Qbank and Blue Box Questions 2022 CFA L3

explain the conditions under which the performance of a past firm or affiliation may be linked to or used to represent the historical performance of a new or acquiring firm; 35i (GIPS)

Generally a performance track record of a composite must stay with the firm where it was generated. The record is not "portable," but if a past firm or affiliation is acquired and if three other conditions are met, the past record must be linked to and used by the new or acquiring firm. The three conditions are: - Substantially all the investment decision makers are employed by the new firm (e.g., research department, portfolio managers, and other relevant staff); - The decision-making process remains substantially intact and independent within the new firm; and - The new firm has records that document and support the reported performance. If a firm acquires another firm or affiliation, the firm has one year to bring any noncompliant assets into compliance.

Hedging costs come mainly in two forms: trading costs and opportunity costs.

Opportunity cost is frequently foregoing positive currency appreciation because you're hedged. Trading is the cost to set up the hedge

formulate a portfolio positioning strategy based upon expected changes in interest rate volatility; 13d (FI II) (Buy calls and buy puts to change duration/ convexity)

Options on bond futures contracts are liquid exchange traded instruments frequently used by FI market participants to buy/ sell the right to enter into a futures position - Buy calls - Increase duration and increase convexity - Buy Puts -Decrease duration and increase convexity - Sell puts - Increase duration and decrease convexity - Sell calls - Decrease duration and decrease convexity - Buy calls and sell puts - Increase duration and keep convexity unchanged - Long payer swaption - decrease in portfolio duration and convexity - Long receiver swaption - increase in portfolio duration and convexity - Callable bond - negative convexity - Putable bond - Positive convexity

Mortality table and Annuities

Mortality table - Indicates individual life expectancies at specified ages - One particular drawback is that an individual client's probability of living to a certain age may exceed that of the general population - (allows for estimating the present value of retirement spending needs by associating each outflow with a probability based on life expectancy.) Annuities - A relatively simple way of calculating the PV of a client's desired retirement spending is by pricing an annuity - (The calculated price of an annuity equals the present value of a series of future fixed outflows during retirement) - Immediate annuity - pays lump sum - Deferred - specified future monthly payments begin at a latter date - Life annuities pay out as long as you're alive

Calculating the notional swap principal and the number of futures required to adjust beta

Notional swap principal = [(Modified duration target - Modified duration of the portfolio)/ (Modified duration of the swap)] * (Market value of portfolio) Number of futures required = [(Portfolio Beta target - current portfolio beta)/ Future's contract beta ]* (Market value/ futures price * multiplier)

describe the basic elements of a life insurance policy and how insurers price a life insurance policy; (PWM 2) 23g (pricing a life insurance policy)

The pricing of life insurance is a large time value of money problem. The pricing model can be broken down into three issues: mortality expectations, discount rate (an assumption of the insurance company's return on its portfolio), and loading: Mortality expectations: - Actuaries at insurance companies estimate mortality based on both historical and future mortality expectations - The underwriting process serves to categorize applicants according to their perceived riskiness - i.e. If an applicant's parents or sibling died early from certain diseases, if the applicant is overweight they would typically have shorter life expectancies Calculation of Net premium - Net Premium represents the discounted value of the future death benefit - The discount rate, or interest factor, representing an assumption of the insurance company's return on the portfolio, is applied to the expected outflow, which gives the net premium. I.e. a 150$ yearly payment discounted at 5.5% gives a $142.18 net premium Loading Load - this is added to the net premium to allow for expenses and a projected profit for the insurance company. - Expenses include - costs of the underwriting, which potentially includes a sales commission; ongoing expenses include overhead and administration etc. - Load plus net premium is the gross premium

describe effective practices in portfolio reporting and review; (PWM 1) 21m

A portfolio report should contain the following 1 Reporting - Portfolio asset allocation report, which may reflect strategic asset allocation targets - Performance summary for the current period - Detailed performance report (asset class level) - Historical performance since inception - Market Commentary - Contribution/ withdrawal, purchase/ sale report - Progress toward meeting goals if utilizing goals based investing - Impact of currency 2 Portfolio Review (Actually meeting with the client) - Reassess any changes to IPS, i.e. client objectives, risk tolerance, time horizon, liquidity needs, family needs, external sources of CF - Any new rebalancing ranges? Are the client's weights within the ranges? - Appropriateness of existing goals and if they have to be changed - Changes or updates in the manager's duties Comparison of client's asset allocation to the target asset allocation

Positive roll yield vs. negative roll yield (Econ)

A positive roll Yield results from buying the base currency at a forward discount or selling it at a forward premium, A negative roll yield typically indicates that the hedger is trading against the forward rate bias by buying a currency at a forward premium Forward rate bias = carry trade = Positive roll yield; Trading the forward rate bias involves buying currencies selling at a forward discount, and selling currencies trading at a forward premium A forward discount is a term that denotes a condition in which the forward or expected future price for a currency is less than the spot price

Alpha skills

Alpha Skills - Simple static exposure to known rewarded factors is no longer widely considered a source of alpha, however, successfully timing that exposure would be a source - Examples of rewarded factors include manager's ability to select trends such as value outperforming growth - Additionally unrewarded factors can generate alpha such as regional/ sector exposure, the price of commodities, or even security selection - In summary, active returns arising from skillful timing of exposure to rewarded/ unrewarded factors or even other asset classes constitutes a manager's alpha Bottom up alpha - security selection related; top down alpha - factor timing

prepare the investment objectives section of an institutional investor's investment policy statement; (PM Inst. Inv.) 24f (Endowment spending methods)

DB Plans For DB pension plans, the primary objective is to achieve returns that adequately fund its pension obligation on an inflation adjusted basis while assuming a level of risk that is consistent with meeting its contractual liabilities. A secondary objective could be to minimize (in present value terms) the cash contributions the sponsor will be required to provide. - Risks may be stated in terms of pension surplus volatility, in terms of shortfall, or in absolute terms (i.e. 10-15% return required) - Objectives may differ for active lives portion vs. the retired lives DC Plan The main objective of DC plans is to prudently grow assets to meet spending needs in retirement. Secondary could be to outperform policy benchmark Endowment The investment objective is to preserve the purchasing power of the assets in perpetuity (i.e., grow in line with inflation) while achieving returns adequate to maintain the level of spending necessary to support the university budget. Secondary objective could be to outperform LT policy benchmark. Spending policy can be formulated in different ways: - Constant growth rule (The endowment provides a fixed amount annually to the university, typically adjusted for inflation (the growth rate). The inflation rate is usually based on the Higher Education Price Index (HEPI) in the United States; A shortcoming of constant growth spending rules is that spending does not adjust based on the endowment's value. If the endowment experiences weak average returns, the spending amount expressed as a percentage of assets may become very high), - Market value rule ( pays a pre-specified percentage, typically between 4-6% of the moving average of asset values; Asset values are usually smoothed using a 3- to 5-year moving average. A disadvantage of this spending rule is that it tends to be pro-cyclical; when markets have performed well, the overall payout increases .) - Hybrid - weighted average of constant growth and market value rule However, a typical spending rate target is 5% of average assets. Foundation The investment objective is to generate a real return over consumer price inflation of the spending rate (minimum 5%) plus investment expenses, with expected annual volatility in a reasonable range (approximately 10% to 15%) over a three- to five-year period. There may be a secondary objective of outperforming a policy benchmark based on a tracking error budget. Banks The primary objective of a bank's investment portfolio is to manage liquidity and reduce risk mismatches between the bank's noninvestment assets (bank loans, deposits etc.) and liabilities. Objectives in managing securities portfolio: - Manage overall interest rate risk - Manage liquidity - Produce income - Manage Credit risk Insurers Manage investment portfolios with a focus on liquidity Grow surplus over time

HMO vs. PPO vs. Indemnity Plan

Health insurance - highly dependent on the country of residence. In certain countries, health care is governmentally funded and there is no private health insurance. In the US there three main types of plans - HMO - allows office visits at no, or very little, cost - PPO - large network of physicians that charge lower prices to individuals within the plan - Indemnity plan - allows the insured to any medical provider, but must pay a specified percentage of the "reasonable and customary fees"

Hedge Ratios Formulas (Derivatives)

Hedge Ratio: BPVHR=(BPVt −BPVp/ BPVCTD)×conversion factor; if you're trying to completely hedge i.e. BPVt = 0 then the equation is just BPVp/ BPV CTD The basis point value hedge ratio (BPVHR), which provides the number of futures contracts needed, is then calculated as follows:(BPVHR=BPVT−BPVP/ BPVCTD) ×CF; this is to calculate the contracts needed for a change in duration BPV = MDur target x .01% x MV portfolio;

demonstrate the use of derivatives in asset allocation, rebalancing, and inferring market expectations; (Derivs.) 9f (Fed Funds)

Inferring Market expectations Fed Funds futures - Federal funds rate - the rates that deposit institutions charge other deposit institutions for loans - Fed Funds target rate - rate set by Fed Reserve in FOMC (Most important rates are the gdp growth rates and inflation in the calculations) - Probability of rate change: (Effective rate implied by futures - current Fed Funds target rate) / (Fed funds rate assuming a rate change - current Fed target funds rate) - Fed Funds rate implied by futures = 100 - Expected FEE if you are given a target range, the midpoint would be used in the current rate. If the FFE rate implied is higher than the current rate you can assume a rate increase, this rate after an increase would be the last input

describe fixed-income portfolio measures of risk and return as well as correlation characteristics; (FI 1) 11b

Macaluay Duration (MacDur) - Weighted average of time to receipt of the bonds promised payments - For a coupon free bond this would just be the maturity. For other types of bonds with coupons it would be shorter Modified Duration (ModDur) - MacDur divided by one plus the yield per period (which estimates the percentage price change for a bond given a change in its YTM) Effective duration - Sensitivity of the bond's price to a change in a benchmark yield curve (better to use for bonds with embedded options) - Essential to measurement of the interest rate risk of a complex bond where future cash flows are uncertain Key Rate Duration - Measure of a bond's sensitivity to the benchmark curve at a specific maturity point Empirical Duration - Measure of interest rate sensitivity that is determined from market data (run a regression of bond price returns on changes in a benchmark interest rate) - For IG, the empirical durations were lower than effective durations and the difference increased moving down in credit rating from Aaa to Baa. - For HY, the differences increased dramatically with empirical duration near 0 for Ba and B rated bonds. For Caa rated bonds empirical duration was negative Money duration - Measure of the price change in units of currency in which the bond is denominated Price value of a basis point - Estimate of the change in a bonds price given a 1 bp change in YTM - Calculating the number of contracts required to adjust the portfolio assets is simply the desired change in BPV divided by the BPV of the contract (BPV is mod dur x market value of assets/ liabilities) Convexity - Describes the bond prices behavior for larger yield movement. If a bond has positive convexity the return will go higher when rates drop and fall less when rates rise than a lower convexity bond. Longer duration or has a coupon = higher convexity. A zero coupon bond has the lowest convexity of all bonds of a given duration - The more widely dispersed a bonds cash flows are around the duration point, the more convexity it will exhibit - Dispersion measures the variance of the time to receive cash flows from FI securities held - Adding convexity is not costless. Portfolios with higher convexity are most often characterized by lower YTM Spread duration Spread duration provides the approximate percentage increase (decrease) in bond price expected for a 1% decrease (increase) in credit spread

compare active currency trading strategies based on economic fundamentals, technical analysis, carry-trade, and volatility trading; (Derivs.) 10d (Risks in Carry trade)

Risks involved in carry trade (include at least two): 1. High-yielding currencies are typically from high-risk countries. 2. In times of global financial crisis, there is a rapid movement from high-risk currencies to low-risk currencies, resulting in unwinding of carry trades. 3. Large-scale losses can be incurred quickly due to the large amount of leverage involved with a carry trade

discuss approaches to liability-relative asset allocation; (Asset All.) 6k

There are three approaches to liability relative asset allocation Surplus Optimization - Surplus optimization involves adapting asset-only mean-variance optimization by substituting surplus return for asset return over any given time horizon. - Optimize over all assets and liabilities (liabilities are included as negative assets) - Surplus optimization links assets and the pv of liabilities through a correlation coefficient, the two portfolio model doesn't - Surplus objective function = Expected surplus return - .005 x risk aversion x standard deviation squared The steps to the surplus optimization approach are: - Select asset categories and determine the planning horizon - Estimate expected returns and volatilities - Determine any constraints - Estimate the expanded correlation matrix - Compute the surplus efficient frontier and compare it with the AO efficient frontier (differences in asset allocations are most significant in conservative portfolios, Risky Surplus Optimization and AO portfolios are similar) - Select a recommended portfolio mix Hedging/ Return Seeking Approach - Create one portfolio that is strictly for hedging, and use the remainder to be managed independently with a return seeking portfolio though MVO or another method - The hedging portfolio can be created using the various techniques such as cash flow matching, duration matching, and immunization. - This approach is often used for insurance or overfunded pension plans that wish to reduce or eliminate the risk of not being able to pay future liabilities - It can be modified to hedge only partially, or increase amount to hedging portfolio as the funding ratio and surplus increase Hedging Portfolio - Must include assets whose returns are driven by the same factors that drive the returns of the liabilities. Even if the assets and liabilities start with equal values they will be inconsistent over time There are two limitations of this approach: · If the funding ratio is less than one, it's difficult to create a hedging portfolio that completely hedges the liabilities, unless there is a sufficiently large positive cashflow (contribution) · A hedging portfolio may not be available to hedge certain kinds of risk, i.e. weather related causes such as hurricanes or earthquakes. The investor has basis risk when imperfect hedges are employed. Compare how surplus optimization and hedging/ return seeking portfolio approach take account of liabilities - Surplus optimization approach links assets and the PV of liabilities through a correlation coefficient. The two portfolio model does not require this. SO considers the AA problem in one step, the H/RS approach divides it into two - When the plan is conservative and underfunded, the SO and hedging portfolio will have basically the same allocation Integrated Asset Liability approach - This is used when decisions regarding the composition of liabilities must be made in conjunction with the asset allocation decision - Some places already have liabilities in place while others like banks, L/S hedge funds, get to make decisions about their liabilities jointly when setting their allocation model - This is called an integrated asset liability approach - Decisions about the AA will affect the amount of business available (i.e. loans a bank can make

explain absolute and relative risk budgets and their use in determining and implementing an asset allocation; (Asset All.) 6e

There are three aspects to risk budgeting - The risk budget identifies the total amount of risk and allocates the risk to a portfolio's constituent parts - An optimal risk budget allocates risk efficiently - The process of finding the optimal risk budget is risk budgeting MCTR/ ACTR - MCTR - marginal contribution to total risk ( identifies the rate at which risk would change with a small change in the current weights) - MCTR = (Asset Class Beta) * (Portfolio Return standard deviation) - ACTR - absolute contribution to risk (measures how much the asset class contributes to the portfolio volatility) - ACTR = weight x MCTR - % of risk contributed by position = ACTR/ total portfolio risk An allocation is optimal when Expected return - risk free rate / MCTR is the same for all assets and matches the Sharpe ratio of the total portfolio

Tracking error and capital commitment for an ETF vs. a swap

Using and ETF vs. a swap to establish a position: The capital commitment of an unlevered ETF equals the full notional value. In contrast, a total return swap generates a similar economic exposure to ETFs with much lower capital. From a liquidity perspective, a Russell 1000 Growth ETF would be more efficient than the total return swap. From a tracking error perspective, ETFs would be less efficient than the total return swap. ETF would have associated tracking error, which may result from premiums and discounts to net asset value

discuss information needed in advising private clients; (PWM 1) 21b

What is the information needed when advising Private Clients? Personal Information - Marital status/ dependents - Proof of Client Identification i.e. Passport - Employment information - Retirement Plan Info/ Client's Wealth - Risk Tolerance and investment objective Financial Information - Cash/ deposit accounts - Brokerage and investment accounts - Retirement Accounts - Employee benefits such as stock options - Life insurance policies - Real estate/ cars/ jewelry Liabilities - Consumer debt - Mortgage loans - Other types of debt (car loan/ student loan) Other Client Information - Wills and trust documents - Insurance policies - Who is authorized to make decisions on behalf of the other

What do HFs look for when investing in insurance settlements

low premiums, high probability person dies early, surrender value is low (amount paid by insurance when the policy is voluntarily terminated)

Asset duration is 1.75, liability duration is .5, equity capital ratio is 12.5%, liability yield is 80%, calculate equity duration.

1.75 (1/.125) - .5 (1/.125 -1) (5) (.8)

Shrinkage vs. prudence trap

shrinkage estimate ( involves taking a weighted average of a historical estimate of a parameter and some other parameter estimate) vs. prudence trap (temper forecasts so they don't seem extreme

explain the role of investment mandates, objectives, or strategies in the construction of composites; 35f (GIPS)

- Composites must be defined according to similar investment objectives and/or strategies. Composites must include all portfolios that meet the composite definition. The full composite definition must be made available on request. - Generic definitions such as "equity" or "fixed income" may be too broad to enable clients to make comparisons, so qualifiers such as sector, benchmark, capitalization (e.g., large, mid, small), style (e.g., value, growth, blend), or even risk-return profile may be useful.

explain requirements of the GIPS standards with respect to composite construction, including switching portfolios among composites, the timing of the inclusion of new portfolios in composites, and the timing of the exclusion of terminated portfolios from composites; 35g (GIPS)

- Firms are not permitted to link simulated or model portfolios with actual performance. - Composites must include new portfolios on a timely and consistent basis after the portfolio comes under management. (Preferably they should be as of the beginning of the next full performance period, but it may take some time to invest the assets in accordance with the investment strategy) - Terminated portfolios must be included in the historical returns of the appropriate composites up to the last full measurement period that the portfolio was under management. - Portfolios must not be switched from one composite to another unless documented changes in client guidelines or the redefinition of the composite make it appropriate. The historical record of the portfolio must remain with the original composite. - To remove the effect of significant cash flows, firms should use temporary new accounts.

explain the fundamentals of compliance with the GIPS standards, including the definition of the firm and the firm's definition of discretion; 35b (GIPS)

- GIPS compliance must be on a firm-wide basis. - Total firm assets are defined as the total fair value of all assets the firm manages, including non-fee-paying and non-discretionary portfolios. Also included in the definition are assets delegated to sub-advisers, as long as the firm has selected the sub-advisers. Assets managed by sub-advisers not selected by the firm are not included in total firm assets. - For GIPS compliance, a single verification report must be issued with respect to the whole firm. Verification cannot be carried out only on a composite and, accordingly, does not provide assurance about the investment performance of any specific composite. The Standards stress that firms must not state or imply that a particular composite has been "verified." - A portfolio is deemed discretionary, it is considered sufficiently free of client-mandated constraints such that the manager is able to pursue its stated strategy, objectives, or mandate. The GIPS require that all actual, fee-paying discretionary portfolios are included in at least one composite

discuss requirements of the GIPS standards with respect to return calculation methodologies, including the treatment of external cash flows, cash and cash equivalents, and expenses and fees; 35c (GIPS)

- GIPS requires comparable calculation methods by all firms to facilitate comparison of results. Returns must be calculated on a total return basis using beginning and ending fair value (Standard 2.A.1). If there are no client contributions or withdrawals (ECFs), this is simply (EV − BV) / BV. - Beginning January 1, 2001, firms must value portfolios and compute periodic returns at least monthly. - Beginning January 1, 2010, GIPS requires firms to also value portfolios on the date of any large external cash flow (ECF) and time weight the subperiod returns. - All return calculations must be gross of fees. This means after actual trading expenses but before all other fees - When the firm controls the timing of ECFs, time-weighted return cannot be used, and internal rate of return (IRR) must be used for return computations. (If relevant, this is covered in the special provisions for RE and PE.) - The GIPS standards state, "Returns from cash and cash equivalents must be included in all return calculations, even if the firm does not control the specific cash investment(s) - A time weighted total return calculation is required for period beginning on or after Jan 1 2005. Examples of acceptable approaches are the Modified Dietz and the Modified IRR method, both of which weight each cash flow by the proportion of the measurement period it is held in the portfolio. For periods prior to Jan 1 2005, cash flows can be assumed to occur at the midpoint of the measurement period. The Original Dietz method reflects this midpoint assumption

explain requirements of the GIPS standards with respect to composite return calculations, including methods for asset-weighting portfolio returns; 35d (GIPS)

- GIPS requires firms to report performance by composite, where a composite is a group of accounts with similar objectives. The return of the composite is the weighted average monthly return of the accounts in the composite. - Weights can be based on either beginning of period account value or beginning of period plus weighted average ECFs for the period. End of period account values cannot be used, as that would increase the relative weighting of the accounts with the higher relative return for the period. - It is also allowable to aggregate total beginning and ending market value and aggregate all the ECFs of the composite. Then, directly calculate the return of the composite as if it were all one account.

