CFA Book 2 Copy Flashcards

Question

Foundation | Company sponsored

Answer 1

* tied to sponsor * grants to charities, ed, institutions; can further corp goals * source: corp sponsor * 5% of assets, not counting exp

Answer 2

* sole purpose is funding an org * source: individual, family or group * spend 85% of div, int income; also 3.3% of assets

Answer 3

* publicaly sponsored * fund social, ed, religious * source: general public, large donors * spending: none

Answer 4

like it sounds: sponsor or participant directs investments

Answer 5

• DB plan w/account balance for each participant • each period: ◎ credit for work (age, salary, etc) ◎ investment credit based on benchmark rate ◎ employer bears investment risk

Answer 6

* employee stock ownership program * DC * allows employees to buy company stock, sometimes discounted * before or after tax dollars

Answer 7

* medium to high * more aggressive than pensions

Answer 8

* If perpetual, preservation of purchasing power * calc: payout + inf + exp; either add or compound * total return

Answer 9

* perpetual, unless mandated to spend down to zero * so long time horizon \>\> more risk

Answer 10

* min spending req = 'spending rate' * many countries specify min spendin rate; US is 5% * smoothing rule: smooth out distribution * may hold portion of distribution in reserve

Answer 11

* not taxable entities; not a major concern • US taxes private foundations at 1% * unrelated income taxed at reg corp rate

Answer 12

* Uniform Management Institutional Funds Act (UMIFA) adopted my most US states * mostly tax exempt status issues * few regulations

Answer 13

• do not have min spending rate • 3 types: ◎ simple: spending = S(begin mkt val); S = spending rate ◎ rolling 3 yr avg: spending = S\*(avg mkt val last 3 yrs) ◎ geometric: spending = R\*(last yr spending)\*(1 + inf) + (1 - R)\*S\*(begin mkt val)

Answer 14

* medium to high * time horizon is infinite \>\> more risk * one qualification to high risk is more essential payout \>\> less risk

Answer 15

* preserve purchasing power * total return * 'inflation' rate should mirror the rate of the costs the endowment must cover (eg. health care costs)

Answer 16

usually low reqs; only current spending and emergencies

Answer 17

tax exempt (other than unrelated business income tax UBIT)

Answer 18

* Uniform Management Institutional Funds Act (UMIFA) adopted my most US states * mostly tax exempt status issues * few regulations

Answer 19

Often have unique restrictions based on their mandate

Answer 20

1. stock company owned by shareholders 2. mutuals (owned by policy holders) • many mutuals have demutualized into stock companies

Answer 21

1. whole life or ordinary life 2. variable life, universal life, variable universal life 3. term life

Answer 22

* fixed payoff at death * cash value if policyholder terminates policy (or can be borrowed) * cash builds up at 'crediting rate' * disintermediation is when rates are high and policyholders withdraw funds \>\> requires liquidity

Answer 23

year to year \>\> short duration assets to fund short duration liability (is this effectively true???)

Answer 24

life whole life, but crediting rate tied to benchmark \>\> fewer withdrawls during high interest rates

Answer 25

• govts view as quasi-trusts; NAIC dictates asset valuation reserve (AVR) \>\> risk based capital \>\> more capital, less leverage • overall conservative 1. valuation risk (ALM): asset and liability duration must be similar 2. reinvestment risk: ALM helps with this 3. cash flow volatility: bad 4. credit risk \>\> diversification

Answer 26

* reqs are by 'line of business' (segment by lines of business) * conservative, fixed income * total return theoretically good, but not practical

Answer 27

Two issues: 1. disintermediation: when rates go up ◎ poor ALM makes problem worse if assets have longer duration 2. asset marketability • more use of derivatives

Answer 28

* 20-40 years * getting shorter due to volatile mkts * segmentation and duration matching by line of business is norm

Answer 29

* taxable entities * often actuarial assumed rate is tax free * laws are fluid in the industry lately * after-tax return is metric

