SS-11 Types of credit derivatves

1. Credit Options - provide proetction from adverse price moevmeents related to credit events or spread of RF rate.

KEY: When underlying based on underlyng price, option is known as binary credit option, when base don underlyng spread, option known as credit spread option.

2. Credit forwards

3. Credit swaps

SS-12 Style Identification methods

1. Returns base style analysis - not good at capturing style drift.

BENEFIT - helps determine if the managers reported style and actual style are the same

DISADVANTAGE - only take a snapshot in time

2. Muti Period returns based style analysis - Same as #1 but helps to check the managers style consistency over time

3. Holdings Based Style Analysis

Better for style drift

Returns based analysis useful for easily characterizing an entire port, it will not detect changes in style as quickly as holdings based analysis due to regression used in returns based typically using monthly and yearly returns.

SS-12 Market Cap weighted Index

Most indexes

Sums the total market value (stock price * shares) of all stocks in index

Assumes holds each company in index pre weight in index

IMPORTANT: Method automatically adjusts for stock splits.

DISADVANTAGE: firms with greater market cap have a greater impact on index. Also may be less diversified. Cannot mimic index if subject to max holdings and concentration positions

SS-9 Types of benchmarks

1. Absolue return - specify min return

2. Manager universe or peer group - outperform median manager

3. broad market index - Wilshire 5000

4. Investment style - Outperform Wilshire 5000 LC Value Index

5. Factor Based models

6. Return based - factor based with sensitivities in regression

7. Custom- built to weigh managers style or normal portfolio

SS-9 Currency points to remember

Up the Bid, Down the ask

DAD - Down ask divide

Up bid multiply

SS-8 Importance of asset allocation

performs 2 processes:

1. Strategic

2. Tactical asset allocation

SSA is generally the prime determinate of performance

94% of the variability of total portfolio returns is explained by the strategic asset allocation

SS10- Primary considerations in selecting a bond benchmark

1. Market Value Risk (greater risk aversion, shorter the duration)

2. Income Risk (CF need to be consisten and low risk if needed today. LT bonds lock in income stream, so longer the maturiy of port, the lower the income risk)

3. credit Risk

4. Liability Framework Risk (If definable liabilities, then ALM is the preferred approach)

ALM - Asset Liability Management

SS-13 Distressed Securities Risks

1. Event Risk - returns usually depend on an event for the particular company

2. Market liquidity risk - low liquidity and the fact there can be cyclical supply and demand for these investments

3. J-Factor Risk (MUST KNOW) - role that courts and judges play in the return, a unpredictable human element.

SS10 - Bond Indexes and Liabilities as Benchmarks

If a manager mostly agrees with market forecast and values, they will follow a passive mgmt approach. Construct a port that mimics the index.

KEY: You mimic the index, not invest in all bonds in the index.

SS-8 Utility adjusted return investor realizes in a portfolio (MUST KNOW)

Up = Rp - .005(A)(O^2)

Up = investor utility from investing in portfolio

Rp = Portfolio expected return

A= the investors risk aversion score

O^2= portfolio variance

SS-10 Tacking Risk (tracking error)

The standard deviation of the portfolio's active return, where the active return is defined of each period:

Active return = port return- bench index return

Tracking risk = SD of the active returns

SS-8 Black-Litterman Strengths

1. Theoretically justified to address sensitivity of inputs

2. Generates more stable SSA and better diversification

3. Can be both constrained and unconstrained

4. Allows manager to diverge from starting point

SS-7 the Fed Model

Assumes earnings yield on SPX should be same as yield on LT treasuries.

(SPX E/P) / 10Yr yield

KEY:

E/P < yield = stocks expensive invest in bonds

comparing apples vs oranges and is ridiculous

MUST KNOW:

Ignores equity risk premium

Ignores earnings growth

compares a real variable to a nominal variable (earnings=real, treasuries = nominal)

SS-9 FX effects on portfolio..must remember ask all the time!!

Asset in foreign Currency:

Home currency depreciates; get return + depreciation as your return

Home Currency Appreciates; Get return - appreciation as your return

SS-10 Three spread duration measures used for Fixed-rate bonds?

1. Nominal Spread - spread between nominal yields

2. Zero-Volatility Spread - Spread added to treasury spot rate curve to force equality between the PV of the bonds CF

3. Option Adjusted Spread (OAS) - determine using a binomial interest rate tree

KEY: spread duration may be computed using any of the methods

SS-15 Foreign Cash Receipts (IE Swaps without exchange of principal)

is a series of exchange rate purchases in the future at a fixed exchange rate

Are a function of current exchange rate and interest rates (Swap rates) in the countries involved.

SS-17 Time weighted rate of return problem -

Account with $2.5m at start of month and $2.7m at end. During month, was a CF inflow of $45k on day 7 and $25k on day 19. Value of account was $2.555m and $2.575m on day 7 and 19. Calculated time weighted rate of return (30 day month)

First, calculate 3 sub-period returns using the rate of return calculation when external CF occur at end of period:

period 1 - Day 1-7

((2.555m - 45k) - 2.5M ) / 2.5m) = .004 or 4%

Period 2 - day 8-19

((2.575m - 25k) - 2.555m) / 2.555m) = -.002 or -.2%

Period 3 - day 20-30

((2.7m - 2.575m) / 2.575m) = .049 or 4.9%

Second, compound the returns together to calculate an overall time weighted rate of return:

(1+.004)(1-.002)(1+.049) - 1 = 5.1%

SS-12 Information ratio (MUST KNOW)

A function of his depth of knowledge about individual securities and the number of investment decisions

ex-ante IR (IE future expecting IR)= information coefficient(IC) * Sq. root of investor breadth(IB)

IC= captures skill in picking securities through regressions

IB = scope of INDEPENDENT investment decisions (i.e. how many made)

KEY: for IB, buying 10 energy stocks is 1 data point

IC measures by comparing investors forecast against actual outcomes

SS-15 Receiver swap

Receiver Swap: Enter a swap to pay floating and received fixed

SS-10 Classical Immunization

IE: Passive Strategy

Immunization is the strategy used to minimize interest rate risk

Can be employed to fund either single or multiple liabilities

SS-13 Advantages of real estate investments

1.Low correlation with stocks and bonds

2. low volatility of returns

3. an inflation hedge (EX REITs)

4. May offer tax advantages

5. Possible leveraged returns

SS-16 Components of Execution Costs - Explicit vs implicit costs

Explicit cost = directly observable; Commission, taxes, fees, etc

Implicit Costs = hard to measure

A. Market impact cost - cost of liquidity

B. Timing cost - Cost of getting trade done

(inversely related)

KEY POINT: Urgency to get trade done ASAP, timing goes down, market impact up..this is implementation shortfall

VWAP - no urgency so timing is high, market impact low

SS-9 Vega

Vega measures change in value of option for change in volatility of underlying

REMEMBER: vega is positive for both puts and calls

predicting higher vol, long straddle

predicting lower vol, short straddle

SS-10 Immunization Strategies MUST KNOWS

Are risk-minimizing strategies

Immunization has reinvestment risk offset price risk

Using a passive strategy and use as a benchmark

Setting unadjusted duration to investor time horizon

Only works for 1 time change in rates

must always rebalance

SS-3 Hindsight Bias

Cognitive Error

Selectively remember what was done or known in the past. You overestimate ability and take too much risk

SS-9 Difference between benchmark and index

Bench - Reference point for evaluating portfolio performance

Index - Represents the performance of a specified group of securities

SS-15 Foreign cash receipts example

US firm wants to convert quarterly CF of 6m euros each to dollars upon receipt. Exchange rate is .80 euros/$, and swap rates in US and Europe are 4.8% and 5%. To get swapped dollar CF, we first back out notional principal in euros, translate this to dollar notional, and then calculate the interest in dollars:

NP^(.05/4) = 6m

NP = 6m / (.05/4) = 480,000,000

The corresponding dollar amount is 480m euros / .9 = $600m. The quarterly interest payments on this amount would be $600m(.048/4) = $7.2m quarterly CF.

The swap would then allow the firm to exchange its 6m euros quarterly inflow for $7.2m per period.

SS-16 Linear, concave and convex re-balancing strategies

refers to the relationship between portfolio returns and equity returns

Buy and Hold = Linearly related to equity returns

Constant Mix = concave relationship (ie flattening of curve)

Constraint proportion port insurance (CPPI) = convex relationship..(ie curve is non-linear and increases or decreases as a faster rate)

SS-7 The Taylor Rule (MUST KNOW LOVE THIS)

Taylor Rule determines the target interest rate using the neutral rate, expected GDP to trend, and expected inflation relative to target.

target rate =

neutral ST rate + (.5 (GDP expected growth - GDP LT trends growth+ + .5 (expected inflation - target inflation) )

SS-13 Backwardation and contango

Normal Backwardation - downward sloping term structure = POSITIVE ROLL RETURN

**PICTURE TODAY PRICE AT $40 IN 1 YR AT $60

Contango - positive term structure = NEGATIVE ROLL RETURN

**PICTURE TODAY PRICE AT $90, IN 1 YR AT $60

SS-8 Mean Variance Optimization (MVO) Weaknesses

1. The number of estimates is overwhelming

2. Estimated returns subject to estimation bias

3. Static approach

4. Can yield concentrated portfolios unless constrained

5. Output super sensitive to inputs

SS-10 Spread Duration

Measures the sensitivity of non-Treasury issues to a change in their spread above treasuries of the same maturity

(REMEMBER: treasury spread duration = 0)

