CFA Level III Outline-Notes (2010)

CFA Level III NotesMark E. ObladFor June 2010 Test

Reading 1: Code of Ethics and Standards of Professional Conduct

Standards of Practice Handbook

CFA Institute Professional Conduct Program: 2 basic principles: 1. fair process; 2. confidentiality Board of Governors Professional Conduct Program Disciplinary Review Committee: responsible for

enforcement of code and standards CFA Institute Designated Officer, Professional Conduct Staff: conduct inquiries:

o 1. self-disclosures, 2. written complaints, 3. media, 4. exam proctorso 1. interview subject, 2. interview complainant, 3. collect docso No disciplinary sanction; cautionary letters; continue proceedingso Designated Officer proposes discipline; if rejected then panel of CFA Institute members

Code and Standards: encourages firms to also adopt

Code of EthicsI. Act with integrity, competence, diligence, respect, and in an ethical manner with the public, clients,

prospective clients, employers, employees, colleagues in the investment profession, and other participants in the global capital markets.

II. Place integrity of the investment profession and the interests of clients above their own personal interests.III. Use reasonable care and exercise independent professional judgment when conducting investment analysis,

making investment recommendations, taking investment actions, and engaging in other professional activities.IV. Practice and encourage others to practice in a professional and ethical manner that will reflect credit on

themselves and the profession.V. Promote the integrity of, and uphold the rules governing, capital markets.VI. Maintain and improve their professional competence and strive to maintain and improve the competence of

other investment professionals.

Standards of Prof’l Conduct (7 items)I. Professionalism

a. Knowledge of Lawb. Independence and Objectivityc. Misrepresentationd. Misconduct

II. Integrity of Capital Marketsa. Material Nonpublic infob. Market Manipulation

III. Duties to Clientsa. Loyalty, Prudence, and Careb. Fair Dealingc. Suitabilityd. Performance Presentatione. Preservation of Confidentiality

IV. Duties to Employersa. Loyalty

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b. Additional Comp Arrangementsc. Responsibilities of Supervisors

V. Investment Analysis, Recommendations, and Actionsa. Diligence and Reasonable Basisb. Comm’n w/ Clients and Prospective Clientsc. Record Retention

VI. Conflicts of Interesta. Disclosure of Conflictsb. Priority of Transactionsc. Referral Fees

VII. Responsibilities as a CFA Institute Member or CFA Candidatea. Conduct as Members and Candidates in the CFA Programb. Reference to CFA Institute, the CFA Designation, and the CFA Program

Reading 6: Asset Manager Code of Professional Conduct:

Intended to be adopted at firm level

General Principals of Conduct:1. Act in a prof’l and ethical manner at all times2. Act for benefit of clients3. Act w/ independence and objectivity4. Act w/ skill, competence, and diligence5. Communicate w/ clients in a timely and accurate manner6. Uphold rules governing capital markets

Asset Manager Code of Professional Conduct (6 parts):A. Loyalty to Clients

1. Place client interests before their own2. Preserve confidentiality of info communicated by clients w/I the scope of the Manager-client

relationship3. Refuse to participate in any business relationship or accept any gift that could reasonably be

expected to affect their independence, objectivity, or loyalty to clientsB. Investment Process and Actions

1. Use reasonable care and prudent judgment when managing client assets2. Not engage in practices designed to distort prices or artificially inflate trading volume w/ the

intent to mislead market participants3. Deal fairly and objectively w/ all clients when providing investment info, making investment

recommendations, or taking investment action4. Have a reasonable and adequate basis for investment decisions5. When managing a portfolio or pooled fund according to a specific mandate, strategy, or style:

a) Only take investment actions that are consistent w/ the stated objectives and constraints of that portfolio or fund

b) Provide adequate disclosures and info so investors can consider whether any proposed changes in the investment style or strategy meet their investment needs

6. When managing separate accounts and before providing investment advice or taking investment action on behalf of client:

a) Evaluate and understand the client’s investment objectives, tolerance for risk, time horizon, liquidity needs, any other unique circumstances (including tax considerations, legal or regulatory constraints, etc.), and any other relevant info that would affect investment policy.

b) Determine that an investment is suitable to a client’s financial situation


C. Trading1. Not act, or cause others to act, on material nonpublic info that could affect the value of a

publicly traded investment2. Give priority to investments made on behalf of the client over those that benefit their own

interests3. Use commissions generated from client trades only to pay for investment-related products or

services that directly assist the Manager in its investment decision-making process and not in the management of the firm

4. Maximize client portfolio value by seeking best execution for all client transactions5. Establish policies to ensure fair and equitable trade allocation among client accounts

D. Compliance and Support1. Develop and maintain policies and procedures to ensure that their activities comply w/ the

provisions of this Code and all applicable legal and regulatory requirements2. Appoint a compliance officer responsible for administering the policies and procedures and

for investigating complaints regarding the conduct of the Manager or its personnel3. Ensure portfolio info provided to clients by the Manager is accurate and complete and

arrange for independent third-party confirmation or review of such info4. Maintain records for an appropriate period of time in an easily accessible format5. Employ qualified staff and sufficient human and technological resources to thoroughly

investigate, analyze, implement, and monitor investment decisions and actions6. Establish a business-continuity plan to address disaster recovery or periodic disruptions of the

financial market7. (record retention recommendation is 6 yrs (as opposed to 7 for individuals))

E. Performance and Valuation1. Present performance info that is fair, accurate, relevant, timely, and complete. Managers

must not misrepresent the performance of individual portfolios or of their firm2. Use fair market prices to value client holdings and apply, in good faith, methods to determine

the fair value of any securities for which no readily available, independent, third-party market quotation is available

F. Disclosures1. Communicate w/ clients on an ongoing and timely basis2. Ensure that disclosures are truthful, accurate, complete, and understandable and are presented

in a format that communicates the info effectively3. Include any material facts when making disclosures or providing info to clients regarding

themselves, their personnel, investments, or the investment process4. Disclose the following:

a) Conflicts of interest generated by any relationships w/ brokers or other entities, other client accounts, fee structures, or other matters

b) Regulatory or disciplinary action taken against the Manager or its personnel related to professional conduct

c) The investment process, including info regarding lockup periods, strategies, risk factors, and use of derivatives and leverage.

d) Management fees and other investment costs charged to investors, including what costs are included in the fees and the methodologies for determining fees and costs.

e) The amount of any soft or bundled commissions, the goods and/or services received in return, and how those goods and/or services benefit the client

f) The performance of clients’ investments on a regular and timely basisg) Valuation methods used to make investment decisions and value client holdingsh) Shareholder voting policiesi) Trade allocation policiesj) Results of the review or audit of the fund or account


k) Significant personnel or organizational changes that have occurred at the Manager

Reading 7: Heuristic-Driven Bias: The First Theme:

I. Heuristic-Driven Bias: 4 elementsa. People develop general principles as they find things out for themselvesb. They rely on heuristics, rules of thumb, to draw inferences from the info at their disposalc. People are susceptible to particular errors b/c the heuristics they use are imperfectd. People actually commit errors in particular situations

Availability Heuristic: back-of-the envelope calculation based on readily available info Representativeness: to view something as a stereo type and make predictions therefrom

i. Regression to the mean – counter to representativeness;ii. Gambler’s Fallacy – to predict the outcome of an independently probable event as a

dependently probable event to fit the aggregate probability distribution; the law of large numbers does not apply to a small sample.

Overconfidence: setting too narrow of confidence bands; get surprised frequently Anchoring-and-Adjustment: to be influenced by and toward the past observation or a number you’re

working fromi. Underreact: when you don’t know how to incorporate the new information, you stay with your

past belief Aversion to Ambiguity: fear of the unknown; proclivity to choose 100% probably $1k over 50%

probably $2k and 50% probably $0.

Such heuristics influence: analysts’ earnings forecasts, investors’ evaluation of mutual fund performance, corporate takeover decisions and the type of portfolios selected by both individual and institutional investors.

Other heuristics: excessive optimism, illusion of validity, hindsight bias, illusion of control and self-attribution error.

Reading 8: Frame Dependence: the Second Theme

Frame: form used to describe a decision problem; traditionally (incorrectly) assumed to be transparent

Frame dependence: equivalent frames may be opaque causing people to feel differently when faced with different but equivalent frames; “the way people behave depends on the way that their decision problems are framed.”

cognitive: the way people organize info the way people feel as they register the info

i. “house money” effect: more likely to take a gamble if you feel like you just got ahead.

Loss aversion: loss has about 2.5x the impact of a gain of the same magnitude [on emotions] “get-evenitis” Concurrent decisions: if lose in first game, may behave differently in second game for chance to get

even. Mental accounts: failure to see two decision problems together as a concurrent package. Hedonic editing: people prefer some frames to others; to choose frames that obscure losses

i. Prefer “transfer your assets” to “close account at a loss”ii. People are not uniform in their tolerance for risk; some appear to tolerate risk more readily

when they face the prospect of a loss than when they do notiii. People do not net two gains: they savor them separately (added attraction to gambling)iv. People are incapable of netting out moderately sized losses of similar magnitudes (shy away

from gambling)


Prospect theory

Emotional frames: self-control: controlling emotions; people put rules in place to guard against temptation: “don’t dip into

capital” and view dividends not as capital. regret minimization: emotion experienced for not having made the right decision; pain of loss and

feeling responsible for loss; may cause people to prefer dividends to finance consumption rather than capital b/c of the regret from the (frame) of the missed capital appreciation

money illusion: people think of money in nominal values (and disregard discounting for inflation)

Reading 9: Inefficient Markets: The Third Theme

De Bondt-Thaler winner-loser effect: investors who rely on representativeness heuristic become overly pessimistic about past losers and overly optimistic about past winners causing price inefficiency

Conservativism due to anchoring-and-adjustment: results in positive earnings surprises to be followed by positive surprises and vice versa (post-earnings-announcement drift).

Frame dependence: loss aversion causes investors to shy away from stock resulting in relatively high returns (mental accounting).

Myopic loss aversion: too short of evaluation horizons resulting in individual investors’ historical reluctance to hold stocks.

House-Money Effect: results in more risk taking after runups and vice versa.

Overconfidence: 1. Investors take bad bets b/c they fail to realize that they are at an informational disadvantage; 2. investors trade more frequently than is prudent

Reading 10: Portfolios, Pyramids, Emotions, and Biases

Fear induces an investor to focus on events that are especially unfavorable; hope induces to focus on events that are favorable.

Specific goals: aspire to purchase home, fund college, comfortable retirement

Fear transforms into regret.

Layered pyramid: bottom: securities to provide security (money market; CDs); securities for specific goals (bonds); top are securities for appreciation (stock, real estate).

layers can be thought of as mental accounts priorities are the mental account associated w/ bottom layer

Use mean-variance to determine portfolio; provide investor w/ probability of achieving at least aspiration level, by which the investor will evaluate in terms of fear, hope and aspiration.

Security design: layers can explain design of securities: guaranteed principal w/ possibility of upside.


Portfolio selection: 1. investors excessively optimistic about their portfolio while not about the market; 2. overconfident: surprised by price changes; 3. price forecasts anchored by past performance; 4. underestimate beta.

also investors discount diversification reject positive tradeoff b/w risk and return

Optimism: inadequate insurance coverage younger people systematically think less likely to experience bad outcomes and more likely to

experience good outcomes failure to diversify excessive risk taking

Overconfidence: too much trading: investors who are high in desire for control and suffer from illusion of control are

prone to trade frequently. believe can pick winners internet stocks and day trading: single young men trade more and in riskier companies, resulting in

men earning 1.4% risk adjusted less return by one study and single men 2.3% less. Failure to diversify: even when assets other than stocks included

i. Naïve diversification: 1/n rule: divide 401k contribution equally among options in plan.ii. Home bias: bias toward U.S. stocks (aversion toward ambiguity: fear)

Reading 11: Investment Decision Making in Defined Contribution Pension Plans

Bounded Rationality: limits on intelligence and timeBounded self-control: fail to do the apparent right thingBounded self-interest;

“myopic loss aversion”: seeking to avoid short-term losses, despite the long time horizon usually involved in planning for retirement

Failure to diversify: “1/n diversification heuristic”: split contributions equally amongst the n funds on offer, w/ little regard

to underlying asset composition of the funds.i. “endorsement effect”: the entire selection of assets is seen as implicit guidance from employer

as to appropriate asset allocation strategy “too much choice”: negative relationship b/w # of funds on offer and employee participation Too much own-company stock; don’t realize it is riskier; preference to “invest in the familiar”/”home

country bias”; also “endorsement effect”

Employer may paternalistically design plan to maximize chance that most appropriate options are taken: opt-out rather than opt-in; default contribution rates; default fund options and range and nature of fund choice on offer; nature of info and advice

UK: DB plans: group personal pension (GPP) and stakeholder plans; DC plans: occupational money purchase (OMP) more common that there is “too little choice” no “own-company stock” problem

Reading 12: Global Equity Strategy: the Folly of Forecasting: Ignore All Economists, Strategists, and Analysts


“Those who have knowledge don’t predict. Those who predict don’t have knowledge.”

Economists seem to lag reality; inflation forecasts appear to be largely a function of past inflation rates: adaptive expectations.

Overconfidence as Driver of Poor Forecasting: overconfident: surprised more often that they expect to be; “not well calibrated” experts more overconfident than lay people

i. illusion of knowledge: we think we know more than everyone elseii. illusion of control

explained as: ignorance: not knowing that overconfidence exists; arrogance: ego defense mechanism Those who are amongst the worst performers actually are the most overconfident “the skills needed to produce correct responses are virtually identical to those needed to evaluate the

accuracy of one’s responses.” “top-down” approach: people start w/ a preconceived belief about their skills or abilities and use those

beliefs to estimate how well they will do at a specific task Ego Defense Mechanism:

i. “expertise thus may not translate into predictive accuracy but it does translate into the ability to generate explanations for predictions that experts themselves find so compelling that the result is massive overconfidence.”

ii. Conservatism bias: tendency to hang on to views too long and only slowly adjust; failure to slash probability after the outcome is known.

iii. 5 common strategies/defenses: “if only” defense: create a counterfactual; if certain event had occurred, or if original

advice or analysis had been followed “ceteris paribus” defense: although advice or analysis was correct, something else

occurred that blew off course “I was almost right” defense: event almost happened “it just hasn’t happened yet” defense: although the predicted outcome has not yet

occurred, it will eventually come to pass “single prediction” defense: analysis is valid, but the act of forecasting was flawed:

“everyone knows (or should know) that forecasting is pointless”iv. Anchoring: tendency to grab onto the irrelevant when faced w/ uncertainty

“little wonder that investors cling to forecasts, despite their uselessness.”

Reading 13: Alpha Hunters and Beta Grazers

Acute inefficiencies: discernible opportunities that can be exploited by accessible arbitrages; surrounding uncertainties can be hedged or minimized; resolution occurs quickly.

Chronic inefficiencies: tend to be less discernible, more ambiguous, more resistant to rapid resolution from available market forces, and generally longer tem in nature (arise from structural and behavioral sources: trading frictions, organizational barriers, imbalances in capital flows, valuation ambiguities, lack of catalysts for resolution, convoy or herding behavior, artificial peer comparisons, rebalancing inconsistencies, compulsive confirmation seeking, filtering of conflicting data, misreading of market signals, inertia, formulaic action plans, and overly rigid “policy portfolios”)

Behavioral factors: convoy behavior, Bayesian rigidity, price-target revisionism, ebullience cycle convoy behavior: herding behavior of institutional funds;

i. "Compounding consensus": tendency to seek the opinions of other "experts" who can confirm one's own views


Bayesian Rigidity: to relentlessly try to retain old views in the face of new information Price-Target Revisionism: price movements in predicted direction tend to be taken as confirmation of

wisdom, and the target is extended; to avoid: have plan to reduce positions as the original target is approached

Ebullience Cycle: during up markets, investors inclined to hold on firmly to winning positions (shining examples of brilliance); in down: "unopened envelope" syndrome and propensity for inaction in the face of losing positions

Portfolio rebalancing behavior of holders, rebalancers, valuators and shifters holders: tend to leave envelopes unopened and positions unchanged in down markets rebalancers: investors who formulaically rebalance to policy portfolio allocation, usually institutions valuators: take positions based on whether market is cheap or rich and expect reversal; also momentum shifters: making fundamental moves from one strategic stance to another (usually individuals), after

event like loss of job

Market impact: holders out of game rebalancers have smoothing effect valuators: those who are contrarians and "reversionists" will act as moderators; momentum investors will have

exacerbating effect shifters: exacerbate market movements

Beta investors: buy indexes; alpha investor: chip away at chronic inefficiencies and behavioral biases

Reading 14: Managing Individual Investor Portfolios

Investor Characteristics: Situational Profiling:

o Source of Wealth: self-made investors have greater familiarity w/ risk taking, but high sense of controlo Measure of Wealth: subjective nature of financial well-being; one portfolio may seem large to one and

small to another, affecting risk attitudeso Stage of Life:

Foundation: establishing base on which to create wealth: skill, establish business, education Accumulation: earnings accelerate Maintenance phase: maintaining desired lifestyle and financial security (usually retired); risk

tolerance decreases Distribution phase: transfer wealth

Psychological Profiling: aka personality typing; bridges differences b/w traditional finance (economic analysis of objective financial circumstances) and behavioral finance

o Traditional finance: investors assumed to 1. exhibit risk aversion, 2. hold rational expectations (coherent, accurate and unbiased forecasters, reflecting all relevant info and learn from past mistakes) and 3. practice asset integration

o Behavioral Finance: investors 1. exhibit loss aversion; 2. hold biased expectations; 3. practice asset segregation

loss aversion: prospect theory: investors place different weights on gains and losses; prefer an uncertain loss to a certain loss, but prefer certain gain to uncertain gain

biased expectations: cognitive errors and misplaced confidence in ability to assess future asset segregation: evaluate investment choices individually rather than in the aggregate resulting in the following assumptions for portfolio construction:


asset pricing reflects both economic considerations, such as production costs and prices of substitutes, and subjective individual considerations, such as tastes and fears

portfolios are constructed as “pyramids” of assets, layer by layer, in which each layer reflects certain goals and constraints

Personality Typing: 1. ad hoc review by investment advisor based on interviews and past investment activity; 2. client questionnaires

Cautious Investors: strong need for financial security; demand low-volatility investments w/ little potential for loss of principal; overanalyze; easily persuaded but often do not seek professional advice

Methodical Investors: relies on hard facts; undertake research; conservative; not emotionally attached to investments

Spontaneous Investors: constantly readjusting; not experts; doubt all advice; overmanage;

Individualist Investors: confident; work hard at info sources and reconcileDecisions based primarily on thinking

Decisions based primarily on feeling

More risk averse Methodical CautiousLess risk averse Individualist Spontaneous

Investment Policy Statement: return objectives: determined in connection w/ risk tolerance; return requirement vs. return desire;

o “total return” approach: seeks to identify a portfolio return that will meet investor’s objectives w/o exceeding the portfolio’s risk tolerance or violating its investment constraints

o consider: inflation, taxes risk objectives: ability and willingness;

o ability: financial goals relative to resources and time frame; critical goals have low margin of error and reduce ability to have volatility

o willingness Constraints:

o Liquidity: anticipated and unanticipated demands for cash distributions; liquidity affected by transaction costs and price volatility; general liquidity requirements: ongoing expenses, emergency reserves, negative liquidity events; should identify illiquid holdings;

o Time Horizon: 15-20 yrs is long; 3 to 15 is intermediate; single vs. multistage; stage of life;o Taxes: types: income taxes, gains taxes, wealth transfer tax, property tax; tax deferral; tax avoidance;

tax reduction; wealth transfer taxes: transfer at death, early transfers Capital gains tax = Price appreciation x CG tax rate x Turnover rate

o Legal and regulatory environment: personal trusts: revocable and irrevocable; Family foundation; jurisdiction: where taxed

o Unique circumstances: social and special purpose investing; assets legally restricted from sale, directed brokerage arrangements, and privacy concerns; assets held outside investment portfolio

Investment policy statement outline:I. BackgroundII. Return ObjectivesIII. Risk Tolerance

a. Abilityb. Willingness

IV. Constraintsa. Liquidityb. Time Horizonc. Taxesd. Legal and Regulatory Environment


e. Unique Circumstances

Asset Allocation: Selecting asset allocation:

o 1. determine asset allocations that meet investor’s return requirementso 2. Eliminate asset allocations that fail to meet quantitative risk objectives or other inconsistent w/ risk

toleranceo 3. Eliminate asset allocations that fail constraintso 4. Evaluate expected risk-adjusted performance and diversification attributes that remain; select most

rewarding Monte Carlo Simulation in Personal Retirement: provides a probability of meeting objectives estimate to

assess risko advantages:

more accurately portrays risk-return tradeoff than deterministic approach gives info on possible tradeoff b/w short-term risk and risk of not meeting long-term goal can model portfolio changes from tax effects well suited to model stochastic process and resulting alternative outcomes

o disadvantages relies on historical data must evaluate performance of specific investments, not just asset classes, and adjust for fees must account for tax consequences

Reading 15: Taxes and Private Wealth Management in a Global Context:

Global tax structures: taxes on income: progressive or flat wealth-based taxes (property and on wealth transfers) consumption taxes (sales taxes; value added taxes)


Classification of Income Tax RegimesRegime 1 – Common

Progressive2 – Heavy Dividend Tax

3 – Heavy Capital Gain Tax

4 – Heavy Interest Tax

5 – Light Capital Gain Tax

6 – Flat and Light 7 – Flat and Heavy

Ordinary Tax Rate Structure

Progressive Progressive Progressive Progressive Progressive Flat Flat

Interest Income Some interest taxed at favorable rates or exempt

Some interest taxed at favorable rates or exempt


Taxed at ordinary rates




Dividends Some dividends taxed at favorable rates or exempt


Some dividends taxed at favorable rates or exempt





Capital Gains Some capital gains taxed favorably or exempt

Some capital gains taxed favorably or exempt






Example Countries

Austria, Brazil, China, Czech Republic, Finland, France, Greece, HK, Hungary, Ireland, Italy, Japan, Latvia, Malaysia, Netherlands, Nigeria, Philippines, Poland, Portugal, Singapore, South Africa, Sweden, Thailand, UK, US, Vietnam

Argentina, Indonesia, Israel, Venezuela

Colombia Canada, Denmark, Germany, Luxembourg, Pakistan

Australia, Belgium, India, Kenya, Mexico, New Zealand, Norway, Spain, Switzerland, Taiwan, Turkey

Kazakhstan, Russia, Saudi Arabia (Zakat)

Ukraine


Future value interest factor (if taxed annually): FVIFi = [1 + r(1 – ti)]n

Tax drag may exceed the tax rate: compounds over time. Tax drag increases as the investment return increases.

For deferred taxation: FVIFcg = (1+r)n – [(1+r)n – 1]tcg = (1+r)n(1-tcg) + tcg

If cost basis differs: FVIFcgb = (1+r)n(1-tcg) + tcg – (1 – B)tcg = (1+r)n(1 – tcg) + tcgB; B is the percentage basis to market value

Annual wealth-based taxes: FVIFw = [(1+r)(1 – tw)]n

Annual return after realized taxes: r* = r(1 – piti – pdtd – pcgtcg); the p’s are the percentages of return and don’t need to add to 1 b/c unrealized capital gains are not included in the equation; does not capture tax effects of deferred CGs.