Answer 30

``` #1often answer is 'complex and extensive, should seek expert legal advice' • heavily regulated at the state level ```

Answer 31

Regs often address: 1. eligible investments by asset class and max % holdings (often min interest coverage ratio on corp bonds) 2. In US, prudent investor rule; replaces eligible investments rule with portfolio risk/return 3. valuation methods • heavily regulated at the state level

Answer 32

* concentration of product offerings * company size * level of surplus

Answer 33

1. health 2. property and casualty 3. surety

Answer 34

treat like life insurance except where differences are mentioned

Answer 35

1. liability duration is shorter (often 1 yr) 2. often long tail to policy resolution (eg. litigation) 3. non-life often has inflation risk (eg. replacement value of property) 4. life insurance is predictable payout, unpredictable timing; non-life is unpredictable in both amount and timing 5. non-life has underwriting or profitability cycle: 3-5 yrs; competition \>\> unprofitable, losing policies 6. non-life can be concentrated geographically or by event

Answer 36

ALM (asset liability managment)

Answer 37

* quasi-fiduciary req * payouts and timing are volatile (katrina, sandy) * inflation (eg. replacement cost) * cash flow req are volatile \>\> low risk tolerance * (common stock-to-surplus was varied over decades)

Answer 38

* operated as two separate companies: insurance and investment * policy premiums were not related to returns \>\> too low premiums * partially improved

Answer 39

1. competition \>\> too low premiums (underwriting cycle) 2. profitability: investment return dictates profitability and offset poor premium pricing; ALM 3. growth of surplus \>\> high return, risky assets 4. seek after-tax, total return 5.less reg \>\> varied return across different companies • buys taxable bonds when in loss period, buys tax-free when in profit period

Answer 40

High (critical aspect) \>\> money market assets, laddered portfolio of govt bonds, ALM

Answer 41

Short because of short liability duration

Answer 42

* taxable entities * after-tax return is metric

Answer 43

* Less reg and investment oversight than for life * asset valuation reserve (AVR) is not req, but risk based capital is req

Answer 44

no universal reqs

Answer 45

Defined by fact that portfolio is a residual use of funds ◎ bank borrows (liability) and loans (asset) ◎ borrowed - loaned = portfolio (unused borrowings) • portfolio is lower return/lower risk than loan portfolio • easier to adjust portfolio than borrowed and loaned funds

Answer 46

* below average * use ALM * Portfolio is used to keep overall asset duration similar to liability duration * Portfolio is also used to manage credit risk and diversification of overall assets \>\> often very liquid to offset illiquid loans

Answer 47

1. VAR 2. Leveraged Adjusted Duration Gap (LADG): duration of assets less leveraged duration of libilities ◎ form of ALM ◎ LADG = Dass - (L/A)Dliab, D = duration, L/A = leverage ◎ theo predicts equity change in value given int rate change (if +, rates up \>\> equity down; if -, move together; if 0 no effect on cap)

Answer 48

Overall, goal is to earn positive interest rate spread: return on assets \> rate on liabilities (cost of funds)

Answer 49

* high liquidity req * function of withdrawls, loan demand and reg

Answer 50

Short and function of liability duration

Answer 51

* taxable entities * after-tax return is metric

Answer 52

* highly regulated * risk-based capital reg \>\> RBC reserves against assets (risk up, reserve up) \>\> high liq portfolio * reserve reqs

Answer 53

no universal constraints

Answer 54

Generalizable IPS: 1. pension funds 2. foundations 3. endowments 4. insurance companies 5. banks Ungeneralizable IPS (intermediaries - invest other peoples' funds): 1. investment companies 2. hedge funds 3. commodity pools

Answer 55

* maximization of surplus (A - L) at each risk level * ALM is preferred framework for portfolio evaluation when defined liabilities * surplus and surplus volatility is key metrics * asset and liability duration should be similar * durations can be gamed to profit from int rate changes * ALM best for DB plans, insurance companies and banks

Answer 56

* Fixed income needed to match liabilities is conservative * Surplus is aggressive

Answer 57

* similar to foundation * may hold portion of distribution in reserve

Answer 58

• Prudent Investor: 1. Foundations and endowments 2. Insurance • Prudent Expert: 1. DB Plan • Prudent expert is tougher than Prudent Investor

Answer 59

long term \>\> capital gains strategy; short term \>\> income strategy

Answer 60

remember to: 1. match duration 2. diversify

Answer 61

1. asset only: pick most efficient portfolio 2. liability-relative: pick assets that mirror the liability risk 3. duration management: better than asset-only, worse than liability-relative • risk free definition ◎ asset only: cash return ◎ liability-relative: highly correlated to liability performance

Answer 62

* ok for short term duration pensions (eg. bankruptcy) * better than asset-only, worse than liability-relative

Answer 63

asset mix that mirrors liability performance and minimizes surplus volatility

Answer 64

• active and inactive participants • active: ◎ obligations from past service ◎ obligations from future service • inflation exposure ◎ fixed, no inf exposure (nominal bonds) ◎ indexed, yes infl exposure (real rate, eg. TIPS) ◎ mixed • accrued benefits: obligations to inactive + active obligations from previous service

Answer 65

* FASB: projected benefit obligation * IASB: defined benefit obligation

Answer 66

• PV of expected future benefits based on wage growth • 2 segments: ◎ inf ◎ real growth • inf liability offset with real rate bonds; real growth liability offset with equities

Answer 67

1. retirees: receiving payments 2. deferred's: not receiving payments yet, but owed money

Answer 68

• non-mkt exposure • 2 segments: ◎ demographic uncertainty ◎ model uncertainty • demo uncertainty decreases as participants increase • model uncertainty: active (many) \> deferred (longevity + timing) \> retired (longevity risk) • hard to hedge

Answer 69