SS-13 Commodities Investments

Direct - buying the physical commodity like oil, metals, agricultural products, OR PURCHASE OF DERIVATIVES

Indirect - Investment in commodity companies.

both futures and publicly traded companies are fairly liquid, especially vs other alt choices

KEY: problem with indirect, is the company going concern is at risk with price volatility. As a result, the company usually offsets risk with hedges so you re buying a hedged investment

SS14- Once risks to firm are ID'ed

Must determine the correct models to QUANTIFY the risk and evaluate possible ways to ADJUST the risk

SS-4 Benefits of Monte Carlo in retirement planning

1. Path Dependency (future returns based off previous returns)

2. Clearly display tradeoffs between risk and return

3. Tax analysis and burden easy to see

4. Clear to understand both ST and LT risk

5. Superior to anything in assessing multi-period effects

Disadvantage:

1. simplistic using only historical data

2. only simulates asset classes not actual assets held

3. tax model generic and not tailored to investor

ss-16 Cobb-Douglas Production Function (MUST KNOW)

relationship with two or more inputs like capital and labor and amount of output that is produced by them

KEY: any change in capital or labor has a LINEAR effect on output

SS-9 Carry Trade

Remember:

1. unhedged trade

2. violation of uncovered interest rate parity

3. only works in normal market conditions..killed with volatility

KEY: Borrow low rate and invest in higher rate currency

SS-4 Unique

1. don't leave it blank

2. Large amount of stock in a company founded by the client or relatives is listed under unique

3. Also: investor-imposed limits on asset classes or even a total dis-allowance of some investment class

4. Home ownership is covered here

SS-10 Secondary Bond Trades and rational for it

1. Yield/spread pick up trades

2. Credit upside trades (usually only in HY land)

3. Credit defense trades

4. New issue swaps

5. Sector rotation trades

6. Yield curve adjustment trades (OAS is preferred way to measure spread)

6A. Mean reversion analysis

6B. Quality spread analysis

6C. Percentage yield spread analysis (do not worry about this)

7. Structure trades (bond better for your volatility and yield curve shape forecast)

8. Cash flow reinvestment trades

SS-15 Delta Hedging problems

1. Delta is only an approximation of the relative price changes of the stock and call and less accurate for larger changes in stock price

2. Delta changes as market conditions change

3. Delta changes over time without any other changes.

SS-7 Fixed Income Risk Premium Approach

Alt to estimating return with YTM, is this build up model

Start with lower risk yield and then add compensation for risks

RF Rate + Inflation risk premium + Default risk premium + illiquidity risk premium + maturity risk premium + tax premium

SS-17 Money weighted rate of return (MWRR)

An internal rate of return (IRR) on all funds invested during period.

Not good to judge PM performance

KEY: only time to use is when PM has discretion on money in and out

SS-10 Classical Single Period Immunization

IE: Duration matching Strategy

KEY POINT: Set duration to investor time horizon

Use effective duration and set this equal to the liability horizon

SS-15 Payer Swap

Payer Swap: Enter a swap to pay fixed and receive floating

SS-13 Why are commodities a good hedge against inflation?

Two factors affect whether a commodity is good hedge against inflation:

1. Storability (main determinant if its value will be a hedge against unexpected inflation)

2. Demand relative to economic activity

SS10- Spread Duration for Treasuries?

Treasuries spread duration is zero because everything is related and relative to treasuries.

SS10- Primary Risk factors in Different PM approaches for bonds

1. Duration (eff Duration) - (KEY: Min yield curve risk) -rate risk measured by SMALL PARALLEL CHANGES IN YIELD CURVE.

Rate risk is movement of general level of rates

Yield Curve risk is non-parallel changes in rates

2. Key Rate Duration - (KEY: Min yield curve risk) - PV of distribution CF are matched, duration and distributions are matched

3. Sector and Quality Percent - (KEY: min tracking error risk)

4. Quality spread duration contribution - (KEY: Min spread and tracking error risk) - measures how the price of one bond will change relative to the price of another bond if the spread changes

5. Sector Duration Contributions

6. Sector/coupon/maturity cell weights - one way to match convexity is to match the sector, coupon and maturity weights in the port to the bench

7. Issuer Exposure

SS-10 Bond characteristics to consider for immunization

No Default

No call or put option

Must be liquid

SS-10 Multiple-Liability Immunization

Need the following 3 conditions:

1. Assets and liabilities have the same PV

2. Asset and liabilities have the same aggregate duration

3. Duration of individual assets in the port exceeds the distribution of liabilities (enables CF generated from assets to meet each cash outflow need

KEY: Satisfying these 3 conditions will assure immunization ONLY against parallel rate shifts

SS-10 Dollar duration problem:

5 yr treasury ($10m), priced at 100.40625 and duration of 4.53. Also have a 10yr treasury at price of 109.09375 and duration of 8.22.

Manager wants to sell all the 5-yr and invest in the 10-yr while maintaining the dollar duration of the portfolio. How do you do this and now much of par value of 10 yr bond is to be purchased?

Sale price of $10m is 10m * 1.0040625 = $10,040,625

Dollar duration of the 5 yr is 4.53 * 10,040,625 * .01 = $454,840.31

Now divide $454,840.31 by the product of the duration of the 10yr and its quoted price and .01 to get par value of 10yr.

$454,840.31 / (8.22*1.0909375*.01) = $5,072,094

SS-13 Advantages / Disadvantages of Alternatives Group

1. Low liquidity - disadvantage

2. Diversification - advantage..low correlation to stock and bond portfolios

3. Due Diligence Costs - this market lacks transparency, making info difficult to obtain .Disadvantage

4. Difficult performance evaluation - disadvantage. hard benchmarks and no transparency

SS-17 Fixed Income attribution - actions the manger can control

1. Interest rate effect - changing port duration and convexity (passive)

2. Sector quality effect - (active)

3. Security selection

4. Trading effect - plug figure

SS-15 Adjusting portfolio beta with futures (MUST KNOW FORMULA)

need to know the beta of the equity portfolio t be hedged or leverage, as well as the beta of the futures contract.

# of futures =

((beta target - beta current) / (Beta future contract)) *(current port value / (futures price*multiplier)

KEY: like dollar duration formula for FI

SS-14 Evaluating Credit Risk

Credit risk is complicated to measure

risk includes:

1. Probability of default event

2. Amount of value lost if defaulted

Current credit risk - jump to default risk - amount of a payment currently due. KEY: is zero most days except day payment is due.

Potential credit risk - associated with payments due in the future and exists even if there is no current credit risk. will change over time.

KEY: Credit risk is one sided - the party with positive market value is at risk if the counter party does not perform. Counter party with negative market value has no potential credit risk.

SS-9 FX forward contracts - FX swaps

KEY: FX swap - rolling forward contracts over...NOT A SWAP....NOT A FX CURRENCY

Forward contracts PREFERRED for FX hedging because:

1. can be customized vs futures

2. available for almost any currency pair, unlike futures

3. Future contracts require margin

4. FX forwards dwarf futures, providing better liquidity

SS-10 Dollar duration example

Port dollar duration has changed from $111,945 to $82,579 with 3 bonds market value 1,023704, 1,004,770 and 1,002,458...

To calculate the rebalancing ratio, we divide the original by the new dollar duration:

111,945 / 82,579 = 1.356

Rebalancing requires each position to be increased by 35.6%. The cash required for this rebalancing is calculated as:

cash required = .356 * (1,023,704 + 1,004,770 + 1,002,458) = $1,079,012

SS-4 IPS two objectives and constraints

Objectives: Starts with return, then risk.

Constraints:

Time Horizon

Taxes

Liquidity

Legal

Unique

KEY: Remember RRTTLLU (return, risk, time, taxes, liquidity, legal, unique)

SS-8 CML Capital Market Line

CML: The CAL with the largest Sharpe ratio. This line is tangent to the efficient frontier, and the tangency point is called the market portfolio. Thus, the slope of the CML is the Sharpe ratio of the market portfolio. The horizontal axis is the standard deviation of returns, and the vertical axis is the expected return

SS-7 There are 3 relative value models

These use assets and markets to ID investment opportunities

1. The Fed Model

2. The Yardeni Model

3. 10Yr MA price/ earnings model

These models used to assess the relative attractiveness of stocks vs bonds

SS-13 Indirect Real Estate investments

1. Companies that develop and manage RE

2. REIT's - publicly traded

3. Commingled RE fund (CREFs) - professionally managed privately help and more flexible then REITs

4. SMA accounts for wealthy investors (similar to CREFs)

5. Infrastructure funds - NEW..purchase of public infrastructure assets like toll roads

SS-10 Maturity Variance - M^2

Variance of the difference in maturities of the bonds used in the immunization strategy and maturity date of the liability

KEY: Want as close to zero as possible. Academic says use zero coupon to liability date, which would make M^2=0, but in reality this is hard to impliment

SS-11 Backwardation and contango

Backwardation = forward lower then the spot

contango = forward higher then the spot

SS-9 Roll Yield part 2 MUST KNOW AND REMEMBER

KEY:

forward - spot = positive = contango = roll yield positive for SELLER = short will do hedge as it reduces cost of hedging

forward - spot = negative = backwardation = roll yield positive for buying = hedger will not hedge as roll yield increases cost of hedge

do not make decisions on roll yield as its just one small component

SS-13 - Components of return for a commodity futures contract

Spot return - how much commodity price changes from beg. to end

collateral return- Periodic Risk Free Rate of Return

roll return - Chg in futures contract price for the time period minus change in spot price

total return = spot return + collateral return + roll return

SS-12 L/S vs long only risks

LO exposed to both systematic and unsystematic risk

L/S can eliminate expected systematic risk by using pair trade.

