CFA Level 3 - Book 2 - Institutional Investors and Economic Analysis

Non-Life Insurance companies? IPS': Risk / Return? Constraints?

-Long Tails -- payouts can take a long time to pay out; -Inflation risk -- replacement cost -- NOT FACE VALUE; -Harder to predict payout amounts AND timing (as opposed to life insurance - just timing) -Underwriting / Profitability cycle -- 3 to 5 yrs -- during periods of intense competition, can go too low on premiums; -Can be concentrated geographically; Return: Greater uncertainty regarding claims, but not as interest rate sensitive. Competitive pricing policy; Risk: Tempered by liquidity requirements; Inflation risk / cash flow is unpredictable. Many cos have self imposed ceilings on common stock to surplus ratio; L: High TH: Short, nature of claims; T: Important L/R: Less onerous than for Life Insurance cos. Unique needs: Financial status of the firm.

Formal tools used for setting capital market expectations: The risk premium approach? Financial equilibrium models? Singer and Terhaar analysis? Ex: E(R), B and covariance for A and B Sharpe Global = .29 St Dev Global = 9% rfr = 5% DEGREE of Market integrationA = 80% DEGREE of Market integrationB = 65% St Dev A = 17% St Dev B = 28% Corr A / Global = .82 Corr B / Global = .63 Illiquidity premium A = 0% Illiquidity Premium B = 2.3%

'Build up approach' - Build up a bond yield and add an equity risk premium. Rb = real rfr + inflation rp + default rp + liquidity rp + maturity rp + tax premium Assumes Supply and Demand are in balance I (international) CAPM: Ri = Rf + B(Rm - Rf). But need to know equity risk premium (or debt): Step 1: Corr(i,m) = Cov(i,m) / σiσm Step 2: Bi = Cov(i,m) / σ²m Step 3: Bi = Corr(i,m) σi / σm Step 4: Ri = Rf + B(Rm - Rf). RPi = B(Rm - Rf) RPi = Corr(i,m) σi * ((Rm - Rf) / σm) **** Last term ((Rm - Rf) / σm) = Market Sharpe ratio **** COVARIANCE BW A & B ASSET: Cov = BaBbσ²m Adjusts ICAPM for market imperfections -- ie liquidity premiums (ie PE firms lockup period) and segmentation premiums (ie not free flow of capital, goverment interventions / restrictions). SEE EXAMPLE Ex: Full integration ERPA = (.82)(.17)(.29) = 4.04% ERPB = (.63)(.28)(.29) +2.3% = 7.42% Full segmentation (ie Corr = 1) ERPA = (.17)(.29) = 4.93% ERPB = (.28)(.29) +2.3% = 10.42% WEIGHTED AVERAGE ERP (degree of integr.)(ERP full integr.)+ (degree of segmentation)(ERP full segmentation) ERPA = (.8)(.0404)+(1-.8)(.0493) = (.0422) ERPB = (.65)(.0742)+(1-.65)(.1042) = (.0847) E(RA) = 0.05+ .0422 =.0922 E(RB) = 0.05+ .0847 =.1347 Ba = .82*.17 / .09 = 1.55 Bb = .63*.28/ .09 = 1.96 Cov = BaBbσ²m = 246.08 (use 9 instead of .09)

Why forwards for currency hedging? Roll yield in relation to to currency trading?

- Can be customized vs. futures contracts - Available for almost any currency pair - Futures contracts require margin - Trade volume in FX is much, much higher than futures so more liquidity; ----------------Fp/b > Sp/b---Fp/b < Sp/b Long forward (B)---Negative RY---Positive RY Short forward (B)---Positive RY---Negative RY Positive RY decreases hedging costs and encourages hedging;

Explain expected effects on share prices, expected returns & return volatility as a segmented market becomes integrated.

- Equity share prices rise as (1) capital can now flow into the formerly uninvestable market and (2) reflect declining standalone risk - E(R) ↑ as capital flows into the market but then declines w higher stock prices and lower risk going forward; - LR return volatility should decline (info more available and standalone risk ↓) - Diversification benefits ↓

Emerging market CURRENCY considerations? Non-deliverable forwards?

- Low trading volume / low liquidity / higher transaction costs to exit. ie carry trades w blow up if everyone exits at once; - Dealers unable to independently transact in 2 emerging market currencies, have to go through other dealers w expertise; - 'Tail risk' - non-normal distributions (gov't intervening in markets) - Higher yield = large forward discounts / negative roll yield; -Contagion is common. Certain emerging markets restrict movement of their currency into / out of the country to settle normal derivative transactions; (Brazil / China / Russia); This is an alternative that just settles up gains in developed country currency; ***Decreases credit risk;

STRATEGIC asset allocation (SAA) approaches: Mean Variance Optimization (MVO) Approach? Ex: 4 asset classes: Port A: E(R) = 10% w₁ = .25; w₂ = .15; w₃ = .20; w₄ = .40) Port B: E(R) = 15% w₁ = .30; w₂ = .20; w₃ = .35; w₄ = .15) Both on efficient frontier; Calculate the asset class weighting for the efficient portfolio w an expected return of 11%. Each investor could have different assumptions on st dev, E(R), and Corr, leading to different ______, however, simplifying theory is that all investors for homogenous expectations (thus 1 CAL: _______). Therefore leads to the same risky portfolio and thus it becomes the ___________ which holds ALL risky assets (tangent w the frontier). NOTE THE EXCEPTION WITH THE CAL, CML, and the EF.

- Static Approach. - Mean-Variance Efficient Frontier -- efficient combination of all risky assets (y-axis = E(R); x-axis = σ). Any portfolio below the global minimum variance portfolio is sub-optimal; - Can be calculated on a constrained / unconstrained basis (uncon. -- = allows short selling -- regardless weights must total 100%; Rp = w₁R₁ + w₂R₂ 11% = w₁ (10%) + (1-w₁) (15%) w₁ = .80; therefore w₂ = .20 w₁ = (0.80)(.25) + (0.20)(.30) = .26 w₂ = (0.80)(.15) + (0.20)(.20) = .16 w₃ = (0.80)(.20) + (0.20)(.35) = .23 w₄ = (0.80)(.40) + (0.20)(.15) = .35 NOTE: the asset classes add up to 1.0; CALs Capital Market Line (CML) market portfolio. ** Most analysis would say that any point on the CML is superior to the EF; While technically correct, there are issues w the theory: 1) Even the most risk free assets will have a st dev over time; A cash equivalent asset should be treated as such to make a EF, not a CML; 2) Borrowing the 'risk free asset' has other ramifications / obligations and will make investors uncomfortable;

Emerging Markets: Characteristics / Risks faced by investors? Country risk analysis techniques?