1. accrued benefits 2. active future wage

Answer 70

1. accrued benefits 2. active future wage growth 3. active future service rendered 4. active future participants

Answer 71

* asset only is 60-70% equities + short, medium nominal bonds * liability-relative is lower risk: derivatives, long bonds, TIPS, equities * asset-only outperforms liability-relative * liablity-relative may require contributions for future service rendered and future participants (not included in model or funding)

Answer 72

1. interest rate 2. inflation 3. economic growth

Answer 73

weighted avg of debt and equity beta • used with CAPM to calc WACC • debt beta can be assumed to be zero • either operating assets or total assets (operating + pension); total is preferred

Answer 74

weighted avg of operating and pension asset betas • = weight of equity in cap structure \* equity beta (BUT WEIGHT CAN CHANGE IF PENSION LIABILITIES INCLUDED)

Answer 75

either avg weighted cost of debt + equity OR calced with asset beta used in CAPM

Answer 76

ALM: ◎ balance sheets don't show asset/liability risk ◎ top 20% of US companies had large pension investments in equities (bad)

Answer 77

• WACC = ◎ We\*Ke + Wd\*Kd\*(1 - t) ◎ Rf + B\*(Rm - Rf), B = op asset beta (systemic risk of op assets)

Answer 78

* found by regressing company's stock return on mkt return * is risk of company's pension assets

Answer 79

• Ba,p = Ws,p \* Bs,p Ba,p=pension asset beta Ws,p = weight of equities in pension assets Bs,p = equity beta

Answer 80

total, operating, pension

Answer 81

lowers WACC because pension liability (no equity) dilutes equity \>\> reducing weight

Answer 82

* op asset beta = (Ba,t - Wa,p \* Ba,p) / Wa,o * WACC = Rf + Ba,o & MRP * if Ba,t is initially calced without pension \>\> overestimation of Ba,t and Ba,o and WACC \>\> reject profitable projects

Answer 83

\>\> increased plan risk \>\> increased: ◎ company equity beta ◎ total asset beta ◎ operating asset beta ◎ WACC

Answer 84

must increase proportion of equity in cap structure (issue shares, buy back debt)

Answer 85

* different risks OR * same risks, but affected differently

Answer 86

without: only on operating asset beta, BUT AFTER recalcing asset operating beta with pension asset/liabilities!

Answer 87

* CME + ISP \>\> SAA (strategic asset allocation) * also help detect ST asset mispricing (tactical asset allocation) * Expectations of return, correlation and standard deviation of each asset class * CME re classes of assets = macro expectations (top down) * CME re specific assets = micro expectations (bottom up)

Answer 88

* beta = CME research * alpha = excess returns of specific stratagies in specific asset classes

Answer 89

1. Needed CMEs based on tax status, allowable asset classes, time horizon 2. assess historical performance, factors, make forecast 3. pick appropriate valuation model 4. Collect data (factors) 5. Inputs 6. Forecast CME 7. monitor performance, refine model

Answer 90

1. calculation methodologies 2. data collection techniques 3. data def 4. error rates 5. investability and correction for free float 6. turnover in index components 7. potential biases

Answer 91

1. econ data limitations 2. data measurement error and bias 3. historical estimate limitations 4. using ex post risk and returns 5. non-repeating data patterns 6. not accounting for conditioning information 7. misinterpretation of correlations 8. psychological traps 9. model and input uncertainty

Answer 92

1. time lag between collection and distribution 2. revisions 3. data and methodology change over time

Answer 93

1. transcription errors (espeically if biased) 2. survivorship bias 3. appraisal (smoothed) data \>\> corr and stan dev are biased lower

Answer 94

* past does not necessarily predict future * regime change, non-stationarity \>\> diff statistical properties period to period * leads to difficulty in picking best time period

Answer 95

* only looking at bet outcomes rather than factors (risks) in the original bet * incorrectly exclude possibilities (eg. risks) that didn't materialize but were issues

Answer 96

• over-fitting data (data mining) or finding spurious patterns • prevention: ◎ ask if economic (theoretical) explanation ◎ out-of-sample testing ◎ look for bias susceptibility

Answer 97

* related to regime change * if diff regimes can be identified, use correct data and inputs for that regime * exp: if gdp is 4% in expansion and 1% in contraction, determine which period is coming and use appropriate value

Answer 98

* correlation vs causality * does economic (theoreitical) explanation justify causality (also possible no causality, but both effects from third varaible) #alt method to corr is multiple regression

Answer 99

1. anchoring 2. status quo 3. confirming evidence 4. overconfidence 5. prudence 6. recallibility

Answer 100

put too much weight on earliest data; new data is given too little weight

Answer 101

too much weight on historical data

Answer 102

* look for data to back up beliefs * prevention: seek counter opinions

Answer 103

* ignore past mistakes and overestimate likelyhood of being right * prevention: increase range of forecasts

Answer 104

* overly conservative * desire to avoid regret * prevention: same as overconfidence, increase range of forecasts

Answer 105

letting extreme events in the past overly influence forecasts

Answer 106

• first principles uncertainty ◎ correct model? ◎ correct inputs?

Answer 107

1. projecting historical data 2. shrinkage estimators 3. time series analysis 4. multifactor models

Answer 108

forecasting mean, stan dev, corr based on past mean, stan dev, corr • use arithmetic or geometric mean (usually preferred)

Answer 109

using weights in historical data to reduce effect of outliers and more generally change influence of certain data

Answer 110

forecast model based on past values of the estimate (eg. volatility)

Answer 111

forecast returns and covariances • see var and covar equations

Answer 112

1. statistical tools 2. discounted cash flow model 3. risk premium model 4. financial equilibrium model

Answer 113

* intrinsic value = PV of future cash flows * exp: Gordon growth model (constant growth model) used for equity * DCF also used with bonds

Answer 114