systematic risk can be added through the use of equity futures or ETF's

Short extension strategy = a 120/20 strategy

SS-4 How to answer Tax considerations on the Exam

Just state the relevant tax situation and rates as given in question

Any details with taxes done in RETURN objective section

GOAL is always to maximize after tax return

SS-14 Senior mgmt in charge of system. Must determine if they want decentralized or centralized

Decentralized - Delegate down from the top and places responsibility for execution within each unit of the organization

Centralized- execution is one central unit of the organization. all done with top management

SS10- Nominal Spread and Z-Spread

Nominal Spread

Only looking at one point on the curve

Spread difference between corporate and treasury

Z-Spread

Solve by trial and error

Compensate on credit risk and liquidity risk

SS-9 Describe investment uses of benchmarks (MUST KNOW...WILL BE TESTED IN ESSAY)

1. A reference point for evaluation

2. Communication - tells manager what return and risk they will be compared to

3. Communication to others on how a manger wishes to be viewed

4. Clearly specifying risk exposures

5. Performance attribution

6. Manager selection

7. GIPS requires it

8. Compliance, laws, regulation

SS-8 Efficient Frontier

Efficient Frontier: The portion of the minimum variance frontier that lies above (and to the right of) the global minimum-variance portfolio: the upper half of the minimum-variance frontier. This is the set of all risky portfolios having maximum return for a given level of risk (standard deviation of returns). The horizontal axis is standard deviation of returns, and the vertical axis is expected return. Any portfolio on the efficient frontier is called an efficient portfolio. All efficient portfolios are optimal, but not all optimal portfolios are efficient. (CURVE LINEAR)

SS-12 Free Float Adjusted Market Cap Index

Market cap weighed index can overstate the free float (includes shares in float, mgmt insiders, etc but these really are not free floating)

Considered the best index by many investors due to more representative and can be followed with minimal tracking risk

most indexes are float adjusted

ss-15 Butterfly spread with calls

Dealing with 4 options...not tested often

Buy one call with low exercise price

Buy another call with a high exercise price

Write 2 calls with an exercise price in between

KEY: expect stock price to stay close to written call area..strategy limits losses..Short makes money on big moves..

SS-14 Examples of non-financial risk

1. Operational or operations risk - loss due to failure of systems.

2. Settlement risk - Herstatt risk bank received swap payments and then defaulted without making payments

3. Model Risk - garbage in garbage out

4. Sovereign Risks - a form of credit risk BUT has other elements as well (ie willingness of gov to repay)

5. Regulatory Risks

6. Tax, accounting and legal risks

7. ESG Risk (environmental, social, governance)

8. Performance netting risk

9. Settlement netting risk

SS-12 L/S vs long only risks

LO exposed to both systematic and unsystematic risk

L/S can eliminate expected systematic risk by using pair trade.

systematic risk can be added through the use of equity futures or ETF's

SS-15 Determine notional principal value needed on an interest rate swap to achieve a desired level of duration in a FI portfolio....(MUST KNOW FORMULA)

MUST KNOW:

Notional Principal of the swap = (portfolio value) ((Desired modified duration - modified duration of portfolio) / (modified duration of swap))

To reduce duration, be a floating rate receiver

SS-4 Example of writing restraints:

Couple needs 200k per year growing with inflation and holds a concentrated position in 1 million shares of restricted stock

Liquidity constraint (LC) - 1 million shares of stock (can list under legal or unique as well, not important were you put as long as you state it)

Return Objective (RO) - na

Asset Base (AB) - na

Strategic asset allocation (SAA) na

SS-15 Swaps

They are not a zero sum game. Both sides of a swap can benefit from the arangement

SS-10 Scenario analysis for fixed income

Provides the tools for the manager to do a better job in quantifying the impact of a change in the horizon yield assumption on the expected total return of the bond

SS- 8 Six approaches to asset allocation

1. Mean Variance

2. Re-sampled efficient frontier

3. Black Litterman

4. Monte Carlo simulation

5. ALM

6. Experience based

SS-16 Quote Driven Markets - Dealer markets

Offer liquidity. Traders transact with dealers

dealer holds inventory and posts bid-ask

Dealer provides liquidity and earn profit on spread

IE HY bond market..

SS-9 Currency Macro Hedge (ALWAYS ON ESSAY QUESTION)

Cross hedge that addresses portfolio wide risk factors rather than risk of individual portfolio assets..

some managers may use currency basket which may not mach exposures exactly but is less costly

must always weigh risk of higher/lower cost and residual currency risk

SS-15 Interest Rate Options

Formula:

Payoff = (Notional principal) (MAX(0, LIBOR - strike rate)) (D/360)

Example:

Notional principal $20m. Option expires in 49 days and strike rate is 6% with d=90 days. IF option maturity in 49 days LIBOR is 6.2%, the payoff is:

(20m)(.002) (90/360) = $10,000

SS-17 Fixed income attribution

Usually duration and interest rates are the dominant factor in returns.

Changes in external rate environments are beyond managers control and he should not penalized for this

SS-3 Status-Quo Bias

Emotional Bias

What exists is comfortable, so do nothing. Often associated with endowment bias and regret-aversion. No initial rational analysis on how you got there.

SS-8 Black-Litterman (MUST KNOW ask the most)

Same as REF and mean variance but instead takes into account the managers viewpoints, if diff then market

Used to construct expectations of returns by asset class and then constructs an MVO portfolio ADJUSTED for the managers views of those returns

SS-14 Credit risk with Swaps

A series of forward contracts. Will have credit risk on each payment exchange date as well as potential credit risk throughout its life.

KEY: As swap nears its maturity and the number of remaining settlement payments decreases, the credit risk also decreases

The exception is CURRENCY SWAPS. due to exchange of principal at inception and return of principal at maturity, credit risk of currency swap is highest between the middle and final maturity of the agreement

SS-15 Transaction Exposure Risk for FX

A CF in FX will be received or paid at a future date

If received, sell a forward (you are long currency position)

If paid, buy a forward (you are short currency position)

ex: If receiving a pound in 60 days, you are long the pound. Worried it may weaken in that time vs the dollar, you sell forward on FX currency

SS-15Q A firm purchases a special 1-yr cap with payoffs at 6 and 12 months after initiation, a stake rate of 4%, a notional principal of $3m, and semiannual settlement. The reference rate at the initiation of the cap is 5% falls to 4.5% at the next settlement and then to 4% one year after the cap initiation. The total payoffs (without discounting) over the maturity of the cap would be:

a. $22.792

b. $7,583

c. $25,500

did not know how to answer this..

Answer: A $22,792

Since the number of days is not given for each period, approximate it with 192 in the first period and 193 in the second period. Remember that payments are made in arrears.

First payoff - $15,167 = $3m*max(0,.05-.04) * (182/360)

Second payoff: $7,625 = $3m * max(0,.045-.04) * (183/360)

Total = $22,792 = $7,625 + $15,167

SS-3 Traditional vs. behavioral finance

Traditional: Based on neoclassical economics; focuses on what people SHOULD do; no way to adjust for risk aversion or risk seeking (assumes all are risk adverse)

Behavioral: Based on psychology, focuses on what people ACTUALLY do, focuses on inefficiencies in the market,

BL: TF is perfect solution, BF is practical solution

SS-8 Mean-Variance Optimization (MVO) Approach

Strategic asset allocation is a static approach

Efficient frontier the portion of the mean variance frontier that contains portfolios with highest return at each level of risk

Constructed on constrained and unconstrained basis

Unconstrained allows short selling

constrained does not

SS-11 Hedges to currency risk in an international bond investment

1. forward hedge - using forward contracts to eliminate most of currency risk

2. Proxy hedge - enter a forward contact. used when forward contract on teh first FX currenty are not activley traded

3. Cross hedge - changes risk exposure instead of eliminating it..ie: take pound risk instead of euro risk

SS-17 Performance Evaluation componentets

1. Performance Measurement - calculate rate of return

2. Performance Attribution - why outperform or under perform and source and where it came from

3. Performance appraisal - Draw some conclusions; luck or skill

SS-7 Grinold and Kroner (A MUST MUST KNOW)

Takes the DCF one step further and includes adjustments for stock repurchases and changes in market valuation (ie PE)

So, expected return of stock is:

dividend yield + inflation rate + real earnings growth - change in stock outstanding shares + changes in PE ratio

SS-4 Stage of Life

Inverse relationship exists between age and risk tolerance; Not a feeling but rational thinking

1. Young investors (Foundation phase) - High ABILITY to take risk

2. Mid-Career Investors (accumulation phase) still LT viewpoint, ABILITY to take risk remains high

3. Retirement (maintenance and then distribution phases) declining time horizons and reduction in ABILITY to take risk

SS-15 Example of duration of rate swaps

Entering into a swap as a fixed rate payer

Receiving floating (duration close to 0) duration fixed is greater so you are REDUCING duration of your portfolio.

OR Floating rate payor receives fixed CF, taking the receiver-fixed/pay floating position in a swap increases the dollar duration of the fixed income portfolio.

SS-15 Butterfly spread with puts

The long butterfly spread with puts will have its highest terminal value if the stock finishes at the exercise price for the written puts

SS-16 Advantages of VWAP

1. Easily understood

2. computationally simple

3. Can apply quickly

4. Most appropriate for comparing small trades

SS-14 VAR need to know how to convert one period SD to another

SD: Monthly = SD annual / square root of 12

SD weekly = SD annual / square root of 52

SD Daily = SD annual / square root of 250**

SD daily = SD monthly / square root of 22**

SS-4 How to answer Risk Objectives

Addressing ability, willingness, then conclusion. Label the steps.