-Many EM countries require a heavy investment in infrastructure, which might require heavy foreign borrowing and create crises; -Also have unstable political / social systems; lack of middle class; -Undiversified economies (ie sale of 1 commodity) 1. Does the country have responsible fiscal / monetary policies? (ie deficit / GDP & Debt / GDP) 2. What is expected growth? (at least 4% to compensate for risk / high growth environment for tariffs taxes etc??) 3. Does the country have reasonable currency values and current account deficits? 4. Is the country too highly levered? (50% foreign debt / GDP) 5. What is level of foreign exchange reserves to short term debt? (Many foreign debts must be paid off in foreign currency -- way if reserves don't match debt repayment for 1 yr) 6. Gov't stance on structural reform?

How does economic information is used in forecasting asset class returns: Cash? Credit Risk free bonds? Credit risky bonds? Emerging market gov't bonds? TIPS?

- Technically cash instruments are short term debt (ie commercial paper), w maturity of 1 yr or less; Managers adjust MATURITY and CREDITWORTHINESS based on forecasts for interest rates and the economy; ie. manager thinks interest rates will rise -- shift from 9 mo cash instrument to 3 mo cash instrument; Typically just a portion of real yield and inflation ; - Investor will typically focus on changes in the economy (higher growth = higher yields and higher inflation) and changes in ST interest rates (increase usually increases all term bonds, but if too high of ST rate increase, then medium / long term might go down); Same as above but with credit risk spreads; higher with declines in the economy, more competitive and less funding available; Key difference is that most emerging market debt is denominated in a hard currency (dollars / euro). Therefore, default risk much higher; Free of credit risk and inflation risk, but not price risk. The YIELD: - Rises as real economy expands; ST interest rates ↑ w the economy; Vice versa - Fall as inflation accelerates and more investors move to buy inflation index bonds; (ie increase in demands) - Other changes in supply / demand (markets for these are small). ***YIELD I BELIEVE DOES NOT INCLUDE INFLATION. THEREFORE AS INFLATION INCREASES, YIELD FALLS).

ALM approach -- pension funds: Asset-only approach? Better approach? Asset only vs. liability relative -- risk free investment? Asset only vs. liability relative -- measuring pension liability?

-- Only looks to select efficient portfolios; Doesn't try to hedge the risk of liabilities or note that liabilities are subject to market risk; ie if portfolio does well -- pension liabilities will grow too in the form of wages etc. -- Recognize economic liability (Various exposures and components of the pension liability). Called LIABILITY RELATIVE APPROACH. --Asset only -- rf investment = return on cash -- Liability-relative -- rf investment = one that mimics liability in performance (breaking into various exposures). --Asset only -- = duration management - interest rates effect on the liability (ONLY OK FOR SHORT TERM) -- Liability-relative -- Complex Liability modelling ---INACTIVE PARTICIPANTS; Could be: ----fixed -- not increasing w inflation. nominal bonds ----fully index to inflation -- TIPS ----partially indexed -- real rate / nominal rate blend ---ACTIVE PARTICIPANTS ----past service -- same as inactive parts. ACCRUED BENEFITS = past service + INACTIVE ----future service -- PV(wages earned in the future) can be broken into wage growth from inflation (TIPS) and real growth (usually due to labor productivity -- correlated w GDP and hence the stock market) ----other changes -- difficult to forecast future changes. ---LIABILITY NOISE ----Due to plan demographics. Inactives - split bw retirees (noise due to mortality risk) and deferreds (not employed for co, but eligible -- noise due to mortality risk, but also uncertainty around when retirement occurs -- affects payout -- therefore noise is greater and less easily hedged). ----Due to model uncertainty

Asset classes have been appropriately specified if? Theoretical and practical effects of asset classes? Thoughts on including these additional asset classes: TIPS? Global Securities? Alternative Securities? Application of mean-variance to decide whether to add an additional asset class?

-Assets in the class are similar from a descriptive as well as a statistical perspective -They are not highly correlated - so provide diversification -Individual assets cannot be classified into more than 1 class -They cover the majority of all possible investible assets -They contain sufficiently large % of liquid assets -Theoertical = effect on portfolio risk / return -Practical = liquidity, taxes, legal, political etc. TIPs: -Correlation with traditional bonds and equities are low -Highly liquid Global -Theoretical: Potential to increase return at all levels of risk -Practical: Other elements / factors to consider added compared to domestic portfolio; Alternative -Diversification benefits -A lot capital needed, important to select outperformers -If Si > Sp x Corr(i,p) then adding the investment will improve the Sharpe ratio (E(R)-rfr / st dev))

Risks, cost, opportunities --- non-domestic equities and bonds. Risks: -Currency risk? -Political risk? -Home country bias? Costs? Opportunities?

-Currency risk - Have LMR (Local market return) and LCR (Local currency return) and these generally have correlations less than 1.0. The closer it approaches -1.0 the more stable the return; Over time diversified currency risk is small in the LT, ie mean-reverting. The st dev of currencies is generally smaller than equity markets (less important for risk) whereas st dev is higher than that of bond markets (more important); -Political risk - 1) When a country has irresponsible fiscal and/or monetary policy; 2) lacks reasonable legal / regulatory rules to support but not stifle financial markets; -HCB - create suboptimal portfolio and investors overweight investments in own country; -Transaction costs higher, liquidity lower (Emerging markets -- Market impact transactions costs - lack of volume so large orders can swing market price before order completion) -Withholding taxes might not be offset by tax treaties -Free float can be an issue (gov't owns a lot of shares and wont sell) -Inefficient market infrastructure; Theoretical argument is that higher expected returns w lower correlations would increase Sharpe; Rise in correlations however happen during financial crises explained by: -Markets are becoming less segmented and more integrated; -Industry risks are becoming more important than country risks; However, benefits of international diversification: -Foreign markets could be undervalued thus offering a better return; -While home market may have had best returns in the past - might not always be the case for future returns -Even if correlations rise in the ST for equity markets; not the case in the long term; -Correlations in bond markets tend to be lower than in the equity markets

How does economic information is used in forecasting asset class returns: Common Stock?

-NOTE: CS valuation is a function of earnings and discount rate. Think back to business cycle for specifics; - P/E ratios -- very high in the expansion periods when interest rates are low and earnings prospects are high; low on a slowdown; (might still be high in recession if quick turnaround expected);

Formal tools used for setting capital market expectations: Statistical tools?