``` R = D1/P0 - Schange + i + g + P/Echange R = exp return on stock D1/P0 = current yield Schange = % change in shares outstanding i = exp inflation g = real growth rate P/Echange = % change in P/E (repricing term) ```

Answer 115

• R = sum of 3 components 1. exp income return = D1/P0 - Schange 2. exp nominal earnings growth = i + g 3. exp repricing return = P/Echange

Answer 116

exp % stock repurchased • new issuance is negative \>\> subtract from current stock yield (D1/P0)

Answer 117

* build-up approach * bond return = real risk free rate + inf + default risk prem + liq risk prem + maturity risk prem + tax prem * equity return = bond + risk premium

Answer 118

* assumes supply, demand in equilibrium \>\> efficient mkts \>\> models correctly price assets * exp: ICAPM and Singer,Terhaar model

Answer 119

Ri = Rf + Bint(Rm - Rf) Bint = systemic risk of asset i returns to int'l mkts (CAPM, B is to domestic mkts) • Bint (or B) = cov(i,m) / var(m) = p(im) sd(i) / sd(m)

Answer 120

RPi = p(i,m) \* sd(i) \* (Rm - Rf) / sd(m) = p(i,m) \* sd(i) \* mkt sharpe ratio

Answer 121

cov(i,j) = Bi \* Bj \* var(m), B is the coefficient to the independent variable in f(x) = i or j, m is the independent var (factor)

Answer 122

cov(i,j) = B(i,1) \* B(j,1) \* var(x1) + B(i,2) \* B(j,2) \* var(x2) + (B(i,1) \* B(j,1) + B(i,2) \* B(j,2))\*cov(x1,x2)

Answer 123

equity risk premium • = corr(i,m) \* sd(i) \* mkt sharpe ratio • if completely segmented, then corr = 1

Answer 124

1. find ERP fully integrated 2. find ERP fully segmented (corr = 1) 3. use integration degree as weight to find ERP 4. Ri = ERP + risk free 5. calc cov(i,j) = BiBjVar(m)

Answer 125

* ask the experts \>\> CME * if same people each time \>\> panel method

Answer 126

adjusting forecasts based on experience and judgement

Answer 127

1. cyclical 2. trend-growth

Answer 128

1. inventory cycle (2 - 4 yrs) 2. business cycle (9 - 11 yrs)

Answer 129

1. real GDP 2. output gap 3. recession (2 consecutive quarters of decreasing GDP)

Answer 130

* 2 - 4 yrs * metric: inventory / sales * less variable due to JIT inventory

Answer 131

• 9 - 11 yrs • 5 stages ◎ initial recovery ◎ early upswing ◎ late upswing ◎ slowdown ◎ recession

Answer 132

1. duration: few months 2. bus confidence rising 3. fiscal + monetary govt stim 4. falling inf 5. large output gap 6. falling int rates 7. bond ylds bottoming 8. rising equity prices 9. riskier assets do well

Answer 133

1. duration: few yrs 2. growth w/ low inf 3. bus confidence rising 4. inventories rising 5. ST rates rising 6. output gap closing 7. rising bond ylds 8. stock mkt rising

Answer 134

1. bus confidence high 2. employ high 3. output gap zero 4. inf rising 5. monetary tightening 6. ST rates rising 7. bond ylds rising 8. stock mkt rising, more vol

Answer 135

1. duration: few months 2. bus confidence decreasing 3. inf rising 4. inv falling 5. ST rates peak 6. bond ylds peak, falling 7. yld curve may invert 8. stock mkt falling

Answer 136

1. duration: 6-12 months 2. large decline in inv 3. bus confidence falls 4. profits fall 5. UE and bankruptcy increasing 6. ST rates fall 7. bond ylds fall 8. stock mkt rises in later part in anticipation

Answer 137

* inflation is fine: 0 - 3% * highly levered firms are always impacted the most by the inf and rates * defl bad \>\> sign of slow growth

Answer 138

* cash is fine in high inflation because the return can float with rates * defl bad due to 0 rates

Answer 139

* inflation 0 -3% fine: equities are hedge * above 3% \>\> concern fed will restrict econ growth * defl bad \>\> sign of low growth

Answer 140

• inflation fine: real assets are hedge unless levered

Answer 141

* consumer: 2/3, largely constant over business cycle, though seasonal over year * business: 1/3, more volatile over business cycle

