2020
Critical
concepts
for the
CFA EXAM
CFA® EXAM REVIEW
Wiley’s CFA
Program Level III
Smartsheets
®
Fundamentals For CFA Exam Success
WCID184
Wiley’s CFA Program Exam Review
®
ETHICAL AND
PROFESSIONAL STANDARDS
Standards of Professional Conduct
• Thoroughly read the Standards, along with related
guidance and examples.
Asset Manager Code of
Professional Conduct
• Firm-wide, voluntary standards
• No partial claim of compliance.
• Compliance statement: “[Insert name of firm] claims
compliance with the CFA Institute Asset Manager Code of
Professional Conduct. This claim has not been verified by
CFA Institute.”
• Firms must notify CFA Institute when claiming
compliance.
• CFA Institute does not verify manager’s claim of
compliance.
• Standards cover:
• Loyalty to clients
• Investment process and actions
• Trading
• Risk management, compliance, and support
• Performance and valuation
• Disclosures
GLOBAL INVESTMENT PERFORMANCE
STANDARDS
• Focus on required disclosures, and presentation and
reporting requirements and recommendations of GIPS.
• Be able to identify and correct errors in a performance
presentation that claims to be GIPS compliant.
BEHAVIORAL FINANCE
Behavioral Finance Perspective
• Prospect theory
• Assigns value to changes in wealth rather than levels
of wealth.
• Underweight moderate- and high-probability
outcomes.
• Overweight low-probability outcomes.
• Value function is concave above a wealth reference
point (risk aversion) and convex below a wealth
reference point (risk seeking).
• Value function is steeper for losses than for gains.
• Cognitive limitations
• Bounded rationality: deciding how much will be done
to aggregate relevant information and using rules of
thumb.
• Satisficing: finding adequate rather than optimal
solutions.
• Traditional perspective on portfolio construction
assumes that managers can identify an investor’s
optimal portfolio from mean-variance efficient portfolios.
• Consumption and savings
• Mental accounting: wealth classified into current
income, currently owned assets, PV of future income.
• Framing: source of wealth affects spending/saving
decisions (current income has high marginal
propensity to consume).
• Self-control: long-term sources unavailable for current
spending.
• Behavioral asset pricing models
• Sentiment premium included in required return.
• Bullish (bearish) sentiment risk decreases (increases)
required return.
• Behavioral portfolio theory
• Strategic asset allocation depends on the goal
assigned to the funding layer.
• Uses bonds to fund critical goals in the domain of
gains.
• Uses risky securities to fund aspirational goals in the
domain of losses.
• Adaptive markets hypothesis
• Must adapt to survive (bias towards previously
successful behavior due to use of heuristics).
• Risk premiums and successful strategies change over
time.
Behavioral Biases
• Cognitive errors (belief persistence biases)
• Conservatism: overweight initial information and fail to
update with new information.
• Confirmation bias: only accept belief-confirming
information, disregard contradictory information.
• Representativeness: extrapolate past information into
the future (includes base-rate neglect and sample-size
neglect).
• Illusion of control: believe that you have more control
over events than is actually the case.
• Hindsight bias: only remember information that
reinforces existing beliefs.
• Cognitive errors (information-processing biases)
• Anchoring and adjustment: develop initial estimate
and subsequently adjust it up/down.
• Mental accounting: treat money differently depending
on source/use.
• Framing: make a decision differently depending on
how information is presented.
• Availability bias: use heuristics based on how readily
information comes to mind.
• Emotional biases
• Loss aversion: strongly prefer avoiding losses to
making gains (includes disposition effect, housemoney effect and myopic loss aversion).
• Overconfidence: overestimate analytical ability
or usefulness of their information (prediction
overconfidence and certainty overconfidence).
• Self-attribution bias: self-enhancing and selfprotecting biases intensify overconfidence.
• Self-control bias: fail to act in their long-term interests
(includes hyberbolic discounting).
• Status quo bias: prefer to do nothing than make a
change.
• Endowment bias: value an owned asset more than if
you were to buy it.
• Regret aversion: avoid making decisions for fear of
being unsuccessful (includes errors of commission and
omission).
• Goals-based investing
• Base of pyramid: low-risk assets for obligations/needs.
• Moderate-risk assets for priorities/desires; speculative
assets for aspirational goals.
• Behaviorally modified asset allocation
• Greater wealth relative to needs allows greater
adaptation to client biases
• Advisor should moderate cognitive biases with high
standard of living risk (SLR).
• Advisor should adapt to emotional biases with a low
SLR.
Investment Processes
• Behavioral biases in portfolio construction
• Inertia and default: decide not to change an asset
allocation (status quo bias).
• Naïve diversification: exhibit cognitive errors resulting
from framing or using heuristics like 1/n diversification.
• Company stock investment: overallocate funds to
company stock.
• Overconfidence bias: engage in excessive trading
(includes disposition effect).
• Home bias: prefer own country’s assets.
• Mental accounting: portfolio may not be efficient due
to goals-based investing as each layer of pyramid is
optimized separately.
• Behavioral biases in research and forecasting
• Representativeness: due to excessive structured
information.
• Confirmation bias: only accept supporting evidence.
• Gamblers’ fallacy: overweight probability of mean
reversion.
• Hot hand fallacy: overweight probability of similar
returns.
• Overconfidence, availability, illusion of control, selfattribution and hindsight biases also possible.
• Market behavioral biases
• Momentum effects due to herding, anchoring,
availability and hindsight biases.
• Bubbles due to overconfidence, self-attribution,
confirmation and hindsight biases.
• Value stocks have outperformed growth stocks; smallcap stocks have outperformed large-cap stocks.
Capital Market
Expectations
CME frameworks and Macro
Considerations
• Good forecasts are:
• Objective and unbiased
• Internally consistent
• Efficient with low errors
• Uncertainty and errors stem from choosing incorrect
model, errors in underlying data, or errors in
estimated parameters
• Errors can also stem from behavioral biases such as
anchoring bias, availability bias, confirmation bias,
status quo bias, overconfidence bias, and prudence
bias
• Aggregate equity market value:
• Three distinct approaches to forecasting economic
change:
• Econometrics
• Economic indicators
• Checklist approach
• Yield curve over the business cycle
• Initial recovery – Steep yield curve with low short-term
rates that start to rise
• Early expansion – Rising curve with steep short
maturities and flat long maturities
• Late expansion – Slowly rising and flattening curve
• Slowdown – Flat or inverted curve that is falling
• Contraction – Falling curve that begins to steepen
Forecasting Asset Class Returns
• Expected returns on fixed income securities can be
determined using:
• A DCF approach, whereby current price and future cash
flows infer a yield to maturity (YTM). Realised return
differ from YTM due to gains/losses from pre-maturity
transactions and reinvestment effects
• A building block approach, whereby expected return
is based on the short-term nominal default-free rate
plus risk premiums such as a term premium, credit
premium and liquidity premium
• Expected returns on equities can be determined using:
• Historical statistics
Wiley © 2020
Wiley’s CFA Program Exam Review
®
Asset AllocAtion with ReAl-woRld
Asset Allocation with Real-World Constraints
• A DCF/dividend discount approach, such as the
asset allocations results in an overall strategic asset
allocation).
Grinold-Kroner model:
Asset AllocAtion
Principles of Asset Allocation
AA
• Mean variance optimization (MVO)
• Produces an efficient frontier based on returns,
• A building block approach, whereby expected return
characteristics
of different asset classes.
After-tax Portfolio
Optimization
• Time horizon: asset allocation decisions evolve
Optimizing a portfolio subject to taxes requires using the after-tax returns and risks on an
with changes in time horizon, human capital, utility
ex-ante basis.
function, financial market conditions, characteristics of
Asset
decisions
shouldowner’s
be made on
an after-tax basis.
the asset
priorities.
ratliability
=allocation
rpt (1 − t )and
• Regulatory:
regulatory
entities
• Taxes
and portfolio financial
rebalancing:markets
As marketand
conditions
change over
time, asset class
is based on either the short-or-long-term
nominal
where: weights
PrinciPles
of Asset AllocAtion
often
constraints.
in aimpose
portfolio additional
change and tend
to move away from previously set target
standard deviation of returns and pairwise
after-tax
return
rat = expected
default-free rate plus risk premiums such as those used
levels. Portfolio rebalancing is needed to return actual allocation to the strategic
• asset
Taxes
pre-tax return
rpt = expected
correlations.
allocation
(SAA). However, discretionary portfolio rebalancing can trigger
for fixed income securities as well as an equity risk
Principles of Asset Allocation
t = expected
taxcapital
rate gains and losses and the associated tax liabilities that could have been
realized
• Place
less tax-efficient assets in tax-advantaged
premium
• Finds optimal asset allocation mix that maximizes
otherwise deferred or even avoided.
Extending this
to a portfolio
with both income
and portfolio
capital gains:optimization.
accounts
to achieve
after-tax
client’s utility.
• An equilibrium approach, whereby expected return forRisk Objectives
Taxable asset owners should consider the trade-off between the benefits of tax
an equity market is based on its sensitivity ( ) to global
rat = pd rpt (1 −
td )the
+ pmerits
tcgmaintaining
)
a rpt (1 −of
minimization
and
the targeted asset allocation by rebalancing.
U p = E ( R p ) − 0.005 × A × σ 2p
market returns and its level of integration ( ) with
global markets (Singer-Terhaar model):
where: Because after-tax volatility is smaller than pre-tax volatility, it takes a larger
where:
movement
a taxable
portfolio
toachange
the portfolio
risk profile of
portfolio.
• Rebalancing
range
forincome
taxable
(Rthe
) can
• investor’s
MVO limitations
pd = proportion
of in
return
from
dividend
taxable
U is the
utility.
can be wider than
Consequently,
rebalancing
for aotherwise
taxable
portfolio
(R taxable)taxbe wider
than
of an
identical
of return
from those
priceranges
appreciation
(i.e., capital
gain)
E(Rp) is the
portfolio
expected return.
• Asset
allocations
are highly sensitive to small changes pa = proportion
R
).
those
of
an
otherwise
identical
tax-exempt
portfolio
(
tax exempt
on dividend
income (R exempt).
td = tax rateexempt
portfolio
tax
A is the investor’s
risk aversion.
in input
variables.
tcg = tax rate on capital gain
σ 2p is the•variance
of
the
portfolio.
Asset allocations can be highly concentrated.
R taxable
= R taxthe
/ (1 − t) benefit from compounding capital gains rather than
This formula
ignores
multi-period
exempt
Roy’s Safety
Firstfocuses
Ratio (SFon
Ratio)
recognizing the annual capital gain.
• Only
mean and variance of returns.
Taxaffect
loss harvesting
is another
commonly used strategy related to portfolio rebalancing
• SourcesE (of
risk may not be well diversified.
Taxes •also
expected
standard
Revision
to asset
an deviation.
allocation
R p ) − RL
and taxes.
Ratio =
and
•SFAsset-only
σstrategy.
p
•σ atChanges
in
goals
= σ (1 − t )
Strategic ptasset location refers to placing less tax-efficient assets into tax-deferred or
• Single-period framework and ignores trading/
• Changes
in constraints
tax-exempt
accounts
such as pension and retirement accounts. For example, equities
where:
rebalancing costs and taxes.
should
heldhigher
in taxable
taxablethe
bonds
high-turnover
Taxes result
in generally
lower highs
and
lows,accounts,
effectivelyand
reducing
meanand
return
and
RL is the lowest acceptable return over a period of time.
•
Changes
inbeinvestment
beliefs
• Does not address evolving asset allocation strategies, muting trading
assets should be placed in tax-exempt or tax-deferred accounts to maximize
dispersion.
portfolio’s expected return.
• Expected returns on real estate can be determined using:E(Rp) is the path-dependent
the
tax
benefits
of
those
accounts.
•
Tactical
asset
allocation
(TAA)
approaches
decisions, non-normal distributions.
σp is the portfolio’s standard deviation.
Equivalent After-Tax Rebalancing Range
• Capitilization rates:
• Discretionary
uses market
skillsprocess.
to avoid
or
• Approaches to improve quality of MVO asset allocation Asset allocation
decisions are aTAA:
dynamically
changingtiming
and adjusting
Market
Including International Assets
hedge
negative
returnsoften
in down
enhance
conditions
asset owner
circumstances
requiremarkets
revising anand
original
asset allocation
Rand
• Use
reverse
optimization
compute
implied returns
at = R pt (1 − t )
• The
Sharpe
ratio of the
proposed new to
asset
class: SR[New]
decision. There
are basically
threeinelements
that may trigger a review of an existing asset
positive
returns
up markets.
improve
quality
inputs,
e.g. Black-Litterman allocation policy:
• Theand
Sharpe
ratio of the
existing of
portfolio:
SR[p]
• A building block approach, whereby expected return is • Themodel.
correlation between asset class return and portfolio return:
where: • Systematic TAA: uses signals to capture asset-classCorr (R[New], R[p])
rebalancing
R = After-tax
based on risk premia that incorporate those used for
Changes
inreturn
goals: range
level
anomalies that have been empirically
• Adding constraints to incorporate short-selling and Ratpt 1.= Pre-tax
rebalancing
range in business conditions and changes in expected future cash
a. As
a result of changes
both fixed income securities and equities
demonstrated
as producing abnormal returns.
other
real-world
restrictions
into
optimization.
flows over time, a mismatch may arise between the original intended goal and the
SR[ New] > SR[ p] × Corr ( R[ New], R[ p])
• An equilibrium approach, with adjustments for
Value
After
Distributions
current
goalTaxable
of
the fund
best serve
the fund’s needs.
• Behavioral
biases
intoasset
allocation
• Resampled MVO technique combining MVO and Monte Portfolio
illiquidity and smoothed returns
b. Changes in an asset owner’s personal circumstances may alter risk appetite or
Carlo
approaches to seek the most efficient and
Portfolio Risk
Budgeting
Asset
•VAllocAtion
Loss
aversion:
mitigate
by
framing
riskchildren,
in terms
=
V
(1
−
t
)
atrisk capacity.
pt
i Life events such as marriage, having
andof
becoming ill
• Expected returns for foreign exchange can be determined
consistent optimization.
shortfall
or needs
funding
high-priority
goals
with from an
may
all haveprobability
an impact on the
and goals
of an individual
benefiting
Marginal contribution to total risk identifies the rate at which risk changes as asset i is
using:
where:Asset AllocAtion
investment
portfolio.
low-risk
assets.
