CFA Book 3 Copy Flashcards

Question

Bond immunization | goal

Answer 1

minimize interest rate risk: ◎ price (mkt value) risk ◎ reinvestment risk • applied to a single or multiple liabilities

Answer 2

* price risk and reinvestment risk (neg corr) offset each other * process: set effective duration = liability horizon \>\> interest rate risk elminated (price risk offsets reinv risk) * immunized for instantaneous, small parallel shift in yld curve * often needs to be extended to be sufficient

Answer 3

1. select bond w/ effective duration = liability duration 2. set bond PV = PV of liability \>\> DONE • unmatched duration: ◎ if bond duration \< liablity duration \>\> reinv loss \> price gain if rates go down ◎ if bond duration \> liability duration \>\> price loss \> reinv gain if rates rise

Answer 4

1. time 2. interest rates • unlikely bonds and liabilities change in identical ways \>\> periodic rebalancing of immunization

Answer 5

1. credit rating 2 embedded options 3. liquidity (neccesary for rebalancing)

Answer 6

* portfolio shortfall risk vs liability * corr with reinv risk (higher reinv risk \>\> higher immune risk) * zero coupon have zero immunization risk

Answer 7

* %change in bond dollar value given 1% change in interest rates (100bp increase) * weighted avg (mkt val) of effective durations of bonds in portfolio

Answer 8

contribution of bond (individual or by some grouping) to portfolio duration = wD w = bond (mkt val) weight in portfolio = bond mkt val / portfolio mkt val D = effective duration of bond • sum of contributions = portfolio duration

Answer 9

effective duration (weighted by mkt val), duration contribution (weighted by mkt val), dollar duration (not weighted, sum of each bond's DD) can all be calced on an individual bond or a group of bonds

Answer 10

DD = -1 \* 0.01 \* (modified or effective duration) \* mkt val

Answer 11

• process: ◎ calc new DD ◎ rebalancing ratio = DDold / DDnew ◎ (rebalancing ratio - 1) \* new portfolio mkt value = new dollar val of bonds to be bot/sold (in same proportion as original portfolio) • alt: buy/sell bond (the controlling position) with greatest duration \>\> lower dollar amount req to rebalance

Answer 12

1. nominal spread: %chg price / 100bp chg in nominal spread 2. zero-volatility spread (aka static spread) = %chg price / 100bp chg zero-vol spread 3. option adjusted spread (OAS) = %chg price / 100bp change in OAS

Answer 13

portfolio spread duration

Answer 14

100bps parallel shift in spread over Treasuries • spread measures risk aversion

Answer 15

1. multifunctional duration (aka key rate duration) 2. multiple-liability immunization (multiple horizons) 3. relaxation of min risk requirement (allow more risk \>\> higher returns) 4. contingent immunization (mix of active and passive strats)

Answer 16

• goal: return maximization • process: 1. set safety net return 2. pursue higher returns with active management 3. if hit safety net return \>\> immunize to lock in safety net return • must have procedures to monitor for safety net trigger

Answer 17

* = Current mkt val - liability PV discounted at immunized rate (current obtainable rate) * current assets PV - liability PV

Answer 18

If PV of asset CF \< liability PV discounted at immunized rate (NEW current obtainable rate) \>\> safety net is triggered \>\> passive management

Answer 19

1. mkt can move to fast and no chance to lock in immunization rate 2. immunization rate might not be achieved once triggered (???)

Answer 20

1. interest rate risk ◎ match duration and convexity ◎ neg convexity hard to match 2. contingent claim risk (call, prepay) 3. cap risk • convexity (non-linear chg) key issue

Answer 21

* minimize distribution of cash flow around liability horizon * bullet strategy best, barbell worst * if maturity too early \>\> reinv risk; if too late \>\> interest rate risk (sensitive to int rate chgs)

Answer 22

* aka M^2 * var of asset maturities around liability maturity date * lower \>\> better

Answer 23

* treat as a zero coupon bond in the immunization portfolio * relates to expected cash flow that arrive around or at the time the liability matures/is due

Answer 24

• process: ◎ select bond that matures on last liability maturity date ◎ combine that bond's extra cash flows with another bond to meet 2nd to last liability maturity ◎ and so on • more costly than duration matching • pros: ◎ reduces non-parallel shift risk ◎ no duration rebalancing necessary • always have assets mature before liability • all cash flows from bonds are included \>\> reinv risk is important