-Projecting historical data -- straightforward mean, st dev, and correlations; geometric mean better for time series vs. arithmetic mean better for any 1 period. Choice of geo vs. ari -- affects MRP selected. ARI = Market return less rfr; GEO = (1+ Market return divded by 1+rfr) - 1; -Shrinkage estimators - weighted average of historical data and some other estimate; These reduce (shrink) the influence of historical outliers through the weighting process -Time series analysis - previous values of itself as well as previous values of other variables. Volatility clustering (when high / low volatility persists -- function of previous year); -Multifactor models Cov(i,j) = Bi1*Bj1*Var1+ Bi2*Bj2*Var2 + (Bi1*Bj2 + Bi2*Bj1)(Cov(1,2))

Major approaches to economic forecasting:

1) Econometrics - economic theory to formulate a forecasting model Adv: - Once establish can be reused - Can be complex / accurately model real world - Can provide quantitative forecasts of economic conditions Disadv: - May be difficult and time intensive to create - Proposed model may not be applicable for future time periods - Better at forecasting expansions 2) Economic indicators - ie leading / lagging indicators Adv: - Available from outside parties - Easy to understand and interpret Disadv: - Not consistently accurate / can give false signals 3) Checklist approach - subjective question list brainstorming questions about an economy

Pension fund risk tolerance from the perspective of: 1) Plan surplus 2) Financial status and profitability 3) Sponsor and pension fund common risk exposures 4) Plan features 5) Workforce characteristics

1) Greater the surplus, greater the ability for plan to withstand negative results... therefore allows greater risk tolerance. *** underfunded plans might have higher WILLINGNESS to increase risk tolerance to avoid costly funding of plan assets, but NOT ACCEPTABLE. 2) The greater the strength of the sponsor (profitability / DE ratio etc), greater risk tolerance 3) Higher the CORRELATION of firm profitability and value of plan assets, LOWER risk tolerance -- i.e. don't want poor results to coincide with needing to fund pension 4) Provisions for early retirement / lump sum distributions decrease the duration of plan liabilities and risk tolerance. 5) Younger workforce &/or high ratio of active lives to retired lives = greater risk tolerance

Active currency trading STRATEGIES: 1) Economic fundamentals 2) Technical analysis 3) Carry Trade 4) Volatility Trading

1) LT currency value approaches FV; Purchasing power parity; Increases associated w. a) lower inflation; b) higher real / nominal interest rates; c) of countries w declining risk premiums; 2) Based on : a) past price data can predict future movements b) humans react to similar events and price patterns repeat c) unnecessary to know fundamental value, only where it will trade; Typical patterns: -Overbought market gone up too far and likely to reverse; -Support / resistance levels exist; Prices become sticky here (although they can break through if the trend continues); 3) Borrowing currency, investing in another, due to currency and interest rate differentials; Carry trade violates uncovered interest rate parity; Traditionally it is done by borrowing in low interest rate country, exchanging, and earning high interest rate; Historically, the investing currency has not depreciated as much as theoretically should, however, during times of financial distress and large volatility, large losses can be expected; 4) Vol trading; Delta = ∆ in option price for a change in underlying price; Vega = ∆ in option price for change in volatility; Delta neutral positions can be created to hedge any small changes in underlying, but can make profit on changes in underlying volatility; Long straddle = buying volatility; **STRANGLE -- similar to straddle, but out of the money for both put/call; costs less, but will profit less as well;

Long term trend growth: Decomposed into 2 main components? What is/ isn't important in the long term growth rate in an economy?

1. Changes in employment levels (labor force participation + pop growth) 2. Changes in productivity a. Spending on new capital inputs b. total factor productivity growth. (more efficient use of inputs and better technology) ***SUM ALL OF THESE ELEMENTS TO GET THE LT PROJECTED GROWTH RATE - Consumer spending is largest component of GDP, but fairly stable over business cycle (Friedman's permanent income hypothesis -- when consumers perceive as temporary slowdown, consumption / spending will not change a great deal). - More imporatnt is gov't structural policy -- designed to enhance growth. 4 guidelines: --1. Gov't should provide infrastructure needed for growth (roads, internet, education), but interfere as little as possible (private sector more efficient) --2. Responsible fiscal policy. HIGH budget deficients lead to inflation (when coupled w fed). Can result in trade deficits -- ie currency devaluation. Crowding out effect. --3. Tax policies that are transparent, consistently applied not overly burdensome. --4. Promote competition in the marketplace (reduce tariffs / technological advances)

9 problems in forecasting capital markets?

1. Limitations to using economic data; - Time lag bw collection and distribution - Data is often revised after the fact - Data definitions and methodology change over time 2. Data measurement error and bias - transcription errors - recording info incorrectly - survivorship bias - appraisal (smoothed) data used, instead of actual returns 3. Limitations of historical estimates -Regime changes that result in non-stationary data. ie bursting bubble in stock market have returns data that are sign different than historical. -Long time period preferable due to i) statistically required ii) larger data set more precise iii) less sensitive to starting and ending points. -However, they i) include regime changes ii) RELEVANT time period too short to be statistically relevant. iii) tempation to use more frequent data points -- even if more likely to have missing / outdated values (asynchronism)

Strategies for reducing hedging costs / modifying risk return characteristics? Exotic options?

1. Over / under hedge w forward contracts (modify the hedge ratio). Low cost (except for opportunity) 2. Buy ATM put option (protective puts). Expensive but no opportunity costs 3. Buy OTM put options. Reduces upfront costs, but doesn't eliminate all risk;** ATM have options have .5 deltas (ABS); Therefore called 50-deltas; 4. Risk reversal or collar. Ie buying a 35-delta put and selling a 35-delta call; 5. Put spreads. ie buying a 35-delta put and selling a 25 delta put; protected if falls below xx but not if falls below yy; 6. Seagull spread: same as put spread, but selling a call as well; 1. Knock-in option -- only comes into existence if underlying reaches xx level; 2. Knock-out options -- ceases to exist if it hits xx level; 3. Binary or digital options -- pays a fixed amount that doesnt vary w the diff in price bw underlying and strike;

4 methods of forecasting exchange rates?