•
Monte
Carlo
simulation
and
scenario
analysis
3. toItthe
canportfolio:
incorporate trading costs and costs of rebalancing a portfolio. It may also
added
AA
portfolio
value Any material change in constrains, including asset size,
vat =2.after-tax
Changes
in constraints:
• A monetary approach, whereby exchange rate
incorporate taxes.
• Illusion
control:
mitigate
byexternal
using constraints,
the globalshould
market
• Used
in a multiple-period framework to improve
portfolio
value
vpt = pre-tax
liquidity,
time of
horizon,
regulatory,
or other
trigger a
model non-normal multivariate return distributions, serial and cross-sectional
movements reflect the expected differences in inflation 4. It can
2.single-period
The =
two-portfolio
or hedging/return-seeking
portfolio approach
AA of
rateportfolio
on distributions
income
ti = taxreexamination
MCTR
βi ,P σ P approach
asset allocation
decisions.
asexisting
aasstarting
point and
using a formal asset
MVO.
correlations,
requirements,
an evolving asset allocation
strategy,partitions
pathi distribution
assets into two groups: a hedging portfolio and a return-seeking portfolio. The
dependent
decisions, nontraditional investments, non-tradable assets, and human
• Capital flows, whereby expected changes in exchange
3.
Changes
in
beliefs:
Investment
beliefs
change
with
market
conditions,
among
allocation process based on long-term return and risk many
hedging portfolio
is managedpicture
so that its assets
are expected to produce
a good hedge
• Provides
a realistic
of distribution
of potential
capital.
other
factors.
TheyAny
areunauthorized
a set of guiding
that
govern
asset owner’s
to cover required cash outflows from the liabilities. The return-seeking portfolio
rates is based on differences between countries in
© wiley 2018
Allforecasts,
Rights
Reserved.
copying
orprinciples
distribution will
constitute
anthe
infringement
of copyright.
optimization
constraints
anchored
around
where:
future
outcomes.
investment decisions. Investment beliefs include expected returns, volatilities, and
can be managed
independently of the hedging portfolio. Portfolio managers and
default-free rates and risk premiums
budget
a particular
allocation
of portfolio
risk.
optimal riskportfolio
budget as
is an
oneassetto
= beta
of isasset
i returns
with
to portfolio
returns
βAi,Prisk
asset class
in the
market
investment
advisors
canrespect
potentially
treat
theAn
return-seeking
correlations
amongweights
asset classes
in theglobal
opportunity
set. portfolio, and
satisfy
portfolio
optimization.
Our
goal
is to seek
an optimal
risk allocation
budget.
Portfolio
risk
can be
• Can
incorporate
trading/rebalancing
costs
and
taxes.
return
volatility
measure
as standard
of asset
i returns
σP = portfolio
only
portfolio
and
apply
traditional
MVO
in thedeviation
asset
process.
The
twostrict policy ranges.
total risk, marketportfolio
risk, active
risk,isormost
residual
risk. Here
are three statements
thatwish
are directly
approach
appropriate
for conservative
investors who
to reduce
Can
model
non-normal
distributions,
and
crossrelated to •the
risk
process:
or budget
eliminate
the
riskrisk
of not
being able
to pay
future liabilities.
Variants
of
two- i
Absolute
contribution
to
total
identifies
the
contribution
toserial
total
risk
fortheasset
• Mental accounting: goal-based investing incorporates
portfolio
approach
include:
correlations,
evolving
asset allocations,
path• A building block approach, whereby expected return is 1. The sectional
Partialidentifies
hedge: Capital
allocated
to the
hedging
reduced
in different
order to
this bias directly into the asset allocation solution by
riska.budget
the total
amount
of risk
and portfolio
allocatesisthe
risk to
dependent
decisions,
non-traditional
194
generate
higher
expected returns
from the return-seekinginvestments,
portfolio.
© 2018 Wiley
asset
classes
in a portfolio.
ACTR
based on risk premia that incorporate those used for
aligning each goal with a discrete sub-portfolio.
i = wi × MCTRi
b.
Dynamic
hedge:
The
investor
increases
the
allocation
to
the
hedging
portfolio
as
2. An optimal
risk capital.
budget allocates risk efficiently, which is to maximize return per unit
human
ACTR
the
funding
ratio
increases.
both fixed income securities and equities
i
of%
risk
taken.
ACTR
to
total
risk
=
•
Recency
or
representativeness
bias:
mitigate
by
using
i two-portfolio approach has its limitations.
The
Risk
budget
σ risk budget is risk budgeting.
process
of finding the optimal
• Expected return for emerging market securities is likely 3. • The
a. It cannot be used when Pthe funding ratio is less than 1.
a formal asset allocation policy with prespecified
c09.indd 194
7 March 2018
b. It cannot be
use when
a true hedging
portfolio
is unavailable;
for example,
• Identifies
total
amount
offorrisk
allocates
risk
tothe
to include considerations for ability and willingness to The concept
of marginal
contribution
to
is anand
important
one because
it allows
allowable ranges.
liabilities are related to portfolio
payments risk
damages
due to hurricanes
or earthquakes.
us to (1) track
the
in
portfolio
risk due
to a change
in portfolio
holding,investors
(2) determine
asset
classes.
3.different
Thechange
integrated
asset-liability
approach
is used by
some institutional
to
pay (fixed income) and risks to shareholder
protections
24
© Wileypositions
2018 All rights
reserved.
Any
unauthorized
or distribution
will constitute
an infringement
of copyright. • Framing bias: mitigate by presenting the possible asset
which
are optimal,
and
(3)and
create
a copying
riskdecisions.
budget.
jointly
optimize
asset
liability
Banks, long/short
hedge
funds, insurance
(equities)
• Asset
allocation
is optimal
when
of excess
return
companies,
and reinsurance
companies often
must ratio
render decisions
regarding
the
allocation choices with multiple perspectives on the
of liabilities
in conjunction
with their asset allocation. The process is
setting,
weishave
thesame
following
relations:
tocomposition
MCTR
the
for
all
assets.
• Expected variance of returns and covariances can be In a risk budget
risk-reward tradeoff.
called asset-liability management (ALM) for banks and dynamic financial analysis
(DFA) for insurance companies. The approach is often implemented in the context
determined using:
Marginal
contribution
to total
(MCTR)
= Asset
beta ×The
Portfolio
standard
deviation
of multiperiod
models
viarisk
a set
of projected
scenarios.
integrated
asset-liability
• Familiarity or availability bias: mitigate by using the
• Historical statistics
approach
provides
mechanism
to discover
the weight
optimal×mix
of assets and liabilities. It
Absolute
contribution
toatotal
risk ( ACTR
) = Asset
MCTR
global market portfolio as the starting point in asset
is the most comprehensive approach among the three liability-relative asset allocation
Ratio of
excess return to MCTR = (Expected return − Risk-free rate)/ MCTR
• Factor models, that seek to reduce problems
approaches.
allocation and carefully evaluating any potential
associated with historical statistics. Shrinkage
deviations.
Characteristics of liability-relative asset allocation approaches are summarized in the
allocation
is
optimal
when
the
ratio
of
excess
return
(over
the
risk-free
rate)
to
• following
Liability-relative
asset
allocation
approaches
estimation, using historical statistics and factor model An asset
table.
MCTR is the same for all assets.
outputs can provide further precision
Surplus optimization
two-Portfolio
Integrated Asset-liability
asset allocation utilizes investment risk factors instead of asset classes to
• Smoothing, especially in the case of illiquid markets: Factor-based
Simplicity
Simplicity
Increased complexity
make asset allocation decisions. These factors are fundamental factors that historically have
Linear or
or nonlinear
correlation
producedLinear
returncorrelation
premiums or anomalies
to nonlinear
investors.correlation
These factorsLinear
include,
but not limited
to:
All levels of risk
1.
2.
3.
4.
5.
6.
7.
• ARCH models, that seek to account for volatility
clustering of returns
•
Conservative level of risk
All levels of risk
Size
(small cap
cap). funding ratio for
Any funding
ratioversus large
Positive
Any funding ratio
Valuation (value stock versus
stock).
basicgrowth
approach
Momentum
losers).
Single period(winners versus
Single
period
Multiple periods
Liquidity (low liquidity versus high liquidity).
Duration
(long
term versus
short term).
It’s important
to examine
the robustness
of asset allocation strategies. Four commonly used
Credit
(low-rated
versus
high-rated bonds).
robustness
tests are:bonds
Goal-based
asset
allocations
Volatility (low-volatility stocks versus high-volatility stocks).
Simulation based
on historical return and
risk data. modules based on
• 1.Creation
of differentiated
portfolio
2. seven
Sensitivity
analysis
where the level
one underlying
risk factor
is changed and the
Note that these
factors
are implemented
asofa zero-cost
investment
or self-financing
capital
market
expectations.
resulting
allocation
outcomes
are investigated.
investment, in which
theasset
underperformer
is short-sold
and outperformer is bought. By
Scenario
analysis
where
the levels
of multiple
risk factors are
changed
in a correlated
construction,3.Identifying
they
are often
market
neutral
and carry
low matching
correlations
with
thegoals
market
and
clients’
goals
and
the
to with
manner and the resulting asset allocation outcomes are investigated. Stress testing is
other factors.
•
ASSET ALLOCATION
Asset Allocation Approaches
• Asset-only: does not explicitly model liabilities
• Liability-relative (liability-driven investing): aims at an
asset allocation that can pay off liabilities when they
come due.
• Goals-based investing: specifies sub-portfolios
aligned with a specific goal (sum of all sub-portfolio
c08.indd 183
one such case. sub-portfolios and modules.
appropriate
Asset
Allocation with Real-World
© 2018 Wiley
Constraints
© 2018 Wiley
c08.indd
185
• Constraints on asset allocation due to:
• Asset size: more acute issue for individual rather than
institutional investors.
• Liquidity: liquidity needs of asset owner and liquidity
EQUITY PORTFOLIO
MANAGEMENT
• Approaches to managing equity portfolios
• Passive management: try to match benchmark
performance.
• Active management: seek to outperform benchmark
by buying outperforming stocks and selling
underperforming stocks.
• Semiactive management (enhanced indexing): seek
to outperform benchmark with limited tracking risk
(highest information ratio).
• Approaches
to constructing an indexed portfolio
185
• Full183replication: minimal tracking risk but high costs.
• Stratified sampling: retains basic characteristics of
index without costs associated with buying all the
stocks.
• Optimization: seeks to match portfolio’s risk exposures
(including covariances) to those of the index but can
be misspecified if historical risk relationships change
7 March 2018 3:34 PM
7 March 2018 3:34 PM
Wiley © 2020
Wiley’s CFA Program Exam Review
®
over time.
selling parent and buying subsidiary) and multi-class
trading (e.g. selling class A shares in company X, while
buying their class B shares).
momentum.
• Event driven:
• Merger arbitrage – Seek returns from the price volatility
• Value style investing: low P/E, contrarian, high yield.
• Growth style investing: consistent growth, earnings
• Market-oriented (blend or core style) investors: market-
oriented with a value bias, market-oriented with a
accompanying takeover bids of acquiring company’s
growth bias, growth at a reasonable price, style rotators.
stock and target company’s equity and debt securities
• Market cap approach: small-cap, mid-cap, large-cap
• Distressed securities – Buying securities of companies
investors.
in financial distress and facing bankruptcy to take
• Investment style analysis
advantage of low price and the restructuring of the
• Holdings-based: analyses characteristics of individual
company
security holdings.
• Relative value:
• Returns-based: regressing portfolio returns on
• Fixed income arbitrage – Exploiting various aspects
returns of a set of securities indices (betas are the
of mispricing of risk premiums between securities.
portfolio’s proportional exposure to the particular style
Strategy managers will tend to hedge/immunize
represented by index).
against market risks such as duration, sovereign risk,
• Price inefficiency on the short side
currency risk, credit risk and prepayment risk
• Restrictions to short selling.
• Convertible bond arbitrage – Seek returns from delta
• Management’s tendency to deliberately overstate
hedging and gamma trading short equity hedges
profits.
against the potential long equity exposure within
• Sell-side analysts issue fewer sell recommendations.
convertible bonds
• Sell-side analysts are reluctant to issue negative
• Opportunistic:
opinions.
• Global macro – Seek returns through trading
• Sell disciplines
of currencies, bonds and derivatives based on
• Substitution: opportunity cost sell and deteriorating
expectations of the relative economic health of
fundamentals sell.
countries and potential economic policy changes
• Rule-driven: valuation-level sell, down-from-cost sell,
•
Managed futures – Systematically seek returns from
up-from-cost sell, target price sell.
technical analysis of markets and signals of expected
lio ManagEMEnt
ManagEMEnt
• Semiactive equity strategies
lio
movements in futures prices across all global markets.
• Derivative-based semiactive equity strategies:
•
Specialist:
exposure to equity market through derivatives and
Core–Satellite
Core–Satellite
• Volatility – Seeks returns through the implied volatility
enhanced return through non-equity investments, e.g.
fixed
income.