Characteristics of endowment that suggest lower risk tolerance

- If endowment spending comprises a smaller proportion of the university's operating budget, then the risk tolerance is higher - Fundraising from donors/ donations - Capability of endowment to issue debt - Smoothing of spending rate (If you don't smooth, your spending will vary a lot year after year while with the smoothing, there will be some stability)

explain requirements of the GIPS standards with respect to composite return calculations, including methods for asset-weighting portfolio returns; 35d (GIPS) explain the meaning of "discretionary" in the context of composite construction and, given a description of the relevant facts, determine whether a portfolio is likely to be considered discretionary; 35e (GIPS)

- The Investment Performance Council defines discretion as "the ability of the firm to implement its intended strategy." - A portfolio becomes nondiscretionary when the manager is no longer able to implement the intended investment strategy. If for instance the liquidity requirements are so great that much of the value must be in cash, or if the portfolio has minimal tracking limits from an index portfolio, then the description of "discretionary" is really no longer appropriate. - When the PM doesn't have discretion about the size and timing of cash flows, GIPS requires, the time weighted rate of return or approximations to TWRR, such as original dietz or modified dietz - When you have portfolios that have certain requirements, which make only certain portion of the portfolio eligible for using the strategy, i.e. if the client wants to hold a certain stock in addition to the normal portfolio allocation. You can either exclude the portfolio from all composite, or include in composites the portion that doesn't include that certain stock

explain the recommended valuation hierarchy of the GIPS standards; 35j (GIPS)

1. Observable quoted market prices for similar investments in active markets 2. Quoted prices for similar investments in markets that are not active 3. Market-based inputs other than quoted prices that are not observable for the investment 4. When no quotes or other market inputs are available, estimates based on quantitative models and assumptions

describe elements of a manager's investment philosophy that influence the portfolio construction process; (Eq. 2) 18a

Active return is the sum of the active weight (difference between portfolio and benchmark weight) x the return on the security Active returns come from three sources: - Assuming excessive idiosyncratic risk - returns related to luck - Exposure to mispriced securities / alpha driven by manager skill - Strategically adjusting the active weights to create long term exposures to rewarded factors such as beta, size, liquidity that are different from those of his benchmark The sources of active return as a formula: (sensitivity of portfolio to each rewarded factor - sensitivity of benchmark to each rewarded factor) (return of each rewarded factor) + (idiosyncratic return + alpha) Three main building blocks of portfolio construction: Rewarded Factor Weightings - Under/ overweighting factors such as: market, size, value etc. factors relative to benchmarks Alpha Skills - Simple static exposure to known rewarded factors is no longer widely considered a source of alpha, however, successfully timing that exposure would be a source - Examples of rewarded factors include manager's ability to select trends such as value outperforming growth - Additionally unrewarded factors can generate alpha such as regional/ sector exposure, the price of commodities, or even security selection - In summary, active returns arising from skillful timing of exposure to rewarded/ unrewarded factors or even other asset classes constitutes a manager's alpha Position Sizing - Position sizing is about balancing managers' confidence in their alpha and factor insights while mitigating idiosyncratic risks - Level of idiosyncratic risks is much higher in concentrated portfolios Fundamental law of active management Expected active return = Information coefficient x square root (breadth) x (Transfer coefficient) x manager's active risk - Transfer coefficient is the ability to translate portfolio insights into investments decisions without constraints, scored between 0 and 1, where 1 represents no constraints - Breadth - number of truly independent decisions made (Higher breadth should lead to more outperformance) IC = Expected information coefficient of the manager—the extent to which a manager's forecasted active returns correspond to the managers realized active returns

discuss the parts of an investment policy statement (IPS) for a private client; (PWM 1) 21i

An IPS for a private client usually covers Background and investment objectives - - do you have family needs, charitable needs, and are the objectives detailed or quantified? - Name/ age, relevant financial info. - Objectives should be quantified whenever possible - Market value of the portfolio and the accounts that make up the portfolio, and the tax status of the accounts - Any other investment assets outside the portfolio Investment Parameters - this section outlines important preferences that influence the client's investment program - Risk Tolerance (In this part of the parameters, the wealth manager indicates that she has considered the client's ability and willingness to withstand portfolio volatility) - Time Horizon (A client's investment horizon is indicated in this section, but often as a range rather than a specific number of years) - Asset class preferences - The IPS should indicate the asset classes that will comprise a client's portfolio, alternatively the wealth manager may list the asset classes that the client has not approved. - Liquidity preferences - some investors need a cash reserve in their portfolio while others must initiate a distribution when they encounter an unanticipated cash need. - Other investment preferences - Could be ESG requirements or legacy holdings through inheritance - Constraints - what the manager can't invest in (common ones: no derivatives, no leverage) Asset Allocation - Contains the target allocation for each asset class in the portfolio Portfolio management Discusses various issues involved in ongoing management of the client portfolio. These issues may include the - level of discretionary authority (ability to act without client approval) - when rebalancing will take place, and if tactical changes are needed - Implementation - Vehicles that are recommended such as ETFs, or individual securities Duties and responsibilities The wealth manager typically addresses the following issues (where applicable) - Monitoring and rebalancing - Monitoring costs - Drafting and maintaining IPS - Monitoring actives or third- party service providers - Voting Proxies - Reporting performance IPS Appendix Frequently includes modeled portfolio behavior and capital market expectations

Break out of plans by type i.e. Liability driven, Asset Only, or Goal Based

Asset Only (SWF, Foundations, Endowments, individual investors) , Liabilitiy Driven ( Banks, DB Plans), Goals Based (Individual investors)

compare the investment objectives of asset-only, liability-relative, and goals based asset allocation approaches; (Asset All.) 5c

Asset only - Asset allocation decisions are made based solely on the assets; liabilities are not explicitly modeled (MVO is the most familiar and studied AO model); - The objective is to maximize Sharpe Ratio for acceptable level of volatility Liability- relative - The objective is mainly paying liabilities when they come due and invest excess for growth - Focus is on surplus i.e. have a positive value for assets minus the PV of liabilities - Typically used by banks/ DB plans/ insurers - Objective: fund liabilities and invest excess for growth Goals Based - Used primarily for individuals and families, including specifying probabilities for sub portfolios - Each goal is associated with a risk tolerance, time horizon, and with specified required probabilities of success - Objective: achieve goals with specified required probability of success

Investment Objectives of an IPS

Background and Objectives - Manager should determine all sources of investments and cashflows, and assets that the client may be holding. - The manager can use capital sufficiency to determine if they are likely to meet their goal - Objectives can be simple as funding college, or retirement - do you have family needs, charitable needs, and are the objectives detailed or quantified? - (purpose, anticipated annual need, annual need met with) - Name/ age, relevant financial info. - Objectives should be quantified whenever possible - Market value of the portfolio and the accounts that make up the portfolio, and the tax status of the accounts - Any other investment assets outside the portfolio

Using SMAs when investing in alternatives

Benefits of SMA: greater transparency and control of capital flows. Disadvantages: Not available or appropriate for many alternative strategies , thus the requirement to invest in an SMA may limit the ability to develop an alternative investment program

Behavioral Portfolio theory, and how it constructs portfolios, and whether covariance is accounted for

Behavioral Portfolio - Behavioral portfolio are not constructed as a whole but layer by layer, where each layer is associated with a goal and is filled with securities that correspond to that goal - Covariance between assets is overlooked - Takes into account mental accounting bias

Lifetime vs. testamentary bequest

Bequeathing assets or transferring assets in some other way upon one's death is referred to as testamentary bequest or testamentary gratuitous transfer The choice between gifting assets during lifetime or after death depends on various considerations including taxation system and expected returns on the asset. Relative value of a gift vs. a bequest FVgift/ FV bequest = (1+r g (1 - t g))^n / (1 +re (1- te))^n(1 - Te) t g is the tax that the donor would pay t e is the tax that the estate pays; Te is the estate tax

analyze bottom-up active strategies, including their rationale and associated processes; (Eq. 2) 17b

Bottom up look for relationships between company level data (i.e. P/E ratio) and what will persist in the future Fundamental investors often focus on one or more of the following parameters: - Business Model and Branding (Companies with superior business models compete successfully, have scalability, and generate significant earnings - Competitive advantages (could be access to natural resources, technology, talent) - Company management and corporate governance (management's role is to allocate resources and maximize growth of enterprise value for the shareholders) Two types of bottom up strategies include both value-based and growth-based approaches Value based approach - Relative value: investors who pursue evaluate companies by comparing their value indicators (i.e. P/E or P/B) to the average valuation of companies in the same industry sector the with the aim of identifying stocks that offer value relative to peers - Contrarian Investing: buying or selling securities against market sentiment. Frequently depressed cyclical stocks with low or even negative earnings or low div. payments - High Quality Value: give valuation close attention but place at least equal emphasis on financial strength and demonstrated profitability. i.e. has consistent earnings power, above average roe etc. - Income investing: focus on high dividend yields and dividend growth - Deep value - focuses on undervalued companies that are available at extremely low valuation relative to the assets (i.e P/B). These companies are often in financial distress - Restructuring: Goal of restructuring is to gain control or substantial influence over a company in distress at a large discount. Restructuring investors seek to purchase debt or equity of companies in distress. - Special Situations: Focuses on mispricings as a result of corporate events such as divestitures or spin offs Growth based approach - GARP - growth at a reasonable price. PEG ratio, P/E / G, looking for a lower value. PEG ratio under 1 you could be getting a bargain - This is a bottom up approach

Bounded rationality

Bounded rationality is a human decision-making process in which we attempt to satisfice, rather than optimize. In other words, we seek a decision that will be good enough, rather than the best possible decision.

discuss the use of credit default swap strategies in active fixed-income portfolio management; 14g (FI II)

CDS contract - Under which a protection buyer purchases credit protection from a protection "seller". Each contract references a specific issuer as well as credit event terms that, when triggered, lead to a settlement payment equal to the LFD multiplied by the notional amount CDS Price = (Fixed coupon - CDS Spread) x EffSpreadDurCDS The most common CDS strategies used are: Single name CDS - Description: protection buyer pays premium to seller in exchange for payment if credit event occurs - Targeted return: Buyer gains and seller loess if single name credit spread widens or credit event occurs - Portfolio impact: Short (buyer) or long (seller) single name credit spread exposure Index based CDS - Description: Protection buyer pays premium in exchange for partial payment if credit event occurs for index member - Targeted return: Buyer gains and seller loses if index member spreads widen or if credit event occurs - Portfolio impact: Short (buyer) or long (seller) index-based credit spread exposure Payer Option on CDS Index - Description: Option buyer pays premium for right to buy protection (pay coupons) on CDS index contract at a future date - Targeted return: Max (CDS Credit Spread Strike - CDS credit spread at expiration, 0) - option premium - Portfolio impact: Short CDS index-based credit spread exposure Receiver Option on CDS Index - Description: Option buyer pays premium for right to sell protection (receive coupons) on CDS index contract at a future date - Targeted return: Max (Credit spread at expiration - CDS credit spread strike, 0) - option premium - Portfolio impact: Long CDS index-based credit spread exposure CDS long-short strategies based on spread level are appropriate for both bottom-up and top-down approaches - For a bottom up, if you believe the credit spread for issuer A is going to narrow and for issuer B is going to widen, then you can sell protection on A, and purchase a CDS on B - For top down, if you believe the economy is worsening you can buy a CDS on high yield bonds and sell protection on investment grade CDS indices of the same tenor - If you are reaching the end of a growth cycle and the curve is flattening amid rising near term rates, you could buy CDS on the short end, and sell on the long end Math Problems behind CDS change in spread. If you have 10M of a 5 year bond with a 5 effspreaddur, and it is going to increase 10 bps at the 5 years level you would want to buy protection: - (- change in CDS spread) (eff spread duration CDS) (CDS Notional) - (10 bps (5) (10,000,000) = 50,000

How do emotional vs. cognitive errors deviate from MVO

Clients with emotional bias tend to show the largest deviation from MVO. I.e. when looking at Friendly follower (cognitive) vs. Passive Preserver (emotional) Least likely to vary from MVO portfolio, would be cognitive, since these biases can be reduced or even eliminated

discuss commonly recognized behavioral biases and their implications for financial decision making; (BF) 1b (Belief Perseverance)

Cognitive Errors can be divided into 5 belief perseverance (tendency to cling to prior beliefs by committing statistical, information - processing or memory errors) biases and 4 processing errors ( information analysis process is flawed) Belief Perseverance Conservatism - Develop an initial view but then fail to change as new information becomes available - Consequences include - slow to update forecast even when presented with new information; hold investment too long because of the mental stress of adapting a new view - May be corrected for or reduced by properly analyzing and weighting new information Confirmation - Look for information that confirms your current POV, distort new info to match your POV, or ignore or undervalue what contradicts - Consequences include: under diversify leading to excessive risk exposure, consider only the positive info, over concentrate in employee stock, set up screens incorrectly to see what they want - May be corrected or reduced by actively seeking out information that changes your beliefs, or additional research in general Representativeness - Belief that the past will persist and that new information is classified based on past experience or classification. Base Rate neglect and sample-size neglect are two types of representative bias. - Base Rate Neglect - When the probability of the initial classification is not adequately considered. I.e. a stock that is initially classified as value but may now be growth - Sample size - neglect - Incorrectly assume that small sample sizes are representative of populations - Consequences include: adopting a view based almost exclusively on new information or a small sample size; update beliefs using simple classifications rather than deal with mental stress of updating beliefs - To counteract the effects of representativeness bias when considering returns, you can look at how asset classes have performed historically Illusion of Control - This is when investors think that they have an oversized role or can control the outcomes when they cannot. (The example is given about rain dances, and humans believing they can control the weather) - Can lead to making more trades than necessary, and not diversifying because they think they have control, and to construct financial models that are overly detailed - To overcome seek contrary view points and keep record, and understand you can't control the market Hindsight Bias - Selective memory of the past, and what was knowable in the past which leads to the individual thinking they are more predictable than they really are. - Can lead to people overestimating the amount that they were right; can cause unfair assessment of a money manager or security performance based on their ability to look back - To guard against hindsight bias, you need to carefully record and examine investment decisions, both good and bad, to avoid repeating past investment mistakes. Education is critical here

Emerging market vs. emerging market debt investor concerns

EM Equity - More fragile economies - Less stable political/ policy frameworks - Weaker legal protections - Generally less fully integrated - Weaker Corp Governance - Weaker Accounting Standards - Inadequate property rights The emerging market debt investor needs to focus on the ability and willingness to pay specific obligations, equity investors in emerging markets face corporate governance risks. Their ownership claims may be expropriated by corporate insiders, dominant shareholders or the government Risks facing EM Bonds include - Inadequate fiscal and monetary policies - Concentration in cyclical industries - Greater Concentration of Wealth; less diverse tax base - Restrictions on trade and capital flows - Less educated and less skilled work force, lower level of industrialization and technological sophistication - Reliance on foreign borrowing, often in hard currencies not their own - Susceptibility to capital flight Common traits of EM: - Fiscal deficit/ GDP > 4%, - Debt/ GDP > 70-80%, - Real GDP Growth <4%, (suggests it is catching up with more advanced economies only slowly if at all) - foreign debt > 50% of GDP - Current Account Deficits > 4% of GDP (Indicates lack of competitiveness) - Reserves < 100% of short term debt - Dependence on commodity exports

Expected Distribution and expected NAV for an alternative investment

Expected distribution = [Prior-year NAV × (1 + Growth rate)] × (Distribution rate); Expected NAV = [Prior-year NAV × (1 + Growth rate) + Capital contributions - Distributions)] × (1 + Growth rate).

