to have a reserve portfolio to meet policy liabilities. - A surplus portfolio is used to earn higher returns. Insurers are more willing to accept liquidity risk in this portfolio, including allocations to alternative assets. Stakeholders The main stakeholders of insurance companies are the policyholders who pay premiums for protection and expect to be compensated for insured events. Investment Objectives - An insurance company’s investment objectives will be consistent with the expected timing and amount of policyholders’ claims. - In general, insurers use their investment portfolios to meet their liquidity needs as well as to manage their exposure to interest rate risk, credit risk, and exchange rates. Banks and Insurers Legal/Regulatory Constraints - Banks and insurers are subject to a relatively high level of regulatory and legal constraints compared to other institutional investors. - Regulators want to ensure that financial intermediaries have sufficient equity capital to provide a buffer against losses on assets (e.g., loan defaults, negative investment returns) to preserve their ability to meet their obligations to depositors, lenders, and policyholders. - Regulators also focus on ensuring that financial intermediaries have sufficient liquidity. Tax Constraints Banks and insurance companies are fully taxable for-profit entities. Balance Sheet Management - Banks and insurance companies use the liability driven investing (LDI) model, which recommends asset allocations based explicitly on their ability to hedge liabilities. - To calculate the change in equity in percentage terms, we must account for leverage using the following formula: π΄π΄ π΄π΄ %π₯π₯π₯π₯ = O P %π₯π₯π₯π₯ − O − 1 P %π₯π₯π₯π₯ πΈπΈ πΈπΈ Copyright © 2023 Salt Solutions. All Rights Reserved. Personal copies permitted. Resale or distribution is prohibited. 8 Managing Interest Rate Risk - Sensitivity to interest rates is captured by the modified duration measure. - The duration of the financial intermediary's equity is calculated as follows: π΄π΄ π΄π΄ π₯π₯π¦π¦4 π·π·H = O P π·π·: − O − 1 P π·π·4 πΈπΈ πΈπΈ π₯π₯π¦π¦: Managing Equity Volatility - Equity volatility (standard deviation) is π΄π΄ π΄π΄ ππH- = O P ππ:- + O − 1 P ππ4πΈπΈ πΈπΈ π΄π΄ π΄π΄ − 2 O P O − 1 P ππππ: ππ4 πΈπΈ πΈπΈ - Actions that can reduce the asset volatility and, by extension, equity volatility, include: o Holding higher quality fixed-income securities to reduce credit risk o Holding more cash and short-term securities to reduce liquidity risk o Matching the durations of assets and liabilities to reduce interest rate risk - For insurance companies, actions that decrease the volatility of liabilities include imposing penalties on surrenders, having more predictable underwriting losses, and diversifying into different product lines to take advantage of the law of large numbers. PORTFOLIO MANAGEMENT (PART(PART II) II) PORTFOLIO MANAGEMENT OVERVIEW OF ASSET OVERVIEW OF ASSETALLOCATION ALLOCATION Approaches to Asset Allocation - Asset-only: Focus is solely on the assets, with mean-variance optimization the most common approach. Liabilities are not explicitly modelled. - Liability-relative: Assets are chosen to fund the liabilities. Surplus optimization is a common approach. - Goals-based: Assets are divided into sub-portfolios to meet specified goals. Each goal specifies the cash flows, time horizon, and risk tolerance. Asset Classes The following five criteria helps specify asset classes: - Assets within a class should be relatively homogenous. - Asset classes should be mutually exclusive. - Asset classes should be diversifying to avoid redundancy. - The asset classes collectively should cover most of the available world investable assets. - The asset class should be able to absorb a significant portion of the investor’s portfolio without undue liquidity impairments. A Framework