CFA Book 1 Flashcards

Question

Excess return anomolies that are not

Answer 1

* Excess return before, but not after expenses * Excess return with too low associated risk

Answer 2

more willing to sell winners than losers

Answer 3

1. Momentum effect ◎ Herding 2. Bubble and crash: panic buying/selling 3. Value vs Growth ◎ Halo effect

Answer 4

1. illusion of knowledge 2. self-attribution 3. representativeness 4. availability 5. illusion of control 6. hindsight

Answer 5

1. seek counter evidence/opinions 2. defined systematic decision process 3. verifiable data 4. correct framing 5. documenting decisions 6. bayes formula

Answer 6

* Bubble: 2 std dev from mean price * Crash: 30% drop in a few months

Answer 7

1. overconfidence 2. confirmation 3. self-attribution 4. hindsight 5. regret aversion 6. disposition effect

Answer 8

* macro: mkt deviaition from traditional finance theory * micro: individuals' decision making process deviation from traditional finance (REM: rational economic men)

Answer 9

The rational actor assumption in traditional finance theory

Answer 10

P(A|B) = P(B|A) \* P(A) / P(B)

Answer 11

• Foundation of traditional finance theory • diminishing marginal utility return ◎ \>\> concave risk averse utility function ◎ \>\> convex indifference curves

Answer 12

* sufficient satisfaction, but not optimal, are sufficient * satis+ficent = satisfice

Answer 13

• associated with traditional finance theory • process of making optimal decision when decision maker is informed, math able, rational (REM)

Answer 14

* associated with behavioral finance theory * Knowledge and cognative limitations of decision maker * Satisfice * More constrained that prospect theory

Answer 15

* associated with behavioral finance theory * similar to bounded theory * risk aversion is replaced by loss aversion * 2 phases: Editing phase, then Evaluation phase

Answer 16

First three steps 1. Codification: gain/loss & prob 2. Combination: Combines similar outcomes 3. Segregation: separation of risk-free and risky aspect of each outcome

Answer 17

1. assign weights and prob ◎ weights and prob are based on behavioral biases ◎ \>\>gains \< losses, large prob \< tail events 2. calc expected utility

Answer 18

1. source of wealth ◎ active (entrepreneurial) vs passive (steady accum & inherit) 2. measure of wealth ◎ perceived wealth vs needs \>\> percieved risk tolerance 3. stage of life ◎ foundation, accumulation, maintenance, distribution

Answer 19

* Active: more risk tol, but possible business risk vs investment risk difference * Passive: less risk tol

Answer 20

1. Foundation (mod risk) 2. Accumulation (highest risk) 3. Maintenance [retirement] (low-mod risk) 4. Distribution: old wealthy giving to others (low - high risk)

Answer 21

1. risk aversion: min risk; risk is volatility 2. rational expectations: unbiased view of the world 3. asset integration: all investments are correlated

Answer 22

1. risk aversion vs loss aversion 2. rational expectations vs biased expectiations 3. asset integration vs ass segregation

Answer 23

1. cautious: low risk, indecisive, difficult 2. methodical: conservative, lots of data 3. confident, decisive 4. spontaneous: high portfolio turnover, chase fads, doubt self and others

Answer 24

\*only front of card\*

Answer 25

1. id's and documents objectives/constraints 2. dynamic in response to changes w/client or mkt 3. easy to understand 4. education about self and investing 5. understand manager's actions 6. transferable across managers

Answer 26

1. knowledge of client 2. guidance for investment decisions 3. resolution of disputes (signed documentation)

Answer 27

* O: RR * C: TTLLU

Answer 28

TTLLU \>\> risk \>\> return

Answer 29

\*only front of card\*

Answer 30

* return: rn * risk: rs * time horizon: tm * taxes: tx * liquidity: lq * legal: ll * unique: u

Answer 31

add inflation in initially so that you include the inflated numbers when calcing taxes

Answer 32

* pre vs after tax * real vs nominal

Answer 33

required vs desired return

Answer 34

* ability (time horizon, wealth & outflow) vs willingness to take risk * always state conclusion * if they differ, pick conservative choice

Answer 35

look at actions as well as statements

Answer 36

1. time horizon 2. critical goals/expenditures 3. liquidity needs 4. portfolios proportion of overall wealth