Answer 142

both the direction rates are moving as well as the absolutel level are important

Answer 143

real growth rate + inf rate

Answer 144

* Est of fed interest rate target * Rtarget = Rneutral + 0.5 \* (GDPexp - GDP trend) + 0.5 \* (i exp - i target)

Answer 145

* only active govt policy to change deficit affects growth * absolute level of deficit and natural changes in deficit do not (eg. reduction due to higher revenues during expansion)

Answer 146

1. both stimulative \>\> steep yld curve and growth 2. both restrictive \>\> inverted yld curve and contraction 3. fiscal stim, monetary tight \>\> flat yld curve 4. fiscal tight, monetary stim \>\> slight upward slope of yld curve

Answer 147

1. cyclical (ST) 2. trend (LT)

Answer 148

1. change in employment levels ◎ population growth ◎ labor force participation 2. changes in productivity ◎ spending on new capital inputs ◎ total factor productivity growth (technology) • sum all components to get exp growth rate

Answer 149

1. provide infrastructure 2. responsible fiscal policy 3. transparent, consistent, broad-based, limited tax policy 4. promote competitive markets

Answer 150

* unanticipated shocks • eg: bank crisis, foreigh crisis (oil shock) * one country's shock affecting another country: contagion

Answer 151

• links: trade, exchange rates (pegged vs floating) • interest rate differentials between countries can indicate diff in growth, monetary and fical policy ◎ theoretically all countries should have same real rate

Answer 152

1. responsible fiscal and monetary policy 2. expected growth ◎ 4+% 3. reasonable currency valuation and current account deficit ◎ current acct deficit \< 4% gdp 4. reasonable leverage ◎ foreign debt \< 50% gdp ◎ debt \< 200% current acct receipts 5. foreigh exchange reserves relative to ST debt 6. efficient govt (structural reform)

Answer 153

1. econometrics 2. economic indicators 3. checklist

Answer 154

• econ theory \>\> model • pros: ◎ can be reused ◎ can accurately model economy ◎ quantitative forecasts • cons: ◎ difficult, time consuming to create ◎ may not work in diff time periods ◎ better at expansions than recessions ◎ scrutiny of output to verify validity

Answer 155

• types: lagging, coincident, leading (preferred) • pros: ◎ available from 3rd parties ◎ easy to understand ◎ adaptable to diff purposes ◎ validated by academic research • cons: ◎ econ relationships change over time ◎ false signals from leading indicators • one method is majority signals change coming

Answer 156

• checklist of questions about economy • pros: ◎ simple ◎ allows change over time • cons: ◎ subjective ◎ time intensive ◎ may not model complex systems

Answer 157

1. generate CME 2. assign returns to asset classes

Answer 158

1. cash: 2. credit risk free bonds: 2-4% real yld 3. credit risky bonds 4. emerging mkt govt bonds 5. inflation indexed bonds: yld falls during high inf as people buy them 6. common stock 7. emerging mkt stocks: corr w/developed countries 8. real estate

Answer 159

1. relative PPP ◎ diff in inf \>\> exchange rate change ◎ true in LT 2. relative economic strength ◎ strong economy attracts investors \>\> appreciation 3. capital flows: eg. flows into equity, FDI \>\> appreciation 4. savings and investment (not common) ◎ if country has current acct deficit, must keep currency strong

Answer 160

Does poorly, prices decline; Does well during deflation as prices rise

Answer 161

1. trade 2. capital flows (debt, equity, FDI)

Answer 162

for stock valuation, know: H-model, Fed model, Yardeni model, Tobin's q, equity q

Answer 163

• estimates country's real economic output • Y = TFP \* K^a \* L^b Y = real output TFP = total factor productivity (aka A) K = capital stock L = labor input a = output elasticity of capital stock b = 1 - a = elasticity of labor

Answer 164

%chg Y = %chg A + a \* %chg K + (1 - a) \* %chg L • if TFP is constant (const returns to scale), then %chg A = 0 \>\> if K and A change by same amount, then Y changes by that % too

Answer 165

1. technology 2. restrictions on labor or capital flows 3. trade restrictions 4. laws 5. division of labor 6. depleting/discovering natural resourcs

Answer 166

%chg TFP = %chg Y - a \* %chg K - (1 - a) \* %chg L • portion of change in output related to change in total factor productivity

Answer 167

* pro is diversification * this can lead to lower required return by global investors

Answer 168

Po = Do / R - Gl \* (1 + Gl + N / 2 \* (Gs - Gl)) • div discount model with initial super growth

Answer 169

* yrs to normal growth UP \>\> P UP * either growth rate UP \>\> P UP * required return UP \>\> P DOWN

Answer 170

* top down: macroecon \>\> economy \>\> asset class \>\> sector \>\> individual firm * bottom up: the opposite * which to use depends on analysts investment strategy