Advantages/ Disadvantages between Fixed Annuity and Variable Annuity

Fixed Annuity Advantages • Known and constant income stream • Annuitant sheltered from market risk • Investment performance risk borne by annuity provider • Lower fee cost • Transparent pricing allows comparative shopping among providers Disadvantages • Rate of return fixed at onset • Inflation erodes purchasing power of cash flow • No early access to funds once established Variable Annuity Advantages • May better adjust payout for inflation over time • Performance adjusts to current market environment • Growth within annuity product tax-deferred • Possible to reclaim some assets early Disadvantages • Payout uncertain • Performance risk borne by annuitant • Eventual success depends on asset allocation to subaccounts • Spending may need to be reduced during periods of investment stress • Higher fee cost • Opaque pricing makes comparative shopping difficult

describe considerations affecting the balance sheet management of banks and insurers. (PM Inst. Inv.) 24i

For both banks and insurance companies, the primary overall objective of the company is to maximize the market value of the institution's equity capital with a high level of assurance that the claims of depositors, creditors, and policyholders can be met. General Accounting Equation: Assets = Liabilities + Equities An expression that captures how changes in the market value of assets, liabilities, and leverage levels affect the change in the market value of equity is: %change (E) = %change in A * (M) - %change in L * (M - 1) where: %change in E = percentage change in the value of equity %change in A = percentage change in the value of assets %change in L = percentage change in the value of liabilities M = leverage multiplier, A / E (equity capital ratio) For example if you have a 1% drop in assets with a multiplier of 10, this would result in a 10% drop in equity. DE = DA * (M) - DL * (M - 1)(estimated change in yield of liabilities) where: DE = modified duration of the institution's equity capital DA = modified duration of the institution's assets DL = modified duration of the institution's liabilities M = leverage multiplier, A / E Effects on Asset and Liability Volatility St. dev squared of change in equity = (A/E)^2 (St. dev squared of change in asset) + (A/E -1)^2(St. dev squared of change in liability) - 2 x (A/E)(A/E -1) x correlation (standard dev. of assets) (standard dev. of liability) Moderate differences between DA and DL can imply durations for equity that can be sizable in either a positive or negative direction - The higher the leverage the more critical it is to have DA = DL To decrease asset duration you can either - Increase liability duration - Decrease equity duration To lower DA - Hold cash, foreign reserves or other zero duration assets - Make business loans with floating rates (credit card loans, adjustable real estate loans) - Increase equity ratio by issuing shares To lower DL - Issue intermediate / long -term debt - Use subordinated capital securities - Use futures/ swaps

MVO vs. Reverse Optimization

For the MVO approach, the expected returns of asset classes are inputs to the optimization, with the expected returns generally estimated using historical data.), reverse optimization approach, the expected returns of asset classes are the outputs of optimization with the market capitalization weights, covariances, and the risk aversion coefficient used as inputs.) (The asset allocation weights for the reverse optimization method are inputs into the optimization and are determined by the market capitalization weights of the global market portfolio) (The asset allocation weights for the MVO method are outputs of the optimization with the expected returns, covariances, and a risk aversion coefficient used as inputs.) (The reverse optimization method takes the asset allocation weights as its inputs that are assumed to be optimal. These weights are calculated as the market capitalization weights of a global market portfolio)

Forward rate bias, forward premium, general understanding of carry trade

Forward rate bias = Positive roll yield; Trading the forward rate bias involves buying currencies selling at a forward discount, and selling currencies trading at a forward premium A forward premium is a situation when the forward exchange rate is higher than the spot exchange rate. Carry trade, apparently different from a forward rate bias ( in the text there are two different methods carry trade and forward rate bias): Buy (invest in) the high-yield currency and sell (borrow) the low-yield currency. Carry trade: If you wanted to borrow in USD at 1.85%, and invest in MXN at 7.70%, with the exchange rate stable the expected profit is (1 = .077/4)^4 - (1+ .0185) = 6.08%

discuss the objectives and scope of the GIPS standards and their benefits to prospective clients and investors, as well as investment managers; 35a (GIPS)

GIPS Objectives - Establish global, industry-wide best practices for the calculation and presentation of investment performance, so that performance presentations for GIPS-compliant firms can be compared regardless of their country location. - Facilitate the accurate and unambiguous presentation of investment performance results to current and prospective clients. - Facilitate a comparison of the historical performance of investment management firms so that clients can make educated decisions when hiring new managers. - Encourage full disclosure and fair global competition without barriers to entry. - Encourage self-regulation. Scope Firm from any country may come into compliance with HIPS. Compliance will facilitate a firm's participation in the IM industry on a global level Benefits to managers and clients - the ability to compare the performance of firms operating in different countries with different sets of established practices. - the GIPS provide managers with the ability to compete fairly in foreign markets.

explain requirements of the GIPS standards with respect to presentation and reporting; 35h (GIPS)

GIPS presentation and reporting requirements Standard 5.A.1. The following items must be reported for each composite presented: At least five years of annual performance (or a record for the period since firm or composite inception if the firm or composite has been in existence less than five years) that meets the requirements of the GIPS standards; after presenting five years of performance, the firm must present additional annual performance up to a minimum of ten years. Annual returns for all years clearly identified as gross- or net-of-fees. For composites with a composite inception date beginning on or after January 1, 2011, when the initial period is less than a full year, firms must present returns from the composite inception through the initial year-end. For composites with a termination date of January 1, 2011, or later, returns from the last annual period through the termination date. Annual returns for a benchmark, which reflects the mandate, objective, or strategy of the portfolio. The number of portfolios in the composite at each year-end. If the composite contains five portfolios or less, the number of portfolios is not required. The amount of assets in the composite at the end of each annual period. Either total firm assets or composite assets as a percentage of firm assets at each annual period end. A measure of dispersion of individual portfolio returns for each annual period. If the composite contains five portfolios or less for the full year, a measure of dispersion is not required, in addition you do not need to report the number of portfolios in the composite. For periods beginning on or after January 1, 2011, firms must present for each annual period: a. Three-year annualized ex post standard deviation using monthly returns for the composite and benchmark. b. An additional 3-year ex post risk measure if management feels standard deviation is inappropriate. The firm must match the periodicity of calculated returns used for the composite and benchmark.

How to address asset allocation with less liquid asset, i.e. should they be excluded? What to do with PE, RE and items that aren't very liquid when running an MVO, less liquid items should be excluded when running, or you can attempt to model their returns

Less liquid asset classes such as real estate and private equity require a liquidity return premium to compensate the investor for the liquidity risk - These asset classes are difficult to include because there are few indexes to track them, thus it is more challenging to make capital market expectations - Even when indices exist they are typically not investable - Due to the illiquid nature it is widely believed that the indexes don't accurately reflect their true volatility In addressing asset allocation involving less liquid asset classes, practical options include the following: - Exclude these asset classes when running an MVO - Include less liquid asset classes in the AA decisions and attempt to model the inputs to represent the specific risk characteristics associated with the likely implementation vehicles - Include less liquid asset classes in the AA decisions and attempt to model the inputs to represent the highly diversified

Macro vs. Micro Attribution

Micro Attribution - understanding the drivers of a manager's returns and whether those drivers are consistent with the stated process Macro attribution - conducted to evaluate the asset owner's (sponsor's) tactical asset allocation and manager selection decisions - To use an example a DB plan decides to allocate a given percentage to certain asset classes - Macro attribution measures the effect of the sponsor's choice to deviate from the strategic asset allocation - Micro attribution measures the impact of the selected manager's allocation and selection decisions on fund performance

Discuss the purpose, scope, and process of verification; 35k (GIPS)

Once a firm claims compliance with the GIPS, it is responsible for its claim of compliance and for maintaining its compliance. In doing so, the firm may voluntarily hire an independent third party to verify its claim of compliance, which adds credibility to the firm's claim of compliance. The primary purpose of verification is to increase the level of confidence that a firm claiming GIPS compliance did, indeed, adhere to the Standards on a firm-wide basis. Verification involves the review of an investment management firm's performance measurement processes and procedures by an independent third-party verifier. Upon completion of verification, a verification report is issued that must confirm the following: - The investment firm has complied with all the composite construction requirements of GIPS on a firm-wide basis. - The firm's processes and procedures are designed to calculate and present performance results in compliance with the GIPS. Without such a report from the verifier, the firm cannot assert that its claim of compliance with GIPS has been verified.

Passive Hedging vs. Discretionary vs. Active Currency Mgmt

Passive Hedging (matches index), Discretionary hedging (deviate modestly from benchmark), Active currency management (broad variance from benchmark)

Joint life vs. life w refund vs. life with period certain

Payout Methods - the primary payout methods are summarized: - Life annuity - Payments are made for the entire life of the annuitant, and cease at his/ her death - Period certain annuity - Payments made for a specified period of time - Life annuity with period certain - Payments are made for the entire life of the annuitant but are guaranteed for a minimum number of year even if the annuitant dies - Life annuity with refund - Individual is guaranteed to receive payments equal to amount paid in - Joint life annuity - Payments continue until both members are no longer living

Principal vs. Broker vs. high touch

Principal trades - the executing broker assumes all or part of the risk related to trading the order, pricing it in her quoted spread; in general trading in larger blocks of securities requires a higher-touch approach - Crossing an order with a broker's own book is known as a broker risk trade or principal trade Large block trades and not urgent or very illiquid, agency trade is appropriate Agency trades - broker is engaged to find the other side of the trade but acts only as an agent - Tries to cross match with other clients orders Large urgent trades are generally implemented as broker risk where risk is transferred to the broker who takes the contract into his inventory large & urgent trades - principal trades Non - urgent trades - agency trades Small trades are usually implemented using DMA. DMA allows buy-side portfolio managers/traders to access the order book of the exchange directly through a broker's technology infrastructure.

describe factors that typically determine the selection of a trading algorithm class; (Trade, Per., Eval.) 25e

Principal trades - the executing broker assumes all or part of the risk related to trading the order, pricing it in her quoted spread; in general trading in larger blocks of securities requires a higher-touch approach - Crossing an order with a broker's own book is known as a broker risk trade or principal trade Large block trades and not urgent or very illiquid, agency trade is appropriate Agency trades - broker is engaged to find the other side of the trade but acts only as an agent - Tries to cross match with other clients orders Liquid, standardized trades with order driven markets - Trading done electronically with multiple venues - For trades other than large orders Algorithmic trading - computerized execution of the investment decision following a specified set of instructions, typically slices orders into pieces and trades across venues - Is well established in most equity, foreign exchange, and exchange traded derivative markets - In fixed income, algorithmic execution is mostly limited to highly liquid government securities - Trading algorithms are typically used for two purposes - trade execution and profit generation Profit seeking Algorithms - Determines what to buy and sell and then implements these decisions in the market as efficiently as possible Execution algorithm Classifications 1. Scheduled algorithms - Scheduled algorithms are appropriate for relatively small orders in liquid markets for managers with less urgency and/or who are concerned with minimizing the market impact. - PM generally also has no expectation of momentum, and has a greater tolerance for longer execution when using scheduled algos POV - Sends orders following a volume participation schedule - As trading volume increases in the market these algorithms will trade more shares - Investors specify participation rate, i.e. if they only want 10% of the market volume until completion while POV algorithms incorporate real-time volume by following (or chasing) volumes, they may not complete the order within the time period specified. - POV relies on current market data, while VWAP is on historical trends VWAP - Slice order into smaller amounts to send to the market following a time slicing schedule based on historical intraday volume profiles - These typically are higher at the open and the close - Following a fixed schedule as VWAP algorithms do, however, may not be optimal for certain stocks because such algorithms may not complete the order in cases where volumes are low. - VWAP is unsuitable when: urgency is high, order size is a large percent of volume, large bid ask spread. - low spread, low % of adv, not urgent = VWAP - TWAP - TWAP will send the same number of shares and the same percentage of the order to be traded in each time period. - This helps ensure the specified number of shares are executed within the specified time period 2.Liquidity Seeking Algorithms - - Trade faster when liquidity exists at a favorable price - These algorithms may trade aggressively with offsetting orders when sufficient liquidity is posted on exchanges. - They may use dark pools and trade large quantities in dark venues when liquidity is present - Appropriate for large orders that the PM would like to execute quickly without substantial impact 3.Arrival Price - Seeks to trade close to current market prices at the time the order is received for execution - Will trade more aggressively at the opening, known as a front loaded strategy - Used for orders where the trader believes the prices are likely to be unfavorable during the trading horizon - Best when the security is relatively liquid and the order is not expected to have significant market impact 4.Dark Strategies - Execute shares away from lit markets, and instead execute in opaque, or less transparent, trade venues, such as dark pools - Used when PMs are concerned with information leakage and when order size is large/ VWAP or arrival price would lead to significant impact - Dark strategies are also appropriate for securities that are illiquid with wide bid ask spreads - PM does not require full execution Smart Order Routers - Determine how best to route an order given prevailing market conditions. SOR will determine the destination with the highest probability of executing the limit order and the venue with the best market price - Market orders - SOR are best used for orders that require immediate execution because of imminent price movement - Appropriate for securities traded on multiple markets (otherwise there wouldn't be any smart order routing) - Appropriate for small orders Small trades are usually implemented using DMA. DMA allows buy-side portfolio managers/traders to access the order book of the exchange directly through a broker's technology infrastructure.

describe returns-based, holdings-based, and transactions-based performance attribution, including advantages and disadvantages of each; (Trade, Per., Eval.) 26d

Returns based attribution - regressions are used to analyze the performance over some period. No attempt is given to identify the holdings - Most appropriate when underlying portfolio information is not available - Easiest to implement and least accurate Holdings based attribution - Returns based won't take into account any changes in that were made after the initial period so could be good in identifying style drift - All transactions are assumed to occur at end of day - Accuracy improves when data has shorter time intervals - Returns-based attribution is the least accurate of the three attribution approaches. This technique does not use underlying holdings and is most vulnerable to data manipulation Transactions based - improves upon the holdings based returns by adding any subsequent trades. This is the most reliable of the trading measures - Difficult and time-consuming to implement - Most accurate

discuss methods of forecasting volatility; (Econ) 4g

Sample Statistics - (estimating a constant VCV matrix computed from historical return data), this is subject to substantial sampling error given typical small sample sizes VCV Matrix from Multi Factor model - based on sensitivity to the factors, and the covariance between the assets (will contains less estimation error than using small historical samples, will also improve cross sectional consistency, and will handle a large number of assets). Shrinkage estimation of VCV matrices - Combine the sample VCV matrix with an alternative estimate, the target VCV matrix, which reflects assumed "prior" knowledge of the structure of the VCV matrix, and thereby mitigate the impact of estimation errors. Estimating volatility from smoothed returns (i.e. RE, PE, HF) - Observed returns are a weighted average of current and past true unobservable returns. - The simplest and most widely used models implies the current observed returns are a weighted average of the true return and the previous observed return. Time varying volatility - ARCH models Financial asset returns tend to exhibit volatility clustering with periods of high and low volatility. ARCH models have been developed to address this.

Surplus Optimization vs. Two Portfolio

Surplus optimization links assets and the pv of liabilities through a correlation coefficient, the two portfolio model doesn't Surplus optimization results in a single portfolio whereas two portfolio approach leads to two portfolios. In particular it yields a conservative portfolio to hedge the liabilities and a more aggressive growth portfolio to increase returns

describe technical and soft skills needed in advising private clients; (PWM 1) 21f

Technical Skills - represents the specialized knowledge and expertise necessary to provide investment advice to private clients. They include: - Capital Market Proficiency (PWM requires an understanding of capital market dynamics as part of helping clients achieve their financial goals) - Portfolio Construction Ability (need to be able to construct portfolios that are appropriate for each situation i.e. understand each asset classes' risk/ returns/ correlations) - Financial Planning Knowledge (Working knowledge of estate law, taxation and insurance; Wealth managers are typically not experts in specialized financial planning, however these fields are highly relevant) - Quantitative Skills - Technology skills (Use of optimization software, modeling simulation tools) - Language Fluency (I.e. with a multinational client base) Soft skills - typically involve interpersonal relationships i.e. the ability to effectively interact with others - Communication skills (Begins with active listening and then asking the right questions) - Social Skills (Ability to understand and relate to others and demonstrate empathy) - Education and Coaching Skills (educate clients about the wealth management process) - Business Development and sales skills

DB vs. DC (benefit payments, contributions, shortfall risk, mortality/ longevity)

The DB plan pools mortality risk such that those in the pool who die prematurely leave assets that help fund benefit payments for those who live longer than expected. The individual bears the risk of outliving her savings with the DC plan.; The shortfall risk of plan assets being insufficient to meet her retirement benefit payments falls to her employer, ith the DB plan. However, for the DC plan, the shortfall risk falls to her; DC plan provides an uncertain benefit based on the company's and the employees contributions as well as the investment performance of the plan assets

Formula for market value of equity and formulas for labor productivity and labor inputs

The growth rate in the aggregate market value of equity is expressed as a sum of the following four factors: (1) growth rate of nominal GDP, (2) the change in the share of profits in GDP, (3) the change in P/E, and (4) the dividend yield. The growth rate in the aggregate market value of equity, for long term note that P/E and change in percentage of GDP go to zero The growth rate of nominal GDP is the sum of the growth of real GDP and inflation. The growth rate of real GDP is estimated as the - sum of the growth rate in the labor input and - the growth rate in labor productivity. growth from labor inputs (Number of workers and hours they work), - growth in potential labor force size and - growth in actual labor force participation, growth from labor productivity, - growth from increasing capital inputs and - growth in total factor productivity (TFP) (this is synonymous with technological improvement)

How to calculate/ estimate the illiquidity premium for alternative investments

The illiquidity premium (also called the liquidity premium) is the expected compensation for the additional risk of tying up capital for a potentially uncertain time period. It can be estimated, by using the idea that the size of a discount an investor should receive for such capital commitment is represented by the value of a put option with an exercise price equal to the hypothetical "marketable price" of the illiquid asset as estimated at the time of purchase. You can derive the price of the illiquid private equity asset by subtracting the put price from the "marketable price." If both the "marketable price" and the illiquid asset price are estimated or known, then the expected return for each can be calculated, with the difference in expected returns representing the illiquidity premium (in %). What they are proposing is the illiquidity premium is represented by the value of the put option on the asset where the strike price is equals to $100 (i.e. the marketable price). So, let's say the value of the put option is $5. You can interpret the $5 as the illiquidity premium (i.e. the minimum compensation the investor requires to invest in the illiquid asset, X). Hence, the price of X should be $100 - $5 = $95. Or, you can also think of the $5 as an insurance premium that the investor is willing to pay to convert an illiquid asset into a liquid asset (protection against price dropping below $100).

describe global considerations of jurisdiction that are relevant to taxation; (PWM 1) 22b

The main types of tax systems we find internationally fall into three broad categories: Tax Haven - Is a country or independent area with no or very low tax rates for foreign investors. - Cayman Islands is a well-known one, with no tax on income or capital gains, no tax on property holdings, and no corporate taxes Territorial tax systems (Source Jurisdiction) - Where only locally sourced income is taxed - a country levies taxes on all income generated within its borders, whether by citizens or foreigners Worldwide tax systems, which may be based on either citizenship or residency - All income taxed regardless of its source. - May result in double taxation (tax treaties or tax credits may exist) Generally impose those taxes on individuals considered to be residents of that country, residence rules become very important

discuss major approaches to forecasting exchange rates; (Econ) 4f (Focus on Capital Flows)

Three important considerations to look at are Capital Mobility - - The expected percentage change in the exchange rate can be computed as the difference between nominal short-term interest rates and the risk (i.e. term, credit, liquidity, equity) premiums of the domestic portfolio over the foreign portfolio. - When there is a relative improvement in investment opportunities in a country, the currency initially tends to see significant appreciation but "overshoot". In theory, the exchange rate will jump to a level where the currency where the currency with the higher risk adjusted expected return will be so strong that it will depreciate going forward. Uncovered interest rate parity (UIP): - UIP states that exchange rate changes should equal differences in nominal interest rates. The higher yielding currency should depreciate by the difference in expected return. Portfolio balance and composition: Strong economic growth in a country tends to correspond to an increasing share of that country's currency in the global market portfolio. Overall capital is likely to flow into the currencies of countries in the strongest phases of the businesses cycle.