for Rebalancing - Calendar rebalancing rebalances on a schedule. - Percent-range rebalancing rebalances if the portfolio drifts out of a specified range. www.saltsolutions.com Strategic Considerations in Rebalancing - Higher transaction costs, less risk-averse investors, more correlated assets, beliefs in momentum, illiquidity, and taxes lead to wider rebalancing ranges. - Belief in mean reversion leads to tighter rebalancing bands. - Illiquid assets can create a problem. - Tax issues can create asymmetric bands. PRINCIPLES OF PRINCIPLES OFASSET ASSETALLOCATION ALLOCATION Developing Asset-Only Allocations Mean-Variance Optimization (MVO) The investor’s utility, U, from an asset allocation mix, m, can be calculated with the following formula: ππB = πΈπΈ[π π B ] − 0.005ππππB where ππ is the investor’s degree of risk aversion. Criticisms of MVO - The outputs are very sensitive to the inputs, especially expected returns. - The optimal allocations are very concentrated in a subset of available assets. - Investors are concerned about more than the mean and variance of returns. - Sources of risk may not be diversified, even if using many asset classes. - MVO allocations are not directly related to the liabilities being funded. - MVO is a single-period framework that does not consider trading costs and taxes. Addressing the Criticisms of MVO - Reverse Optimization: Start with allocation weights that are assumed to be optimal, along with covariance and risk aversion estimates. Then, the expected returns are solved for. - Black-Litterman Model: Start with excess returns from reverse optimization, then applies a method to incorporate the investor’s views. - Resampled Mean-Variance Optimization: Combine MVO with Monte Carlo simulation. Approaches that Address Issues Related to Illiquid Assets - Exclude them from the asset allocation decision, but use them for the target strategic asset allocation. - Include the less liquid assets and attempt to model the inputs for the specific risk of assets likely to be used. - Include the less liquid assets and model the highly diversified characteristics with the true asset classes. Risk Budgeting The marginal contribution to total risk (MCTR) and the absolute contribution to total risk (ACTR) can be calculated as: - ππππππππ7 = (π΅π΅π΅π΅π΅π΅π΅π΅ ππππ ππ π€π€. ππ. π‘π‘. ππππππππ. )(ππππππππ. π£π£π£π£π£π£π£π£π£π£π£π£π£π£π£π£π£π£π£π£) - π΄π΄π΄π΄π΄π΄π΄π΄7 = (ππππππππβπ‘π‘7 )ππππππππ7 Developing Liability-Relative Asset Allocations Characterizing the Liabilities Characteristics of liabilities that affect asset allocation in liability-relative asset allocation include: - Fixed or contingent liabilities - Legal liabilities and quasi-liabilities - Duration and convexity of liability cash flows - Size relative to organization - Factors driving the liability, timing, and regulations Approaches to Liability-Relative Asset Allocation - Surplus optimization substitutes surplus return for the asset return in traditional mean-variance optimization. 4V = πΈπΈ.π π A,B 5 − 0.005ππππ - .π π A,B 5 ππB o Surplus return is: πΆπΆβππππππππ ππππ ππππππππππ π£π£π£π£π£π£π£π£π£π£ − πΆπΆβππππππππ ππππ ππππππππππππππππππ π£π£π£π£π£π£π£π£π£π£ πΌπΌπΌπΌπΌπΌπΌπΌπΌπΌπΌπΌπΌπΌ ππππππππππ π£π£π£π£π£π£π£π£π£π£ o Simple, linear correlation, all risk levels, any funded ratio, single period - A hedging/return-seeking portfolios approach assigns assets to one of two portfolios. The objective of the hedging portfolio is to hedge the investor’s liability stream. Any remaining funds are invested in the return-seeking portfolio. o Simple, linear or non-linear correlation, conservative risk levels, positive funded ratio, single period - An integrated asset-liability approach integrates the asset and liability decisions when optimizing a portfolio. o Complex, linear or non-linear correlation, all risk levels, any funded