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Speculators want underlying to go up
Hedgers better price will go down (i.e. own underlying and hedging)

Backwardation happens when more hedgers vs speculators
Contango has more speculators then hedgers

IF index not investable, its not a valid bench
1. Bond market securities are more heterogeneous and illiquid vs stocks
2. Indexes from various vendors can appear similar but have different characteristics
3. Risk characteristics can change quickly over time as new issues of bonds are added
4. Cap weighted index carry exposure to credit downgrade risk
5. Hard for investors to find an index that matches their risk profile. (mainly diff durations)

finally, Issue with customized bench - PM will set up for something easy to beat

Risk utility function changes at different levels of wealth
Poor - usually risk-averse (concave curve)
Wealth increases - risk-seeking increases (convex)
Super wealthy - risk becomes risk-averse again

Bonds:
Duration
Key rate duration
PV distribution of CF's
Sector Qualities
Sector duration

Stocks:
PE
Leverage
Earnings Growth Rate
Size

For most, its .0001...quotes given in basis points

Duration contribution is 6 * .42 = 2.52...

formula:
# of contracts = ((target beta - B port)*V) / (B fut * fut price)

First step, convert mid cap to cash, V=$15m and target beta is 0. So,

(0-1)*($15m)/(1.05*$260k) = -54.95

manager shoudl short 55 contract of mid cap index. Then manager should take a long positon in the following contracts on SC index:

(1.6-0)* ($15M) / (1.5*222,222) = 72 contracts

Manager should take a long position in 72 contracts of SC index.

1. Pure Bond Indexing (buy ever bond..costly and difficult)
2. Enhanced indexing by matching primary risk factors (index matching with limited # of securities, does not own every bond, risk controlled strategy, same risk factors as index)
3. Enhanced indexing by small risk factor mismatches (Tilt strategy..sectors and qualities diff, duration the same)
4. Active mgmt by larger risk factor mismatches (tilt AND change in duration)
5. Full blown active mgmt (can change anything)

(#1 is purely passive, #5 no restrictions on manager)
#1 same securities as index in your portfolio
#2 and #3 match index duration
#4 and #5 deviating from index duration as well as other deviations

1. low correlation with stocks and bonds; WITH DIVERSIFICATION BEING THEIR MAIN ADVANTAGE (correlation with stocks low or slightly negative)
2. business cycle sensitivity
3. Positively correlated with inflation (EX: AGRICULTURE PRODUCTS) and provide a hedge against inflation

KEY: Portfolio with commodities return over time is slightly lower, BUT the Sharpe Ratio is higher

yield change foreign = beta(yield change domestic)+e

Example:
Japan yield beta is .45 for british investor and duration of Japan bond is 6. Est the change in price of teh japan bond given 100bps change in domestic rate?

for 100bps change, japan will change 45.

% price = 6*(.01*.45) = .027 = 2.7%

The process of elimination by behavior:

IE:
60/40 mix
100- investors age

Cognitive Error

Money is treated differently based on how its categorized. Wants dividend or income instead of focusing on total return (mcdonalds vs steak portfolio)

Portfolio insurance. It limits the downside risk...Does not work with no volatility and a stable market...Return of owning stock and put is similar to buying a call option..

for the buyer, the payoff functions as follows:

payoff = (credit spread at the forward contract maturity - contracted credit spread ) * notional amount * RISK FACTOR

faulty reasoning (corrected with better training or info) - 5 belief perseverance (stick with previous decision, and 4 processing errors (info analysis flawed)

Active wealth - Self made Wealth - Greater WILLINGNESS to take risk

Passive wealth - wealth from inheritance, windfalls, LT employment - WILLINGNESS to take LESS risk

People who FEEL wealth may take more risk vs those who FEEL less wealthy. WILLINGNESS to take risk higher

1. Electronic Crossing Network - trader is an institution..does not know ID of counterparty and thier trade size

2. Auction market - put forth orders to compete with other orders for execution providing price discovery

3. Automated Auction - electronic limit order markets..NYSE Arca

Compare single A rated debt as teh required return on equities
Yardeni uses a 5 year growth forecast

E/P = yield on A rated debt - d(LTEG)

d= weighting factor for importance of earnings growth around.10
LTEG = 5 yr growth forecast for SPX

compared to the market earnings yield...over 1.0 market is undervalued less then 1.0 market overvalued

Cognitive Error

New evidence is sought or used to support an original view. Ignores contradictory info and goes with info to support thesis

Most bond and equity hedging is done with futures even with basis risk because futures are liquid and continually priced

Hedging of interest payments or receipts is usually done with forward FRA's, so exact amounts and dates can be hedged

Currency hedging usually uses forwards to tailor amounts and dates

Eurodollar futures are mainly used bye dealers and market makers to hedge their own business needs and not used by final customers

KEY: Great for hedging. Puts a band around the possible returns with both upside and downside limited

A collar is combination of protective put and covered call. Buy a protective put and then sell a call to pay for the put. If premium for the two are equal, this is called a zero cost collar

Nominal = real + inflation
Real = 250k/5m = 5% + inflation of 2% = 7% return

The objective is that at least 2/3's of the timer periods, the return on the fund is within plus or minus 1% of the return of the benchmark. The smaller the tracking risk , the more closely the fund matches the bench.