Answer 25

* duration requires duration rebalancing; cash flow does not * cash flow reduces non-parallel yld curve movement risk * duration matching is easier and less expensive * zero-coupon bonds \>\> eliminate all immunization risk

Answer 26

* aka horizon matching * combination of multiple liability matching (duration matching) and cash flow matching * usually entails matching cash flow for near term liabilities * cash flow matching reduces non-parallel yld curve movement risk and eliminates need to rebalance * more expensive than multi-liability matching

Answer 27

• relative value of bonds is compared across: ◎ sector ◎ issuer ◎ duration ◎ structure

Answer 28

1. top-down: macroeconomic 2. bottom-up: specific undervalued issues • same as with equities

Answer 29

* use both top-down and bottom-up * look at total return

Answer 30

a long term time frame (eg. 10 yrs)

Answer 31

* chg in supply \>\> chg in demand * increase supply \>\>good credit signal to demand \>\> lower credit spreads & higher prices * reduced supply \>\> bad credit signal to demand \>\> higher credit spread & lower prices

Answer 32

• corp bond mkt is dominated by intermediate term, bullet structures • high yld mkt dominated by callable issues ◎ this is expected to decline as credit quality improves \>\> easier credit • 3 results: ◎ bonds with embedded options trade at premium due to scarcity ◎ longer durations trade at premium due to scarcity ◎ credit-based derivatives will increase in use for diversification and tailoring structure

Answer 33

* greater liquidity \>\> lower risk premium * bonds becoming more liquid due to cheaper, faster transactions due to technology and other factors

Answer 34

1. yld spread/pickup trades: more yld given credit rating (ignores total return) 2. credit upside trades: buy before credit upgrade 3. credit defense trades: sell bonds in risk of downgrade 4. new issues swap: swap into newer issues for liquidity 5. sector rotation: move into outperforming sectors; out of underperforming 6. yld curve adjustment: adjust portfolio given yld curve forecast 7. structure trades: adjust portfolio given volatility and yld curve forecast 8. cash flow reinvestment

Answer 35

1. nominal spread ◎ corp yld - govt yld of similar maturities ◎ basic unit of price and relative value analysis for global mkt 2. swap spreads:rate paid by fixed-rate payer over on-the-run T's with same maturity ◎ widely used in Europe for indication of credit spreads 3. option adjust spread ◎ good for comparing corp vs MBS ◎ declining due to reduction in bonds w/ optionality

Answer 36

1. spread mean reversion ◎ most common reason 2. quality spread analysis: high credit quality spreads vs low credit quality spreads 3. percentage yld spread analysis: corp yld / T ylds with simiar duration ◎ not commonly used

Answer 37

• short term: 1 - 5 yrs • medium term: 5 - 12 yrs ◎ most common (esp in europe) • long term: 12 - 30 yrs

Answer 38

• callable bonds: ◎ underperform with rates rise ◎ outperform when rates fall • sinking funds ◎ portion of issue is retired on a schedule ◎ don't fall as much when rates rise due to buy back provision • putable bonds: few bonds have puts

Answer 39

1. corp: ability to pay 2. ABS: collateral & servicer 3. Municipal: ability to assess and collect taxes 4. govt: ability (econ) and willingness (political) to pay

Answer 40

1. total return analysis 2. primary mkt analysis (supply/demand effects) 3. liquidity and trading analysis (liquidity effects) 4. secondary trading rationales 5. secondary trading constraints 6. spread analysis (volatility effects; mean rev, quality spread, % yld) 7. structural analysis (derivatives + macro econ) 8. credit curve analysis (yld curve + macro econ) 9. credit analysis (up/down grades) 11. asset allocation / sector analysis (econ: sectors/firm performance)

Answer 41

1. portfolio constraints ◎ quality ◎ structure ◎ foreign bonds ◎ floating rate for commercial banks ◎ high yld limit for insurance firms ◎ structure, quality for european investors cause of global bond mkt inefficiency 2. 'story' disagreement: buy/sell side disagreement 3. buy and hold ◎ desire not to recoganize loss 4. seasonality ◎ trading slows at end of mon, qtr, yr due to paper work • cause of global bond mkt inefficiency