Which is better SMA or pooled for: Transparency, Investor Behavior, Cost, Liquidity, Tracking risk)

Which is better SMA or pooled for: Transparency (SMA), Investor Behavior i.e. investor micromanagement (Pool), Cost (Pool), Liquidity (SMA, investor owns securities and is not influenced by redemption of others), Tracking risk (Pool, since SMA can customize this increases tracking risk, so pool is better)

distinguish between Active Share and active risk and discuss how each measure relates to a manager's investment strategy; (Eq. 2) 18c

distinguish between Active Share and active risk and discuss how each measure relates to a manager's investment strategy; (Eq. 2) 18c Active risk is the standard deviation of the differences between a portfolio's returns and its benchmark's returns. It is also called tracking error or tracking risk. - Active Risk is affected by degree of cross correlation, active share is not - Manager can completely control active share, but cannot control active risk because it depends on the correlations and variances of securities beyond her control - Active risk increases when a portfolio becomes more uncorrelated with its benchmark - High net exposure to a risk factor will lead to a high level of active risk The Active Share calculation involves no statistical analysis or estimation; it is simple arithmetic. The equation is ½ x absolute value of the (sum of weight of portfolio of security i - weight in benchmark of security i ) If a portfolio has an Active Share of 0.5, we can conclude that 50% of the allocation positions of this portfolio are identical to that of the benchmark and 50% are not. Active share would be 0 for an index. Active Share measures the extent to which number and sizing of positions differ from benchmark. There are only two sources of Active Share: - Including securities in the portfolio that are not in the benchmark - Holding securities in the portfolio that are in the benchmark but at weights different than the benchmark weights An index fund would have 0 for active share and active risk, while a concentrated stock picker would be closer to 1

Butterfly spread and yield curvature

Butterfly spread (yields) - -2 year + 2x 10 year - 30 year Yield Curvature strategies - Negative butterfly (expect lower ST, LT yields, and higher medium) (active position: short bullet long barbell) - Positive butterfly (expect higher ST, LT yields, and lower medium) (active position: long bullet short barbell) Yield curvature - When the curvature increases, middle rates go up and/or the end rates (ie ST and LT) go down. Likewise, when the curvature decreases, the middle rates go down and/or the end rates go up Negative Butterfly spread - short the wings, long the body Yield Curvature strategies - Negative butterfly shift/twist (expect lower ST, LT yields, and higher medium) (active position: short bullet long barbell) - Positive butterfly shift/ twist (expect higher ST, LT yields, and lower medium) (active position: long bullet short barbell)

Effective Beta

Effective Beta - Usually done after you have adjusted the beta of the portfolio, to show what the actual beta move was. I.e. if you went up 2.2% vs. 2% for the market that would represent 1.1 Beta - You'll calculate the return on the actual stock index you own, and then calculate the change in value of the swap/ etc. you have. This is then compared to the original market value

discuss approaches to asset allocation to alternative investments; (Alts.) 20f (Skewness and Kurtosis, when to use mean cvar vs. mvo for a new investor)

Kurtosis - Excess kurtosis (taller peaks, fatter tails, more outlier events), Positive skewness (Mean > median, less chance of a downside risk) - Unsmoothed Alts frequently are negatively skewed and have excess kurtosis based on 20 year of data from 97-17 - Higher kurtosis or more negative skewness usually increases the severity of tail risk. Observed cVAR typically exceeds normal distribution based cVAR when kurtosis is high and skewness negative. - The non-normal distributions present challenges - To address analysts can: adjust the observed return by unsmoothing, determine whether a normal assumption is appropriate (in which case you can use MVO), choose an optimization approach that takes tail risk into account Mean variance optimization - This can produce an overweight to alternative investments if the smoothed returns are not accounted for - Investors should consider the asset allocations to be a guideline in the context of their liquidity requirements - With unconstrained portfolios, allocations to cash and fixed income dominate at the lower end and PE becomes the dominant for high risk - With constraints you get a more diversified allocation Mean CVar Optimization - When concern is about downside risk of a proposed SAA, risk objective may be to minimize cVar rather than volatility for a given return target When to use Mean Cvar vs. Monte Carlo, blue box suggests, MVO for someone with limited investment experience, to illustrate potential ups and downs Risk factor optimization - Similar to MVO but instead of asset classes, the investor is modeling risk factors - A risk factor based approach requires the additional step of translating the risk exposure to allocations. Conditional Value at Risk (CVaR) quantifies the scale of expected losses once the Value at Risk (VaR) breakpoint has been breached

discuss how levels of service and range of solutions are related to different private clients. (PWM 1) 21p

Mass affluent segment (250k - 1M) - Many different clients for each advisor - Characterized by the use of a lot of technology in account creation, and reporting - Wealth managers don't tend to tailor their portfolios in this segment - Compensation can be based on commissions or fees (AUM) High Net Worth (1M- 10M) - At this point you're more likely to focus on tax planning or estate planning - These portfolios have more sophisticated strategies - Typically are involved with longer timelines Ultra-High Net Worth (50M+) - Typically have to be managed by a team of experts including, tax, legal, and investments - Focus on multigenerational wealth and will have more comprehensive services and lower client to manager ratio because of the need for highly customized service - Other services: bill payment, travel planning, advice on acquiring assets such as artwork/ wine Robo Advisors - These are more automated and can be scaled a lot more quickly - They gather client information using online questionnaires - Client's portfolio is constructed with ETFs or mutual funds Will also monitor and rebalance as needed

Seagull Spread Derivs

Seagull Spread - An option structure with at least 3 individual options, and in which the most distant strikes (the wings), are on the opposite side of the middle strike (the body) A bullish seagull strategy involves a bull call spread (debit call spread) and the sale of an out of the money put. The bearish strategy involves a bear put spread (debit put spread) and the sale of an out of the money call.

Return on Domestic Currency

- Return on domestic currency = (1+ return on foreign currency) (1+ percent change of the foreign currency against the domestic currency) - Rdc = Rfc + Rfx (approximation removing the 1+) - Domestic asset - is an asset that trades in the investor's domestic currency. From a PM's perspective the domestic currency is the one in which portfolio valuations are reported. Foreign assets are assets denominated in currencies other than the investors

Risk tolerance vs. risk perception vs. risk capacity (PWM)

- Risk Tolerance - client's willingness and ability to take risk - Risk capacity - private client's ability to accept financial risk based on client's wealth income and investment horizon. Risk capacity is more objective in nature than risk tolerance. Capacity is determined by wealth, income etc., while tolerance is more of an attitude. - Risk perception - how a client perceives the riskiness of an investment decision or the investment climate

Social proof vs. herding Behavioral biases and questionnaires and education

- Risk questionnaires generally fail for emotionally biased individuals and work best for institutional investors, they are generally effective for cognitive based individuals - Education generally more effective for cognitive while, while moderation of biases to adopt a program to reduce or eliminate the bias, rather than accept is better for emotional

Time Series vs. cross series momentum (Alrs)

- Time Series Momentum - buy securities that have been rising and sell those that have been falling - Cross Sectional Momentum - This is done within a particular asset class. looking at a specific sector and going long the top 50% that have appreciated, and short the bottom 50% who haven't, holds a net zero position typically

When given multiple goals to achieve with portfolios with varying % of success

- Trying to attain two goals, when given two different portfolio with different returns per %, i.e. 80% certainty; you'll be given time horizons, so you will first match the highest value for each time horizon with one portfolio - You would then take the value you need from one portfolio and discount it back by the return at that confidence level.

Delta and theta

- When the share is ATM the delta is approximately .5 (for a call), and -.5 (for a put). ITM calls have a delta approaching 1, while ITM puts delta approaches -1 - The theta of the short stock/long call position is negative and is exposed to time decay. The theta for the short stock/short put position is positive and benefits from time decay.

Free float adjustment (Equity)

A free-float adjustment factor is introduced in the float-adjusted market-capitalization weighting. It represents the proportion of shares that are free-floated as a percentage of issued shares. The index therefore does not include restricted stocks. The indexes which considers market capitalization of company stocks as they are available for trading. Closely held, and cross held shares and illiquid stocks are removed from counting as these shares are not available for buy and sell.

A well constructed efficient portfolio

A well-constructed portfolio should have the characteristics promised to investors in a cost and risk efficient manner. The well-constructed portfolio possesses: - Clear investment philosophy and consistent investment process - Risk and structural characteristics as promised to investors - Risk- efficient delivery methodology - Reasonably low operating costs given the strategy Funds aiming to deliver different required characteristics will have different well-structured portfolios. The following general points can be made about portfolios that have the same desired characteristics: - Portfolios that can achieve desired risk exposures with fewer positions are likely to have more focus on risk management in the portfolio construction process. - If two portfolios have similar risk factor exposures, the product with lower active risk and the lower absolute volatility (Q bank seems to rank active risk as the more important metric) will likely be preferred (assuming similar costs). - Also will have low idiosyncratic risk i.e. low unexplained risk If two portfolios have similar active and absolute risks, similar costs, similar manager alpha skills, then the portfolio with the highest Active Share is preferable because this will leverage the alpha skill of the manager and have higher expected return. In summary Risk efficient Portfolio - - lowest active risk, - lower number of securites, - high active share, - low portfolio volatility, - low idiosyncratic risk (i.e. low unexplained risk)

Annuity Puzzle vs. consumption gap (PWM)

Behavioral Considerations - Increased loss aversion - unlike younger investors older people tend to be more loss averse - Consumption gaps - Retirees consumption tends to be lower than what is forecasted by studies due to loss aversion - Annuity Puzzle - While annuities tend to help mitigate longevity, individuals tend not to prefer to invest in annuities - Preference for investment income over capital appreciation - People tend to spend dividends rather than sell shares of securities.

Bull/ Bear Flattener and yield curve strategies to increase/ decrease duration (FI)

Bull (decrease in rates level), Bear (Increase in rate level) Bear Steepener (LT YTM rises more than ST YTM) - You want net negative duration position (reduce long pos. add to short pos.) Bull Steepener ( ST rates fall more than LT yields to maturity if monetary authority cuts benchmark rates to stimulate economic activity during recession) Yield Curve Steepener Strategies - Duration neutral (portfolio gain from yield curve slope increase) - Bear Steepener - net negative (short) duration (Portfolio gain from slope increase and/ or rising yields) - Bull steepener - Net positive (long) duration (Portfolio gain from slope increase or lower yields) Bear Flattener (if policy makers respond to inflation and higher LT rates by raising ST policy rates) Bull Flattener - caused by flight to quality as long term rates fall more than ST rates (during this you would buy convexity, increase duration, roll down the yield curve) Yield Curve Flattener Strategies - Duration neutral - net zero duration position (portfolio gain from yield curve slope decrease) - Bear Flattener - you want net negative duration position (Portfolio gain from slope decrease and/ or rising yields) - Bull Flattener - you want net positive duration position ( Portfolio gain from slope decrease or lower yields) Major Yield curve Strategies to increase portfolio duration - Cash bond purchase (buy-and-hold strategy to increase duration) (Extend duration with longer-dated bonds) - Receive Fixed Swap - Swap MTM gain plus carry - Long futures position - Futures MTM gain - margin cost Major Yield Curve strategies to reduce duration - Cash bond sale - Pay Fixed Swap - Swap MTM gain plus carry - Short futures position - Futures MTM gain - margin cost

Caps rates formula, and cap rates for low quality vs. high q properties, and level of interest rate vs. cap rates

Capitalization rate- Net Operating Income/ Property value - When an infinite time period is observed: E (Rre) = Cap rate + NOI Growth rate - Over finite horizons: NOI/ price + NOI growth rate - change in (NOI/ P) - A decline in NOI/ P is generally a good thing, as the price will be increasing - Cap rates are higher for low quality properties, and lower for high quality properties - What puts downward pressure on cap rates: narrowing credit spreads, low central bank rates, availability of credit - Cap rates are pro cyclical with interest rates, rising and falling with the level of average yields, increased levels of debt, and widening credit spreads lead to higher cap rates Real estate assets require several risk premiums including: - Liquidity risk (considered to be 2 to 4% for commercial real estate) - Term Premium - long lived asset, very sensitive to level of long term rates - Credit Premium to account for risk of non-payment - Equity risk premium above corporate bond returns, since the owner bears the full brunt of fluctuations in property values - Risk Premium is higher than that of Corporate Bonds but lower than those of equities REITs have a relatively high correlation with equities in the short run and tend to act like real estate in the long run Delevered REITs are much more similar to direct real estate returns than levered real estate returns Industrial REITs had the lowest return and highest volatility. Retail REITSs had the highest return and second lowest volatility.

explain the relationship of inflation to the business cycle and the implications of inflation for cash, bonds, equity, and real estate returns; (Econ) 3g

Cash - As long as ST interest rates adjust with expected inflation, cash is essentially a zero-duration, inflation protected asset that earns a floating rate (think of a 30 day commercial paper that is continually reinvested) - Cash is unattractive in a deflationary environment, unless a "zero lower bound" is binding on the nominal interest rates Bonds - inf. as expected -> short term rates and bonds yields will rise with expectations - inflation above expected -> the yield curve will steepen not flatten, as investors reassess the likelihood of a change in the long run average of inflation - Rising inflation erodes the purchasing power of a bond's future (fixed) coupon income, reducing the present value of its future fixed cash flows - deflation -> positive for highest quality bonds because it increases purchasing power of cash flows, negative impact for lower quality debt, impairs their credit quality Stocks - at expectation - little effect, both expected cash flows and discount rates move in line with inflation expectations - higher inflation - negative unless company has pricing power; could mean that the central bank needs to act to slow the economy - lower inflation - threatens a decline in asset prices, especially detrimental for asset-intensive commodity producing and or highly leveraged (debt does not deflate) firms Real Estate - Higher-than-expected inflation is likely to coincide with high demand for real estate, expectations that rental income will rise even faster than general inflation, and rising property values - unexpectedly low inflation (or deflation) will put downward pressure on expected rental income and property value, especially for sub prime properties

discuss investment characteristics, strategy implementation, and role in a portfolio of relative value hedge fund strategies; (Alts.) 19d (Setting up convertible bond

Convertible bond Arbitrage - Convertible bonds are fixed income debt securities that make regular coupon payments but can be exchanged for the underlying equity - You purchase the convertible security and then sell short the stock - Significant amounts of leverage are usually needed to implement these strategies because of the money legs needed to implement convertible arbitrage trades - This strategy performs best when there is liquidity available, modest volatility, and when there is a good selection of bonds - Perform best when convertible securities issuance is high, general market volatility is moderate, and the liquidity to trade and adjust positions is ample - HF: Shorting Selling - Short squeeze and have to find securiteis to lend; Credit issues: securities have exposure to credit risk; Time decay of call, as it drags on and securities don't move; Vol. - may face redemptions during periods of high volatility

prepare the investment objectives section of an institutional investor's investment policy statement; (PM Inst. Inv.) 24f (Sovereign Wealth)

Development - - Established to allocate resources to priority socio-economic projects, usually infrastructure - Help support a nation's LT economic development with ultimate goal of raising a country's economic growth - achieve a real rate of return in excess of real GDP or productivity growth - Asset Allocation - invest in local infrastructure projects (Low liquidity needs); Savings - - Intended to share wealth across generations by transforming non-renewable assets into diversified financial assets - maintain purchasing power of the assets in perpetuity while achieving investment returns sufficient to sustain governmental activities - Asset Allocation - Long horizon so relatively high allocations towards equities and alternative investments (Low liquidity needs) Reserve - - Intended to reduce the negative carry cost of holding reserves or to earn higher return on ample reserves - achieve a rate of return over what government pays on their stabilization bonds - Asset Allocation - similar to savings with lower allocation to alternatives due to liquidity needs Pension Reserve - - Meet future unfunded pension, social security, and/ or health care liabilities of the plan participants - earn sufficient returns to maximize likelihood of meeting unfunded pension, social security, and/or health care liabilities of plan participants (Largest Equity allocation of the 5) - Asset Allocation - high allocation to equities and alternatives due to long horizon (liquidity varies between accumulation and decumulation stages) Budget stabilization - - Insulate budget and economy from commodity and external shocks - Capital Preservation; returns in excess of inflation, with a low probability of a negative return in any year - Asset Allocation - majority in government bonds and other debt securities due to defensive nature

describe the roles of equities in the overall portfolio; (Eq. 1) 15a (Impact vs. thematic)

ESG: Negative screening, practice of excluding certain sectors or companies, positive screening: identify companies that score most favorably Thematic investing: focuses on investing in companies within a specific sector or following a specific theme: energy efficiency, climate change. Impact Investing: seeks targeted social or environmental objectives along with measurable finance returns through direct investment in companies.