To minimize the difference in risk exposures between port and bench, the investor can use a completeness fund

it is combined with the active port so the combo will have risk exposure similar to the bench

Used when want to align with the bench, usually when have to much risk and want more exposure

Active + completeness = bench active risk

More competition resulting in better price
Traders transact with other traders
No intermediary dealers
Liquidity may be poor

1. High information and Transaction costs
2. Political risk related to potential tax law change
3. High operating expenses
4. inability to subdivide direct investments
5. Large idiosyncratic risk (KEY POINT)

1 Tracking risk – (tracking error) measure of the variability with the portfolios return tracks the return of the bench. Arises primarily from mismatches between a port risk profile and the bench risk profile
a. Defined as the SD of the active returns

1. Long only value investing - creates opportunities because some investors cannot participate in this market and many do not want to do the due diligence
2. Distressed debt arbitrage - purchase debt, short the equity
3. Private Equity - active approach here investor acquires positions in the company

Answer: 564

$45m(1.0404)^3/12 / $50(1610.50) = -564.39

Buy call $45 for $2.10
Sell call $50 for $.50

Stock goes to $100 (max gain)
1. premium - $1.60
2. G/L on stock +$55
3. G/L on the option -$50
Max gain +$3.40

Stock goes to 40 (max loss)
1. Premium -$1.60
2. G/L on stock $0
3. G/L on option $0
Max loss -$1.60

Start with beginning and ending market values
6 levels of analysis in between:
1. Net contributions
2. Risk free assets (what returns would be in RF)
3. Asset categories (passive strategy)
4. Benchmarks (passive style)
5. Investment managers (active return)
6. Allocation effects (anything left is noise; the allocation effect; a plug number)

It only measurable but fails everything else:
1. Fails to ID median manager in advance
2. Fails the unambiguous property
3. Its not investable, as it differs form one year ot the next
4. Impossible to verify the bench

1. LT FX vol is lower then ST
2. Returns of asset and its FX exposure are effected by correlation between the two..Vol higher for positive core
3.Correlation vary's over time
4. Hedging more appropriate for bond portfolios because higher correlation there vs equities with FX
5. Hedging port varies by each manager preference

NCREIF- National Council of Real Estate Investment Fiduciaries
Value weighted index
Values obtained usually on annual appraisals
Volatility of the index is downward biased

Long commodity INDEX futures put in with 100% cash, NOT LEVERED, so totally collateralized with cash

Individual Futures contracts can and will margin up front making these uncollateralized

1. Not informative for trades that dominate trading volume
2. can be game for traders
3. does not evaluate delay or unfilled orders
4. does not account for market movements or volume

$246,210,097

payoff of futures plus t-bill =
886*250*(1120-1100) +240M * 1.03^.25

difference in inflation between two countries will be reflected in changes in the exchange rate between them

1. full hedging and frequent rebalancing is costly
2. Purchasing options has upfront premium cost, that can go to zero..also costly
3. MUST KNOW Forward currency contract are ST and shorter then hedging period. contracts must be rolled over as they mature; FX swap, creating CF vol
4. 100% FX hedge has big opportunities cost, with no app for any favorable FX movement, so most go with 50% or so hedging ratio
5. Managers generally chose partial hedging

At initiation of standard forward, there is no exchange of cash and initial value is zero.

As time passes, rates or prices have changed so one of the counter-parties will have a gain, putting that party at risk of counter party defaults
At any point, credit risk is with the party with a gain

KEY: potential credit risk will be highest in the middle to later part of the contracts life

focus on Ability and Willingness:

Ability decreases: Remember (TLC DS)
Time horizon shorter
Liquidity Needs Higher
Critical goal in relation to size of port

Deferral of goals cannot happen
Sole source of support

Willingness - always determined by statements the client makes, actions or life experiences.

Backwardation = Futures price below spot

Contango = Future price above spot

**most of the time in the market, it is in contango as most assets increase in price

Rebalancing ratio is the original dollar duration divided by the new dollar duration:
162,635 / 136,381 = 1.193

Money needed for rebalancing. We need each position to increase by 19.3%. Cash required is .193* $3,090,823 = $596,529

UBIT must be paid by either a endowment and or foundation if income is produced that is not substantially related to a foundations or endowments charitable purpose

They pay me market rate and I pay them fixed rate

KEY:
If market goes up, I get paid the market return MINUS fixed rate
IF market goes down, I pay loss on market PLUS fixed rate

Scenario Analysis and stressing models

Suggest that investors may view risk of loss differently from risk of gain..IE being LOSS AVERSE

1. Investors loss averse (prefer uncertain losses to certain losses)
2. Exhibit biased expectations (due to overconfidence in ability to see the future)
3. Construct portfolio via asset segregation (to focus on assets individual investment features vs its impact on the overall portfolio positions

Immunized portf with CF's that are concentrated around the investment horizon have the lowest immunization risk

Answer: Manager X because she has greater breadth.

IR question...for each manager is calculated as IC * SQ of breadth:
X= .03*(SR of 300) = .52
Y = .05*(SR of 100) = .50

Manager X has better performance as measured by the information ratio because she has a greater breadth of decisions.

Uses a countries labor input and capital stock to estimate real economic output

KEY: everything linear. Any change in capital or labor has a linear effect on output.

Advantage:
Diversification
Stable performance

disadvantage:
Price discrepancy
Illiquidity of some bonds in index
Reinvestment assumptions

1. Default risk
2. Credit spread risk
3. Downgrade risk

1. Buy and hold
2. Constant Mix - Re-balance to target weights either periodic basis or when asset class weights move form selected weights or ranges
3. constraint proportion port insurance (CPPI) - As equities increase, the weight of equities in port is increased..IE momentum strategy

OTC have much more credit risk than exchange traded.

Credit risk is part of financial risk, so that would increase too with OTC vs exchange.