Answer 42

* magnifies outcome, good or bad * return generated on assets, but return rate is off of equity

Answer 43

Re = Ri + (D/E \* (Ri - Rd) Re = return on equity Ri = return on assets D/E = debt/equity ratio Rd = cost of debt • as leverage OR investment return increase, return variability increases

Answer 44

``` De = (Di \* I - Db \* B) / E De = equity duration Di = asset duration Db = borrowed funds duration I = assets B = debt E = equity ```

Answer 45

• repo agreement: collateralized loan • repo rate = loan rate • process: ◎ A sells B a security with a promise to repurchase with a specified date and price ◎ A buys the security back from B ◎ diff in price is the cost of borrowing (at the repo rate) • 360 days/yr

Answer 46

1. none: small credit risk or short loan period 2. physical delivery (most expensive) 3. custodial acct at borrower's clearing firm 4. electronic bank transfer (expensive)

Answer 47

1. credit risk & delivery ◎ high credit risk & no delivery \>\> high repo rate 2. quality of collateral 3. repo term: longer \>\> higher repo rate 4. collateral scarcity: if scarce and lender needs it \>\> lower repo rate 5. seasonal factors • fed funds rate (bank to bank) is repo rate benchmark

Answer 48

not Christmas, but end of period (mon, qtr, yr) where trading slows due to paper work

Answer 49

1. bond returns often not norm dist 2. many inputs into calc: N \* (N + 1) / 2, N = # bonds 3. estimates for inputs is hard

Answer 50

• only measures variance below the mean • cons: ◎ computation is hard ◎ if returns symmetric \>\> same as var, but var is better understood ◎ if returns not symmetric, semi-var may not be the best ◎ estimated with 1/2 the dist \>\> smaller sample \>\> less statistifcally accurate

Answer 51

* prob return will be below target * cons: no info as to size of shortfall * similar to VAR

Answer 52

* prob, given a period of time, return will be less than target * con: no info as to size magnitude of shortfall * similar to shortfall

Answer 53

* adjust portfolio without as big capital outlay • contracts not securities * 30 days - 30 years * react the same as bonds, but exactly the same * exchange: CBOT

Answer 54

* CTD * exchange allows short position to deliver various bonds to fulfill contract * options: quality or swap, timing, wild card * use conversion factor (from exchange) to calc correct price for bonds delivered

Answer 55

1. more liquid 2. less expensive 3. easier to short

Answer 56

* same as bonds * buy futures \>\> increase duration * sell futures \>\> decrease duration

Answer 57

dollar duration = duration \* 0.01 \* mkt value

Answer 58

DDt = DDp + DDfut DDt = total DD DDp = portfolio DD DDf = futures DD • if DDfut \> 0, then but futures; if

Answer 59

• # contracts = (DDt - DDp) / DDf DDt = total DD DDp = portfolio DD, DDf = ONE futures DD • OR # contracts = (Dt - Dp) \* Pp \* CTD conversion factor / (Dctd \* Pctd) D = duration P = price

Answer 60

date when the trade is complete, taken off, matures, etc

Answer 61

* risk the price basis will not be the same at the horizon date * price basis = spot price - futures delivery price * risk of using futures rather than identical bonds; more risky with 'cross hedge'

Answer 62

* using one security to hedge a different security * if derivatives: using a diff underlying than the asset to be hedged

Answer 63

* hedge ratio = bond exposure to risk factor / futures exposure to risk factor * OR = (bond exposure to risk factor / CTD exposure to risk factor) \* (CTD exposure to risk factor / futures exposure to risk factor) * when risk is interest rates: = Dp \* Pp \* CTD conversion factor \* yld beta / (Dctd \* Pctd) * hedge ratio and # contracts for when hedge is finished (lifted)

Answer 64

• when cross hedging • bond yld = a + b(CTD yld) b = yld beta • needed because change in spreads will not be identical (if they are then yld beta = 1) • if b \> 1, then # contracts \> than if b = 1, and vice versa

Answer 65

1. forecast of basis when hedge is lifted 2. estimated duration 3. estimated yld beta

Answer 66

* contract * one party pays floating, receives fixed; other party pays fixed, receives floating

Answer 67

* fixed receiver increases duration (pos duration) * fixed payer decreases duration (neg duration) * floating sides don't have much duration because bond value is continually reset

Answer 68

* options on interest rate futures (to go long or short the futures) * call protects existing lenders and future borrowers from an increase in interest rates * put protects existing borrowers and future lenders from a decrease in interest rates * collars are sometimes used