Answer 171

* top down weakness: model is poor due to regime change, poor input variables (specfication problem), etc * bottom up weakness: firms are too optimistic on the way down in a business cyclee and too pesimistic on the way up

Answer 172

1. Fed model 2. Yardeni model 3. 10-yr moving average PE model

Answer 173

• Fed ratio = S&P earnings yld / 10 yr Treasury yld S&P yld: total op earnings / index value • some say it should equal 1; in practice, is great than 1 and analysts look for significant changes away from LT average

Answer 174

1. Ignores equity risk premium 2. Ignores SP earnings growth 3. compares real variable (index) to nominal variable (T yld)

Answer 175

• Yardeni 'fair' earnings yld for mkt = Yb - d(LTEG) Yb = yld on A-rated corp bonds d = weight for earnings growth (historically: 0.10) LTEG = 5 yr consensus growth forecast • estimates equilibrium earnings yld • based off of constant growth div discount model (CGM) \>\> total earnings not just divs

Answer 176

* if E1/P0 \> Yardeni \>\> mkt undervalued * if E1/P0 \< Yardeni \>\> mkt overvalued * can also be used as a ratio: mkt / Yardeni

Answer 177

1. uses corp bond yld as proxy for equity risk premium; this is a default risk, not a equity risk metric 2. relies on estimate of value investors place on earnings growth (d); could be wrong 3. relies on consensus estimate of growth (LTEG); could be wrong 4. assumes d and LTEG are constant; might not be

Answer 178

* Pnow/10 yr MA(E) * compare the current 10 yr MA P/E to it's historical value * uses real, inf adj figures for both P and E's

Answer 179

1. considers inf effects 2. captures business cycle 3. backward looking (negative) 4. does not capture accounting rule changes 5. not good for ST analysis because extreme P/E can persist for a while

Answer 180

• Tobin's q = mkt val of debt + equity / asset replacement cost • equity q = mkt val equity / net asset replacement cost • if \> 1 \>\> overvalued; \< 1 \>\> undervalued • weaknesses ◎ estimating replacement cost ◎ discrepancies persist • mean-reverting (makes it easy to use)

Answer 181

1. China 2. US 3. India 4. Japan 5. Brazil 6. Russia

Answer 182

• relative to their PPP, BRIC currencies are weak due to low income levels, high inflation and prices

Answer 183

1. stable inflation 2. fiscal policy 3. stable currency 4. good govt

Answer 184

1. macreconomic stability 2. instiutional efficiency 3. open trade 4. worker education

Answer 185

1. financial 2. markets 3. legal 4. govt 5. health 6. education

Answer 186

* SAA is investor's desired exposure to systemic risk * SAA = Capital Market Expectations + IPS * asset weights are 'targets' * portfolio is 'policy portfolio' or 'target portfolio' or 'benchmark' * specific weights with each asset give desired systemic risk exposure

Answer 187

* managers attempt to generate alpha (excess return) * deviates from SAA * taking advantage of ST opportunities in the market * TAA creates additional risk * big focus: possible high cost of TAA due to transaction cost and illiquidity of alternative investments

Answer 188

* SAA is LT allocation to different assets towards the goals and limitations of the IPS * TAA is ST alpha * SAA is systemic risk * TAA is specific risk * SAA accounts for almost the entire risk and return of the portfolio

Answer 189

* ALM SAA models liabilities and allocates assets in relation to those liabilities * Asset-only SAA disregards liabilites and maximizes return in relation to a specified level of risk * ALM can be applied to any investor (eg. individiual) * seems like ALM is superior

Answer 190

* Dynamic looks at the investment outcomes of one time period on following time periods * Static assesses each time period independently (often just a single period) * Dynamic is superior (often used with ALM SAA)

Answer 191

loss \>\> desire to make back the loss \>\> taking on too much risk

Answer 192

* investor segments his needs and creates an independent investment strategy for each need * investor does not look at portfolio in the aggregate \>\> does not access correlations or overall risk / return and diversification

Answer 193

• regret \>\> not taking a loss \>\> bigger loss / inefficient investment strategy • fear of regret ◎ \>\> not taking action / too conservative \>\> inefficient investment strategy ◎ holding both winners and losers too long

Answer 194

• use compound when ◎ asked for ◎ multi-period ◎ path dependent • otherwise use addition

Answer 195

• adjusts return based on investor's risk aversion and portfolio variance • U = R - .005 \* A \* var(portfolio) U = utility adjusted return on specific portfolio R = expected return A = investor's risk aversion score var(portfolio) = portfolio variance • if using decimals for return, then use .05

Answer 196

1. shortfall 2. semivariance 3. target semivariance 4. Roy's Safety-First Measure

Answer 197

* RSF = (Rp - Rmar) / std dev p * downside risk measure * finds num of std devs the exp return is from the min acceptable return

Answer 198

* class includes similar assets by description, system risk and other statistics * classes are not highly correlated \>\> diversification * distinct (no single investment fit two classes) * aggregate of classes should encompass all investments \>\> increases return at all risk levels * in aggregate contain many liquid assets