Ability decreases by: shorter time horizon, larger critical goals, high liquidity needs, goals that cannot be deferred, port main source of support

willingness - look at statements client makes, actions or lifestyle

CONCLUSION: Go with more CONSERVATIVE of the two, with any conflict between them pointed out

SS-14 Stylized Scenarios

Rather then manager select risk factors, some stylized scenarios are more like industry standards

SS-7Q Cobb Douglas...Have the following data:

% growth in total factor productivity = 1.0

% growth in capital stock = 1.0

% growth in labor input = 1.5

output elasticity of capital = .7

output elasticity of labor (1-alpha) = .3

If the next expected divvy is 150 and the required equity return is 8%, the intrinsic price level of the equity index is closest to?

Using the Cobb Douglas production function and the data provided, the LT sustainable growth rate in GDP is:

1.0 + .7(1.0) + .3(1.5) = 2.15%

Using the constant growth divvy discount model and the growth rate above over 2.15%, the intrinsic value is:

150 / (.08 - .0215) = 2,564.10

SS-11 Drawbacks of using Standard Deviation for FI

1. SD assumes normal distribution which is not true for bonds

2. Number of inputs increases significantly with larger portfolios

3. Obtaining estimates for each of these inputs ins problematic

SS-4 IPS treatment of inflation and taxes

Client in 30% tax bracket with $1m needs $30k after tax at end of year with this amount growing at 2% inflation.

1. First calculate the real, AT return: 30/1m = 3%

2. Add inflation for the nominal 3%+2% = 5%

Last gross up for taxes 5% / (1-.3) = 7.14%

SS-17 Macro Performance Attribution (MUST KNOW)

three main input:

1. Policy allocation - form IPS, risk, LT expectations, etc

2. Benchmark Portfolio returns - Fund sponsor may use broad market indices

3. Fund returns, valuations, and external CF - calculated at the individual manager level, giving fund sponsor to make decisions on manager selection

SS-11 Limitations of Duration as risk mgmt tool

Limitations as a risk measure include the fact that it is not accurate for LARGE YIELD CHANGES and for bonds with negative convexity

SS-3 Anchoring and Adjustment Bias

Cognitive Error

Subsequent adjustments for new information are anchored to initial point. Usually makes adjustments insufficient

SS-15Q A PM with market value of $78m and beta of .95 thinks market to go up, and wants to increase the beta by 40%, using SPX futures trading at 856. Multiplier is 250. What is the number of contracts that is needed to achieve this?

139

Determine the target beta by multiplying current beta by 1.4, to get a new beta of 1.33

Then use:

((Beta T - Beta p) / Beta f )(V p / ( P f * multiplier))

(1.33-.95 / 1)(78m) / (856*250) = 138.5 or 139 contracts

SS-4 Example of writing restraints:

A retired couple needs 200,000 per year growing with inflation to live on..

then ,

Same couple wishes to hold 6 months of living expenses as emergency reserve:

Return objective (RO) - Earn 200,000

Liquidity constraint (LC) - State a need to meet ongoing distributions

Asset Base (AB) - NA do not know

Strategic asset allocation (SAA) - NA do not know

Then,

LC: Hold 200k / 2 a cash reserve

SAA: hold 100k as a cash reserve

RO: na

AB: na

**cash reserve always listed under liquidity constraints, does not affect asset base or return objective

SS-14 Credit risk in a forward contract

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 the forward contract and calculate the 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 position is obligated to buy the asset for $104 in 1 years. The value to the long is:

$101.50 - ($104 / (1.04)^(3/12)) = -$1.4852

Value is negative, the long position would owe the short having the short bear the potential credit risk. Since it settles in 3 months, there is no current credit risk.

SS-15 Interest Rate Floors (more on personal notes)

Opposite of a cap

The buyer receives the interest rte difference if rates are below the strike rate

Each payoff is called a floor let

Natural user of a floor is the receiver on a floating rate loan

SS-16 Effective Spread

Actual transaction price vs midquote

effective spread for a buy order = 2*(execution price - midquote)

Effective spread for a sell order = 2*(midquote - execution price)

KEY: average effective spread is insight into liquidity

SS-10 Interest rate Risk broken down into 2 key risks

Reinvestment Risk - risk of reinvesting income as rates move

Price Risk - market value risk (bond price movement)

KEY POINT: Price risk and reinvestment rate risk cause opposite effects

SS-15 Three types of FX risk

1. Transaction exposure

2. Economic Exposure

3. Translation exposure

**only really know #1..#2 not a real issue and #3 did in level 2 not real CF

SS-9 currency example forwards: IF manager sells 1m AUD forward 90 days, calculate what the manager will deliver and receive.

Spot AUD/EUR 1.2571 / 1.2574

30 Day -1.0 / -0.9

90 Day +11.7 / +12.0

Exchange will be 90 days from trade date. The manager will deliver 1m AUD.

90D forward quote are 1.2571 + .00117 by 1.2574+.00120.

The manager is delivering AUD and receiving EUR. Manager must deliver more AUD or receive fewer EUR.

The manager must deliver at AUD/EUR 1.25860.

The manager will receive EUR: AUD 1m / (1.25860 AUD/EUR) = 794,533.61 EUR

SS-10 How often rebalance immunized portfolio

Immunization assumes a one time instantaneous change in market yield

Answer is balancing the costs and benefits of rebalancing

SS-11 Leverage effect on duration and returns

Leverage effects BOTH duration and Returns

Leverage is beneficial when the strategy earns a return greater than the cost of borrowing

KEY:

As leverage increases, the variability of returns increases

As the investment return increases, the variability of returns increases

Leverage increases duration if borrowed funds have less duration then invested funds

Remember to use A = L+E to solve these problems..A-invested funds, L=borrowed funds

SS-17 TWRR vs MWRR rate of return calculations

Neville accoutn is valued at $400k at beginning of month. Day 8, it is valued at $1.3m after receiving $900k on that day. At end of month, the account is valued at $2,695,398. What are the TWRR return and MWRR return over this time?

TWRR:

day 1-8: ((1.3m-900k) - 400k) / 400k) = 0%

day 9-30: ((2695398 - 1300000) / 1.3m) = 107.34%

so, (1+0)(1+1.0734) -1 = 2.0734 - 1 = 1.0734 or 107.34%

MWRR:

(trial and error to get to number)

2695398 = 400k(1+R)^30 + 900k(1+R)^22, trial and error gets us R=3 so,

1.030^30 - 1 = 142.7%

Client added fund right before second subperiod so more fund were in accoutn during high returns. MWRR weights returns by amount of funds invested, mroe funds in the high return period produce a higher MWRR then TWRR. TWRR uneffected by external CF's

SS-3 Endowment Bias

Emotional Bias

Ownership increases an asset perceived value. I cannot sell because I inherited it 20 years ago or my dad was part of that company so cannot sell..

SS-11 Foreign country rates

Rates on exam always nominal annualized

Real rates should be the same across all developed markets. So difference in nominal is inflation across countries.

Higher inflation = depreciation currency

Lower inflation = appreciating currency

example:

Japan lower inflation = currency appreciating against dollar

SS-8 Determining to add an investment to the portfolio (MUST KNOW ASK EACH YEAR)

In mean variance analysis, you can take the new investments Sharpe ratio, the portfolio Sharpe ratio, and the correlation of the returns of the two to see if it should be included

KEY: if Sharpe of new investment is greater than current port Sharpe * correlation of returns, adding the investment to port. will improve the entire port Sharpe

Sharpe investment > (Sharpe port * correlation), add investment.

SS-9 Liability-based bench vs asset based bench

Asset based bench - focus on return of the asset and the ability of managers to beat this bench

Liability based bench (used by pension plans) - objective of fund is to stream of liability payments at low risk. Matching duration of assets to duration of liabilities

SS-9 Roll Yield example

Sells CHF 1m (6 month forward for USD 1.05 when spot rate is 1.04). Forward price is at a premium so the roll yield on a short is positive. Investor sells at a higher price and price rolls down for a gain. Investor can deliver CHF 1m for 1.05 USD when its initial cost is 1.04, for a gain of USD 10,000. Unannualized roll yield is .01/1.04 = .96%

SS-11 Interest Rate Futures impact on Dollar Duration

To INCREASE dollar duration, BUY futures contract

To DECREASE dollar duration, SELL futures contract

SS-12 Information Ratio (MUST KNOW)

Combines active return and tracking risk into one measure

Passive management = low expected active return and low tracking risk

Active management = high expected active return with high tracking risk

SS-3 Regret Aversion Bias

Emotional Bias

Do nothing out of excess fear that actions could be wrong. Follow consensus so its not my fault if it goes wrong. consequence is being too conservative or too risky.

SS-11 Repurchase Agreements - REPOS

To increase leverage of ports, PM's sometimes borrow funds on ST basis uses REPOs

Take form dealer perspective:

Dealer selling securities, borrowing fund then buys it back at later date

Borrower - Borrower of funds, seller of securities

REPO is basically a collateralized loan

Usually overnight to max of 30 days

SS-4 IPS Time Horizon

State the number of stages in the time horizon, main objective of each stage, and the number of years in each stage

Look for stages defined by people other than the client

A focus on leaving assets to kids, the horizon is "multi-generational"

Most of the time, the time horizon is long term

SS-9 MUST KNOW...Distinguish between benchmarks and market indexes

Remember: SAMURAI

Remember: the more qualities a bench has, the better the benchmark

1. Specified in advance

2. Appropriate

3. Measurable

4. Unambiguous - known ID of securities and weights

5. Reflective of managers current investment options

6. Accountable - diff in bench and port is active mgmt

7. Investable

SS-10 Duration management with Futures problem...Portfolio has $50m with duration of 9.52. They want duration of 7.5 and will use futures priced at 100 with duration of 8.47 (conversion factor is 1.1).