Answer 37

1. state: ◎ number of stages ◎ each stage objective ◎ # yrs in each stage 2. other involved people (eg giving/receiving inheritance) 3. multi-generational horizon 4. retirement time horizon default: 20-25 yrs

Answer 38

1. income 2. capital gains 3. wealth transfer 4. personal property (eg car, house)

Answer 39

1. Tax deferral (eg cap gain investment, loss harvesting, low turnover) 2. Tax avoidance: tax free securities 3. Tax reduction: investments with lower tax rates (eg cap gains vs income) 4. Wealth transfer timing: (eg. no sales)

Answer 40

state that tax situation is complex and manager should seek qualified tax advice

Answer 41

1. ongoing, known expense (or in return jbj) 2. emergnecy reserves (if requested) 3. one-off, infrequent outflows (college falls under time horizon) 4. one off positive inflows 5. illiquid assets: restricted from sale, illiquid (eg house)(or in unique), large tax cost (or in unique or tax)

Answer 42

1. Trust: revocable vs irrevocable 2. Family foundation

Answer 43

1. If no big legal issues state there are none beyond normal Code & Standards responsibilities 2. manager must follow the trust document; weigh needs of different stakeholders 3. mention other legal issues or lack of 4. if complex issues, state manager will seek qualified expert advice

Answer 44

1. Special investment concerns (eg social) 2. Special instructions (liquidate holdings) 3. Restrictions on sales 4. Forbidden asset / asset classes 5. Assets outside of portfolio (eg. houses) 6. Bequests 7. Unattainable objectives

Answer 45

* State what is there and what is NOT there * Complex issues, seek qualified expert * Re-state all the facts * point out conflicting factors

Answer 46

is the mix of asset classes that will meet the IPS objectives and constraints

Answer 47

1. eliminate portfolios that violate stated or appropriate constraints 2. assess return to risk ranking ◎ sharpe ratio ◎ most often you will never need to get to this stage bc/only one portfolio remains

Answer 48

1. excess/insufficient cash equivalents 2. hold/fail to hold assets specified in constraints 3. violates risk constraints 4.generate insuffient return (after-tax) 5.inappropriate asset classes or weightings (even if not specificed) ◎ 60 equity/40 bond&cash is default ◎ do not ignore home ownership \>\> too much real estate holdings • address concentration issues (eg. low-basis inheritance, former employer stock)

Answer 49

• Pros: 1. path dependency 2. better display of risk/return by providing multiple possible outcomes 3. better tax analysis 4. better display of short-term & long-term performance (eg more ST vol, but better LT return) 5. better analysis of multi-period effects 6. can look at different points in timeline (major decision/event points) • Cons: 1. if simplistic model of returns is used 2. if generalized asset class returns are used rather than specific investments (w/costs) 3. if simplistic tax model is used

Answer 50

1. income 2. wealth: assets and asset transfers 3. consumption: sales & VAT

Answer 51

tax rate paid on the last dollar of income

Answer 52

* every one pays same rate on 1st dollar * each dollar after is taxed on whichever tax rate basket that dollar falls into * for example: $20K income: first $8,350 is taxed at 10%, remaining is taxed at 15% * the overall rate (avg tax rate) is the weighted average of the different rates \* the amount taxed at that rate

Answer 53

``` #1: common progressive (progressive, light on all investment) #2: LIght capital gains tax (progressive, light on cap gains) ```

Answer 54

• paid periodically (eg annually)

Answer 55

FVIF = [1 + R\*(1 - T)]^N R = pre-tax return ◎ or FVIF = (1 + Rart)^N T = tax rate N = number of investment periods • = after-tax value of each dollar invested

Answer 56

more, due to effect on compounding

Answer 57

* gain lost to taxes * stated as a dollar value or %

Answer 58

``` FVIF = [(1 - T) \* (1 + R)^N + T\*B] R = investment return N = # periods T = tax rate B = % of original investment ALREADY taxed ```

Answer 59

* accrual $ and % \> deferred * deferred is constant % of total gain (horizon and return do not affect it) and equal to tax rate * accrual $ and % grow with return and horizon