1. PPP. - differences in inflation will be reflected in changes in exchange rate bw them; Country w higher inflation will see its currency value decline; DOES NOT HOLD IN SHORT / MEDIUM TERM, but does in the long term; 2. Relative economic strength approach - favorable investment climate will attract investors -- increase demand for currency value; OR high short term rate will attract investors -- increase demand for currency even if currency overvalued. MORE SUITED TO SHORT RUN CHANGES IN CURRENCY VALUE 3. Capital flows approach -- focuses on LT capital flows like equity investments or FDI. COMPLICATES #2. ie a CUT IN ST rates might INCREASE the value of the currency bc promotes growth / attractiveness of the stock market; (MAKES CENTRAL BANK JOB DIFFICULT) 4. Savings-investment imbalances approach. Explains why currencies may diverge from equilibrium values for extended periods. Investment must be made by domestics savings, and if not through FDI. In order to attract / keep FDI, must have / keep strong currency; But the FDI inherently causes a current account deficit, which typically weakens a currency; Tight rope;

Currency movements on portfolio risk and return: 1. Investor's returns in domestic currency on a foreign asset? Ex: Euro investment; value of portfolio increases 5%, Euro goes from 1.3 USD/EUR to 1.339 USD/EUR **NOTE? 2. Investor's returns in domestic currency on multiple foreign assets? 3. Variance of returns in domestic currency on a foreign asset? 4. St Dev of returns in domestic currency on a foreign asset if Rfc is a risk free asset?

1. Rdc = (1+Rfc) (1+Rfx) - 1 = Rfc + Rfx + (Rfc * Rfx) 1.03*1.05 - 1 = 8.015% Make sure you are careful on the Rfx returns; ie you have the foreign currency and you are PRICING the domestic -- so EURO / USD rate would yield a different result; 2. Rdc = ∑wi (Rdci) 3. Based on the variation of the variance of a two asset portfolio σ²(Rdc) ≈ w²(Rfc)σ²(Rfc)+w²(Rfx)σ²(Rfx)+ 2w(Rfc)w(Rfx)σ(Rfc)σ(Rfx)Corr(Rfc,Rfx) BUT can 'weight' the '2' returns as 1.0 each σ²(Rdc) ≈ σ²(Rfc)+σ²(Rfx)+2σ(Rfc)σ(Rfx)Corr(Rfc,Rfx) 4. σ(Rdc) = σ(Rfx)(1+Rfc)

Spot exchange rate - immediate delivery, ie. exchange of currencies take place __ days after the trade Dealer provides bid-ask prices for currency, the spread is known as ____. They are worth ______. Example. Euro quote bid $1.4124-ask 1.4128. How many? ****NOTE Dealers manager inventory in the ______; Spread quote by dealer depends on? Interbank spread usually depends on?

2; pips; 1/10000; 4 pips. PIPS are generally based on how long the decimal point goes to!!! interbank market (spreads narrower); -Spread in interbank market -Size of transaction (larger = more spread); -Relationship with client -Currencies involved (USD/EUR, low spread, unlike AUD/CZK) -Time of day; if its a time overlap with when the NY and London currency markets are open, then more liquid -Market volatility -Maturity

9 problems in forecasting capital markets (4-9)?

4. The use of ex post risk and return measures -ex post (after the fact); ex ante (before the fact) -Problematic when trying to determine ex ante risk and return; 5. Non-repeating data patterns; - data mining - random chance that something will correlate. - time period bias -- pattern holds for specific period 6. Failing to account for conditioning information; ie security returns and economic data isn't constant over time. ie firms historical Beta = 1.2, but also 1.0 in expansions and 1.4 in recessions. 7. Misinterpretation of correlations. ie what variable causes which, might be another variable we are missing, or not a linear relationship. Need multi-variable regression; 8. Psychological traps; a. anchoring trap - too much on first info received b. status quo trap - too much on recent info c. confirming evidence trap - look for evidence that supports their view d. overconfidence trap - overestimate accuracy of predictions and underst. past mistakes. e. prudence trap - overly conservative because they don't want regret about making extreme predictions f. recalliblity trap - past disasters / dramatic events too heavily weighted. 9. Model and input uncertainty - Model -- unsure which model to use (ie DCF vs. GCM);

Explain the business cycle

5 phases 1. Initial recovery 2. Early Upswing 3. Late Upswing 4. Slowdown 5. Recession Confidence ↑↑↔↓↔ Interest Rates ↓↑↑↔↓ Inflation ↓↔↑↑↔ Output gap ↑↑↑↓↓ Bond yields↓↑↑↔↓ Stock Prices ↑↑↑↓↓

IPS / SAA - rate needed - compounded vs. additive? Foundation needs 5% current distribution, expenses of 0.5%, and inflation of 3%; required return using additive? Compounded?

Additive - most questions use this, more common in real world IPS's Compounded - CFA says use in 'multi-period calculation' or have path dependency issues; (5+3+0.5) = 8.5% (1.05)(1.03)(1.005) - 1 = 8.69%

Types of benchmarks? Tradeoffs in constructing market indexes?

Asset based: -Absolute return = minimum return -Manager universe / peer group = outperform medians of other managers + OTHERS (broad market indices, style, etc.) Liability based benchmarks are used to match a company's liability payouts (ie duration of nominal bonds / real rate bonds / and equities) - Completeness vs. investability -- complete index will meet complete benchmark criteria but might be more costly or difficult to purchase small cap / certain global securities - Reconstitution (add/remove) and rebalancing (quantity) frequency vs. turnover -- high transaction costs vs. better reflection of intended characteristics. - Objective and transparent rules vs. judgement. -- planing for changes in the index allows lower costs vs. realistic application of judgement.

ALM approach vs. asset only allocation? ALM approach that best minimizes surplus volatility? What can this also be?

Asset only more focused on return rather than asset volatility - therefore more allocated to equities. ALM just focusing on surplus volatility minimization; however, active management looking to capitalize on changing interest rates can intentionally mismatch asset / liability duration to make more surplus. Liability Mimicking portfolio (LMP). Benchmark for those managers looking for higher return -- whether the extra risk was worth the greater returns. Can also mimic LMP through use of derivatives.

Benchmark vs. Index? Valid benchmark?

Benchmark -- reference point for evaluating portfolio performance Index -- Represents the performance of a specific group of securities. A valid benchmark will be: - Specified in advance - Appropriate - Measurable - Unambiguous (clearly defined) - Reflective of the manager's current investment opinions - Accountable (manager accept the applicability to the portfolio) - Investable (possible to invest in benchmark as alternative to active management)

Index weighting schemes and the pros / cons?

Capitalization weighted -- most common (based on market cap or the free float); -Pros: -- objective measure (market price) --Macro-consistent (all securities must be owned so aggregate 'market' is weighted this way). --Under assumptions of CAPM, only efficient portfolio --No stock split / dividend rebalance. -Cons: --heavy weight on largest market cap -- so exposed to bubbles & over concentration issues; **S&P / Russell Price weighted -- owning share of 1 stock, influenced heavily by price Pros: -- Easy to construct Cons: -- Market cap reflects relative importance; -- Stock splits mean that successful companies have importance reduced. -- Most portfolios are not constructed w a equal # of shares in each security; **Dow Jone Industrial Equal-weighted -- Same initial investment in each security; Pros: -- More emphasis on smaller cap securities -- Some argue that it better reflects the market bc it reflects average return of each security in the index; Cons: --Biased to smaller issuers; --Requires constant rebalancing -- selling winners, buying losers

Inflation and the relationship to: Cash? Bonds? Equity? RE returns?