1. Would the pension need to buy or sell contracts?

2. How many contracts would be needed to change the duration to what they want?

1. It would be selling futures contracts

2. (((7.5 - 9.52) * 50m) / (8.47*100k)) * 1.1 = -131.17

would sell 131 futures contracts to get desired duration.

SS-8 Efficient Frontier Example (MUST KNOW A LOT OF PROBLEMS LIKE THIS)

assume 4 asset classes combined into a portfolio A (1=.25, 2=.15, 3=.20, 4=.40) and portfolio B (1=.30, 2=.20, 3=.35, 4=.15)

Port A expected return of 10% and port B expected return of 15%.

Calculate the asset class weightings for the efficient port with expected return of 11%.?

We solve for w in the following:

Rp = WaRa + WbRb, letting Wb=(1-Wa)

so,

.11 = Wa(.10) + (1-Wa)(.15)

Wa = .80, so Wb = .20

So weights of asset classes are as follows:

1 = (.8*.25)+(.2*.30) = .26

2 = .16

3= .23

4=.35

SS-15 Delta Hedging

Assumptions:

short period of time

maintain value of portfolio over ST period and receive RF rate in that time

Combines the option position with a position in the underlying asset to form a portfolio, whose value does not change int action to changes in price of underlying over ST period of time

SS-8 Monte Carlo Simulation Strengths

1. Statistical tool to further analyze SSA output

2. Models path dependency issues

3. Generates statistical probabilities

4. Used to compliment other approaches

SS-9 Cross Hedging Currency

Refers to hedging with an instrument that is not perfectly correlated with exposure being hedged (INDIRECT HEDGES)...usually not necessary due to forward contracts

When using indirect hedging, correlation between correlation may not be 1.00 and the minimum variance hedge ratio may not be one for one. (MVHR min value of the tracking error between these two variables)

SS-3 Social Proof Bias and Group Think

When individuals tend to follow the beliefs of a group.

Group think is when the group setting is very amiable thus leading to little or no conflicting discussions resulting in the group making decisions as if the group was a single individual

SS-12 Core-Satellite Approach

Core holding of a passive index and/or an enhanced index that is complemented by a satellite of active manager holdings

Core address basic needs

Satellite is active returns

Consistent with constraints and objective of client

manager targets an active risk and return and then uses optimization to find the best mix of equity mangers to deliver that performance

SS-3 Overconfidence Bias

Emotional Bias

Classic issue with analyst. Unrealistic high opinion of intuitive reasoning/cognitive ability. Usually comes with underestimating risk, overestimating returns, failing to diversify, excessive trading and subpar results

SS-15 Why do a covered Call?

Believe not much return in the stock...Enhance your income in the portfolio..expect stability to enhance income

SS-12 R^2 left over

one minus this amount indicates the amount unexplained by style and due to the managers security selection

SS-13 - Distressed securities returns

High average return but large negative skew

HFR Distressed Index outperformed both stocks and bonds, both on absolute and risk adjusted basis.

Returns are often event drive, so are uncorrelated with overall stock market

SS-3 Illusion of Control Bias (a big one)

Cognitive Error

Individuals incorrectly think they can influence results

IE: junior employee at firm owning firms stock...can trade too frequently and under diversify

SS-7 Shrinkage Estimate

a weighted avg estimate based on history and some other projections

SS-11 Credit spread forwards (formula MUST KNOW)

forward contracts wherein the payment at settlement is a function of the credit spread over the bench at the time the contact matures.

Payoff formula:

FV = (spread at maturity - contract spread) * notional * risk factor

SS-9 Effects currency movements have on portfolios

There are two sources of risk and return:

1. the return on the assets in foreign currency...the stocks normal return

2. The return on the foreign currency from any change in its exchange rate with the investors domestic currency...the movement in currency with your currency over the holding period

equation:

return in foreign currency + return in FX + (Rfc)(Rfx)

SS-11 Repo rate depends on? (always ask this question so know)

1. higher credit risk = higher rate

2. lower Quality of collateral = higher rate

3. Longer terms = higher rate

4. held by borrower = rate is higher, delivered = lower rate

5. Availability of collateral high = higher rate

6. Higher fed funds = higher rate

7. off season and demand = higher rate

SS-7 Tobin's Q

compares the current market value of a company to the replacement cost of its assets...above 1.0, stock is presumed to be overpriced

SS-14 Key point for Centralized System of risk management

Also called Enterprise risk management (ERM) system

KEY: individual risks are less than perfectly correlated, so the risk of the firm is less than the sum of the units risks.

IE: Calculating VAR is not just summing up all divisions VAR. This will give you a wrong number because not taking into account the correlation of these departments.

SS-4 Ability vs Willingness

Ability vs Willingness

Ability - Can sustain losses without putting client goals in jeopardy???

Effected by : Time Horizon, size of expenditure

As importance of expense increase, the more we need to ensure it is met (less ability)

Willingness - Subjective and determined through analysis of the psychological profile

SS-15 Bull Call Spread

Provides limited upside if the underlying rises with limited downside

Buy call option with low exercise price IE Call at 45 for $2.10

Selling a call with higher exercise price IE Sell call at 50 for 50 cents..

SS-3 Self Control Bias

Emotional Bias

Lack of self discipline to delay gratification in pursuit of long term goals. Saving too little, excessive risk, etc

SS-10 Cash flow matching

Used to construct a port that will fund a steam of liabilities with portfolio coupons and maturity values

Use optimization systems

Work backwards in meeting CF needs

Easy way to construct a CF match is to purchase only zero coupon bonds

KEY: You should conclude cash flow matching is more restrictive, simpler to understand and safer

SS-10 Immunization of a single obligation

Ideal way for single liability is to buy a zero coupon bond to time needed

We use a zero because:

Its a bullet

No reinvestment risk

SS-3 Availability Bias

Cognitive Error

Probability estimates are based on ease of recall or too much focus on the info that is readily available. Make decisions on what is familiar, failing to diversify (IE home country bias to stocks)

SS-4 How to answer return objectives (DO IN STAGES)

1. List objectives client want to eh port to achieve

2. Quantify investable asset base (ie house not included)

3. Calculate the % return

SS-14 Actual extreme events and hypothetical events

Actual - events that happened ie 9/11 or 87 crash

Hypothetical - events that could happen but have not yet happened

SS-4 How to answer Time Horizon on Exam

Usually 15 years or more is LT

ST is 3 years or less

Always state number of stages, main objective in each stage, and number of years in the stage

If giving money to kids, time horizon can be multi-generational

SS-8 Mean Variance Optimization (MVO) Strengths

1. Programs inexpensive and readily available

2. ID port with highest expected return for level of risk

3. Cash equivalents modeled as risky asset if included

4. Understood and accepted

5. Easily adaptable

SS-15 Effective Beta ex post (after returns)

effective beta = % change in value of port / % change in index

SS-15 Question:

Portfolio holds 20m in assets in index fund of SPX. SPX has a divvy yield of 2.8%. Manager was to synthetically convert half the position to cash for 1 month. The futures contract priced at 14520.01 and expires in 1 month. Mutiplier is equal to $10. RF rate is 3.85%. How many contracts the fund needs?

($10,000(1.0385)^(1/12)) / (14520.01 *$10) = -69.08

need to take a short position of 69 contracts

SS-8 Resampled Efficient Frontier (REF)

drawback of mean variance method is sensitivity of frontier to inputs

REF is a simulation approach utilizing historical means, variances, and covariances of asset classes

Technique based on Monte Carlo

Resulting efficient frontier is the result of an averaging process and is a BLUR

SS-14 Risk Governance

Developing and putting a risk management system into use

SS-12 Methods of passive investing - 4 methods

1. Index MF or ETF

2. Separate or pooled accounts

3. Equity futures

4. Equity total return swap.

SS-10 Adjusting the portfolios dollar duration

1. Calculate new dollar duration of port

2. Calculate Re-balancing Ratio

Re-balancing ratio = Original Dollar Duration / Current dollar duration - 1 = % change needed to make in port to get back to original

SS-7 Time series models

Assumes the past value of a variable is at least in part a valid estimator of its future value

SS-3 Loss-Aversion Bias

Emotional Bias

Hold losers too long and sell winners too soon

More pain from loss then pleasure from equal gain

Mypoic Loss Aversion - when ST risk in stock leads to excessively high equity premiums in the market, ignoring LT equity returns

SS-3 Prospect Theory

Decisions not based on level of wealth (like Friedman-Savage double inflection utility says) but instead on gaining and losing value

KEY: When people have gains, quicker to make sale; people have losses, hold losses longer then gains (sell winners, hold losers)

KEY: We focus on too many events unlikely to happen

SS-12 Are equities a good inflation hedge?

Yes

ss-12 Price Weighted Index

the Dow...

adds together the market price of each stock and divides by total number of stocks in index. Assumes investors hold 1 share of each stock...

ADVANTAGE: Easy to compute, longer history of data

DISADVANTAGE: Higher price stocks have greater impact in index value. Stock price is an arbitrary measure, rarely do investors by one share each...

SS-3 Framing Bias

Cognitive Error

Data presentation order affects the decision. Excessive focus on ST and trading and failing to properly ID the risk objective

SS-12 Bench for long short fund?