Differ from rate swaps in 2 ways:

1. There are two notional principals, one in each currency, with counter-parties exchanging principals on the effective date and return them at maturity date
(IE in plan swaps, no change of payment in the beginning)

2. CF in these swaps are denominated in diff currencies, the periodic interest payments are not usually settled on a net basis, so each makes a payment to the other in the appropriate currency

KEY: Only interest payments subject to exchange rate risk, not principal

1. Many expenses are tax deductible
2. Ability to sue more leverage than most other investments
3. Direct control o the properties
4. Ability to diversify geographically
5. Lower volatility of returns that stocks even after correcting for smoothing

More challenging environments so use H model to value such markets

(D0 (1+gl) / r-gl) + ( (D0)(T/2)(gs-gl) / r-gl)

When foreign bonds are added to portfolios, the duration based analysis results deteriorate

this is due to international rates and US rates not changing inline with each other

1. Numerator and denominator are not based on same item
2. Betas and duration used in hedging calculation are not accurate and change with time
3. The hedge results are measured prior to contract expiration
4. the number of contracts is rounded
5. Future and spot price are not fairly priced based on cash and carry arb model

Value a portfolio anytime cash inflow or outflow happens...
Idea is client decisions with CF should not impact performance

TWRR = Geometric mean

Direct - ownership of residence, commercial RE and agg land. Ownership is direct management of the assets

Indirect - defined middle group that manages the properties

Needs:
Ongoing distribution for living, emergency reserves, one time liquidity events, positive liquidity inflows, illiquid assets should be noted, home ownership can be noted here or UNIQUE
Assets with low cost basis and big tax bills can be listed as less liquid

KEY: Higher liquidity needs reduced risk, lower liquidity needs increase risk ability

answer: B a concern for futures not options

Basis risk is the difference between the forward or futures price and the spot price. the variability of this measure is a source of risk in a futures or forward hedge where the maturity o the derivative is diff from the horizon. Basis risk is not an issue in hedging with options.

Remember: MCDSCM - 6 in total
1. Market selection - appropriate national bond market
2. currency selection
3. Duration management
4. Sector Selection
5. Credit Analysis
6. Markets outside the benchmark

Interest rate risk - bond or interest rate futures contract

Credit risk - credit derivatives options, credit forwards, credit swaps

volatility risk - volatility trading strangles and straddles

Basis risk occurs whenever the item hedged is not a perfect match for the hedging vehicle

Is the denominator of the exchange rat and it is priced in terms of the numerator. buy or sell refer to the base currency.

i.e.: sell spot 1m at .98 CAD/USD means, immediate delivery of 1m USD and buy 980k Canadian dollars

Assumes a normal distribution:

Z-value = number of SD away from mean
99% confidence = z value of -2.33
95% confidence = Z value of -1.645

Example:
Expected return is 10%. SD = 20%. What is the 99% VAR?

-2.33 = (x-10%)/20% = -36.5%

Median manager is bad bench because it meets none of the qualifications outlined in SAMURAI besides being measurable

1. Lack of divisibility meaning a single investment may be a large part of their portfolio
2. High information costs
3. High commissions
4. High operating and maintenance costs plus hands on mgmt requirements
5. Special geographical risks, such as neighborhood deterioration
6. Political risks, such as changing tax codes.

Same idea s my mcdonalds vs steak portfolio
Low priority goals funded with higher risk
high priory goals funded with lower risk
DRAWBACKS: Ignores correlation, looks diversified but not mean variance optimal

Investor requires a before tax return of 8%, risk aversion score of 7, and can invest in A or B which meet his return and risk objectives:
A = 8.5% return 9% SD
B = 8.8% return 10% SD

Investor is better off with A as its risk adjusted return is actually higher:

Ua = 8.5% - .005(7)(9%^2) = 5.67%
Ub = 8.8% - .005(7)(10%^2) = 5.30%

KEY: .5 used when inputs of return and risk are decimals, otherwise use .005

The IR foreach manager can be about:

manager X = .05*(sqrt 400) = 1.00

Manger Y = .07*(sort 150) = .86

Manager X earns more excess returns per unit of active risk

1. Considers allocation of assets with respect to liabilities
2. Generates surplus frontier
3. Similar to MVO

WEAKNESSES:
Same issues as MVO

Forward contract that expires in one year is available on an asset that is currently worth $100 and the RF rate is 4%; so forward price would be 100*1.04 = $104. Now its 9 months later, and asset is worth $101.50. Determine who bears the credit risk in teh forward contract and calculate teh amount of the credit risk?

Always look for the long side perspective. Long side taking delivery of asset at forward price.
G/L = Value of asset on that date subtracting PV of forward price

Long positon is obligated to buy the asset for $104 in 1 years. Teh value to the long is:
$101.50 - ($104 / (1.04)^(3/12)) = -$1.4852

Value is negative, the long position would owe the shrot having the short bear the potential credit risk.

Answer: 4.5%

= 4% +(.05*(1%-3%)+.5*(5%-2%)) = 4.5%

the higher projected inflation overrides the growth concern and the targeted rate is actually higher than the neutral rate.

DDt = DDp + (DD futures) (# of futures contracts)

DDt = target dollar duration of the portfolio
DDp = dollar duration of the portfolio before adding futures
DDfutures = total dollar duration of the added futures contracts

KEY:
A positive DD of futures indicates increasing duration and buying contracts
A negative DD of futures indicates decreasing duration and selling contracts
Not a set and forget strategy..need to adjust..

OAS - Callable if higher volatility, lower bond price

OAS - Putable if higher volatility, higher bond price

Gamma measures the change in the value of delta with a change in value of underlying stock

Gamma has most value when option is AT THE MONEY
Gamma close to zero when way in the money or way out of the money

KEY: Risk of a delta hedge is greatest when gamma is large, so hedgers may take position in 2 options to get delta and gamma equal to zero

Can change over time due to:
1. KEY: changing technology
2. Changing restriction in capital flows and labor mobility
3. changes in trade restrictions
4. Changes in laws
5. Changes in divisions of labor
6. depleting or discovering natural resources

Top 4 method attempt to ID the strategic allocation that achieves the best LT results.

ALM considers the allocation of assets with respect to a given liability or set of liabilities
Looks for the allocation that maximizes the difference between assets and liabilities at each level or risk

ALM efficient frontier can be presented in terms of funding ratio

Still suffers from same est biases as mean variance

I got wrong the fact i took the duration of the port minus the bench and multiplied by the port weight..this is wrong!!

Instead, just need to take everything that is not treasuries (spread dur of 0) and multiply them together..