Cash -- inflation doesnt have a big impact on cash instruments bc it tracks inflation typically. Deflation is bad, bc can only go to 0. Bonds -- inflation ↑, pricing down, hence decline in strong expansion; Vice versa (except for credit declines in a recession) Equities -- low inflation can be positive for equities -- providing a hedge when business can pass along to the consumer; inflation above 3% can be problematic due to central bank's likely interference; declining inflation bad bc signal of declining economic growth; RE: Inflation = ok for RE; high inflation great for RE bc return rise -- good hedge; deflation reduces value of RE (due to having debt financing);

Cobb Douglas and DDM? Why use real rates, rather than nominal for estimating MARKETS?

Cobb Douglas provides a macroeconomic forecast of the growth rate for the underlying economy. Applying the growth rate to the cash flow / dividend growth rates in a DDM -- there are likely to be differences bw a developed and less developed country. DEVELOPED -- dividend payouts and economic activity stable, so div growth and economic growth closely tied. GGM is appropriate bc LTGR is stable. LESS DEVELOPED -- H-model more appropriate - Economic data is less available / reliable. - Link bw economic and cash flow / dividend growth is less direct (structural / govt changes) - Periods of dramatic change in inflation can disrupt valuation inputs; H-Model = D₀ / (r - gl) [(1 + gl) + N/2 (gs-gl)] ALSO Can use justified PE = P₀ / E₁ =C-D commonly used to estimate real growth =Inflation fluctuates over time and varies between countries. =Real inputs more stable easier to estimate.

What is Strategic Asset Allocation? Compare to Tactical Asset allocation. Static vs. Dynamic asset allocation?

Combines capital market expectations (E(R), St dev) with individuals IPS (risk, return and investment constraints). Each asset class has its own quantifiable systematic risk and SAA is a conscious effort to gain the desired exposure to via specific weights to individual asset classes; TAA is the result of active management where managers deviate from the SAA to take advantage of ST opportunities (to generate alpha). SAA is generally the prime determinate of performance (a study showed that 94% of the variability of total portfolio returns is explained by SAA). Dynamic - takes a multi-period view of the investment horizon, performance in 1 period affects, the ROR and risk for subsequent periods; Static - ignores link bw optimal asset allocation over time; (ie estimate necessary mean-variance inputs as of a point in time and then construct a LT portfolio);

Defined Benefit Plan vs. Defined Contribution Plan? Cash balance plan? Profit sharing plan? ESOP

DB -- sponsor makes payments to employees after retirement based on criteria. Company accrues a liability as future benefits earned -- and funds the plan assets. Employer bears investment risk. DC -- Company makes contribution as they are earned by employees. Investment risk borne by employees. PORTABILITY -- investor can move plan assets -Type of DB plan in which individual account balances are recorded so they are portable. BUT balances are based on what is promised (i.e. the plans liabilities), therefore the employer still bears investment risk. Usually receive lump sum or annuity at retirement. -Type of DC plan where contributions based on company profits -Type of DC plan where employees can purchase shares at a discounted price with before / after tax dollars.

Formal tools used for setting capital market expectations: DCFs: Adv / Disadv? GGM? Grinold and Kroner? Fixed Income?

DCF Adv: Emphasis on future cash flows; ability to back out a required return Disadv: Do not account for current market conditions like supply / demand; GGM: Div₁ / Ri - g ==> Ri = Div₁/P₀ + g g = nominal growth rate of GDP; (can be adjusted for differences in economy growth rate and equity index = EXCESS CORPORATE GROWTH RATE Grinold and Kroner Same as above but adjusts for Stock reps and PE ratios Ri = Div₁ / P₀ + i + g - ∆S + ∆(P/E) Ri = expected return / CAGR i = expected inflation g = real growth rate ∆S = % change in shares outstanding ∆(P/E) = % change in the P/E ratio CAN BE GROUPED INTO 3 components: 1. Expected income return (current yield S/H can expect to receive): (Div₁ / P₀ - ∆S). NOTE: REPURCHASE YIELD -- if negative repurchase yield -- that means that sold stock: +∆S, if repurchase yield just shown as -1.0% etc, that is a positive repurchase yield) 2. Expected nominal earnings growth: (i+g) 3. Repricing return: ∆(P/E) **Capital gains return = 2&3 CAN USE DCF For fixed income too -- use YTM on the reference bond as expected return. However, downside is that assume that CF are reinvested at the YTM;

Covered interest rate parity? Ex: USD interest rate = 8%; Euro = 6% Spot exchange rate = 1.3 USD / EUR 1 yr forward rate = 1.35 USD / EUR Arbitrage?

F = S₀ ((1 + Ra (days / 360)) / (1 + Rb (days / 360))) F = forward rate quoted as A/B S = spot rate quoted as A/B Ra = interest rate in country A Rb = interest rate in country B 1.3 (1.08 / 1.06) = 1.324 imputed 1 yr F 1. Borrow $1k at 8% and purchase 1000/1.3 Euro = 769.23 2. Invest euros at 6% 3. Enter into 1 yr forward contract at 769.23 * 1.06 * 1.35 dollars. after 1 year 1. Convert 769.23 * 1.06 *1.35 = 1100.76 2. Repay the USD loan = 1080. 3. Profit.

Utility adjusted return the investor will realize from the portfolio? Shortfall risk? Semivariance? Target Semivariance? Roy's safety first measure?

First classify the investors risk aversion on a scale of 1-10 (1 = high tolerance, 10 = low) Up = Rp - 0.005 (A) (op^2) Up = the investor's utility from investing in the portfolio (utility adjusted return) Rp = portfolio's expected return A = Investor's risk aversion score op^2 = portfolio variance; *NOTE use (0.5) if you plan to use the actual decimal fashions. -Risk of exceeding a maximum acceptable dollar loss; -Bottom half of the variance (variance calculated using returns below the E(R)); -Semi variance using some target minimum return (ie 0) One of the oldest and most cited measures of downside risk. RSF = (Rp - Rmar) / op Rp = Expected return Rmar = investors minimum acceptable return op = portfolio st dev.

Arguments for / against not hedging currency risk? Currency management strategies? Strategic currency diversification issues? Strategic currency cost issues?