Effective CGs tax rate: T* = tcg(1 – pi – pd – pcg)/ (1 – piti – pdtd – pcgtcg)

Future after-tax accumulation for each unit of currency in a taxable portfolio: FVIFtaxable = (1 + r*)n(1 – T*) + T* - (1 – B) tcg

Accrual equivalent return: the IRR of the after-tax return: starting amount (1 + RAE)n = after-tax returnAccrual equivalent tax rate: the hypothetical tax rate that produces an after-tax return equivalent to the accrual equivalent return: r(1 – TAE) = RAE

Future after-tax accumulation of a contribution to a tax-deferred account (like IRA): FVIFTDA = (1 + r)n(1 – Tn)Future accumulation of a tax-exempt account (like Roth IRA): FVIFTaxEx = (1 + r)n

Risk: if investment returns taxed annual at ti, then return is reduced to σ(1 – ti)

Value created by using investment techniques that effectively manage tax liabilities: tax alpha asset location

o if strategy causes allocation of heavily taxed asset held in pension fund etc. to be too high, an offsetting short position in heavily taxed asset outside the pension fund can offset the excessive exposure

Trading behavior: optimally locating assets in TDAs and taxable accounts cannot overcome negative impact of poor investment strategy that either produces negative pretax alpha or is highly tax inefficient

Tax loss harvesting: realizing loss to offset gain or income, thereby reducing current year’s tax obligation; recognizing an already incurred loss for tax purposes increases amount of net-of-tax money available for investment

o highest-in, first-out (HIFO) tax lot accounting: sell highest cost basis first Holding Period Management: discourage short-term trading; gross up available long-term gain if held by

short-term tax rate to determine if short-term trade will yield greater; defer transaction just long enough for long-term capital gains

After-Tax Mean-Variance Optimization: pretax efficient frontiers may not be reasonable proxies for after-tax efficient frontiers; also substitute after-tax standard deviations of returns for pretax standard deviations in the optimization algorithm

Reading 16: Estate Planning in a Global Context

Trust: vehicle through which an individual (settlor) entrusts certain assets to a trustee who manages the assets; many civil countries do not recognize foreign trusts


Civil law: forced heirship rules:

o children have right to fixed share of parent’s estate (may exist regardless of estangement or nonmarital)

maybe move assets to offshore trust to avoid maybe gift or donate assets during lifetime; some jurisdictions have “clawback” provisions for

lifetime giftso spouses have guaranteed inheritance rights

community property regimes: each spouse has automatically passing, indivisible 1/2 interest in income earned during marriage (gifts and inheritances received b/f and after marriage are separate property) (other half through will or intestate)

separate property regimes: each spouse is able to own and control property as individual and to dispose, subject to spouses other rights

Net worth tax / Net wealth tax: on assets’ entire capital base lifetime gratuitous transfers (inter vivos transfers): lifetime gifts; gift tax may apply depending on residency or

domicile of donor, residency or domicile of recipient, tax status of recipient, type of asset and location of asset Testamentary gratuitous transfers: transfers upon death; taxation depending on residency or domicile of donor,

residency or domicile of recipient, type of asset and location of asset taxes may apply to transferor or the recipient; may be flat or progressive; usually after deduction for statutory

allowance; may depend on relationship of transferor or recipient (spouses often tax exempt)

Core Capital: amount of capital required to fund spending to maintain given lifestyle, fund goals and provide adequate reserves for unexpected commitments

survival probability: multiply future cash flow needs by probability that such cash flow will be neededo joint probability if married couple: p(survival) = p(H survives) + p(W survives) – p(H survives) x p(W

survives)

o PV(Spending need) =

o estimated that two people can maintain same living standard for 1.6 times the cost of oneo discount such probable cash flow needs

using the expected return of pension fund assets to discount liabilities they are intended to fund systematically under-prices those liabilities

Monte Carlo simulation w/ expected returns and volatilityo safety reserve: for capital market volatility and uncertain future family commitments; suggested 2 yrs

of spending Monte Carlo simulation: determine core capital that sustains spending at least, say, 95% of the simulated trials

o Ruin probability: probability of depleting one’s financial assets b/f death)

o volatility reduces future accumulations: ; geometric mean approximately equals

arithmetic mean minus half the volatility; also b/c withdrawals after down volatility reduce capital base

Excess Capital: anything over core capital may gift during lifetime:

o certain gifts may be tax-free: allows for gifts to grow to benefit of donee: relative after-tax value of tax-free gift made during one’s lifetime compared to bequest transferred as part of taxable estate is:

o taxable gifts:


, if paid by recipient; efficient if gift tax is

lower than estate tax; same if progressive tax rate (small gifts over time are efficient); but U.S. and other jurisdictions may required cumulative lifetime gift and estate tax

computation generation skipping: transfer high-returning assets; relative value is 1/(1-T1), where T1 is tax

rate of capital transferred from first to second generation; consider specific generation skipping transfer tax

o location of gift tax liability: could result in taxation of donor and donee in case of cross-border gift

if paid by donor: ; (benefit from

reduction of size of taxable estate)o spousal exemptions: note that there are two, and good to use to transfer to someone else than to living

spouse.o Valuation discounts: tax levied on fmv, which requires valuation; lack of liquidity; lack of control; use

family limited partnershipso Deemed dispositions: gains may be taxed at death; may benefit from avoiding by giftingo Charitable Gratuitous Transfers: 1. usually not subject to gift transfer tax; 2. may be exempt from

paying tax on investment returns

Estate Planning Tools: Trusts: relationship in which trustee holds and manages assets for benefit of beneficiaries; avoid probate

o revocable trust: settlor is responsible for tax payments and reporting; assets reachable by creditorso irrevocable trust: trustee responsible for tax payments and reporting; greater protection against

creditorso fixed vs. discretionary trustso controlo asset protection (from creditors, from beneficiaries); use to avoid forced heirship ruleso tax reduction: may be progressive schedule and move assets into lower bracket; time discretionary

distributions; create trust in low tax jurisdiction however, income of trust may be taxable to settlor

Foundations: legal entity set up for particular purpose;o can survive settloro allow for settlor’s wishes to be carried outo control, avoidance of probate, asset protection, and tax minimization

Life Insurance: death benefit proceeds paid to life insurance beneficiaries are tax exempt in may jurisdictionso premiums also not in estate and not considered gifto may have cash value building tax deferredo avoids probateo proceeds used to pay inheritance taxo avoid forced heirship ruleso asset protection: premiums not available to creditorso can combine w/ discretionary trust


Companies and CFCs:o defer taxes; and set up in no-tax jurisdictiono however, tax rules may quash w/ deemed distributions

Cross-Border Estate Planning: Hague Convention of the Conflict of Laws Relating to the Form of Testamentary Dispositions: will valid if

consistent w/ internal law associated w/:o place will madeo nationality, domicile, or habitual residence of testatoro location of immovable assets covered under willo certain exceptions, though, maybe requiring two willso required recognition of written trusts if:

assets constitute separate fund and are not part of trustee’s own estate title to trust assets stands in name of trustee or name of another on behalf of trustee trustee has power and duty to manage, employ or dispose of assets in accordance w/ trust and

special legal duties Tax system:

o taxation of income: source jurisdiction / territorial tax system vs. residence jurisdiction; (U.S. is worldwide!)

o taxation of wealth and wealth transfers: may be source or residence basedo exit taxation: deemed disposition on unrecognized gains; taxation on income during “shadow period”

Double Taxation: o residence-residence conflict: two counties both claim residenceo source-source conflict: two claim source (say based on location of assets and management of assets)o residence-source conflict: most common and most difficult to avoid;

source country commonly viewed to have primary jurisdiction; residence country typically expected to provide relief

Foreign tax credit provisions: credit method: reduces tax liability for foreign taxes paid: TCreditMethod = Max[TResidence,

TSource] Exemption Method: no domestic tax on foreign-source income: TExemptionMethod = TSource

o usually the few territorial-based systems adopt Deduction Method: partial concession: TDeductionMethod = TResidence + TSource(1-TResidence) =

TResidence + TSource – TResidenceTSource

o Double Taxation Treaties: OECD model treaty sanctions the exemption and credit method to resolve residence-source

conflicts interest and dividends: source taxation by withholding by source country; rates

encouraged to be limited to 15% and 10% respectively. capital gains are taxed in residence country, except on immovable property also resolves residence-residence conflicts based on following ordered list: 1.

permanent home; 2. center of vital interests; 3. habitual dwelling; 4. citizenship (don’t typically resolve source-source conflicts)

o Transparency and Offshore Banking: consider tax avoidance vs. tax evasion banking secrecy: benefits are security, privacy, intra-family dynamics and politics, and efficient

for clients residing abroad tax evasion strategies predicated on bank secrecy and being exposed by increasing info

exchange b/w tax authorities


Qualified Intermediaries: banks that document info for all customers and provide info about U.S. customers upon request, w/o requirement to provide info on other non-U.S. persons beneficially owning U.S. securities

Reading 17: Low-Basis Stock

Usually resulting from: being an entrepreneur being an executive being an investor

Issues: Psychological risk and return taxes

Specific risk / residual risk increases from investor, to executive, to entrepreneur

Equity Holding Lives: 3 stages:1. entrepreneurial stage: high specific risk: no diversification desired at this stage; seeking max profit2. executive stage: after taken business public; relatively concentrated positions w/ some entrepreneurial bent

still; greater diversification as one descends the management hierarchy3. investor stage: multisecurity portfolio (either diversified investor stages or indexing stage (indexing being

more diversified)): no longer have control over underlying fortunes of company

Reducing exposure: outright sale: simplest and most expensive; results in max flexibility; eliminates residual risk; lower

amount of money to reinvest exchange funds: pool concentrated positions from multiple individuals

i. public exchange funds: partnership for >= 7 yrs; 20% exposure to other illiquid investments; portion of pool distributed after 7 yrs

but, management costs, lack of control and inflexibilityii. private exchange fund alternative: usually single security; partner w/ another investor who

purchases same stock at current market prices; p’ship then enters into series of partial hedging, borrowing and reinvesting transactions (avoiding constructive sales);

increases borrowing ability lessens psychological blow no need for exposure to illiquid investments 7 yrs but unclear whether tax sound

completion portfolios: i. single asset class completion portfolios: make other investments to offset the concentrated

position; may reinvest dividends passive structured strategy: reinvest dividends and use all available opportunities to

harvest investable losses experienced by one or several of the stocks in the completion portfolio.

ii. multi-asset class completion portfolios: reach across asset or sub-asset classes requires substantial pool of other assets diversification process takes time


hedging strategies: diversified but to avoid constructive sales; borrows against value of portfolio (monetization) and reinvests

i. Constructive sale: short sale of same or substantially identical proprty offsetting notional principal K wrt the same or substantially identical property or futures or forward K to deliver same or substantially identical property

ii. Equity collars: pure hedging strategy: buy put and sell call (can cost money, be cashless, or income-producing).

suggested that 15% remaining exposure avoids constructive saleiii. Monetization of position: w/ equity collar, could borrow up to ~90% of put strike price;

however, if more than 50%, must be nonpurpose loan and be intended for investments in anything other than equities (however, may still increase leverage through margin).

iv. Variable Pre-Paid Forwards: forward sale of contingent number of shares of underlying stock w/ agreed future delivery date in exchange for cash advance today.

“properly constructed and documented, does not constitute a constructive sale and not subject to margin lending restrictions.” (unbalanced collar)

v. debate over whether interest must be capitalized for tax purposes

Reading 18: Goals-Based Investing: Integrating Traditional and Behavioral Finance

Define portfolio efficiency in terms of client goals instead of relying on traditional measures of return and standard deviation, then create strategies matched to each goal

Investor goals: 1. lifestyle needs, 2. wealth transfers, 3. charitable gifts

Risk Measurement: traditionally standard deviation, etc.

i. however, return distributions are non-normal: skewed, excess kurtosis and heteroskedasticii. doesn’t describe risk in terms of clear outcomes / the way investors experience risk

loss aversion: investors are not risk averse, but loss aversei. risk measures should address : likelihood that loss will occur, severity of loss or both (say

probability of loss and downside deviation) risk measures are usually annualized or some short period, failing to convey risk over multiple periods

i. consider troughs occurring at end date

Risk Profiling: Decision Framing: slight differences in the way that questions are posed lead to very different answers about

people’s preferences Mental Accounting: multiple attitudes about risk; manage risk on goal-by-goal basis; maintaining separate

investment accounts, either mentally or in practice, and making decisions differently depending on the nature of the account.

Managing Behavioral Biases: loss aversion: develop strategies to manage losses mental accounting: develop strategies that can be aligned w/ investors’ separate goals and accounts biases should be controlled rather than accommodated

o Overconfidence: overestimate abilities; take risks w/o commensurate returns; overtradeo Hindsight bias: believe that predicted event when didn’to Overreaction: to overinterpret patterns that are coincidental and unlikely to persisto Belief perseverance: unlikely to change opinions even when new info becomes available


o Regret avoidance: tendency to avoid actions that could create discomfort over prior decisions, even though those actions may be in the individual’s best interest

hold losers too long (disposition effect)o recommendations:

goals and preferences should be defined as clearly as possible and supported through risk management, using measures such as probability of breaching goal and potential loss

progress towards goals should be monitored, w/ performance evaluated in this context strategy adjustments should be based on changes in circumstances or goals rather than behavioral

factors

Implementing a Goals-Based Approach: goals-based investing: aligning investment strategies w/ goals of individual investor

o match investment strategies to four buckets: liquidity, income, capital preservation and growth investing to meet current lifestyle needs:

o measuring risk to current lifestyle goals: use efficient frontier but have worst sustainable spending rate as risk axis and expected spending

rate as return axis event specific rather than period specific: 1% probability that sustainable spending rate will fall as

far as or below the worst levelo implementing the new measures of reward and risko lifestyle protection strategies: investor determines minimum sustainable spending rate based on lifestyle

needs, which is translated to target for potential loss, and portfolios are considered; expected spending rate can be increased if investor is willing to accept a lower sustainable spending rate in a worst-case scenario

o cash flow matching: state current lifestyle goals more precisely using targets for amount of cash required in each period; can use laddered bond portfolios to match expenses; high degree of certainty that CF targets are met

not appropriate if expense patterns likely to change low return CFs are predictable but corpus may be volatile

Investing for a fixed planning horizon: for growth rather than expenses (say retirement, or college enrollment)o measure reward as expected portfolio value at horizon dateo risk measured depending on psychology of investor

amt of capital that could be lost measure of worst portfolio value at horizon based on confidence interval (efficient frontier w/ axes: worst portfolio value and expected portfolio value) for fixed horizon strategy, risk free investment would be high-quality zero-coupon bond w/

maturity near horizon date; then balance w/ other investments but if horizon likely to change, or is zero-coupon bond sufficient return, or volatility of

corpus ok?

Reading 19: Lifetime Financial Advice: Human Capital, Asset Allocation, and Insurance

Human Capital: economic PV of investor’s future labor income early life stages: financial and investment capital should hedge and diversify human capital implications of model:

o younger investors invest more in stocks than older investorso investors w/ safe labor income invest more in financial portfolio in stockso investors w/ labor income that is highly correlated w/ stock markets invest their financial assets in less

risky assets


o ability to adjust labor supply increases as investor’s allocation to stocks labor income typically has low correlation w/ stock market

Human capital as a risk-free asset: invest in stocks and gradually scale back as gets older Human capital as a risky asset: 1. if correlated w/ other risky financial assets, buy risk-free asset when young and

gradually move to risky-assets (as risky human capital declines); 2. if not correlated w/ other risky financial assets, same as case 1.

Impact of initial financial wealth: greater percentage allocation to risk-free asset (b/c initial wealth reduces portion of wealth that is safe human capital)

Correlation b/w wage growth rate and stock returns: make greater allocation to risk-free asset

Implications for Advisors:1. investors should invest financial assets to diversify and balance human capital2. young investor w/ safe human capital should invest more financial assets in risky assets than older3. if human capital correlated to risky assets, reduce allocation to risky assets

Mortality risk: asset allocation and life insurance decisions should be made jointly life insurance is perfect hedge of human capital in event of death optimal amt of insurance depends on: 1. expected value of human capital and 2. risk-return

characteristics of the insurance contract.

life insurance (θ) optimization:

i. q is subjective probability of deathii. U is utility function

as correlation b/w shocks to income and risky assets increases, optimal allocation to risky assets declines and optimal quantity of life insurance declines (implies lower amt of human capital)

the more financial assets one has, the less optimal quantity life insurance less risk tolerance, the more risk-free assets and the more life insurance demand for insurance decreases w/ age (primary driver of life insurance is human capital)

Retirement Portfolio and Longevity Risk: goals: 1. comfortable life style and 2. bequests risks: 1.financial market risk; 2. longevity risk; and 3. risk of not saving enough (including effects of

inflation)i. financial market risk: portfolio values fluctuate in short run, and may occur early in retirement

mitigate w/ diversificationii. longevity risk: outlive assets

hedge w/ insurance products: lifetime annuities / payout annuities1. fixed: doesn’t account for erosion by inflation; typically can’t trade out of once

purchased2. or variable: fluctuates w/ performance of funds investor chooses

main sources of income: social security; DB pension plans; personal savingsiii. risk of spending uncertainty: may not save enough to adequately fund retirement

behavioral issue combination of types of annuitization and systematic withdrawals helps manage financial risks and

income needs

Reading 20: Managing Institutional Investor Portfolios


DC plans may be profit-sharing: based on plan sponsor’s profits sponsor directed: sponsor chooses the investments participant directed: sponsor provides menu and participants determine

DB plans: funded status: fully funded; has pension surplus; underfunded ABO: PV of benefits if plan terminated immediately (for accumulated service but not future service

and wage increases) PBO: PV of benefits if plan assuming future comp increases (funding status usually determined off of

PBO) Total future liability: PV of accumulated and projected future service benefits including projected

future comp increases (most comprehensive but most uncertain; used internally) retired lives (retired workers) vs. active lives (active workers)

DB Investment Policy Statement: Risk objectives:

Factors Affecting Risk Tolerance and Risk Objectives of DB PlansCategory Variable ExplanationPlan Status Plan funded status (surplus or

deficit)Higher pension surplus or higher funded status implied greater risk tolerance

Sponsor financial status and profitability

Debt to total assets; Current and expected profitability

Lower debt ratios and higher current and expected profitability imply greater risk tolerance

Sponsor and pension fund common risk exposures

Correlation of sponsor operating results w/ pension asset returns

The lower the correlation, the greater risk tolerance, all else equal

Plan features Provision for early retirement; Provision for lump-sum distributions

Such options tend to reduce the duration of plan liabilities, implying lower risk tolerance, all else equal

Workforce characteristics Age of workforce; Active lives relative to retired lives

The younger the workforce and the greater the proportion of active lives, the greater the duration of plan liabilities and the greater the risk tolerance

i. Asset/liability management (ALM): subset of company’s overall risk management practice that typically focuses on financial risks created by the interaction of assets and liabilities; for given financial liabilities, asset/liability management involves managing the investment of assets to control relative asset/liability values.

ii. DB plans may state risk objective relative to level of pension surplus volatilityiii. Shortfall risk: risk (probability) that portfolio value will fall below some minimum acceptable

level over some time horizoniv. risk objective to: minimize year-to-year volatility of future contribution paymentsv. risk objective to: minimize probability of making future contributions, if sponsor is currently

not making any contributions b/c plan is overfunded Return objectives: broadly: to achieve returns that adequately fund pension liabilities on inflation-

adjusted basisi. consider: current funded status; contributions in relation to accrual of pension benefits;

ii. return objective may be such to eliminate future pension contributionsiii. return objective may be such to increase pension income in income statementiv. may have separate return objectives for each of retired lives and active lives

Liquidity requirement: net cash outflow: benefit payments minus contributionsi. consider percentage of retired lives; corporate contributions in relation to benefit

disbursements; options for early retirement or option to take lump-sum payments Time horizon:


i. whether plan is going concern or termination expectedii. age of workforce and proportion of active lives

iii. may be multistage Tax concerns: usually tax exempt (though contributions and termination involve tax planning) Legal and regulatory factors:

i. ERISA for corporate and multi-employer plans: standards of careii. Taft-Hartley Labor Act for union plans

iii. fiduciary: person standing in special relation of trust and responsibility wrt other parties assets to be managed solely in interests of beneficiaries

Unique circumstances:i. due diligence wrt alternative investments

ii. prohibitions on investment in certain industries w/ negative ethical or welfare connotations; or in companies operating in certain countries

Corporate Risk Management and the Investment of DB Pension Assets: managing pension investments in relation to operating investments: if business and pension risks are

positively correlated, high degree of operating risk would limit amt of risk that pension could assume coordinating pension investments w/ pension liabilities: ALM perspective to match interest-rate

sensitivity of assets and liabilities

DC Plans: sponsor directed: IPS is simpler subset of DB plan IPS participant-directed:

i. diversification: Section 404(c) of ERISA safe harbor for DC plan sponsors against claims of insufficient or imprudent investment choice if plan has 1. at least 3 investment choices diversified versus each other and 2. provision for participant to move freely among options.

ii. Company stock: should be limited to allow for diversification plan participants set on risk and return objectives IPS becomes overall set of governing principles rather than IPS for a specific plan participant

Hybrid and other plans: combination of DB (benefit guarantees, years of service rewards, ability to link retirement pay to % of salary) and DC (portability, administrative ease and understandability) plans

cash balance plans, pension equity plans, target benefit plans and floor plans Cash Balance Plan: DB plan w/ benefits displayed in individual recordkeeping accounts; facilitates

portability to a new plan.i. contribution credit: % of pay based on age

ii. earnings credit: % increase in acct balance typically tied to long-term interest ratesiii. no actual account balance b/c no separate accountiv. some allow for some investment choices

ESOP: DC plans that invest all or a majority of assets in company stock; contributions based on employee pay; vesting schedules; (not diversified)

Foundations and Endowments: Foundation: grant-making institutions funded by gifts and investment assets

i. typically have single donorii. have minimum levels of annual spending

iii. typically do not receive new contributionsiv. typically four types: 1. independent, 2. company sponsored, 3. operating and 4. community


Type of Foundations in U.S.Foundation Type

Description Source of Funds

Decision-Making Authority

Annual Spending Requirement

Independent foundation (private or family)

Independent grant-making organization established to aid social, educational, charitable, or religious activities

Generally an individual, family, or group of individuals

Donor, members of donor’s family, or independent trustees

At least 5% of 12-month average asset value, plus expenses associated w/ generating investment return

Company-sponsored foundation

A legally independent grant-making org w/ close ties to corp providing funds

Endowment and/or annual contributions from a profit-making corp

Board of trustees, usually controlled by sponsoring corp’s executives

Same as independent foundation

Operating foundation

Org that uses its resources to conduct research or provide a direct service (e.g., operate a museum)

Largely the same as independent foundation

Independent board of directors

Must use 85% of interest and dividend income for active conduct of institution’s own programs. Some are also subject to annual spending requirement equal to 3.33% of assets.

Community foundation

A publicly supported org that makes grants for social, educational, charitable, or religious purposes. A type of public charity.

Multiple donors; the public

Board of directors No spending requirement.

Foundation IPS:i. risk objectives: desire to keep spending whole in real terms or to grow institutions, but can be

more fluid or creative and aggressive than pensions; still ability and willingnessii. return objectives: total return; long-term return objective for foundations w/ indefinitely long

horizons: preserve real (inflation-adjusted) value of investment assets while allowing spending at appropriate (statutory or decided-upon) rate; intergenerational equity/neutrality: equitable balance b/w interests of current and future beneficiaries of foundation’s support;

spending (say 5%) times investment management expenses (say 0.3%) times inflation (say 2%)

iii. liquidity requirements: anticipated (spending rate) or unanticipated needs for cash in excess of contributions; investment management expenses don’t count toward payout req, though overhead associated w/ grant making does.

may use smoothing rule that averages asset values over period of time to dampen spending rate’s response to asset value fluctuations

IRS allowes certain carry-forwards and carry-backs w/i limits cash reserve to allow for end-of year rush spending in case of large asset growth

iv. Time horizon: usually into perpetuity, but sometimes intended to be “spent down”v. Tax concerns:

avoid UBTI, including debt-financed portion of income from debt-financed real estate private foundations must estimate and pay quarterly in advance 2% tax on net

investment income: dividends, interest and cap gains less foundation’s expenses related directly to production of such income; reduced to 1% if charitable distributions for year >= 5% and avg of previous 5 yrs’ payouts plus 1% of net investment income.

vi. Legal and regulatory factors:


IRC Section 4944: graduated excise taxes if jeopardize carrying out of tax-exempt purposes

Uniform Management of Institutional Funds Act (UMIFA): primary state legislation governing any entity organized and operated exclusively for educational, religious, or charitable purposes.

vii. Unique circumstances: restrictions on diversification (may avoid w/ swaps)

Endowments: long-term funds generally owned by operating non-profit institutions involved in charitable activities

i. not subject to legally required spending levelii. may be supplemented w/ quasi-endowments: funds functioning as endowment (FFE) w/ no

spending restrictionsiii. usually several funds, each w/ specific indenture detailing conditions and intended uses of gifts,

but may be unrestrictediv. UMIFA both income and cap gains (realized and unrealized) included in determining total

return, freeing from strictures of yield as spending limitv. frequently use trailing market value in calculating spending, to create stability; possible rules:

simple spending rule: Spendingt = Spending rate x Ending market valuet-1

Rolling three-year avg spending rule: Spendingt = Spending rate x (1/3) [Ending market valuet-1 + Ending market valuet-2 + Ending market valuet-3]

Geometric smoothing: Spendingt = Smoothing rate x [Spending ratet-1 x (1 + Inflationt-

1)] + (1 – Smoothing rate) x (Spending rate x Beginning market valuet-1); smoothing rate usually 60 to 80%

vi. Endowment IPS: Risk objectives: consider in conjunction w/ spending policy and long-term objective

1. w/o smoothing rule, may have less tolerance for volatility2. consider endowment’s role in operating budget and ability to adapt to drops in

spendingi. correlation w/ donor base may limit ability to take risk b/c cannot rely on

donors in down markets3. consider recent returns in relation to smoothing rule (high recent returns

indicates greater risk tolerance)4. may have short-term performance time horizons limited risk tolerance

Return objectives: have high return objectives: significant, stable and sustainable flow of income to operations

1. should maintain long-term purchasing power after inflation2. consider high inflation for U.S. higher ed (HEPI averages 1% more than CPI or

GDP deflator)3. low-volatility, low-return portfolio increases risk of endowment failing

objectives4. returns must exceed spending rate, expected inflation rate and cost of generating

investment returns5. use Monte Carlo simulation to set (may be higher than point above)

Liquidity requirements: perpetual and measured spending limit need for liquidity1. need cash for capital commitments and for rebalancing2. maybe major capital projects3. generally suited for illiquid investments

Time Horizon: extremely long1. planned decapitalizations (large projects) may make for multistage horizons

Tax concerns: exempt from taxation1. avoid UBTI


2. dividend withholding tax from non-U.S. securities Legal and regulatory factors:

1. UMIFA: i. allows for delegation of investment responsibility to external advisors

and managers and setting comp for suchii. board must “exercise ordinary business care and prudence”

iii. spending gain as well as income okiv. if fall below historical book, then spend only income

2. 501(c)(3): ensure that no part of net earnings inure or accrue to benefit of any private individual

i. excise taxes for individuals receiving “excess benefit transactions” (too high comp)

Unique circumstances:1. variance in size: variety of expertise and resources2. diligence of alternative investments: active management3. whether investments limited to Qualified Purchasers (>$25M) can be considered4. ethical investment policies:

i. voting shareholder proxies on issues of social or political significanceii. exclusions for companies: child labor, gambling, tobacco, firearms,

violations of human rights

Insurance: 1. life; 2. health; 3. property and liability life insurance cos:

i. risk objectives: to fund future policyholder benefits and claims; looked upon as quasi-trust fund—so conservative fiduciary principles; sensitive to change of principal loss or interruption of income; must maintain asset valuation reserve based on NAIC quality tests; GAAP-required

market valuations increase balance sheet volatility; also fund interest-rate-sensitive liabilities: annuities and deposit-type contracts Valuation concerns : a/l duration mismatches create risk of capital adequacy problems

during periods of changing interest rates: limits risk tolerance Reinvestment risk : ability to invest maturing assets at rates sufficient to cover the

guarantee rate of annuity contracts on which no interest is paid until maturity Credit risk : risk objectives may relate to losses caused by credit risk Cash flow volatility : low tolerance for loss of income or delays in collecting and

reinvesting cash flow from investments competition has motivated greater risk tolerance

ii. Return objectives: policyholder reserve (BS liability of estimated pmts to policyholders) rates set by

actuaries; to obtain a net interest spread to increase surplus policyholder reserves total return is difficult as only asset side of BS would reflect resulting volatility competitive pressures to offer competitive crediting rates Segmentation: sub-portfolio return objectives; need to grow surplus to support expanding business volume

iii. Liquidity requirements: disintermediation: withdrawing or borrowing against cash value; or surrendering policy

for cash value; has resulted in actuaries reducing duration estimates and portfolio managers to reduce duration of portfolio

Asset marketability risk: liquidity needs limit ability to invest in private placement bonds, commercial mortgage loans, equity real estate and venture capital; also liquidity


requirements for forward commitments to purchase private placement bonds or mortgages

derivatives and lines of credit have decreased liquidity requirementsiv. Time horizon: traditionally the classic long-term investor, but segmentation creates unique time

horizons; ALM has tended to shorten time horizonv. Tax concerns: subject to income, capital gains, etc.; focus on after-tax returns; only corporate

share of income (not policyholder share) is taxable could be tax law changes regarding deferral from inside buildup of cash values

vi. Legal and regulatory factors: heavily regulated by states—permitted lines of business, product and policy forms, authorized investments; industry accounting rules and financial statement forms

Eligible investments : asset classes and quality standards; interest coverage ratios or minimum credit ratings; max allocation to common stocks (~20% in U.S.)