Market vs. Production Activity (Equity)

Economic Activity There are two major classifications either the market oriented approach and the production approach - Market oriented - groups companies based on the markets they serve, the way revenue is earned and the way customers use companies products. - A production oriented approach groups companies that manufacture similar products or similar inputs in their manufacturing process - Advantages of econ activity: PMs may also obtain better industry representation by segmenting their equity universe according to economic activity - Disadv.: The business activities of companies may include more than one industry or sub-industry

Economic Balance Sheet (PWM)

Economic Balance Sheet = human capital + financial capital Human capital is the net present value of an investor's future expected labor income weighted by the probability of surviving to each future age - One simple approach is to use a discount rate that reflects the risks associated with the future cash flows (i.e. wages) - Government employment and teaching are examples of stable growth - Higher risk employment requires a higher discount rate Human capital can be calculated by using the following formula: ((probability of surviving to year t)(Income in period t-1)(1 + annual wage growth rate))/ (1 + rf + risk premium associated with income volatility) - Viewing human capital as an asset with its own risk and return characteristics allows us to develop a holistic investment strategy that includes tangible and intangible assets Financial capital includes the tangible and intangible assets (outside of human capital) owned by an individual or household. It can be subdivided into various components such as personal assets (cars, clothes, not expected to increase in value) and investment assets (stock, bonds etc.).

discuss investment policy of institutional investors; (PM Inst. Inv.) 24b (Norway, Endowment etc)

Endowment model - High Allocation to alternatives - Significant active management - Externally managed funds - Difficult to implement for small inst. Investors as they might not be able to access high quality managers Canada pension plan - High allocation to alternative - Internally managed assets - Significant active management Liability driven - The primary investment objective is to generate returns sufficient to cover liabilities - As such the focus is on maximizing surplus (Assets - liabilities) and managing surplus volatility - In some LDI implementations, institutional investors separate their portfolios into a hedging portfolio and a return generating portfolio Norway fund - Passively managed 60/40 with little to no alts Advantage is low fees, while the disadvantage is limited potential for value-add above market returns

Financial Stage of Life (PWM)

Financial Stages of Life Education - Little emphasis on saving or risk management largely on knowledge accumulation - In some cases an individual in the education phase may be largely financially dependent on his parents Early Career (generally lasts to mid 30s) - Begins when an individual has completed his or her education and enters the workforce - Savings can be difficult at this stage, and life insurance may be needed to insure HC again death - Individual often marries and has kids Career Development (35-50) - Financial obligations can increase to fund educations of children - Often a time of upward mobility and income growth - Retirement savings begin to accumulate at a rapid pace Peak Accumulation (50-60) - Most people have reached or are moving toward maximum earnings and have the greatest opportunity for wealth accumulation - Greater emphasis on portfolio stability and less emphasis on growth - Great concern about tax strategies - Career risk is a factor as it can be difficult to find equivalent employment in the event of job loss Pre-Retirement (61-65) - Emphasis still on accumulating FC for retirement, and reducing investment risk - May restructure their portfolio to reduce risk and look for investments that are less volatile - Further emphasis on tax planning, including the ramification of retirement plan distribution options Early Retirement (first 10 years of retirement) - Portfolio emphasis on making sure that it will last into retirement - Primary objectives is to find activities that provide enjoyment and possibly look for another job Later Retirement Individuals have longevity risks. Risks of outliving their assets. May have items such as health care issues

demonstrate how interest rate swaps, forwards, and futures can be used to modify a portfolio's risk and return; (Derivs.) 9a (Fixed Income Futures & BPV)

Fixed Income Future (Cheapest to Deliver Bonds) - Portfolio managers that want to hedge the duration risk of their bond portfolio use fixed-income futures - In the case of delivery the seller has the obligation to deliver and the right to choose which security to deliver. - Thus the price sensitivity of the bonds future will reflect the CTD bond - A conversion factor, that when multiplied by the futures settlement price will generate a price at which the deliverable bond will trade, is used - A bond with a low coupon rate, long maturity, and thus a long duration will most likely be the CTD Fixed Income Futures (Hedge Ratios) - Hedging the CTD bonds: Hedge Ratio = (change in portfolio value/ change in CTD bond) * Conversion Factor - Target BPV = MDur target x .01% x MV portfolio - You could use the same formula for BPV of the portfolio/ CTD etc. - BPV of hedge ratio = [(BPV target/ BPV Portfolio)/ (BPV CTD)] * Conversion Factor With these formulas you could easily first have to calculate the BPV of the bond, and then plug it into the BPV of the hedge ratio equation

describe and interpret a model for fixed-income returns; (FI 1) 11d

Fixed income assets can be viewed as having five components - Income Yield: Annual coupon payment/ current bond portfolio price - Rolldown Return: Bond Price end of horizon - Bond price at beginning of horizon/ bond price at the beginning of the horizon The first two can be called the rolling yield - Expected gains / losses vs. investor's currency - View of Benchmark Yields: (- modDur x change in yield) + (1/2 x convexity x yield squared) - View of yield spreads: (-ModDur x change in spread) + (1/2 x convexity x change in spread squared) The price return is the rolldown return + change in price ( i.e. (- modDur x change in yield) + (1/2 x convexity x yield squared) Limitations - Only uses duration and convexity to summarize the price - yield relationship Assumes all intermediate CFs are reinvested at the yield to maturity

Rule Based vs. Transparent vs. Investable

For an index to become the basis for an equity investment strategy it must meet three initial requirements: Rules based - The rules for inclusion/ exclusion/ weighting / frequency of rebalancing must be consistent so that investors can replicate Transparent - The rules have to be publicly stated and clear to understand Investable - Investors can replicate the return and risk of the index, i.e. the FTSE 100 may be easy to purchase the components while a fund of funds index may be difficult because you would need to buy the underlying HFs - Many indexes require that stocks have float (shares available for public purchase) and average shares traded above a certain percent of shares outstanding

discuss approaches to setting expectations for fixed-income returns; (Econ) 4a

Forecasting FI can be done through one of three methods DCF - Yield to Maturity (YTM) is an estimate of the expected return. Where YTM is the rate which would make the future bond cash flows when discounted back equal to the bond's price - For a portfolio of bonds, the YTM is the weighted average YTM of all of the bonds Why realized return might not equal YTM - The investment horizon is shorter than the amount of time until the bond's maturity - The cash flow may be reinvested at rates above or below the initial YTM. The longer the return the more sensitive to reinvestment risk Building Block Approach Short Term default free rate In principle, the short-term default-free rate is the rate on the highest quality, most liquid instrument with a maturity that matches investment horizon Term Premium Four Main Drivers - Higher Inflation levels, lead to high uncertainty which causes rates to rise and the premium to increase - Assets who perform well when the economy is weak earn a low or negative risk premium - The relative supply of short and long term default free bonds determines the slope of the yield curve - Cyclical Effects: The slope is also related to the business cycle Credit Premium Bonds with high credit quality have low default rates, and their biggest risks are for downgrades - Credit premiums tends to be higher at shorter premium, possibly due to event risk (i.e. defaults) Liquidity Premium Liquidity is higher for bonds that are: - New - Issued by an established issuer - Large in size - Simple - High Credit Quality - Issued at par or market rates

discuss motivations to trade and how they relate to trading strategy; (Trade, Per., Eval.) 25a

Four trading strategies Profit Seeking - Trading is based on information not fully reflected in prices - To prevent information leakage, or the disclosure of information about their trades, active managers take steps to hide their trades by using less transparent trade venues - Greater trade urgency is associated with executing over shorter execution horizons. - Portfolio managers may execute their orders at prices nearer to the market if they believe the info. is likely to be realized in the near term - Alpha decay - refers to the erosion or deterioration in short-term alpha once an investment decision is made. - Value managers may hold securities for months or years, in this case minimal trading is required, and can be carried out in a patient manner Risk Management/ Hedging Needs - As the market and the risk environment change, portfolios need to be traded or rebalanced to remain at targeted risk levels or risk exposures - May be simple rebalancing, or may involve using derivatives - Liquid derivatives are more cost efficient - Managers may also trade to hedge risks when they do not have a view on the specific risk Cash Flow Needs - Caused by flows into or out of a fund - Collateral/ margin calls could require close to immediate liquidation, whereas a fund redemption due to longer-term client asset allocation changes might not require immediate liquidation - Inflows can be monetized with etfs/ futures - In most cases, client redemptions are based on the fund's net asset value, where the NAV is calculated using the closing price of the listing market, so a fund manager would want to trade at closing price; this reduces redemption price risk Corporate Action/ Margin Call/ Index rebalance - Cash needs also arise from margin calls for leveraged positions as PMs are asked to increase cash collateral - Index tracking funds need to be rebalanced as the index changes, as do long only funds using a market- weighted index as a benchmark Cash dividends/ coupons have to be reinvested

discuss investment characteristics, strategy implementation, and role in a portfolio of multi-manager hedge fund strategies; (Alts.) 19g (FoF vs. Multi Strat)

Fund of Funds What it can provide - Diversification across HF strategies - Expertise in manager selection - Due diligence - Economies of scale for monitoring Disadvantages - Double layer of fees - Lack of transparency into HFs - No performance fees meeting Characteristics: HFs have a 2 and 20 fee structure while the FOF have an additional 1% on top of that - HFs almost always require 1M investment, so FOF for as little as 100k can provide diversification - Lockups can be as long as a year for FOF - But they can provide access to HFs that the normal investor may not have had Strategy implementation: - Review databases - Choose an appropriate strategic allocation to different HF strategies, - Review audit materials - Examine funds personnel and risk management Role in portfolio: greater diversification and steady returns Multi strategy Hedge Funds - These are like FOFs only all of the strategies are managed within one funds - This is generally cheaper than FOFs - This also allows them the ability to make tactical allocations when needed unlike FOFs which have to completely shift funds - Role in Portfolio: generally MS funds have performed better than FOFs due to better fee structure and greater ability to execute HFs vs. FoFs: - FoF offer a more diverse strategy mix with lower leverage - FoF have lower operational risk (each separate underlying HF is responsible for its own risk management); FoF have lower operational risk since it is diversified, while MSF have are not well diversified because all operational processes are performed under the same structure - MSF can reallocate capital into different strategy areas more quickly and efficiently than would be possible by a fund-of-funds (FoF) manager - Multi strat have increased transparency - MS have an investment friendly fee structure - FOF - doesn't have performance netting, since you can have 10 funds down, and 1 up, and you would still have to pay performance fees on the 1

Quantitative vs. fundamental - when it comes to rebalancing etc. , characteristics (Equity)

Fundamental relies on research into the company's financial statements - There are more likely to be fewer securities in the portfolio - Fundamental is subjective in nature - Utilizes human skill, experience and judgement - Valuation process: prescreen to identify potential investment candidates, and perform in depth analysis - For rebalancing - set limits on max sector/ country/ ind. Stocks, can increase/ decrease at any time; Continuously monitor each stock and sell when above price targets Quantitative - Decision making process is systematic/ non-discretionary - Focus is just on metrics, and is objective in nature - Utilizes data and statistics and requires expertise in statistical modeling - The models focus on identifying relationships between returns and factors, and attempt to draw conclusion from a variety of historical data - Quantitative investors construct models by back-testing on historical data, using what is known about or has been reported about a company to search for the best company characteristics - Valuation process: construct factor exposures across all shares in same industry, forecast each factor - Risk is that the factors will not perform as expected - Rebalance at regular intervals Risks - Quantitative - risk is at the portfolio level (factor returns will not perform as expected) - Fundamental - risk is at the company level (valuation, forecasts, convergence time frame)

Heuristic vs. Formal Constraints (Equity)

Heuristic Risk Constraints Heuristic constraints are often based on experience or practice, rather than empirical evidence. Examples include limits on exposure to individual positions, sectors or regions, limits on leverage - Heuristic constraints may limit active managers' ability to fully exploit their insights into expected returns, but may also viewed as safeguarding again overconfidence - Managers will often impose heuristics even if they use more formal statistical measures Heuristic risk controls may be used to limit - exposure concentrations by security, sector, industry, or geography. - net exposures to risk factors, such as beta, size, value, and momentum. - net exposures to currencies. - degree of leverage. - degree of illiquidity; Formal Risk constraints - Formal risks are distinct from heuristic controls. They are often statistical in nature and directly linked to the distribution of returns for the portfolio. Formal measures of risks include: - Volatility - Skewness - positive skew - mean is greater than median, negative skew - mean is less than the median - Active Risk - standard deviation of differences between a portfolios returns and its benchmark returns - Drawdown - portfolio loss from its high point to when it begins to recover - Incremental VaR - change in VAR from adding a new position - Marginal VaR - impact of a very small change in position size - Conditional Var - average loss that would be incurred if the VaR cutoff is exceeded

describe construction, benefits, limitations, and risk-return characteristics of a laddered bond portfolio; (FI 1) 12d

In a ladder portfolio roughly equal par amounts are purchased and come due each year Advantages include: - The most desirable aspect of the ladder is in the liquidity management. It has Natural liquidity as bonds come due each year - The diversification over time provides the investor a balanced position between the two sources of interest rate risk - CF reinvestment and market price volatility - A laddered portfolio will have more convexity than a bullet, a benefit if there are large parallel shifts. If three portfolios have the same duration (and cash flow yield0 then the barbell clearly has the highest convexity and the bullet the lowest. Laddered will also be high since its CFs are spread out - Bonds mature and are reinvested at the long end of the ladder (portfolio duration is constant) - In terms of reinvestment risk, we have: Barbell > Ladder > Bullet. - The higher the convexity the higher the reinvestment risk Limitations: - If the entire portfolio needs to be liquidated and sold, it can be done cheaper with mutual funds Mutual funds provide greater diversification of default risk

discuss commonly recognized behavioral biases and their implications for financial decision making; (BF) 1b (Information Processing)

Information Processing Anchoring and Adjustment - There is generally an initial estimate and the person's views are then modified from the initial POV. Regardless of how the initial anchor was chosen, people tend to adjust their anchors insufficiently - Consequences include people who stick with the initial estimate and don't update for new information; hold investments too long or sell too early - To overcome you should look at the basis for any recommendation to see whether they are anchored to previous estimates or based on an objective, rational view of changes Mental Accounting - Putting money into different buckets and treating it differently based on how it is characterized. I.e. treating you base salary differently than your bonus. - Problems include: failing to lower portfolio risk by adding assets with low correlation, putting portfolio in different buckets which doesn't take into account correlations, neglecting total return - To detect and overcome this bias, you should recognize the drawbacks of engaging in this behavior. You should combine all the assets into one spreadsheet to see the true asset allocation Framing - Decision can be affected by the way the questions are framed. I.e. 200 out of 600 people will die vs. 1/3 of the people will die. The second sounds worse - Consequences include potentially selecting a suboptimal portfolio based on how it is presented; misidentifying risk tolerances because of how questions about risk tolerance were framed - To overcome, try to eliminate any reference to gains and losses already incurred; instead focus on future prospects; reframe the problem Availability Bias - Take a mental shortcut approach to estimating the probability of an outcome based on how easily the outcome comes to mind. Four different sources of availability bias: - Retrievability - If an idea can be thought of more quickly it is generally thought of as correct - Narrow Range of Experience - A person with limited experience who extrapolates their experience for the entire population - Categorization - I.e. putting items together that share characteristics, and then treating all items similarly - Resonance - People are often biased by how closely a situation parallels their own personal situation Consequences: choose an investment based on advertising rather than on a thorough analysis of options, limit the opportunity set and fail to diversify To overcome availability people need an appropriate IPS strategy, and to carefully research and analyze investments

discuss commonly recognized behavioral biases and their implications for financial decision making; (BF) 1b (Emotional)

Loss aversion - feeling more pain from losses than pleasure from winning. Individuals display asymmetric responses to gains and losses. We fear losses far more than we value gains Consequences include - holding on to losers too long, and selling winners early - Trading too much by selling for small gains - Holding risker portfolios than is acceptable based on the risk/ return objectives - Limit upside potential by selling winners and holding losers Detection/ guidance: A disciplined approach to investment based on fundamental analysis is a good way to alleviate the impact of loss aversion Overconfidence bias - People demonstrate unwarranted faith in their own intuitive reasoning, judgements and / or cognitive abilities Consequences include: - Underestimating risk - Under diversification - Excessive turnover A conscious review process forces the investor to acknowledge their losers, because a review of trading activity will demonstrate not only the winners but also the losers Self-control bias - Individuals lack self-discipline and favor immediate gratification over long -term goals Consequences include: - Insufficient Savings - Taking undue risks to try and compensate for insufficient savings - Cause asset allocation imbalance problems These can be overcome by establishing an appropriate investment plan and should have a personal budget Endowment Bias - An asset is deemed to be more valuable simply because it is owned Consequences include: - Failing to sell an inappropriate asset resulting in inappropriate asset allocations - Holding things you're familiar with because they have some sense of comfort - Maintain an inappropriate asset allocation An effective way to address desire for familiarity, when that desire contradicts good financial sense, is to review the historical performance and risk of the unfamiliar securities Regret aversion bias - people tend to avoid making decisions that will result in action out of fear that the decision will turn out poorly Consequences include - Being too conservative in their investment choices as a result of poor outcomes on risky investments in the past - Engage in herding behavior In overcoming regret-aversion bias, education is essential. You should quantify the risk-reducing and return-enhancing advantages of diversification and proper asset allocation Status quo bias- people choose to do nothing instead of making a change even when change is warranted, positions are maintained largely because of inertia Consequences include - Unknowingly maintain portfolios with risk characteristics that are inappropriate for their circumstances - Fail to explore other opportunities Education is essential for overcoming status quo bias

discuss risks (earnings, premature death, longevity, property, liability, and health risks) in relation to human and financial capital; (PWM 2) 23e

Managing risks to financial and human capital is an essential part of the household financial planning process. Below is an overview of the risks faced by individuals. Earnings risk - refers to the risks associated with the earning potential of an individual—that is, events that could negatively affect the individual's human and financial capital. I.e. unemployment, loss of job, health risks. Career disruptions include having a - risky job, or - having a spouse have to relocate jobs. - Some jobs may be cyclical Premature death (also referred to as mortality risk) - Relates to the death of an individual earlier than anticipated whose future earnings or human capital, were expected to help pay for financial needs and aspirations of the individual's families - Besides the obvious reduction in human capital there are also effects on financial capital. Death expenses include funeral and burial amongst others Longevity Risk - Opposite of premature death risk as individuals who live too long are at risk of outliving the Financial Capital - Longevity risks relates primarily to financial capital - that is, spending one's retirement portfolio - Longevity risk also affects human capital in the sense that an individual who is concerned about living too long may choose to work longer than someone else might Property Risk - - Relates to the possibility that a person's property may be damaged, destroyed lost or stolen - House or car can be damaged in a flood in which case you may need temporary living space or transportation - Because property represents a financial asset, property risk is normally considered to be associated with a potential loss of financial capital - But property used in a business to create income is rightfully considered in a discussion of human capital Liability Risk - - being legally responsible for property damage or physical injury and having a reduction in Financial Capital - The most common legal liability involves driving an automobile Health Risk - Refers to risks and implication associated with illness or injury. - Direct costs may include coinsurance, copayments, deductibles, treatments and procedures - Health risks manifest themselves in different ways over the life cycle and can have significant implications for human as well as financial capital. Kinds of insurance that can be added to an existing portfolio of products: more life insurance, disability insurance, property insurance, liability insurance

discuss how assets under management, position size, market liquidity, and portfolio turnover affect equity portfolio construction decisions; (Eq. 2) 18f

Market Impact - this is an implicit cost caused by the managers executing trade. I.e. if they buy the security it would cause the price to appreciate Factors that affect market impact costs include: - Higher turnover and shorter horizons lead to higher market impact - Managers whose trades include information will generally have high market impact - AUM vs. market cap of securities (I..e. if you're a large cap manager your AUM may be too big to merit investments in small caps. ) The lower absolute level of trading volume of the smaller securities can be a significant implementation hurdle - Average trading volume - for example when placing a trade, a SC manager will generally have a higher percentage of the volume, which could have higher market impact A large AUM fund can address the trading volume constraint in several ways - It may establish position limits on individual stocks related to the market cap of each security - It may establish position limits based on the average trading volume - It may build a rebalancing strategy into the investment process that gradually rebalances over time Market impact of a single trade is measured by slippage Slippage is defined as the difference of the execution point and the mid-point of the bid ask spread. Four conclusions that can be drawn on slippage costs: - Slippage costs are greater for small caps - Slippage costs are higher in times of market volatility - Slippage costs are higher than explicit costs (i.e. commission costs) - Slippage costs are not necessarily greater in emerging markets

discuss how hedge fund strategies may be classified; (Alts.) 19a

Most important characteristics of hedge funds: - Legal/ Regulatory overview - Flexible Mandates - Few Investment Constraints - Large Investment Universe - Aggressive Investment Styles - Relatively liberal use of leverage - Hedge Fund liquidity constraints (i.e. lock ups, exit windows) - Relatively high fee structures There are six main ways to classify hedge funds that are focused on in the CFA curriculum Equity related - focus primarily on equity markets - Subcategories include L/S, dedicated short, and equity market neutral Event driven- These relate to corporate actions such as M&A, bankruptcies, acquisitions - Subcategories include merger arb and distressed securities Relative value- focuses on the relative valuation between two or more securities - Subcategories include Fixed Income arb, and convertible bond arbitrage Opportunistic - take a top down approach, focusing on a multi-asset opportunity set - Two that are being discussed are global macro and managed futures Specialist - focus on special or niche opportunities - Volatility and reinsurance are two strategies of note Multi manager - focus on building a diversified portfolio of managers - Fund of funds and multi strategy

evaluate strategies for managing a single and multiple liability; (FI 1) 12b

Multiple Liabilities 1. Market value of assets (MVa) equals (or exceeds) PVL. 2. Portfolio and liability basis point values match (BPV = BPVL). (BPV is Also called dollar duration which measures the change in the value of a bond portfolio for every 100 basis point change in interest rates. Dollar duration is often referred to formally as DV01 or BPV (i.e. dollar value per 01). 3. Asset dispersion of cash flows and convexity exceed those of the liabilities. (But not by too much, in order to minimize structural risk exposure to curve reshaping). 4. Regularly rebalance the portfolio to maintain the BPV match of A and L as time and yields change. Single Liabilities 1. Initial portfolio market value (PVA) equals (or exceeds) PVL (There are exceptions to this for more complex situations where the initial portfolio IRR differs from the initial discount rate of the liability.) 2. Portfolio Macaulay duration matches the due date of the liability (D = DL). 3. Minimize portfolio convexity (to minimize dispersion of asset cash flows around the liability and reduce risk to curve reshaping). 4. Regularly rebalance the portfolio to maintain the duration match as time and yields change. (But also consider the tradeoff between higher transaction costs from more frequent rebalancing versus the risk of allowing durations to drift apart.)