Answer 60

``` FVIF = [(1 + R) \* (1 - T)]^N R = investment return N = # periods T = tax rate ```

Answer 61

* tax drag \> tax rate * horizon increase \>\> greater $ and % tax drag * return increase \>\> greater $ lower % tax drag

Answer 62

* tax drag \> tax rate * horizon or return increase \>\> greater $ and % tax drag

Answer 63

constant % tax drag regardless of horizon or return • tax drag % = tax rate

Answer 64

Rart = R(1 - Trealized) = R[1 - (PiTi + PdTd + PcgTcg)] Pi, Pd, Pcg = % of gain attributed to interest, div, realized cap gains Ti, Td, Tcg = tax rate on interest, div, realized cap gains

Answer 65

* using investment loses ot offset investment gains * main gain reducing tax bill in near term and those saving can be invested

Answer 66

* Highest In (basis), First Out * allowed by some govts * Also LIFO if you believe taxes will rise

Answer 67

usually the frequent trader falls under a higher tax rate, which leads to lower returns, especially over longer horizons and higher return rates

Answer 68

* if gain, wait until next year * if loss, sell this year to harvest the loss

Answer 69

Optimizing portfolio allocation should be done on an after tax basis using equivalent after-tax returns and risk on an after tax basis

Answer 70

Tecg = Tcg\*[1 - (Pi + Pd + Pcg)] / [1 - (PiTi + PdTd + PcgTcg)]

Answer 71

FVIFt = (1 - Tecg) \* (1 + Rart)^N + Tecg - (1-B)\*Tcg • Tecg = effective cap gains adj for annual taxes • Rart = return after realized taxes

Answer 72

Rae = (ending balance after all taxes / beginning balance)^N N = number of periods • as horizon or amount deferred increases Rae approaches pre-tax return

Answer 73

Tae = 1 - (Rae / Rpre-tax)

Answer 74

* pre-tax income * entire balance when withdrawn * FVIFtda = (1 + R)^N \* (1 - Tfuture)

Answer 75

* not Tea (equivalent accrual tax rate) * after-tax income * no tax upon withdrawl * FVIFtea = (1 + R)^N \* (1 - Tnow)

Answer 76

* if Tfuture \< Tnow, then TDA is better * if Tfuture \> Tnow, then TEA is better * if Tfuture = Tnow, then no difference * if $ amounts are restricted and equal then compare FV's of each, but remember to include extra taxed $ for TDA

Answer 77

Future Value Interest Factor

Answer 78

1. tax deferred acct 2. tax exempt acct 3. all taxes 4. accrued annual tax 5. wealth tax 6. deferred cap gains

Answer 79

FVIFcgt = (1 - Tcg)\*(1 + R)^N + Tcg \* B • Tcg = cap gains tax rate • B = cost basis PERCENT • R = annual return

Answer 80

after tax risk = stan dev \* (1 - T) • govt absorbs part of variability • tax exempt accts (TDA & TEA): investor bears all risk

Answer 81

type of acct asset is located (eg tax advantaged acct)

Answer 82

value created by effective tax management

Answer 83

1. Traders: high turn-over, ST cap gains \>\> bad 2. Active investors: med-turn-over, LT cap gains \>\> so-so 3. Passive investors: LT cap gains over many years \>\> good 4. Exempt investors: hold assets in tax-exempt accts

Answer 84

Every thing a person owns • financial • real estate (aka immovable property) • collections (eg art) • businesses • non-tangible (eg trademarks, patents

Answer 85

Planning of transfer of person's estate to other during lifetime or at death

Answer 86

* aka testament * legal doc that states rights of others to person's estate

Answer 87

• Legal process that takes place at death • court determines ◎ will validity ◎ decedent's property inventory ◎ claims against decedent ◎ distributes property according to will

Answer 88

Dying without a valid will

Answer 89

• There are ways to avoid probate ◎ joint ownership w rights of survivorship ◎ living trusts ◎ retirement plans ◎ life insurance

Answer 90

* aka lifetime gratuitous transfer or inter vivos transfer * given while living * subject to gift taxes; who pays is up to govt law

Answer 91

1. gifts 2. bequests

Answer 92

* testamentary gratuitous transfer * given after death * estate taxe (paid by grantor/transferor); inheritance tax (paid by recipient); who pays is up to govt law * taxes can vary based on relationship to decedent

Answer 93

civil law system based on old Roman law; top down system where laws are handed down from legislative body

Answer 94

common law system; bottom up; judges create precedents that are applied in future cases

Answer 95

* children or spouse have a right to a portion of parent's estate * all assets are usually included

Answer 96

* each spouse entitled to half of the estate earned during mariage * gift and inheritence can be held separately * part of forced heirship

Answer 97

* each spouse owns their property separately * common in civil law countries

Answer 98

* aka net employment * PV of net employment income over lifetime

Answer 99

* Assets: all tangible and intangible assets including human capital and any other future income * Liabilities: all current and future liabilities incurred by living life plus any required reserve fund (Core capital) * Equity is anything left over (Excess capital)

Answer 100

equals liabilities on Individual Balance Sheet • sum product of expected annual spending x prob of living that long

Answer 101

equals equity on Individual Balance Sheet

Answer 102

death table (fun) • combined prob: prob either one is alive next year • real annual spending: living exp for coming year • exp real spending: real annual spending \* combined prob • present value:PV of real annual spending • total: PV of core capital required to meeting exp THROUGH the given year (row) • 0 prob to live past 100 in table

Answer 103

gives a distribution of outcomes vs just a mean

Answer 104

* risk of running out of money in retirement prior to death (ruin) * generally, retiree should spend

Answer 105

* before death: donor, recipient * after death: testator, beneficiary

Answer 106

* Rg, Tig = investment return and annual tax rate of recipient * Re, Tie = investment return and annual tax rate of giver * Te = estate tax rate paid by the estate * Tg = gift tax rate paid by either giver, receiver

Answer 107