ratio, multiple periods ASSET ALLOCATION ASSET ALLOCATIONWITH WITH REAL-WORLD CONSTRAINTSCONSTRAINTS REAL-WORLD Constraints in Asset Allocation - Asset Size - Liquidity - Time Horizon - Regulatory and Other External Constraints Asset Allocation for the Taxable Investor - The after-tax return is the pre-tax return adjusted for taxes: ππ($ = ππO$ (1 − π‘π‘) - For equity assets, the typical return includes dividend income and capital gains: ππ($ = ππI ππO$ (1 − π‘π‘I ) + ππ( ππO$ 21 − π‘π‘CJ 4 ππI is the proportion of ππO$ from dividends ππ( is the proportion of ππO$ from price appreciation - The after-tax standard deviation is also affected by the tax rate: ππ($ = ππO$ (1 − π‘π‘) Strategies to Reduce Tax Impact Other strategies can be used to reduce the tax impact: - Tax-loss harvesting is intentionally realizing capital losses to offset capital gains in another part of the portfolio. - Strategic asset location is placing less taxefficient assets in accounts with more favorable tax treatment such as tax-exempt or taxdeferred accounts. Copyright © 2023 Salt Solutions. All Rights Reserved. Personal copies permitted. Resale or distribution is prohibited. 9 In general, to minimize overall taxes: - Equities are placed in taxable accounts because they incur lower tax rates. - Taxable bonds and high-turnover strategies should be in tax-exempt or tax-deferred accounts. - Assets held for liquidity purposes should be placed in taxable accounts. Short-Term Shifts in Asset Allocation - Strategic asset allocation (SAA) is for long-term investment policy. - Tactical asset allocation (TAA) attempts to deviate in the short term from SAA to take advantage of current market situations. o Discretionary TAA depends on a qualitative interpretation of political, economic, and financial market conditions. It relies on manager skills in predicting and timing shortterm market moves. o Systematic TAA depends on qualitative signals to exploit persistent anomalies in the market, such as value and momentum. TRADE STRATEGIES STRATEGIESAND ANDEXECUTION EXECUTION Implementation Shortfall - IS is calculated as the difference between a trade’s paper return and its actual return. - The paper return is the return that would have been earned if all shares were transacted at the decision price without any associated costs or fees: ππππππππππ ππππππππππππ = (ππ" − ππI )ππ where o S is the total order shares (value is positive for buy orders and negative for sell orders) o ππI is the decision price o ππ" is the current price - The actual return of the portfolio is calculated as: π΄π΄π΄π΄π΄π΄π΄π΄π΄π΄π΄π΄ ππππππππππππ = çÉ π π Y é ππ" − É π π Y ππY − πΉπΉπΉπΉπΉπΉπΉπΉ where o π π Y represents the number of shares executed in the jth trade o ππY represents the transaction price of the jth trade o ∑π π Y represents the total number of shares executed o Fees include all costs paid by the fund to complete the order - Rearranging the basic IS formula allows us to decompose the total trade costs into three parts: o Execution cost: Cost that arises due to the buying/selling pressure of the order É π π Y ππY − É π π Y ππI o Fixed fees: Includes all fees such as commissions, exchange fees, and taxes o The restated formula is: πΌπΌππ = πΈπΈπΈπΈπΈπΈπΈπΈ. ππππππππ + ππππππππππ. ππππππππ + πΉπΉπΉπΉπΉπΉπΉπΉπΉπΉ ππππππππ Expanded Implementation Shortfall - The execution cost can be further decomposed into two parts: ππππππππππππππ ππππππππ = É π π Y ππY − çÉ π π Y é ππ' π·π·π·π·π·π·π·π·π·π· ππππππππ = çÉ π π Y é ππ' − çÉ π π Y é ππI Evaluating Trade Execution - Trade costs can be stated in absolute terms or on a per share basis, but investment professional typically express these costs in terms of basis points (bps) using the following formula: ππè − ππ ∗ × 10,000 ππππππ πΆπΆπΆπΆπΆπΆπΆπΆ (ππππππ) = ππππππππ × ππ ∗ where o Side has a value of +1 for a buy order