(.1479*5.8)+ (.4774*5.5)+ (.1235*4.5) + (.2512*4.65) = 5.21

Answer: Semi Active Enhanced Indexing
Lowest for indexing with active in between

not buying all securities in the index but mimic on risk..we use as many risk factors as we can to mimic index.

All actual, fee paying, discretionary portfolios must be included in at least one composite

Non fee paying discretionary portfolios MAY be included in a composite

Non-discretionary portfolios ARE NOT included

Sharpe = (port return - RF) / Port SD
Treynor (same as Sharpe but divided by beta) =
(port return - RF) / Beta
M^2 = RF + Sharpe * Market SD
Jensen = alpha =
Port return - (RF + port beta(market return - RF)

Variance/covariance method relies on the assumption of normality

extension of scenario analysis focused on adverse outcomes.
1. Factor push analysis - push factors to more disadvantageous combination of possibilities
2. Maximum loss optimization - finds worst combo of factors and gives you a loss number
3. Worst-case scenario - worst case analyst thinks is likely to occur

KEY: any bond analysis should focus on total return

price of future * conversion factor = price of cheapest to deliver

Equates to the difference between the generic bond and the real underlying bond IE: adjustment factor

Idea is to buy contract in anticipation of cash that will be received in the next few days

synthetic futures to get money in 10 days that settles contract

index is constructed from a set of rules

1. Scope vs breadth (completeness vs inevitability (Cvs.I) - want to be complete but not include less liquid or difficult to own securities
2. Reconstitution and rebalancing (R&R) - tradeoff increased turnover vs transaction costs...Wilshire 5000 less turnover vs Russell value and growth
3. Objective and Transparent (O&T) - Based on rules publicly disclosed; allow those who copy the index or base holdings off of it to anticipate and plan changes. While desirable, most include some judgement in application.

HF: management fee is 1-2% of assets under management with an incentive fee

PE: 1-2% of the Committed Capital is management fee

NOMINAL = REAL + INFLATION

Client 30% tax bracket with $1m needs $30k after tax each year and needs to grow with 2% inflation.
Step 1: Calculate real, AT return = 30/1,000 = 3%
Step 2: Add inflation for nominal = 3% +2% = 5%
Step 3: Gross up for taxes to calc nominal, pretax return = 5% / (1-.3) = 7.14%
KEY: individuals we do additive, Foundations and Endowments we do compounded = (1.03)(1.02) - 1 = 5.06%

**No single repo rate exists for all repurchase agreements.

1. Can be complex to implement
2. Can generate false confidence

1. Higher real or nominal rates = currency higher
REMEMBER: Higher nominal rates, currency higher IF country inflation rates are the same..
2. Increases happen with lower inflation relative to other countries
3. Countries with decreasing risk premiums

High dispersion of cash flow about the horizon date (ie barbell strategy), reinvestment risk and immunization risk will be high

Face value:
Corporate = $1,000
T-Bills and Eurodollars = $1 million
Treasury Bonds = $100,000
Municipals = $5,000

1. Availability bias - individuals est. future probabilities by how easy they can recall a past event

2. Confirmation bias - notice only info that agrees with your perceptions of beliefs

3. Framing bias - View info differently depending on the way it is presented and received

Spot AUD/EUR 1.2571 / 1.2574
30-Day -1.0 / -0.9
90 Day +11.7 / 12.0

What is 30D and 90 D forward bi offer quote?
(these are basis points quotes, so remember .0001)
30 day 1.2570 - 1.25731
90 day 1.25827 - 1.25860

Synthetic equity or bond positions requiring purchasing contracts and holding cash equivalents earnings RF rate to pay for contracts at expiration

Synthetic CASH holding underlying and shorting contracts to hedge position with the hedged position earns RF rate over the period

PM uses a repo to finance $5 million position. Repo term is one day and repo rate is 4% (nominal, inflation included, annualized rate)

Dollar interest = $5 million * .04 * (1/360) = $555.55

Use 360 as its a money market instrument..interest on overnight repo is $555.55

Translation: PM (borrower) agrees to sell a treasury security to the lender for $5M and simultaneously agrees to repurchase the same security the next day for $5,000,555.55. The PM gets the use of $5m for the day. Lender exposured to credit risk and due to this, repos will be structured with different delivery scenarios based on rate.

Like a bond, future contract will change with rates with price change opposite the direction of rates.

if aggregate economic activity and dividend payouts are stable, use GGM

(D0(1+g) / r-g)

there are 3 primary financial risks:
1. Market Risk
2. Liquidity Risk
3. Default (credit) risk (second largest financial risk)

Everything else is a non-financial risk

Credit VAR based on SD is inherently difficult to apply to one sided credit risk. Credit change for most securities is on the downside with limited upside. This is why we do the following to list credit risk more then VAR:
1. Limiting exposure
2. Marking to market
3. Collateral
4. Payment netting - net the two payments on contracts
5. Closeout Netting

an agreement in which the cap seller agrees to make a payment to the cap buyer when the reference rate exceeds a predetermined level called the cap strike or cap rate.

The cap is a series of interest rate call options
Each individual option is called a caplet

Caps and floors are over the counter contracts, os each agreement can be tailored

1. Inputs based on historical data
2. Complicated

SLR = critical needs / asset base

Low SLR go along with what client wants even though its not optimal; Go with their biases (risk can afford to be eccentric)

High SLR need to force them more towards a balanced portfolio and need to optimize return and risk

Manger A has $25m in 3M treasury bills yielding 1% and wishes to create $20M of synthetic SPX for 3 months. SPX contract is priced at 1,750, the dollar multiplier is 250 and the underlying stock has a divvy yield of 2.5% . Calculate # of contracts to buy or sell? assume both betas are 1.07

**Futures price already includes dividend yield**

((1.07 - 0) / 1.07)) * ((20m * 1.01^ 3/12) / (1750*250))

answer is 45.83 so use 46 contracts..