``` RV = FVgift / FVbequest ◎ = (1 - Tg)\*(1 + Rg\*(1 - Tig))^N / (1 - Te)\*(1 + Re\*(1 - Tie))^N F = future vale ```

Answer 108

* add in + Tg\*Te due to reduced estate taxes * RVg = (1 - Tg + Tg\*Te)\*(1 + Rg\*(1 - Tig))^N / (1 - Te)\*(1 + Re\*(1 - Tie))^N

Answer 109

``` RV = 1 / 1 - T T = wealth transfer tax ```

Answer 110

1. calc excess above core capital requirements for giver and next generation 2. give excess to third generaiton

Answer 111

some govts allow tax-free transfers between spouses

Answer 112

discount value of estate assets, such as discounting value of family business

Answer 113

• tax deduction to giver, no taxes for recipient • FVchar gift = (1 + Rg) + Toi \* [1 + Re \* (1 - Tie)]^N \* (1 - Te) Rg = return at charity Toi = ordinary income tax rate of giver

Answer 114

• giving a gift to charity NOW vs giving gift to beneficiary in N years • RVgift = FVchar gift / FVbequest ◎ = [(1 + Rg) + Toi \* [1 + Re \* (1 - Tie)]^N \* (1 - Te)] / [1 + Re \* (1 - Tie)]^N \* (1 - Te)]

Answer 115

* grantor (settlor) transfers assets to beneficiaries outside of probate * ownership is fuzzy * ownership and tax obligations can be split (eg beneficiary owns, but settlor or trust owes taxes)

Answer 116

* settlor can revoke trust and resume ownership of assets * settlor is owner of assets for tax purposes * assets included in claims against the settlor

Answer 117

* settlor relinquishes ownership and control, trustee (not beneficiary) is the owner * protected from claims against the settlor; not protected if judged to be set up in anticipation of a claim

Answer 118

distributions to beneficiary is predetermined by settlor

Answer 119

trustee determines how assets will be distributed to beneficiary (settlor can convery wishes) • beneficiaries have no legal right to assets or income \>\> trust is protected from claims against beneficiaries

Answer 120

beneficiary is unable to manage trust responsibly; settlor maintains some control

Answer 121

trusts more common in common law; foundations more common in civil law

Answer 122

some countries, settlor responsible for taxes, even when trust owns the assets

Answer 123

* efficient transfer of wealth * often not taxed * sometimes tax-free accumulation of weath to policy holder * sometimes source of loans to policy holder * trusts can be beneficiaries

Answer 124

1. source jurisdiction (aka territorial tax system): tax on assets/income generated in jurisdiction 2. residence jurisdiction (majority of countries): tax on all resident's assets/income, regardless of source

Answer 125

• response to residents leaving to tax havens • tax on gains • deemed disposition: tax on assets as if they were liquidated ◎ shadow period: taxes on earnings even after the resident leaves

Answer 126

1. residence-residence 2. source-source 3. residence-source

Answer 127

1. res-res: OECD tie-breaker 2. source-source: none 3. res-source: ◎ credit: full resolution ◎ exemption (lowest tax rate): full resolution ◎ deduction (highest tax rate) • on exam: rem to calc tax on non-disputed income

Answer 128

• credit: full resolution; res pays source and deducts that from res tax bill (ie pays higher of two tax rates) • exemption (lowest tax rate): full resolution; res pays source, no res tax (even if higher rate) • deduction: worst for res; res can deduct from INCOME taxes paid to source ◎ T = Tres - Tsrc \* (1 - Tres) • on exam: rem to calc tax on non-disputed income