A core–satellite
core–satellite
portfolio
is constructed
constructed when
when applying
applying the
the optimization
optimization to
to aa group
group of
of equity
equity captured in option prices by buying cheap volatility
A
portfolio
is
Equity Portfolio ManagEMEnt
managers• that
that
includes indexers,
indexers,
enhancedindexing
indexers, and
and
active managers,
managers,
judged by
by their
their
and selling expensive volatility
managers
includes
enhanced
indexers,
active
judged
Stock-based
enhanced
strategies:
portfolio
information ratios.
ratios. Index
Index and
and semiactive
semiactive managers
managers constitute
constitute the
the core
core holding,
holding, and
and active
active
information
looks like
benchmark
except
in those
areas
onsowhich
•
Insurance-linked – Seeks returns from investing and
managers
represent
the
opportunistic
ring
of
satellites
around
the
core,
as
to
achieve
an
managers represent the opportunistic ring of satellites around the core, so as to achieve an
Enhanced-index
portfolio
managers
aremitigating
essentially
active
who
portfolios
the manager
explicitly
wishessome
to bet
onactive
(within
riskcore
acceptable level
level
of
active return
return
while
some
of managers
the
active
risk. build
The
core
shouldwith trading in reinsurance securities (e.g. cat-bonds)
acceptable
of
active
while
mitigating
of
the
risk.
The
should
aresemble
high degree
of
risk
control.
Their
information
ratio
can
be
explained
in
terms
of
Grinold
and
thelimits)
investor’s
benchmark
for
the asset
asset class,
class, while
while the
the satellite
satellite portfolios
portfolios may
may also
also be
be or life settlements (i.e. purchasing of life policies
to benchmark
generatefor
alpha.
resemble the
investor’s
the
Kahn’s
Fundamental
Law ofasset
Active
Management.
that:
benchmarked
to the
the overall
overall
class
benchmark The
or aa law
stylestates
benchmark.
benchmarked
to
asset
benchmark
style
benchmark.
with attractive surrender values and mortality
• Information
ratioclass
(Grinold
andorKahn)
To evaluate such managers, it is useful to divide their total active return into two components: characteristics)
.indd
PRIVATE WEALTH
MANAGEMENT
Advising Private Clients
• Compared to institutional clients, private clients tend
to have:
• objectives that are goals-based, less-defined and less
stable
• multiple, finite time horizons
• informal/limited governance structure
• - Private wealth manager skills include:
• - technical skills such as financial planning
knowledge, capital market proficiency and portfolio
construction ability
• soft skills such as communication, social, coaching and
business development skills
• Private clients can be segmented into mass affluent,
high-net-wealth (HNW), and ultra-high-net-wealth
segments
• - Private client objectives are likely to include return
objectives, retirement goals, funding priorities,
investment preferences and risk tolerance
• Tax for private clients might be based on level of income,
wealth and/or consumption
• Tax strategies employed by private clients might include:
• tax avoidance - utilizing tax mechanisms/concessions
• tax reduction - investing in tax-effective assets
• tax deferral - preference for capital gains over income
• Capital sufficiency for a private client assessed by using:
• deterministic forecasting, which uses expected returns
and cashflows to determine the expected level of
capital over time
• Monte Carlo simulation, which utilises probability
distributions of returns and cashflows to produce a
range of possible outcomes over time
• Retirees exhibit four main behavioral tendencies in their
financial planning being:
1. heightened loss aversion
2. consumption gap
To evaluate
IR such
≈ IC managers,
Breadth it is useful to divide their total active return into two components:
3. annuity puzzle
• Multi-manager:
1. Manager’s
Manager’s “true”
“true” active
active return
return =
= Manager’s
Manager’s return
return −
− Manager’s
Manager’s normal
normal benchmark
benchmark
1.
Taxes and PrivaTe WealTh ManageMenT in a glo
4. income preference
• Manager’s
Core-satellite
portfolio:
index
and semiactive
managers
• Multistrategy – Combination of the above strategies in
2.
Manager’s
“misfit”
active
return
= Manager’s
Manager’s
normal
benchmark
− Investor’s
Investor’s
“misfit”
=
normal
benchmark
−
The2.
information
ratio
(IR) isactive
equalreturn
to what
you know about
a given
investment
(the
constitute
core
holding
while
active
managers
represent
•
The
Investment
Policy
Statement
(IPS)
for
a
private
client
benchmark
the
one
fund
benchmark
information coefficient [IC]) multiplied by the square root of the investment discipline’s
Taxes
and Private Wealth Management in a Global Context
includes:
satellites.
breadth, which
is defined as the number of independent, active investment decisions made
•
Fund
of
funds
–
A
manager
that
invests
in
other
hedge
The
manager’s
normal
benchmark
(normal
portfolio)
represents
the
universe
of
securities
from
The manager’s
normal
benchmark
(normal
represents
themore
universe
of securities
each
year.
Therefore,
a lower-breadth
strategy
necessarily
requires
accurate
insightfrom
about
• Background and investment objectives
• manager
Total
active
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and
riskportfolio)
Annual Accrual with a Single, Uniform Tax Rate
which
normally
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securities
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the portfolio.
portfolio.
The breadth.
investor’s benchmark
benchmark
funds that will generally have multiple layers of
manager normally
might
select
for
The
investor’s
awhich
givenaa investment
to produce
the
samesecurities
IR as a strategy
with higher
• Investment parameters
refers to
to the
the
benchmark the
thetrue
investor
uses to
toreturn
evaluate=performance
performance
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given portfolio
portfolio
or asset
asset class.
class. management and fees
• Manager’s
active
Manager’s
–
refers
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investor
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evaluate
of
given
or
Taxes and PrivaTe WealTh ManageMenT in a glo
r•after-tax
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A semiactive
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manager’s “true”
“true” active
active risk
risk is
is the
the standard
standard deviation
deviation of
of true
true active
active return.
return. The
The
The
•
Portfolio management
•
Manager’s
misfit
active
return
=
Manager’s
normal
Asset
Allocation
to
Alternatives
manager’s
“misfit”
risk
is
the
the
standard
deviation
of
“misfit”
active
return.
The
manager’s
manager’s
“misfit”
risk that
is the
the standard
deviation
of “misfit”
active
return.
The manager’s
• Any
technique
generates
positive
alpha may
become
obsolete
as other
investors
Taxes
and Private
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n
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+ (Manager’s
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The most
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manager’s
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computed as:
EQ
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t = tax rate
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on the various goals of the client • Low correlation to equities
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n = numberbased
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Taxable
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where:
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an overall
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portfolio with
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risk exposures
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the • Private real estate
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investor’s
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objective of
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the
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FVIFpre-tax = 1 + rpre-tax
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ALTERNATIVE INVESTMENTS
Taxes and Private Wealth
Management
Hedge Fund Strategies
(
Alpha might also be chased by “beta-tilting” and risk
• Alternatives might be classified based on:
becomes one of active return versus active risk. The amount of active risk an investor wishes
factor exposures
will bemanagers.
influenced
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the mix of specific
For example,
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assume no active
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In contrast,
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time
higher-active-risk managers with little or no exposure to index funds.
• Macroeconomic performance (normal economy,
• Dedicated short-selling and short-bias – Dedicated
© 2018
2018 Wiley
Wiley
©
short-selling strategies seek returns from short
positions only, whereas short-bias strategies may
balance their portfolios with long positions
• Market neutral – This includes pairs trading (e.g. selling
© 2018 Wiley
267
company A, buying company B), stub trading (e.g.
inflationary economy, deflationary economy)
• Exposure to risk factors (equity market, size, value,
liquidity, duration, inflation, credit, currency)
7 March 2018 3:51 PM
7 March 2018 3:51 PM
267
7 March 2018 3:51 PM
)
where:
where:
where:• VFuture
valuefactor when deferring taxes on capital gains
T = terminal
value
basis
FVIFCost
= Future
valuepaid
interest
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tCM =Max (tRC, tSC)
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Wiley’s CFA Program Exam Review
®
Costin basis
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INSTITUTIONAL INVESTORS
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107
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107
Risk Mana
(higher income volatility requires higher discount rate).
• Income volatility risk can be diversified by appropriate
The international shift away from defined-benefit (DB) pension plans has caused a shift
financial capital, e.g. if human capital is equity-like,
toward annuities. At the individual level, there are five factors that would likely increase
financial
should contain more bonds.
demand
for capital
any annuity:
• Economic
(holistic) balance sheet
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© Wiley
2018T
all
reserved.
or distributionwith
will constitute
an infringement
copyright.
D−−
FVIF
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ttCG

taxed annually,
theformula
1−
PI tt −
PD tt D −
Pto:
−P
−reduces
−P
CG tCG 
t DM = t RC + tSC − t RC tSC
1
P
3. Less concern
for value.
leaving money to heirs
I
D D
CG tCG 
capital,
pension
t
=
t
+
t
−
t
t
DeductionDM
Method
RC
SC
RC SC
4. More conservative investing preferences
If the portfolio is non‐dividend paying equity securities with 100 percent turnover and
• Liabilities:
total debt,
lifetime
consumption
n
5. Lower guaranteed
income
from other
sources (such asneeds,
pensions)
The
after-tax
future
value
multiplier
under
this blended
blended
taxregime
regime then
then becomes:
becomes:
taxedafter-tax
annually,
thevalue
formula
to:
 blended
FVIF
= 1 +multiplier
rreduces
(1 − tCGwith
)under
after-tax
The
future
value
this
tax
regime
• Future
factor
tax
bequests.
t DM = t RC + tSC − t RC tSC
Lesson 7: IMpLeMentatIon oF RIsK ManageMent FoR IndIVIduaLs
Concentrated Single-Asset Positions
n
n
9 is the difference between total assets and
© Wiley 2018 all Rights Reserved. any unauthorized copying or distribution will constitute an infringement of copyright. • Net wealth
FVIFafter-tax =Return
= (1
+ rr*)
−
(1 − B)
FVIF
1+
Accrual Equivalent
(1tCG
−T
T) *)
+T
T*
− ttCG
(1n−(1
*)
*) +
*−
after-tax
after-tax = 
CG (1 − B)
(1
9
© Wiley 2018 all Rights Reserved. any unauthorized copying or distribution will constitute an infringement of copyright.
total liabilities.
Los 12j: analyze and critique an insurance program. Vol 2, pp 431–440
• Objectives: risk reduction (diversification), monetization,
• Young family has high % of economic assets in human
n
If
the portfolio
portfolio
is
non‐dividend
paying equity
equity securities
securities with
with no
no turnover
turnover (i.e.,
(i.e., P
PD =
=P
PI =
= 00
Vn = Vis
1 +equivalent
rReturn
Accrual
tax
optimization,
control.
If
the
paying
0 (non‐dividend
AE )
9
D
I Wiley
• =Equivalent
Accrual
after-tax
return
©
2018
all Rights
Reserved. any unauthorized
copying or distribution will constitute an infringement of copyright. Los
12l:As
Recommend
and justify
strategies for asset allocation
capital.
the
household
ages,appropriate
weight of human
1)
held
to
the
end
of
the
horizon,
the
formula
reduces
to:
and
P
CG
and PCG = 1) heldVto the end of the horizon, the formula reduces to:
• Considerations: illiquidity, triggering taxable gains
and
risk reduction
given an investor
profile of key inputs.
(financial)
capitalwhen
will decrease
(increase).
rAE = n n − 1 n
Vol
2,
pp
440–443
Vn = V0 (V10+ rAE )
on
sale,
restrictions
on
amount
and
timing
of
sales,
FVIF
(1 − r )nn (1 − tCG ) + tCG
• Risks to human and financial capital
after-tax =
FVIFafter-tax
emotional and cognitive biases.
V = (1 − r ) (1 − tCG ) + tCG
r = n n −1
The
decision torisk:
retainprotect
risk or buyagainst
insuranceearnings
is determined
byrelated
a household’s
• Earnings
risk
to risk tolerance.
where: AE
V0
• Monetization strategies
At injury
the samewith
level disability
of wealth, a more
risk-tolerant household will prefer to retain more
Ifnthe
the
portfolio
isn non‐dividend
non‐dividend
paying
equity securities
securities with
with 100
100 percent
percent turnover
turnover and
and
insurance.
= value
afteris
compoundingpaying
periodsequity
V
If
portfolio
risk, either through higher insurance deductibles or by simply not buying insurance. A
taxed
annually,
the
formula
reduces
to:
•
Monetization
by
(1)
hedging
the
position,
and
(2)
taxed annually, the formula reduces to:
• Premature
death
(mortality
protect
with life
Accrual
where: Equivalent Tax Rate
risk-averse
household
would
have lower risk):
deductibles
and purchase
more insurance. For
borrowing against hedged position.
• Accrual equivalent tax rate
Vn = value after n compounding periods
all insurance.
households, insurance products that have a higher load (expenses) will encourage a
n
n
FVIFafter-tax =
= 1
1+
+ rr ((1
1−
− ttCG )) 
•
Hedging
for
monetization
strategies
can
be
achieved
household
to
retain
more
risk.
Finally,
as
the
variability
of
income
increases, the need for
FVIF
r (1 − TTax
• Longevity risk: protect with annuities.
AE = after-tax
AE) Rate CG 
Accrual rEquivalent
life insurance decreases because the present value of future earnings (human capital) will
by: (1) short sale against the box (least expensive); (2)
rAE
be
lower
with
a
higher
discount
rate.
•
Property
risk:
protect
with
homeowner’s
insurance.
TAE = 1 − Return
total return equity swap; (3) short forward or futures
Accrual
r Return
Accrual rEquivalent
Equivalent
AE = r (1 − TAE )
contract; (4) synthetic short forward (long put and
• Liability
risk:
withofliability
insurance.
Table
7-1 shows
the protect
appropriateness
the four risk
management techniques depending on
rAE n
short call).
the
severity of
lossprotect
and the frequency
of loss. insurance.
=Accounts
1 − of tax
n
Tax‐Deferred
• Health
risk:
with health
• TMeasure
drag = Difference between accrual
VAE
n = V0 (1 + rAE )
V
n = V0 (1 +r rAE )
Taxes and
in a global ConTexT
• Hedging
strategies
equivalent
after-tax return and the actual return
ofPrivaTe
theWealTh ManageMenT
• table
Risk management
techniques
V
7-1: Risk Management
techniques
= nn Vnn −
−1 n
rrAE
portfolio.
FVIF
AE =Accounts
Tax‐Deferred
V=0 (1 1+ r ) (1 − t ) tCG B
•
Buy
puts
(protect downside and keep upside while
TDAV
Private
Wealth
ManageMent
0
Loss Characteristics
High Frequency
Low Frequency
deferring capital gains tax).