Prudent Investor Rule : replaced laundry lists of approved investments Valuation methods: uniform valuation methods established and administered by NAIC

vii. Unique circumstances: say company’s size and surplus position non-life insurance cos: (including health, property, liability, marine, surety and worker’s comp):

differences from life: shorter durations; longer claim processing and payments periods some liabilities exposed to inflation risk (but not interest rate risk directly) liabilities are relatively uncertain in value and timing; greater operating volatility

ii. underwriting (profitability) cycle: 3 to 5 yrs; resulting from adverse claims experience or periods of extremely competitive pricing (often coincide w/ business cycle and require liquidation of investments)

iii. models attempt to account for: 1. underwriting cycle; 2. liability durations by product line; 3. any unique cash outflow characteristics

non-life insurance co IPS:i. Risk objectives: quasi-fiduciary role; risk of catastrophic events; current cost or replacement

cost coverage: inflation risk; Cash flow characteristics: can be erratic; low tolerance for loss of principal or

diminishing investment income; (no regulatory required asset-valuation reserve); ratio of casualty insurance co’s premiums to total surplus: generally 2-to-1 or 3-to-1

Common stock holdings to surplus ratio: often self-imposed limits on common stock holdings

ii. Return objectives: Competitive policy pricing: lead to high return objectives; insurance cos may lower

premiums as a result of past high returns Profitability: investment income and portfolio return are primary profitability

determinants; influenced by underwriting cycle; maximize return on capital and surplus to extent that prudent ALM, surplus adequacy considerations and management preferences allow (rather than policy crediting rate); investment returns expected to offset underwriting losses

1. profitability measured using “combined ratio”: % of premiums that insurance co spends on claims and expenses (been over 100%)

Growth of surplus: allows for expansion of volume of underwriting Tax considerations: balance of taxable and tax-exempt bonds; managing and optimizing

operating loss carrybacks and carryforwards Total return management: active bond portfolio management strategies have increased

as a result of accounting rules requiring capital gains and losses to flow through income statement


iii. Liquidity requirements: typically maintains portfolio of short-term securities and maintains balanced or laddered maturity schedule

uncertainty of cash flow variable tax position results in liquidity requirements to alter amount of tax-exempt

holdings interest rate conditions

iv. Time horizon: casualty liabilities typically shorter duration than that of life insurance underwriting cycles yield curve for tax-exempts is steeper, so move out on yield curve for yield

1. may be willing to sacrifice A/L matches to degree historically long-term for common stock, but recently more turnover in common stock

b/c realized gains and losses flow through income statementv. Tax concerns:

current tax provisions require series of calculations to determine net tax levied on tax-exempt bond income; hence careful mix of tax-exempt and taxable securities

uncertainty of further tax code modificationvi. Legal and regulatory factors:

less regulated than life insurance; classes of eligible assets and quality standards otherwise remainder can be invested in broad array of assets (though some states have

additional reqs on max asset class holdings) not required to maintain asset valuation reserve new U.S. risk-based capital regulations: min amt of capital that must hold as function of

size and degree of asset risk, credit risk, underwriting risk, and off-balance sheet riskvii. Determination of portfolio policies:

limited risk tolerance is dominant capital appreciation to build surplus base and support additional investment in business underwriting experience current tax policy

Banks: liabilities chiefly of time and demand deposits, but also include purchased funds and sometimes publicly

traded debt assets are loan and securities portfolios; (also trading accounts, bank premises and fixed assets, and other real

estate owned) net interest margin: net interest income divided by avg earning assets interest spread: avg yield on earning assets minus avg % cost of interest-bearing liabilities leverage-adjusted duration gap: DA – kDL where DA is duration of assets, DL is duration of liabilities and k =

market value of liabilities over market value of assets; positive interest rate shock: market value of net worth will decrease for bank w/ positive gap; unaffected w/ zero gap, and increase w/ negative gap.

position and aggregate Value at Risk (VAR): minimum value of losses expected over specified time at give probability

credit measures: internally developed and other like CreditMetrics: overall portfolio objectives:

o manage overall interest rate risk of balance sheeto manage liquidityo produce incomeo manage credit risk

pledging requirement: pledge gov’t securities against uninsured portion of deposits (in U.S.) Bank IPS:


o risk objectives: ALM considerations focusing on funding liabilities; below-average risk toleranceo return objectives: earn a positive spread over cost of fundso liquidity requirements: net outflow of deposits; demand for loans; management and regulatory concerno time horizon: overall short maturity for liabilities than for portfolio; generally 3 to 7 yrs (intermediate)o Tax concerns: securities portfolios are fully taxable; no longer tax exemptions for municipal securities

etc.; securities gains and losses affect net operating income: leads to managing earningso Legal and regulatory factors: reg restrictions on holding common shares and below-investment-grade

risk fixed-income securities hold short-term gov’t securities: legal reserve and pledging reqs risk-based capital regs

Basel II: minimum 8% capital requirement for assets weighted 0%, 20%, 50%, 100% and 150%

o Unique circumstances: no common unique circumstances

other institutional investors: mutual funds; closed-end funds; unit trust; ETFs; commodity pools; hedge funds; nonfinancial corporations (major investors in money markets)

Reading 21: Linking Pension Liabilities to Assets

Selecting portfolios from asset-only perspective implicitly assumes that liabilities have no market risk pension liabilities: PV of deferred wages; focus on volatility of estimated benefit pmts and how they change

over time

o

discount rate must reflect market-related exposures of benefit pmts: say real if inflation, then rate should have real-rate bond component

o benefit volatility results from: volatility of wages, inflation, many non-market-related factors; growth attributable to future service costs, new entrants and other non-market related factors

o Market related exposures: inactive participants: fixed unless indexed for inflation

mimic w/ bond; exposure to term structure mimic w/ real rate bonds if inflation indexed

active participants: benefits attributable to past service and wages (accrued benefits) and attributable to future service and wages (future benefit)

accrued benefits: fixed unless inflation indexed future benefits: risk is capital market driven for funded liabilities; if plan is frozen, then

zero future benefito future wages: estimated future wage increases/benefits: future wage liability;

both real wage growth and wage inflation future wage inflation: long-term relationship b/w general inflation and

wage inflation; exposed only until retirement, after which fixed so combination of real rate bonds and nominal bonds

future real wage growth: economic growth through labor’s share of productivity increases; evidence of stability of share of labor in national income, so linked to productivity increases; fixed at retirement, though

so combination of equities and nominal bonds future services rendered: uncertain

future participants: rarely funded; (zero if closed to new entrants)


Market Related Exposures and Liability Mimicking AssetsPortion of the Investment Benchmark Market Related Exposures Liability Mimicking AssetsInactive Term structure Nominal bondsActive-accrued Term structure Nominal bondsActive-future wage Inflation

Growthterm structure

Real rate bondsEquitiesNominal bonds

o Non-Market Related Exposures: Liability Noise: plan demographic experience different from actuary’s model given certain underlying

probabilities model uncertainty: uncertain probabilities inactive participants: mortality experience differing from model: difficult to hedge; also

uncertainty of age of retirement active participants: mortality assumption; withdrawal, disability, retirement

Linking assets and liabilities via fundamental factors: combination of nominal bonds, real rate bonds and equities accrued benefit: discount rate market-related exposure -->term structure-->real rate, inflation and nominal

bond premium future wage liability-->change in wage level-->economic growth and inflation

accrued liabilities (w/ inflation indexation):

future wage liability: ; s yrs to retirement

resulting sensitivity exposures sets asset allocation and is liability mimicking portfolio; is also appropriate investment benchmark; this low risk portfolio is the baseline: often greater allocation to equities while minimizing amt of unrewarded risk taken versus liability

o hedge the liability w/ derivativeso use remaining capital on efficient return generation (asset-only)

Reading 22: Allocating Shareholder Capital to Pension Plans

Marked-to-market funding status is picture of current status and doesn’t reveal risk of status change: asset/liability mismatch is great concern;

equity portion of pension portfolios often even larger than entire market cap of company mismatch doesn’t show up in accounting statements equivalent to fixed-interest for equity swap pension assets are encumbered by a lien against by the pensioners, while gains and losses flow to shareholders PBGC bears losses from default study result: companies w/ larger fraction of equity in pension portfolio tended to have larger beta

By failing to take account of pension assets and liabilities when estimate WACC, companies probably distorting operating risk: 1. leaving out pension risk from total risk; 2. understates leverage ratio

result is larger WACCs: too high of hurdle rates by lowering risk in pension plan, risk is freed up to be spent in core operations

o risk budget:


determine unleveraged/asset beta by adding pension assets to total assets and pension liabilities to total liabilities; the beta of the assets will be the beta of the stocks in portfolio times % of portfolio plus the beta of bonds (0). Then calculate asset beta.

Reading 23: Capital Market Expectations

Frameworks for Developing Capital Market Expectations:1. Specify the final set of expectations that are needed, including time horizon to which they apply2. Research historical record

i. collect macroeconomic and market info on 1. geographic area; or 2. broad asset class

3. Specify the method(s) and/or model(s) that will be used and their information4. Determine the best sources for information needs5. Interpret the current investment environment using the selected data and methods, applying experience and

judgment6. Provide the set of expectations that are needed, documenting conclusions7. Monitor actual outcomes and compare them to expectations, providing feedback to improve the expectations-

setting process

Beta research: related to systematic risk and returns to systematic risk; development of capital market expectationsAlpha research: related to capturing excess risk-adjusted returns by a particular strategy

Good forecasts are: unbiased, objective and well researched efficient (reducing magnitude of forecast errors to a minimum) internally consistent

Challenges in Forecasting: Limitations of economic data

o time lag of collection, processing and disseminationo changes in definitions and calculation methods (say CPI-U)

re-basing indices Data measurement errors and biases

o Transcription errors: errors in gathering and recordingo Survivorship bias: data series reflect only survivorso Appraisal (smoothed) data (say real estate or alternative investments): results in 1. calculated

correlations w/ other assets tend to be smaller in absolute value than true correlations; 2. true standard deviation of asset is biased downward

Limitations of historical estimates: analysis should include discussion of what may be different from pasto changes in technological, political, legal, and regulatory environments; disruptions such as warso change of regime: change of governing set of relationships creates nonstationarity (different parts of

data series reflect different underlying statistical properties)o long data series:

risk that data cover multiple regimes time series of required length may not be available in order to get data series of required length, temptation is to use high-frequency data (weekly

or daily): more sensitive to asynchronism (discrepancy in dating of observations that occurs b/c stale (out-of-date) data may be used in absence of current date) across variables, producing lower correlation estimates

Ex Post Risk Can be a Biased Measure of Ex Ante Risko ex post returns may reflect that didn’t materialize resulting in overstated estimates of ex ante returns


Biases in Analysts’ Methods:o Data-mining bias: repeatedly “drilling” or searching dataset to find statistically significant patterno Time-period bias: research findings that are sensitive to selection of starting and/or ending dates, may

bias out-of-time period analysis Failure to account for conditioning info: analyst should condition forecasts on the state of economy to

formulate most accurate expectations (say different betas in expansion economies and recession economies) Misinterpretation of correlations:

o distinguish b/w exogenous and endogenous variables; o correlation may be spurious w/ no predictive relationship

test w/ multiple regression variable significance test using time series analysis w/ independent variables including lagged value of dependent

variable, lagged value of tested variable and lagged value of control variables Psychological traps:

o anchoring trap : tendency to give disproportionate weight to first info received on topico status quo trap : tendency to perpetuate recent forecasts—to predict no changeo confirming evidence trap : bias that leads individuals to give greater weight to info that supports

existing or preferred point of view examine all evidence w/ rigor enlist an independent-minded person to argue against be honest about motives

o overconfidence trap : tendency to overestimate accuracy of forecastso prudence trap : tendency to temper forecasts so that they don’t appear extreme; to be overly cautious in

forecastingo recallability trap : tendency of forecasts to be overly influenced by events that have left strong

impression on person’s memoryo model uncertainty: uncertainty whether selected model is correct

input uncertainty: uncertainty whether inputs are correct

Tools for Formulating Capital Market Expectations: Formal tools: established research methods amenable to precise definition and independent replication of

resultso Statistical methods: descriptive statistics; inferential statistics

historical statistical approach: sample estimators (assuming stationarity) sample arithmetic mean total return or sample geometric mean total return as estimate

of expected return sample variance as estimate of variance sample correlations as estimate of correlations

Shrinkage estimation: taking weighted average of historical estimate of parameter and some other parameter estimate based on analyst’s belief of weights

target covariance matrix: selecting an alternative estimator of covariance matrix Time-Series Estimators: forecasting a variable based on lagged variables

good for short-term forecasts volatility clustering: tendency for large (small) swings in prices to be followed by large

(small) swings of random directiono ; beta is the rate of decay of the influence of the value of

volatility in one period on future volatility; epsilon is random noise Multifactor Models:

useful for estimating covariances:o estimates of covariances b/w asset returns can be derived using assets’ factor

sensitivities


o may filter out noiseo make it relatively easy to verify consistency of covariance matrix

factor covariance matrix: cross tabulations showing covariances / variances of factorso Discounted Cash Flow Models:

equity markets: Gordon (constant) growth model

o

estimate g by nominal GDP could also use: Earnings growth rate = GDP growth rate + Excess

corporate growth (for the index companies)

Grinold-Kroner model: ; ΔS is expected % change in

number of shares outstanding; i is expected inflation; g is expected real total earnings growth; ΔPE is per period % change in P/E multiple; if share repurchases, then ΔS is negative and represents repurchase yield

o expected income return: D/P – ΔSo expected nominal earnings growth return: i + go expected repricing return: ΔPEo S&P 500 achieved 10.7% compound return from 1926-2001: 4.4% from

income; 4.8% from nominal earnings growth; 1.5% from repricing Fed model: stock market overvalued if market’s current earnings yield is less than 10-yr

Treasury bond yield fixed-income markets:

YTM approach: use single discount rateo Risk Premium Approach (build-up approach): risk-free rate plus one or more risk premiums that

compensate investors for risky asset’s exposure to sources of priced risk generally: E(Ri) = RF + (Risk premium)1 + (Risk premium)2 + ... + (Risk premium)K

fixed-income premiums: E(Rb) = Real risk-free interest rate + inflation premium + default risk premium + illiquidity premium + maturity premium + tax premium

real risk-free rate: single-period interest rate for completely risk-free w/ no inflation; reflects time preference

inflation premium: expected inflation: avg inflation rate expected over maturity plus premium (or discount) for probability attached to higher inflation than expected (or greater disinflation)

default risk premium: sum of expected default loss plus nondiversifiable risk of default illiquidity premium: risk of loss to fair value if to convert to cash quickly maturity premium: increased sensitivity to change in market interest rates tax premium

equity risk premium: E(Re) = YTM on a long-term gov’t bond + equity risk premiumo Financial Market Equilibrium Models:

Black-Litterman: reverse-engineers the expected returns implicit in a diversified market portfolio, combing them w/ investor’s own views in systematic way that take account of confidence

Singer-Terhaar approach: International CAPM: (assumes zero risk premium on currency): domestic risk-free rate plus risk premium based on asset’s sensitivity to world market portfolio and expected return on world market portfolio in excess of risk-free rate

o β = asset’s sensitivity to returns on world market portfolio: Cov(Ri, RM)/Var(RM)o world market risk premium: RPM =


o ; estimated at 0.3 or 0.28

RPM/σM is the Sharpe ratio; an asset class’s risk premium is therefore the expected excess return

accruing to the asset class given its global systematic risko illiquidity: ICAPM assumes perfect markets

illiquidity premium should be related to length of any period of lock-up multi-period Sharpe ratio (MPSR): based on investment’s multiperiod

wealth in excess of wealth generated by risk-free investment (i.e., compounded return over compounded cash return).

o market segmentation: (market integration: no impediments or barriers to capital mobility across markets);

use weighted average of risk premiums for completely integrated and completely segmented markets based on degree of segmentation

developed markets estimated to have 80% integration weighting risk premium for fully integrated market will be beta times the

world market risk premium (or the correlation times the country market standard deviation times the world market Sharpe ratio):

risk premium for fully segmented market will not include the correlation, so is country market standard deviation times the

world market Sharpe ratio:

then weight the two and add to the risk-free rate. covariance of two markets given betas to world markets:

global investable market (GIM): practical proxy for world market portfolio consisting of traditional and alternative asset classes w/ sufficient capacity to absorb meaningful investment

o Survey and Panel Methods: survey method: of expectations setting involves asking group of experts for expectations

2002 survey: 2 to 2.5% equity risk premium; other 3.9% panel method: if survey involves a stable expert group queried

Livingston Survey: covers U.S. GDP growth, CPI and PPI inflation, unemployment rate, and 3-month T-bill and 10yr T-bond yields

o Judgment: economic and psychological insight to improve forecasts checklists

Economic Analysis: Business cycle analysis: short-term inventory cycle (2-4 yrs); longer-term business cycle (9-11 years)

o chief measurements of economic activity: GDP: consumption, investment, change in inventories, gov’t spending and exports less imports output gap: difference b/w GDP trend (potential GDP) and actual; affects inflation recession: two successive quarterly GDP declines

o inventory cycle: caused by companies trying to keep inventories at desired levels as expected level of sales changes


up phase: businesses confident and increase production down phase: business cuts back production to reduce inventories inventory / sales ratio: when moved down, economy likely to be strong in next few quarters, as

businesses try to rebuild; when ratio moved sharply up, period of economic weakness can be expected

however, downward trend from improved technology (“just in time” inventory management); but more visibility so sharper changes

o business cycle: 1. initial recovery; 2. early upswing; 3. late upswing; 4. slowdown; 5. recession 1. initial recovery: short phase (few months) when economy picks up from slowdown; business

confidence rising, though consumer confidence still low from unemployment; stimulatory economic policies; usually upswing in inventory cycle; inflation still falling and output gap still large

gov’t bond yields may still be falling (matching declining inflation) or bottoming; stock market may rise sharply, w/ demand for cyclical and riskier assets

2. Early upswing (1 yr to several years): confidence up and momentum in economic activity, w/o overheating or sharply higher inflation; consumers prepared to borrow and spend; businesses build inventories and investment, w/ higher sales and increased capacity use; profits rise from lower unit costs;

short rates starting to rise as stimulus withdrawn; longer bond yields stable or rising stocks still trending up

3. Late upswing: output gap has closed and danger of overheating; high confidence and low unemployment; high growth; inflation starts to pick up w/ accelerating wages

interest rates rising from tighter monetary policy; pressure on credit markets from heavy borrowing; central banks aiming for soft landing

bond yields rising stock markets rising still but nervously; volatile

4. Slowdown (few months to 1 year): economy slowing from rising interest rates; vulnerable to shock; business confidence wavers; inflation still rising; businesses reduce inventories (inventory correction);

short-term interest rates are high and rising to peak bonds top out at first sign of slowing economy, then rally sharply (yields fall) yield curve inverts stock market falls, w/ utilities and financial services performing best

5. Recession (6 mos to yr): large inventory pullback and sometimes large decline in business investment; consumers reduce big-ticket expenses; upon recession confirmation, monetary policy cautiously eased; consumer and business confidence decline; profits drop sharply; financial system may be stressed by bad debts, so cautious lending; major bankruptcies and uncovered fraud; maybe financial crisis; maybe quickly risking unemployment

short-term interest rates and bond yields drop; stock market begins to rise at later stages (b/f recovery)

trends affecting business cycle: growing China aging populations deregulation oil crises financial crises

Five Phases of Business CyclePhase Economy Fiscal &

Monetary PolicyConfidence Capital Markets


1. Initial recovery

Inflation still declining

Stimulatory fiscal policies

Confidence starts to rebound

Short rates low or declining; bond yields bottoming; stock prices strongly rising

2. Early upswing

Healthy economic growth; inflation remains low

Increasing confidence

Short rates moving up; bond yields stable to up slightly; stock prices trending upward

3. Late upswing

Inflation gradually picks up

Policy becomes restrictive

Boom mentality

Short rates rising; bond yields rising; stocks topping out, often volatile

4. Slowdown Inflation continues to accelerate; inventory correction begins

Confidence drops

Short-term interest rates peaking; bond yields topping out and starting to decline; stocks declining

5. Recession Production declines; inflation peaks

Confidence weak

Short rates declining; bond yields dropping; stocks bottoming and then starting to rise

o Inflation and deflation in the business cycle: central bank orthodoxy:

central bank policymaking must be independent so monetary policy not too loose central bank should have inflation target for discipline and to set expectations central banks should use monetary policy to prevent overheating or recession

deflation: 1. undermines debt-financed investments (resulting in panicked asset sales); 2. limits ability of central bank to conduct monetary policy (liquidity trap)

inflation should result in higher profits and higher stock prices, but too high results in efforts to cool down the economy, resulting in lower stock prices

o Market Expectations and the Business Cycle: “growth recession”: slowdown in growth, but not recession; more likely if:

upswing was relatively short or mild no bubble or severe overheating in stock or property markets inflation relatively low, so central bank willing to cut interest rates quickly world economic and political environments are positive

Inflation/Deflation Effects on Asset ClassesCash Bonds Equity Real Estate/ Other Real

AssetsInflation at or below expectations

Short-term yields steady or declining. [Neutral]

Yield levels maintained; market in equilibrium. [Neutral]

Bullish while market in equilibrium state. [Positive]

Cash flow steady to rising slightly. Returns equate to long-term average. Market in general equilibrium. [Neutral]

Inflation above expectations

Bias toward rising rates. [Positive]

Bias toward higher yields due to a higher inflation premium. [Negative]

High inflation a negative for financial assets. Less negative for companies/industries able to pass on inflated costs. [Negative]

Asset values increasing; increased cash flows and higher expected returns. [Positive]

Deflation Bias toward 0% short-term rates. [Negative]

Purchasing power increasing. Bias toward steady to lower rates (may be offset by increased risk of potential defaults due to falling asset

Negative wealth effect slows demand. Especially affects asset-intensive, commodity-producing (as opposed to

Cash flows steady to falling. Asset prices downward pressure. [Negative]


prices). [Positive] commodity-using), and highly levered companies. [Negative]

Evaluating Factors that Affect the Business Cycle: consumers; business; foreign trade; gov’t activity: monetary and fiscal policy

o consumer spending: 60 – 70% of GDP retail sales; store sales data; consumer consumption data

can be erratic; affected by weather and holidays after-tax income: wages, inflation, tax changes, employment growth

non-farm payrolls weekly new unemployment claims savings rate

o business spending: business investment and spending on inventories volatile: say decrease by 10-20% for recession and increase by same during upswing inventories: rising may mean businesses are confident (early stages of inventory upswing), but

rise may be involuntary from lower sales (late stages of inventory cycle) purchasing managers index (PMI); ISM survey of non-manufacturing companies

o foreign trade: 30-50% of GDP in smaller economies; 10-15% in largero gov’t policy: 1. try to control business cycle; 2. try to moderate inflation; 3. incumbents try to affect

policy during elections monetary policy: monetary authorities watch: 1. pace of economic growth; 2. amt of excess

capacity still available; 3. level of unemployment; 4. rate of inflation relative interest rates matter: in relation to neutral interest rates (4% argued in U.S.) Taylor Rule: target short-term interest rate based on rate of growth of economy and

inflation:o say:

money supply trends: long run stable relationship b/w growth of money supply and nominal GDP

if interest rates at zero, can then 1. push cash (bank “reserves”) directly into banking system; 2. devalue currency; 3. promise to hold short-term rates low for extended period; 4. bank to buy assets directly from private sector.

fiscal policy: change spending; cut or raise taxes; changes, not levels, are important; and deliberate changes (rather than changing levels

resulting from fluctuating tax revenues based on economy)

Policy Mix and the Yield CurveFiscal PolicyLoose Tight

Monetary Policy Loose Yield curve steep Yield curve moderately steepTight Yield curve flat Yield curve inverted

Economic Growth Trends: consumer impacts: consumption and demand

o permanent income hypothesis: consumers’ spending behavior is largely determined by their long-run income expectations

o consumer trends usually stable or even countercyclical over business cycle (may reduce savings if temporary CF reductions to maintain long-term spending patterns): spending rises less than income rises and falls less than income falls

Decomposition of GDP Growth and Its Use in Forecasting:


o growth from changes in employment (growth from labor inputs) growth in size of potential labor force growth in labor force participation rate

o growth from changes in labor productivity growth from capital inputs growth in total factor productivity (TGP growth): technical progress

Gov’t Structural Policies: gov’t policies that affect limits of economic growth and incentives w/i private sector; pro-growth policies:

o 1. Fiscal policy is sound large budget deficit leads to current account deficit (“twin deficits” problem), leads to

borrowing abroad; when foreign debt too high, usually requiring devaluing currency high inflation if deficit is financed by printing crowds out private sector

o 2. Public sector intrudes minimally on the private sector: allow marketplace to provide the right incentives to individuals labor market rules raise structural level of unemployment

o 3. Competition w/i the private sector is encouraged: causes efficiency and productivity growth; reduction of trade tariffs and barriers; advances in networking technology; openness to foreign investment; (but competition may reduce stock market valuations from lower profits)

o 4. Infrastructure and human capital development are supported: health and education infrastructureo 5. Tax policies are sound: simple, transparent, and rarely altered tax rates; low marginal tax rates; very

broad tax base

Exogenous Shocks: from changes in gov’t policy unexpected breakup of OPEC “peace dividend” from fall of Berlin Wall new products, markets and technologies Oil shocks: sudden rises affects consumers’ income and reduces spending; inflation rises, maybe offset by

contractionary effect of higher oil prices restricting employment and opening up output gap Financial Crises: bank lending and investor confidence

International Interactions: Macroeconomic linkages: foreign demand for exports; cross-border direct business investment; but not

perfectly integrated Interest Rate / Exchange Rate Linkages: formal or informal exchange rate links; unilateral pegs; Emerging Markets:

o Essential Differences b/w Emerging and Major Economies: need higher rates of investment than developed countries in physical capital and infrastructure

and in human capital periodic crises from managing foreign debt required for investment volatile political and social environment often relatively small and concentrated in areas such as commodities or narrow range of

manufactured goods; may rely heavily on oil importso Country Risk Analysis Techniques:

emerging bonds: risk of country being unable to service debt stock: growth prospects and vulnerability to surprises Checklist:

1. How sound is fiscal and monetary policy? ratio of fiscal deficit to GDP: persistently above 4% is concern; ratio of debt to GDP: 70-80% extremely vulnerable


2. What are the economic growth prospects for the economy? if slow growth w/ population growth, likely political stress from falling per capital income

o Economic Freedom Index 3. Is the currency competitive, and are the external accounts under control?

o current account deficit 4. Is external debt under control? if reluctance to lend new money, may be exodus of

capital; ratio of foreign debt to GDP: 50% is dangerous; debt to current account receipts: 200% in danger zone

5. Is liquidity plentiful? foreign exchange reserves in relation to trade flows and short-term debt; ratio of reserves to short-term debt (maturing w/i 12 mos): under 100% is risky

6. Is the political situation supportive of required policies? whether gov’t will implement necessary adjustment policies: cutting budget deficit, privatization, ending monopolies

Economic Forecasting: econometric models:

o limitations: finding adequate measures for real-world activities and relationships to be modeled measurement error relationships may change over time from changes of structure of economy

o constrains the forecaster to a certain degree of consistency and also challenges the modeler to reassess prior views based on what the model concludes

o forecasts upturns much better than recessions leading indicators: lagging, coincident and leading

o diffusion index: how many indicators pointing up and how many downo world:

OECD Composite Leading Indicatorso Europe:

Eurozone Harmonized Index of Consumer Prices German Industrial Production German IFO Business Survey French Monthly Business Survey

o Asia Pacific: Tankan Survey China Industrial Production

o South America: Brazil Industrial Production

o North America: Conference Board’s Index of Leading Economic Indicators:

1. Avg weekly hrs, manufacturing 2. avg weekly initial claims for unemployment insurance 3. manufacturers’ new orders, consumer goods and materials 4. vendor performance, slower deliveries diffusion index 5. manufacturers’ new orders, non-defense capital goods 6. building permits, new private housing units 7. stock price, 500 common stocks 8. money supply, M2 9. interest rate spread, 10-yr Treasury bonds less federal funds 10. index of consumer expectations


three consecutive mos of increases, or 3 consecutive mos of decreases, signaled upturn or downturn in economy w/i 3 to 6 mos

checklists: o subjectiveo ex:

1. Where in the cycle is the economy now? Aggregate activity

review previous data on GDP growth and its components (consumer spending, business investment, inventories, net exports, and gov’t spending)how high is unemployment relative to estimates of “full employment”?has unemployment been falling?How large is the output gap?What is the inventory position?Where is inflation relative to target, and is it threatening to rise? inflation2. How strong will consumer spending be? ConsumerReview wage/income patterns. ConsumerHow fast will employment grow? ConsumerHow confident are consumers? Consumer confidence indices. Consumer3. How strong will business spending be? BusinessReview survey data (e.g., purchasing managers indices.) BusinessReview recent capital goods orders. BusinessAssess balance sheet health of companies. BusinessAssess cash flow and earnings growth trends. BusinessHas the stock market been rising? BusinessWhat is the inventory position? Low inventory/sales ratio implies GDP strength. Business4. How strong will import growth be? GovernmentExchange rate competitiveness and recent movements. GovernmentStrength of economic growth elsewhere. Government5. What is the government’s fiscal stance? Government6. What is the monetary stance? Central bankReview recent changes in interest rates. Central bankWhat do real interest rates tell us? Central bankWhat does the Taylor rule tell us? Central bankMonetary conditions indices (i.e., trends in asset prices and exchange rate). Central bankMoney supply indicators. Central bank7. Inflation InflationHow fast is inflation rising, or are prices falling? Inflation

Advantages and Disadvantages of 3 Approaches to Economic ForecastingAdvantages DisadvantagesEconometric Models ApproachModels can be quite robust with many factors used that can approximate reality.Once models are built, new data may be collected and consistently used w/i models to quickly generate output.Provides quantitative estimates of the effects on the economy of changes in exogenous variables.