Answer 69

* options on bond futures * call protects existing bond issuers * put protects existing bond owners * collars are sometimes used

Answer 70

* same as call (caps) and puts (floors) * caps are for future borrowers (and existing lenders) * floors are for future lenders (and existing borrowers) * eg. caps: future ST bank borrowings; floors: future insurance lending * collars are sometimes used

Answer 71

3 factors ◎ underlying contract ◎ option delta ◎ leverage • out-of-money options have more leverage, smaller delta • duration and delta have same sign (pos call; neg put)

Answer 72

* existing lenders and future borrowers have same risk: higher interest rates * existing borrowers and future lenders have same risk: lower interest rates

Answer 73

1. Default risk (only one actually based on firm's actions) 2. Credit spread risk 3. Downgrade risk

Answer 74

1 credit options ◎ binary credit option = based on underlying's price ◎ credit spread option = based on underlyng's yld spread 2. credit forwards 3. credit swaps

Answer 75

• trigger both must happen ◎ defined event ◎ option is in-the-money • upon exercise: ◎ long gives short the bonds ◎ short pays long the strike price

Answer 76

* trigger ('credit event'): asset's spread (asset's yld - benchmark yld) \> option spread strike * upon exercise: payoff = max[(spread - strike) \* notional \* risk factor, 0] * inputs: strike, risk factor, notional * both calls and puts available

Answer 77

• payoff = (spread at maturity - contract spread) \* notional \* risk factor

Answer 78

options are similar to futures, except one side has the obligation (as in a future), but the other side has the choice (not like a future) • could be called half of a future

Answer 79

• insurance on a bond • specified credit events \>\> insurance trigger • 2 types of payoffs: ◎ cash = par - bond value; long side keeps the bonds ◎ physical delivery = short pays par to long; long delivers bonds to short

Answer 80

1. market selection (best nat'l mkts) 2. currency selection 3. duration management 4. sector selection 5. credit analysis (of individual securities) 6. mkts outside benchmark ◎ usually int'l is govt debt; adding int'l corp can increase returns

Answer 81

chg foreign yld = b \* chg domestic yld

Answer 82

%chg foreign bond price = foreign bond duration \* chg yld \* b b = yield beta (country beta)

Answer 83

= duration \* yld beta

Answer 84

= duration \* yld beta \* mkt val weight in portfolio

Answer 85

F = So \* (1 + Cd) / (1 + Cf) F = forward fx rate So = current fx rate C = short term rate • if foreign currency appreciates \>\> premium; depreciates \>\> discount

Answer 86

prem/discount = (F - So) / So =~ Cd - Cf F = forward fx rate So = current fx rate C = short term rate • aka forward currency differential

Answer 87

• given fx spot and fx forward contracts, interest rate parity must hold otherwise there are arb opportunities

Answer 88

• is there arb opportunity? • = (1 + Cd) - (1 + Cf) \* (F / So) F = forward fx rate So = current fx rate C = short term rate • \>0 \>\> forward rate too high \>\> buy domestic, buy foreign thru spot, lend foreign, sell foreign thru forward; \< 0 vice versa

Answer 89

1. forward hedge: sell the foreign currency forward 2. proxy hedge: when foreign currency is hard/expensive to hedge, use third currency corr to foreign currency 3. cross hedge: sell foreign currency forward into a third currency \>\> change risk to third currency; not a hedge

Answer 90

Rd =~ Rf + Rc =~ Id + (Rf - If) Rc = exp currency return (ie forward prem/discount) Id = dom risk free rate If = foreign risk free rate • choose foreign bonds with greatest excess return

Answer 91

* if mkt overestimates foreign currency appreciation (but actually appreciates less) \>\> hedge (sell foreign currency forward) to take advantage of over estimation * if underestimates \>\> no hedge

Answer 92

• determine how much spread between two bonds must widen before returns are equal • must 1) be over a specific period 2) use the bond with the higher duration • yld chg = price chg / - duration • proces: ◎ calc necessary price change to make returns equal ◎ calc yld chg that leads to the price change (rem: de-annualize)

Answer 93

* manager holds 'core' of investment grade debt * outside of core, invests in higher return/higher risk debt, such as emerging mkt debt (EMD)

Answer 94