• Tax-deferred
accounts (TDAs): contributions from
Tax‐Exempt
Accounts
High severity
Risk avoidance
Risk transfer
n
untaxed
ordinary
income,
tax-free
growth
during
the
1
1
FVIF
=
+
r
−
t
t
B
(
)
(
)
where:
Private
Wealth
ManageMent
TDA
CG
•
Use
zero-premium
collars
(long
put
and
short
call
with
where: Probability Approach
Survival
Low severity
Risk reduction
Risk retention
= value
value
after n
n compounding
compounding
periodsat time of withdrawal
Vn =
holding
FVIF
1 + r )n taxed
(period,
after
periods
V
offsetting premiums) to reduce costs vs buying puts.
n
TEA =
Exhibit
10,
Volume
2,
CFA
Curriculum
CFA
2017
Joint
survival
probability
for a couple is:
Accrual
Equivalent
Tax Rate
Rate
• Use prepaid variable forward (combine hedge and
• Adequacy of life insurance
Accrual
Equivalent
Tax
Survival
Probability
FVIFTDA = Approach
(1 + r)n (1 – tn)
margin loan in same instrument), with number of
An
investmentlife
advisor
willmethod:
often be asked
how muchthe
life PV
insurance
is enough. There are
FVIF
(1 − t ) ) + p(survival )
• Human
value
estimates
of earnings
TDA = FVIF
p(survival
) = pTEA
(survival
Taxes and PrivaTe WealTh ManageMenT in a global ConTexT
J
H
W
r
=
r
1
−
T
Joint survival
AE =probability
AE )) for a couple is:
twothat
techniques
will be responsible for on the exam:
shares delivered at maturity dependent on share price
rAE
r ((1 −reserved.
TAE
mustthat
beyou
replaced.
© Wiley•2018
all rights
any
unauthorized
copying
orafter-tax
distribution
willcontributions,
constitute an infringement of copyright.
−
(
)
×
(
)
p
survival
p
survival
Tax-exempt
accounts
(TEAs):
H
W
at maturity.
rrAE
T
=
−
Value Formula
agrowth
Tax Exempt
Account
AE
• Needs
analysis
method:
financial
needs
ofvalue of earnings
1. Human
life value
method:estimates
This technique
estimates the
present
T
=1
1for
− JAE
tax-free
during
holding
period, no future tax
pAE
(survival
(survival
H ) + pthe
W)
rr) = p(survival
IMPORTANT:
Tax‐Exempt
Accounts
• Yield enhancement
strategies:
that must be replaced.
A more conservaBased
joint
survival
probability,
present
value
of )joint will
spending
needs
is:
dependents.
liabilities.
© Wileyon
2018
all rights
reserved.
unauthorized
copying
or
distribution
constitute
an
infringement
of
copyright.
− pany
(survival
)
×
(
p
survival
H
W
tive approach as2.
needs
analysis
method:
This
technique
estimates
the
financial
needs of the
n
V0 (1 − t0)(1n+ r)
Vn = Accounts
• Write
covered
sumes
both spousescalls to generate income.
Tax‐Deferred
Tax‐Deferred
N
dependents.
IMPORTANT:
FVIFAccounts
live
through the
p(survival
(spending
TEA = (1 + r )
J ) × value
J ) spending needs is:
A more
conservaBased onPV
joint
survivalJ )probability,
present
of
joint
longest
expectancy
(spending
=∑
•
Does
not
reduce
downside
risk.
tiveeither
approach
(1 + r )t
for
life. as1
Value Formula
for
a Tax‐Deferred
Account
sumes both spouses
=
rr ))nn t((N=1
B
TDA
CGreturn
• Tax optimized
1+
1−
FVIF
= ((1
+after-tax
− tt )) ttCG
B
• FVIF
TDATDA
offers
advantage over TEA if tax
live through the equity strategies
p−(survival
J ) × (spendingJ )
FVIF
=
FVIF
(1
t
)
longest
expectancy
PV
(
spending
)
=
TDA
TEA
∑t ) isdiscounts
J n approach
t
rate
at withdrawal
lower
than
tax rate
at initial
The survival
probability
period’s
spending
needs by the real risk-free
• Index-tracking
separately managed portfolio: designed
V
(1 + r )each
for either life.
n = V0(1 + r) (1 t−
=1 n
IMPORTANT:
Sovereign Wealth Funds
rate because
they are nonsystematic
(i.e., unrelated to market-based risk inherent in the ascontribution.
Do not discount
to outperform
benchmark from an investment and tax
sets).
theya can
hedgedAccount
using life insurance.
ValueHowever,
Formula for
Taxbe
Exempt
expected spending
Investor’s
After‐Tax
Risk ofdiscounts
The survival
probability
approach
each period’s
spending
needs
by the real risk-free perspective.
with the required
• Investor’s
shared
investment
risk on
a taxed
return
• SWF types include:
IMPORTANT:
return on a portforate because
theyreserve
are nonsystematic
(i.e.,
market-based
risk inherent
in the asDo
notassets
discount
The
emergency
incorporated
into unrelated
liabilities to
considers
the shortfall
risk of funding
lio of
used to portfolio: tracks index given
• Completeness
sets).
they
using
life insurance.
expected
spending
• budget stabilization funds (used by commodity
=V
(1
−−can
tt0))(1be+ hedged
r)nreserve
fund
them.
nAT
σtwo-year
= 0σ
(1emergency
assets.However,
AV
is designed
to satisfy anxiety about market cycles and is
© 2018 Wiley
with the required portfolio characteristics and new
concentrated
exporting countries)
usually sufficient for planning.
return on a portfoThe
emergency
reserve
incorporated
intocopying
liabilities
considers
the shortfall
risk ofoffunding
investments.
lio of assets used to
©
Wiley
2018
all
rights
reserved.
any
unauthorized
or
distribution
will
constitute
an
infringement
copyright.
Value
forreserved.
a Tax‐Deferred
Account or distribution will constitute an infringement of copyright.
© WileyFormula
2018
all rights
any unauthorized
where:
fund them.
• development funds (reserves ear marked for big
assets.
A
two-year
emergency
reserve iscopying
designed to satisfy anxiety about market cycles and is
Monte
Carlo
Approach
•
Exchange
fund:
investors
with
concentrated
positions
Estate
Planning
σ = standard
deviation
of returns
usually
sufficient
for planning.
r12.indd 95
projects)
Vn = V0(1 + r)n (1 − tn)
contribute these positions in exchange for a share in a
The Monte Carlo approach examines many paths, with outcomes based on random values within Private Wealth ManageMent
• pension reserve funds (similar to private sector defined
Monte
Carlo
Approach
•
Core
capital
diversified
fund
(non-taxable
event).
PWM
Ratio of
Gains return,
to Short-Term
Gains
ranges
forLong-Term
each variableCapital
(i.e., portfolio
mortality, Capital
emergency
experiences, tax changes, etc.).
benefit funds)
The Investor’s
After‐Tax
Risk
Combining
the
many
potential
outcomes gives
a feeling of
the portfolio’s
risk as a funding portfolio.
• Carlo
Assets
for maintaining
lifestyle,
funding
desired
The
Monte
approach
examines many paths,
with outcomes
based
on random values within• Monetization strategies for concentrated private shares
• reserve funds (investing of foreign exchange reserves
Survival
Probability
Approach
n
PWM
spending
goals
and
providing
emergency
reserve.
ranges
for
each
variable
(i.e.,
portfolio
return,
mortality,
emergency
experiences,
tax
changes,
etc.).
1
1
+
−
V
r
t
(
)
(
)
V
•
Strategic
buyers:
gain
market
share
and
earnings
LTG
0
σ LTG
tCapital
)
transferring
AT =excess
to enhance return)
=σ (1 −potential
n
Combining
the
many
outcomes
gives afor
feeling
of the portfolio’s risk as a funding portfolio. growth.
•VSTG
Joint
probability
a couple
Joint survival
probability
couple
1 + r (1for
− taSTG
V0survival
) is:
• savings funds (used for multi-generational national
Inter vivos gifting bypasses the estate tax on a bequest at death. Local jurisdictions have
where:
transferring
excess
Capital taxes to minimize the revenue loss from inter vivos gifting. • Financial buyers: acquire and manage companies using
wealth transfer)
implemented
gift
and
donation
p(survival
survival H
H ) + p(survivalW
W)
JJ ) =
σ = standard
deviation
ofp(returns
private equity fund.
− p(survival
× pon
(survival
H )tax
W ) at death. Local jurisdictions have
• Risk tolerance/objective: range of risk tolerance based
H
W
Inter
vivos
gifting
bypasses
the estate
a bequest
Tax-Free Gifting
•
Leveraged
recapitalization:
private
equity
firm
uses
implemented gift and donation taxes to minimize the revenue loss from inter vivos gifting.
on SWF type generally related to time horizon (budget
IMPORTANT:
IMPORTANT:
Ratio of Long-Term Capital Gains to Short-Term Capital Gains
PV survival
of jointprobability,
spending
needs
debtAA more
to purchase
majority of owner’s stock for cash.
conservaBased on•joint
present
value of joint spending needs is:
more
conservastabilzation funds have lower risk tolerance; savings
Relative value describes the relative benefit of an inter vivos gift to the value of a bequest
tive
tive approach
approach asasTax-Free
Gifting
sumes both
both spouses
spouses
at death. In this scenario, the
relative value of the tax-free gift equals return on investments • Management
sumes
buyout: management borrow money to
funds have higher tolerances)
live through
through the
the
−pt(LTG
)n (NN1tax
live
) gift’s
survival
spending
)
0 (1r+g rless
JJ ) × (return
on the
tig,JJ divided
by return on estate investments purchase
purchasedVLTG
with=aVgift
owner’s stock.
longest expectancy
expectancy
longest
PV (spending
tt an inter vivos gift to the value of a bequest
n benefit of
Relative
describes
the∑relativereturn
JJ ) =
•
Return objective:
Von
estate
investment
t
and
tax
on
the
estate
bequest
T
.
re less taxvalue
for either
either life.
life.
+
r
(1
)
for


1
1
+
−
r
t
ie
e
STGthe V
t
=
1
(
)
t =1 relative
STG  value of the tax-free gift equals return on investments
0
at death. In this scenario,
the
• Divestiture of noncore assets: owner uses proceeds to
• budget stabilization funds seek returns uncorrelated
purchased with a gift rg less tax on the gift’s return tig, divided by return on estate investments
diversify
asset
pool.
n
survival probability approach
discounts
each
period’s spending needs by the real risk-free
FVGift
[1 +tiergand
(1
− ttax
with business cycle
return
rThe
ig )]on the estate bequest Te.
e less tax on the estate investment
IMPORTANT:
IMPORTANT:
RVtaxthey
=
= (i.e.,ofunrelated
• Relative
value
a
tax-free
gift
− freeGift
rate because
areafter-tax
nonsystematic
to
market-based
risk
inherent
in
the
as• SaleDo
to family members.
Door
notgift
discount
not
discount
FV
[1 + re (1 − tie )]n (1 − Te )
• development funds look for a return greater than GDP
expected spending
spending
sets). However, they can beBequest
hedged using
life insurance.
expected
with the
the required
required
FVGift
[1 + rg (1 − tig )]n
with
• Personal
line of credit secured by company shares.
growth return on
on aa portfoportfoRVtax − freeGift =
=
return
Gifts
Taxable
to reserve
the Recipient
The emergency
incorporated
the shortfall risk of funding • Initial
lio
assets
to
FV
[1into
+ re (1liabilities
− tie )]n (1considers
− Te )
lio of
ofpublic
assets used
usedoffering.
to
Bequest
• pension reserve funds seek long-term returns in line
fund
them.
fund them.
IMPORTANT:
assets. A two-year emergency reserve is designed to satisfy anxiety about market cycles and is
with pension liabilities
Taxable giftsshare
can
• Employee
ownership plan (ESOP) exchange:
usually
forthe
planning.
For
a gift
taxable to
recipient:
still be efficient if
• sufficient
Relative
after-tax
value of a gift taxable to the recipient
Gifts Taxable
to the Recipient
the tax rate buys
on gifts owner’s shares for ESOP distributions.
company
• reserve funds seek a return in excess of monetary
IMPORTANT:
to
the
recipient
Monte Carlo Approach FV
[1 + rg (1 − tig )]n (1 − Tg )
Taxable
giftsiscan
stabilization bond yield
(numerator)
less
Gift
For a giftRV
taxable to the
recipient:
• Monetization
strategies
for real estate
=
still
if
taxable Gift =
thanbe
theefficient
estate tax
FVBequest [1 + re (1 − tie )]n (1 − Te )
the tax
rate on gifts
rate
(denominator).
• savings funds seek some real target return
The Monte Carlo approach examines
many paths, with outcomes based on random values within • Mortgage
financing
(no tax consequences and can use
to the recipient
n
PWM
PWM
FV
[1
r
(1
t
)]
(1
T
)
+
−
−
ranges for each variable (i.e., portfolio
return,
emergency
experiences, tax changes, etc.). proceeds
(numerator) is less
Gift
g mortality,
ig
g
to diversify).
• Liquidity: generally related to time horizon
RVtaxable Gift =
=
than the estate
n
7 tax
Trusts
Combining
many
potential
outcomes
as a funding
portfolio.
©
Wiley •2018
allthe
rights
reserved.
unauthorized
copying
distribution
constitute an risk
infringement
of copyright.
FVany
[1 + gives
re (1 −atoriefeeling
)]
(1 −ofTethe
)willportfolio’s
Bequest
rate (denominator).
•
Donor-advised
funds (contribute property now for tax
• Time horizon:
• Revocable:
owner (settlor) retains right to assets and
107
©
2018 Wiley
transferring
excess Capital
deduction).
• budget stabilization funds - short-term
can use trust assets to settle claims against settlor.
• Sale and leaseback
(frees up capital for diversification
Inter
bypasses owner
the estateforfeits
tax on a bequest
at death.