Break cash flow down into 3 areas:
1. Premium
2. G/L on the stock
3. G/L on the option

1. Interest Rate Risk - main concern with FI portfolios as both assets AND liab. change
2. Contingent claim risk - Call or prepayment risk if rates declie, issuer can call bonds (reinvestment risk(
3. Cap Risk - Floating rate risk with floors..does not adjust till rates hit that floor rate.

Looks at left tail risk

Is max potential loss incurred on a portfolio or company or market over specific period of time at a specific confidence interval

KEY: NO understanding of absolute loss risk because you do not know what is in the tail

considers adverse outcomes, not he most adverse outcome

Asset, liability, mgmt strategy..

Immunizable rate of return = market return (passive)

PV assets > PV of future liability ran at market return, we/I can manage actively

PV assets < PV of future liability, part has to be managed passively and will only return immunized return

KEY: Contingent immunization strategy is a complex time value of money strategy

1. EF is more stable
2. Small changes in inputs produces minor changes
3. Portfolios better diversified then MVO
4. Commercially available software

1. Relative Value Analysis
2. Cyclical Changes
3. Secular Changes
4. Liquidity Analysis

1. Relevance of past data is questionable
2. Popularity bias - they do not need to report their returns, so only really report if returns are good
3. Survivorship Bias - Big problem, indices drop off poor track records, causing upward bias in reported values
4. Stale price bias
5. Backfill or inclusion bias - Filling in missing past data with only manages with good returns focus on getting past data filled, so pushes index returns upward

change in price = 7 * change in yield

assuming that the increase in price caused by spread widening will be .75%, the yield advantage of the french bonds is:

.75 = 7* W

A spread widening of just 10.71bps of a decline in the yields in japan would wipe out the added gain by french bonds. A change in rates of only 10.71bps in this case would wipe out the quarterly yield advantage of 75bsp.

KNOW:
Duration fixed - Duration floating > 0

Duration of floating is settlement period so quarterly, its .25 or .125 or lower...can use Settlement period OR settlement and zero average
(Quaterly reset duration is .25..Just before the payment is due, however the duration is 0. So the AVERAGE duration over this period is half the length of the settlement or .125)

The portfolio that has the lowest reinvestment risk is best job of immunization
KEY: most ideal is zero coupon bond

All stock returns given same weight

Investor has equal dollar investment in each stock in the index

DISADVANTAGE: biased toward small cap due to same weight as large. Required rebalancing requiring higher transactions costs..hard to find liquid in some small issues

1. Multi-functional Duration (key rate duration)
2. Multiple-liability immunization (has enough liquidity to cover all liabilities that come due)
3. Relaxation of the minimum risk requirement (allowing for increased risk)
4. contingent immunization ( mixes active and passive strategies)

KEY: only focus on #2 and #4 ..especially #4

This is the managers security selection

The standard deviation of active return and is the measurement of active risk

Positive for longs in backwardation, opposite for containgo

Normal state of commodities (prior to 2008) was backwardation.

Roll return - spot price assumed remain constant and futures price moves up to the spot...Long wins!!

1. Top level mgmt of the organization setting policies and procedures for managing risk.
2. Defining risk tolerance to various risks in terms of what the organization is willing to bear.
3. Identifying risks faced by the organization (financial and non-financial risks)
4. Measuring the current levels of risk
5. Adjusting the levels of risk

KEY: Risk management process is ONGOING!!

Investors might be slow to react to new info or may avoid the difficulties associated with analyzing new info and simply stay with previous forecasts.

Duration assumes a one-time parallel shift in the yield curve, which causes the yields on all bonds (including treasuries) to increase or decrease the same amount.
Spread duration measures the % change in the total value of the portfolio given a parallel 100bps change in the spread over treasuries

KEY: Duration caused by change in inflation expectations. Spread duration caused by risk aversion or risk premium of all bonds in a given class

Mainly used as a compliment to other approaches

It can generate multiple simulated paths

KEY: Remember that in Security selection allocation (SSA), MCS does not replace mean variance optimization (MVO) and other techniques

Instability of the efficient frontier is the most serious problem. Asset class returns very hard to estimate and small changes in estimates have large shifts in allocation.

Re-sampling approach address this by forcasting a range of outcomes.

Diminishing marginal returns - leads to concaved risk averse utility function (more wealth added, satisfaction increases at a diminishing rate)

ID and quantify the source of returns that are diff form the bench
Macro attribution - down on sponsor level
Micro attribution - investment manager level

An investor has 30k share position in a stock with current market value of $80 per share and divvy yield of 2%. The investor wishes to reduce the position by half for a position in the SPX. Demonstrate how this can be accomplished with a swap?

The owner of the stock would probably approach a dealer and swap the returns on $1.2 million (30k*80) / 2 worth of the stock for the returns on a $1.2m SPX investment. Each settlement period (quarterly) the total return on each position is calculated. The net amount is transferred between the parties.

**Risk factor for bonds is always interest rate risk**

(Change in underlying bond) / (change in price of futures contract over life of hedge) = hedge ratio

or the same thing:
Dollar duration of port / dollar duration of cheapest to deliver = hedge ratio = conversion factor

focus on LT capital flows, such as into equity investments or foreign direct investment.

flow of LT funds complicates relationship between ST rates and currency value as discussed in relative strength approach

1. list the objectives the client wants the portfolio to achieve
2. Quantify the investable asset base and the numeric needs

KEY: Ownership of a personal residence is something that will be notes in the IPS, usually under unique. Not part of investable assets and not included in this number

Minimum-Variance Frontier: The set of all risky portfolios having minimum risk (standard deviation of returns) for a given level of expected return. The horizontal axis is the standard deviation of returns, and the vertical axis is the expected return. The risk-free asset is not included in the portfolios considered for the minimum-variance frontier. The portfolio furthest to the left on the minimum-variance frontier is called the global minimum-variance portfolio, and any portfolio on the minimum-variance frontier is called an optimal portfolio