1. diversification benefit 2. increased quality of sovereign EMD 3. sovereign EMD often able to reduce impact from negative events 4. resilient 5. undiversified index, such as EMBI+, offers higher returns

Answer 95

1. corp EMD does not have ability to reduce impact like sovereigns 2. high volatility 3. negative skew 4. lack of transparency 5. lack of strong legal system and protection from govt 6. lack of standard covenants 7. political risk (geopolitical risk): instability, taxation, fx restrictions, bankruptcy frequency, fx manipulation (pegging) 8. lack of diversification with EMBI+ index

Answer 96

1. style analysis 2. selection bets (credit spread analysis, relative value) 3. investment process 4. alpha corr (need diversification)

Answer 97

* MBS structured as an annuity with identical payments over its life * due to even payments (no bullet payment), MBS is affected more by rates across the yld curve (eg. twists), not just at the end * MBS has prepayment (call) * due to even annuity structure and prepayment, cash flow is weighted on the front end than bullet bonds

Answer 98

1. spread risk 2. interest rate risk 3. prepayment risk 4. volatility risk 5. model risk

Answer 99

* risk: spread between MBS and benchmark widens * often not hedged * avoid by only buying when spread is attractive

Answer 100

• risk: interest rates rise • hedge: ◎ duration hedge (simple) ◎ 2-bond hedge (better) • 2-bond hedge does not address prepay (neg convexity issue)

Answer 101

• risk: prepayment (call) • hedge: ◎ options: buy calls and puts (why not just calls???) ◎ dynamic hedging (neg gamma): buy/sell futures to adjust short futures duration hedge ◎ 2-bond hedge does not help

Answer 102

• risk: volatility increases \>\> increasing short call value • hedge: ◎ if implied option vol in mkt \< estimated vol \>\> buy options ◎ if implied option vol in mkt \> estiimated vol \>\> dynamic hedge

Answer 103

• risk: ◎ incorrectly assuming past interest rate behavior predicts future ◎ ignoring technology and other changes • cannot be hedged; manager must pay close attention; MBS is complex

Answer 104

* measure the sensitivity of the portfolio to a inidividual changes in a set of key rates along the yld curve (often 11) * sum(key rate durations) = effective duration

Answer 105

* aka PO and IO * PO has negative duration short and intermediate term (to 10 yrs) and positive duration after #IO is reverse; positive duration early on, then negative

Answer 106

the portfolio manager: 1. incorporations reasonable yld curve shifts 2. adequate prepayment model 3. reasonable assumptions in Monte Carlo model 4. knows security's price chg given small yld chg 5. knows avg price chg method \>\> good approximations

Answer 107

Given: 1. MS (MBS security), H1 (hedge 1 security), H2 (hedge 2 security) 2. Pms (MBS pricce), Ph1 (hedge 1 price), Ph2 (hedge 2 price) Steps: 1. calc avg absolute price chg per $100 for all 3 securities given parallel shift in yld curve 2. calc avg absolute price chg for all 3 securities give twist of yld curve 3. simultaneously solve for ◎ given shift: H1 \* chgPh1 + H2 \* chgPh2 = - chgPms ◎ given twist: H1 \* chgPh1 + H2 \* chgPh2 = - chgPms ◎ essentially H1 \* chgPh1 + H2 \* chgPh2 + chgPms = 0 for both equations ◎ simultaneously solve by subtracting one equation from the other where one of the H terms is subtracted out

Answer 108

if increase in value with drop in rates \< drop in value with equal increase in rates \>\> negative convexity

Answer 109

* goal: better hedge the cash flows of MBS; single bond is better for bullet bonds, not MBS * uses 2 bonds to hedge the MBS * often with shorter durations (eg. 2, 10 yr) to match front loaded cash flow of MBS * hedge does NOT address negative convexity from prepay; use options and dynamic hedging for that

Answer 110

* coupon just above current ylds * in danger of prepay if rates fall * often attractive OAS

Answer 111

yes - especially equities that can pass on inflation to customers (less competitive industries)

Answer 112

* passive: indexing, meet benchmark, lower exp return and tracking risk, no forecasts * active: outperform benchmark, higher exp return and tracking risk, majority of managers opt for this strategy * semi-active: inbetween passive and active

Answer 113

* active return = portfolio return - benchmark return * tracking risk = std dev of active return * information ratio = active return / tracking risk

Answer 114

* risk / return metric for managers * =active return / tracking risk (aka tracking error)