• development funds - medium to long-term • gifting
Irrevocable:
right to
assetsLocal
andjurisdictions
cannot have
107
©
2018vivos
Wiley
but sale 7triggers
taxable
gain).
implemented gift and donation taxes to minimize the revenue loss from inter vivos gifting.
March 2018 3:49 PM
use trust assets to settle claims against settlor.
• pension reserve funds - long-term
Tax-Free
Gifting taxation
• Double
• reserve funds - very long-term
Risk Management
for Individuals
7 March 2018 3:49 PM
• allCredit
method:
residence
country
provides
a tax
credit
• savings funds - long-term
7
Relative
value
describes
benefit
inter vivos
gift to an
theinfringement
value of ofa copyright.
bequest
©
Wiley 2018
rights
reserved.the
any relative
unauthorized
copyingoforan
distribution
will constitute
paid
in source
at death. In for
this taxes
scenario,
the relative
valuecountry.
of the tax-free gift equals return on investments• Financial capital: includes all tangible assets including
purchased with a gift rgg less tax on the gift’s return tig
ig, divided by return on estate investments
ree less tax on the estate investment return tie
ie and tax on the estate bequest Tee.
RVtax
tax −
− freeGift
freeGift =
FVGift
Gift
=
)]nn
[1 + rgg (1 − tig
ig )]
nn
Wiley © 2020
Wiley’s CFA Program Exam Review
®
• Tax: SWFs generally enjoy tax-free status in their
• Tax: not taxable unless they are unrelated business
Defined benefit pension plan
Life insurance companies
• Risk tolerance: greater ability to assume risk if
• Plan surplus
• Lower sponsor debt and/or higher current profitability
• Lower correlation of plan asset returns with company
• Risk tolerance/objective
• Liquidity risk: arises from changes in investment
jurisdictions
• Legal/regulatory: SWF’s are generally established by
way of legislation. Many have adopted the Santiago
Principles that addresses governance and best-practice
taxable income.
• Legal/regulatory: UPMIFA (US).
• Unique: types of investments constrained by size or
board member sophistication.
portfolio that affects reserves.
• Interest rate risk: reinvestment risk and valuation
• Time horizon: duration spread of assets over liabilities
constrains time horizon for securities portfolio to an
intermediate-term.
• Tax: pay corporate tax.
• Legal/regulatory
• Large % of securities portfolio in government securities
as pledge against reserves.
• Regulators restrict allocation to common shares and
below-investment-grade bonds.
• Risk-based capital requirements.
• Unique: Lending activities may be influenced by
community needs and historical banking relationships.
risk (due to duration mismatch between assets and
liabilities).
• Credit risk of bond investments.
options
• Cash volatility risk: relates to timely receipt and
• Greater proportion of active versus retired lives
reinvestment of cash.
• Higher proportion of younger workers
• Disintermediation risk: policy owners withdraw
Options
• Risk objective: usually related to shortfall risk of
funds to reinvest with other intermediaries in higherachieving funding status.
returning assets.
• Option strategies
nvestors
• Return objective: to achieve a return that will fully fund
• Return objective: minimum return requirement (based
liabilities (inflation-adjusted), given funding constraints.
Strategy
Construction using
Motivation
on rate initially specified to fund life insurance contract)
European options
• Liquidity: to meet required benefit payments.
foundations
and net interest spread.
Covered
Own underlying share and
Earn premium to
• Time horizon: usually long-term and could be multi• Liquidity: limited liquidity needs since cash inflows
call
sell call on share.
cushion losses.
Types stage.
• Independent (private or family): Funded by donor, donor’s family, or independent exceed cash outflows, but need to consider
Protective Own underlying share and
Downside protection
•trustees
Tax: investment
income
and
capital
gain
usually
taxto further educational, religious, or other charitable goals
disintermediation risk (when interest rates are rising)
put
buy put on share.
with upside potential.
• Company-sponsored:
Same as independent foundation, but a legally independent
exempt.
and asset marketability risk.
Bull
Buy call at lower strike and
Speculation on stock
organization sponsored by a profit-making corporation
• Legal/regulatory: plan trustees have a fiduciary
spread
sell call at higher strike (can price increase in a
• Operating: Funded same as independent foundation, but conducts specific research•orTime horizon: different product lines have different time
responsibility
to beneficiaries
(US).
use
puts
instead
of
calls)
range
provides
a special service
(e.g., operates aunder
private ERISA
park or museum)
horizons and will be funded by duration-matched assets.
• •Community:
Multiple donors
or publicly
funded
to make grants
for purposes similar
Unique: limited
resources
for due
diligence,
ethical
Bear
Buy call at higher strike and Speculation on stock
•
Tax:
pay
corporate
tax.
to independent foundation; no spending requirement as with the others
spread
sell call at lower strike (can
price decrease in a
constraints.
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use puts instead of calls)
range
Risk Objectives
prudent
investor
rule,
NAIC
risk-based
capital
(RBC)
and
Bet on low volatility
Butterfly
Buy call at lower strike,
Foundations
asset
valuation
reserve
(AVR)
requirements.
spread
buy call at higher strike, sell
Higher risk tolerance due to noncontractually committed payout.
• Unique: look out for restrictions on illiquid investments.
two calls at strike halfway
• Risk tolerance/objective: higher risk tolerance due to
Return Objectives
between strikes of long calls
noncontractually committed payout.
(can use puts instead of calls)
Non-life insurance companies
• Return objective:
cover
inflation-adjusted
spending
Asset management
fees cannot betoused
toward
the spending requirement
(although grantCollar
Buy stock, buy put and sell
Downside protection
making expenses
can count
toward that).
seek
returns required
to cover at least inflationgoals and
overheads
notFoundations
countable
toward
and with limited
call. (zero-cost collar if
• Risk tolerance/objective
adjusted spending goals and overhead not countable toward the required spending minimum:
spending minimum.
call and put premiums are
upside
• Policyholder reserves use lower-risk assets due to
the same)
r = % spend + % management + % inflation
unpredictable operating claims.
Straddle
Buy call and put with same
Bet on high volatility
or
• Maintaining surplus during high-volatility markets
strike
= (1 + % spend)(1 + % management)(1 + % inflation) − 1
reduces ability to accept higher risk.
Strap
Buy two calls and one put
Bet on high volatility
• Risk measured against premiums-to-capital and
with same strike
(stock price rise more
• Liquidity:
Liquidity
Requirementto quickly fund spending needs (including
likely)
premiums-to-surplus ratios.
noncountable overheads) greater than current
Strip
Buy one call and two puts
Bet on high volatility
Foundations
must be able to quickly fund spending needs (including noncountable overhead)
• Return objective
contributions.
InstItutIonal Investors
greater than current contributions.
with same strike
(stock price fall more
• Investment earnings on surplus assets must be
• Time horizon: usually infinite.
likely)
Private •and
family
foundations income
must spendand
percentage
of gain
12-month
average in the fiscal year, sufficient to offset periodic losses and to maintain
Tax:
investment
capital
taxable.
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Buy call and put, put has
Bet on high volatility
Banks
so they typically have 10% to 20% of assets in reserve to make sure they can make grants
policyholder reserves.
different exercise price
equal to• atLegal/regulatory:
least 5% of assets. UPMIFA (US).
•
Larger
companies
use
activeand
management
strategies
Liabilities
of
banks
consist
primarily
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time
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but
may
include
publicly
Box
Bull call spread and bear
Replicate risk-free
• Unique: May use swap agreements or other transactions
traded debt for
and total
funds purchased
from other
banks
or the
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to satisfy regulatoryspread
return rather
than
yield
orFederal
investment
Time Horizon
put spread
return or make
to diversify returns if funding is primarily via large blocksrequirements.
Risk ManageMent applications of DeRivative
strategies.
arbitrage profit
of
stocks.
Usually the time horizon is infinite, but this depends on the purpose of the foundation. A
Risk ManageMent applications of DeRivatives
• Liquidity:
meetless
policyholder
claims.
Bank surplus
consists to
of assets
liabilities, the cash
portion of which is invested in
• Interest rate options
longer horizon implies greater risk-taking ability.
interest Rate option Strategies
marketable
securities.
Endowments
• Time
horizon: generally shorter duration than life
• Buy interest rate call option to protect a future
interest
Rate option Strategies
DE
Tax Concerns
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insurance companies.
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•
Risk tolerance/objective
The payoff of an interest rate call option is:
•
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pay
corporate
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liabilities
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the
pledging
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Interest rate call option payoff = Notional principal × max (Underlying rate at
Greater
ability
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the minimum
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rate
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if five-year
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risk-based capital (RBC) requirements.
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averages of return and previous spending.
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to primarily
fixed liabilities,
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risk tolerance. • Buy interest rate put option to protect a future lending
Unique:
look for
restrictions
on illiquid
investments.
The payoff of an interest rate put option is:
• Lower ability to take risk if high donor contributions as
stitutional investor Portfolios
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not hold
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positon
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titutional investor Portfoliosa % of total spend.
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delta.
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option
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rate
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payoff
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=
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Managing
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• Lower
ability
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if contributing
a significant % • Net interest margin: Net interest income divided by average earning assets
titutional investor Portfolios
− Underlying rate at expiration,0)
×
rate
Change−in
option price
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rate at expiration,0)
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• • Interest
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S
interest-bearing liabilities
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Wiley
• Below-average risk tolerance.
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Rule
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Institutional Investor Portfolios
using interest
Rate calls with
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• Cap:
interest rate call options.
using interest
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calls withof
Borrowing
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• Spending
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duration gap (LADG)
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overall
interest
rate exposure based on
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duration
gap
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ofare
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theofrisk
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atare
theatrisk
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liabilities:
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rate
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turnincreases
increases
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of debt.
To reduce
this while
risk while
keeping
Rolling Three-year Average Spending Rule
rate increases,
increases, which
ourour
cost
To reduce
this risk
keeping
the the
7 March 2018 3:50 PM
Interest
rate collar
to ofprotect
a future
borrowing:
buy
benefit
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potential
ratedecreases
decreases
in
future,
purchase
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∆
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c is is
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D
−
kD
Rolling Three-year
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1
five-step
sequence
of
transactions
as
follows:
interest
rate
cap
and
sell
interest
rate
floor.
A
L
Spendingt = Spending rate × ⁄3 [Ending market valuet−3
option
greeks
and
Risk
Management
Strategies
DE
+ Ending market valuet−2 + Ending market valuet−1]
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ananinterest
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Today
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c option
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we we
Geometric Smoothing Rule
rate
ofthe
thecall
call
option
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match
term
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loan.
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in January,
When interest
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rise,risk
banks
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•
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minimum
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S
∆
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To
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also
known
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option
delta.
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decide
to
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funds
inin
March
forfor
sixsix
months.
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we should
put
decide
to
borrow
funds
March
months.
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implement
the
strategy,
we
should
with negative
LADG
experience net
worth
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bankslevel
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over
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time
period
at aand
given
of (i.e., immunized)
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market valuet−1]
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valuet−2 + Ending
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Rule rate × [Spending
t = Smoothing
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where: Leverage-adjusted
k=
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A
k = ratio of liabilities
to assets, both at market value
The interest income allocation focuses on positive spread over cost of funds.
buy
onon
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rate rate
in January
that matures
buy an
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interestrate
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calloption
option
six-month
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in January
that matures
March.
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is a function ofChange
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in optionasset
pricevalue, as∆the
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c value changes, delta changes
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=a previously
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no longer
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stock
price
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Spending
rate × [Spendingt−1 × (1 + Inflationt−1)]
borrowing rate is lower
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interest rate call
option’s
exercise
rate, the call option
• Credit
risk in the
bank’s
loan portfolio.
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(VaR) measures
position
and aggregate
portfolio minimum loss over some period
t = Smoothing
borrowing
rateasset
is lower
than
the interest
rate
call option’s
exercise
rate, the call
option
after
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value
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is
a
problem
because
a portfolio
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higher than
+Duration
[(1
Smoothing
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× Beginning
market valueatt−1a)]specified probability.
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to−fund
and× planned
capital
distributions
expires
worthless
and
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enjoy
low
cost
of
debt.
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the
borrowing
rate
is
higher
than
Leverage-Adjusted
Gapgiftsrate)
tointerest
monitor
a hedged
portfolio
frequently.
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gamma
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rateand
call rebalance
option’s exercise
rate, the
call option
generates a payoff
will measures the
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the
interest
rate
call
option’s
exercise
the
call
option
generates
payoff
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options
that
at-thefor construction
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the
end
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loan
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To hedgebe
number
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we
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N Sfor
number
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stocks.
of
with
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c option
positive spread over cost of funds, with the remaining sensitivity
+ [(1 − duration
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be delivered
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loan
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the payoff
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gap rate)
= D A ×− kD
option is not
delivered
the
option
expiration;
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is delivered
one of
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L
INST
money
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close
to
expiration.
rebalancing.
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spending
requirement.
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Gap
rate option
is not delivered
the option
expiration;
rather,
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one time
allocation
focusing
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higher(up
total
return.
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the previous
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if the interest
loan portfolio
credit risk,
and produce
to a quarter
or more of revenue).
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=
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=after
0option
=N
∆S +
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period
option
expiration.
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the
previous
example,
in March,
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rate
the
call
option
payoff
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in September
(and
Sfinishes
c ∆cChange
option
delta
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usually
infinite (maintain principal in
A horizon:
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duration
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gamma
= expiration).
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Gap gap = D A − kDL
rate
option
finishes
in-the-money, the call option payoff is paid in September (and
not
incall
March
at option
Return Objectives
Change
underlying
stock
price
perpetuity).
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to consider
both
the callinoption
premium
as well
as the time value
not need
in March
at option
expiration).
of deposits.
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+ [(1 − Smoothing rate) × (Spending rate × Beginning market valuet−1)]
L
A
where:
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where:
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The remaining allocation focuses on higher total return.
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cost/financing
of the
call option
premium.