Answer 129

tax avoidance is legal; tax evasion is illegal

Answer 130

Reference (starting) point for calculating capital gains on assets

Answer 131

1. entrepreneurs 2. Executive 3. Investor (less attached) • psychological issues selling stock for all three; tied to control of firm

Answer 132

• aka unsystemic risk • risk associated with the individual security • companions to this are market risk (systemic) and residual risk (trading strategy: counter party and regulatory) ◎ broker may screw up; irs may dispute valuation

Answer 133

1. specific 2. systemic 3. residual

Answer 134

1. entrepreneurial 2. executive 3. investor (still attached to stock) 4. investor indexing; unattached to stock)

Answer 135

1. sale: simple, max flexibility, complete, but realize gains 2. public and private exchnage funds: better collateral, but 7 yr lock up and management fees 3. completion portfolio: build diversified portfolio over time, but can take a while 4. heding: fast, but danger of 'constructive sale'

Answer 136

* IRS term to indicate a hedging strategy is effectively a sale and that gains must be realized * exps: a collar without any risk, a forward without any risk * risk must be \> 15% of the asset price

Answer 137

same as a forward, but payment for the asset is made up-front

Answer 138

PV of future earnings • social security and pensions are included

Answer 139

current market value of portfolio

Answer 140

human capital + financial capital

Answer 141

* risk earnings could stop due to health or economics (job loss) * minimized by higher savings, picking uncorrelated financial capital investments

Answer 142

* risk of out living financial capital (ruin) * hedged with life time payout annuities

Answer 143

good things to have in portfolio

Answer 144

untility (U) = exp(hc + fc)^(1 - d) / (1 - d) hc + fc = human + financial capital d = risk aversion score

Answer 145

* use capital mkt theory (CML) * if income is corr to equity mkt and volatile treat as an equity asset and overweight financial cap in low risk assets (eg bonds), otherwise treat as fixed income asset and do opposite

Answer 146

max E[(1 - Pdeath,t)\*(1 - D)\*(Ualive)\*(FCt+1 + HCt+1)] + (Pdeath,t)\*(D)\*(Udead)(FCt+1 + LIPO) Pdeath,t = subjective prob of dying before t+1 D = scale 0 to 1 of desire to leave bequest; 1 is strong U = utility from total wealth (if alive or if dead) LIPO = life insurance payout

Answer 147

* asset allocation and life insurance holdings should be solved for jointly * if HC is risky (higher discount rate) or small, this reduces the amount of life insurance needed to replace it * individual's subjective belief of Pdeath * If FC is large, then it should begin to mirror HC risk as HC decreases to balance risk in portfolio (???)

Answer 148

inability to predict spending per year and number of years

Answer 149

* contract paid for upfront (sometimes over time) * pays out over life of beneficiary * removes longevity risk * 2 types: fixed, variable (combo is good in retirement)

Answer 150

1. fixed: constant nominal payment (eg $3,000/mo) ◎ inflation risk 2. variable: constant variable payment tied to underlying asset (eg market index, interest rate) ◎ exp. pays 6% of mkt val of initial principal ◎ reduces inflation risk

Answer 151

sudden death and follow on effects • hedge is life insurance

Answer 152

1. mkt risk 2. longevity risk 3. savings risk (aka spending uncertainty)

CFA Book 1 Flashcards

(179 cards)