of a -1 for a sell order o ππè is the average execution price of the order o ππ ∗ is the reference price - Market-adjusted cost can be calculated using the following formula: ππππππππππππ − ππππππππππππππππ ππππππππ (ππππππ) = π΄π΄π΄π΄π΄π΄π΄π΄π΄π΄π΄π΄π΄π΄ ππππππππ (ππππππ) − π½π½ × πΌπΌπΌπΌπΌπΌπΌπΌπΌπΌ ππππππππ (ππππππ) where o πΌπΌπΌπΌπΌπΌπΌπΌπΌπΌ ππππππππ (ππππππ) = ππππππππ × K"I%G L^:?,K"I%G (++7_(8 O+7C% K"I%G (++7_(8 O+7C% × 10,000 ππππππ o π½π½ is the stock’s beta relative to the underlying index - The formula for calculating the added value metric is: π΄π΄π΄π΄π΄π΄π΄π΄π΄π΄ (ππππππ) = π΄π΄π΄π΄π΄π΄π΄π΄π΄π΄π΄π΄π΄π΄ ππππππππ (ππππππ) − πΈπΈπΈπΈπΈπΈ. ππππππ − π‘π‘π‘π‘π‘π‘π‘π‘π‘π‘ ππππππππ (ππππππ) PORTFOLIO PERFORMANCE PORTFOLIO PERFORMANCEEVALUATION EVALUATION Three Approaches to Performance Attribution - Transaction-based attribution: It uses both portfolio holdings and transaction data to fully explain excess return, including the impact of trading costs. Most comprehensive and accurate. - Holdings-based attribution: It compares a portfolio’s holdings at the beginning and end of a period. Holdings are valued at the end of a period and a return is calculated relative to their value at the end of the previous period. - Returns-based analysis: It can be used when complete data on a portfolio’s holdings are unavailable. Least accurate. Approaches to Return Attribution - When an arithmetic attribution approach is used excess return is defined as the difference between a portfolio’s return (R) and the return on its benchmark (B). - When a geometric attribution approach is used, geometric excess return (G) is calculated as follows: π π − π΅π΅ 1 + π π −1= πΊπΊ = 1 + π΅π΅ 1 + π΅π΅ Equity Return Attribution – The Brinson Model - Returns for the portfolio and its benchmark are calculated as the weighted average of sector returns: " ππππππππππππππππππ ππππππππππππ: π π = É π€π€7 π π 7 7T& " π΅π΅π΅π΅π΅π΅π΅π΅βππππππππ ππππππππππππ: π΅π΅ = É ππ7 π΅π΅7 7T& where o π€π€7 : portfolio weight of the ith sector o π π 7 : portfolio asset return in the ith sector o ππ7 : benchmark weight of the ith sector o π΅π΅7 : benchmark asset return in the ith sector - Under the Brinson model, there are three sources of excess return for an equity investment: o Asset allocation effect: π΄π΄7 = (π€π€7 − ππ7 )π΅π΅7 o Security selection effect: ππ7 = ππ7 (π π 7 − π΅π΅7 ) o Interaction effect: πΌπΌ7 = (π€π€7 − ππ7 )(π π 7 − π΅π΅7 ) Equity Return Attribution—Factor-Based Return Attrition - A common factor model used for equity attribution analysis is the Carhart model: π π O − π π # = ππO + ππO& π π π π π π π π + ππO- ππππππ +ππO` π»π»π»π»π»π» + ππOa ππππππ + πΈπΈO Fixed-Income Return Attribution - Exposure Decomposition – Duration Based: Topdown approach that breaks down the portfolio risk exposures based on certain characteristics such as bond duration and sector. - Yield Curve Decomposition – Duration Based: Can be either top-down or bottom-up. It estimates the return on investment using the relationship between duration and the change in yield to maturity (YTM). %ππππππππππ ππππππ. = %πΌπΌπΌπΌπΌπΌπΌπΌπΌπΌπΌπΌ ππππππ. +%ππππππππππ ππππππ. where %ππππππππππ ππππππ. ≈ −π·π·π·π·π·π·π·π·π·π·π·π·π·π·π·π· × πΆπΆβππππππππ ππππ ππππππ - Yield Curve Decomposition – Full Repricing: A bottom-up technique that measures the contributions from the change in spot rates and the quality of active management. o Opportunity cost: Cost that arises when an order cannot be fully executed due to adverse price movement or a lack of liquidity during the trading period çππ − É π π Y é (ππ" − ππI ) www.saltsolutions.com Copyright © 2023 Salt Solutions. All Rights Reserved. Personal copies permitted. Resale or distribution is prohibited. 