Width of rebalancing

Optimal width of the corridor for an asset class depends on the following - Transaction costs - the more expensive it is to trade, the less frequently you should trade and the wider rebalancing ranges - Risk tolerance - more risk averse people will have tighter bands - Correlations - The more correlated assets are the less you will have to rebalance; i.e. wider rebalancing ranges; less correlated have tighter rebalancing ranges - Liquidity - illiquid investments are usually associated with higher trading costs. The liquidity costs encourage the use of wider rebalancing corridors - Taxes - taxable portfolios will want to have wider bands than nontaxable ones - Belief in momentum, wider trading ranges, belief in mean reversion narrower - Volatility - Generally speaking, the higher the volatility of the rest of the portfolio (in relation to the asset class in question), the smaller the corridor

evaluate risk considerations of private defined benefit (DB) pension plans in relation to 1) plan funded status, 2) sponsor financial strength, 3) interactions between the sponsor's business and the fund's investments, 4) plan design, and 5) workforce characteristics; (PM Inst. Inv.) 24e

Plan Funded Status - fair value of plan assets/ PV of DB obligations. Higher funded status potentially increases risk tolerance since the plan will have the ability to absorb short term losses. When plan is fully funded: - Seek to match assets to liabilities using a LDI approach When a plan is underfunded the plan sponsor can take several approaches to minimize the risk of generating a financial liability: - Seek to grow assets at a higher rate of return than the expected growth of liabilities - Seek to investment in more defensive assets expected to deliver less volatile returns Sponsor financial status - Lower debt ratios and higher profitability will lead to capacity to make contributions in the event of losses in plan assets Interactions between the sponsor's business and the fund's investments - It is advisable for the plan to diversify out of the company's stock. The lower the correlation the greater the risk tolerance all things equal. - It is desirable for plan assets to have low (high) correlations with the sponsor's operating assets (liabilities)' ( If xyz company is performing poorly as a company, this will constrain its ability to make additional contributions that may be necessary to address the shortfall in the pension's funding.) Plan Design - Options such as provision for early retirement or provision for lump sum distributions tend to reduce the duration of plan liabilities, implying lower risk tolerance Workforce Characteristics- younger the workforce, the greater the proportion of active lives, the greater duration of liabilities, the greater the ability to take on risk - Lower workforce turnover means higher vesting rates and higher liabilities

identify and formulate client goals based on client information; (PWM 1) 21d (Planned vs. unplanned goals)

Planned Goals - goals that can be somewhat reasonably estimated or quantified within an expected time frame - Retirement Goals - Specific Purchases (i.e. primary residence) - Funding education of dependents - Family events i.e. weddings - Philanthropy Unplanned Goals - goals related to unforeseen financial needs. These are typically more challenging because of the difficulty in estimating the timing and funding needed - Health bills not covered by health insurance - Property repairs - Other unforeseen spending (beyond property repairs and medical expenses) How can private wealth managers help in formulating client goals? - Quantifying goals - may need to quantify things that are not as easy to quantify i.e. future retirement lifestyle needs - Prioritizing Goals - Private clients tend to have multiple, sometimes competing goals. Goal prioritization depends on what is most important to the client, not necessarily what happens sooner. Changing goals - May need to reevaluate financial goals after certain circumstances

Active Accumulator vs. Ind. Individualist vs PP vs. Friendly Follower (Behavioral)

Pompian Behavioral types Passive Preserver - - Basic Type: Passive, place emphasis on security and preserving, may have had an inheritance - Risk Tolerance: Low - Primary biases: primarily emotional biases (loss aversion, regret aversion, endowment, status quo) - How to advise: PP are more receptive to "big picture" advice that does not dwell on such details as standard deviation and Sharpe ratios Friendly follower - - Basic Type: Passive - Risk Tolerance: Low to medium, tend to follow leads from friends, colleagues and advisors - Primary biases: primarily cognitive biases (availability, hindsight, framing) - How to advise: FF may be difficult because they often overestimate risk tolerance. Because FF are mainly cognitive, education on the benefits of diversification is usually the best course of action Independent Individualist - - Basic Type: Active, strong willed and independent thinker - Risk Tolerance: Medium to high - Primary biases: primarily cognitive biases (conservatism, availability, confirmation representative) - How to advise: Education is essential to changing their behavior because their biases are predominately cognitive Active Accumulator - - Basic Type: Active, most aggressive and are typically entrepreneurial and often the first generation to create wealth - Risk Tolerance: High - Primary biases: primarily emotional (overconfidence, self-control, illusion of control) - How to advise: AA maybe the most difficult type. The best approach is to take control of the situation. If advisers let the AA client dictate the terms of the engagement, the client's emotionally oriented decision making will result in an unhappy client. Advisers need to prove they have the ability to make wise, object and LT decisions Limitations on using these classifications - Individuals may exhibit both cognitive and emotional biases - People can be multiple behavioral types - Individuals are likely to require unique treatment even if they are classified as the same investor type because human behavior is so complex - People will go through behavioral changes as they age, and their investment profile may change

evaluate the execution of a trade; (Trade, Per., Eval.) 25h (VWAP/ TWAP/ Arrival Cost, Market Adjusted Cost)

Proper trade cost evaluation enables PMs to better manage costs throughout the investment cycle and helps facilitate communication between the PM, traders and brokers Trade cost calculations are expressed such that a positive value indicates underperformance - Cost ($) = side x (average price - reference price) - Cost (bp) = side x ((price - reference price)/ Price ) x 10,000 bps - Side: buy order = +1, sell order = -1 VWAP/ TWAP / Arrival costs/ Market on Close - VWAP cost = side x (average price - vwap)/ vwap x 10^4 bps - TWAP cost = side x ((average price - twap)/ twap) x 10^4 bps - Arrival cost (bps) = side x ((average price - price when submitted)/ price when submitted ) x 10^4 bps - Market on close cost = side x ((average price - close/ close) x 10^4 bps For TWAP of VWAP for example, the average price is what your fund traded on that security. If it is lower than VWAP/ TWAP it indicates outperformance Index cost = side x ((Index VWAP - Index arrival price)/Index arrival price) x 10^4 Market adjusted cost = Arrival cost (bps) - Beta x Index cost (bps) arrival price = decision price = benchmark price; Arrival cost in bps is: ((average price paid - price when decision was made to place order)/ price when decision was made to place order) x 10^4 bps Added value (bps) = arrival costs (bps) - estimated pre-trade cost (bps) Allows traders to be evaluated against what costs were assumed to be

Representative Bias (BF)

Representative Bias - the tendency to overweight the importance of the most recent observations. - The strongest defenses against recency bias are an objective asset allocation process and a strong governance framework. It is important that the investor objectively evaluate the motivation underlying the response to recent market events - A formal asset allocation with pre-specified allowable ranges will constrain representativeness bias Representative Bias is when we arrive at a conclusion based on the facts that suggest (represent) it without delving deeper into it. For ex : You invested in a company because you feel its a good company with an ethical outlook

interpret the sources of portfolio returns using a specified attribution approach; (Trade, Per., Eval.) 26e (Brinson B, F, and meaning of SMB, HML etc.)

Return attribution - set of techniques used to identify the sources of excess return of a portfolio against its benchmark, quantifying the consequences of active investment decisions Geometric excess return = (portfolio return - benchmark return) / (1 + benchmark return) Brinson Model attribution effects Allocation effect - Refers to the value the portfolio manager adds (or subtracts) by having portfolio sector weights that are different from benchmark weights - Allocation effect (BB) = (W portfolio - W benchmark) * benchmark return for the sector - Allocation effect (BF) = (W portfolio - W benchmark) * (Benchmark sector return - benchmark return for the whole portfolio) - For BF when looking at allocation you can overweight to a negative, but still have a positive allocation if it is less negative than the benchmark. This isn't the case with BB Security Selection - Benchmark weight x ( Portfolio return - benchmark return) Interaction effect - This is the residual amount - Interaction effect = (weight of the investor's portfolio (sector) - benchmark weight(sector)) ( investors return (sector)- benchmark return (sector)) all summed. Carhart Model - Alpha + - beta * High minus low (difference between average return on high book to market portfolios - low book to market portfolios) + - sensitivity to factor * SMB (small minus big market cap) factor + - sensitivity to factor * WML (winner - losers), momentum factor equal to difference between last years winners and losers + - sensitivity to factor * RMRF - return on value weighted equity index above the 1 month t bill SMB (Small minus Big, -1 is large caps outperforming), RMRF ( return on a value weighted index in excess of the one month t bill), HML (High minus low, high book-to-market portfolios minus the return on low book-to-market portfolios, lower indicates growth, higher indicates value),

Risk Reversal Long and Short(Derivs)

Risk Reversal - delta hedged trading strategy seeking to profit from a change in the relative volatility of calls and puts - A long (short) risk reversal combines long (short) calls and short (long) puts on the same underlying - Short risk reversal is buying otm put options and sell otm call options (The put provides some downside protection while the call provides some limit to upside; Specifically, one would enter this trade if call implied volatility is viewed as being too high relative to put implied volatility) - A Long Risk Reversal strategy involves buying an out-of-the-money call (at strike B in the diagram above) and selling an out-of-the-money put - Belief is that the put IV is too high relative to call IV - Call has positive delta, short put has positive delta, so the underlying is sold to delta hedge

discuss the stakeholders in the portfolio, the liabilities, the investment time horizons, and the liquidity needs of different types of institutional investors; (PM Inst. Inv.) 24c (Sovereign Wealth Funds)

SWF stakeholders - - Current and future citizens - government - external asset managers - SWF management, investment committee and boards Liabilities, Investment Horizons, and Liquidity Budget Stabilization Funds - Liabilities - Uncertain, may be needed on a short term basis to help support the government budget. - Investment Horizon - short term (mainly fixed income) - Liquidity - High level of liquidity with a low risk of significant losses Development Funds - Liabilities - not clearly defined and typically uncertain, but overall objective is to raise a country's economic growth - Investment horizon - some initiatives, such as infra/ industrial development may be ongoing and LT, while other may be medium to ST - Liquidity - depends on the particular strategic economic development initiatives, but generally low Savings Funds - Liabilities - mission is to transfer wealth to future generations, so the liabilities are LT - Investment Horizon -Very long term investment horizon and low liquidity needs - Liquidity - low, main objective is to grow wealth for future generations Reserve Funds - Liabilities - the central bank's monetary stabilization bonds, objective is to earn a higher return than that on FX reserves - Investment Horizons - very long, with typically no immediate or interim payouts - Liquidity needs - lower than stabilization, higher than savings, typically holds 50-70% in equity Pension Reserve funds - Investment Horizon - Accumulation / Decumulation phase where the government predominantly contributes/ withdraws from the fund - Liabilities - future pension related obligations - Liquidity - during accumulation they can hold a significant amount in equities/ relatively illiquid assets, during decumulation there are high liquidity needs External Constraints - Legal and Regulatory - established by national legislation Tax and Accounting - tax-free status by legislation

calculate and interpret the Sortino ratio, the appraisal ratio, upside/downside capture ratios, maximum drawdown, and drawdown duration; (Trade, Per., Eval.) 26n

Sharpe Ratio - - Excess return over the risk free rate divided by standard deviation - One of the weaknesses is that the use of standard deviation as a measure of risk assumes investors are indifferent between upside and downside volatility - Doesn't capture other characteristics such as VaR and funded ratio. Treynor Ratio - - Portfolio return - risk free/ Beta - The usefulness of the Treynor ratio depends on whether systematic risk or total risk is most appropriate in evaluating performance Information ratio - - Active return (mean returns - benchmark)/ active risk (variability of performance with the benchmark) - Appraisal ratio - active return/ portfolio's tracking risk Appraisal Ratio (aka Treynor Black Appraisal ratio) - It is the annualized alpha divided by the annualized residual risk (non-systematic risks). Both the alpha and the residual risk are computed from a factor regression - Alpha/ standard error of regression - Alpha can be calculated as the portfolio return - (rfr + Beta (Market return - risk free) Sortino - - only considers the standard deviation of the downside risk; Equation is portfolio return - minimum acceptable return/ downside deviation (semi-standard) - The Sortino ratio is arguably a better performance metric for such assets as hedge funds or commodity trading funds, whose distributions are purposely skewed from normal and non symmetrical - Semi standard deviation is the sum of the difference between the target return and the actual return for every value below the target return. Each of these values is squared. You would then sum up everything and take the squared root Capture Ratios - - Measure the manager's participation in up an down markets - If a portfolio is up 10% and the Benchmark is up 5%, then the capture ratio is 10%/5% or up 200%, this was then be divided by the downside capture ratio - Upside/ downside capture ratio simply divides the two, looking for a value greater than 1 (positive asymmetry, concave return profile). Negative asymmetry is less than 1. - A capture ratio of 1 is indicative of a symmetrical return profile. Drawdown ratio - - Maximum drawdown is measured as the cumulative peak to trough loss during a continuous period. - Drawdown duration is the total time from start of the drawdown until the cumulative drawdown recovers to zero. - Recovery typically takes longer than drawdown You could also use Roy's Safety First Criteria which is - Expected Return - minimum needed return / standard deviation

demonstrate how an asset's returns may be replicated by using options (Derivs.) 8a

Synthetic Long Forward Position- Combination of a long call and a short put with identical strike prices. This is essentially the same as owning the underlying - Uses: Hedge an existing short forward positions - Arbitrage an overpriced forward - Create a long forward to acquire a stock because it allows for contract customization Synthetic Short Forward Position- Combination of a short call and a long put with identical strike prices. This is essentially the same as going short - Uses: Hedge an existing long forward positions - Arbitrage an underpriced forward - Create a short forward Synthetic Long Put Position - Buy a call option and sell short shares Synthetic long call position Buy a long position in the stock, and a long put on the same stock

demonstrate how an asset's returns may be replicated by using options (Derivs.) 8a (Synthetic forward vs. long put vs. long call)

Synthetic Long Forward Position- Combination of a long call and a short put with identical strike prices. This is essentially the same as owning the underlying - Uses: Hedge an existing short forward positions - Arbitrage an overpriced forward - Create a long forward to acquire a stock because it allows for contract customization Synthetic Short Forward Position- Combination of a short call and a long put with identical strike prices. This is essentially the same as going short - Uses: Hedge an existing long forward positions - Arbitrage an underpriced forward - Create a short forward Synthetic Long Put Position - short stock and long call position in which the call strike price equals the price at which the stock is shorted. Synthetic long call position - long stock and long put position in which the put strike price equals the price at which the stock is purchased.

discuss strategic implementation choices in asset allocation, including passive/ active choices and vehicles for implementing passive and active mandates; (Asset All.) 5i

Tactical asset allocation - (TAA) is an active management strategy that deviates from the strategic asset allocation (SAA). TAA introduces additional risk, seeking incremental return, often called alpha. - Key barriers to successful tactical asset allocation are monitoring and trading costs. For some investors higher short term capital gains taxes will prove a significant obstacle. - Seeks to take advantage of perceived short-term opportunities in the market Dynamic asset allocation recognizes that the performance in one period affects the performance in the next. - A multiperiod view of the investment horizon, DAA recognizes that asset (and liability) performance in one period affects the required rate of return and acceptable level of risk for subsequent periods. - Deviations from SAA motivated by longer term valuation signals or economic view. Passive/ Active - With active the portfolio composition changes with investor insights and when expectations change Decisions between passive/ active depends on: - Availability of investments - Active management ability to scale - Ability to be passive with client constraints i.e. ESG - Belief in efficient markets (a strong belief in market efficiency for the asset class would orient the investor away from active) - Tax status of investors (taxable investors would tend to have higher hurdles to profitable active management than tax exempt investors) - Cost benefit tradeoff, of the increased transactions from being active, investment management costs etc.

explain how asset classes are used to represent exposures to systematic risk and discuss criteria for asset class specification; (Asset All.) 5e (Criteria of asset classes)

The following criteria can be used to specify asset classes - Homogenous - Assets within a class should have similar attributes - Mutually exclusive - Assets cannot be classified into more than one class - Diversifying- Asset classes should not be highly correlated between themselves, as this would duplicate risk exposures already present - Investable: asset classes as a group should make up a preponderance of world investable wealth - Liquidity: Asset classes selected for investment should have the capacity to absorb a meaningful proportion of an investor's portfolio. If liquidity and transaction costs are unfavorable, the class may not be practically suitable for investment

describe how fundamental active investment strategies are created; (Eq. 2) 17g

The fundamental process will typically include - Define the investment universe - Pre screen investment universe (can often be associated with a particular investment style i.e. low P/E multiples) - Analyze the industry/ competitive position and financial reports (If a manager is agnostic on an industry he may remain neutral to it) - Forecast performance - Convert forecast to valuations - Construct a portfolio with desired risk profile - Rebalance as needed Pitfalls include - Behavioral biases (Illusion of control, Loss Aversion, Overconfidence, confirmation, availability, regret aversion bias) - Value traps - a stock that appears to be attractively values - with low P/E or P/B or P/CF multiples - because of a significant stock drop that may still be overpriced because of its prospects - Growth trap - company may deliver above average earnings of CF growth, but the share price may not move any higher due to its high starting level

explain how trade costs are measured and determine the cost of a trade; (Trade, Per., Eval.) 25g