L/S create 0 beta, so no systematic risk

This makes the bench the Risk free Rate

L/S can earn 2 alphas, one long one short book

SS-13 Return Enhancement and Diversification for Real Estate in a Portfolio

direct real estate typically reacts to macroeconomics changes differently than stocks and bonds, and each investment has a large IDIOSYNCRATIC (unsystematic) risk component

KEY POINT: Adding either direct Re or REITs to a stock/bond portfolio significantly increases the portfolio Sharpe Ratio.

SS-13 Fund of funds returns

FOF have been more highly correlated with the equity markets than those of individual hedge funds

Good entry-level investment

SS-17 Misfit Risk

Results from differences in the managers normal portfolio and the broader asset class bench.

SS-13 HF fees vs PE fees?

HF: management fee is 1-2% of assets under management with an incentive fee on performance usually of 20%

PE: 1-2% of the Committed Capital (not just funds already invested) is management fee

incentive fee is called carried interest, and a share of the profits around 20% paid to manager after the fund has returned the outside investors capital, usually has hurdle rate

SS-16 Optimal Corridor for re-balancing program...5 inputs to consider (MUST KNOW ask ALOT)

1. Transaction costs - higher costs = larger deviation

2. Risk Tolerance - Higher risk tol = larger deviation

3. Correlation of returns with other assets - Higher correlations = larger deviation

4. Volatility of asset class return - Lower Volatility = larger deviation

5. Volatility of returns on the other assets in portfolio - Lower total volatility = larger deviations

SS-15 Delta Hedging Example

Call options the stock at a price of $51.30 and has a delta of .533. A dealer is short 100 contracts or 10,000 calls. Calculate the number of share of stock to delta hedge the portfolio.

Stocks goes up $1, each call goes up .533, which is increased liability for the dealer, but dealer can hedge each call with .533 shares of stock. So owning 10,000(.533) = 5,330 shares of stock will provide delta hedged call position.

SS-8 Resampled Efficient Frontier (REF) Weaknesses

1. No theoretical basis for the approach

2. Inputs base don historical data

SS-17 Micro Performance Attribution

3 components

1. pure sector allocation

2. allocation / selection

3. within sector selections

KEY: Usually the allocation/selection interaction tends to be small if bench is correct.

SS-15 Forwards and Futures differences

Forward contracts can be tailored to meet the specific needs of the counter-parties but have higher default risk and less liquidity than futures.

Futures are standardized, trade on an exchange, risk of loss from default is minimal

SS-12 Justify a passive strategy over a active strategy

Passive is:

better on taxes for investor

Large cap investor - very efficient market that is informationally efficient

Investing internationally hard to know both companies AND the economic picture.

**KEY: If IFS states the investor is taxable, the asset allocation is more likely to favor passive management

SS-7 preference for economic models

Preference to use real (before inflation) rather then nominal values in the model

Real more stable

Cobb-Douglas is commonly used to estimate the real growth rate

SS-17 Out-performance vs performance

out-performance - related to a benchmark

performance - absolute return

SS-10 most useful measurement of bond risk

duration

Standard deviation is historical and the number of estimates needed to calculate SD increases dramatically as the bond holdings increase

SS-4 IPS question approach

1. Pay attention to minutes assigned to the question

2. Read question BEFORE starting to read the story. Underline anything relevant.

3. Practice making small notes in margin that you can understand..IE facts that effect each R, Each T, Each L and the U

4. Think before you write

SS-3 Conservatism Bias

Cognitive Error

Rational view is maintained even when new info contradicts (slow to update views)

SS-15 Futures must know mutiplier

For the SPX futures, 250 is the multiplier if not stated

SS-15 Using Swaptions to hedge future loan transaction

Manager is planning to take out a 3 yr loan for $10m at floating rate, say LIBOR plus 250, then the manager could hedge the risk of rising rates by purchasing a payer swaption with a notional principal of $10m (premium may be $200k but not important here). The swap would be to receive 90D LIBOR each quarter, to hedge the loan payments, an dpay a fixed rate. The fixed rate might be 3.6% or .9% each quarter. At the exercise date of the swaption and the beginning of the loan, one of the follow 2 scenarios will result:

1. Fixed rate 3Yr swaps that pay LIBOR is greater then 3.6%. Then manager exercises the swaption to pay the contracted 3.6% and receive LIBOR.

Net payment = $10m(.036 + .025)(90/360) = $152,500

2. Fixed rate 3yr swaps that pay LIBOR is less than 3.6%. Then manger lets swap expire.

If exercised, the swap does its job. If not, the manager is free to hedge or not hedge.

SS-13 Speculators vs hedgers in roll return impact

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

SS10 - Issues with using bond market indexes as benchmarks

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

SS-3 Friedman-Savage Double Inflection utility (do not worry about knowing name, just understand concept)

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

SS-12 Primary risk factors for:

Bonds

Stocks

Bonds:

Duration

Key rate duration

PV distribution of CF's

Sector Qualities

Sector duration

Stocks:

PE

Leverage

Earnings Growth Rate

Size

SS-9 What is a basis point in currencies

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

SS-10 DURATION of a foreign bond example...A British PM wants German bonds. wants to figure out foreign construction to the duration. Duration of the German bond is 6 and country beta is .42.

What is the duration contribution to a british portfolio?

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

SS-15Q Manager of $30M in mid cap would like to move half of the positon to an expsosure like Small cap equities. The beta of mid cap is 1.0 and small cap beta is 1.6. Betas of the correspending futures contracts are 1.05 and 1.5. Mid and small cap futures prices are $260k and $222,222. What is the appropriate strategy?

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.

SS10 - Five Classifications of bond PM

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

SS-13 Commodity investment advantages / disadvantages

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

SS-11 Standardizing duration between countries (MUST KNOW FORMULA

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%

SS-8 Experience Based Techniques (EBT)

The process of elimination by behavior:

IE:

60/40 mix

100- investors age

SS-3 Mental Accounting Bias

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)

SS-15 Why do a protective put?

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..

SS-10 Credit forwards payoff formula (payoffs based on bond values or credit spreads)

for the buyer, the payoff functions as follows:

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

SS-3 Cognitive Errors

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

SS-4 Active versus Passive Wealth

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

SS-16 3 types of order driven markets

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

SS -7 The Yardeni Model

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

SS-3 Confirmation Bias

Cognitive Error

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

SS-15 Hedging with futures or forwards?

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

SS-15 Collars

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

SS-4 Example:

Couple retiring, has $5m in investable assets (ex home), needs $250k AT annually, inflation 2%, calculate after tax nominal return? What is real after tax return?

Nominal = real + inflation

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

SS-10 Target tracking risk of a FI fund is 1%, what does that mean?

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.

SS-12 Completeness Fund Approach

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

SS-16 Order Driven Market -

More competition resulting in better price

Traders transact with other traders

No intermediary dealers

Liquidity may be poor

SS-13 Disadvantages of real estate investments

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)

SS-10 Tracking Risk (tracking error)

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

SS-13 Distressed securities investing strategies

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

SS-15 Manager wants to synthetically convert to cash $45m of a diversified stock port for 3 months. Manager will sue the SPX futures, multiplier equal to $50, and the price of the three month contract is 1610.50. Divvy yield is 2.4% at port. RF rate is 4.04%. The number of contracts the fund needs to use is?

Answer: 564

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

SS-15 Example of using easy way to beak down P&L for bull call spread

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

SS-17 Conducting a macro attribution analysis (MUST KNOW)

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)

SS-17 What is wrong with using median manager as a benchmark? (MUST KNOW)

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

SS-9 Strategic diversification issues for FX

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

SS-13 Real Estate Direct Investment Benchmark

NCREIF- National Council of Real Estate Investment Fiduciaries

Value weighted index

Values obtained usually on annual appraisals

Volatility of the index is downward biased

SS-13 Futures collateralized vs uncollateralized

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

SS-16 Disadvantage of VWAP

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

SS-15Q Investment of $240m in T bills earnings 3% combined with 886 stock index futures that have a price of 1,100 and a multiplier of 250. In 3 months, when the futures mature and the index value is 11,20, what will be the value of the position?

$246,210,097

payoff of futures plus t-bill =

886*250*(1120-1100) +240M * 1.03^.25

SS-7 Forecasting exchange rates - Purchasing power parity PPP

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

SS-9 Strategic Cost issues for FX

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

SS-14 Forward Contract Risks

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

SS-4 IPS Risk objective

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.

SS-13 Backwaration vs Contango

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

SS-10 Dollar duration problem: A portfolio of bonds has a dollar duration today of $162,635 and in one year $136,381. If the value of the bonds in 1 year is $3,090,823, what is the rebalancing ratio and how much cash is required for rebalancing?

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

SS-6 UBIT (Unrelated business income tax

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

SS-15 Equity Swaps

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

SS-14 Compliment to VAR - Stress Testing

Scenario Analysis and stressing models

SS-4 Behavioral Finance affect on a clients risk objectives

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

SS-10 Immunization portfolios with lowest immunization risk

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

SS-12Q Manager X follows the stocks in a broad market index and has made independent forecasts for 300 of them. Her info coefficient is .03. manager Y has made independent forecasts for 100 stocks. His information coefficient is .05. Which manager has the better performance and why?

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.

SS-7 Cobb-Douglas Production Function

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.