Most complex and time-consuming to formulate.Data inputs and relationships not easy to forecast and not static.Requires careful analysis of output.Rarely forecasts recessions well.

Leading Indicator-Based ApproachUsually intuitive and simple in construction. Historically, has not consistently worked, as relationships


May be available from third parties.May be tailored for individual needs.A literature exists on the effective use of various third-party indicators.

between inputs are not static.Can provide false signals.

Checklist ApproachLimited complexity.Flexible: allows structural changes to be easily incorporated

Subjective.Time-consuming.Complexity has to be limited due to the manual nature of the process.

Using Economic Info in Forecasting Asset Class Returns: Cash and Equivalents: reflects markets expectations of rates over maturity period—forecast economy and the

central bank’s reaction to the economy Nominal Default-Free Bonds: components of yield are (i) growth rate of GDP and supply and demand for

capital and (ii) forecast inflation over period.o watch business cycle and short-term interest rates

news of stronger economic growth usually makes bond yields rise (prices fall) b/c implied greater demand for capital and possibly higher inflation

rise in short term rates often leads to rise in longer-term bond yields; but may also be expected to slow economy and bond yields could fall

if bond markets expect central banks will achieve inflation targets, bond yields should not change on inflation expectations but could fluctuate w/ short rates

assess future effects of inflation Defaultable Debt: spread over Treasuries in part represents market’s perception of default risk

o spreads tend to rise during recession b/c companies under stress from weak business conditions and usually higher interest rates

o during strong economic growth, spreads narrow as fears of default decline Emerging Market Bonds: sovereign debt of nondeveloped countries;

o country risk: economic and political factors, including whether has power to follow necessary policies to stabilize economy; compared to spreads over domestic Treasuries of similarly rated domestic corporate debt

Inflation-Indexed Bonds: fixed coupon plus adjustment equal to change in consumer prices

Macroeconomy and Real YieldsEconomic Observation Effect on Real Bond YieldsEconomic growth rising (falling) Rise (fall)Inflation expectations rising (falling) Fall (rise)Investor demand rising (falling) Fall (rise)

Common Shares: consider (i) company earnings and (ii) interest rates, bond yields and liquidityo price of oil; demand for airline travelo Economic factors affecting earnings: long term: aggregate company earnings mainly determined by

trend rate of growth of economy labor force growth; level of investment; rate of labor productivity growth

overinvestment; gov’t overregulation; political instability; bursting of asset bubble share of profits in GDP varies w/ business cycle and influenced by: final sales, wages, capacity

utilization, interest rates recession: reduced sales w/ burden of fixed costs; some companies (food companies)

may not change in earnings in recession, so may go up


early stages of economic upswing: earnings recover strongly: capacity utilization and increasing employment; wages modest; efficiency gains from recession;

later upswing: wage growth; profits contracto cyclical stocks: sensitive to business cycle from large fixed costs and

pronounced sales cycle (car manufacturers and chemical producers)o P/E Ratio and the Business Cycle:

high and rises when earnings expected to rise low and falling if earnings falling but may anticipate future earnings recovery (Molodovsky effect) high inflation tends to depress (past P/Es must be compared after controlling for inflation)

o Emerging Market Equities: ex post risk premiums in U.S. dollar terms positively correlated w/ expansion phases in G-7 economies (industrial production): trade, finance, direct sectoral linkages

country analysis sector-specific research

Real Estate: growth in consumption, real interest rates, term structure and unexpected inflation Currencies:

o current account balance: import more --> currency depreciateso strong domestic growth and opening of new industries: rise in fdi --> currency appreciateso volatility from inflows and outflows for stocks, bonds and short-term instrumentso high interest rates: usually high inflows --> currency appreciateso low interest rates ... currency usually depreciateso however: high interests may be result of slowing economy --> currency depreciateso approaches to forecasting:

PPP: exchange rate should offset any difference in inflation rates (useful for long run: say 5 yrs)

Relative Economic Strength: investment flows: strong economic growth creates attractive investment opportunities (say high short-term deposit rate) --> currency appreciates

if particularly high interest rates, speculators less likely to short currency b/c likely to strengthen from higher rates

converse: Japan’s carry trade as a result of low interest rates Capital Flows: focuses on expected capital flows, particularly long-term such as equity

investment and fdi; inflows --> currency appreciates long-term capital flows may reverse usual relationship b/w short rates and currency:

central bank may want to raise interest rates to respond to weak currency that is threatening to stimulate economy too much and boost inflation, effect may actually be to push currency lower; reduced effectiveness of monetary policy.

Savings-Investment Imbalances: (may explain long-term equilibrium departures): if private sector or gov’t currency-related trends change (re current accounts), current

account position must change too and the exchange rate moves to help achieve that. currency needs to stay reasonably strong as long as domestic investment exceeds

savings; if economy becomes weak enough at this point and domestic investments no longer exceed domestic savings, then currency will also weaken

o Gov’t intervention: difficulty in attempts to control b/c 1. total value of foreign exchange trading, in excess of US$1 trillion daily, is large relative to total foreign exchange reserves of major central banks combined; 2. gov’ts just another player in the market; 3. experience is not encouraging in the absence of capital controls (unless willing to move interest rates and other policies).

Info Sources for Economic Data and Forecasts: Selection of Data Sources for Researching U.S. MarketsCategories of Factor Measures Data Data Data Source


Economic Interest Use: LT

Use: ST

Economic fundamentals

Measures of economic output/growth (e.g GDP, industrial production)

+ www.bea.govBloomberg

General Price level stability +Consumers Employment/unemployment + Bloomberg

Measures of consumption/income + www.bea.govMeasures of savings, investment, and leverage +Measures of sentiment + U. of Michigan Survey

Business Measures of profitability + www.bea.govMeasures of productivity + Federal Reserve BankIndustry price level stability + + Internal or third-party

research; Trade pub.Capacity utilization rates +Central bank Measures of monetary policy + + www.stls.frb.org

General price level stability (inflation) + + BloombergAssessment of central bank independence + Internal analysis

Government Fiscal policy + + Congressional Budget Office; Bloomberg; Internal; www.wto.org

Assessment of exchange rate stability/trends + +

Measures of political stability + Internal analysisAssessment of legal system’s ability to protect assets (including intangible assets) and ability to settle disputes (due process)

+ Internal analysis

Economic technical factors

Capital flows + Internal / third-party research; Trade publicationsSector/industry supply and demand +

Market fundamentals Rates of return + + Relative (industry) internal research; Third-party research; Trade publications

Valuation trends (e.g., equity P/E multiples) + +Asset class price volatility: Large-cap equities + Corporate bonds vs. overall market + + Short sovereign debt +Exchange rate movements +

Market technical factors

Ratio of advances/declines in equity market + Reuters; Internal researchCorporate bond issuance (market yield) + Internal research

Other: unique; social; political

Demographic influences + + Third-party; Trade pub.Seasonal patterns of consumption + +Current account trends; net exports versus imports

+ + Bloomberg

also:www.imf.orgwww.worldbank.orgwww.oecd.orgwww.federalreserve.govwww.ecb.intwww.bankofengland.co.ukwww.boj.or.jb/enwww.bis.orgwww.nber.org


http://www.nber.org/

http://www.bis.org/

http://www.boj.or.jb/en

http://www.bankofengland.co.uk/

http://www.ecb.int/

http://www.federalreserve.gov/

http://www.oecd.org/

http://www.worldbank.org/

http://www.imf.org/

http://www.wto.org/

http://www.stls.frb.org/

http://www.bea.gov/

http://www.bea.gov/

http://www.bea.gov/

Reading 24: Macroanalysis and Microvaluation of the Stock Market

Economic series and the economy: NBER has classified numerous economic series as: leading, coincident or lagging: leading: peaks and troughs occur before aggregate economic activity

o stock market is a good leading indicator of the economy: expectations of CFs; response to other leading indicators

o cyclical indicator approach: expansion and contraction can be identified by movements reflected in specific economic series

coincident: peaks and troughs coincide lagging: peaks and troughs lag selected series: influence economy but don’t neatly fit into three above: U.S. balance of payments; federal

surplus/deficit composite series: combination of series ratio series: coincident over lagging sometimes leads leading or otherwise diverges analytical measures:

o diffusion index: say % of reporting units in a series indicate a given result trend of diffusion index always reaches peak or trough prior to index

o rates of change: (momentum)o comparison w/ previous cycles: slower or faster

Limitations:o false signals: sudden reverseso currency of data and revisions (esp if revisions are other direction)o not all economic sectors represented (e.g., service, import-exports, int’l)

Conference Board’s Index of Leading Economic Indicators:o 1. Avg weekly hrs, manufacturingo 2. avg weekly initial claims for unemployment insuranceo 3. manufacturers’ new orders, consumer goods and materialso 4. vendor performance, slower deliveries diffusion indexo 5. manufacturers’ new orders, non-defense capital goodso 6. building permits, new private housing unitso 7. stock price, 500 common stockso 8. money supply, M2o 9. interest rate spread, 10-yr Treasury bonds less federal fundso 10. index of consumer expectations

coincident:o 1. number of employees on nonagricultural payrollso 2. personal income less transfer payments, expressed in 1992 dollarso 3. Index of industrial productiono 4. Manufacturing and trade sales, expressed in 1992 dollars

lagging:o 1. average duration of unemploymento 2. ratio of manufacturing and trade inventories to saleso 3. percentage change in labor cost per unit of output in manufacturingo 4. average prime rate charged by bankso 5. commercial and industrial loans outstandingo 6. ratio of consumer installment credit outstanding to personal incomeo 7. change in consumer price index (inflation rate) for services


Center for International Business Conditions Research (CIBCR) (at Columbia): Long-Leading Index Leading Employment Index Leading Inflation Index International Leading Indicator Series

Surveys of Sentiment and Expectations: University of Michigan Consumer Sentiment Index; Conference Board Consumer Confidence Index

Goldman Sachs Financial Conditions Index: increase in index indicates tightening / rising interest rates

Relationship b/w money supply and stock prices: necessary to forecast unanticipated changes in money supply growth

Inflation and interest rates: strong relation; (spread changes over time)

Inflation, Interest Rates, and Stock Prices: 1. positive scenario: negative effect of interest rate increase (required rate of return) partially or wholly offset

by increase in growth of earnings and dividends (inflation pass through) 2. mild negative scenario: higher costs and not able to pass through, so higher k and flat g 3. very negative scenario: k increases; g declines

Microvaluation: 1. DDM; 2. FCFE; 3. earnings multiplier technique; 4. other relative valuation ratios DDM: discount the dividends:

o k: nominal risk-free rate: 10-yr Treasury note; 30-yr Treasury bond;o k: equity risk premium: geometric for long-term: say 6.5% from Ibbotson Associates; other b/w 2%

and 6%o g: current and expected changes in growth;

b x ROE ROE: NI/Equity = NI/Sales x Sales / Total assets x Total assets / equity

o so w/ dividend estimate and k and g, can them estimate market value; further can estimate implied spread from current market prices

o can obtain implied k: k = D/p + g FCFE: = NI + Depr – capex – change in working capital – principal debt repayments + new debt issues

o single stage; two-stageo estimate g from historical (say same in DDM)o estimate k same as DDM

Earnings multipliers:o estimate of spread:

P = D1 / (k-g) P/D1 = 1 /(k-g) D1/P = k-g

o 1. estimate future EPS for stock series; 2. estimate earnings multiplier based on k-g spread

Expected EPS: 1. estimate sales per share based on GDP: single variable regression 2. estimate operating profit margin: profit / sales; (say EBITDA for operating profit)

o can estimate net profit margin, oro can estimate net before tax profit margin and then estimate taxes, oro estimate EBITDA profit margino affected by: 1. capacity utilization rate; 2. unit labor cost; 3. rate of inflation; 4. foreign competition


3. estimate depreciation per share for next year: estimate PPE and then use historical depr rate 4. estimate interest expense for next year: estimate 1. amt of total assets for firm based on expected total asset

turnover and 2. expected capital structure based on avg total debt to total assets 5. estimate corporate tax rate for next year: evaluate current tax rate and recent legislation

Estimating the Stock Market Earnings Multiplier:

determinants: use long-term estimates of k and g:

o use long-term estimate of D/E: use time-series analysis then relate to earnings estimate can estimate direction of change from current, or specific value from specific estimates of D/E, k and g.

Other Relative Valuation Ratios: P/BV; P/CF; P/S.

Microvaluation of World Markets: 1. basic valuation model and concepts apply globally 2. input values can vary dramatically 3. valuation of nondomestic markets be more onerous: say forecasting exchange rates for hedging

Sources of economic info: www.morganstanley.com www.globalinsight.com www.yardeni.com www.whitehouse.gov/fsbr/esbr.html www.federalreserve.gov www.worldbank.org www.bankamerica.com www.spglobal.com www.bis.org/cbanks.htm www.nabe.com www.conference-board.org www.federalreserve/gov/pubs/bulletin www.bea.doc.gov/bea/pubs.htm www.stats.bls.gov www.cbo.gov www.whitehouse.gov/cea www.gpoaccess.gov/indicators/browse.html www.census.gov/csd/qfr www.access.gpo.gov/eop www.census.gov/statab/www/ www.federalreservebanks.org www.stlouisfed.org research.stlouisfed.org/fred2/ www.phil.frb.org/econ/ www.eiu.com www.oecd.org www.economist.com un.org/depts/unsd/sd_economic.htm www.un.org www.imf.org


http://www.imf.org/

http://www.un.org/

http://www.economist.com/

http://www.oecd.org/

http://www.eiu.com/

http://www.phil.frb.org/econ/

http://www.stlouisfed.org/

http://www.federalreservebanks.org/

http://www.census.gov/statab/www/

http://www.access.gpo.gov/eop

http://www.census.gov/csd/qfr

http://www.gpoaccess.gov/indicators/browse.html

http://www.whitehouse.gov/cea

http://www.cbo.gov/

http://www.stats.bls.gov/

http://www.bea.doc.gov/bea/pubs.htm

http://www.federalreserve/gov/pubs/bulletin

http://www.conference-board.org/

http://www.nabe.com/

http://www.bis.org/cbanks.htm

http://www.spglobal.com/

http://www.bankamerica.com/

http://www.worldbank.org/

http://www.federalreserve.gov/

http://www.whitehouse.gov/fsbr/esbr.html

http://www.yardeni.com/

http://www.globalinsight.com/

http://www.morganstanley.com/

Reading 25: Dreaming with BRICs: the Path to 2050

BRICs have larger US$GDP than G6 in less than 40 yrs; currently only 15%

Have less capital, so higher returns on capital, resulting in higher growth of capital stockTechnological catch up.

Countries grow richer on back of appreciating currencies; convergence to PPP.

GDP Growth: growth in employment; growth in capital stock; technical progress/TFP. Maybe lower convergence in India and Brazil than Russia and China b/c lower education levels and poorer

infrastructure Maybe 1/3 of increase in US$GDP of BRICs from rising currencies and 2/3s from faster growth

Conditions for growth: Robert Barro:

o Higher schoolingo Higher life expectancyo Lower fertilityo Lower gov’t consumptiono Better maintenance of rule of lawo Lower inflationo Improvements in terms of trade

Macro stability: price stability (fiscal deficit reduction, tighter monetary policy, exchange-rate realignment) Institutions: efficient legal system, functioning markets, health and education systems, financial institutions

and gov’t bureaucracy Openness: trade and fdi Education: skilled workers

Reading 26: Asset Allocation

Strategic Asset Allocation: establish exposures to IPS-permissible asset classes by integrating investor’s return objectives, risk tolerance, and investment constraints w/ long-run capital market expectations.

result is the Policy Portfolio In long run, diversified portfolio’s mean returns are reliably related to systematic risk exposures. Strategic asset allocation specifies investor’s desired exposures to systematic risk. b/c investors in aggregate are the market and costs do not net out across investors, return on avg actively

managed dollar should be less than return on avg passively managed dollar after costs

Tactical asset allocation (TAA): short-term adjustments to asset-class weights based on short-term expected relative performance among asset classes.

creates active risk

Asset-Only (AO) vs. Asset/Liability Management (ALM): ALM: explicitly modeling liabilities (and quasi-liabilities) and adopting optimal asset allocation in

relationship to funding liabilities; concern for net returns and risko Cash flow matching: exact matching: use bonds to match liabilities and quasi-liabilitieso Immunization: structures investments in bonds to match (offset) weighted-avg duration of liabilities


riskier than cash flow matching as duration is first-order approximation of interest rate risko favored by:

investor w/ below-avg risk tolerance if have high penalties for not meeting liabilities if market value of liabilities interest rate sensitive if risk taken in investment portfolio limits investor’s ability to profitably take risk in other

activities if legal and regulatory reqs and incentives favor holding fixed-income securities if tax incentives favor holding fixed-income securities

AO: no explicit liability modeling; concern for absolute return and risko Black-Litterman model: take global market-value-weighted asset allocation (Market equilibrium

portfolio) as default and then incorporate deviate from weights reflecting views on asset classes’ expected returns and strength of views

Dynamic vs. Static approach: dynamic: link optimal investment decisions to all future time periods static: do not consider links b/w optimal decisions at different time periods

Characteristic Liability Concerns of Various InvestorsType of Investor Type of Liability (Quasi-Liability) Penalty for Not

MeetingAsset Allocation Approach in Practice

Individual Taxes, mortgage pmts (living expense, wealth accumulating targets)

Varies AO most common; ALM

Pension plans (defined benefit)

Pension benefits High, legal and regulatory

ALM AO

Pension plans (defined contribution)

(Retirement needs) Varies Integrated w/ individual’s asset allocation approach

Foundations and endowments

Spending commitments, capital project commitments

High AO ALM

Life insurance companies

Death proceeds, annuity payments, return guarantees on investment products

Very high, legal and regulatory

ALM

Non-life insurance companies

Property and liability claims Very high, legal and regulatory

ALM

Banks Deposits Very high, legal and regulatory

ALM

Risk objectives: Investor’s expected utility for asset mix: ; E is expected return for mix; R is

investor’s risk aversion (1 to 10?); σ2 is variance of return for mix shortfall risk: risk that fall below minimum during time downside risk: risk relating to losses or worse than expected outcomes only (also semivariance and target

semivariance) Roy’s safety-first criterion: optimal portfolio minimizes probability over stated time horizon that portfolio

return will fall below some threshold level:

could specify maximum probability of not meeting a return threshold

Behavioral Influences on Asset Allocation:


loss aversion: worry about avoiding losses more than gains; risk-seekers when faced w/ losses (could use shortfall risk criterion or ALM)

Mental accounting: associate different level of risk tolerance depending on mental account regret avoidance: may promote diversification; may limit divergence from peers’ avg asset allocation

Selection of Asset Classes: Criteria for specifying asset classes:

o 1. assets w/i asset class should be relatively homogenouso 2. asset class should be mutually exclusiveo 3. asset classes should be diversifyingo 4. asset classes as group should make up preponderance of world investable wealtho 5. asset class should have capacity to absorb significant fraction of investor’s portfolio w/o seriously

affecting portfolio’s liquidity Traditional asset classes:

o domestic common equityo domestic fixed incomeo non-domestic (international) common equity (maybe developed-emerging distinction)o non-domestic fixed income (maybe developed-emerging distinction)o real estate (maybe including other alternative investments)o cash and cash equivalentso (consider also tax concerns)

o test for adding asset class:

o also consider following for whether to add international assets: currency risk increased correlations in times of stress emerging market concerns

o alternative assets: heterogeneous; high diligence costs

Steps in Asset Allocation: asset allocation review:

o (AO is special case where liabilities equal 0)

Capital Market Conditions Investor’s Assets, Liabilities, Net Worth, and Risk Attitudes| |

Prediction procedure Investor’s Risk Tolerance Function| |

Expected Returns, Risk, and Correlations Investor’s Risk Tolerance| |Optimizer

|Investor’s Asset Mix

|Returns|

(back to top)

Optimization: mean-variance approach


o identify efficient frontier (part of minimum variance frontier bordered on the bottom by global minimum variance portfolio)

o mean-variance optimization (MVO): unconstrained MVF: asset-class weights sum to 1. (allows for short positions) sign-constrained MVF: no short-positions and sum to 1.

corner portfolios: 1. portfolios hold identical assets and 2. rate of change of asset weights in moving from one portfolio to another is constant.

o corner portfolio theorem: In a sign-constrained optimization, the asset weights of any minimum-variance portfolio are positive linear combination of corresponding weights in two adjacent corner portfolios that bracket it in terms of expected return (or standard deviation of return)

o find adjacent portfolios for desired return and then weight such two portfolios to obtain return; then weight underlying assets by such weights

most important inputs in mean-variance optimization are expected returns: highly sensitive to small changes in inputs

for cash equivalents: risk-free rate suggests single-period perspective; reported positive standard deviation suggest multiperiod perspective

capital allocation line is the line from the risk-free rate and tangent to efficient frontier may not be able to use tangency portfolio if have restraint on borrowing

Selected Extensions to Mean-Variance ApproachConcern Adaptation SourceA. Downside risk 1. Mean-semivariance

2. MVO w/ shortfall constraint3. MV surplus optimization

Markowitz(1959)Leibowitz and Henriksson (1989)Leibowitz and Henriksson (1988)

B. Tracking risk relative to benchmark

5. MVO w/ constraints on asset weights relative to benchmarks6. Mean-tracking error (MTE) optimization7. Mean-variance-tracking error (MVTE) optimization

Ad hoc practice

Roll (1992)Chow (1995)

C. Changing correlations in times of stress

9. MVO w/ adjusted correlation matrix Chow et al. (1999)

Resampled Efficient Frontier: set of resampled efficient portfolioso resampled efficient portfolio: for given return rank, portfolio defined by avg weights on each asset

class for simulated efficient portfolios w/ return rank (after rerunning optimization many times using range of inputs around point estimates)

o (if asset class shows up at all in any run, will show up on resampled efficient frontier, however small)o (lacks theoretical underpinning)

Black-Litterman Approach: o unconstrained Black-Litterman (UBL) model: taking weights of asset classes in global benchmark as

neutral starting point, and adjust to reflect views according to Bayesian procedure (allowed to sell short)

o Black-Litterman (BL) model: combines reverse optimization w/ investor’s views on expected returns systematically w/ confidence of views (no short sales)

reverse optimization: reverse engineers expected returns implicit in diversified market portfolio

Steps in BL ModelStep Purpose1. Define equilibrium market weights and Inputs for calculating equilibrium expected returns


covariance matrix for all asset classes2. Back-solve equilibrium expected returns Form neutral starting point for formulating expected returns3. Express views and confidence Reflect investor’s expectations for various asset classes; the confidence

level assigned to each view determines the weight placed on it4. Calculate the view-adjusted market equilibrium returns

Form the expected return that reflects both market equilibrium and views

5. Run mean-variance optimization Obtain efficient frontier and portfolios

Monte Carlo Simulation: simulation that imitates an asset allocation’s real-world operation in an investments laboratory

ALM: focuses on surplus efficient frontiero surplus efficient frontier is bordered on bottom by minimum surplus variance (MSV) at which point

strategy might be cash flow matching or immunizationo surplus beta decision: increment of risk accepted above the MSV portfolioo ALM w/ simulation:

1. determine surplus efficient frontier and set of efficient portfolios among range 2. conduct Monte Carlo simulation for each proposed asset allocation and evaluate 3. choose most appropriate.

o Surplus objective function’s expected value for particular asset mix for specified risk aversion:

Experience-Based Approaches: o 1. 60/40 stock/bond asset allocation is appropriate or at least a starting point for an average investor’s

asset allocationo 2. Allocation to bonds should increase w/ increasing risk aversiono 3. Investors w/ longer time horizons should increase their allocation to stockso 4. A rule of thumb for % allocation to equities is 100 minus age of investor

Implementing the Strategic Asset Allocation: approaches:

o passive investingo active investingo semi-active investing or enhanced indexingo some other combination

instruments:o tracking portfolio of cash market securitieso derivatives: swapo derivatives: index futureso cash market securities w/ no tracking attempto commodity-like derivatives plus market-neutral long-shorto tracking portfolio w/ over- or under-weightingo derivatives plus cash positions

currency risk management: active or passive hedging; can be joint decision w/ asset allocation, or after-the-fact

Rebalancing: set thresholds for triggering rebalancing: say percentage-of-portfolio approach

Strategic Asset Allocation for Individual Investors: consider: taxes; labor income; correlation of financial asset returns and future labor income; outliving

resources


Human capital:

Asset Allocation and Human Capital: investors w/ safe labor income will invest more in equities investors w/ labor income highly positively correlated s/ stock markets should have less

exposure to stocks ability to adjust labor supply tends to increase investor’s optimal allocation to equities

o establish risk and return characteristics of individual’s human capital Mortality risk: life insurance and maybe liquidity reserve Longevity risk: should be directly related to asset allocation; consider allocating for higher long-term returns

o life annuity (fixed or variable; equity-indexed annuity)

Strategic Asset Allocation for Institutional Investors: Defined-Benefit Plans: strong focus on ALM

o 1. regulatory constraints: min, max and “basket clause” (say limit on alternative asset holdings)o 2. liquidity constraintso consider acceptable levels of: risk of funding shortfalls; anticipated volatility of surplus; anticipated

volatility of contributionso consider whether liabilities nominally fixed (inflation)

Foundations and Endowments: need high long-term rateo low-cost-, easy-to-monitor, passive investment strategieso may have limited resources to fund costs and complexities of due diligence

Insurance Companies: mix of assets to 1. counterbalance risks inherent in mix of insurance products; 2. achieve stated return objectives

o taxableo contractual liabilities to insuredso usually ALM including yield, duration, convexity, key rate sensitivity, value at risk and effects of asset

risk on capital reqso Portfolio Segmentation: subportfolios for product lineso credit quality regulatory reqso casualty insurers tend to have higher liquidity reqs

Banks: taxable w/ short- and intermediate-term liabilitieso ALM approach

loan portfolio not liquid, so securities portfolio offsets regulatory reqs on holdings

Tactical Asset Allocation: deliberately underweighting or overweighting asset classes relative to target weights can use derivative securities over asset classes: overlay strategy based on principles:

o 1. market prices tell explicitly what returns are availableo 2. Relative expected returns reflect relative risk perceptionso 3. Markets are rational and mean reverting

but consider: o changes in assets’ underlying risk attributeso changes in central bank policyo changes in expected inflationo position in business cycle


Reading 27: The Case for International Diversification

Traditional case: risk reduction (from low correlation) and superior expected returns Portfolio variance of return: σp

2 = w12 σ1

2 + w22 σ2

2 + 2w1w2ρ1,2σ1σ2; Portfolio standard deviation of return: σp = w1

2 σ12 + w2

2 σ22 + 2w1w2ρ1,2σ1σ2

currency: return in $: r$ = r + s + (r x s); r is return in local currency and s is exchange rate movement; cross product usually ignored

var(r$) = var(r+s) = var(r) + var(s) + 2cov(r,s) = σf2 = σ2 + σs

2 + 2ρσσs; (ignoring cross product); σf2 is the

variance of foreign asset in $; σ2 is variance in local currency; σs2 is variance of exchange rate; and ρ is

correlation of local currency asset return and exchange rate movemento contribution of currency risk is the difference between the combined standard deviation and the local

currency equity return standard deviation. historical correlation experience:

o equity: generally low correlations across equity markets with or without currency hedgingo bonds: low correlations when unhedged; regional blocs exist; hedged different b/c existence of

“leaning against the wind” policies of raising interest rates to defend currencies leads and lags: some lagged correlation but can be explained by differences in time zones and not by some

international market inefficiency that is exploitable, and drastically reduced correlations for longer periods Returns: int’l investing increases Sharpe ratios (both numerator and denominator effects)

o consider active vs. passive; costs and benefits of both Optimization must be based on forward-looking / expected returns: real growth; economic flexibility;

o forecasts may already be reflected in asset prices Currency risk: less than local equity risk but more than local bond risk

o market and currency risks are not additiveo currency risk can be hedgedo should be measured for whole portfolio rather than individual markets; offsetso contribution of currency risk decreases as time period increases (PPP and mean reversion)

Low correlations: factors causing equity market correlations across countries to be relatively low are independence of different nations’ economies and gov’t policies, technological specialization, independent fiscal and monetary policies, and cultural and sociological differences

for bonds: differences in national monetary and budgetary policies

Case against int’l diversification: increase in correlations: correlations have trended upward

o capital market deregulation leads to more integrationo capital mobility has increasedo free trade opening has created more economic synchronizationo global corporations

Correlation increases when markets are volatile: deviations from normality:o fat tails (leptokurtic)o market volatility varies over time, but is contagiouso correlation across markets increases dramatically during periods of high volatility (“correlation

breakdown”) positive surprises create returns and can’t always be surprised; one country doesn’t always outperform Barriers to int’l investments:

o familiarity w/ foreign markets: prefer to invest in local corps w/ int’l exposureo political risk: unstable and crises (which, in the face of, may have driven past high returns)o market efficiency:

liquidity: thin volume; capital controls;


lack of timely and reliable info price manipulation and insider trading

o Regulations: on max amts of investment; o Transaction costs: brokerage commission; stamp tax; custody costs; money-manager management fees

higher for int’l investments; market impact of large purchases in the ADR marketo Taxes: withholding; o Currency risk: (can be hedged)

Correlation during volatile periods: may estimate correlation in periods of high volatility of returns: “conditioning correlation on high volatility”

(but is biased sampling) conclusion that correlation increases in periods of crisis seems to be simply a statistical bias due to faulty

econometrics still some evidence of increased correlation in volatile periods

Global rather than int’l investing: global industry factors: increasing importance of industry factors; regional and country factors country factors still significant

Case for Emerging Markets: large returns over long run positive but moderate correlation w/ developed markets volatility: much larger; higher probability of shocks; lack of infrastructure; corruption correlation: int’l corr tends to increase in periods of crisis; crises may spread depending on whether factors

creating the boom or crisis are primarily local or global currency risk: in crisis both stocks and currencies drop (compared to common situation of negatively

correlated stocks and currencies) investability:

o max foreign ownership reqso small free floato constrained repatriation of income and capitalo discriminatory taxeso foreign currency restrictionso may be limited to authorized investorso market price impact

Reading 28: Fixed-Income Portfolio Management—Part 1

See chart p. 7 in book 4.

Fixed-Income investment management process: 1. setting investment objectives (and constraints)2. developing and implementing portfolio strategy3. monitoring portfolio4. adjusting portfolio

Classification strategies: 1. Pure bond indexing (or fully replication approach): perfectly match benchmark (costly to implement)2. Enhanced indexing by matching primary risk factors:


a. primary matched factors: say level of interest rates, yield curve twists, changes in spreads over treasuries

b. by not fully replicating, reduces costsc. can try to enhance return

3. Enhanced Indexing by small risk factor mismatches: increase return by tilting toward sector, quality, term structure, etc.; intended to enhance return only slightly to cover admin

4. Active management by larger risk factor mismatches: active management; deliberately larger mismatches5. Full-blown active management: aggressive mismatches on duration, sector weights and other

Indexing: benchmark: generally:

o market risk: have comparable market risk (maturity and duration)o income risk: comparable assured income streamso credit risk: comparable, diversified and satisfying IPSo liability framework risk: some relation to duration of liabilities if play a roleo risk profiles: yield curve changes (shift (90%), twist, other)

matching techniques: cell matching (or stratified sampling): divide benchmark into representative cells and

then match multifactor model: use set of factors that drive bond returns:

o effective duration; convexity adjustment; o key rate duration and PV distribution of CFs:

key rate duration divide into nonoverlapping periods and match PVs

o Sector and quality percento sector duration contribution: o quality spread duration contributiono sector/coupon/maturity cell weightso issuer exposure (event risk)

Tracking risk: variability w/ which portfolio’s return tracks benchmark index return: standard deviation of active return; active return = portfolio’s return – benchmark index’s return.

o tracking risk results from mismatches from: 1. portfolio duration, 2. key rate duration and PV distribution of CFs; 3. sector and quality percent; 4. sector duration contribution; 5. quality spread duration contribution; (and other factors listed under multifactor model technique)

Enhanced Indexing Strategies: o lower cost enhancements: control costs (say competitive bidding)o issue selection enhancements: conduct own credit analysiso yield curve positioning: overweighting undervalued areas of curve and

underweighting overvalued areaso Sector and quality positioning:

say tilt toward short-duration corporates periodic over- or underweighting of sectors

o Call exposure positioning: determine probability of call around crossover point

Active Strategies: accept large tracking risk: process:

o 1. Identify which index mismatches are to be exploitedo 2. Extrapolate market’s expectations (or inputs) from market data


o 3. Independently forecast necessary inputs and compare w/ market’s expectationso 4. Estimate relative values of securities in order to identify areas of under- or overvaluation

Total Return Analysis and Scenario Analysis: o total return analysis: assessing expected effect of trade on portfolio’s total return given interest rate

forecast

Semiannual total return =

o scenario analysis: conduct analysis on varied assumptions

Monitor/Adjust Portfolio and Performance

Managing Funds Against Liabilities: Dedication Strategies:

o Immunization: portfolio over specified horizon that will earn predetermined return regardless of interest rate changes

o Cash Flow Matching: provides future funding of liability stream from coupon and matured principal payments of portfolio

Immunization: rate changes offset by effect of reinvestmento Classical Single-Period Immunization: assured return (insulation from effects of interest rate changes)

for specific time horizon; set portfolio’s duration to duration of specified time horizon set initial PV equal to PV of future liability Rebalancing an Immunized Portfolio: as interest rates actually change, must rebalance;

frequency based on cost/benefit Determining Target Return: total return as opposed to yield to maturity; alternative would be

zero-coupon bond w/ same duration and quality as portfolio Time Horizon: immunized time horizon equal to portfolio duration Dollar Duration: dollar duration = duration x portfolio value x 0.01; rebalancing for dollar

duration: 1. move forward in time w/ shift in yield curve; calculate new dollar duration 2. calculate rebalancing ratio: original dollar duration / new dollar duration – 1; result is

% each position needs to change to be rebalanced 3. multiply new market value by %: amt of cash needed for rebalancing

Spread Duration: measure of how market value of bond portfolio changes when parallel 100 bps change in spread over benchmark

nominal spread: spread of bond over yield of certain Treasury static spread (or zero-volatility spread): constant spread over Treasury spot curve that

equates calculated security price to market price option-adjusted spread (OAS): current spread over benchmark yield minus spread from

embedded optiono extensions of classical immunization:

multiple liability immunization: strategy that guarantees meeting specified schedule of future liabilities regardless of type of interest rate shift

contingent immunization: degree of active strategy will ensuring certain minimum return in case of parallel rate shift; immunization serves as fall-back strategy if actively managed portfolio does not grow at certain rate

cushion spread: difference b/w minimum acceptable return and higher possible immunized rate


Duration and convexity of assets and liabilities: if liabilities and assets are duration matched but not convexity matched, economic surplus will be exposed to variation in value from interest rate changes reflecting convexity mismatch

Types of Risk: interest rate risk contingent claims risk: (say prepayment risk) cap risk: say caps on floating rates

Risk Minimization for Immunized Portfolios: barbell portfolio is high risk while bullet portfolio is low risk

portfolio w/ least reinvestment risk has least immunization risk if manager can construct portfolio that replicates pure discount instrument that matures

at investment horizon: immunization risk will be zero maturity variance: how much given immunized portfolio differs from ideal immunized

portfolio consisting of single pure discount instrument w/ maturity equal to time horizon use linear programming confidence intervals

o Multiple Liability Immunization: for parallel rate shift, conditions: 1. duration of portfolio equals duration of liabilities; 2.

distribution of durations of individual portfolio assets must have wider range than distribution of liabilities; 3. PV of assets must equal PV of liabilities

o Immunization for General Cash Flows: model cash contributions as part of the portfolio along w/ their durations

o Return Maximization for Immunized Portfolios: the greater the cushion spread, the more scope the manager has for active management policy

Cash Flow Matching: select securities to match timing and amount of liabilities compared to immunization:

o no reinvestment risko cash flow matching requires conservative rates of returno cash flow matching requires cash to be on or before liability dateo generally inferior to immunization

extensions of basic CF matching:o symmetric cash flow matching: short-term borrowing funds to satisfy liability prior to liability due date

(and matched CF maturity)o combination matching (or horizon matching): creates portfolio that is duration-matched w/ added

constraint that it be cash-flow matched in first few years Application considerations:

o universe considerations: quality and characteristics of securities allowed to useo optimizationo monitoring: periodic performance measuremento transaction costs

Reading 29: Relative-Value Methodologies for Global Credit Bond Portfolio Management

Credit Relative-Value Analysis Relative value: ranking of fixed-income investments by sectors, structures, issuers, and issues in terms of their

expected performance during some future period of time classic analysis: top-down and bottom-up analysis Relative-Value Methodologies:


o Total return analysiso primary market analysiso liquidity and trading analysiso secondary trading rationales and constraints analysiso spread analysiso structure analysiso credit curve analysiso credit analysiso asset allocation / sector analysis

Total Return Analysis: optimize risk-adjusted total return; analyze detailed dissection of past returns and project expected returns; uncover patterns (large v. small issue performance variation, seasonality, election-cycle effects, gov’t benchmark auction effects, etc.)

Primary Market Analysis: new issue supply & demand; contrary to normal supply-price relationship, relative credit returns often perform best during periods of heavy supply

o effect of market-structure dynamics: adapt portfolio to long-term structure changes in composition of global credit asset class due to desire of issuers to minimize funding costs under different yield curve and yield spread, as well as needs of both active and asset/liability bond managers to satisfy their risk and return objectives

o Effect of product structure: 1. dominancy of bullet structures translates into scarcity value for structures w/ embedded call

and put features 2. bonds w/ maturities beyond 20 yrs are small share of outstanding credit debt 3. use of credit derivatives has skyrocketed

Liquidity and Trading Analysis: maybe trade potential liquidity disadvantage for incremental yields Secondary Trade Rationales:

o popular reasons for trading: 1. yield/Spread Pickup Trades: say determine rating differential b/w two issues irrelevant and

pickup yield difference 2. Credit-Upside Trades: when manager expects upgrade to issuer’s credit quality but not

already reflected in yield spread; popular in crossover sector 3. Credit-Defense Trades: in defense of geopolitical and economic uncertainties 4. New Issue Swaps: use swaps to add exposure to a new issuer or a new structure 5. Sector-Rotation Trades: 6. Curve-Adjustment Trades: portfolio duration tilt based on projected changes in credit term

structure or credit curve 7. Structure Trades: swaps into structures expected to have better performance given expected

movements in volatility and shape of yield curve 8. Cash Flow Reinvestment: take advantage of cash flow reinvestment effect on spreads

o Trading constraints: 1. Portfolio constraints: say from IPS or regulatory; say can’t own non-investment grade 2. “Story” Disagreement: action may be limited by uncertainty of one story over another 3. Buy-and-Hold: as a result of accounting constraints 4. Seasonality: say when month ends, or at year-end, when reports etc. made

Spread Analysis: Alternative Spread Measures:

o OAS has diminished from reduction in structures w/ embedded optiono zero-volatility spreado swap spreads in Europeo credit spread using U.S. agency benchmark curve


o credit-default swap spreads Closer look at swap spreads: many practitioners envision convergence to single global spread standard derived

from swap spreads Spread tools:

o 1. mean-reversion analysiso 2. Quality-Spread Analysis: examine spread differentials b/w low- and high-quality creditso 3. Percent Yield Spread Analysis: ratio of credit yields to gov’t yields for similar duration securities;

not very predictive

Structural Analysis: bullet, callable, putable, sinking fund bullets

o front-end bullets (1 to 5-yr maturities): useful for barbellers; asset swappers may convert short bullets into floating-rate products

o intermediate credit bullets (5- to 12 yr maturities): o 30-yr maturity

Callables Sinking Funds: series of partial calls prior to maturity Putables:

Credit Curve Analysis: almost always positively sloped credit barbell strategy: take credit risk in short and intermediate maturities and substitute less-risky gov’t

securities in long-duration portfolio buckets default risk increases non-linearly as credit-worthiness declines

Credit Analysis: predict upgrades and downgrades

Asset Allocation/Sector Rotation: “macro” among industrials, utilities, financial institutions, sovereigns, and supranationals “micro” detailed risk/return breakdown of main credit sub-sectors (banks, brokerage, energy, electrics, media,

railroads, sovereigns, supranationals, technology); exhibit on book 4, p. 85

Reading 30: Fixed-Income Portfolio Management—Part II

Other Fixed-Income Strategies: Combination Strategies: active/passive combination; active/immunization combination Leverage: 1. the larger the amt of borrowed funds, the greater the variation in potential outcomes; 2. the

greater the variability in annual return on invested funds, the greater the variation in potential outcomeso portfolio rate of return =

o duration:

o Repurchase Agreements: K involving sale of securities such as Treasury instruments coupled w/ agmt to repurchase same securities on later date (functions like collateralized loan)

difference b/w selling price and purchase price referred to as “interest” provides low-cost way for managers to borrow funds by providing Treasury securities as

collateral enables investors to earn return above risk-free rate on Treasury securities w/o sacrificing

liquidity transfer of securities: forms:


physical delivery (costly) transferred simply be credits and debits at clearing agent (still involves fees and

charges) deliver securities to custodial account at seller’s bank (reduces costs) may not require delivery at all if comfortable

Factors affecting repo rate: Quality of collateral Term of repo Delivery requirement: the greater the repo investor control, the lower the rate Availability of collateral: the more difficult (in short supply) it is to obtain the securities

the lower the rate Prevailing interest rates in economy: if federal funds rate (unsecured overnight loans of

excess reserves) higher, higher rate seasonal factors

Derivatives-Enabled Strategies: means to create, reduce or magnify factor exposures of an investmento Interest rate risk:

portfolio duration is weighted avg:

adjustments to portfolio often such to keep duration same, so often reference to dollar duration:

Dollar duration =

o Other risk measures: Semivariance: measures dispersion of return outcomes below target returns Shortfall risk: probability of not achieving some specified return target Value at risk (VAR): estimate of loss portfolio manager expects to be exceeded w/ given level

of probability over specified timeo Bond Variance v. Bond Duration: standard deviation difficult to use to measure risk: number of

parameters to estimate increases dramatically w/ number of bonds; variances and covariances change w/ time

o Interest Rate Futures: cheapest-to-deliver; delivery options: quality option; timing option; wild card option Strategies w/ Interest Rate Futures: price negatively correlated w/ interest rates: increases

duration/sensitivity to interest rates Duration Management: use to match portfolio duration when deviates from target

o portfolio’s target dollar duration = Current portfolio’s dollar duration w/o futures + dollar duration of futures Ks

o Dollar duration of futures = dollar duration per futures K x number of futures Kso Approximate # of Ks =

Duration Hedging: futures Ks involves taking futures position that offsets existing interest rate exposure; if properly constructed as cash and futures prices move together any loss realized by hedger from one position will be offset by profit in other

o basis risk: risk that basis (difference b/w cash price and futures price) will change in unpredictable way

o cross hedging: bond to be hedged is not identical to underlying in futures; may involve substantial basis risk

o price risk: risk that cash market price will move adversely; reason for hedging


o hedge ratio = factor exposure of bond (portfolio) to be hedged / factor exposure of hedging instrument = (factor exposure of bond to be hedged / factor exposure of CTD bond) x (factor exposure of CTD bond / Factor exposure of futures K) =

o Yield on bond to be hedged = a + b(Yield on CTD bond) + error term b is beta yield

o

Interest Rate Swaps:o Dollar duration of interest rate swap:

for pay float receive fixed: dollar duration of swap = dollar duration of fixed-rate bond – dollar duration of floating rate bond

Interest Rate Options: o duration for option = delta of option x duration of underlying x (price of

underlying / price of option instrument)o protective put establishes minimum value for portfolioo covered call yields best results if prices are essentially going nowhereo buy calls to protect against decline in reinvestment rateso also caps, floors and collars

Credit Risk Instruments: o credit risk: default risk, credit spread risk, downgrade risko credit options: protect against credit risk;

1. credit options written on underlying asset: binary credit options provide payoffs contingent on occurrence of

specified negative credit eventso credit put option pays difference b/w strike price and

market price when event triggered 2. Credit Spread Options: payoff based on spread over benchmark:

Payoff = Max [(Spread at option maturity – K) x Notional amt x risk factor, 0]

o credit forwards: for buyer of credit forward: payoff = (Credit spread at forward K

maturity – Ked credit spread) x Notional amt x risk factoro credit swaps: credit default swaps, asset swaps, total return swaps, credit-linked

notes, synthetic collateralized bond obligations, basket default swaps cds: for periodic premiums, agree to deliver physically or cash upon

default event

International Bond Investing: Active v. Passive Management; active:

o bond market selection: analyze global economic factors for selecting national marketso currency selection: o duration management / yield curve managemento sector selectiono credit analysis of issuerso investing in markets outside benchmark

Change in value of foreign bond = - Duration x Change in foreign yield given change in domestic yield x 100o ; beta is country beta


Currency risk: 1. expected effect captured by forward discount/premium; 2. unexpected movement of foreign currency relative to forward rate

o interest rate parity: forward foreign exchange rate discount/premium over fixed period should equal risk-free interest rate differential b/w two countries over period:

o hedging currency risk: forward hedging, proxy hedging, cross hedging forward hedging: use forward K b/w bond’s currency and home currency proxy hedging: use forward K b/w home currency and currency highly correlated w/ bond’s

currency; cross hedging: using two non-home currencies to convert to a less-risky exposure to investor for hedged position while IRP holds, hedged bond return: ;

sum of domestic risk-free interest rate plus bond’s local risk premium Breakeven Spread Analysis: determine the size of spread widening that would offset any yield advantage

o spread widening that would eliminate yield advantage: ; use the higher of the two

countries’ durations Emerging Market Debt:

o Growth and Maturity of the Market: after 1980s Mexican crisis, Brady plan allowed emerging country gov’ts to securitize their date: Brady bonds; has resulted in liquid market for Brady bonds

o Risk and Return Characteristics: potential for consistent attractive rates of return; countries can cut spending and raise taxes and borrow from IMF and World Bank; have currency reserves; but volatile; negative skewness; lack transparency: unclear laws and regs; little standardization in covenants and lacks enforceable seniority structure

o Analysis of Emerging Market Debt: look at: fundamentals: source of revenues, fiscal and monetary policies; current debt levels, willingness

of citizens to make sacrifices risk of being able to exchange currency political risk and currency risk changes in liquidity and taxation

Selecting a Fixed-Income Manager: Historical Performance as predictor of future performance: not necessarily good approach Developing Criteria for Selection:

o 1. Style analysis: helps explain historical performanceo 2. Selection bets: decompose portfolio returns to determine manager’s selection skillo 3. organization’s investment process: research methods; decision process for changeso 4. Correlation of alphas: prefer low correlations across managers

Comparison w/ selection of equity managers:o 1. both usually involve using consultantso 2. in both, past performance not reliable guideo 3. same qualitative factors: philosophy of manager and org, market opportunity, competitive

advantages, delegation of responsibility, experience of prof’lso 4. avoid high mgmt fees

Reading 31: Hedging Mortgage Securities to Capture Relative Value

Convexity Value of mortgage security = value of Treasury security – value of prepayment option many investors consider mortgages to be market-directional investments that should be avoided when interest

rates expected to declinedocument.doc

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Mortgage Security Risks: 1. Spread risk:

o portfolio manager does not seek to hedge spread risk, but increases allocation to mortgage securities when yield spreads are wide and reduces when narrow

2. Interest Rate Risk: corresponds to interest rate risk of comparable Treasury securities; can be hedged directly by selling Treasury notes or Treasury note futures

o yield curve risk: exposure to nonparallel change in yield curve shape rate duration: can provide some measure of exposure key rate duration: rate duration for key maturities

can model steepening POs have high positive duration; IOs have high negative duration

3. Prepayment Risk: o w/ prepayment option, duration of mortgage securities extends as rates rise and shortens as rates fall

the percentage increase in price becomes smaller and smaller as rates decline; percentage decline in price becomes greater and greater as interest rates rise.

o hedge by hedging dynamically or buying options 4. Volatility Risk: option value increases w/ interest rate volatility

o hedge by hedging dynamically (when high volatility expected to normalize) or buying options (when low volatility and expect to increase)

5. Model Risk: current models calibrate to historical experience; consider prepayment innovationo cannot hedge, but can measure

How Interest Rates Change Over Time: statistical technique used to decompose rate movements: principal components analysis 95% of historical movements in rate changes explained by 1. overall level of interest rates and 2. twists in

yield curve

Hedging Methodology: Interest Rate Sensitivity Measure: Richard and Gord’s Interest Sensitivity (IRS): measures % price change in

response to shift in yield curveo two bond hedge (say 2-yr and 10-yr Treasuries)o calculate appropriate two-bond hedge for typical yield curve shifts and twistso for shift: 1. compute prices for assumed interest rate increases and decreases (say 24.3 basis points as

the typical monthly change in level) for each of (i) the mortgage security (ii) the 2-yr, and (iii) the 10-yr

o for shift: 2. determine 6 changes (yields) in step 1.o for shift: 3. calculate averages from increase and decrease (absolute values) for each of 3 in step 2.o for twist: 4. compute prices for assuming flattening and steepening (say 13.8 basis points as the typical

monthly twist) for each of 3o for twist: 5. determine 6 changes (yields) in step 4o for twist: 6. calculate averages from flattening and steepening (absolute values) for each of 3 in step 5o for shift: 7. compute change in value of 2-bond hedge for level change in yield curve

H2 x (2-H priceL) + H10 x (10-H priceL)o for twist: 8. compute change in value of 2-bond hedge for twist

H2 x (2-H priceT) + H10 x (10-H priceT)o 9. determine system of equations that equates change in value of 2-bond hedge to change in price of

mortgage security H2 x (2-H priceL) + H10 x (10-H priceL) = -MBS priceL

H2 x (2-H priceT) + H10 x (10-H priceT) -MBS priceT


o 10. solve simultaneous equations for H2 and H10

properly hedged mortgage securities are not “market-directional” underlying assumptions of 2-bond hedge: 1. yield curve shifts are reasonable; 2. prepayment model estimates

changing cash flows well; 3. underlying assumptions in Monte Carlo simulation hold; 4. avg price change is good approximation of price change for small interest rate movements

Hedging Cuspy-Coupon Mortgage Securities: where small changes in interest rates have large effect on prepayments and thus prices

so, tangent line at yield is not a good proxy for price/yield changes more negative convexity than current coupon mortgages hedge by buying interest rate option

Reading 32: Equity Portfolio Management Role of the Equity Portfolio

o inflation hedge: if returns are sufficient on average to preserve purchasing power during periods of inflation

superior protection for unanticipated inflation than nominal bondso long-term portfolio growth

Approaches to Equity Investment: passive, active, semiactive:

o Semiactive (aka enhanced indexing and risk-controlled active management): tracking risk watchedo Information ratio = mean active return / tracking risk

Passive Equity Investing: Equity Indices:

o Index Weighting Choices: Price Weighting: according to absolute share price; performance represented by one share (as

adjusted for splits) of each index component; biased toward highest priced share Value weighted (or market-capitalization weighted): weighted according to market cap;

performance represents owning all outstanding shares of index components; biased toward highest market cap

float-weighted index: not all, but all of the free float (principal S&P funds are float weighted)