Answer 199

1. domestic equity 2. domestic fixed income 3. global equity 4. global fixed income 5. cash & equivalents 6. alternative investments (real estate, PE, hedge funds, etc)

Answer 200

If Si \> Sp \* corr(i,p), Then yes, add it. Otherwise, no. Si = new investment sharpe Sp = existing portfolio sharpe

Answer 201

1. capital market expectation (CME) 2. effects on each asset class 3. allocate across classes that best meet IPS 4. monitor 5. revise

Answer 202

1. action 2. monitor/evaluate 3. revise

Answer 203

1. mean-variance optimization (MVO) 2. resampled efficient frontier 3. Black-Littman 4. Monte Carlo 5. ALM 6. experience-based

Answer 204

unconstrained allows short selling to create efficient portfolios; constrained does not

Answer 205

any min-variance portfolio can be described as the weighted average of two other min-variance portfolios

Answer 206

* CAL is the line defined by a risk free asset and an efficient frontier (EF) risky portfolio * CML is the CAL with the market portfolio (everyone should hold it if everyone had same assessments)

Answer 207

* often a risk free asset does not effectively exist (known return, std dev and corr = 0) * Borrowing/lending the risk free asset is often effectively non-optimal with obligations \*borrowing) and fees (both)

Answer 208

unless risk free or CML is specified, assume world of portfolios are those on the efficient frontier (EF)

Answer 209

* EF is recreated using monte carlo, historical data and CME * at each point on the frontier is the distribution from an average of multiple portfolios with the same expected return * if the current portfolio is within a specificed confidence interval of the efficient portfolio (statistically equivalent), then no need to rebalance

Answer 210

1. averaging process \>\> more stable frontier \>\> minor input changes \>\> minor effects on REF 2. portfolios more diversified 3. less rebalancing because existing portfolio likely to be statistically same as EF portfolio \>\> less turnover \>\> less cost

Answer 211

1. lack of sound theoretical basis 2. same as MVO, historical data may not forecast future outcomes

Answer 212

1. manager picks global index as portfolio template 2. adjusts weights based on manager's expectations of asset classes

Answer 213

1. manager selects global index \>\> historical weights, std devs, corrs 2. reverse optimization / back solve / back out expected return (mkt consensus), market risk premium and cov of the assets (mkt consensus???) 3. adjusts returns and std dev based on manager's opinions 4. generate MVO (mean variance optimization) based on adjusted values • no negative weights (short sales) • more systematic/mathematical than UBL • assumes financial mkts equilibrium

Answer 214

1. mkt consensus exp return (only model that does not require estimates of exp return) 2. more diversification 3. less sensitive to input changes

Answer 215

similar to CAL, but Y = expected surplus; X = st dev of surplus

Answer 216

BL and monte carlo can both be used to help set ALM asset weights

Answer 217

* R = W1 \* R1 + W2 \* R2 * SD = W1 \* SD1 + W2 \* SD2 (approx when corr = 1) * portfolio 1 weight \* asset A weight in portfolio 1 + portfolio 2 weight \* asset A weight in portfolio 2 = new asset weight

Answer 218

minimum surplus variance portfolio (min var and lowest surplus)

Answer 219

* process of elimination using IPS * 60/40 equity/bonds is mix for avg investor

Answer 220

1. optimization programs to find EF are inexpensive and commercially available 2. typically no negative weights 3. cash is included in risky assets 4. widely accepted 5. easy to adapt to Roy's 6. EF model can be simplified with corner portfolios

Answer 221

1. number and nature of required estimates 2. estimation bias in exp returns 3. static 1 period approach 4. output may be under diversified 5. ouput can be very sensitive to inputs

Answer 222

1. EF more stable (less impact from small input changes) 2. more diversified than traditional MVO 3. commerially available software

Answer 223

1. no theoretical basis 2. inputs based on historical data

Answer 224

1. Theo justifiable way to address input sensitivity & incorporate manager's views 2. more stable SAA 3. more diversification 4. unconstrained or constrained (better) 5. constrained quantifies and begins with mkt consensus returns, then let's manager adjust 6. commercially available

Answer 225

1. inputs based on historical data 2. complex

Answer 226

1. stats tool to augment other approaches 2. incorporates path dependency 3. prob distribution can be used to answer liklihood to meet/miss returns 4. can be used to model liabilities and surplus 5. commercially available

Answer 227

1. complex 2. false confidence due to complexity; only as good as assumptins, inputs

Answer 228

1. allocation of assets based on liabilities 2. surplus frontier; surplus vs risk 3. commercially available 4. otherwise similar to MVO

Answer 229

• same as MVO 1. number and nature of required estimates 2. estimation bias in exp returns 3. static 1 period approach 4. output may be under diversified 5. ouput can be very sensitive to inputs

Answer 230

1. uses decades of experience 2. easy to understand; consistent with more complex approaches 3. inexpensive