Total costs of trading can be measured using implementation shortfall - Mathematically IS is calculated as = paper return - actual return Implementation Shortfall can be broken down into the following parts - Execution Costs - due to executing a trade at a less favorable cost than the reference amount - Fixed Fees - any explicit commissions or fees - Opportunity costs - Cost of not trading any unfulfilled portion More commonly, the IS is expressed as a fraction of the total cost of the paper portfolio trade in bps. Expanded Implementation Shortfall Decomposes execution cost further into two categories: - Delay Cost - arises when the order is not submitted to the market in a timely manner and the asset experiences adverse price movement, making it more expensive to transact - (Delay cost is due to adverse price movements in the time between the portfolio manager submitting the order to the trader and the time the trader releases it to the market. This delay is usually due to the time it takes the trading desk to determine the optimal execution strategy for the trade) - Trading Cost - Calculated as the ending price of the security minus the execution price paid on shares executed Negative implementation shortfall means you did better than the paper portfolio Execution risk is the risk of an adverse price movement occurring over the trading horizon owing to a change in the fundamental value of the security or because of trading-induced volatility. Execution risk is often proxied by price volatility The delay cost reflects the adverse price movement associated with the untimely submission of order, have to double check which prices to use market impact risk as it represents the highest percentage of ADV. . The larger the size of the trade expressed as a percentage of ADV, the larger the expected market impact cost

describe types of insurance relevant to personal financial planning; (PWM 2) 23f (Whole life, vs. universal and Riders)

Types of Life Insurance Temporary - covers only a designated period such as 1, 5, or 20 years (commonly referred to as term life insurance) - Typically cheaper than permanent life insurance and the cost per year is less for shorter insured periods because of increasing mortality risk Permanent Insurance - more costly and lasts for the life of the insured. Two main types: - Whole Life - typically has a fixed annual premium (Cannot be cancelled as long as premiums are paid) - Universal life - adds more flexibility as the insurance can be increased or decreased to adjust the levels (Premium payments can stop and insurance will continue until the earnings on cash aren't sufficient) Life insurance may also have additional clauses Non -forfeiture clause - policy owner has the right to receive some portion of the benefits if premium payments are missed Riders - modifications that add some risk mitigation beyond the basic policy, i.e. - guaranteed insurability (allows owner to purchase more insurance in the future at certain predefined intervals), - accelerated death (which may allow the insured parties who have been diagnosed as terminally ill to collect all or part of the death benefit while they are still alive) - waiver of premium (if policy holder becomes disabled)

Ex post vs. ex ante

- Ex post risk is based on historical data which includes historical events, the historical events affect the return. So if you extrapolate ex post risk to calculate ex ante risk, it is not accurate. - Ex ante - before the event actually occurs, make a prediction. Ex post - after the event occurs looking at historic return/risk

discuss investment characteristics, strategy implementation, and role in a portfolio of event-driven hedge fund strategies; (Alts.) 19c (Merger Arb payoffs)

- Firm A is going to acquire Firm B - Firm A moves from 45 to 42, while B moves from 15 to 19 - The HF managers sell short 10k shares of A, buys 20k shares of B - The payoff if it completes is (42 x 10k from short selling) - (20k x 19 to buy the stock) The payoff if it fails is (42-45) * 10k + (15-19) x 20k The benefits of the merger will just be the difference in the amount short sold - the amount long

Which HF strategies have levered returns

- HFs with high leverage: merger arb, market neutral, global macro, managed futures, convertible arb; Dedicated short and Distressed have enough volatility that they don't need to add leverage - The more market neutral or quantitative the strategy approach the more levered the strategy applications tend to be to achieve a meaningful return Global macro focuses on identifying trends and performs poorly in markets that are mean reverting

describe uses of calendar spreads; (Derivs.) 8g

- In all of the options we've seen so far they all expire at the same date - Calendar spreads take advantage of the difference in theta between close to expiry contracts and farther away contracts - A long calendar spread entails buying longer dated options and selling shorter dated ones - In principle the premium on the short-dated options falls quick that the longer dated ones - A short calendar spread is the opposite, selling longer dated and buying shorter dated with same strike and underlying - A long calendar spread will benefit from stable market while short calendar spread benefits from big moves

VWAP vs. TWAP vs. POV

1. Scheduled algorithms - Scheduled algorithms are appropriate for relatively small orders (5-10% of ADV) in liquid markets for managers with less urgency and/or who are concerned with minimizing the market impact. - PM generally also has no expectation of momentum, and has a greater tolerance for longer execution when using scheduled algos POV - Sends orders following a volume participation schedule - As trading volume increases in the market these algorithms will trade more shares - Investors specify participation rate, i.e. if they only want 10% of the market volume until completion while POV algorithms incorporate real-time volume by following (or chasing) volumes, they may not complete the order within the time period specified. - POV relies on current market data, while VWAP is on historical trends VWAP - Slice order into smaller amounts to send to the market following a time slicing schedule based on historical intraday volume profiles - These typically are higher at the open and the close - Following a fixed schedule as VWAP algorithms do, however, may not be optimal for certain stocks because such algorithms may not complete the order in cases where volumes are low. - VWAP is unsuitable when: urgency is high, order size is a large percent of volume, large bid ask spread. - low spread, low % of adv, not urgent = VWAP TWAP - TWAP will send the same number of shares and the same percentage of the order to be traded in each time period. - This helps ensure the specified number of shares are executed within the specified time period

discuss and analyze the tax efficiency of investments; (PWM 1) 22c (Post liquidation return)

A tax efficient strategy is one that gives up very little of its return to the friction of taxes. Generally speaking, equity portfolios are often more tax efficient that strategies that rely on derivatives, real assets, or taxable fixed income. - Dividends on stocks have preferential tax treatment - Capital gains are taxed less heavily than ordinary income - The flexibility to manage sell decision timing gives asset managers an additional measure of control Higher yield, higher turnover strategies tend to be less tax efficient; momentum strategies are more tax efficient (sell losers early, let winners run) - Style funds tend to be less tax efficient, as they sell holdings if they drift out of style Calculating After-Tax Returns After Tax Holding Period Return - Returns are adjusted for the tax liability generated in the period - Pre-tax holding return: ((value - value0) + income)/ value0 - After Tax holding Return: ((value - value0) + income - tax)/ value0) After Tax post-liquidation return - The post liquidation return assumes that all portfolio holdings are sold as of the end date of the analysis and that the resulting capital gains tax that would be due is deducted from the ending portfolio value - Post liquidation return = ((1+R1)(1+R2)(1+R3) etc. - (liquidation tax/ final value))^(1/n)-1 - Post liquidation return = ((1+R1)(1+R2)(1+R3) etc. - (embedded gain * tax rate))^(1/n)-1 - Liquidation tax = (final value - tax basis) * capital gains tax rate After tax excess returns - After tax return - after tax return of the benchmark - If the mandate is passive, the benchmark portfolio is an index; if it is active, we might select an index that represents the manager's state approach Tax-efficiency ratio - Simply the after-tax return divided by the pre-tax return - For example if the total annualized return is 10% and the return after tax is 8%, the tax efficiency ratio would be 80% - Tax efficiency is not as useful when returns are negative, i.e. if you had a -10% pre tax and -12% after tax return, the ratio would be 120%

As interest rates fall, the expected decline would be: callable bond, option free bond, puttable bond,

As interest rates fall, the expected decline from least to most would be: puttable bond, callable bond, option free bond. Since the bond investor is short the embedded call, and the option value has fallen, this will partially offset the loss compared to option free

discuss the use of leverage, alternative methods for leveraging, and risks that leverage creates in fixed-income portfolios; (FI 1) 11e

As long as funds can be borrowed at rates below the return on the investments made, leverage will enhance the portfolio return - Return of portfolio = return on invested assets + (Borrowed funds/ amount of equity invested) * (return on invested assets - return on borrowed assets) Methods of leverage: Futures contracts - Essentially buying options for a much smaller amount that the actual underlying Swaps - Fixed rate payer is effectively short a fixed rate bond and long a floating rate bond - When interest increase the value to the fixed rate payer increases because the PV of the fixed rate liability decreases and the floating rate payments received increase - The only capital needed to enter a swap is collateral required by counterparties Repo agreements - A securities owner sells the security for cash but agrees to buy it back at a specific date (typically one day later) - The repo rate is the difference between the security's selling price and its repurchase price Securities Lending - The primary motive of security lending transactions is to facilitate short sales - The lender of the securities can receive cash in exchange for the securities lent - When bonds are posted as collateral, the income earned on the collateral usually exceeds the lending rate. The rebate rate is the collateral earnings rate - security lending rate

explain the uses and limitations of classifying investors into personality types; (BF) 2a (BBK Five Way)

Bailard Biehl and Kaiser (BBK)Five way model Adventurer - Confident, may hold concentrated positions - Unwilling to take advice and hard to work with Celebrity - Will take advice about investing - Recognizes limitations but is anxious and impetuous Individualist - Independent and confident - Good to work with listens to advice & process info. rationally - Likes to make own decision only after careful analysis Guardian - Cautious and concerned about the future, as people age they may become guardians, may seek advice - Concerned with protecting assets Straight arrow - Average investor - Willing to take on some risk in the expectation of earning a commensurate return

Tax avoidance, reduction, deferral and risk avoidance, reduction, transfer (PWM)

Basic Tax Strategies - Tax avoidance - using accounts that are legally exempt from taxes on income and capital gains, also tax free gifts - Tax reduction - investing in tax free securities and more tax efficient securities such as utilizing long term gains instead of ST gains - Tax deferral - By deferring the recognition of certain taxes until a later date, clients can benefits from compounding that is not diminished by taxes (i.e. 401k) 1. Risk avoidance - is the purest form of loss control. That is one can remove the possibly of the loss occurring. I.e. you can sell the asset and remove the possibility of a loss occurring. 2. Risk reduction - seeking to reduce the size of a loss if a loss event occurs, i.e. maintain a high quality fire extinguisher, or having an airbag in a car 3. Risk Retention - maintain sufficient assets to absorb the loss 4. Risk transfer - Generally involves the use of insurance or annuities High frequency, high severity - risk avoidance High frequency, low severity - risk reduction Low frequency, high severity - risk transfer Low frequency, low severity - Risk retention

Types of assets (PWM)

Common types of financial capital include: Personal Assets - assets an individual uses or consumes in some form, including: cars, clothes, furniture, house - Investment Assets - Investment assets extend beyond relatively tangible investment assets (such as a liquid portfolio) to include less tangible asset (such as accrued DB pension) - Publicly traded marketable assets - includes money market instruments, bonds and common and preferred equity - Non-publicly traded marketable assets - non-publicly traded marketable assets include real estate, some types of annuities, cash value life insurance, business assets, and collectibles - Non Marketable assets - includes employer pension plans (vested), government pensions - Account type - i.e. taxable and tax- deferred accounts

Ex post vs. ex ante Overshooting

Capital Mobility - - The expected percentage change in the exchange rate can be computed as the difference between nominal short-term interest rates and the risk (i.e. term, credit, liquidity, equity) premiums of the domestic portfolio over the foreign portfolio. - When there is a relative improvement in investment opportunities in a country, the currency initially tends to see significant appreciation but "overshoot". In theory, the exchange rate will jump to a level where the currency where the currency with the higher risk adjusted expected return will be so strong that it will depreciate going forward.

SAMURAI (Trading)

Characteristics of a valid benchmark - Specified in advance - benchmark must be constructed prior to the evaluation period so that the manager is not judged against benchmarks created after the fact - Appropriate - consistent with manager's area of expertise - Measurable - must be possible to measure on a reasonable frequency - Unambiguousness - securities and their weights should be clearly identifiable - Reflective of the manager's current investment opinions - manager should be familiar with constituent securities - Accountable - manager should accept ownership and be willing to be held accountable - Investable - must be possible to replicate and hold benchmark

compare traditional and risk-based approaches to defining the investment opportunity set, including alternative investments; (Alts.) 20c (Strengths and weaknesses)

Comparing risk based and traditional approaches Traditional approaches Strengths - Easy to communicate - Relevance for liquidity management and operational considerations (i.e. public and private equity have very different liquidity, but have similar risk factor exposures) Weakness - Overestimation of portfolio diversification (An allocation spread across a large number of asset classes may appear to be diversified when in fact the underlying investments may be subject to the same underlying risks) - Obscured primary drivers (grouping distinct investments in the same asset class category i.e. government and HY bond may both be under Fixed Income) - can commingle assets with very different risk characteristics, Risk based approaches Benefits - Common risk factor identification across all investments - Integrated risk framework - able to build an integrated risk mgmt. framework Limitations - Sensitivity to the historical look back periods - Implementation hurdles: Determining what factors should be used and how to measure them in different asset classes (i.e. which liquidity factor to use) - systematic approaches can explain public asset's risk but not private as well

compare different approaches to passive equity investing; (Eq. 1) 16c (Completion and rebalancing overlay)

Derivatives based strategy - advantageous in that they are low cost, easy to implement and provide leverage. Derivatives are typically used to adjust a pre-existing portfolio to move closer to meeting objectives - Completion overlays - addresses an indexed portfolio that has diverged from its proper exposure. A common example is a portfolio with surplus cash from investor flows or dividends - Currency overlay - adjust the forex risk of the holdings in a foreign currency back to the home country's currency (used when you have a view on the movement of currency, or if you have a passive hedging BM. You wouldn't want to use a currency overlay when you don't have a particular view, when you have a short time horizon you would fully hedge, or when you have a local currency benchmark you will hedge) - Rebalancing overlay - addresses a portfolios need to sell certain constituents securities and buy others. Particularly in the contexed of a mixed stock/ bond portfolio Advantages of derivatives - Can quickly adjust at low cost - Trade in liquid markets - Make it easy to leverage Disadvantage - Derivatives expire so they will eventually have to be rolled - Some portfolios may not be able to be hedged with the given offerings of derivatives - Some contracts have position limits - Basis risk results from using a hedging instrument that is imperfectly matched to the investment being hedged Equity Swaps Disadvantages - swaps include counterparty, liquidity, interest rate, and tax policy risks - Equity swaps tend to be non-marketable so there is not a highly liquid market that allows them to be sold Advantages - As long as there is a willing counterparty a swap can be initiated on virtually any index - Swaps can be customized with respect to the underlying as well as settlement frequency and maturity Separately managed equity index based portfolios - Requires trading platform, data subscription, broker relationships, compliance - Index based strategies seek to replicate an index that is price at the close of each business day, therefore most index based trades take place as Market on Close orders - Program trading is a strategy of buying or selling many stocks simultaneously

compare major approaches to economic forecasting; (Econ) 3e

Econometric (application of statistical methods to model relationships among economic variables) Advantage - Models can be quite robust - New data may be collected and consistently used within models - Imposes discipline and consistency on the forecaster and challenges modeler to reassess prior view based on model results. Disadvantage - Complex and time consuming - Data inputs not easy to forecast - May give false sense of precision - Rarely forecasts turning points well Leading Indicator (These move ahead of the business cycle by a fairly consistent time interval) Advantage - Usually intuitive and simple in construction because it requires only a limited number of variables - Focuses primarily on identifying turning points - Can focus on individual or composite variables that are readily available and easy to track. Disadvantage. - Can provide false signals - May provide little more than binary yes/ no guidance - History may be revised each month, current data not reliable as input for historical analysis Checklist (Forecasters consider a whole range of economic data to assess the economy's future position. Checklist is straightforward but time-consuming, because they require continual monitoring) Adv. - Limited complexity - Flexible (can draw on any information, from any source, as desired) - Breadth can include virtually any topics Disadvantage. - Subjective, arbitrary - Time-consuming - Manual process which limits depth of analysis. Imposes no consistency of analysis across items or at different points in time

Economic Capital and HC equations

Economic net worth = Net worth from the traditional balance sheet + (Present value of future earnings + Present value of unvested pension benefits) − (Present value of consumption goals + Present value of bequests) HC0=∑t=p(st)(wt−1)(1+gt)(1+rf+y)^t ; essentially human capital is the probability of survival x wages at t-1 x 1 + growth rate / (1 + risk free rate + volatility adjustment)

Excess return of a corp. (FI)

Expected Excess Return = (time in years (holding period) x Spread) - (EffSpreadDur x change in spread) - (time xPOD x LGD)

discuss investment characteristics, strategy implementation, and role in a portfolio of event-driven hedge fund strategies; (Alts.) 19c

Event driven try to profit from predicting the outcome of corporate events - To do this funds take positions in securities of the corporations or related derivatives Merger Arbitrage - Works by correctly predicting the outcome of the deal - You would typically purchase the stock of the acquired company and short the stock of the purchaser - Hard catalyst - Investments made in reaction to an already announced corporate event in which security prices related to the event have yet to fully converge - Soft catalyst - Investments made proactively in anticipation of an event that has yet to occur - Hard approach is generally less volatile and less risky - Leverage of 300-500% is usually used to generate meaningful returns - When merger deals do fail, the initial price rise (fall) of the target (acquirer) company is typically reverse Role in portfolio - Sharpes tend to be relatively high as these strategies tend to produce steady returns with typically low double-digit returns and mid-single digit standard deviation Distressed Securities - Firms will take positions in securities of firms that are in financial distress including firms in or near bankruptcy - If/when a firm is liquidated the various participants are paid back in order of seniority - By nature, distressed and other illiquid assets may take several years to resolve and they are generally difficult to value, therefore HF managers typically require lockups Investment Characteristics - Returns of distressed securities tend to be greater with larger volatility - Leverage: Modest levels of leverage with 1.2 to 1.7 times NAV invested Strategy implementation - This can vary as you can target certain different types of securities - You can have a passive interest or acquire a certain class - In liquidation the focus is on determining the recovery value for different classes of claimants - In reorganization, the hedge fund manager's focus is on how the firms finances will be restructured and on assessing the value of the business enterprise Role in portfolio - These can be relatively illiquid but will return higher than other event driven strategies.