For: - Best to avoid time / cost of hedging and trading currencies - In the long run, currencies revert to a theoretical fair value Against: - In the SR, currency movement can be extreme; - Currency inefficient pricing can be exploited for gain; Central bank policies aren't focused on FV of currencies -Passive hedging - matches portfolio currency exposure to a benchmark; requires periodic rebalancing; -Discretionary hedging - allows managers minor discretion to deviate by a certain % from a full passive hedge; -Active currency management - more discretion than above -- manager expected to generate alpha on currency returns -- not reduce risk; -Currency overlay - broad term for outsourcing of currency management; At the extreme an outlay manager just tries to generate alpha independent of the portfolio assets; -In the LR, currency volatility lower -- reducing need to hedge for LT portfolios -Positive Corr(Rfc, Rfx) tends to increase vol, therefore need to hedge; -Higher positive Corr in bond to currency markets than with equities; -"Hedge ratio" (% of currency exposure to hedge) is subjective - Options / bid-ask / overhead costs are costly - Hedging time period is often longer than the forward time period, therefore, FX swaps create cash flow volatility from realized G/Ls

Various types of Foundations?

Foundations -- generally GRANT-making entities funded by gifts and investment portfolio Endowments -- long term funds owned by a non profit (and PERMANENTLY supporting that institution). BOTH non profit -- very well should be aggressive and serve a social purpose. Name ------- Description ---- Purpose --- Source of Funds ---- Annual spending requirements Independent -- Private or Family -- Grants to charity, education etc. --- Typically individual / family ---- 5% of assets (not including expenses) Company sponsored --- Tied to corporation sponsor ----- Same as independent but can be used to further biz interests ---- Corporate --- 5% of assets (not including expenses) Operating ----ESTIABLISHED FOR SOLE PURPOSE of funding an organization (museum, zoo, etc) or research / medical initiative. ----- same as independent ---- Must spend at least 85% of div / int. for own operations. May also be required to spend 3.33% of assets. Community -- Publicly sponsored grant awarding --- Fund social, education, religious --- General public including large donor ---- NONE!

Cross hedge? Macro hedge? Minimum variance hedge ratio?

Hedging with an effective but imperfect substitute; ie AUD and NZD are very positively correlated, but cross hedge risk exists; Hedges risk factors rather than individual portfolio assets; ie bond portfolio has exposures to interest rate risk, credit risk and volatility risk; Can hedge w bond futures (IRR), credit derivatives, and volatility trading; Mathematical approach to hedging; Look at historical price changes on the underlying portfolio and the hedge; Regress the changes between the two to calculate the slope coefficient (beta): ** A strong positive correlation bw Rfc and Rfx increases the volatility of Rdc. A hedge ratio > 1.0 would reduce volatility; ** A strong negative correlation bw Rfc and Rfx decreases the volatility of Rdc. A hedge ratio of < 1.0 would reduce volatility;

Uncovered interest rate parity? Formula? What does this mean?

If forward contracts not available or capital flows restricted. E(St) = expected spot rate at time t = (1+Ra / 1+Rb)^t (S₀) Therefore if Ra > Rb, then base currency (B) is expected to appreciate. Forward rates in the long run are typically an unbiased predictor of E(S₀).

Cross rates (A/B x B/C = A/C) WITH BID-ASK SPREADS? What if you don't have perfect information ie if you have bid ask for (A/B) and (C/B), but need A/B bid ask? Triangular arbitrage?

If we need A/C bid-ask and we have A/B and B/Cs, then (A/C)ask = (A/B)ask x (B/C)ask (A/C)bid = (A/B)bid x (B/C)bid To convert any bid ask: (B/C)ask = 1 / (C/B)bid (B/C)bid = 1 / (C/B)ask Start with your current currency (A) and then convert to B, B to C then C to A. Do again in the opposite direction. If you see that the cross rate w bid ask is above / below a dealer rate, then might be possible!

STRATEGIC asset allocation (SAA) approaches: Resampled Efficient Frontier?

MVO is very sensitive to its inputs AND THEREFORE HAS UNSTABLE ASSET ALLOCATION RECOMMENDATIONS (HIGH TURNOVER). therefore this method takes a Monte Carlo approach to stimulate various efficient frontiers; Therefore it shows a distribution of efficient frontiers above / below the averages; Advantages: - averaging process generates EF that is more stable than traditional mean variance; - portfolios generated through this process tend to be better diversified; - By having a range of multiple asset mixes across multiple portfolios -- possible to see if portfolio is acceptable; Leads to less portfolio turnover and lower transaction costs; Disadvantages: - Like MVO -- based on historical data - Lack of theoretical basis; no support that a portfolio constructed this way would be superior to MVO;

Capital Market Expectations: Marco vs. Micro expectations? Beta vs. Alpha research? To formulate capital market expectations should use 7 step process.

Marco -- classes of assets Micro -- individual assets Beta -- Formulating capital market expectations Alpha -- Earning excess returns within specific asset groups. 1. Determine specific capital market expectations needed according to investor's tax status, allowable asset classes, and time horizon. 2. Investigate historical performance to determine return drivers and future performance range. 3. Determine valuation model used and its requirements; 4. Collect best data possible 5. Use experience / judgement to determine current conditions and values for various inputs. 6. Formulate capital market expectations 7. Monitor performance and use it to refine the process.

Bank IPS Primer: Risk / Return?

NOTE: Bank's security protfolio -- ie deposits less loans / requirements. While can earn an attractive return, primary purpose is to address the mismatch of liabilities (deposits) and assets (loans), including duration. Also use security portfolio to manage credit risk and diversification. Interest rate risk (including VAR and leverage adjusted duration gap -- duration of the banks assets less the LEVERAGED duration of the banks liabilities. If 0, equity doesnt change w interest rates, +, equity inverse to interest rates, - equity moves with interest rates) RISK -- below average risk RETURN -- Positive interest spread

FX Swap? ie manager purchases 3 months forward 1,000 ZAR at ZAR/USD 0.1058; Two days before expiration, manager decides to extend another 30 days. How would he use FX swap to accomplish Call options on currencies?

Not a traditional 'swap' just an extension of the forward contract; sell 1,000 ZAR at the spot rate to offset the maturing contract; both will settle in 2 business days; Enter new 30 days forward contract; Increases as the base currency appreciates; ***NOTE: A call option on a base currency is the same as a put option on a price currency;

Conditional return correlations? Additional Emerging market INVESTING considerations?