Going from basic to sophisticated:
Coupon
Current Yield
YTM or IRR (assume yield curve is flat)
YTC (assume yield curve is flat)
YTP (assume yield curve is flat)
YTW (Assume yield curve is flat)
Spot Yield Curve ( treasuries and other zero coupon securities)
Static yield or Z-Spread (option free corp bond)
Option adjusted spread or OAS

1. Passive hedging - goal to eliminate currency risk relative to the bench ENTIRELY..not ideal
2. Discretionary hedging -goal to reduce FX risk while allowing manager to try and capture some modest currency returns
3. Active currency mgmt - Goal to create incremental return (alpha) NOT to reduce risk; GOAL increase returns
4. Currency overlay - Same as active except all currency exposure treated as separate asset class and outsourced to other managers..GOAL increase returns by an outsider

Choose bonds to match the following characters of the index:
1. Key rate distribution and PV distribution of Bfs
2. Sector duration contribution
3. Quality spread duration contribution
4. Sector, coupon and maturity weights
5. Issuer exposure

1. Anchoring - First info received is over weighted
2. Status Quo - Predictions influenced by recent past
3. Confirming Evidence - only info supporting existing belief is considered
4. Overconfidence - Past mistakes ignored
5. Prudence - forecasts conservative to avoid the regret of making extreme error
6. Recallability - What is easiest to remember (often extreme events) is overweight

Due to psychological predispositions, these are harder to overcome then cognitive errors.
There are 6 emotional biases

These stem from feelings or impulses or intuition

Without re-balancing, classical immunization only works for a one time instantaneous change in interest rates

Portfolios cease to be immunized for a single liability when:
Interest rates fluctuate more than once
time passes

KEY: Immunization is not a buy and hold strategy and Must be re-balanced periodically

A favorable investment climate will attract investors which will increase demand for domestic currency and increase its value; also high ST rates will attracted investors.

Bond B purchase yield gain 6.45-5.60 = 85BPS..6M = 85/2= 42.5BPS

We use 42.5BPs in the formula to indicate the price of Bond A will increase. Change in yield on Bond A: (.425/8.15)*100 = -5.21472, implying that the change in yield for bond A is -5.21472bps and the spread must increase by this amount. This will result in cap gains for bond A which will offset bond B yield advantage.

Floating rate only changes between settlement so its a CASH FLOW RISK

Fixed rate change is on bond price, with CF fixed, so its a MARKET VALUE RISK

1. True active return (fund return against a real best fit bench)

2. Misfit active return ( difference between true bench and the other bench that is actually being used)

Total active risk = sqrt((true active risk)^2 + (misfit active risk)^2 )

True information ratio = true active return /true active risk

Duration measures percentage change in value

dollar duration is related and measures dollar change in value

DD = (duration)(0.01)(price)

Manager has a positive alpha because his return was greater than the bench. However, the managers return is lower then normal port so alpha and true IR are negative:

true active return = 14% - 16% = -2%
Misfit active return = 16% - 11% = 5%

the true active risk is backed out of the toal misfit risk:

total active risk = SR of ((true active risk)^2 + (misfit active risk )^2

so

5% = SR truce active risk^ 2 + 3.2%^2

true active risk = 3.84%

True information ratio = -2% / 3.84% = -.52

NAREIT - National Association of Real Estate Investment Trusts
Cap-weighted
Includes all REITs traded on the NYSE or AMEX
Monthly NAREIT index is live (represent current values)

the P&amp;L of forward or futures if spot price unchanged at expiration.
roll yield = initial forward - spot price / initial spot price

1. Price Weighted
2. Market cap weighed
3. Equal Weighted
2b. Free float adj market cap index

SML: The line running from the risk-free asset through the market portfolio and on to infinity. The horizontal axis is the beta of the portfolio, and the vertical axis is the expected return. The slope of the SML is the market risk premium: the expected return of the market portfolio minus the risk-free rate.

1. Trading constraints
2. Story disagreement
3. Buy and hold
4. Seasonality

1. Changes in employment levels; population growth and rate of labor force participation

2. Changes in productivity; spending on new capital inputs, and total factor productivity growth

CDS is protection against default on underlying credit instrument
CDS is negotiated between parties

CDS steps:
PM taking money from issuing junior tranche, put this money in treasuries and issuing insurance to the bank. then paying a rate over treasury (treasury +insurance premium) get paid to junior tranche.

Payoffs:
Bank thinks 5 defaults in the portfolio
PM thinks less - if less, PM and junior tranche get paid, if over 5 defaults, junior tranche gets lower return

Junior always holds initial risk but once tapped out, senior gets hit

cash settled or physical delivery

KEY: portfolio may be switched from one composite to another if documented changes to a port investment mandate, objective, strategy, or redefinition of the composite make switch appropriate.

Answer: C Position Limit

Position limit places a dollar nominal cp on a given position. Idea is if you place a max dollar amount on each position, the firm will diversity its capital across a greater number o sectors.

Liquidity limit is a position limit that is based on trading volume so that liquidity risk is minimized

Risk factor limits restrict the exposure of the portfolio to individual risk factors.

based on 4 broad approaches:
1. Economic fundamentals - PPP will determine LT rates
2. Technical analysis - fallible human react to similar events
3. The carry trade - borrow lower rate FX and invest in higher rate FX
4. Volatility Trading

Has 2 parts: Objectives and Constraints (RRTTLLU)
There are 2 objectives - Return and Risk
There are 5 Constraints - Time, tax, liquidity, legal, unique

CTD - bond that the counter party in the short position can deliver to satisfy the obligation of the futures contract.