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We need to consider
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the call
option
premium
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as should
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(opportunity
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the amount
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thethe
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andchanges,
loan
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Because
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isona the
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costs. Using the previous example, in March, we should reduce the call option
(option expiration). The net amount is the funds we receive after considering hedging
with it. Consequently,
a previously
constructed
delta-hedged
portfolio
is nothelonger hedged
premium and financing
cost (interest
accrued) between
January and
March from
Cross-Reference to CFA Institute Assigned Reading #28
losses)
+−EE(Credit
gains/losses )
( Currency
E(Currency
incomegains and losses)
E ( R) ≈+Yield
Wiley’s CFA Program Exam Review
The goal of this reading is to understand how to use forward®and futures contracts to achieve a
+Rolldown return
This model for fixed-income returns can help investors better understand the assumptions
Assuming in
notheir
reinvestment
income,
yield
income
(aka
current
yield) is computed
+E(return
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∆P based
embedded
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across
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–E(Credit losses)
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returnlosses
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any reinvestment
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the
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Annual
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gains
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losses)
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relative
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price.
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the absence
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The
numberequity
of stock
index futures
the
expected
losstoseverity
loss
default):
Bond
price
Managing
Market
Risk contracts needed to achieve the goals is given by the
simply the bond’s annual current yield.
following expression:
where:
Market risk is measured by beta, so our risk management of an equity Risk
portfolio
isapplications
all around
Yield income
= Annual
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price =asCurrent
yield
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Roll-down
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the bond
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Risk ManageMent
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Rolldown
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recognizes
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− B0) / B1 =yield
% change
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changing
to price
maturity
Rolldownassuming
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T portfolio has a beta β S , the stock index futures have a beta
1unchanged
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curve.
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the absence
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default,
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 V (1 + r ) 
under
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M × the
approaches
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the
time
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fq 

Expected
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terms
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DEDE
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against
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Rolling
return
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Yield
income
+ Rolldown
Note: Credit
losses
and
gains
or
lossesdepreciates
are return
discussed
elsewhere.
Cross-Reference
to of
CFA
Institute
Assigned
Reading
#30
CFA
Institute
Assigned
Reading
where
money
to be
invested,
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investment horizon, q is the futures contract price multiplier, f is the stock index • Passive hedging: manager protects portfolio with full Limitations
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of the portfolio
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220
© 2018 Wiley
• Active currency management
N * = Round 
VE = Equity
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equity exposure.
duration
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eventually converge to fair market values, with short- The remainder of the equation indicates the return
effect of leverage such that r1 > rB
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term increases in the domestic currency
due to (1)
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representing
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long
stock
index
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price,
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in
a
positive
from
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N
f
fixed-rate
bond
to
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floater.
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section
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VE
fixed-rate
bond
to a floater.
particular
level of risk exposure of an underlying risk factor. Risk factors include market risk,
nt applications
of DeRivatives
sector risk, interest rate risk, currency risk, and others. We may either reduce our existing risk
exposure (hedging) or increase our existing risk exposure (speculation).
Forward and Futures
increase in domestic currency’s real purchasing power,
Using Futures
• where
Leverage
with futures
(2) higher domestic interest rates, (3) higher expected Leverage
rI = investment asset return, rB is the cost of funds, and VE and VB are
r21.indd 135
11 Au
foreign inflation, and (4) higher foreign risk
premiums.
the values of equity and borrowing, respectively. Therefore, the numerator
An interest rate swap can be viewed as a portfolio of a long floating/fixed-rate bond and a
short fixed/floating-rate
fixed/floating-rate bond.
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interest
valuerepresents
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value of
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allocation
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Technical analysis: based on belief that historical
changes.
interest
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bond
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changes. Consequently,
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rate futures
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index
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index
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over the
achieve
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interest
options expire within that range. The “short” position comes from the fact that the out-ofNotional amount − Margin
the portfolio’s existing interest rate risk to achieve a synthetic target bond allocation.
the-money
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seagull spread
been shorted.
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currency
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Similarly,
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one(Fixed-rate
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and anotherExotic Options
nt applications
of DeRivatives
• Market value of assets is greater
than or equal to PV of
trading against the forward rate bias (selling base
Dollar
duration
=
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× Bond value1 × 0.01
(e.g., long-term bonds and short-term bonds), or to adjust allocations between one equity class
liability
Currency
Ancannot
Introduction
Exotic options
are those that Management:
are creative in nature and
be categorized as being
Duration
floatingand
and receive fixedstocks,
interest rate S&P
swap] = Duration
bond)
Swaps allow conversion to a long/short portfolio for minimal collateral required by the
currency
at forward
discount
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large-cap
Index,(Fixed-rate
and the Nasdaq-100
Index).
Duration
[pay
floating andsmall-cap
receive fixed interestthe
rate swap]500
= Duration
(Fixed-rate
bond)
“plain.”
Exotic strategies
provide
the
lowest
cost
investment
to
achieve
a
specific
outcome.
309
32
© 2018 Wiley
Duration (Floating-rate bond)
© Wiley 2018
rights
reserved.duration
any unauthorized
copying
or distribution
will constitute
an infringement
• all
Macaulay
offinancial
assets
matches
liability’s
due Aof copyright.
or,
increasingly
since the
crisis
of 2008,
a clearinghouse.
manager
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helpful for clients with significant unique circumstance constraints counterparties
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• Usecontracts,
pay
and
interest
rate
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to
produced
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traditional
financial
securities.
floating
rate.
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in
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long/short
portfolio.
committing
funds
to that
asset class.
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we
futures contracts
duration,
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may use
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rate
swap based
on buy
the following
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1 + (i FC × Actual 360)
Spread Duration
• Convexity of asset portfolio is minimized.
increase
duration
of bond
portfolio.
indd 309
7 March
PM
FFC/DC
= SFC/DC
× 2018 3:52
Currency Management: An Introduction
One
commonly
used
exotic
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1 + (i
×isActual
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the
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is positive)
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consider a call option with an exercise rate of
Forward
Exchange
P
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PCexample,360
duration
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FPC/BC
317 = SPC/BC
• Risk: non-parallel shifts in yield curve (risk is reduced
© 2018 Wiley
CAD1.15/USD
and a ×barrier
rate ×
ofActual
CAD1.12/USD.
If the spot rate is currently CAD1.10/
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)
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Wiley contracts used to lever up (if N Bf is positive) or lever down (if N Bf is negative)
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like a regular option, but if the barrier rate is never realized, it’s as if the option never
FFC/DC = SFC/DC ×
existed. A knock-out option ceases to exist when the exchange rate touches the barrier.
© 2018• Wiley
• Zero-volatility
Cash flow spread
matching
for multiple
liabilities
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•theVolatility
trade: long (short) straddle or strangle if
rates at all maturities that forces equality between the bond’s price and the present
NP = bonds
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and another (e.g., large-cap and1 small-cap
stocks,
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exotics
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traded
options and offer
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+ (i BC × Actual
currency
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price currency”
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timing of liabilities.
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Currency Management: An Introduction
spot
rate
for domestic
currency in
terms
of foreign currency c10.indd 221
SFC/DC •=Exhibit
Currency
management
tools
5‐1: Select
Currency Management
Strategies
• where
Uses
of currency
swap
incorporating
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any embedded
options in the bond.
Using futures
contracts,
can
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asset
class inrate
advance
of and
actually
• after
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matching
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7 March 2018 3:52 PM
MDURwe
is
the
modified
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S
committing
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buy
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Forward
Rates
where: NP
Over‐/under‐hedging
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Convert
loannotional
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Market value of assets is greater than or equal to the
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Option Contracts
OTM options
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market value of liabilities.
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domestic
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market value
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than
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Knock‐in/out
features
© 2018 Wiley
PVLiabilities = present value of liabilities
Interest rate swaps can be used to create and manage leveraged floating-rate notes (leveraged
Forward•Premium/Discount
(ioptions
− i BC ) × Actual 360


•
Derivatives
overlay
Achieve
international
diversification.
Digital
Extreme
payoff
strategies
PC
floaters) and inverse floaters.
FPC/BC − SPC/BC = SPC/BC 
Fixed income
income
Derivatives Overlay
Fixed
where:
 1 + (i BC × Actual 360) 
• Uses bond futures contracts to immunize liabilities.
• Change
asset allocation
between
stocks
and bonds.
Actualof foreign
(iissue
)×
rate
currency
terms
currency;
sameprincipal
as “base of FPA digital option, which might also be called an “all‐or‐nothing” or binary option, earns a
FFC/DC = forward
to

360floater
FC − i DC
Leveraged
A for
firmdomestic
intends
ain
leveraged
with
a notional
•
Minimum
variance
hedge ratio for a cross-hedge
Ffloaters:
S
S
−
=
FC/DC inFC/DC
 1 + (i × Actual ) 
ofFC/DC
price
• currency
Swaptions
predetermined,
fixed
payout
if
the
underlying
reaches
the
strike
price
at
any
time
during
and a floating
rate of terms
kL, where
k iscurrency”
the leverage
factor
(e.g.,
2.5)
and
L
is
the
LIBOR
rate.
360
DC
Liability portfolio BPV – Asset portfolio BPV
Domestic
Return
on
Global
Assets
the
life
of
the
option.
It
does
not
have
to
cross
the
strike
price,
nor
does
it
have
to
remain
Nf =
Lower
liquidity
with:
= spot
rate
for to
domestic
currency in termsActual
of foreign currency
SFC/DCare
• Obtained
from a regression of change in value of
with:
There
steps
the process.
) × right
•Fthree
Payer
swaption:
holder
has
Futures BPV
 (i PC − icountry
 enter interest rate Lower liquidity
in‐the‐money until expiration to earn the payoff amount. This feature makes the option
360 to
BC
rates in foreign currency
iFC = interest
underlying
asset
in
domestic
currency
terms
against
PC/BC − SPC/BC = SPC/BC 

Actual
more
appropriate
for
currency
speculation
than
hedging.
)
1
(i
+
×


swap
as fixed-rate
payer
(in-the-money
when interest •• Time
Time
since
issuance
(because
dealers have
have supply
supply right
right after
after issuance,
issuance, but
but buyers
buyers of
of Futures BPV ≈ BPVCTD
BCcountry
interest
rates
domestic
currency
i1.
RDC since
= (1 +issuance
RFC )(1 + (because
RFX ) − 1 dealers
DC =To
achieve
theingoal,
the firm
enters
into an 360
interest rate swap with a notional principal
change
in
value
of
the
hedging
security.
those
bonds
may
hold
them
to
maturity).
CF
ratesThe
gofirm
up).chooses to be the fixed rate (FS) payer and floating rate receiver. those bonds
CTD
= RFC may
+ RFXhold
+ Rthem
of k(FP).
FC RFXto maturity).
Lower
credit
quality.
• Beta
(slope
coefficient) of the regression equation is
The
firm pays
(FS)k(FP)
and receives
where
FS is the
fixed rate in the•• Lower
Forward
≈credit
RFC +quality.
RFX
•Premium/Discount
Receiver
swaption:
holder(L)k(FP),
has right
to enter
interest
Domestic
Return
on Global
Assets
Lower
acceptance
ashedge
collateral
in repo
repo market
market (sovereigns
(sovereigns are
are more
more liquid
liquid than
than lowerlower•• Lower
acceptance
as
collateral
in
interest rate swap to make the interest rate swap have a zero value at swap initiation.
the
optimal
ratio.
where:• Contingent immunization
rate as fixed-rate receiver (in-the-money
when interest
quality corporates).
corporates).
quality
FS is the price of the swap.
Actual
Nf = number of futures contract to immunize portfolio
360 
)(1
= (1S+go
RFCdown).
RFX )−(i1FC − i DC ) ×
• Basis
risk
to imperfect
correlation
Smaller
issue
sizeoccurs
(becausedue
smaller
issues will
will not
not
be included
included in
inbetween
index/benchmark).
DC
• Active
management if surplus (assets less liabilities) is
rates
FRFC/DC
= S+FC/DC
where:
•• Smaller
issue
size
(because
smaller
issues
be
index/benchmark).
2. The
firm−now
passes
through
cash Actual
inflow from
FC/DC
 1 the
 the interest rate swap (L)k(FP)
point value
)
(i
+
×


360
DC
= RFC
+ RFX +of
RFC
RFX
movement
and hedging instrument. BPV = Basisabove
= returncurrency
in domesticprice
currency
terms
a designated threshold.
as interest
payments
the
leveraged floater with a notional principal of FP R
and
DC a
CTD = Cheapest to deliver
Actual
Using
exchange-traded
options
(e.g.,
futures
and
options
on
futures)
may
provide
a
more
(i
i
)
−
×
return in foreign currency
termsfutures and options on futures) may provide a more
RFC = exchange-traded
 PC BC
Using
options (e.g.,
+R
R of
floating≈ rate
kL. Management
360 
Currency
factor
FPC/BC − SFCPC/BC FX
=S
• If the surplus
falls below threshold, revert to a pure
liquid
alternative. change
Using over-the-counter
over-the-counter
(OTC)-traded
instruments
(e.g., interest
interest
rateCF
and= Conversion
 a notional principal of FP and
Actual with
=
percentage
in
S
(i.e.,
foreign
currency
in
terms
of
domestic
currency)
R
liquid
alternative.
Using
(OTC)-traded
instruments
(e.g.,
rate
and
3. Now
the issuer may PC/BC
sell aleveraged
a
)
1 + (i BC ×floater
FX
DC/FC

360
credit
default swaps)
swaps) may
may also
also help
help reduce
reduce risk.
risk.
immunization strategy.
credit
floating rate of kL and use the funds to buy a fixed-rate bond to (partly) offset
the default
Domestic
return
on
global
asset
(where
exchange
rate
is
where:•fixed-rate
FI
Portfolio
Return
in
Domestic
Currency
Terms
payments in the interest rate swap (FS)k(FP).
The leveraged floater is
FI
Exchange-traded funds
funds (ETFs)
(ETFs) may
may provide
provide aa liquid
liquid option.
option. Portfolio
Portfolio managers
managers may
may purchase• Use gains on actively managed funds to reduce cost of
RDC = return
in domestic
) terms
expressed
ascurrency
SDC/FC
Domestic
Return
onengineered.