Equal weighted: say $1000 in each index component; require periodic rebalancing; small company bias

o Composition and Characteristics of Major Indices: most major are float-weighted DJIA is price weighted

Passive Investment Vehicles:o Indexed portfolios: 1. conventional index mutual funds; 2. ETFs; 3. separate or pooled accounts

separate or pooled accounts are extremely low-cost products (may be able to cover costs by security lending)

4 differences b/w ETFs and mutual funds: 1. shareholder accounting at mutual fund level and expensive; none for ETFs 2. ETFs pay higher index license fees 3. ETFs more tax efficient: in kind redemptions 4. ETFs pay transaction costs to trade but better protected w/ liquidity

full replication: say if fewer than 1000 stocks: costs that cause differences from index: cost of managing and administering fund


transaction costs of adjustments to reflect changes in index composition transaction costs of investing and disinvesting cash flows drag from cash positions while market is upward trending

stratified sampling (aka representative sampling): 1. divide index along multiple dimensions (create multidimensional cells); 2. determine weight of each cell; 3. take random sample from w/i cells and weight according to cell weight; consider diversification reqs;

optimization: use multifactor risk model of index and individual securities, and function to minimize tracking risk; factors may be market cap, beta, industry, macro etc.

accounts for covariances (stratified sampling does not) model risk overfitting data requires periodic trading

o Equity Index Futures: use stock index futures; delivery involves portfolio trades / program trades / basket trades

consider uptick ruleso Equity Total Return Swaps:

application has been curtailed by U.S. tax law changes (constructive sales?) tax-oriented applications focus primarily on differences in tax treatment accorded domestic and

int’l recipients of corporate dividends (withholding taxes) may save costs in case of rebalancing portfolio (tactical allocation)

Active Equity Investing: Equity Styles:

o value: focus on purchasing at low P/E say b/c of mean reversion may be cheap for good economic reasons low P/E style: usually found in defensive, cyclical and simply out of favor contrarian style: look for stocks that have been beset by problems (P/B < 1); in depressed

industries; buy when expected rebound high yield style: purchase w/ high and growing dividend yield

o growth: focus on selecting high-earnings-growth cos industries include: technology, health care, consumer products consistent growth style: long history of unit-sales growth, superior profitability and predictable

earnings relative strength indicators: compare stock’s performance during specific period to past

performance or performance of group earnings momentum style: bet on continual high earnings growth

o Other active management styles: market oriented (aka blend or core): intermediate grouping; buy stocks based on intrinsic value

regardless of whether value or growth; tends to resemble broad-market equity index w/ value bias: almost value style w/ growth bias: almost growth style growth-at-a-reasonable price: above avg growth prospects selling at conservative

valuations (not as diversified as straight growth style) style rotators: invest in style that will be favored in the near term small cap style / micro cap style (underresearched, or better growth prospects) mid cap (underresearched but stronger than micro caps) large cap: emphasis on superior analysis and insight

o Technique for identifying investment styles:


returns-based style analysis on portfolio returns (RBSA): regress realized returns on return series for set of securities indices (set must be mutually exclusive, exhaustive and risk distinct); betas set to total 1.

the weights set the “normal portfolio/benchmark” 1 minus style fit equals selection error term represents selection return

holdings-based style analysis (aka composition-based style analysis): categorize individual securities by characteristics and aggregate results; evaluate:

valuation levels forecast EPS growth rate earnings variability: (greater would be indicative of value-oriented) industry sector weightings: value-oriented would have financing and utilities; growth

have info tech and health care Barra fundamental multifactor risk model: commercial holdings-based style analysis

model consider category approach (stick security in basket representing one style); quantity

approach: divide security among baskets based on spectrum

2 approaches to style analysis: advantages and disadvantagesAdvantages Disadvantages

Returns-based style analysis

Characterizes entire portfolioFacilitates comparisons of portfoliosAggregates effect of investment processDifferent models usually give broadly similar results and portfolio characterizationsClear theoretical basis for portfolio categorizationRequires minimal infoCan be executed quicklyCost effective

May be ineffective in characterizing current styleError in specifying indices in model may lead to inaccurate conclusions

Holdings-based style analysis

Characterizes each positionFacilitates comparisons of individual positionsIn looking at present, may capture changes in style more quickly than returns-based analysis

Does not reflect way many portfolio managers approach security selectionRequires specification of classification attributes for style; different specifications may give different results

o Equity Style Indices: buffering: rules for maintaining style assignment of stock consistent w/ previous assignment

when stock has not clearly moved to new style style index publishers use growth and value either as categories (no overlap) or as quantities

(w/ overlap)o Style Box: cross tabs by market cap and style based on holdings-based style analysis; Morningstar’s

style box:

Value Core GrowthLarge-cap # stocks # stocks # stocksMid-cap # stocks # stocks # stocksSmall cap # stocks # stocks # stocks

o Style Drift: inconsistency in style Socially Responsible Investing: positive and negative screens by:

o industry classification (avoid tobacco, gaming, alcohol, armaments, etc)document.doc

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o corporate practices (re: environmental pollution, human rights, labor standards, animal welfare, integrity in corp governance, etc.)

o may bias the style: say shift toward small-cap shares Long-Short Investing:

common constraint on shorting two alphas: from long position and from short position market neutral: zero beta, resulting in “portable alpha” pairs trades

o Price Inefficiency on Short Side: impediments to short selling; opportunities arising from management fraud, “window-dressing”, negligence; analysts always make many more buy recommendations;

o Equitizing Market-Neutral Long-Short Portfolio: given equity market systematic exposure; by holding permanent stock index futures position equal to cash position from shorts

may be better to short ETFs than to continually roll short futures positions market neutral should have no systematic risk, so risk-free rate is benchmark; if equitized, then

equity benchmarko Long-Only Constraint: underweighting is similar to shorting, but limited on extent of underweighting

(e.g., can’t short); asymmetrico Short Extension Strategies (aka partial long-short strategies): specifies use of stated level of short

selling; say 130/30o Sell Disciplines/Trading:

opportunity cost sell discipline: find stocks w/ higher risk-adjusted expected return and replace lower

deteriorating fundamentals sell discipline: sell when fundamentals deteriorating rule driven: say P/E reaches historical avg: valuation-level sell discipline; also down-from-cost,

up-from-cost, target price sell disciplines

Semiactive Equity Investing (aka enhanced index or risk-controlled active): perform better than benchmark w/o much additional risk

derivatives-based semiactive equity strategies: exposure to equity market w/ derivatives and enhance w/ other than equity (say equitize cash and enhance by altering duration)

based on stock selection: generate alpha by selecting stocks Grinold and Kahn’s Fundamental Law of Active Management: : info ratio approximately

equal to what you know about given investment (info coefficient) multiplied by square root of investment discipline’s breadth (number of independent active investment decisions made each year)

Managing a Portfolio of Managers:

portfolio active return = : weighted avg of active return of managers

portfolio active risk = : square root of weighted sum of individual

manager’s variances; assumes uncorrelated Core-Satellite: to anchor a strategy w/ index or enhanced index and use active managers opportunistically

around anchor to achieve acceptable level of active return while mitigating some active risk associated w/ portfolio consisting entirely of active managers

o core should resemble benchmarko further breakdown of active return:

manager’s return – manager’s normal benchmark = manager’s true active return manager’s normal benchmark – investor’s benchmark = manager’s misfit active return


o manager’s total active risk = [(Manager’s “true” active risk)2 + (Manager’s “misfit” active risk)2]1/2

o manager’s risk-adjusted performance = IR = (Manager’s “true” active return) / (Manager’s “misfit” active risk)

Completeness Fund: when added to active managers’ positions, establishes overall portfolio w/ approximately same risk exposures as investor’s overall equity benchmark

o can be passive or semiactiveo needs to be re-estimated periodicallyo misfit may be optimal while completeness fund tends to eliminate misfit

Other Approaches: Alpha and Beta Separationo say index for beta exposure, then hire managers for portable alpha

Identifying, Selecting and Contracting w/ Equity Portfolio Managers: Developing a Universe of Suitable Manager Candidates: consultants evaluate managers qualitatively (people

and org structure, investment philosophy, decision-making process, strength of equity research) and quantitatively (comparisons w/ benchmarks and peers, measures style orientation and valuation characteristics)

Predictive Power of Past Performance: good investment record of set of managers over long period following consistent disciplines, more likely to indicate future satisfactory results than comparable record for manager w/ turnover and shifts in investment orientation

Fee Structures: o ad valorem fees: multiply % by assets managed (management fee or AUM fees)o performance-based fees: usually base fee plus sharing %;

may have fee cap may have high water mark one sided performance fee can be valued as an option

Equity Manager Questionnaire: 5 areas:o 1. organization/peopleo 2. philosophy/processo 3. resourceso 4. performanceo 5. fees

Structuring Equity Research and Security Selection: Top-Down v. Bottom-Up: most investors use some combination Buy-Side v. Sell-Side: Industry Classification:

o S&P and MSCI: Global Industry Classification Standards (GICS): divided into: 10 sectors (consumer discretionary, consumer staples, energy, financials, health care,

industrials, info tech, materials, telecomm, utilities) 24 industry groups 62 industries 132 sub-industries

o Industry Classification Benchmarko North American Industry Classification System

Reading 33: Corporate Governance

Separation of Ownership and Control:


corporate governance: “ways in which suppliers of finance to corps assure themselves of getting return on investment”

o consider stakeholders Moral Hazard:

o insufficient effort: allocation of work time to various taskso extravagant investmentso entrenchment strategies: invest in lines of activities that make managers indispensible; manipulate

performance measures; excessive or insufficient risk taking; resist hostile takeovers; lobby for limits on shareholder control and set up complex cross-holding structures

o self-dealing: perks; pick a friend as successor; select costly supplier based on friendship; finance their political picks; below-market-price asset sales w/ related party; insider trading

Dysfunctional corporate governance: o lack of transparency: levels of comp; stock options; perks;o comp level: “runaway compensation”o tenuous link b/w performance and comp: comp stable or increased despite poor performance; see

upside of market rises, but not downside of market falls; “getting out on time”: say selling options before problems surface; golden parachutes

o accounting manipulations: off-balance-sheet deals; hide poor performance; prevent violation of bank covenants; continued financing

Managerial Incentives: Sophisticated Mix of Incentives: bonuses and stock options; concern about future; threat of being fired;

financial distress; monitoring by large investors (also intrinsic motivation; fairness, horizontal equity, morale, trust, corp culture, social responsibility and altruism, feelings of self-esteem, interest in job; though economists concerned about residual incentives to act in firm’s interest over and beyond absence of rewards and monitoring)

o monetary incentives: comp package: salary, bonus and stock-based incentives bonuses and shareholdings: substitutes or complements comp base straight shares or stock options: exec comp controversy

o implicit incentives: keep job; avoid proxy fight; avoid bankruptcy or reorg;o monitoring: by Boards, auditors, large shareholders, large creditors, investment banks, rating agencies

active monitoring: interfering to increase investors’ claims; exercise of control rights speculative monitoring: adjust position in firm: invest further, hold, sell (the analyst)

o product market competition: beneficial effects; may also create gambling behavior

Board of Directors: watchdogs or lapdogs:

o lack of independence: may be hand picked by CEO; may have business relationships; bribes: lucrative consultancy etc; mutual interdependence of CEOs

o insufficient attention: unprepared and rely on management infoo insufficient incentives: mostly just fees and perks; huge barriers to liabilityo avoidance of conflict: ongoing relationship

Reforming the Board:o teammates or refereeso knowledge versus independence: those closest to firm have knowledge but susceptible to conflicts of

interesto Link from performance to board comp:


Cadbury report calls for: 1. nomination of recognized senior outside member where chairman of the Board is CEO; 2. procedure for directors to take independent professional advice at company’s expense; 3. majority of independent directors; 4. comp committee dominated by nonexecutives directors and audit committee conferred to nonexecutive directors most whom should be independent; also recommends against performance-based comp

CalPERS criteria % companies in complianceHas outside chairman 5%Only one insider on Board 18%Some form of mandatory retirement for directors 18%Independent nominating committee 38%Fewer than 10% of directors over 70 68%Independent governance committee 68%No retired CEO on the Board 82%Independent ethics committee 85%Independent audit committee 86%A majority of outside directors on Board 90%Independent comp committee 91%

Investor Activism: Active monitoring requires control:

o formal control: majority of voting shares etc.o real control: sufficient ownership to build coalition

proxy fight Pattern of ownership:

o pension funds play minor role in France, Germany, Italy and Japan; ownership concentration in such countries is substantial; also cross-shareholdings

o ownership concentration: high in Italy, France, Germany, Sweden, Europe generally, East Asia extremely dispersed in U.S. dispersed in Anglo-Saxon countries

o stability of holdings v. active management: Japan and German stable; Anglo-Saxon reshuffle frequently

Limits of Active Monitoring:o who monitors the monitor: monitors not always acting in interest of their beneficiarieso congruence w/ other investors:

undermonitoring: substantial free-riding by small institutional shareholders collusion w/ management: quid pro quo self-dealing: transactions w/ affiliated firms

o Cost of providing proper incentives to monitor: entails liquidity costs to cause long-term holding which allows for proper monitoring

o Perverse effects on the monitorees: become short-term focusedo Legal, fiscal, and regulatory obstacles: liability for directors; holding restrictions once reach ownership

threshold; diversification rule;

Takeovers and Leveraged Buyouts: keep managers on their toes, but may cause myopia allow for fresh ideas from new managerial teams raider may be value-reducing may shatter implicit Ks w/ stakeholders Takeover Bids and Defenses:

o usually preceded by toehold


o tender offero defenses:

corporate charter defenses: staggered board supermajority rule fair price clauses placing shares in ESOP differential voting rights dual-class recapitalizations move to state w/ tougher antitakeover statutes

dilution defenses: Scorched-earth policies litigation poison pills

post-takeover bid defenses: white knights greenmail

Leveraged Buyouts: o buyout partnership arrangement: 1. strong monetary incentives of new managers of that of publicly

traded corp; 2. active monitoring taken seriously; 3. high leverageo Rise and backlash:

Hypothesis 1: Decline of corp governance Hypothesis 2: Financial innovation: new and superior form of corporate governance Hypothesis 3: Break-up of conglomerates verdict:

large gain for target shareholders neutral outcome for acquirer increase in total value

Debt as a Governance Mechanism: as incentive mechanism: forces firm to disgorge cash flow

o managers can’t consume casho managers must focus on repaying creditorso threat of financial distresso residual claim goes to entrepreneur so right incentives

limits:o costs of illiquidity; say to fund projects; say in face of uncontrollable adverse shockso bankruptcy costs:

direct costs indirect costs: managerial decisions in anticipation

o transaction costs: lots of parties to deal w/o bargaining inefficiencies:

International Comparisons of the Policy Environment: protection of shareholders is strongest in common law countries, weakest in French-style civil law countries

and somewhere in b/w in German- and Scandinavian-style law positive covariation b/w shareholder protection and breadth of equity market substitute protections:

o mandatory dividendso more concentrated ownership structures


Shareholder Value or Stakeholder Society? list of stakeholders:

o duties toward employeeso duties toward communitieso duties toward creditorso ethical considerations: environment, pay taxes, avoid bribes

rather than simply make longer-term investments, stakeholder perspective is at extreme of “socially responsible corporation is one that consciously makes decisions that reduce overall profits.”

arguments against:o discourages financing in first placeo inefficiencies in decisionmaking: conflicting objectives resulting in deadlockso difficulty in accountability created by such wide array of immeasurable missionso tax on business whose proceeds escape control by political process

shareholder value position: freedom of contract:

stakeholder society: Incentives and Control Issues:o monetary incentives:

explicit: bonuses and stock options: measure on aggregate welfare; but recommendation that stakeholder value would be best promoted by fixed wage

enlarged fiduciary duty implicit: substitute for explicit incentives in environments in which performance cannot be

well-described ex ante, but can be better assessed after the fact due to accrual of new info career concerns

analogy to joint ventures: heterogeneity of interests among partners of joint venture seriously impedes efficacy: conflicts of interest among partners create mistrust and lead to deadlocks to decision making

Cadbury Report: Code of Best Practice:

o 1. Board of Directorso 2. Non-Executive Directorso 3. Executive Directorso 4. Reporting and Controlso Notes and add’l recommendations

Reading 34: International Equity Benchmarks: Need for Float Adjustment: consider cross-holdings; no int’l equity benchmark uses full cap any more Trade-Offs in Constructing Int’l Indexes:

o Breadth v. investability: consider illiquidity of smallest-cap in emerging marketso Liquidity and crossing opportunities v. index reconstitution effects: most popular and widely used

indexes and benchmarks have greater index level liquidity for investors seeking to buy or sell index fund position or actively managed position resembling index

also program/portfolio trades: crossing, but with a broker reconstitution effects: upward price pressure on stocks chosen for inclusion in index and vice

versao Precise float adjustment v. transaction costs from rebalancing: no longer matter of controversy: all

indexes have some float adjustment float bands allow for less transaction costs

o Objectivity and transparency v. judgment:


Emerging market benchmark: MSCI EMF for emerging markets (similar to MSCI EAFE for developed markets)

some transaction costs and reconstitution effects in index changes

Reading 35: Emerging Markets Finance

Market integration and liberalization: financial liberalization: allowing inward and outward foreign equity investment market prices can change upon announcement of liberalization or as soon as investors anticipate liberalization

may occur in the future expected returns should decrease as volatility decreases; but may become more sensitive to world events

(increasing covariance w/ developed markets) Barriers to integration:

o legal barriers treating foreign and domestic investors differentlyo indirect barriers from differences in available info, accounting standards and investor protectiono emerging market risks: liquidity, political risk, economic policy risk, currency risk

Financial Effects of Market Integration: Liberalization and returns:

o dividend yields decline after liberalization but by less than 1% on averageo possibility that pre-liberalization returns already biased from integrationo unconditional correlations and betas increase after liberalization

liberalization and capital flows:o net capital flows to emerging markets increase rapidly after liberalization, but level out after 3 yrso concern that portfolio flows are not as “sticky” as fdi

liberalization and political risk: o some evidence country ratings significantly increase (lower risk) w/ equity market liberalization

liberalization and diversification benefits: small but significant increase in conditional correlations and reduced diversification benefits

Real Effects of Financial Market Integration: inflow of foreign investment, boom, currency appreciation

Contagion: speculative attacks on the currency?

o after gov’ts follow policies inconsistent w/ peg?o as self-fulfilling: investors just decide to speculate against and cause crisis?

if self-fulfilling, then channel for contagion income effect channel: reduced growth and lower income levels after crisis reduce demand for imports from

other countries “wake up call” channel: second country also experienced similar negative macroeconomic conditions or

followed similar inconsistent policies other channels: credit crunch; forced-portfolio recomposition or liquidity effect

Other issues: Corporate finance: emerging markets as testing ground for legal institutions / agency theories Fixed Income: high correlation b/w emerging market debt and equity returns Market Microstructure: price discovery; liquidity Stock Selection: information asymmetry; returns not explained by traditional asset pricing models Privatization: transfer of productive resources from public sector to private sector


Reading 36: Alternative Investments Portfolio Management

Diligence on Alternative Investments:1. market opportunity2. investment process3. organization4. people5. terms and structure6. service providers7. documents8. write-up

Also: tax issues determining suitability communication w/ client decision risk concentrated equity position of client in closely held company

Real Estate: types:

o direct: residences, commercial real estate, agricultural lando indirect:

homebuilders, real estate operating companies, etc. REITs

Equity REITs own and manger office buildings, apartment buildings, shopping centers, etc.

Mortgage REITs invest >75% of assets in mortgages; lend money to builders and make loan collections

Hybrid REITs: operate real estate and buy mortgages Commingled real estate funds (CREFs )

Opened ended and closed ended (closed are usually leveraged) Private investment vehicles

Separately managed accounts Infrastructure funds:

Designs, finances, and builds projects Financed by debt and equity Leased to public sector to operate; allows public sector to avoid raising debt

Benchmarks and historical performance:o Direct real estate: in U.S.: National Council of Real Estate Investment Fiduciaries (NCREIF) Property

Index; Value weighted Includes subindices for apartments, industrial, office and retail and by geographic region Based on property appraisals; underestimate volatility Not an investable index

o Indirect real estate investment: NAREIT

Real time market-cap weighted index of all REITs actively traded on NYSE and Amex Also monthly equity REIT index Also other specialized subindexes


Note that the underlying REITs often leveraged Real Estate: Investment Characteristics and Roles:

o Has intrinsic valueo Substantial income componento Lack of liquidityo Large lot sizeso High transaction costso Heterogeneityo Immobilityo Low info transparencyo Factors: interest rates (real interest rates); term structure of interest rates; change in GDP; growth in

consumption; population growth; unexpected inflationo Inflation hedge?o Idiosyncratic variableso Benefits:

Deductible mortgage interest Permits more financial leverage Direct control over property Can obtain diversification through different geographic locations Low volatility compared to public equities

o Disadvantages: Not easy to divide parcels; only large part of portfolio High cost of info High broker commissions Substantial operating and maintenance costs Risk of neighborhood deterioration Political risk on tax deductions

o Follows economic cycleso Provides some diversification benefits relative to stock/bond portfolio, but relatively less effective than

hedge funds and commodities But unsmoothed NCREIF provided greater diversification benefits

o Apartments have highest risk-adjusted returns; office have lowest

Private Equity / Venture Capital: Private equity funds: financing private businesses, leveraged buyouts of public companies; distressed debt

investing; public financing of public infrastructure projectso Buyout funds: mega-cap buy-out funds: take public companies private; middle-market buy-out funds:

purchase private companies whose revenues and profits are too small to access capital from public equity markets

Add value by: restructuring operations and improving management Opportunistically purchasing at discount Gains from adding debt or debt restructuring

Insert management Dividend recapitalization Capital commitments come from: public pension funds, corporate DB pension plans,

endowments, foundations, family offices Types:

Investment Processes of (Direct) Private Equity Investment and Investment in Publicly Traded Equities


Private Equity Investments Publicly Traded SecuritiesStructure and ValuationDeal structure and price are negotiated b/w the investor and company management

Price is set in context of market. Deal structure is standardized. Variations typically required approval from securities regulators.

Access to Info for Investment SelectionInvestor can request access to all info, including internal projections

Analysts can use only publicly available info to assess investment potential

Post-Investment ActivityInvestors typically remain heavily involved in the company after the transaction by participating at the Board level and through regular contact w/ management

Investors typically do not sit on corporate Boards or make ongoing assessments based on publicly available info and have limited access to management.

Venture capital: equity financing of new or growing private companieso Assist in IPOo May use PPMo Demand for VC:

Formative-stage companies: newly formed to product development stage Expansion-stage: expanding sales stage, significant revenues, stage of preparing for IPO Financing stages:

Early-stage financing:o Seedo Start-upo First-stage

Later-stage financing:o The Exit:

Merger Acquisition IPO

o Supply of VC: Angel investors VC Large companies: corporate venturing / strategic partners

o Convertible preferred stock PE and VC usually indirect investment vehicles: limited partnerships

o Management fee plus incentive fee (carried interest) Carried interest sometimes subject to hurdle rate and subject to claw back

o Funds of funds: Benchmarks: annualized IRRs compiled by Cambridge Associates, Thomson Venture Economics, and NVCA.

o Performance of fund based on manager’s appraisalso Make vintage year comparisons

PE: Investment Characteristics and Roles:o Growtho Investment characteristics:

Illiquidity Long-term commitments required Higher risk than seasoned public equity investment High expected IRR required (for VC) limited info


o Differences b/w PE and VC: Buyout funds are usually highly leveraged CFs to buyout fund investors come earlier and are often steadier than VC Returns to VC fund investors subject to greater error in measurement

o Roles: PE has moderately high correlation w/ public equity More idiosyncratic risk Ability to achieve sufficient diversification (high commitments) Liquidity of position Provision for capital commitment Appropriate diversification strategy

Other issues:o Evaluation of prospects for market success

Markets, competition and sales prospects Management experience and capabilities Management’s commitment (consider % ownership and comp incentives) Cash invested (by management) Opinion of customers Identity of current investors

o Operational review Expert validation of technology Employment contracts Intellectual property

o Financial/legal review Potential for dilution of interest Examination of financial statements

Commodity Investments: Types:

o Direct commodity investment: cash market purchase involving actual possession and storageo Indirect commodity investment: say as equity in companies specializing in production

Benchmarks:o Reuters Jefferies/Commodity Research Bureau (RJ/CRB) Index – uses unequal fixed weights based on

perceived relative importanceo Goldman Sachs Commodity Index (GSCI) – arithmetic averaging of monthly component returns; total

return version and spot versiono Dow Jones-AIG Commodity Index (DJ-AIGCI)o S&P Commodity Index (S&PCI)

Historical performance:o On stand-alone basis, commodities have lower Sharpe ratio than U.S. and world bonds and equitieso Correlations w/ traditional asset classes are close to zeroo Return components: spot return / price return; collateral return; roll return (positive for long in

backwardation market) Investment characteristics:

o Understand investment characteristics of commodities on sector- or individual-commodity levelo Special risk characteristics:

Unusually low correlations w/ equities and bonds Price risk in periods of financial and economic distress Long-term growth in world demand in limited supply: long-term trend growth Generally business cycle sensitive


Determinants of return: 1. business cycle-related supply and demand: 2. convenience yield: embedded consumption timing option; inverse relationship b/w

level of inventories and convenience yieldo Samuelson effect: term structure of forward price volatility generally declines w/

time to expiration (mismatched supply and demand at shorter horizons, but equilibrium in longer horizons)

3. Real options under uncertainty: Inflation: “natural” sources of return; protection against unexpected inflation

Positive correlation w/ unexpected inflation Roles:

o Potent risk diversifiero Inflation hedge: classes such as livestock and agriculture exhibit negative correlation w/ unexpected

inflation as measured by monthly changes in inflation rate; storable commodities directly linked to economic activity exhibit positive correlation w/ changes in inflation and have superior inflation-hedging properties

Hedge Funds: Types:

o Equity market neutral: roughly equal exposure long and shorto Convertible arbitrage: o Fixed-income arbitrage: mispricing based on term structure of interest rates or credit qualityo Distressed securities:o Merger arbitrage:o Hedged equity: not equity market neutralo Global macro:o Emerging markets:o Fund of funds

Groups:o Relative valueo Event driveno Equity hedgeo Global asset allocatorso Short selling

Fees:o AUM fee and incentive feeo High-water mark

Initial Lock-up period: maybe 1 to 3 yrs Benchmarks:

o CISDM of the University of Massachusettso Credit/Suisse/Tremonto EACM Advisorso Hedge Fund Intelligence Ltd.o HedgeFund.neto HFRo MSCIo Dow Jones Hedge Fund Strategy benchmarkso HFR hedge fund indiceso MSCI Hedge Invest Index


o Standard & Poor’s Hedge Fund Indices Differences in major manager-based hedge fund indices:

o Selection criteria: which hedge funds are includedo Style classification:o Weighting scheme:o Rebalancing scheme:o Investability:

Absolute return vehicles? Defined as having no benchmark, while estimates of alpha must be made relative to a benchmark

o Can establish comparable portfolios using 1. single factor or multifactor methodology; 2. optimization to create tracking portfolios w/ similar risk and return characteristics

Historical performance:o HFCI has higher Sharpe ratio than any other reported assets; correlation of 0.59 w/ S&P 500o b/c equity hedge funds load on similar return factors as S&P 500, offer less diversification than many

relative-value strategies and can be more rightly considered return enhancers Interpretation Issues:

o Biases in Index Creation: concern is whether index reflects actual relative sensitivity of hedge funds to various market conditions, such that each index provides info on true diversification benefits of underlying hedge fund strategies

o Relevance of Past Data on Performance: best forecast of future returns is one that is consistent w/ prior volatility and not one that is consistent w/ prior returns

o Survivorship Biaso Stale price bias: results in lower reported correlationso Backfill bias (inclusion bias): when missing past return date for component of index are filled at

discretion of component when it joins the index—only components w/ good past results will be motivated to supply them

Investment Characteristics:o Common set of return drivers based on trading strategy factors (e.g., option-like payoffs) and location

factors (e.g., payoffs from buy-and-hold policy) help explain returns of each strategyo Long-biased hedge funds are return enhancers rather than diversifierso Hedge funds attempting to be least affected by market direction may be diversifiers

Role in portfolio:o Scrutinize managerso Emphasize style selectiono Often have option characteristics that present challenge when relying on MVOo Mean-variance improvemento Lower skewness and higher kurtosis

Adopt mean-variance, skewness and kurtosis-aware approach to hedge fund selection Invest in managed futures: tends to have skewness opposite many hedge funds

Other issues:o Young funds outperform old funds on a total-return basis, or at least old funds do not outperform

young oneso On average, large funds underperform small fundso FOFs may provide closer approximation to return estimation than indices doo Performance fees and lock-up periods: some evidence of better performance of funds w/ quarterly

lock-ups over monthlyo FOFs: style drift: may time one market and have become less useful in asset allocation strategieso FOFs: don’t usually impose lock-up periodso Fund size: smaller more nimble and higher risk-adjusted returns; larger have more clout


o Age (vintage) effects Hedge Fund Due Diligence:

o Structureo Strategyo Performance datao Risko Researcho Administrationo Legalo References

Performance Evaluation: o Returns: monthly usually;

Rate of return = [(Ending value of portfolio) – (Beginning value of portfolio)]/(Beginning value of portfolio)

Usually compounding over 12 mos; frequency can materially affect reported performance b/c entry and exit and drawdowns

Typically “look through” leverage as if asset were fully paid Rolling return: moving average of holding-period returns that matches investor’s time horizon:

; o Volatility and Downside Volatility:

Annualize monthly by multiplying by Positive excess kurtosis and skewness

Downside deviation =

Maximum drawdown: largest difference b/w high-water point and subsequent low Length of drawdown period: time from high-water mark until next high-water mark

o Performance Appraisal Measures: Sharpe ratio; limitations:

Time dependent and increases proportionally w/ square root of time Doesn’t account for asymmetrical return distribution or negative or positive skewness Illiquid holdings bias upward Doesn’t account for serial correlation Doesn’t account for correlations w/ other investments Not very good predictive ability for hedge funds Can be gamed: lengthening measurement interval; compounding monthly returns but

calculating standard deviation from not compounded monthly returns Writing out of the money puts and calls on a portfolio Smoothing of returns w/ derivative structures Getting rid of extreme returns w/ total return swaps

Sortino ratio = (Annualized rate of return – annualized risk-free rate)/Downside deviation Gain-to-loss ratio = (Number of months w/ positive returns / Number of months w/ negative

returns) x (Average up-month return/ average down-month return) Calmar ratio Sterling ratio

o Correlations: assumes normalityo Skewness and Kurtosis: positive skewness is good; high kurtosis means extreme returnso Consistency:

Number of positive months


% positive months Avg return in up-months Number of negative months % negative months Avg return in down-months Avg monthly return in index up-months Avg monthly return in index down-months

Managed Futures: private pooled investment vehicles that can invest in cash, spot, and derivative markets for benefit of investors and have ability to use leverage; run by general partners known as commodity pool operators (CPOs)

skill based, absolute-return strategies types: private commodity pools; separately managed accounts; publicly traded commodity funds

o investment style: systematic (rule based or trend based) or discretionary (based on trader beliefs or economic data)

o markets traded: currency, financial, or diversified (financial, currency and commodities)o trading strategy (e.g., trend following or contrarian)

Benchmarks: o Mount Lucas Management Index: based on technical trading ruleso CISDM CTA: based on peer group

Performance: o standard deviations comparable to U.S. blue-chip stocks; o Sharpe ratio better than equities but not bondso correlations slightly negative w/ equities; 0.42 and 0.46 w/ U.S. and global bonds respectively

Interpretation:o survivorship bias

Investment characteristics: potential for improved risk and returno derivative markets are zero-sum games: passively managed, unlevered futures position should earn

risk-free return on invested capital less management fees and transaction costso momentum strategies and trend following; resulting in positive skewnesso diversification capabilities (to stocks and bonds)

Roles:o diversification from stocks, bonds and hedge fundso improved Sharpe ratios

other issues:o performance persistence;o leveraged

Distressed Securities: securities of companies in financial distress or near bankruptcy or already in Chapter 11: many investors cannot hold b/c of IPS; unresearched: exploit the inefficiency skill in negotiation or influencing management Types:

o hedge fund structure: more liquido private equity fund structure: closed endo types of assets:

publicly traded debt and equity securities in distressed company newly issued equity of co emerging from reorg (orphan equity) bank debt and trade claims “lender of last resort” notes variety of derivative instruments for hedging purposes

Benchmarks:


o subindexes of major hedge fund indices: EACM, CISDM, HFR; Altman-NYU Salomon Center Defaulted Public Bond and Bank Loan Index

Performance:o non-normal: negative skewness (downside risk); large kurtosis (outlier events)o high mean returns w/ low standard deviation: high Sharpe ratioo low correlation w/ world stock and bond investments

investment characteristics: o consider IPS restrictions (limits to investment grade; might be required to sell fallen angels)

Roles: o Long-Only Value Investing: investing in undervalued distressed securities; if public debt: high-yield

investing; if orphan equities: orphan equities investingo Distressed Debt Arbitrage: purchasing co’s traded bonds and selling short its equityo Private Equity: become major creditor to influence

prepackaged bankruptcy: converting distressed debt to private equityo Risks:

event risk market liquidity risk market risk J factor risk: judge’s track record in adjudicating bankruptcies and restructuring not normal illiquid stale pricing

other issues:o Bankruptcy in U.S. v. other countries:

other countries, bankruptcy usually liquidation; rehabilitation of debtor is distinctive to U.S.o Absolute Priority Rule: satisfy senior claims first (but new value exception)o Prepackaged Bankruptcy Filing: debtor agrees in advance w/ creditors on plan of reorg b/f formally

files for Chap 11 protection

Reading 37: Swaps

Commodity swaps: fixed price of swap is weighted average of corresponding forward prices.

With varying quantities:

For summer and winter varying:

Because fixed swap payment equal, while the futures prices vary, the mismatch creates a borrowing/lending component.


Reading 38: Commodity Forwards and Futures

Synthetic commodity: long forward plus zero coupon bond w/ face value equal to forward price

Link b/w expected commodity price and forward price:

Nonstorability: Electricity: different prices in summer and winter and in night and day

Commodity Lease Rate:

Cash and carry arbitrage: borrow cash, buy commodity, lend commodity and short forward Reverse cash and carry arbitrage: short commodity, lend cash, long forward Contango occurs when lease rate is less than risk-free rate; Backwardation occurs when lease rate is greater than risk-free rate Carry: storage Forward price with storage costs (like negative dividend; applies only when storage occurs):

Forward price factoring in convenience yield: o Those who earn convenience yield likely already hold optimal amount of commodity; there may be no

way for you to earn convenience yield when performing cash and carryo For average investor arbitrageur, price range w/I when no arbitrage is

Gold Futures: Easily storable; often sold certificated; Has lease rate: use lease formula to determine lease rate; synthetic gold

generally preferable way to obtain exposure

Seasonality: Corn Forward Market: Harvested in U.S. from Sept to Nov. Prices rise at interest rate plus storage costs; falls at harvest Occasional storage across harvests

Natural Gas: Seasonality and storage costs Difficult to transport internationally so, forward curves vary regionally Costly to store In U.S., demand highest in winter months Steady stream of production w/ variable demand (as opposed to corn)

Oil: Easy to transport Easier to store than gas

Commodity spreads: some commodities are inputs in creation of other commodities Crush spread: position in soybeans and opposite position in equivalent quantities of soybean meal and soybean

oil


Crack spread: oil and distillates: oil => gas & heating oil

Hedging Strategies: Basis risk: the price of the commodity underlying the futures contract may move differently than price of

commodity you are hedgingo Say based on differing delivery locations and timeso Say differing grades

Strip hedge: buy commodity over time for over-time obligation; stack hedge: enter futures w/ single maturity w/ number of Ks selected so that changes in PV of future

obligations are offset by changes in value of “stack” of futures Ks. Stack and roll: stacking futures Ks in near-term K and rolling over into new near-term K (profitable in

backwardation) Weather derivatives: (a cross hedge): contracts that make payments based upon realized characteristics of

weathero Heating degree-dayo Cooling degree-day

Reading 39: Risk Management:

Risk Management Process: 1. Set Policies & Procedures 2. Define Risk Tolerance 3. Identify Risks 4. Measure Risks 5. Adjust Level of Risk 6. Execute Risk Management Transactions 7. Identify Appropriate Transactions 8. Price Transactions 9. Execute Transactions

Risk Governance: Enterprise risk management (ERM): centralized risk management for overall company at level close to senior

management. Steps:o 1. Identify each risk factor exposed too 2. quantify each exposure’s size in money termso 3. map inputs into risk estimation calculationo 4. identify overall risk exposures as well as contribution from each factoro 5. set reporting process to senior mgmt: committeeo 6. monitor compliance

Identifying Risks: market risk (interest rate risk, exchange rate risk, equity price risk, commodity price risk); credit risk; liquidity risk; operational risk; model risk; settlement risk; regulator risk; legal/contract risk; tax risk; accounting risk; sovereign/political risk

Market risk: interest rate risk, exchange rate risk, equity price risk, commodity price risk Credit risk: counterparty risk Liquidity risk: that financial instrument cannot be purchased or sold w/o significant concession in price

o Size of Bid-ask spread: a measure of liquidity risko Volume

Operational Risk: risk from failure in co’s systems and procedures or from external events Model Risk:


Settlement (Herstatt) Risk: paying counterparty while counterparty is declaring bankruptcyo May net to reduce

Regulatory Risk: how transactions will be regulated or that regulation will change Legal/Contract Risk: say fraud or illegal contract, or otherwise unenforceability of K Tax Risk: uncertainty associated w/ tax laws Accounting Risk: uncertainty about how transaction should be recorded and potential for accounting rules and

regulations to change Sovereign and Political Risks: changing political conditions in countries

o Sovereign risk: where borrower is gov’t o Political risk: changes in political environment

Other risks:o ESG risk: environmental, social and governanceo Performance netting risk: potential for loss resulting from failure of fees based on net performance to

fully cover contractual payout obligations to individual portfolio managers that have positive performance when other portfolio managers have losses and when there are asymmetric incentive fee arrangements w/ the portfolio managers

o Settlement netting risk: that liquidator of a counterparty in default could challenge netting arrangement so that profitable transactions are realized for benefit of creditors

Measuring Risk Measuring Market risk:

o standard deviation / volatilityo active risk / tracking risk / tracking error volatilityo beta, duration, deltao convexity, gammao vega, theta

Value at Risk (VAR): probability-based measure of loss potential, expressed as % or units of currency; “estimate of loss (in money terms) that we expect to be exceeded with a given level of probabiliby over a specified time period.”

o requires: 1. probability level; 2. time period; 3. modelo analytical or variance-covariance method: infer VAR from standard deviation and normal distribution

delta-normal method: assume that change in option price is assumed to equal change in underlying price multiplied by delta (avoids non normality of options)

o Historical Method (historical simulation method): set VAR according to actual historical experience / historical distribution

nonparametrico diversification effect: difference b/w sum of individual VARs (say for different divisions) and total

VARo Monte Carlo Simulation Method: o “Surplus at Risk”: VAR as it applies to pension fundso backtesting: process of comparing number of violations of VAR thresholds w/ figure implied by user-

selected probability level Extensions and Supplements to VAR:

o Incremental VAR (IVAR): measures incremental effect of an asset on VARo cash flow at risk (CFAR)o earnings at risk (EAR)o tail value at risk (TVAR): VAR plus the expected loss in excess of VAR, when such excess loss occurs

Stress Testing: identify unusual circumstances that could lead to losses in excess of typicalo Scenario analysis: under different states of the world

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hypothetical eventso Stressing Models:

factor push: push prices and risk factors of underlying model in most disadvantageous way and work out combined effect

maximum loss optimization: optimize mathematically the risk variable that will produce the max loss

worst-case scenario analysis Measuring Credit Risk: likelihood of loss and amount of associated loss

o current credit risk (jump-to-default risk): risk of events happening in immediate futureo credit VAR (default VAR or credit at risk)o option-pricing theory and credit risk: bond w/ credit risk can be viewed as default-free bond plus

implicit short put option on the assets written by bondholders for stockholderso credit risk of forward Ks: current credit risk at expiration; otherwise, potential credit risko credit risk of swaps: credit risk present at series of points

for interest rate and equity swaps: potential credit risk is largest during middle period of swap’s life

currency swaps have greatest credit risk b/w midpoint and end of lifeo credit risk of options: unilateral credit risk

Liquidity Risk: o maybe liquidity-adjust VAR estimates

Measuring Nonfinancial Risks: maybe more suitable for insurance (maybe extreme value theory)o operational risk: o Basel II

Managing Risk: key components:

o effective risk governance model, which places overall responsibility at senior mgmt level, allocates resources effectively and features appropriate separation of tasks b/w revenue generators and those on control side of business

o appropriate systems and technology to combine info analysis in such way as to provide timely and accurate risk info to decision makers

o sufficient and suitably trained personnel to evaluate risk info and articulate it to those who need info for purposes of decision making

Managing Market Risk:o Risk Budgeting: might be set in terms of VAR units or on individual transaction size, amount of

working capital needed to support the portfolio or amount of losses acceptable for any given time period, or IR for portfolio managers, or risk to the surplus. Also:

performance stopouts working capital allocations VAR limits Scenario Analysis limits risk factor limits position concentration limits leverage limits liquidity limits

Managing Credit Risk: one-sided risko Reducing Credit Risk by Limiting Exposure: limit transactions w/ any single counterpartyo Reducing Credit Risk by Marking to Market: OTC derivatives (options not marked to market)o Reducing Credit Risk with Collateral: usually cash or highly liquid, low-risk securities


o Reducing Credit Risk with Netting: used in two-way contracts (forwards, swaps); also netting among multiple contracts: closeout netting

cherry picking: bankrupt company enforcing only profitable contracts (not netting)o Reducing Credit Risk w/ Minimum Credit Standards and Enhanced Derivative Product Companies:

Enhanced Derivatives Products Companies (EDPCs): subsidiaries separated from parent’s debts so as to minimize counterparty risk

o Transferring Credit Risk with Credit Derivatives: credit default swaps total return swap credit spread option credit spread forward

Performance Evaluation:o Sharpe ratioo Risk-Adjusted Return on Capital (RAROC): divides expected return by a measure of capital at risko Return over Maximum Drawdown (RoMAD): average return in given year over maximum difference

b/w high-water mark and subsequent lowo Sortino Ratio: Sortino Ratio = (Mean portfolio return – minimum acceptable return (MAR))/Downside

deviation (below MAR) Capital Allocation: measure of capital:

o 1. nominal, notional, or monetary position limits (seldom sufficient risk control)o 2. VAR-based position limitso 3. Maximum loss limitso 4. Internal capital requirements: say using VARo 5. Regulatory capital requirements

Psychological and Behavioral Considerations: risk governance should anticipate points in cycle when incentives of risk takers diverge from those of capital allocators (say when fall into negative performance)

Reading 40: Currency Risk Management

Hedging w/ Futures or Forward Currency Ks: Basic Approach: Hedging Principal:

o unhedged asset return:

o return on hedge: Realized gain =

o Profit =

o hedged position rate of return:

Minimum-Variance Hedge Ratio: used when foreign currency value of foreign investment reacts systematically to an exchange rate movement

o

o optimal hedge ratio (regression hedge ratio): ; also can be estimated as R* = a + h*RF +

error termo Translation risk: from translation of value of asset from foreign currency to domestic currency; hedge

ratio for translation risk is 1 : minimizing the first term comes from an h of 1

o Economic Risk: when foreign currency value of foreign investment reacts systematically to an exchange rate movement (say when country raises interest rates to fight currency depreciation)


hedge ratio estimated by:

o Hedging Total Currency Risk: both translation risk and economic risk Influence of the Basis: futures and spot exchange rates differ by a basis

o Basis risk: basis equals interest rate differentialo Implementing hedging strategies:

1. short-term Ks, rolled over at maturity 2. Ks w/ matching maturity 3. long-term Ks w/ maturity extending beyond hedging period

o Hedging Multiple Currencies: try to find Ks on other currencies that are closely correlated w/ (nonactively traded) investment

currencies optimization techniques can be used to construct hedge w/ futures Ks in only a few currencies practice:

select independent major currencies w/ futures Ks available run multiple regression of domestic currency returns of portfolio on futures returns of

selected currencies use regression coefficients as hedge ratios

Insuring and Hedging w/ Options: as insurance or as hedging by accounting for relationship b/w premium and underlying exchange rate

Insuring w/ Options: o Net dollar profit on put = when K>St; = otherwise.o Not a good hedge unless variations in spot price swamp the premium

Dynamic hedging w/ options: match dollar loss (gain) in underlying w/ dollar gain (loss) in optiono Good currency hedge requires holding –V0/δ options; hedge ratio is 1/δ; (delta hedge)o Hedge ratio fluctuateso Where direction of currency movement is clearly forecasted, currency futures provider cheaper hedge

Other Methods for Managing Currency Exposure: Buying high beta equities Increase duration of foreign portfolio to foreign interest rates w/o increasing currency exposure w/ options, currency fluctuations affect mostly translation of profit into dollars not the principal (if the

underlying were bought instead) see chart on p. 314

Strategic and Tactical Currency Management: Strategic Hedge Ratio: see IPS for private investors and benchmark hedge ratio for institutional investors

o Traditional approach: minimize variance: fully hedge currencyo Total Portfolio Risk: depends on proportion of int’l assets; may add some diversificationo Asset Types: different currency sensitivitieso Investment Horizon: longer the horizon, the lower the benchmark hedge ratioo Prior Beliefs on Currencies: may see weakness in own currencyo Costs: transaction costs, administrative and monitoring; interest rate differentialo Is Regret Proper Measure for Currency Risk? Hedge 50% to minimize regret?

Currency Overlay: manage currency risks in existing portfolio; not to speculateo Given parameters on hedge ratios and max level of tracking error relative to benchmark; or set of

acceptable currencieso Tactical approaches:


Management of the Currency Risk Profile: active risk management through dynamic hedging or option-based approaches: protect from downside and allow for upside potential

Technical Approach: exploit temporary market inefficiencies by identifying predictable price patterns and volatility

Fundamental Approach: economic analysis o Shouldn’t separate asset allocation from currency exposure: currency overlays are suboptimal

Currencies as an Asset Class: o Low correlation b/w currencies and equities; also low b/w currencies and bondso Absolute return basis: currency for alpha funds

Reading 41: Risk Management Applications of Forward and Futures Strategies

Strategies and Applications for Managing Equity Market Risk:

Beta:

o Dollar beta: beta times portfolio value; for futures, beta times futures price

o Number of futures contracts to obtain target beta:

Creating equity out of cash: long stock = long risk-free bond + long futures

o Rounded off number of futures contracts to buy: ; resulting investment is no longer V

but V*: ; and dividends are treated as reinvested and result in larger number of contracts

than if just received the dividends, the implicit number of contracts starting with (growing to the

previous number of contracts by the dividend reinvestment) is ; however transaction does not

actually capture dividends, just the performance of the indexo Equitizing Cash: do above transaction; maintains liquidity of casho Consider the under/over pricing of the futures

Creating Cash out of Equity: Long stock + short futures = Long risk-free bondo Effectively convert (V/S)(1+δ)T to cash;

o

o

Asset Allocation w/ Futures: If reducing equity position, use futures to reduce the beta of the dollar amount of such reduction to zero: say

want to turn $10M of equity position to bonds, sell futures such that beta on $10M is zero; then buy bond futures.

o For the bonds:

Pre-Investing in an Asset Class: don’t have the cash currently, but will in future; long underlying + loan = long futures; like a fully leveraged position in the underlying;

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Transaction exposure: risk of exchange rate movement on a somewhat predictable future cash flow in foreign currency (say a co’s foreign sales)

Translation exposure: need to consolidate balance sheets of foreign subs Economic exposure: say reduced sales when currency appreciates Transaction exposure:

o Managing risk of foreign currency receipt: as if long the foreign currency; lock in exchange rate by selling forward (short)

o Managing risk of foreign currency payment: as if short the foreign currency; lock in exchange rate by buying forward (long)

o Managing risk of foreign-market asset portfolio: future value of portfolio unknown; If only foreign stock market return hedged, portfolio return is foreign risk-free rate b/f

converting to domestic currency; if both foreign stock market and exchange rate risk are hedged, return equals domestic risk-free rate

Futures or Forwards? Risks that have specific dates: use forwards Forward market been around for longer than futures market and is liquid Dealers of forwards use futures to quickly hedge their own risk Forwards allow to keep private transaction activity

Reading 42: Risk Management Applications of Option Strategies

Risk Management Strategies w/ Options and the Underlying: Reduce exposure to underlying by: 1. selling a call; or 2. buying a put. Covered call: underlying plus short call.

o Profit: Protective put: underlying plus long put

o Profit: o Can be viewed as insurance

Money Spreads:o (as compared to time spreads: which differ by expiration date)o Bull spreads: makes money if market rises: long position in call w/ exercise price and short position in

call w/ higher exercise price Value at expiration:

Profit:

Maximum profit = Maximum loss = Breakeven price:

o Bear spreads: makes money if market goes down: sell call w/ exercise price and buy call w/ higher exercise price; or: buy put w/ exercise price and sell put w/ lower exercise price

Value at expiration:

Profit:

Maximum profit = Maximum loss = Breakeven:

o Butterfly spreads: combines bull and bear spread: buy calls w/ exercise price X1 and X3 and sell two calls w/ exercise price X2


Value at expiration:

Profit:

Maximum profit = Maximum loss = Breakeven: and Strategy based on expectation of low volatility in underlying; profitable if less volatility than

market expects; if expect to be more volatile than market expects, sell the butterfly spread Can create w/ puts: buy puts w/ exercise prices X1 and X3 and sell two puts w/ exercise price

X2. Combinations of Calls and Puts: (aka range forward or risk reversals)

o Collars: underlying plus long put plus short call zero-cost collar: premium received for call offsets premium paid for put Value at expiration:

Profit: ; (assuming zero-cost collar) maximum profit = X2 – S0

maximum loss = S0 – X1

breakeven: o Straddle: buy call and put as same price; bet on large volatility

makes sense only when investor believes market will be more volatile than everyone else value at expiration:

profit:

maximum profit = ST – c0 – p0;

maximum loss = c0 + p0

breakeven ST*= ST + c0 + p0 or ST – (c0 + p0)

o Strap: add call to straddleo Strip: add put to straddleo Strangle: straddle with different exercise prices; similar graph as straddle but w/ flat section in stead of

point on bottomo Box Spreads: combination bear and bull spread: buy call w/ exercise price X1 and sell call w/ exercise

price X2 and buy put w/ exercise price X2 and sell put w/ exercise price X1. value at expiration: ;

thus: X2 – X1

profit: maximum profit = (same as profit) maximum loss = (no loss possible, given fair option prices) Breakeven: no breakeven; transaction always earns risk-free rate, given fair option prices

Interest Rate Option Strategies: calls pay off if option expires w/ underlying interest rate above exercise rate (used by / benefits borrowers);

puts pay off if option expires w/ underlying interest rate below exercise rate (used by / benefits lenders). payoff of interest rate call option: (notional principal) max(0,Underlying rate at expiration – Exercise rate)

(Days in underlying rate / 360). say borrow at LIBOR and want cap on interest rate paid payoff of interest rate put option: (notional principal) max(0,Exercise rate – Underlying rate at expiration)

(Days in underlying rate / 360). say lend at LIBOR and want floor on interest rate received Interest rate cap w/ floating-rate loan: Cap: series of interest rate call options w/ same exercise rate on

individual capletso note that first payment is set at start so makes no sense to set cap on such known rate


Interest rate floor w/ floating-rate loan: floor: series of interest rate put options w/ same exercise rate on individual floorlets

Interest rate collar w/ floating-rate loan: long cap plus short floor (to offset some or all of premium). (usually used by borrowers, but could be reversed for a lender)

Option Portfolio Risk Management Strategies: could lay off risk using put-call parity: c = p + S-X/(1+r)T; not commonly employed b/c of availability and

pricing could delta hedge:

o delta = change in option price / change in underlying price

o

o but gamma gamma = change in delta / change in underlying price as expiration approaches, deltas of in-the-money options will move toward 1.0 and deltas of

out-of-the money options will move towards 0.0. So if close to expiration and at-the-money, can have fast moves to 1.0 or to 0.0

o delta constantly changing (price and time) further away the underlying price moves from current price, the worse the delta-based

approximation and effects are asymmetric for calls, delta underestimates effects of increases in underlying and overestimates

effects of decreases in underlyingo some error from roundingo delta is the N(d1) term in Black-Scholeso use continuously compounded rateso can delta hedge with a similar option rather than underlying: need delta b/w the optionso any additional funds released from selling underlying or other options are invested in risk-free bonds

Vega and Volatility Risk: vega = change in option price / change in volatilityo option more sensitive to vega when at-the-money

bullish equity investors buy calls; bullish bond investors buy puts

Reading 43: Risk Management Applications of Swap Strategies

Using Interest Rates Swaps to Convert a floating-rate loan to a fixed-rate loan (and vice versa) (swaps are most common instrument used to manage interest rate risk) duration: pay-fixed is similar to long position in floating-rate bond and short position in fixed-rate bond. swaps function as hedge from planning and accounting perspective, but tremendously speculative from market

value perspective

Using Swaps to Adjust Duration of Fixed-Income Portfolio: pay-fixed: duration of floating-rate bond minus duration of fixed-rate bond: value is negative

; NP is notional principal of swap; B is value of bond portfolio

approximation of duration of swap: 75% of the maturity minus (1 divided by 2 times the frequency of the floating payments); so for 4 year maturity w/ quarterly floating payments: .75 x 4 – 0.125 = 2.875.