Answer 115

passive: less portfolio turnover

Answer 116

• active underperforms passive by about the extra expense \>\> sans expenses, active = passive performance

Answer 117

1. price: artimetic avg of prices ◎ sum(prices) / # stocks ◎ hold one share of each stock 2. mkt cap (aka value) ◎ sum (mkt caps) ◎ hold each stock in proportion to mkt cap 3. free float adjusted mkt cap: same as mkt cap, but mkt cap is calced from free float ◎ best metric; most major indices are free float 4. equally: each stock given indentical weight ◎ hold same dollar value in each stock

Answer 118

* stock price relative to other stock prices is not indicative of relative value or performance * higher priced stocks impact vs lower priced * stock impact changes as price changes * unrealistically assumes investor holds equal shares of each stock

Answer 119

* higher mkt cap firms have larger impact * larger firms may be mature and/or overvalued * too little diversification if dominated by large firms * institutional investors may not be able to mirror due to max holding restrictions

Answer 120

* small caps have same weight as large caps * often index has many small camps, compounding small cap issue * high rebalancing costs * small cap liquidity issues

Answer 121

price: DJIA, Nikkei value: SP, Russell, MSCI, CAC40, DAX30 equal: Value Line Composite Avg

Answer 122

rebalancing an index

Answer 123

1. trade frequency: mutual once per day; ETF like a stock 2. recordkeeping for shareholders: mutual funds have to; ETFs do not 3. license fees to index creator (eg. S&P): mutuals pay lower fees than ETFs 4. tax efficiency: ETF more efficient due to fewer taxable events 5. fees: ETF usually have lower fees

Answer 124

* for indexed institutional portfolios * advantageous to small funds that cannot afford full time manager * fees can be as low as a few basis points

Answer 125

• alternative to ETF • popular due to 'portfolio trades' (aka basket or program trades) • 2 cons relative to ETFs: ◎ finite life \>\> roll over \>\> fees and slippage ◎ basket trade + futures strat has basket shorting issue (uptick rule); ETFs do not

Answer 126

swap return on a single stock or interest rate for return on an equity index

Answer 127

1. full replication 2. stratified sampling 3. optimization

Answer 128

* exactly mirroring stocks and weights * return = index return - mng fees, transaction fees, cash drag (cash kept for redemptions) * good method for few stock (\< 1000), liquid stocks, large investment pool * pro: low tracking risk * con: expensive

Answer 129

• aka representative sampling • good when index has many (\>1000), illiquid stocks • process: ◎ breakdown index by trait (eg. industry, PE, size) ◎ pick a representative stocks from each bucket ◎ purchase stocks so weight = bucket weight • pros: fewer stocks to track • cons: more tracking error

Answer 130

* good when index has many (\>1000), illiquid stocks * factor model of factor exposures of index * pros vs stratifed sampling: less tracking error; takes factor corr into account * cons: based on historical data that may change; historical data may be flawed; frequent rebalancing due to changing risk sensitivities * optimization + partial replication (of largest stocks) has lower tracking risk

Answer 131

1. value 2. growth 3. market oriented • also mkt cap (eg. micro, small, mid, large)

Answer 132

• focus on the numerator in P/E and P/B • rationale: ◎ firm's earnings are temporarily depressed ◎ growth style is too risky; P/E can contract • 3 sub-groups: high dividend yld, low price multiple, contrarian

Answer 133

* focus on denominator in P/E * 2 sub-styles:consisten earnings growth, momentum (play)

Answer 134

* hard to define: broad mkt avg over time * sub-stylyes: value-tilt, growth-tilt, growth at reasonable price (GARP), style rotation

Answer 135

* micro, small, mid, large * can be combined with value, growth, mkt oriented

Answer 136

* determine mng's style using their returns * mng's returns (dep var) are regressed against various style indices (eg. large cap value) * ind vars: mutually exclusive, uncorr risk, comprehensive (cover all investments) * output is mng's benchmark portfolio or 'normal' portfolio * Rsquared = proportion of mng's returns explained by indices (style fit) * unexplained is 'selection return' * pro: de facto analysis of mng's style

Answer 137

1. returns based 2. Holdings based style analysis

Answer 138