Global
Assets
Exchange-traded
successfully
108
© 2018 Wiley purchase meeting liabilities.
ETF shares
shares and
and then redeem
redeem them for
for the
the underlying
underlying bonds
bonds using
using authorized
authorized participants
participants
RFC = return in foreign currency terms
ETF
RDC = then
[ w1 × (1 + RFCthem
1 )(1 + RFX 1 ) + w 2 × (1 + RFC 2 )(1 + RFX 2 )] − 1
(e.g.,
qualified
banks and
and other
other institutions)
institutions) as
as intermediaries
intermediaries with
with ETF
ETF sponsors.
sponsors.
in+SRDC/FC
(i.e.,an
foreign
currency
terms
of domestic
currency)
RFX = percentage
qualified
banks
Inverse
floaters:
to issue
inverse
floater in
with
a notional
principal
of(e.g.,
FP and
a
• Horizon matching: cash flow matching for short-term
RDC = A
(1change
+firm
RFCintends
)(1
FX ) − 1
floating rate of=(bR– L),
b isRa constant rate (e.g., 8%) and L is the LIBOR rate. ThereIntroduction
are
liabilities
(< 5anyyears),
duration
matching
for long-term
+ Rwhere
FCDomestic
FX + RCurrency
FC FX
Fixed-Income
Returns
Model
© Wiley 2018
all rights reserved.
unauthorized
copying or distribution
will constitute
an infringement of copyright.
Portfolio
Return
in
Terms
where:
Fixed-Income
Returns Model
three steps
to the process.
IntroductIon to FIxed-Income PortFolIo management
• Portfolio
return
in
domestic
currency
terms
liabilities.
≈ RFC + RFX
cuRRency
intRoduction
weight ofAnasset
in the portfolio
wn =MAnAgeMent:
•
Fixed-income
returns
model
Portfolio
managers
use
expected
returns
to
position
assets
for
risk
and
return
properties
× (1goal,
+ RFCthe
+ RFX
(1 +interest
RFC 2 )(1rate
+ RFX
1 a notionalPortfolio
1. ToRachieve
firm
enters
into
swap
principalmanagers use expected returns to position assets for risk and return properties • Interest rate swap overlay to reduce duration gap
DC = [ w1the
1 )(1
1) + w
2 × an
2 )] −with
desired
for the
portfolio:
desired
for
portfolio:
The
• the
Expected
return decomposition
where: of FP. The firm chooses to be the fixed rate (FS) receiver and floating rate payer.
Liability portfolio BPV – Asset portfolio BPV
issuer
pays
L(FP)
and
receives
(FS)(FP),
where
FS
is
the
fixed
rate
in
the
interest
Risk
on
Global
Assets
in
Domestic
Currency
Terms
RDC = return
in domestic currency terms
NP =
× 100
where:• Variance of the domestic return
futures contracts to convert a cash position to an equity position or the number
of short
stock
index
to convert
an existing equity position into
using Swaps
Swaps
to
aa fixed-income
portfolio
Duration
 futures
using
to Adjust
Adjust
the
ofcontracts
fixed-income
portfolio
βT − βthe
S  of
S Duration
aN
cash
position.
Sf = risk-free

  +Long futures = Long stock index
Long
bond
 fS  as a portfolio of a long floating/fixed-rate bond and a
 βcan
An interest rate swap
f beviewed
c15.indd
317
c15.indd
317
7 March 2018 3:52 PM
7 March 2018 3:52 PM
7 March 2018 3:52 PM
FIXED INCOME PORTFOLIO
MANAGEMENT
r19.indd
108
12 August 2017 11:54 PM
rate swap
to make
the interest
Swap BPV
E(R) ≈≈ Yield
Yield income
income
in foreign
currency
terms rate swap have a zero value at swap initiation. FS is theE(R)
RFC = return
of
in the portfolio
wn = weight
price
ofasset
the
= percentage
domestic
RFX
σ2 (R
) ≈swap.
σ 2 ( RinFCS)DC/FC
+ σ 2 ((i.e.,
RFX )foreign
+ [2 × σcurrency
( RFC ) × σin( Rterms
ρ( R
Roll down
down return
return
DC change
FX ) × of
FC , RFX )]currency)
++ Roll
2. The firm now issues an inverse floater with a notional principal of FP and a floating
+ E(
E(∆
∆ Price
Price due
due to
to yields
yields and
and spreads)
spreads)
where:
+
rate
of (bin– Domestic
L). InterestCurrency
paymentTerms
is (b – L)FP. Cash inflow from the interest rate swap
Portfolio
Return
• Factors
favoring more currency
hedging
• Risksprincipal
when of
managing
NP = Notional
the swap portfolio against a liability
E(Credit losses)
losses)
Roll Yield
−− E(Credit
28
Reserved. Any unauthorized copying or distribution will constitute an infringement of copyright. structure: model risk, spread risk, counterparty credit
•RDCSignificant
objectives, e.g. income/liquidity © wiley 2018 All Rights
E(Currency gains
gains and
and losses)
losses)
= [ w1 × (1 + Rshort-term
++ E(Currency
FC1 )(1 + RFX 1 ) + w 2 × (1 + RFC 2 )(1 + RFX 2 )] − 1
Index
Matching
to
a
Fixed-Income
Portfolio
© 2018 Wiley
risk.
requirements.
( F − SP / B )
YRoll = P / B
• noYield
incomeincome,
equals
current
yield
assuming
no
SP / B
Assuming
reinvestment
yield
income
(aka
current
yield)
is
computed
as:
•
Global
fixed-income
investments.
Assuming no reinvestment income, yield income (aka current yield) is computed as:
where:
Active return = Portfolio return – Benchmark index return
reinvestment income
• All
Markets
high
currency
assetwillvolatility.
= weight
ofRights
assetReserved.
in with
the Any
portfolio
w©n wiley
2018
unauthorized
copying or or
distribution
constitute an infringement of copyright. 7 March 2018 3:52 PM
Annual
coupon
payment
where || indicates
value. Positive roll yield occurs when a trader buys base
• Highabsolute
risk aversion.
Current yield
yield =
= Annual coupon payment
Current
• Total return mandates
currency at a forward discount or sells it at a forward premium.
Bond price
price
Bond
Index-Based Strategies
• Doubt about value of currency return potential.
• Variance
Lower possibility
of regret if the hedge is not profitable.Rolldown return recognizes the value change as a bond approaches maturity (“pull to par”)
Minimum
Hedge
Rolldown
return:
value
change
asapproaches
bond approaches
Rolldown•return
recognizes
the value
change
as a bond
maturity (“pull to par”)
• Low costs of hedging.
under an
an assumption
assumption
of zero
zero
rate
volatility
(i.e., unchanged
unchanged yield
yield curve).
curve).
under
of
maturity
(pullrate
tovolatility
par) (i.e.,
yt = α + βxt + εt
• Pure indexing (full replication): match benchmark
Rolling return = Yield income + Rolldown return
© wiley 2018 All Rights Reserved. Any unauthorized copying or distribution will constitute an infringement of copyright. Rolling return = Yield income + Rolldown return
where:
yt = percentage change in asset to be hedged
Expected price
price change
change due
due to
to change
change in
in the
the yield
yield or
or spread
spread depends
depends on
on the
the bond’s
bond’s modified
modified
Expected
xt = percentage change in hedging instrument
duration and
and convexity,
convexity, or
or effective
effective duration
duration and
and convexity
convexity in
in the
the case
case of
of bonds
bonds with
with options:
options:
duration
β = hedge ratio for minimum variance hedge
weights and risk factors by owning all bonds in the
index with the same weighting.
Wiley © 2020
rategieS
Wiley’s CFA Program Exam Review
®
• Enhanced indexing: sampling approach to match
primary risk factors; slight mismatch with benchmark
weights to achieve a higher return compared to full
replication.
• Active management: aggressive mismatches with
benchmark weights and primary risk factors to achieve
outperformance.
• Laddered bond portfolio
• Maturities and par values spread evenly along the yield
curve.
• Protection from yield curve shifts and twists by
balancing the position between cash flow reinvestment
and market price volatility.
• Suited to stable, upwardly sloped yield curve
environments.
• Higher convexity and liquidity.
Yield Curve Strategies
• Stable yield curve strategies
• Buy and hold: choose parts of curve where yield
• Using butterflies: long the wings (barbell) and short the
body (bullet) if flattening curve, volatile interest rates,
buying convexity or parallel yield curve increase; short
the wings and long the body if steepening curve, stable
interest rates or selling convexity.
• Using options: sell convexity bonds (30-year maturity)
and purchase call options to outperform in both rising
and falling rate scenarios.
Credit Strategies
• Risk considerations
• High yield bonds: credit risk (includes default risk and
loss severity).
• Investment grade bonds: interest rate risk, credit
conditions, market impact, execution risk and trade
benchmark
• Trading strategies include:
• Short-term alpha
• Long-term alpha
• Risk rebalance trade
• Cash flow-driven trade
• Trading algorithm classes include:
• scheduled execution algorithms based on percentage
of volume, colume weighted average price or time
weighted average price
• liquidity seeking algorithms that execute trades quickly
across all available venues
• arrival price strategies which look to trade as closes
as possible to the market price at the time the order is
received
• dark strategies that use dark pools to trade in low
liquidity or low urgency orders
• smart order routers that find the best market price for
the order across venues
• Implementaion shortfall (expanded):
migration risk, spread risk.
• Spread duration (measure of spread risk): percentage
changes will not affect return or purchase longerincrease in bond price for a 1% decrease in spread.
duration/higher-yield securities.
Portfolio duration generally can be increased by reallocating cash (which has duration at • Credit spread measures
•
Rolldown:
riding
the
yield
curve
when
yield
curve
is
or close to zero) to duration assets, or by replacing shorter-duration securities with longer• G-spread: bond’s yield to maturity less interpolated
upward-sloping.
duration securities.
Decreasing duration involves selling securities for cash. If the manager
yield of correct maturity benchmark bond.
prefers to•continue
certain securities,
however, the same
types of duration altering
Fixed-inCome aCtive management: Credit StrategieS
Sellingholding
convexity:
sell lower-yielding
higher-convexity
may be accomplished via derivatives.
• I-spread: uses swap rates rather government bond
bonds if expecting low interest rate volatility.
yields.
Fixed-Income
Active Management: Credit Strategies
altering •portfolio
withlonger-maturity,
derivatives
Carry duration
trade: buy
higher-yielding
• Market-adjusted cost:
• Z-spread: spread added to each yield-curve point so
securities and finance them with shorter-maturity,
Excess Return on Credit Securities
that
PV
of
bond’s
cash
flows
equals
price.
LoS 23d:lower-yielding
explain how derivatives
may be used to implement yield curve
securities.
strategies. vol 4, pp 137–141
• Option-adjusted spread (OAS) for bonds with
XR ≈ (s × t ) − ( ∆s × SD)
• Changing yield curve strategies
Fixed-inCome aCtive management: Credit StrategieS
embedded options: spread added to one-period
• Durationportfolio
management:
shorten
(lengthen)
if
A derivatives-overlay
makes duration
management
a separateduration
decision from
forward rates that sets arbitrage-free value equal to
where: Fixed-Income Active Management: Credit Strategies
security selection
andyield
can avoid
the costly(decreases).
capital gain component present for a securities
expect
increases
price
Performance evaluation
sale. For this discussion, the overlay consists of puts and calls on bonds and interest rates = spread at the beginning of the measurement period
• Buying
with falling
yields,
portfolios
withstructured
• Return
Excess
and expected
t = holding
period
(i.e., fractional
portion ofexcess
the year)return on credit
futures (which
are alsoconvexity:
a form of derivative).
Other types
of derivatives
include
Excess
onreturn
Credit
Securities
• Return attribution and risk attribution analyses the
greater
convexity
increase
more
inused
value
than of MBS
SD = spread
duration of the bond
notes, interest-only
strips
(IOs) and will
principal-only
strips
(POs)
for portfolios
securities
assets, and collateralized
obligations
(i.e., securities
basedyields,
on underlying MBS
sources of return and risk respectively
portfolios mortgage
with less
convexity;
with rising
≈ (s ×Return
t ) − ( ∆s on
× SD
)
ExpectedXR
Excess
Credit
Securities
assets).
Fixed
income
portfolios with greater convexity will decrease less.
• Macro and micro return attribution evaluates how
decision of asset owners and portfolio managers
Fixed-income
futuresand
contracts
may structures
be used to adjust duration without any cash outlay
• Bullet
barbell
where: EXR ≈ (s × t ) – ( ∆s × SD) − (t × p × L )
other than initial margin and the mark-to-market cash flows required to maintain margin.s = spread at the beginning of the measurement period
respectively affect returns
Managers can findRelative
the correct
number of futures
contracts
to buy or sell as a function oft = holding period (i.e., fractional portion of the year)
Outperformance
Given
Scenario
• Attribution analysis may be returns-based (most
the money duration or, more specifically, the price value of a basis point (PVBP). Recall
•
Bottom-up
approach
to
credit
strategy
(security
where:
SD = spread duration of the bond
Yield Curve Scenarios
Structure
common - using total returns only), holdings-based
that money duration is the currency change in portfolio market value for a 1% changepin= annual
probability of
default
selection):
for
two issuers with similar credit risks,
rates: Level change
Parallel shift
Barbell
L = expected
severity
of
loss
(using end of day data) or transactions-based (least
Expected
Excess
Return
on Credit
Securitiesspread to benchmark rate.
purchase
bond
with greater
Slope change
Flattening
Barbell
common – using weights and returns of all transactions)
• Top-down approach to credit strategy: macro approach
DModified Steepening
Bullet
DMoney = VP ×
EXR
≈ (s × t ) – ( ∆sand
× SDoverweight
) − (t × p × L ) sectors with better relative
• Equity return attribution
to
determine
100
Curvature change
Less curvature
Bullet
value.