10 Benchmarking Investments and Managers Properties of a Valid Benchmark - Investable: It is possible to invest passively in the benchmark as an alternative accepting the portfolio’s active risk exposures. - Appropriate: The benchmark is consistent with a manager’s style and any constraints imposed by the client. - Measurable: The benchmark’s performance can be easily measured. - Specified in advance: The identity of the benchmark is known before the evaluation period begins. - Owned/Accountable: The manager owns the benchmark and agrees to be held accountable to it. - Unambiguous: The composite securities and their weights in the benchmark are clearly identifiable. - Reflective of opinions: The manager knows and has opinions on all of the securities in the benchmark. Decomposing Portfolio Returns - A portfolio’s total return, R, can be decomposed into the benchmark return, B, and the manager’s active return, A. π π = π΅π΅ + π΄π΄ - The benchmark return can be further decomposed into the market index return, M, and the style return, S. π΅π΅ = ππ + ππ - Using these formulas, we can think of portfolio return as the sum of three components: π π = ππ + ππ + π΄π΄ o If a portfolio’s benchmark is a broad market index, the S is zero and R = M + A. o If a portfolio is meant to replicate the performance of a broad market index with zero tracking error (e.g., an index ETF), then both S and A are zero and R = M. Performance Appraisal Measure Sharpe ratio Numerator ππ? − ππ# Denominator ππ? Sortino ratio ππ? − ππ. ππ6 Information rat. ππ? − ππE ππ(+',+() Treynor ratio Appraisal ratio ππ? − ππ# πΌπΌ www.saltsolutions.com π½π½? ππb Capture ratios measure a portfolio’s return relative to its benchmark in different market conditions. o The upside capture (UC) ratio measures the ratio of the portfolio return to the benchmark return in periods when the benchmark return is positive. o The downside capture (DC) ratio expresses the same relationship in down markets. o The upside and downside ratios combine to give a single capture ratio (CR) that is calculated as UC divided by DC. - Drawdown is a portfolio’s cumulative peak-to-trough loss over a continuous period. Investors measure drawdowns in terms of both money and time. o The financial impact of drawdown is measured by maximum drawdown, which is a portfolio’s largest peak-to-trough loss (in percent). o The time component of a drawdown is captured by drawdown duration, which is the amount of time that extends from when a portfolio starts to fall from its peak until it returns to that level. INVESTMENT MANAGER INVESTMENT MANAGER SELECTION SELECTION Actual Performance Hire/Retain Not hire / Fire Below Expectations Above Expectations Type I error Correct decision Correct decision Type II error The active share measure is based on the difference between the weights given to securities in a portfolio and their benchmark weights. π΄π΄π΄π΄π΄π΄π΄π΄π΄π΄π΄π΄ ππβππππππ = P 1 É|ππππππππππππππππππ ππππππππβπ‘π‘7 2 7T& − π΅π΅π΅π΅π΅π΅π΅π΅βππππππππ ππππππππβπ‘π‘7 | ETHICAL AND PROFESSIONAL STANDARDS ETHICAL AND PROFESSIONAL STANDARDS I(A) Knowledge of the Law Obey strictest applicable law. Disassociate immediately from any illegal or unethical activity. I(B) Independence and Objectivity Do not offer or accept gifts that might impair independence and objectivity. Gifts from clients may be permissible. I(C) Misrepresentation Cite sources. Do not plagiarize or omit important information. Act quickly to correct any errors. I(D) Misconduct Does not apply to personal behavior unless it reflects poorly on the investment profession. II(A) Material Nonpublic Information Do not act or cause others to act on material nonpublic information. Seek public dissemination. II(B) Market Manipulation Do not take any actions that distort prices or trading volume. Market making and legitimate trading strategies are allowed. III(A) Loyalty, Prudence, and Care Place clients’ interest above yours. Disclose policies on proxy voting