* observe mng's holdings to determine style * high earnings growth \>\> growth; high earnings volatility \>\> value * sectors also help identify (eg. tech \>\> growth)

Answer 139

* return pros: assesses entire portfolio, backed by theory, few inputs, robust across models, low cost * holdings pro: assesses each security, looks at current portfolio snapshot \>\> style drift detection * return cons: historical data \>\> miss style drift, mis-specified model * holdings cons: subjective analysis, diff from common mng stock selection, more data requited than returns based

Answer 140

* display portfolio style traits * 3 x 3 box; mkt size x style (value, core, growth)

Answer 141

manager strays from original, stated style

Answer 142

* investing based on 'ethics' * positive and negative screens (ie filters)

Answer 143

* long-short is less restricted \>\> 2 alphas (long and short) * long only in ability to express negative sentiment (max is zero position in stock) * long-short can eliminate SYSTEMIC risk eith a 'pairs trade' in same industry to play relative value * long-short considered alternative investment, not equity strat

Answer 144

1. barriers to short selling 2. firm's promote their stock \>\> constant overvaluation 3. sell recommendations have small audience and large counter-audience, so sell-side avoids making them 4. pressure from companies (eg. investment banking business) on sell-side analysts

Answer 145

doing a long-short strategy and then buying futures or ETFs to go long the mkt (seems like two independent strategies)

Answer 146

* extension of long-only strats * eg. 120% long / 20% short * beta around 1.0 (as opposed to L-S strat of beta 0) \>\> considered equity strat (not alternative)

Answer 147

pros: ◎ implement positive/negative sentiment better than long-only ◎ equity strat, not alternative ◎ can invest over 100% of funds ◎ no derivatives needed ◎ more efficient that 100/0 + 20/20 (long-only + long-short) bc/long only would include short stocks in long-short cons: ◎ more than 100% \>\> more transaction fees ◎ mkt-neutral long-short portfolio (EMNLSP) has more ways to generate return

Answer 148

1. substitution (loss) 2. opportunity cost (loss) 3. deteriorating fundamentals (loss) 4. valuation level (profit) 5. down-from-cost (loss) 6. up-from-cost (profit) 7. target price (profit)

Answer 149

growth: 60 - 200+% value: 20 - 80%

Answer 150

* aka semi-active * higher information ratio than passive or active * cons: copy-cats will elminate alpha, historic data may not reflect future

Answer 151

over/under weight certain stocks; all other stocks same weight as index (in active, neutral stocks would not be held at all)

Answer 152

* equity exposure with derivatives * equitize cash: cash (in bonds) + equity futures; alter duration of cash position to generate alpha

Answer 153

IR =~IC \* sqrt(IB) IR = information ratio IC = information coefficient (depth of knowledge) IB = breadth of knowledge = # of decisions (eg. invest in energy sector) • this is an alternative way to calc IR (vs active return / tracking error)

Answer 154

instead of return by risk, it is active return by tracking error

Answer 155

1. must believe alpha is possible and that investor can pick successful manager 2. if investor has a boss, boss will judge against passive benchmark \>\> safest path is passive 3. less diversification with active

Answer 156

1.5 - 2.5%

Answer 157

* portfolio = indexed or enhanced index + satellite of active managers * indexed core mitigates risk of active management

Answer 158

* active return = sum(Wi \* Ri), Wi = weight, Ri = return * active risk = sqrt(sum(Wi^2 \* VARi)), Wi = weight, VARi = variance, assume 0 corr

Answer 159

* active managment risk factors + completeness fund risk factors =~ index fund risk factors * completeness fund compliments the active portfolio by providing risk factors in benchmark, but not in active portfolio * cons: misfit risk

Answer 160

* true active return = mng's return - mng's normal portfolio return * misfit active return = mng's normal portfolio return - benchmark return * total active return = true active return + misfit return * total active risk = sqrt(true active risk ^ 2 \* misfit active risk ^ 2)

Answer 161

= true active return / true active risk • a third way to calc information ratio

Answer 162

* two distinct and separate strats (ETF and long-short) * eg. invest in S&P ETF for beta strat, employ mng for long-short alpha strat * portable alpha: can switch beta strat, but keep alpha strat untouched * cons: long-short strat not always mkt neutral