SS10 - advantages and disadvantages of pure bond indexing (PBI)

Advantage:

Diversification

Stable performance

disadvantage:

Price discrepancy

Illiquidity of some bonds in index

Reinvestment assumptions

SS-11 Types of Credit risk (IE default risk)

1. Default risk

2. Credit spread risk

3. Downgrade risk

SS-16 Three strategies for rebalancing

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

SS-14 Credit risk of OTC derivatives vs exchange traded derivatives?

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.

SS-15 Currency Swaps

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

SS-13 Advantages of direct equity real estate investing

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

SS-7 H-Model for emerging economies

More challenging environments so use H model to value such markets

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

SS-11 International bond duration

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

SS-15 Reasons for Basis Risk

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

SS-17 Time weighted Rate of return

Value a portfolio anytime cash inflow or outflow happens...

Idea is client decisions with CF should not impact performance

TWRR = Geometric mean

SS-13 Direct and indirect Real Estate

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

Indirect - defined middle group that manages the properties

SS-4 How to answer Liquidity considerations on the exam

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

SS-15Q In the hedging of currency risk, the issue of basis risk is:

a. A concern when using options and not futures contracts

b. a concern when using futures and not options

c. not a concern when using either

i did not know basis risk

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.

SS-11 International Bond Excess Returns (MUST KNOW !!)

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

SS-9 Risk hedging Review: Interest rates, credit, volatility

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

SS-15 Basis Risk

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

SS-9 The base currency

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

SS-14 VAR

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%

SS-9 Why is the median manager a bad benchmark

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

SS-13 Disadvantages of direct equity real estate investing

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.

SS-3 Behavioral Portfolio Theory (BPT)

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

SS-8 Utility adjusted return investors realizes in portfolio example (MUST KNOW)

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

SS-12 Information Ratio example..

Manager X follows the stocks in a broad market index and has made independent forecasts for 400 of them. Her IC is .05.

Manager Y has made independent forecast for 150 stocks. His IC is .07. Which manager has the best performance as measured by the information ratio?

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

SS-8 Surplus Asset Liability Management (ALM) Strengths and Weaknesses

1. Considers allocation of assets with respect to liabilities

2. Generates surplus frontier

3. Similar to MVO

WEAKNESSES:

Same issues as MVO

SS-14 Credit risk in a forward contract

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.

SS-7Q The Taylor Rule...Calculate the ST interest rate target given the following info:

Neutral rate = 4%

Inflation Target = 2%

Expected Inflation = 5%

GDP LT trend = 3%

Expected GDP = 1%

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.

SS-11 Portfolio Dollar Duration and futures impact on it formula (MUST KNOW)

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..

SS10- Option Adjusted Spread OAS

OAS - Callable if higher volatility, lower bond price

OAS - Putable if higher volatility, higher bond price

SS-15 Gamma Effect. (Delta is first derivative, gamma is second derivative )

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

SS-7 TFP (the Slow Residual) part of Cobb Douglas

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

SS-8 Surplus Asset Liability Management (ALM)

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

SS-10 Spread duration problem..I GOT WRONG

port has 4 different security types. below is their weights and duration along with that of the index:

name/weight/duration

Portfolio:

treasuries 47.74%/5.5

agencies 14.79%/5.8

corporates 12.35%/4.5

MBS 25.12% / 4.65

Bench:

treasuries 49.67% / 5.96

agencies 14.79% / 5.10

corporates 16.54% / 5.61

MBS 19.10% / 4.65

What is the spread duration on the FI portfolio?

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

SS-12 What has the highest information ratio over time?

a. indexes

b.active strategies

c. semi active

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.

SS-18 Composites

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

Calculate Sharpe, Treynor, M^2, and Jensen measures

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)

SS-14 Method of computing VAR that relies on the assumption of normality?

Variance/covariance method relies on the assumption of normality

SS-14 Stressing Models

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

SS-10 Relative value analysis

KEY: any bond analysis should focus on total return

SS-11 Futures contract on interest rates Conversion factor

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

SS-15 Preinvesting

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

SS-9 Tradeoffs in constructing market indexes (MUST KNOW, TESTED ALOT) must be able to explain all 3 trade offs in-depth

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.

SS-13 HF fees vs PE fees?

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

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

SS-4 Return Example

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%

SS-11 The Repo Rate

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

SS-8 Monte Carlo Simulation Weaknesses

1. Can be complex to implement

2. Can generate false confidence

SS-9 Increases in value of FX are associate with??

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

SS-10 Immunization portfolios with the highest immunization risk

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

SS10 - Face Value components of bonds

Face value:

Corporate = $1,000

T-Bills and Eurodollars = $1 million

Treasury Bonds = $100,000

Municipals = $5,000

SS-3 Individual behavioral biases

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

SS-9 Currency example with basis points

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

SS-15 Synthetic Positions

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

SS-11 REPO example

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.

SS-11 Futures contracts on Interest Rates

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

SS-7 Gordon Growth Model for mature economies

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

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

SS-14 Company Financial and non-financial risks

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

SS-14 Methods to limit credit risk other then VAR, which is inherently difficult

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

SS-15 Interest Rate Cap (more on personal notes)

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

SS-8 Black-Litterman Weaknesses

1. Inputs based on historical data

2. Complicated

SS-3 Standard of Living Risk (SLR)

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

SS-15 Synthetic Position Example

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..

SS-15 Easy way to break down P&L for any options strategy..

Break cash flow down into 3 areas:

1. Premium

2. G/L on the stock

3. G/L on the option

SS-10 Immunization Risks

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.

SS-14 VAR

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

SS-10 Contingent Immunization (#4 in extensions needed to address classical immunization deficiencies..must know)

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

SS-8 Resampled Efficient Frontier (REF) Strengths

1. EF is more stable

2. Small changes in inputs produces minor changes

3. Portfolios better diversified then MVO

4. Commercially available software

SS-10 Primary Market analysis for new FI issues

1. Relative Value Analysis

2. Cyclical Changes

3. Secular Changes

4. Liquidity Analysis

SS-13 - Issues with Hedge Fund Benchmark selection

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

SS-10 Break even analysis with international bonds:Spread between japan and french bonds is 300bps, giving Japan investors who purchase France bonds an added yield of 75bps per quarter. Japan bond has a 7 duration. What does the spread widening need to be to wipe out all additional gains from the french bonds?

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.

SS-15 Duration of rate swaps (MUST KNOW)

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)

SS-10 portfolios that do the best job of immunization

The portfolio that has the lowest reinvestment risk is best job of immunization

KEY: most ideal is zero coupon bond

SS-12 Equal Weighted Index

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

SS-10 Extensions needed to address the deficiencies in classical immunization

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

SS -9 If portfolio has an R^2 of 86% to its bench, what is the other 14%

This is the managers security selection

SS-12 Tracking Risk (or tracking error)

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

SS-13 Roll Return on futures explained

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!!

SS-14 Risk Management Process Requires:

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!!

SS-3 Conservatism bias

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.

SS-10 Duration vs Spread Duration

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

SS-8 Monte Carlo Simulation (MCS)

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

SS-8 Mean Variance most serious problem?

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.

SS-3 Utility Theory

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

SS-17 Performance attribution (MUST KNOW)

ID and quantify the source of returns that are diff form the bench

Macro attribution - down on sponsor level

Micro attribution - investment manager level

SS-15 Equity Swap..Diversifying concentrated positions example

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.

SS-11 Interest Rate futures hedge ratio

**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

SS-7 Forecasting exchange rates - Capital flows appoach

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

SS-4 IPS Return objective 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

SS-8 Minimum-Variance Frontier

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

SS10- Sophistication of the yield curve

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

SS-9 Strategic choices in currency management

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

SS-10 Asked to try to reduce the target tracking risk. What are some ways for achieving a lower tracking risk

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

SS-7 Psychological Traps

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

SS-3 Emotional Biases

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

SS-10 Immunization weakness

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

SS-7 forecasting exchange rates - Relative Economic Strength Approach

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.

SS-11Q Evaluate 2 bonds. Bond A yield of 5.60% duration 8.15. Bond B yield of 6.45% and duration of 4.50%. Can realize yield gain of 85bps with bond B. He hopes to hold for 6 months. The BE change in BP spread due to change the yield on bond A is?

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.

SS-15 Market value risk and cash flow risk in interest rate swaps

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

SS-12 Total Active Return is usually made up of 2 things:

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

SS-10 Dollar Duration (love to ask questions on this!!)

Duration measures percentage change in value

dollar duration is related and measures dollar change in value

DD = (duration)(0.01)(price)

SS-12 Question on information ratio?

What is the investors true information ratio, using the below data?

manager return 14%

investors bench 11%

normal port return 16%

total active risk 5%

misfit active risk 3.2%

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

SS-13 Real Estate Indirect Investment Benchmark

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)

SS-9 FX Roll Yield - small component of entire return even though its a focus of CFA

the P&L of forward or futures if spot price unchanged at expiration.

roll yield = initial forward - spot price / initial spot price

SS-12 Equity Index Weighting Schemes (MUST KNOW TEST A TON!!!)

1. Price Weighted

2. Market cap weighed

3. Equal Weighted

2b. Free float adj market cap index

SS-8 SML Security Market Line

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.

SS-10 Rationales for not trading

1. Trading constraints

2. Story disagreement

3. Buy and hold

4. Seasonality

SS-7 Forecasting LT economic growth trend, can be broken down into two components

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

SS-11 Credit Swaps

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

SS-18 GIPS composites and changing from one composite to another

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.

SS-14Q A firm that uses enterprise risk mgmt, what type of limit should be used to ensure firm diversification?

a. liquidity limit

B risk factor limit

C Position limit

(i did not know what these were)

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.