Observation that correlations increase during financial crises -- inconsistent that correlations are stable over time (ie evaluating whether an asset class should be added via mean-variance analysis); When correlation is plotted bw markets over time it shows -- a) correlations have been rising over time (diversification benefit decreases as market integrate); b) correlations generally rise during crises and then fall back afterwards, within a general upward trend; - Investibility (free float limited in adverse sit) - Non normal return distribution (leptokurtic -- fat tails -- extreme returns) - Strong economic growth might not benefit shareholders (gov't prefer others -- labor more benefits) - Contagion from another market - Currency deval. - Inefficient markets may allow others (including local firms) to earn excess returns;

Whole life / ordinary life? -- portfolio implications? Term life? Variable / universal life? Life Insurance company IPS': Risk / Return? Constraints?

Premiums over years, payout at death, BUT includ cash value allowing policyholder to terminate that policy and receive CSV. Cash value build up at the CREDITING rate -company faces pressure to offer high crediting rate; -disintermediation risk - high interest rates usually associated w depressed investment values and also time when policyholder more likely to withdrawl; --TL: yr/ yr basis - short duration assets / short duration liability --VL: Same as Whole, but CSV linked to investment returns; Return: 1) Have minimum RoR -- set statutory requirements by actuarial assumptions of growth in payout. More desirable to earn a net interest spread; 2) Surplus RoR usually based on aggressive investments, as opposed to the majority RoR based on fixed income investments; Risk: Public Policy views as QUASI TRUST FUNDs. NAIC requires that cos have an AVR (asset valuation reserve); 1) Valuation risk -- mismatch of duration of Asset / Liabilities will cause volatility 2) Reinvestment risk is a concern due to long horizons and fact that many investments are coupons 3) seek investments w minimal cash flow volatility 4) credit risk is concern L: Disintermediation; asset-liability duration mismatch (compounds disintermediation); asset marketability risk TH: Traditionally 20-40 yrs but less and less due to interest rate volatility and competitive market factors. T: Policyholders share not tax, but funds transferred to the surplus are. L/R: Regulated at the state level, complex and extensive; Eligible investments (xx investments allowed) vs prudent person rule (what is total return vs. risk of whole portfolio). Valuation methods commonly book value and limits ability to focus on MV

IPS for DC plan?

Simpler than for DB plans. Risk / Return objectives and constraints run the gamut for all investors. IPS' for these deal more with -- eduction for employees, providing adequate choice of funds, etc. ** NOTE for sponsor directed DC plan, would be similar to DB plan.

DB IPS: DB risk objective: ALM framework? (in relation to pensions' IPS) Shortfall risk? DB return objectives? Liquidity? Time Horizon? Taxes? Legal and regulatory factors? Unique circumstances?

RISK is measured by the variability (st dev) of PLAN SURPLUS (as opposed to plan assets traditionally) Probability that plan asset value will be below some specific level over a time horizon. -Reduce future pension contributions -Pension Income on financial reporting L: # of retired lives, Plan features. TH: Termination date?, plan participants T: Most are tax exempt L/R: Must use country's framework (ERISA Employee Retirement Investment Securities Act for US); Pension plan trustees are fiduciaries U: Size of plan -- smaller ones have tough time w complex instrument due diligence; Self restrictions on asset classes;

Neutral rate? Taylor rule? Yield curve and fiscal / monetary policy?

Rate in which a balance bw growth and inflation is achieved. What central banks strive for. Determines the target interest rate for central banks; rtarget = rn + [0.5(GDPexp-GDPtrend)+0.5(iexp-itarget) rn = neutral ST interest rate GDPexp = expected GDP growth rate GDPtrend = LT trend in GDP growth rate iexp = expected inflation rate itarget = target inflation rate; Both stimulative = yield curve steep / likely to grow Both restrictive = yield curve inverted / likely to decline Mon restrictive / Fis stimulative = yield curve flat, unclear economy Fis restrictive / Mon stimulative = yield curve moderately steep, unclear economy

Foundation / Endowment IPS': Risk / Return? Constraints? Endowment spending rules?

Risk - Generally higher (endowment depending on amount of support annually. Return -- Concern is the preservation of purchasing power -- inflation and spending expenses need to be taken into account. TH: Usually perpetual Liquidity: Usually low Tax: usually tax exempt - except for unrelated business income tax in US (1%) L/R: Usually limited. Can't be used for private individuals. Uniform Management Institutional Fund Act (UMIFA) in US Most endowments have spending rules. In US, must have rules but can decide your own. 3 forms: 1. Simple spending = rate x beg Assets 2. Rolling 3 yr average 3. Geometric spending rule -- combats #2 (say large 3 yr decline -- would need HIGH spending relative to current value). USE SMOOTHING RATE; spendingt=R*spendingt-1*(1+it-1) + (1-R)*S*MVt-1) R = Smoothing rate it-1 = last year inflation rate S = spending rate

Corner portfolio? 3 requirements? CAL?

Same as the efficient frontier (constrained), left most point is global min variance; The rest are various combinations (efficient) of asset weights that result in an EF; NOTE: the 'corner' w the highest Sharpe ratio represents the 'MARKET' portfolio; 1. On Efficient Frontier. 2. positive asset class weight shifts to 0% or 0% shifts to a positive weight. 3. GMVP = starting CP. ie tangency portfolio; Where the Sharpe ratio is highest and a reasonable investor would invest in this + the rfr to attain the return desired or borrow at the rfr and invest in the TP to attain return desired; IF -- borrowing prohibited, then the rest of the EF required to attain a higher return;

Survey vs. Panel methods for capital market expectations.

Survey = poll of market participants, including economists and analysts, as to what their expectations are regarding the economy / cap markets. Panel = if the group from above is consistent over time.

Top Down forecast vs. Bottom up forecast? Estimating MARKET earnings per share (EPS) using top-down and bottom-up methods. Why can it yield different results?

Top Down -- use macroeconomic indicators to estimate performance of market wide indicators. - Value to historical patterns indices - Momentum in indices - Expected performance in indices to general asset classes. Bottom Up -- - individual firms product / service to rest of industry; - managements ability to adapt right technology. - cash flow estimate 1. Top-Down -- - Variables change over time. - Variables no longer relevant (specified incorrectly) 2. Bottom-Up -- - Based on managerial expectations of future growth / profitability which is upwards biased. *** ALSO CAN BE MORE DOWNWARD BIASED as the market recovers from recession.

Exogenous shocks? 2 common? Linkages bw economies: Macroeconomic links? Exchange rates? Interest rate differentials?