• Brinson-Hood-Beebower approach:
More curvature
Barbell
PVBP, then, is money duration divided by 100 yet again:
where:• Managing liquidity risk
Bullet
Decreased volatility
Volatility change
p = annual probability of default
increased
volatility
Barbell
• Cash
DMoney
D
L = expected
severity of loss
PVBP = VP ×
= VP × Modified
100
10,000
FI
• Liquid, non-benchmark bonds
(higher incremental
• Duration management
methods
return vs cash).
Formulating a Portfolio Positioning Strategy for a Market View
(Allocation effects – performance difference from the
• Buy (sell)
futures
to desired
increase
(decrease)
duration.
That information
can thenbond
be used
along with
additional
PVBP and
PVBP of the
benchmark due to allocation decisions – Note: The
• Credit default swaps index derivatives (more liquid
futures contract
determine
Parallel to
Upward
Shiftthe number of contracts to be purchased or sold:
Brinson-Fachler approach that is used for macro and
than credit markets).
micro attribution replaces Bi with [Bi – B])
Additional
PVBP
Bonds
with forward
implied
yield change greater than forecast yield change will enjoy
higher (liquid but unpredictable price movements in
• ETFs
# Contracts
=
return in a magnitude
based
on duration as they roll down the yield curve.
Futures
PVBP
volatile markets).
Yield Curve StrategieS
The leverage (i.e., value of bonds to be purchased to reach the desired additional PVBP) • Tail risk
rTotal
= Y0 − D1 (Y1 − Y0 )
can be found by the
formula:
•
Assess tail risk by modelling unusual return
• Use leverage to increase duration
(Selection effects – performance difference from the
patterns and using scenario analysis (historical and
where
subscripts
indicate
beginning
or end
The portfolio duration
is then
in effect
multiplied
by the ratio
of of
thethe
newperiod.
notional value
Additional PVBP
benchmark due to manager selection decisions)
hypothetical).
after adding
the overlay
to the original portfolio
VLeveraged
=
× 10,000 value so that the PVBP of the combined
D
of
bonds
Modified
portfolio is as desired:
• Manage tail risk using (1) diversification strategies and
A portfolio facing no constraints can position to maximize rTotal.
(2) hedges using options and credit default swaps.
VEquity + VLeveraged
DNew = D
Parallel
Yield
Old × Changes of Uncertain Direction
• Advantages of using structured financial securities such
VEquity
Increase convexity by using a barbell strategy when a yield change is certain, but the direction
as ABSs, MBS, CDOs and covered bonds
(Interaction effects – performance difference from the
of the change is not. Current portfolio duration is maintained by weighting the best bonds at
benchmark due to manager selection decisions)
The leveraged
value
is assumed to be funded by overnight loans, which would have
either end
by:
• Higher returns vs other types of bonds.
• Useto interest
ratehave
swaps:
receive-fixed,
duration equal
0 and therefore
no effect
on the equation.pay-floating
S + I = Full selection effect
© 2018 Wiley • Improved portfolio diversification.
swaps increase duration; pay-fixed, receive-floating
DPunable
= ws Dto
wL D
If the manager
were
bonds
with the same duration, bonds of different
s +find
L
A + S + I = Portfolio excess return (alpha)
• Different exposures to investment grade and high yield
swaps
reduce
duration.
duration could be added.
it would
take twice as many bonds if the manager
= wFor
+ (1 − ws )D
s Ds example,
L
bonds.
• Factor-based return attribution
• Convexity
management
17 August 2017 12:35 AM
used those
with duration
equal to half thatmethods
of the current portfolio, or half as many bonds if
we used those
withwhere
duration
twice
that ofindicate
the
current
portfolio.
Clearly,
theseP,alternatives
thein
subscripts
duration
forlarge
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portfolio
the short-maturity
• Shift
bonds
portfolio
(difficult
with
portfolios).
have different outcomes
forS,transaction
costs and curve
risk. L.
security
and the long-maturity
security
37
• Buying callable bonds and MBS (equivalent to selling © Wiley 2018 all rights reserved. any unauthorized copying or distribution will constitute an infringement of copyright.
Using leverage
in portfolios with credit risk amplifies both credit and liquidity risk. The
• Fixed-income return attribution
convexity).
Using Butterflies
higher duration
of the leveraged portfolio amplifies interest rate risk.
• Exposure decomposition (duration based):
• The
Portfolio
positioning
appropriate
long positionstrategy
depends on whether the manager expects flattening (i.e., long
Although
as liquid
as futures,
swaps
also
beasused
adjustimplied
duration.
Swaps
barbell)
or steepening
(i.e.,
longcould
bullet),
just
itforward
istooutside
the
butterfly
structure:
Top down approach which compares portfolio duration
•notParallel
upward
shift:
bonds
with
yield
have the advantage of being created for any maturity rather than being limited to standard
and returns to that of the benchmark in order to
change
greater
than
forecast
yield change
will enjoy repo
maturities as•areLong
futures.
futures
contract
can be compared
theAwings
(barbell
structure)
and shortto
thea long
bodybond/short
(bullet structure):
understand which decisions (e.g. duration bets, sector
as they
roll
down
the yield
curve
(upward
position, andhigher
leverage
can
be compared
long
bond/short
financing
position.
Receive○ return
Flattening
curveto
ora volatile
interest
rates
37
© Wiley 2018 all rights reserved. any unauthorized copying or distribution will constitute an infringement of copyright.
allocation, bond selection) contribute to excess returns
sloping).
fixed, pay-floating
swaps
are comparable
long bond/short
short-term
○ Buying
convexitytoinaexchange
for lower
yield debt security
position.
○
Parallel
yield
curve
increase
• Yield curve decomposition (duration based)
• Parallel yield change of uncertain direction: increase
TRADING, PERFORMANCE
EVALUATION, AND
MANAGER SELECTION
TRADING STRATEGY AND EXECUTION
convexity
by using
strategy.
Because a new
futures position
or newbarbell
swap position
is initiated at a value of 0, there
is an undefined duration for the position itself. Portfolio duration, however, will still be
relatively easy to calculate using money duration or PVBP effects on the portfolio’s equity
value.
© 2018 Wiley
Sizing the swap position resembles sizing a futures position, but will be scaled to
USD1,000,000 in the absence of any standard contract size (such as with the standard
• Trading strategy will be based on order characteristics,
security characteristics, market conditions, user-based
237
Top down or bottom up approach that identifies
Wiley © 2020
Wiley’s CFA Program Exam Review
®
Institutional Investor: Illiquid
Investments, Ethics and Derivatives
Where:
• Illiquidity premium is likely to be based on the illiquidity
horizon. It might be calculated by way of put option costs
or premiums offered by low-liquidity equities
• Sortino ratio
• Illiquidity risk management tools include:
• Liquidity profiling – classifying assets based on their
level of liquidity and investing in line with a liquidity
budget
• Rebalancing strategies – managing asset allocation
and transaction costs involved with rebalancing
• Commitment strategies – managing capital calls
• Stress testing – assessing liquidity under market stress
• Derivatives – altering liquidity levels through use of
• Capture ratios
highly liquid derivatives and associated leverage
• The manager selection process can raise ethical
considerations between stakeholders (researcher,
portfolio manager, external managers, end investors, etc)
including Standard IV(A) Conflicts of Interest; Standard
I(B) Independence and Objectivity, and Standard III(E)
Preservation of Confidentiality
Where:
• The use of derivative overlays can raise important
Investment Manager Selection
• Type I error: Hiring/retaining a manager with no skill
• Explicit cost
• Measured
• Obvious to investors
• Type II error: Not hiring/firing a manager with skill
• Opportunity cost
• Seldom measured
• Not obvious to investors
• Quantitative metrics used to evaluate managers include
1. Ex post alpha
RA − rf
Sharpe ratio
ratio A = RA − rf
Sharpe
−Ar ) + ε
Rt − r ft = α +Aβ=( RMtσ
σ
ft
t
A
4.
2.
4.
Case Studies
• Appraisal ratio
contributions to total return from changes in yield
to maturity and which can be used to determine
success of yield curve decisions based on yield curve
components (e.g. yield, roll, shift, slope, curvature,
spread)
• Yield curve decomposition (full repricing)
Bottom up approach that reprices constituent bonds
from zero-coupon curves.
• Risk attribution
• Bottom up approach will look at each position’s
contribution to tracking risk (relative) or total risk
(absolute)
• Top down approach will look to attribute tracking
risk to allocation and selection effects (relative) or at
each factor’s contribution to total risk and specific risk
(absolute)
• Factor-based approach will look at each factor’s
contribution to tracking risk and active specific risk
(relative) or at each factor’s contribution to total risk
and specific risk (absolute)
• Asset-based benchmarks include absolute return
benchmarks, broad market indices, style benchmarks,
factor-based benchmarks, returns-based benchmarks,
manager metrics and custom security-based
benchmarks
valuation
valuation
• Alternative asset benchmark issues include the
following:
risk-adjusted Performance
Performance measures
measures
risk-adjusted
• Hedge funds will
often use the risk-free rate plus a
The
following
are
five
risk-adjusted
performance
measures:
spread
(absolute
relative)measures:
to account for respective
The following are five risk-adjustedor
performance
strategy
1. Ex
Ex post
post
alpha risks
1.
alpha
• Unlisted real estate and private equity indices will
− rr ft == α
α ++ ββ((RRMt −− rr ft)) ++ εεt
RRtt −
likely
include
ft
Mt assets
ft
t that are not investable
•
Commodity
investment benchmarking is not able to
valuation
2.
Treynor
measure
2. Treynor measure
use market-weighting as futures values offset to zero
RA − rf
•
Appraisal
TA == RA − rf measures used in comparing portfolios
T
risk-adjusted
Performance
measures
A
ββAA
include:
The following
are
fiveratio
risk-adjusted performance measures:
•
Sharpe
3.
Sharpe
ratio
3. Sharpe ratio
• Treynor ratio
M22
Treynor
measure
M
analysis of style (returns-based or holdings-based),
active share, up/down capture, and drawdowns
• Qualitative metrics used to evaluate managers include
analysis of philosophy, personnel, decision-making
process (idea generation and implementation; portfolio
construction and monitoring), operations (trading
process, firm characteristics), investment vehicle and
terms, and fee structure
RA − rfRA − rf 
TMA22== rf +  RA − rf  σ
M
= rf β+  σ
σM
AA  M
A
σ
5. Information
Information
ratio ratio
3.
Sharpe
ratio ratio
• Information
5.
RRAA −− RRBB= RA − rf
IR
A = ratio
Sharpe
IR
A
A = A
σ
σσAA−−BB
2 Ex post alpha and Treynor measure provide the same conclusion about manager
Note4.that
thatMthe
the
Note
Ex post alpha and Treynor measure provide the same conclusion
about manager
rankings because
because they
they are
are based
based on
on systematic
systematic risk.
risk. The
The Sharpe
Sharpe ratio
ratio and
and M
M22 also
also provide
provide the
the
rankings
same
conclusion
about
manager
rankings because
because they
they are
are based
based on
on total
total risk.
risk.
 RAmanager
− rf  rankings
same conclusion
about
2
M = rf + 
σM

 σA 
Performance Evaluation
Evaluation
Performance
5.
Information
Quality control
control charts
chartsratio
are one
one effective
effective and
and visual
visual means
means of
of presenting
presenting the
the performance
performance
Quality
are
of an
an investment
investment manager
manager over time. It uses statistical methods to systematically evaluate
of
RA − RB over time. It uses statistical methods to systematically evaluate
performance
data
and
assist
in
making
retention
or
removal
decisions.
IR
=
A
performance data σ
assist in making retention or removal decisions.
and
A− B
considerations between overlay types (ETFs, futures,
and swaps) including trading costs, cash usage, liquidity,
monitoring, and counterparty risk
Private Wealth Clients: Ethics a
• Illiquidity premium is likely to be based on the illiquidity
horizon. It might be calculated by way of put option costs
or premiums offered by low-liquidity equities
• Illiquidity risk management tools include:
• Liquidity profiling – classifying assets based on their
level of liquidity and investing in line with a liquidity
budget
• Rebalancing strategies – managing asset allocation
and transaction costs involved with rebalancing
• Commitment strategies – managing capital calls
• Stress testing – assessing liquidity under market stress
• Derivatives – altering liquidity levels through use of
highly liquid derivatives and associated leverage
Wiley’s CFA Program Exam Review
®
Manager continuation policies
policies (MCPs):
Manager
Note thatcontinuation
the Ex post alpha and(MCPs):
Treynor measure provide the same conclusion about manager
2
rankings
because
they arewith
based
on systematic
•
Retain
managers
investment
skills.risk. The Sharpe ratio and M also provide the
• conclusion
Retain managers
with investment
skills.
same
about manager
rankings
because
theyand
aredo
based
on total
risk.
•
Remove
managers
without
investment
skills,
so before
before
they
produce negative
negative
• Remove managers without investment
skills,
and do
so
they
produce
results.
results.
Performance
Evaluation
•
Minimize
manager
turnover.
• Minimize manager turnover.
Include relevant
relevant nonperformance
nonperformance information
information in
in the manager
manager review process.
process.
•• Include
Quality
control charts
are one effective and
visual meansthe
of presentingreview
the performance
of an investment
manager
over
time. It uses statistical methods to systematically evaluate
Reduce
the
following
two
errors:
Reduce
the following
errors:
performance
data and two
assist
in making retention or removal decisions.
• Type
Type II error:
error: keeping
keeping (or
(or hiring)
hiring) managers
managers who
who do
do not
not have
have investment
investment skills.
skills.
•
Manager
continuation
policies
(MCPs):
•
Type
II
error:
firing
(or
not hiring)
hiring) managers
managers who
who do
do have
have investment
investment skills.
skills.
• Type II error: firing (or not
The secret is out.
CFA® EXAM REVIEW
•
•
•
•
Retain managers with investment skills.
Remove managers without investment skills, and do so before they produce negative
©2018
2018Wiley
Wiley
results.
©
LEVEL II CFA
Minimize manager turnover.
MOCK EXAM
Include relevant nonperformance information in the manager review process.
®
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Type I error: keeping (or hiring) managers who do not have investment skills.
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