Answer 231

1. too simple for some investors 2. rules can be contradictory

Answer 232

* on the efficient frontier of MVO * not clear how they are defined, but they are portfolios on the EF, which linear combination can be used to calculate other portfolios of a specific return or risk

Answer 233

don't forget to use compound calc on returns if 'compounding' or 'multiperiod' are mentioned

Answer 234

the portfolio with the highest sharpe ratio ~ market portfolio

Answer 235

* pick a portfolio on the EF with the required return * can use corner portfolios to approx the new portfolio return, std dev and asset allocations

Answer 236

1. wealth accumulation is to meet goals like retirement and college (???) 2. structure of income and wealth accumulation 3. longevity risk 4. mortality risk

Answer 237

• Example; none of the inputs are true in all cases, eg. ◎ HC = 100% bond ◎ retire at 60 ◎ etc. • HC is always 100% like a bond • age 30: 10/90 FC/HC; FC: 100% eqty \>\> TC (total cap): 10/90 equity/bond • age 50: 60/40 FC/HC; FC: 83.3 eqty / 16.6 bond \>\> TC: 50/50 • age 60: 100/0 FC/HC; FC: 50/50 \>\> TC: 50/50

Answer 238

1. reduced risk through low correlation 2. higher returns (if low corr and domestic is down, int'l might be up)

Answer 239

1. volatility of foreign asset value 2. volatility of foreign currency value

Answer 240

1. govt regulations 2. tech specialization 3. fiscal policy 4. monetary policy 5. culture & social differences

Answer 241

shifts curve up (same risk, higher return)

Answer 242

• positive • 3 factors: ◎ corr of global bond mkts ◎ corr of bonds to the stock portfolio ◎ if currency is hedged

Answer 243

Rdom = Rlc + S + S \* Rlc Rdom = return in investor currency(DC) Rlc = return in local currency OF ASSET S = %chg in FC(foreign currency) • Local currency is NOT domestic currency!

Answer 244

VARdom = VARfa + VARfc + 2 \* SDfa \* SDfc \* Corr(fa, fc) VARdom = var of domestic return VARfa = var of foreign asset value VARfc = var of foreign currency value SD = standard deviation Corr = correlation • weights for both are 1, so can be dropped

Answer 245

``` SD = stand dev fa = foreign asset value fc = foreign currency value ```

Answer 246

• =SDdom - SDfa ◎ SD = stand dev ◎ dom = domestic return ◎ fa = foreign asset value

Answer 247

1. combined risk of currency and foreign assets \< sum of currency risk + foreign assets risk 2. currency risk can be hedged 3. reduced thru diversification across multiple countries • half the risk of foreigh stock risk (tho 2x bond risk) • currency value mean reverts and dictated by fundamentals

Answer 248

• correlations have increased over time • correlations among markets increase during volatile times when diversification is most important • reason corr has increased: ◎ more trade ◎ capital mkt integration ◎ foreign corp are not multi-national and do not offer diversifcation ◎ capital mobility

Answer 249

as volatility increases, correlations increase (due to economic forces) • empirical evidence is mixed; some crises have it, others do not

Answer 250

1. transaction costs 2. regs 3. taxes 4. currency risk 5. political risk 6. mkt efficiency 7. unfamiliarity

Answer 251

* trading costs often higher outside US (eg. brokerage comm) * stamp taxes * price impact fees (on large block trades) * custodial costs (multiple layers) * record keeping and accounting costs * management costs * altogether: 10-12 basis pts * alternative: ADR's for smaller investors (not great for large investors)

Answer 252

* domestic regs limiting foreign investment (eg. pension fund regs) * foreign regs limiting "foreign" investment in their companies (eg. many emerging mkts limit % owned of their companies)

Answer 253

• eg. foreign country withholding taxes on dividends for a period of months is nuisance

Answer 254

* costs of accounting and trading (eg. converting) * increased return volatility, tho this can be hedged

Answer 255

• eg. ◎ govt led currency devaluation ◎ nationalization ◎ special regs on foreign investors

Answer 256

* illiquidity of emerging mkts * capital controls (eg. restricting withdrawl from country) * lack of info * integrity (insider trading)

Answer 257

fear of the unknown \>\> belief that foreign investments are riskier

Answer 258

* corps are less conglomerate (across industries) and more int'l (across countries) than in the past * global diversification = country diversification + industry diversification

Answer 259

• good investments due to high return (in part from lack of integration), and low corr to developed mkts • higher return and volatility • not normal dist; large left tail • crises persist longer • high corr with other emerging mkts during crises • common issues: ◎ unstable govt and social order ◎ undeveloped infrastructure ◎ poor education ◎ corrupt govt ◎ currency and asset value often pos corr

Answer 260

1. reg limits on amount of stocks foreigners can own in aggregate or in a company 2. low free float due to govt ownership \>\> illiquidity 3. restrictions on cap repatriation 4. discriminatory taxation on foreigners 5. restrictions on currency conversions 6. reg req authorized investor status 7. low liquidity