Unanticipated events that occur outside the normal course of an economy; bc unexpected not built into current market prices; Usually negative and can spread to other countries as 'contagion'; -Oil shocks -- historically increasing prices lead to increased inflation (to lower spending, thus lower employment); Decline in oil prices can produce lower inflation, subsequent overheating of the economy; -Financial crises - Banks usually vulnerable, central bank steps in to provide financial support; -Ie economies are linked via international trade so a slowdown in one can lead to a slowdown in another. But there are different central banks that lead to different policy responses to crises -Pegging currency to maintain fixed exchange rate; however, give up control of montetary policy -Sometimes due to differences in economic growth / monetary policy / fiscal policy.. REAL interest rates can be different among country. SHOULD NOT EXIST LONG TERM;

STRATEGIC asset allocation (SAA) approaches: Black-Litterman model? NORMALLY RUN ON CONSTRAINED BASIS AS SHORTING ASSET UNLIKELY. Monte Carlo? ALM? Experienced based?

Unconstrained -- allows for negative asset weighting; Constrained -- does not allow; - Effectively this allows managers to indicate their views on the asset class returns and reverse optimize the market's consensus of E(R) by asset class to construct an optimal MVO based on the manager's views; Basically the manager gets a global market index, solves for the E(R) for the asset classes, reviews returns and inserts his or her views (for E(R) and perhaps σ), and then runs a new MVO; -- Slightly different from the REF in that it considers client specific issues (like withdrawls / tax issues in the portfolio) and that it considers a single MVO and the path dependency on that; All of the prior strategies were asset-only based. This is a surplus efficient frontier; The minimum surplus variance portfolio can actually be negative (also least risk); EBT is just the process of elimination;

Foreign Exchange quotes: Main rule? Ex: Dealer is quoting AUD/GBP 1.5060 - 1.5067 a. Proceeds of converting 1 million GBP? b. Proceeds of converting 1 million AUD? c. If you want to obtain 1 million AUD?

Up-the-bid and multiply and down-the-ask and divide (ie up from GBP (denom) to AUD (numerator)) a. 1 million x 1.5060 : 1,506,000 AUD b. 1 million / 1.5067 : 663,702 GBP c. STILL UP THE BID x * 1.5060 = 1,000,000 AUD; x = 664,011 GBP;

COBB - DOUGLAS? Original? Expected changes model? Solow residual?

Y = AK^α L^β Y = real economic output A = total factor productivity K = Capital stock L = Labor input α = output elasticity of K (0<α<1) β = output elasticity of L (α+β = 1) However, more relevant to look at EXPECTED CHANGES in economic growth ∆Y / Y ≅ (∆A / A) + α (∆K / K) + (1-α) (∆L / L) ∆Y / Y = % change in real output etc... REASONABLE TO ASSUME CONSTANT RETURNS TO SCALE (ie change in capital or labor -- > linear relationships to output); (∆A / A) = TFP ∆ = Solow residual (just rearrange equation) = measure of managerial and technological innovation; - Can change over time due to: --- Changing technology --- Changing restrictions on capital flows and labor mobility --- Changing trade restrictions --- Changing laws --- Changing division of labor --- Depleting / discovering natural resources;

Relative value models? 3 different models? Tobins q? Equity q?

Use the relative value of assets / markets to ID investment opportunities. 1. Fed model; Assumes the S&P EARNINGS YIELD (expected aggregate operating earnings divided by the index level) should be the same as the yield on long term US Treasuries; Fed model ratio: S&P Earnings yield / 10 yr Treasury yield IF S&P EARNINGS YIELD is higher than Treasury, interpretation is that the index is too low, equities are undervalued; WEAKNESSES: a) does not consider ERP (inherent extra risk of equity) b) ignores earnings growth c) compares a real variable (index level) to a nominal variable (Treasury yield). Future level of earnings isn't fixed and in long run adjusts upwards w inflation; STRENGTH: analysts use in spread analysis to see where the ratio is in comparison w long term estimates; 2. Yardeni Model - estimate equilibrium earnings yield. GGM BUT WITH EARNINGS -- ie E₁ / r-g.. then earnings yield = r - g; Yardeni - a) assumes r (ROE) = A-rated corporate bonds = PROXY for equity market premium (ie default risk not equiry risk); b) g = 5 yr long term earnings growth forecast (LTEG) = might not be accurate estimate of growth; c) value of investor's importance of earnings growth (d) E₁ / P₀ = Yb - d (LTEG) **NOTE: Can also use this model as a ratio like the Fed Model; 3. 10 year moving average P/E ratio; Numerator = market price of the S&P 500 price index Denominator = average of the previous 10 yrs reported REAL earnings. ***Use CPI and back out the inflation impact on earnings AND the current market price; - To use this metric - compare 10 yr moving average NOW to historical amounts; - Captures effects of business cycles BUT IS STILL HISTORICAL / not forward looking; doesn't consider changes in accounting -Empirical studies have shown high P/10yr MA have persisted over time; Tobins -- MV of assets / asset replacement value Equity -- MV of equity / replacement value of equity Theotrically 1.0 otherwise over / under valued; THESE are mean-reverting, will revert to 1.0 if incorrectly priced;

Inflection points? Economic growth can be partitioned into 2 groups? Cyclical can be sectioned into? 3 measures of economic activity? Explain inventory cycle

When the economy changes direction 1) cyclical (ST) 2) trend-growth (LT) 1) Inventory cycle (2-4 yrs) 2) Business cycle (9-11 yrs). Vary in duration and hard to predict bc wars etc can interrupt. 1) GDP (real terms) 2) Output gap (actual GDP vs. potential GDP -- when the former is higher = economic / inflationary pressures high and vice versa) 3) Recession -- decreases in GDP over 2 straight quarters -Often measured w inventory to sales ratio. Increases when businesses have confidence in economy - add inventory. Then employment increases with subsequent increases in economic growth. This continues until some other factor (tightening MS) intervenes, decreasing inventory. *** NOTE : LT -- this measure has been decreasing due to JIT inventory systems etc.

Forward premium / discount. This is usually for the _____ currency. Formula? Ex: AUD/CAD Spot = 1.0511 / 1.0519 30-day +3.9 / +4.1 All-in rate? Mark-to-market value of a forward contract at maturity (time t)? Value prior to expiration?

base; forward premium (discount) = F - S₀ Ex: these are pips and it indicates that the CAD is trading at a forward premium. ie 30-day = 1.05149 / 1.051231 Rate after adjusting for forward premium/discount. Vt = (FPt - FP)(contract size) Vt = Value of the forward contract at time t (in PRICE currency) FP = forward price at inception to BUY BASE currency. FPt = forward price to SELL the BASE currency at time t Vt = ((FPt - FP)(contract size)) / (1+R (days/360)) R = interest rate of price currency days = number of days to maturity.