SS-9 Tactical FX management

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

SS-4 Creating an IPS - remember RRTTLLU

Has 2 parts: Objectives and Constraints (RRTTLLU)

There are 2 objectives - Return and Risk

There are 5 Constraints - Time, tax, liquidity, legal, unique

SS-11 Futures contract on interest rates Cheapest to Deliever

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

SS-13 - Issues with Hedge Fund Benchmark selection (KEY POINT: Level 3 loves to test why a benchmark is a good one or bad one)

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

SS-15 Hedging FX risk for a portfolio

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...

SS10 - Bonds Duration contribution to a Portfolio of Cash Flows

Duration Contribution:

Duration * Weight = Duration contribution

SS-15 Interest Rate Swaptions (Option on a swap)

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

SS-12 KEY POINT ON CASH and IPS questions

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

SS-8 CAL Capital Allocation Line

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)

SS-10 What does it mean when duration of the FI portfolio is not equal to the duration of the liability?

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

SS-4 How to answer Unique Considerations on the Exam

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

SS10 - Discuss criteria for selecting a benchmark bond index

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

SS-15 Target Duration (Formula MUSH KNOW..same as adj equity beta)

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

SS-14 Scenario Analysis

The user defines the events and compare before and after the change

Consider both favorable and unfavorable scenarios

SS-3 Representativeness Bias

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.

SS-8 Roy's Safety First Measure

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

SS-15 How to use a swap to create synthetic debt

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

SS-11 Achieving target dollar duration example

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

SS-7 Business Cycle - Initial Recovery (1 of 5)

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

SS-7 Business Cycle - Early Expansion (2 of 5)

Output gap quickly approaching zero

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

SS-7 Business Cycle - Late Expansion (3 of 5)

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

SS-7 Business cycle - Slowdown (4 of 5)

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

SS-7 Business cycle - Recession (5 of 5)

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

SS-7 Components of GDP

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&E and inventory) more volatile

3. Gov spending counter cyclical tax receipts

4. Net exports = exports - imports

SS-7 Taylor Rule

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

SS-7 Yield Curve

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)

SS-7 Pro-Growth Government Policies

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

SS-7 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

SS-7 Nominal Rates

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

SS-7 Inflation Index Bonds (TIPS)

• 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

SS-7 Forecasting Exchange Rates (none of these ever work all the time)

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

SS-7 Cobb-Douglas

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

SS-7 Solow Residual

Takes Cobb-Douglas and back solve for TFP

Cobb Douglas:

GDP real growth = Growth in labor + growth in capital + TFP

SS-7 Cobb- Douglas Total Factor Productivity how to increase over time

1. Improving Technology

2. Fewer restrictions on capital flows and labor mobility

3. Fewer trade restrictions

4. Discovery of and increase in natural resources

SS-7 H-Model

Real growth and discount rates are preferred

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

SS-7 Relative Value Models for the equity markets

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

SS-7 Fed Model

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

If earnings yield > treasury yield, stocks undervalued

IF earnings yield < treasury yield, stocks overvalued

SS-7 Fed Models Positives and Drawbacks

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)

SS-7 Yardeni Model

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

SS-7 Yardeni Model Positives and Drawbacks

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

SS-7 CAPE Positives and Drawbacks

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

SS-7 Tobins Q and Equity Q Asset Based Models

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

SS-7 Tobins Q and Equity Q positives and drawbakcs

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

SS-4

Time Horizon IPS how to answer

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

SS-4.

Liquidity for IPS. How to answer

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)

SS-15 Fund goal is to change $4m in equity to debt, where the beta is 1.2 and target duration is 4.5. Futures price for equity is $102,100 and 1.05 beta and price and duration of bond futures is $98,5000 adn 5.1

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

SS-15 $200m portfolio allocated 65% stocks with beta of 1.15 and 35% bonds with duration of 6.75. For a 6 months period want to shift allocation to 85/15 and increase stock beta to 1.20 and duration to 8.25. Stock contract price is $157,500, beta of .95 and bond contract price is $109,000 with duration of 5.25

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

SS-15 The word synthetic means what?

Word Synthetic means we need to use FV

ss-15 Synthetic Example:

Manager will receive $8m in 3 months from now

Synthetically preinvest the funds while maintaining the existing 60/40 mix

The equity portion has a beta of 1.1, and the bond portion has a duration of 3.6

Stock index futures price = $210,550 with a beta of 1.05

Bond futures price = $98,675 with a duration of 6 and a yield beta of 1.1

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

SS-15 Hedging exchange rate risk

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.

SS-15 Hedging a Foreign Market Portfolio

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

SS-15 FX hedging..What is RFC

• 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)

SS-15 FX hedging..What is RFX

Issue is we are exposed to what happens to the value of the local currency when the investor is invested in that market (Rfx local currency return)

SS-15 Hedging RFC and RFX

• Hedge only Bond Risk (Rfc): If we hedge the foreign market bond market, we would calculate the bond contracts to sell to hedge this risk, and WE LOCK IN THE RF RATE OF THAT FOREIGN MARKET..Will earn the US RF rate and still exposed to the currency change in value..

• Hedge only the Foreign Currency: If we hedge the USD we will sell forward the USD, and buy forward the AUD. Differential between S0 and F0 we use interest rate parity (lose rate of what you are selling forward and gain rate of what you are buying forward) (in example below, +2% - 3% = -1%)…NEVER a precise hedge…

• Hedge both Risks: We will lock in the RF rate of the foreign market which is 3%, and the -1% for FX hedge, our rate of return will be 2%, which is EQUAL to the RF rate in AUD..Back to the start..

SS-15 Hedging a Foreign Market Example:

• An Australian investor holds a US bond portfolio with a duration of 5.7 worth $23m

• The one year T-bond contract is priced at $97k with a duration of 5.4

• The initial spot and forward exchange rates are AUD/USD 1.06 and 1.05

• The initial AUD and USD RF rates are 2% and 3%

Hedge all risk and earn the investors RF rate:

Sell T bond contracts to hedge the foreign market (US):

((0-5.7)/5.4)*($23m / $97k) = -250

Earn the foreign market (US) RF rate:

$23m * 1.03 = $23,690,000 (known USD exposure at the end)

Sell $23,690,000 forward at AUD/USD 1.05 to receive:

AUD 24,874,500

Beginning value was:

$23m * AUD/USD 1.06 = UAD 24,380,000

The AUD return was :

24,874,500 / 24,380,000 – 1 = 2.03% is about the RF rate in AUD of 2%

SS-15 Interest Rate Option Formulas

Call payoff: (NP(max(0, LIBOR – strike rate))(D/360))

Put payoff: NP(max(0, Strike Rate – LIBOR))(D/360))

NP = notional principal

D= days in the underlying rate

SS-15 Interest Rate Option Example:

Compute payoff on a 40 day, $10m call and put on 90 day LIBOR with a strike rate of 5%?

LIBOR rates at option purchase and expiration are 5.33% and 5.44%

Time Line:

Day 0 to day 40, then day 40 to day 130

LIBOR is at 5.44% so put is out of the money

The call is in the money by 44bps, and payoff occurs 90 days after option expires

$10m*(.0044)(90/360) = $11,000

Key point to this reading is to understand hedging a future borrowing or lending rate

SS-15 Why do a borrow or lender buy an interest rate call or put?

Borrower:

• Borrower is at risk of increasing rates

• To hedge this, we buy an interest rate call

• If rates rise above the call strike price, receive the difference, setting a max EAR

Lender:

• Lender is at risk of decreasing interest rates

• To hedge this, we would buy an interest rate put

• If rates fall below the put strike price, receive the difference, setting a min EAR

SS-15 Calculating and figuring out interest rate option problems

Initial point trying to do something T0

Borrowing and lending at Tt

Capital and option come due at TT

KEY: We always finance the purchase of the option so have 0 net cash flow at time 0 or T0. Then we will have only cash flows on Tt and TT

1. At T0, buy the option and finance the option premium for a zero net cash flow

2. At Tt, the primary loan transaction occurs and the option expires

3. At TT, the primary loan is repaid and any option payoff occurs

KEY: LIBOR uses actual day counts for period 360-day with simple calculation

KEY: EAR uses actual day count for period and year with compound interest calculations

SS-15 Interest rate option example

• Currently, LIBOR is 5%, and in 40 days a firm plans to borrow $5m for 180 days at LIBOR plus 300bps

• The firm buys a call that matures in 40 days with a NP of $5 million, 180 days in underlying, and a strike rate of 4.5%

• The call premium is $18,000

Calculate the EAR on the loan if LIBOR is 5.1% in 40 days?

Answer:

Make time Line:

T0 = buy and finance the option for zero net cash flow

T40 = Borrow the $5m, repay the option loan. Option payoff is determined but paid at T220

T220 = Repay P and I on the $5m and collect any option payoff

T0:

Buy call for $18k

Borrow the $18k at T0 LIBOR of 5% plus spread of 300bps (8%) for 40 days

Option loan repayment at T40 is:

$18k(1+ .08(40/360)) = $18,160

T40:

Borrow $5m for 180 days at T40 LIBOR of 5.1% plus 300 (8.1%)

Net cash flow is $5m less option financing

Net received = $4,981,840

The call is in the money (5.1 – 4.5 = 60bps) with payoff at T220

T220:

Repay the Primary Loan

$5m(1+(.081(180/360))) = $5,202,500

Receive the call payoff of:

$5m(.006(180/360)) = $15,000

Net cash flor T220 is $5,187,500

Finally, calculate the EAR:

(5,187,500 / 4,981,840)^(365/180) – 1 = 8.55% EAR which is max because option was in the money