Grinold Kroner/ Singer Terhaar

Grinold Kroner (DCF Approach to Equity Returns) Expected Equity Return = Dividend Yield + (% change in earnings - % shares outstanding) +% change in P/E - For the delta s, shares outstanding, if the change in shares is decreasing then it will be a negative number and thus add to the expected return - Over the long run the change in P/E and the change in shares outstanding are expected to go to 0 Grinold can also be broken up into three different components - Cash Flow - Dividend Yield - change in shares outstanding = income return - Repricing Return - change in P/E - Expected nominal earnings growth - real growth in earnings Singer Terhaar (Risk Premium Approach, combo of 2 CAPM formulas) - The first assumes all global markets and asset classes are fully integrated, the second assumes complete segmentation of markets such that it is priced without regard to other countries/ asset classes. The ultimate formula is Risk premium of integrated market : correlation with global market*volatility of the country* (Risk Premium Global Market / volatility global market) (i.e. Sharpe ratio) Risk premium of segmented market: Volatility of the country * (Risk Premium (global market) / volatility (global market)) Total equals: Degree of global integration (RP integrated) + (1- degree of global integration ) * (RP Segmented) + illiquidity premium + Risk free rate Singer Terhaar model implies that when a country becomes more integrated, its required returns will decline, as prices adjust to a lower required return, the market should dliver an even higher level return

Static hedge vs. dynamic hedge (Econ)

Hedge Ratios with Forward Contracts - Static hedge - unchanging hedge, tends to accumulate unwanted currency exposures - Dynamic hedge - rebalanced periodically (while this will keep the actual hedge ratio close to the target hedge ratio, it will also lead to increased transaction costs)

Social proof vs. herding

Herding is when investors trade in the same direction or in the same securities, and possibly even trade contrary to the information they have available to them. Two behavioral biases associated with herding are the availability bias and fear of regret Social proof bias is when a person follows the beliefs of a group. Either consciously or subconsciously, individuals may seek the endorsement or favorable judgment of others within the group.

Wealth and Standard of Living and how to act (Behavioral

High Wealth & Low Standard of Living & Emotional Biases : Adapt Low Wealth & High Standard of Living & Cognitive Bias: Moderate Low Wealth & High Standard of Living & Emotional Biases: Moderate & Adapt High Wealth & Low standard of Living & Cognitive Biases: Moderate & Adapt

discuss volatility skew and smile; (Derivs.) 8h

Implied volatility - An important factor in the current price of an option is the outlook for the future volatility of the underlying asset's returns, the implied volatility - implied volatility increases for put options at strike prices that are lower than the current stock price, whereas implied volatilities decrease for call options for strike prices that are higher than the current stock price; - This is not observable but derived from an option pricing model Volatility smile - when the implied volatilities price into both OTM puts and calls trade at a premium to implied volatilities of ATM options, the curve is U shaped, and resembles a smile - volatility smile occurs when OTM call and put option volatilities are higher than ATM option volatilities and are also higher than normal volatilities for OTM put and call options. - This is a bullish indicator, similar to the skew but you see increased volatility for OTM calls Volatility skew - where implied volatility increases for more OTM puts but decreases for more OTM calls, as the strike moves away from the current price - This is a bearish indicator as it reflects a demand for insurance (OTM puts)

discuss how business cycles affect short- and long-term expectations; (Econ) 3f

Initial Recovery - - Monetary Policy: Stimulative Stance, transitioning to tightening, negative output gap is large, and inflation is decelerating - Money Market Rates: Low Bottoming - Yield Curve: Yield curve is steep at the bottom of a cycle. Short term rates will be falling or low, long term rates bottom - Stocks: stocks rally, riskier assets (SC stocks, HY bonds, EM securities) outperform Early Expansion - - Monetary Policy: Start to withdraw stimulus, output gap remains negative, profits typically rise rapidly - Money Market Rates: Short rates are moving up as the central bank starts to withdraw stimulus put in place during recession - Yield Curve: Curve remains steep though may begin to flatten. Short term rates will tend to rise first, while long term yields may be stable. (Front steepens, back-half flattening) - Stocks: trend upward Late Expansion - - Monetary Policy: Becoming Restrictive (Central Bank limits the growth of the money supply), output gap has closed - Money Market Rates: short-term interest rates are typically rising as monetary policy becomes restrictive because the economy is increasingly in danger of overheating - Yield Curve: longer bond yields are usually rising but more slowly than short-term interest rates are, so the yield curve flattens - Inflation and wages are increasing, inflation hedges such as commodities outperform - Stocks: stocks typically rise but are subject to high volatility as investors become nervous about the restrictive monetary policy and signs of a looming economic slowdown Slowdown - - Monetary Policy: Tight, tax revenues may surge as capital gains are realized - Money Market Rates: Approaching/ Reaching Peak - Yield Curve: Curve flat to inverted, especially may invert if central bank continues to exert upward pressure on short rates - Inflation often continues to rise - Stocks: Stock may fall with interest sensitive stocks such as utilities and quality stocks with stable earnings performing best Contraction - - Typically last 12 to 18 months - Short term interest rates drop during this phase as do bond yields - Yield Curve: Yield curve will start steepening as short term yields drop faster than long term yields. However, yields will decrease overall. Will be steepest again on cusp of recovery. - Monetary policy: progressively more stimulative. Aim to counteract downward momentum - Money Market Rates: Declining - Inflation tops out - Stock prices decline in early stages but usually start to rise during the latter stages anticipating the end of the recession

interpret the shape of the yield curve as an economic predictor and discuss the relationship between the yield curve and fiscal and monetary policy; (Econ) 3i

Loose fiscal policies (large deficits) increase the level of real interest rates because the domestic/ private sector must be induced to save more/ invest less, and results in higher inflation - Fiscal Policy tight (Low real rates), fiscal policy loose (high real rates) Tight monetary policy ultimately reduces actual and expected inflation resulting in lower nominal rates - Monetary policy tight (low inflation), monetary policy loose (high inflation) - Loose Fiscal and Loose monetary, gives you high nominal rates (i.e. inflation + real) - Tight fiscal and monetary, gives you low nominal rates (i.e. inflation + Real) - Tight monetary and loose fiscal gives mid nominal rates - Tight fiscal and loose monetary give mid nominal rates This section also discusses the business cycle and shape of the yield curve/ level of MM rates - In simplest terms the curve tends to steepen at the bottom of the cycle, flatten during expansion until it is very flat or even inverted at the peak, and re-steep during the contraction - The monetary policy is more stimulative during contraction, begins to withdraw during early expansion, and becomes restrictive The shape of the curve contains information about how market participants perceive the economy's state

describe and evaluate the use of mean-variance optimization in asset allocation; (Asset All.) 6a

Mean variance optimization - provides a framework for determining how much to allocate to each asset in order to maximize the expected return of the portfolio for an expected level of risk - MVO is a single period framework in which the single period could be a week, month, year, or some other period The objective function is expressed as: Investors Utility = Expected return of the portfolio - .005 x investor's risk aversion coeff. X variance of the portfolio with a given asset allocation - Risk aversion coeff. (0 is risk neutral, 4 is moderately risk averse, 6 would be very risk averse) - Lower risk aversion coefficient leads to a riskier point on the efficient frontier while a higher risk aversion coefficient leads to a more conservative point - This equation involves estimating the investor's risk aversion parameter and then finding the efficient portfolio that maximizes expected utility The inputs for MVO are - expected return, - standard deviation, and - correlations between the between the asset classes MVO portfolios are more sensitive to measurement errors in the expected return than to measurement errors in correlation and risk. MVO solves for optimal asset weights based on expected returns, covariances, and a risk aversion coefficient. Constraints: weights must sum to 1 Only positive weights allowed Problems with MVO - The outputs (asset allocation) are highly sensitive to small changes in the inputs, so if you have poor inputs you can't expect fair results - The asset allocations tend to be highly concentrated in a subset of the available asset classes. This leads to lack of diversification -Many investors are concerned about more than the mean and variance of returns, the focus of MVO, they may be concerned about skewness and kurtosis (Tools developed to address include mean-semivariance optimization, mean-variance skewness optimization, mean conditional VaR optimization) - While MVO can diversify across asset classes, some asset classes will share similar risks so those can't be diversified away (Remedy: use factor based allocation) - Most portfolios exist to pay for a liability or consumption series, and MVO allocations are not directly connected to what influences the value of the liability or the consumption series (Remedy: Liability Relative or goals based allocation) - MVO is a single period framework that does not take account of trading/ rebalancing costs and taxes (Remedy: Use Simulations) Problems 1 and 2 are solved by reverse optimization or Black Litterman Problems 3, 5, 6 solved by MVO

contrast Type I and Type II errors in manager hiring and continuation decisions; (Trade, Per., Eval.) 27b

Null hypothesis is that the manager doesn't provide any value Type 1 is incorrectly rejecting the null hypothesis and hiring or retaining a manager who subsequently underperforms expectations - Type 1 is an error of commission, an active decision that turned out to be incorrect, creates explicit costs - Type 1 errors are more transparent to investors, since they entail the regret of an incorrect decision but the pain of having to explain to an investor Type 2 is an error of omission, or inaction; null hypothesis is not rejected where there was in fact value added; - not hiring or firing a manager who subsequently outperforms or performs in line with expectations - Type 2 errors are less transparent to investors, unless the investor tracks fired managers Smaller the expected cost of Type 1 or Type 2 errors. - The smaller the difference in sample size and - the smaller the distribution mean between skilled and unskilled managers - and the wider the dispersion of the distributions ((The wider the dispersion of returns between strong and weak managers, the easier it is to distinguish between their relative skills) The greater the expected cost - The wider the mean difference between skilled and unskilled managers (The wider the dispersion of returns between strong and weak managers, the easier it is to distinguish between their relative skills) More efficient markets are likely to exhibit smaller differences in distributions of managers indicating a lower opportunity cost.

PCGE (PWM)

PCGE formula = (gains - losses - capital distributions)/ (Starting assets + gains - losses - capital distributions) PCGE is an estimate of the percentage of a fund's assets that represent gains and measures how much the fund's assets have appreciated; PCGE can be used to gauge the amount of tax liability embedded in a mutual fund; if a fund has losses, negative PCGE, it is likely to be more tax efficient going forward. You subtract losses and distributions from the gains and divide by starting assets

Shifts when using CF match and duration matching

Parallel Shifts can be tolerated by duration and CF Match, Non parallel shifts only tolerated by CF match; duration matching assumes parallel shift Which portfolio offers protection from non parallel shifts and twists -ladder

explain the following components of portfolio evaluation and their interrelationships: performance measurement, performance attribution, and performance appraisal; (Trade, Per., Eval.) 26a

Performance evaluation includes three primary components: Performance measurement - Calculates both the return and risk of the portfolio over a specified time typically relative to a benchmark Performance attribution - determines the key drivers that generated the accounts performance. - What portion was driven by active manager decisions - Decompose risk and return Performance appraisal - determines whether the performance was affected primarily by investment decisions, by the market, or by chance; makes use of risk, return, and attribution analyses to draw conclusions regarding quality of a portfolio's performance These help to answer three questions - What performance did the fund achieve during the period? (performance measurement) - How did the manager achieve their performance or that risk was incurred? (attribution) - Did the fund manager achieve their performance via skill or luck? (appraisal) - performance appraisal (indicates whether the portfolio's performance was achieved through manager skill or through luck) vs. - attribution (analyzes the impact of active investment decisions on returns and the risk consequences of those decisions) vs. - measurement (an overall indication of the portfolio's performance, usually relative to a benchmark)

P= M + S + A (Trading)

Portfolio = Benchmark + active Benchmark = market + style returns Style = Benchmark - Market Portfolio return can be broken up into 3 components: market, style, and active management Portfolio return = Market + Style + Active management Active return is the difference between manager's overall portfolio return and the style benchmark Excess return to style, difference between managers style index return and the broad market return

Holdings vs Returns vs. Transactions Based (Equity)

Returns based attribution - regressions are used to analyze the performance over some period. No attempt is given to identify the holdings - Most appropriate when underlying portfolio information is not available - Easiest to implement - least accurate - Vulnerable to data manipulation - Returns-based attribution is the least accurate of the three attribution approaches. This technique does not use underlying holdings and is most vulnerable to data manipulation Holdings based attribution - Returns based won't take into account any changes in that were made after the initial period so could be good in identifying style drift - Good for strategies with low turnover (i.e. passive strategies) - Accuracy improves when data has shorter time intervals - Drawbacks: may not reconcile to portfolio return, fails to capture impact of transactions - All transactions are assumed to occur at end of day Transactions based - improves upon the holdings based returns by adding any subsequent trades. This is the most reliable of the trading measures - Difficult and time-consuming to implement - Most accurate

describe and evaluate the use of mean-variance optimization in asset allocation; (Asset All.) 6a (Resampled Eff, BL, MC)

Reverse Optimization takes as its inputs a set of asset allocation weights that are assumed to be optimal and, with the additional inputs of covariances and the risk aversion coefficient, solves for expected returns. These reverse- optimized returns are sometimes referred to as implied or imputed returns. - The most common set of starting weights is the observed market capitalization value of the assets or asset classes that form the opportunity set - However, reverse optimization can work with any set of starting weights - If one has strong views on expected returns that differ from the reverse-optimized returns, an alternative or additional approach is needed - Helps solve the MVO problems of concentrated positions and sensitivity to small difference in inputs. Black Litterman Model - is a complementary addition to reverse optimization - Starts with excess returns produced from reverse optimization and then provides a technique for altering reverse optimized expected returns - allows for the investor's own distinctive views on the implied returns from those produced by reverse optimization. analyst adjusts the output from reverse optimization with his expectations of the market before he continues to retrieve asset weights. - BL has two methods for showing viewpoints: one in which the absolute return forecast is associated with a given asset class, and one in which the return differential relative to another asset is expressed (i.e. Japan will outperform UK by 100 bps - Can add constraints beyond the budget constraint (i.e. upper limit to an asset class, allocation range for an asset) - Helps solve the MVO problems of concentrated positions and sensitivity to small difference in inputs. Resampled Mean Variance Optimization - combines the mean variance optimization framework with Monte Carlo simulation and leads to more-diversified asset allocations - Resampling uses MC simulation to estimate a large number of potential capital market assumptions for MVO and the resampled frontier Resulting asset allocations are averaged

Generating liquidity (PWM)

Strategies for business owners to generate full or partial liquidity include the following: - IPO - Sale to third party investor - Sale to insider - Divestiture of non-core assets - Personal line of credit against company shares - Leverage Recapitalization - typically a private equity firm will invest equity and take partial ownership of the business. The owner receives cash for his stock and maintains a minority interest - Employee stock and ownership plan - sale over time that allows for partial diversification

Super Asset Classes (AA)

Super asset classes - Capital assets - ongoing source of something of value (such as interest or dividends) - Consumable/ transformable assets - Assets, such as commodities, that can be consumed or transformed - Store of value assets - Neither income generating nor value as a consumable, examples include currencies, gold , art HFs would be considered diversifying strategies and would not fit in the 3

discuss the effects of monetary and fiscal policy on business cycles; (Econ) 3h (Taylor Rule and QE)

Taylor Rule determines the target interest rates using the neutral rate, expected GDP relative to long term trend, and expected inflation - R target = r (Neutral) + inflation (target) + (.5(GDP (expected) - GDP (Trend)) + .5 (inflation expected - inflation target) - A negative rate is defined as a net payment to keep money on deposit at a financial institution Quantitative Easing - Central banks commit to large scale, ongoing purchases of high quality domestic fixed income securities by creating an equally large quantity of reserves - In theory, there should be growth, since banks could use the increased reserves to extend loans, and low interest rates would stimulate businesses and households to borrow Central Bank mandates - Maintain Price Stability and/ or - Maintain growth consistent with the economy's potential The mix of monetary policies has its most apparent impact on the level of interest rates and shape of the yield curve

How changes to plans, i.e. early retirement option, affect the portfolio (asset allocation)

To best determine how a liability based benchmark should be constructed, the manager first needs to understand the features of the plan. The following features influence the structure of the liability - Average number of years to retirement (longer less liquidity needs) - Percentage of workforce that is retired (Higher, more liquidity needs) - Average participant life expectancy (higher more liquidity needs) - Whether the benefits are indexed to inflation (less liquidity needs) - Whether the plan offers an early retirement option (more liquidity needs)

discuss the advantages and disadvantages of credit spread measures for spread based fixed-income portfolios, and explain why option-adjusted spread is considered the most appropriate measure; 14b (FI II)

Yield Spread (or benchmark spread) - is the simple difference between a bond's YTM and the YTM of an on-the run government bond of similar maturity - Advantages - simple to calculate and observe - Disadvantage - maturity mismatch and curve slope bias, only useful in relative value for bonds of identical maturity, benchmark security can change over time G-spread uses constant maturity Treasury yields to maturity as the benchmark (frequently using a linear interpolation) - Advantages - transparent and maturity matching default risk-free bond - Disadvantage - subject to changes in government bond demand - Calculating G Spread on a corporate. You'll essentially have to interpolate government bonds, i.e. if it's a 12 year corp, you'd have to find a middle ground with 10 and 20 year bonds potentially I spreads use interest rate swaps as the benchmarks. Swaps are derived using short-term lending or market reference rates (MRRs) so it is transaction based - Advantages - can be used as a duration hedge directly or for carry trade; quoted across all maturities - Disadvantages - point estimate of term structure and limited to option- free bonds - In a problem you will be given swap spreads of two different maturities say 20 bps and 25 bps. You would add these spreads to the yields, then interpolate the yearly value to match the corp or whatever bond you're comparing against. Asset swap spread (ASW) is the difference between the bond's fixed coupon rate and the fixed rate on an interest rate swap versus MRR - Advantages - traded spread to convert current bond coupon to market plus a spread - Disadvantages - Tradable spread rather than spread measure corresponding to cashflows and limited to option- free bonds Z spread - Constant spread over a government (or swap) spot curve - Advantages - Accurately captures term structure of government or swap zero rates, more accurate than the G or I spread - Disadvantages - more complex calculation, limited to option - free bonds Credit Default swap (CDS) basis - refers to the difference between the z-spread on a specific bond and the CDS spread of the same (or interpolated) maturity for the same issuer - Negative basis if the z-spread is above the CDS spread - Advantages - interpolated CDS spread versus z spread - Disadvantages - Tradable spread rather than spread measure corresponding to cashflows and limited to option- free bonds Option adjusted spread - constant yield spread over the forward rates which makes the arbitrage free value of such a bond equal to its market price - Advantages - Provides generalized comparison for valuing risky option-free bonds with bonds with embedded options - Disadvantages - Complex calc based on volatility and prepayment assumption; bonds with embedded option are unlikely to earn OAS over time - The z spread for an option free bond is simply its OAS - OAS = Zspread + Option Cost; Having a callable bond is detrimental to the owner of the bond so its negative - A Put Option is an option for the bondholder, written by the issuer. It gives the bondholder the option to demand early repayment of principle at the exercise date(s).

formulate a portfolio positioning strategy given forward interest rates and an interest rate view that coincides with the market view; 13b (FI II) (static yield curve)

two basic ways to actively position a bond portfolio versus a benchmark index are to add duration or leverage Static Yield curve - Buy and hold (buy bonds with a duration greater than the benchmark (higher coupon income), may involve less liquid bonds (higher YTM)) - Rolling down the yield curve ( active trading strategy where a bond trader buys bonds with a maturity longer than their investment horizon. Therefore, buying a longer maturity bond will yield higher returns due to price gains, provided that it is held for a period less than maturity) - Repo Carry trade - buy a bond financed in the repo market (adds leverage and generates repo carry return if coupon plus rolldown exceeds financing cost) - Sell Convexity