and soft commissions. III(B) Fair Dealing Treat all clients fairly. Treat non-immediate family like other clients. Communicate investment recommendations and changes simultaneously. III(C) Suitability Use a regularly updated IPS during investment decisions. Evaluate decisions in a portfolio context. III(D) Performance Presentation Performance data should be fair, accurate, and complete. Do not promise returns for risky assets. III(E) Preservation of Confidentiality Keep all client information confidential unless: client is involved in illegal activity, you are legally required, or you have the client’s permission. Copyright © 2023 Salt Solutions. All Rights Reserved. Personal copies permitted. Resale or distribution is prohibited. 11 IV(A) Loyalty Get permission before taking outside work (even unpaid) that competes with employer. Abide by non-compete agreement (if applicable) and do not take employer’s property. IV(B) Additional Compensation Arrangements Obtain written permission from all parties before receiving any compensation for outside work. IV(C) Responsibilities of Supervisors Supervisors must adequately train and monitor subordinates. Responsibilities may be delegated. V(A) Diligence and Reasonable Basis Exercise diligence and thoroughness. Support actions with research and investigation. V(B) Communication with Clients and Prospective Clients Make appropriate disclosures. Distinguish between fact and opinion in analysis and recommendations. V(C) Record Retention Maintain records to support recommendations and decisions. 7-year retention period recommended. VI(A) Disclosure of Conflicts Disclose any matters that may impair independence and objectivity, prominently and in plain language. VI(B) Priority of Transactions Execute clients’ transactions before accounts in which you have a beneficial interest. BA II PLUS CALCULATOR TIPS BA II PLUS CALCULATOR TIPS Basic Operations 2ND : Access secondary functions (in yellow) ENTER : Send value to a variable 2ND + ENTER : Toggle between options ↑ ↓ : Navigate between variables/options STO + 0 - 9 : Store current value into memory RCL + 0 - 9 : Recall value from memory Time Value of Money (TVM) For annuity, loan, and bond calculations N : Number of periods I/Y : Effective interest rate per period (in %) PV : Present value PMT : Payment/coupon amount FV : Future value/redemption value CPT + one of the above : Solve for unknown 2ND + BGN : Toggle between ordinary annuity and annuity due 2ND + CLR TVM : Clear TVM worksheet Cash Flow Worksheet ( CF , NPV , IRR ) For non-level payments Input ( CF ) CF0: Initial cash flow C01: 1st distinct cash flow after initial cash flow F01: Frequency of CO1 C0n: nth distinct cash flow F0n: Frequency of C0n Note: - Always clear the CF worksheet before starting a new calculation - The use of F0n is optional. You can leave them as 1 and input repeating cash flows multiple times. If you do so, C01 will be the cash flow at time 1, C02 will be the cash flow at time 2, and so on. Output ( NPV , IRR ) I: Effective interest rate per period (in %) NPV + CPT : Solve for net present value IRR + CPT : Solve for internal rate of return Note: - Always clear the TVM worksheet before starting a new calculation - For bonds, PMT and FV should have the same sign, and opposite signs to PV VI(C) Referral Fees Disclose referral fees to clients and employer, including non-monetary arrangements. VII(A) Conduct as Participants in CFA Institute Program Do not share confidential exam details. Expressing opinions about CFAI policies is permissible. VII(B) Reference to CFA Institute, the CFA Designation, and the CFA Program Do not misrepresent the meaning of CFA Institute membership, designation, or candidacy. www.saltsolutions.com Copyright © 2023 Salt Solutions. All Rights Reserved. Personal copies permitted. Resale or distribution is prohibited. 12