Underlying is generic treasury bond. Coupon is 6% or higher OR 15 years to maturity

1. Relevance of past data is questionable
2. Popularity bias - they do not need to report their returns, so only really report if returns are good
3. Survivorship Bias - Big problem, indices drop off poor track records, causing upward bias in reported values
4. Stale price bias
5. Backfill or inclusion bias - Filling in missing past data with only manages with good returns focus on getting past data filled, so pushes index returns upward

two strategies utilized by global port managers to manage the risk of foreign-denominated portfolios involved selling forward contracts or foreign market index and selling forward contract on foreign current.

Can Hedge market risk or hedge currency risk

KEY POINT:
When hedging FX, you have 3 options?
Do all, do none, or do partial hedge

Answer ALWAYS: Partial hedge...

Duration Contribution:

Duration * Weight = Duration contribution

Payer Swaption - Based on Fixed Rate Side
Buy Payer = pay premium to have right but not obligation to exercise it to be fixed rate payer and floating rate receiver
Can be European (maturity) or American (anytime)...Only European in readings
Want rates to go higher
Like a protective put in that it allows the holder to pay a set fixed rate, even if rates have increased

Receiver Swaption - Buy receiver pay premium
Exercise the fixed rate receive, pay floating
Want rates to go lower
Swap ensures receipt of a higher fixed rate while paying a lower floating rate

Anytime seeing cash over 5%, it is a major RED FLAG on IPS questions

CAL: A line (technically, if you’re a geometer, a ray) running from the risk-free asset through a given (risky) asset (a single stock, a portfolio, whatever) and on to infinity. The horizontal axis is the standard deviation of returns, and the vertical axis is the expected return. The slope of the line is the Sharpe ratio of the given asset (LINEAR) (CAL SLOPE IS THE SHARPE RATIO)

If port duration is less than liability duration, the port is exposed to reinvestment risk

If port duration is greater than liability duration, port is exposed to price risk

DO NOT LEAVE THIS BLANK

Special investment concerns, special instructions, assets outside investment portfolio, desired bequests
also large stock position on founding company
Home ownership can be listed here

KEY POINT:
Bond PM should move from pure indexing to more active ONLY when the clients objectives and constraints permit and the mangers abilities justify it

# of contracts = (yield beta) * ((target modified duration - modified duration of port) / modified duration of futures) * (current port value / (Futures price * multiplier))

The user defines the events and compare before and after the change
Consider both favorable and unfavorable scenarios

Cognitive Error

New evidence classified and interpreted based on past classification. Error is too much emphasis on data covering ST period.
Includes: Base rate neglect, sample size neglect, etc.

Oldest and more cited measure of downside risk. Key measure for shortfall risk (risk fo exceeding max acceptable dollar loss):

RSF = (Rp - Rmar) / Op

Rp = portfolio expected return
Rmar = investors min acceptable return
Op = Portfolio SD

KEY: higher = lower probability of not returning minimum acceptable return

Company X pays a fixed rate to bond holder (concerned about rates going down)

Company X may enter into a Receiver Swap: Enter a swap to pay floating and received fixed

Bond PM expects an increase in rates, so duration should be reduced. The port has a dollar duration of $32,000 and he would like to reduce to $20,000. Futures have a dollar duration of $1,100. How can the manager achieve the target duration?

# of contracts = $20k - $32k / $1,100 = -10.91

Manager should short 11 contracts

1.Gov Policy stimulative
2. consumer confidence improving
3. Inflation INITIALLY declining
4. ST rates low or declining
5. LT rates bottoming
6. Stocks do well in anticipation of recovery

1. Economy growing faster then trend
2. Gov policy turning less stimulative
3. consumer confidence increasing
4. Inflation low (because still under trend)
5. ST rates increasing
6. LT rates bottoming or increasing
7. Stock prices increasing

1. GDP above trend, growth slowing
2. Gov policy restrictive
3. Consumer confidence excessive
4. Inflation increasing (growth above trend)
5. ST rates increasing
6. LT rates increasing
7. Stock prices volatile and topping out

1. GDP still above trend bot growth rate below trend
2. Gov policy turning neutral
3. Consumer confidence peaking
4. Inflation still increasing
5. ST rates peaking and then declining
6. LT rates high and then declining; bond returns favorible
7. Stock prices declining in anticipation of recession

2 consecutive quarters of negative real growth
1. Output gap increasing
2. Policy easing
3. Consumer confidence weak
4. Inflation peaking
5. ST and LT rates declining, bonds do well
6. Stock prices generally turn up later in the recession

GDP = C + I + G + Net Exports

1. Consumer spending is largest component; usually tends to stay stable
2. Investment is business capex and inventory accumulation (IE PP&amp;E and inventory) more volatile
3. Gov spending counter cyclical tax receipts
4. Net exports = exports - imports

Policy Neutral Rate + .5(current inflation - target) + .5(GDP growth - GDP LT trend) = target interest rate

Fiscal and Monetary policy expansive:
1. Economy should improve
2. Yield curve sharply upward sloping with higher LT rates

Fiscal and Monetary policy restrictive:
1. Economy shoudl contract
2. Yield curve downward sloping (reduces money in market, increasing ST rates and LT rates are reflecting the contraction policy and economy slowdown)

1. Minimal interference with free markets
2. Support infrastructure and human capital
3. Promote competition, free trade, and capital flows
4. Sound tax policy, lower and predictable
5. Sound fiscal policy; balanced budget over economic cycle
6. Avoid twin deficit problem

Large gov deficit (G>T) are associated with large current account deficits (Driven by imports > exports)
Gov spending financed domestically, drives up rates and crowds out business borrowing and capital spending

Usually reduces future growth

Nominal = Real RF rate + expectations of future level of inflation

real rates do not change much, so if a LT bond holder, main question is what will inflation expectations be in the future

• Coupon payments are based on a real rate applied to principal that adjusts with inflation
• If real rates increase/decrease, the bond prices will decrease/increase
• If the desire for inflation protection increases/decreases, the bond prices will increase/decrease
• With TIPS the price moves higher with inflation, and coupon stays the same on that changing price point…real bonds price always stays the same…they still fluctuate up and down in price