Answer 163

1. qualitative: investment approach, research, personnel 2. quantitative: performance, style, fees 3. consistency of stated vs actual approach

Answer 164

1. staff and org structure 2. investment philosophy and procedures: alpha strat, risk management, stock selection 3. resources, research, quant models, trade execution 4. performance 5. fees

Answer 165

1. ad valorem (aka AUM fees): known in advance, but not aligned interests 2. performance based: volatile, but aligned interest; highwater marks and fee caps 3. combo

Answer 166

* buy-side: non-public, internal to a management company * sell-side: public (for fee), provided by investment banks

Answer 167

designed to minimize ethics problems and address underlying business ethics problem, principal-agent relationship

Answer 168

* groups with interest or claim in company * internal or external * make contributions to company \>\> company must consider their interests

Answer 169

1. stockholders (risk capital / ROIC and growth): principal in principal-agent; information disadvantage 2. employees (labor / wages) 3. managers (run company / wages+): agent in principal-agent; information advantage 4. board of directors (oversee mng's / wages): also information advantage; can be too close to mng's

Answer 170

1. customers (make purchases / products): stable relationship, lower prices 2. suppliers (inputs / cash): stable relationship, higher prices 3. creditors (debt / interest) 4. unions (stability / higher wages): potentially disruptive and damaging to ST & LT company health 5. gov't (rules & regs / comliance): potentially disruptive 6. local communities (infrastructure / good citizenship): potentially disruptive 7. general public (infrastructure / higher quality of life): potentially disruptive

Answer 171

• goal: force company to make choices between stakeholders and ID which are most critical to company: ◎ ID relevant stakeholders ◎ ID critical interest of each group ◎ ID demands of each group ◎ prioritize stakeholders ◎ business strategy to meet critical demands

Answer 172

• the company should focus on return on invested capital (ROIC) and growth in order to increase the pie that is divided among many stakeholders

Answer 173

* principal delegates power to agent * PAR problems (PAP) often arise due to asymmetric information in favor of agents and agent's self interest * in corporations, board of directors job is to oversee managers on behalf of stockholders; this often fails when BOD is co-opted by managers

Answer 174

• aka PAP • 3 measures: ◎ set goals and principals of behavior ◎ reduce asymmetry of information ◎ remove agents who misbehave/violate ethics

Answer 175

1. self-dealing 2. information manipulation 3. anti-competitive behavior (even if legal) 4. opportunistic behavior of suppliers 5. substandard working conditions 6. environmental degredation 7. corruption

Answer 176

1. agents with flawed personal ethics 2. failure to realize issue may lead to ethics violations 3. too focused on profit and growth 4. management sets unrealistic goals 5. unethical leadership set unethical tone

Answer 177

concept that successful companies have obligation to give back to society

Answer 178

1. Friedman doctrine 2. Utilitarianism 3. Kantian ethics 4. Rights theories 5. Justice theories

Answer 179

1. Hire, promote those with strong personal, business ethics 2. culture of ethics 3. leaders that will implement #2 4. systematic decision process that incorporates ethics philosophies 5. appoint good ethics officers 6. corp gov procedures that include: ◎ majority BOD are independent ◎ separate chaiman and CEO ◎ comp directors are independent and outsiders ◎ BOD use outside, independent auditors

Answer 180

two companies hold ownership stakes in each other \>\> double accounting in an index

Answer 181

• float (aka free float) = shares available for purchase by the public • tradable value = float \* stock price ◎ most important in emerging mkts, but often hard to calc

Answer 182

1. breadth vs investability ◎ # stocks vs liquidity 2. liquidiy, crossing opportunity vs reconstitution effects ◎ reconstitution effects: popular, liquid index \>\> mng pays more for added stocks, receives less for deleted stocks 3. precise float adjustment vs rebalancing transaction costs 4. objectivity, transparency vs judgement ◎ subjective judgement of index composition \>\> frequent reconstitution \>\> higher transaction costs

Answer 183

leads to upward biases in average size and performance