1. Purchasing Power Parity: Higher inflation is associated with currency depreciation
2.Relative Economic Strength: Economic strength is associated with currency appreciation
3.Capital flows: Better investment opportunity is associated with currency appreciation
4.Savings-investment imbalances: May explain why currencies diverge from fair value of extended time periods

GDP real growth = Growth in labor + growth in capital + total factor productivity

ALWAYS REMEMBER: uses 3 inputs: labor, TFP and capital
Labor and capital weights always sum to 1.0 with TFP (total factor productivity) a given constant

Takes Cobb-Douglas and back solve for TFP

Cobb Douglas:
GDP real growth = Growth in labor + growth in capital + TFP

1. Improving Technology
2. Fewer restrictions on capital flows and labor mobility
3. Fewer trade restrictions
4. Discovery of and increase in natural resources

Real growth and discount rates are preferred

Value = (D0 / R-Growth long) ((1+ growth long) + N/2(growth short-growth long))

1. Fed Model - earnings yield vs treasury yield
2. Yardeni Model - Theoretical vs actual earnings yield
3. CAPE - Current PE vs MA PE
4. The Q Models - Market vs replacement value

First 3 income statement driven last balance sheet driven

Fed Model = SPX earnings yield / 10-yearr treausry yield

If earnings yield > treasury yield, stocks undervalued
IF earnings yield < treasury yield, stocks overvalued

Positives
Easy to understand, consistent with DCF analysis

Drawbacks:
No equity risk premium, ignores growth, LT make more money in equities vs treasury, compares a real to nominal (treasury is nominal, stock is real)

E1/P0 = Yb - d*(LTEG)

E1/P0 = fair value of SPX earnings yield
Yb= "A" rated corporate bond yield
LTEG= 5-year consensus est

Actual earnings yield < FV yield, market overvalued
Actual earnings yield > FV yield, market undervalued

Positive:
Improves on Fed model: Incorporates equity risk by using corporate bond yield, and it includes earnings growth

Drawbacks:
True equity risk premiums higher than corporate bond risk premiums, Earnings est can be wrong, assumes discount rate applied to future earnings is constant, d is a fudge factor

Positive:
Removes the effects of the business cycle and inflation

Drawbacks:
Accounting changes can make an adjusted avg of past earnings inappropriate, long periods of high or low PE can persist

Compares current market value to replacement cost of its assets

Tobins Q = market value of debt+ equity / asset replacement cost

Equity Q = Market value of equity / replacement cost of assets - liabilities

Positives:
Supported by economic theory and empirical evidence that in LT< market values should reflect replacement value

Drawbacks:
Estimating replacement is hard
Divergence from 1 can persist for very long time

Many time horizons are multi state

Usually Long Term (over 15 years) with short term stages (under 3 years)
State is a change in circumstance significant to evaluate the IPS

Answer these questions when answering:
1. How many stages?
2. What is time horizon in years for each stage?
3. What is main objective for each stage?

With kids leaving money left over, it’s multi-generational

Answer following questions:
What are needs ongoing for living, emergency, one time events, positive inflows?

Listing debt payoffs, inheritance is recommended and I going distributions can be discussed under returns but also here to be safe

Assets with low cost basis and big tax bill can be said to ha e less liquidity (can list under tax or unique as well)

Step 1: Amount to be adjusted = $4m
Step 2: Remove unwanted positions =
((0-1.2) / 1.05)) * ($4m / 102,100) = sell 45 equity futures contracts at $102,100
Step 3: Buy contracts to get desired expsoure
((4.5-0 / 5.1)*($4m / $98,500) = Buy 36 bond futures contracts at $98,500

Step 1: 20% shift of $200m is $40m
Step 2: Sell bond contract to decrease by $40m
(0-6.75 / 5.25) *(40m / 109,000) = -471.82
KEY AREA: Need to buy bond contracts to INCREASE duration on the $30m to 8.25 (70m – 40m= $30m so increasing duration on what is left in bonds)
(8.25 – 6.75 / 5.25) *(30m / 109,000) = 78.64
Net result: 472 – 79 = 393 bond contracts

Step 3: Buy Stock contracts to increase the allocation by $40m:
(1.15 – 0 / .95) * (40m / 157,500) = 307.44
KEY AREA: Buy more stock contracts to INCREASE beta on the resulting $170m to 1.20
(1.20 – 1.15 / .95) * (170m / 157,500) = 56.81
Net result: Buy 364 (307+57) stock contracts

Word Synthetic means we need to use FV

Remember: Word Synthetic means we need to use FV…In this problem, the $8m is a FV number..
REMEMBER: Trick here..also showing yield beta we have to adjust our calculations for bonds with
Step 1:
$4.8m (8mX.6) equity exposure
$3.2m(8m*.4) bond exposure
Step 2:
Equity contracts = (1.1 -0 / 1.05) (4.8m / 210,550) = 24
Bond contracts = (1.1)(3.6 – 0 / 6) (3.2m / 98,675) = 21

REMEMBER FOR TEST: You want the foreign currency in the denominator. Why? When the number value goes down, its losing and when it goes up its gaining..so simpler to remember this and keep foreign in denominator.

An investment in a foreign market has both foreign market risk and foreign exchange risk
1. Hedge neither risk (earn both the Rfc and Rfx; highlighted below). will earn the local market return AND the local currency return
2. Hedge one risk but not the other
3. Hedge both risk – a special case (earn RF rate)
KEY: Two sources of risk: What happens to the Rfc and what is the change of value in the Rfx (the US dollar for AUD investor in the US), neither of which can be known in advance

• Have an Australian Investor and want to invest in US bond market
o (Best way to work with this is AUD/USD)
• Beginning value in USD – If invested in US bond market, then you will have an ending value in USD (shown as Rfc (return on foreign market))…Need to turn this into an ending value in local currency, AUD (RDC – return domestic currency)