Using Swaps to Create and Manage Risk of Structured Notes: Structured Notes: short- or intermediate-term floating-rate securities w/ feature: leverage, or inverse feature,

etc.document.doc

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using swaps to create and manage risk of leveraged floating-rate notes (leveraged floating-rate note or leveraged floater): issue structured note w/ say 1.5 times LIBOR interest payments; invest 1.5 times proceeds (not clear where extra .5 comes from) in fixed rate bonds; swap the fixed rate payment for LIBOR; swapped LIBOR payment is on a notional principal 1.5 times structured note so its payments equal the payment on the structured note.

using swaps to create and manage risk of inverse floaters: issue structured note, invest proceeds in fixed-rate note, then swap fixed rate for floating rate to match structured note

Strategies and Applications for Managing Exchange Rate Risk: Converting a loan in one currency into a loan in another currency:

o say issue bond in home country in home currency, swap proceeds for foreign currency and receive interest payments in home currency (to further pay bond payments in home country) while paying interest in foreign currency; (may have to come up with additional proceeds to cover the fixed payments on the home country bond); at end of life, undo notional amounts of swap.

Converting Foreign Cash Receipts into Domestic Currency: no exchange of notional principals; say pay fixed amount in foreign currency and receive fixed amount in home currency

Using Currency Swaps to Create and Manage Risk of Dual-Currency Bond: interest paid in one currency and principal paid in another: say multinational generates sufficient cash in foreign currency to pay interest but not enough to pay principal; (equivalent to issuing ordinary bond in one currency and combining w/ currency swap that has no principal payments)

Strategies and Applications for Managing Equity Market Risk: (to continue managing equity market risk after expiration, swap would need to be renewed periodically and

would be subject to new environment) Diversifying a Concentrated Portfolio: (say large equity gift that can’t sell)

o pay return on one equity and receive return on another equity; no exchange of principalo consider problem of negative return: could mean payment of both negative return normally to be

received from other party and payment of positive return normally to be paid. Achieving International Diversification: swap such that give up domestic market performance for return on

international marketo also consider possibility of negative cash flowo consider tracking error if keyed to indexes

Changing Asset Allocation b/w Stocks and Bonds: swap return on one class for return on another classo consider tracking error if keyed to indexeso consider cash flow problems

Reducing Insider Exposure: same as diversifying concentrated portfolioo consider issues of insiders selling (b/c not avoided by swap)

Strategies and Applications Using Swaptions: options to enter into swaps payer swaption: put equivalent on coupon bond; receiver swaption: call equivalent on coupon bond Using Interest Rate Swaption in Anticipation of Future Borrowing: Using Interest Rate Swaption to Terminate Swap: Synthetically Removing (Adding) a Call Feature in Callable (Noncallable) Debt:

o remove call by selling receiver swaption: equivalent to selling call on coupon bond; makes sense if rates not expected to fall: receive premium and if rates don’t fall swaption not exercised and not required to pay at the underlying fixed rate.

o add call by buying receiver swaption: equivalent to buying call on coupon bond; makes sense if interest rates expected to fall; pay premium, and then have ability to receive underlying fixed rate in case interest rates fall.


o (difference is that synthetically removing (adding) involves lump sum premium whereas with embedded feature, premium is allocated over time in the coupon payments)

o use payer swaptions if want to synthetically replicate put features on putable bonds. not common.

Reading 44: Execution of Portfolio Decisions

Context of Trading: Market Microstructure: Order Types:

o market order: instruction to execute order promptly in public markets at best price available emphasizes immediacy of execution; bears some degree of price uncertainty

o limit order: trade at best price available but only if price is at least as good as specified limit price emphasizes price; has execution uncertainty

o market-not-held order: where handled by broker; not-held means not required to trade at specific price or specific time interval; allows for discretion to not trade based on judgment

o Participate (do not initiate) order: variant of market-not-held: broker stays deliberately low-key and waits and responds to initiatives of more active traders (to capture better price)

o Best efforts order: even more discretion to broker to judge market conditionso undisclosed limit order: doesn’t disclose total quantity of ordero Market on open order: to be executed at opening of marketo market on close order: to be executed at market closeo (principal trade: broker buys/sells the position for self)o (portfolio trade (or program trade or basket trade): specified basket of securities; reduces risk to other

side of asymmetric info) Types of Markets: (markets provide liquidity, transparency and assurity of completion)

market fragmentation: many places to trade straight through processing: automatic settlement of trade after execution open outcry auction market: old style

o Quote-Driven (Dealer) Market: dealers establish firm prices at which securities can be bought and sold (closed-book markets: if limit order book is not visible in real time to public) bond markets are overwhelmingly dealer markets (b/c of lack of liquidity) effective spread: 2 x deviation of actual execution price from midpoint of market quote at time

order is entered (may result in effective spread lower than quoted spread)o Order-Driven Markets: transaction prices established by public limit orders

Electronic Crossing Networks: buy and sell orders are batched (accumulated) and crossed at specific point in time, usually anonymous fashion (POSIT is an electronic crossing network)

avoids dealer costs and effects a large order can have on price and information leakage volume may be low doesn’t provide price discovery (where transactions prices adjust to equilibrate supply

and demand) Auction Markets (periodic/batch auction markets or continuous auction markets): orders of

multiple buyers compete for execution (after reopening market for day may be auction market) Automated Auction (Electronic Limit-Order Markets): computer-based auctions that operate

continuously w/i day using specified set of rules to execute orderso Brokered Markets: transactions largely effected through search-brokerage mechanism away from

public markets mostly used for block transactions also in less liquidity countries

o Hybrid markets: say NYSE: batch market at opening, continuous auction market (intraday trading) and quote-driven market


Roles of Brokers and Dealerso represent the ordero find opposite side of tradeo supplying market informationo providing discretion and secrecyo providing other supporting investment serviceso supporting market mechanism

Evaluating Market Quality:o liquidity:

low bid-ask spreads market is deep market is resilient: only small discrepancies b/w market price and intrinsic value and corrected

quickly factors contributing to liquidity:

many buyers and sellers diversity of opinion, info and investment needs convenience market integrity

o transparency: pretrade transparency: quickly, easily and inexpensively obtain accurate info about quotes and

trades post-trade transparency: details of completed trades are quickly and accurately reported to

publico Assurity of the contract

Costs of Trading: transaction cost components:

o explicit costs: broker commissions, taxes, stamp duties and exchanges feeso implicit costs:

bid-ask spread market impact missed trade opportunity delay costs (b/c of size of order and liquidity of market)

o (measures) time-of-trade midqoute volume-weighted average price (VWAP): avg price security traded at during day weighted by

trade volume implementation shortfall: difference b/w money return on notional or paper portfolio in which

positions are established at prevailing price when decision to be made (decision price) and actual portfolio return

explicit costs (commissions, taxes, fees) realized profit/loss: price movement from decision price (often using previous day’s

close). though if broken over several days, each day has its own benchmark Delay costs (slippage): close-to-close price movement over day order placed when

order is not executed that day and based on amount of order actually subsequently filled; This is zero for any shares traded same day as decide to trade.

missed trade opportunity cost (unrealized profit/loss): price difference b/w trade cancellation price and original benchmark price based on amount of order that was not filled

market adjusted implementation shortfall: difference b/w money return on notional or paper portfolio and actual portfolio return, adjusted using beta to remove effect of return on market


if 1% market move and beta of 1.0, then subtract 1% from implementation shortfall; the 1% is not counted against you

Comparison of VWAP and Implementation ShortfallVWAP Implementation Shortfall

Advantages - easy to compute- easy to understand- can be computed quickly to assist traders during execution- works best for comparing smaller trades in nontrending market

- links trading to portfolio manager activity; can relate cost to value of investment ideas- recognizes tradeoff b/w immediacy and price- allows attribution of costs- can be built into portfolio optimizers to reduce turnover and increase realized performance

Disadvantages - does not account for costs of trades delayed or cancelled- becomes misleading when trade is substantial proportion of trading volume- not sensitive to trade size or market conditions- can be gamed by delaying trades

- requires extensive data collection and interpretation- imposes unfamiliar evaluation framework on traders

Pretrade analysis: Econometric Models for Costs:o factors: stock liquidity characteristics; risk; trade size relative to available liquidity; momentum;

trading style

Types of Traders and Their Preferred Order Types: Types:

o information-motivated traders: act quickly on info; need liquidity and speed of execution over better price likely use market orders and rely on market makers use less obvious orders and may use dealers

o value-motivated traders: based on slow research wait for better price and accumulate over time use limit orders

o liquidity-motivated traders: not based on info, but may simply need to release cash use market, market-not-held, best efforts, participate, principal trades, portfolio trades and

orders on ECNs and crossing networkso passive traders: work for index funds etc.

concerned about cost of trading: exchange lack of urgency for lower-cost execution use limit orders, portfolio trades and crossing networks

o day traders: rapidly buy and sell

Trade Execution Decisions and Tactics: Decisions Related to Handling Trade:

o small, liquidity-oriented trades can be packaged up and executed via direct market access (DMA; platforms sponsored by brokers that permit buy-side traders to directly access equities, fixed income, futures, and foreign exchange markets, clearing via the brokers)

o large, info-laden trades: need skill Objectives in Trading and Trading Tactics:

o Liquidity-at-Any-Cost Trading Focus: expensive but timely execution

o Costs-Are-Not-Important Trading Focus: market orders


o Need-Trustworthy-Agent Trading Focus: for larger orders best efforts, market-not-held or participate

o Advertise-to-Draw-Liquidity Trading Focus: IPOs, secondary offerings, sunshine tradeso Low-Cost-Whatever-the-Liquidity Trading Focus:

limit orders

Objectives in TradingFocus Uses Costs Advantages WeaknessesLiquidity at any cost (I must trade)

Immediate execution in institutional block size

High cost due to tipping supply/demand balance

Guarantees execution High potential for market impact and info leakage

Need trustworthy agent (possible hazardous trading situation)

Large-scale trades; low-level advertising

Higher commission; possible leakage of info

Hopes to trade time for improvement in price

Loses direct control of trade

Costs are not important

Certainty of execution

Pays the spread; may create impact

Competitive, market-determined price

Cedes direct control of trade; may ignore tactics w/ potential for lower cost

Advertise to draw liquidity

Large trades w/ lower info advantage

High operational and org costs

Market-determined price for large trades

More difficult to administer; possible leakage to front-runners

Low cost whatever the liquidity

Non-info trading; indifferent to timing

Higher search and monitoring costs

Lower commission; opportunity to trade at favorable price

Uncertainty of trading; may fail to execute and create need to complete at later, less desirable price

Automated Trading:o algorithmic trading: automated electronic trading subject to quantitative rules and user-specified

benchmarks and constraintso smart routing: use algorithms to route orders to most liquid venueso classifications of algorithmic execution systems:

Logical Participation Strategies: Simple Logical Participation Strategies:

o break up order over time according to prespecified volume profile: a VWAP strategy

o or time-weighted average price (TWAP) strategy: assumes flat volume and trades in proportion to time

o or percentage-of-volume strategy Implementation Shortfall Strategies: solves for optimal strategy to minimize trading

costs as measured by implementation shortfall Opportunistic Participation Strategies: post some orders at beneficial prices, use hidden orders

and take advantage of crossing networks, seize liquidity when arises Specialized Strategies:

passive order strategies: no guarantee of execution “hunter” strategies: seek liquidity


market-on-close algorithms: target closing price smart routing

Serving the Client’s Interests: CFA Institute Trade Management Guidelines:

o best execution: “trading process Firms apply that seeks to maximize the value of a client’s portfolio within the client’s stated investment objectives and constraints.”

intrinsically tied to portfolio-decision value and cannot be evaluated independently prospective, statistical, and qualitative concept that cannot be known with certainty ex ante has aspects that may be measured and analyzed over time on an ex post basis, even though such

measurement on a trade-by-trade basis may not be meaningful in isolation interwoven into complicated, repetitive, and continuing practices and relationships

o Trade Management Guidelines: 1. processes: formal policies and procedures aimed at best execution, and then measure 2. disclosures: general info on trading techniques and on conflicts of interest 3. record keeping: showing compliance w/ firm policies and showing necessary disclosures

Importance of Ethical Focus: any trader who does not adhere to his word quickly finds that no one is willing to deal with him; loyalty to client

Reading 45: Monitoring and Rebalancing

Monitoring: Investor Circumstances and Constraints:

o changes in investor circumstances and wealtho changing liquidity requirementso changing time horizonso tax circumstanceso changes in laws and regulationso unique circumstances: say emotional ties to holding or SRI (socially responsible investing)

Market and Economic Changes:o Changes in asset risk attributes: mean return, volatility, correlationso market cycles: tactical adjustmentso central bank policyo yield curve and inflation

Monitoring the portfolio:o events and trends affecting prospects of individual holdings and asset classeso changes in asset values that create unintended divergences from client’s strategic asset allocation

Rebalancing the Portfolio: 1. adjusting portfolio to strategic allocation; 2. changes from changes to investor’s objectives and constraints or capital market expectations; 3. tactical asset allocation. here, discuss only 1.

cost/benefit: o drifts from strategic allocation results in expected utility losso level of portfolio risk may drift upward (higher risk returning more and taking greater % of portfolio)o drift toward holding over priced assets

rebalancing by selling appreciated assets and buying depreciated assets can be seen as contrarian

o transaction costs: explicit costs

illiquid assets; but may be able to accomplish some of rebalancing through cash flows


implicit costs bid-ask spread market impact

o tax costs: incur short- or long-term capital gains; reduces deferral benefit from long-term capital gains Rebalancing disciplines:

o Calendar rebalancing: on periodic basiso Percentage-of-Portfolio Rebalancing:

ad hoc approaches: say +/- 5% points of target allocation, or +/- 10% of target allocation %: target +/- (target allocation x P%).

ad hoc doesn’t account for 1. transaction costs; 2. risk tolerance: tracking risk v. strategic asset allocation; 3. correlation; 4. volatility; 5. volatilities of other asset classes

Factors Affecting Optimal Corridor WidthFactor Effect on Optimal Width of Corridor (All

Else Equal)Intuition

Factors positively related to optimal corridor widthTransaction costs The higher the transactions costs, the wider

the optimal corridorHigh transaction costs set a high hurdle for rebalancing benefits to overcome

Risk tolerance The higher the risk tolerance, the wider the optimal corridor

Higher risk tolerance means less sensitivity to divergences from target

Correlation w/ rest of portfolio

The higher the correlation, the wider the optimal corridor

When asset classes move in synch, further divergence from targets is less likely

Factors inversely related to optimal corridor widthAsset class volatility

The higher the volatility of a given asset class, the narrower the optimal corridor

A given move away from target is potentially more costly for a high-volatility asset class, as a further divergence becomes more likely

Volatility of rest of portfolio

The higher this volatility, the narrower the optimal corridor

Makes large divergences from strategic asset allocation more likely

o Calendar-and-Percentage-of-Portfolio Rebalancing: monitor say quarterly and rebalance only if % outside corridor

o Equal Probability Rebalancing: corridor for each asset class as a common multiple of standard deviation of asset class’s return

o Tactical rebalancing: calendar rebalancing but less frequent when markets trending and more frequent when reversal occurring

rebalancing to target weights v. to allowed range: latter allows from tactical adjustments; better manage weights of relatively illiquid assets

setting optimal thresholds: minimize expected utility losses and transaction costs

Perold-Sharpe Analysis of Rebalancing Strategies: Buy-and-Hold Strategies: buy risky asset and risk-free asset and do nothing

o portfolio value = investment in stocks + floor value (e.g., risk free asset value)o upside is unlimited, but portfolio value can be no lower than allocation to billso portfolio value is linear function of value of stocks, and portfolio return is linear function of return on

stockso value of stocks reflects cushion (above floor value)o implication of using this strategy is that investor’s risk tolerance is positively related to wealth and

stock market returns. risk tolerance is zero if value of stocks declines to zero. Constant-Mix Strategies: always rebalancing; contrarian and supplies liquidity

o Target investment in stocks = m x portfolio value


o consistent w/ risk tolerance that varies proportionately w/ wealth Constant-Proportion Strategy: CPPI: dynamic strategy in which target equity allocation is function of value of

portfolio less floor value: o Target investment in stocks = m x (portfolio value – floor value)o consistent w/ zero tolerance for risk when cushion is zeroo if m is greater than 1, then: constant-proportion portfolio insurance (CPPI)

consistent w/ higher tolerance for risk than buy-and-hold strategy sell shares as stock value declines and buy shares as stock values rise

Relative Return Performance of Different Strategies in Various MarketsMarket Condition Constant Mix Buy and Hold CPPIUp Underperform Outperform OutperformFlat (but oscillating) Outperform Neutral UnderperformDown Underperform Outperform OutperformInvestment ImplicationsPayoff curve Concave Linear ConvexPortfolio insurance Selling insurance None Buying insuranceMultiplier 0 < m < 1 m = 1 m > 1

Execution Choices in Rebalancing: cash market trades: actually transact in the asset: more costly and slower derivative trades: say futures Ks and total return swaps; lower transaction costs; rapid implementation; leaves

active managers’ strategies undisturbed

Reading 46: Evaluating Portfolio Performance

Fund Sponsor’s Perspective: enhances effectiveness of fund’s investment policy by acting as feedback and control mechanism

Investment Manager’s Perspective: feedback and control loop, helping to monitor proficiency of various aspects of portfolio construction process

3 components of performance evaluation: 1. account’s performance? (performance measurement) 2. why did account produce observed performance? (performance attribution) 3. luck or skill? (performance appraisal)

Performance Measurement: w/o intraperiod external cash flows

o

o cash flow at start of period:

o cash flow at end of period:

Total Rate of Return: measures increase in investor’s wealth due to both investment income and capital gains Time-Weighted Rate of Return (TWR): compound rate of growth over stated evaluation period of one unit of

money initially invested in the account; requires account be valued every time external CF occurso chain linking: create wealth relative by adding return to 1; multiply all wealth relatives for cumulative

wealth relative; subtract one; or take to time period power to weight by time


o requires valuation on each date of CF Money-Weighted Rate of Return (MWR): the IRR

o

Linked Internal Rate of Return: take MWR of frequent periods and chain-link those (account valuations should be reported on trade-date, fully accrued basis: that is stated value of account should

reflect impact of unsettled trades and any income owed by or to the account but not yet paid)

Benchmarks: P = M + S + A: portfolio performance is equal to market return plus style return (together the benchmark

return) plus the active management return Properties of Value Benchmark:

o unambiguouso investableo measurableo appropriateo reflective of current investment opinionso specified in advanceo owned

Types of Benchmarks: o absolute: say a return objective; not investable and not really valid benchmarko manager universes: median manager or fund from broad universe; measurable, but not otherwise valid

benchmark critique of median manager benchmark: not investable, is ambiguous, can’t verify

appropriateness, subject to survivor biaso Broad market indexes: say S&P 500; may not reflect styleo Style Indexes: still may not reflect manager’s styleo Factor-Model-Based:

market model is one factor (beta) normal portfolio: portfolio w/ exposures to sources of systematic risk that are typical for

manager, using manager’s past portfolios as guideo Returns-Based: constructed using 1. series of manager’s account returns (ideally monthly and back to

beginning) and 2. series of returns on several investment style indexes over same period; allocation algorithm solves from combination of investment style indexes that most closely tracks account’s return

o Custom Security-Based: simply manager’s research universe weighted in a particular fashion Building custom security-based benchmarks: steps:

identify prominent aspects of manager’ investment process select securities consistent w/ investment process devise weighting scheme for benchmark securities, including cash position review preliminary benchmark and make modifications rebalance benchmark portfolio on predetermined schedule

o Tests of Benchmark Quality: minimal systematic biases or risks in benchmark relative to account tracking error: should reduce noise in performance evaluation process risk characteristics: should systematically differ over time (okay to rotate from greater and

lesser, but shouldn’t stay on one side) coverage: should have high overlap of securities turnover: of the benchmark: if too high, then not really investable positive active positions: high proportion of positive active positions is good; high proportion

of negative active positions indicates not very good benchmark fitdocument.doc

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o Hedge Funds and Hedge Fund Benchmarks: tend to be “absolute return”, have investment strategies that incorporate high degree of optionality (skewness), but usually have clearly definable investment universes

Performance Attribution: identifies differential returns (on fund sponsor level: macro attribution; on investment manager level: micro attribution) Impact equals (active) weight times return Macro Attribution: 1. policy allocations; 2. benchmark portfolio returns; and 3. fund returns, valuations, and

external cash flowso analysis: break return down to 6 levels:

1. net contributions: net cash inflows/outflows (basically starting point) 2. risk-free asset: as if all invested in risk-free asset 3. asset categories: incremental return over risk-free return from policy asset allocation:

; (if stopped here, would be all-passive approach)

4. benchmarks: incremental return from weighted average benchmark returns:

; calculated by multiplying each manager’s policy proportion of

the total fund’s beginning value and net external cash inflows by difference b/w the manager’s benchmark return and the return of the manager’s asset category, and then summing across all managers; (if stop here, would be passive in the benchmark)

5. investment managers (value of active management): ;

assumes that fund sponsor has invested in each of the managers according to managers’ policy allocations

6. allocation effects: incremental contribution from difference b/w fund’s ending value and value calculated at investment manager level

Micro attribution: investment results of individual portfolios relative to designated benchmarks

o value added: ; from both differing weights and differing returns from

securities selection: outperform only if both positive or both negative; underperform if one negative and other positive (e.g., overweighting underperforming securities, or underweighting outperforming securities)

o factor models (instead of looking at each individual security): market model is just beta. sector weighting/stock selection micro attribution:

return may be weighted sum of sectors: and thus difference to actual return is from

security selection:

based on buy and hold: so category for trading and other to catch these effects

o pure sector allocation return: equals difference b/w allocation (weight) of portfolio to given sector and portfolio’s benchmark weight for that sector, times the difference b/w the sector benchmark’s return and the overall portfolio’s benchmark return, summed across all sectors


o within-sector selection return: equals difference b/w return on portfolio’s holdings in given sector and return on corresponding sector benchmark, times weight of benchmark in that sector, summed across all sectors

o allocation/selection interaction return: joint effect of portfolio managers’ and security analyst’s decisions to assign weights to both sectors and individual securities: difference b/w weight of portfolio in given sector and portfolio’s benchmark of that sector, times difference b/w portfolio’s and benchmark’s returns in that sector, summed across all sectors

can also have factor model based on fundamentals: company’s size, industry, growth characteristics, financial strength, and other factors

o Fixed Income Attribution: instead of sectors: gov’t bonds, agency and investment-grade corporate credit bonds, high-yield

bonds, mortgage-backed securities, etc. determinants: changes in general level of interest rates; changes in sector, credit quality,

individual security differentials or nominal spreads to yield curve yield curve twists, steepening, flattening Total portfolio return:

effect of external interest environmento return of default-free benchmark assuming no change in forward rateso return due to change in forward rates

contribution of management process:o return from interest rate management: performance from predicting interest rate

changes (also duration, convexity, and yield-curve shape change)o return from sector/quality management: from selecting right issuing sector and

quality groupo return from selection of specific securities: specific securities w/i sectoro return from trading activity: effect from sales and purchases (residual)

Performance Appraisal: skill? (investment skill: ability to outperform appropriate benchmark consistently over time) Risk-Adjusted Performance Appraisal Measures:

o ex post alpha (Jensen’s alpha): ; alpha is the measure

o Treynor measure (reward-to-volatility or excess return to nondiversifiable risk): ; bars

indicate average values over time

o Sharpe ratio (reward to variability):

o M2: mean incremental return over market index of hypothetical portfolio formed by combining account w/ borrowing or lending at risk-free rate so as to match standard deviation of market index; measures what account would have returned if it had taken on the same total risk as market index:

o Information ratio:

Quality Control Charts:o cumulative annualized value-added: x-axis is time and y-axis is benchmark return; alpha will be a

jagged line around the benchmark return (set to zero); funnel-shaped confidence interval set around


benchmark return; skill would be expected to exceed the benchmark return and (at least some of the time) be outside of the confidence funnel.

if inside the funnel, then can’t reject null hypothesis that manager has no skill.

Practice of Performance Evaluation: 6 criteria for manager selection (among finalists):

o 1. physical: organizational structure, size, experience, other resourceso 2. people: investment professionals, compensationo 3. process: investment philosophy, style, decision makingo 4. procedures; benchmarks, trading, quality controlo 5. performance: results relative to an appropriate benchmarko 6. price: investment management fees

manager continuation policies (MCP): policy for deciding whether to replace a managero manager monitoring: identify warning signso manager review: if manager monitoring identifies item of sufficient concern to trigger reviewo MCP as filter: null hypothesis is that managers under evaluation are best zero-value-added managers:

Type I error: keeping (or hiring) managers w/ zero value-added (rejecting null hypothesis when it is correct); (course filter creates this error)

Type II error: firing (or not hiring) managers w/ positive value-added (not rejecting null hypothesis when it is incorrect); (fine filter creates this error)

Reading 47: Global Performance Evaluation

Performance Attribution in Global Performance Evaluation: return in local currency: capital gains in percent plus dividend yield return in base currency:

o

o ; or

total return is weighted average return of returns of all segments:

Performance Attribution: o

o

o Asset allocation:

here Ij0 is return on market index j, translated into base currency 0: Ij0 = Ij + Cj

o can also attribute based on: Market timing Industry and Sectors Factors and Styles Risk Decomposition

o Measuring active currency exposure relative to benchmark: document.doc

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any deviations from benchmark should be thought of as active exposure using derivatives:

linear approximation for forward sale: : exchange rate movement plus interest rate differential

overall currency component is sum of: 1. currency component of passive benchmark; 2. currency allocation contribution; 3. return on currency hedges

Multiperiod Attribution Analysis: o correct multiperiod attribution is not equal to either simple sum of individual periods or compound

return of individual periods; o two-period attribute can be decomposed into first-period attribution compounded at second-period

benchmark rate of return plus the second-period attribution compounded at the first-period portfolio rate of return

o performance evaluation services may use different methods of allocating cross products

Performance Appraisal in Global Performance Evaluation: Risk: 1. calculate absolute risk; 2. calculate risk relative to benchmark Absolute:

o ; if monthly, annualize by multiplying by

Relative risk: Tracking Error:

o

Risk-Adjusted Performance: o Sharpe ratioo Treynor ratioo Jensen measureo (consider problems from what constitutes “passive” world market portfolio)o Information ratio

Risk Allocation and Budgeting: 1. absolute risk allocation among asset classes; 2. active risk allocation of managers in each asset class

Potential Biases in Risk and Return:o infrequently traded assetso option-like investment strategieso survivorship bias: returno survivorship bias: risk

Implementation of Performance Evaluation: benchmarks: consider

o individual country/market weightso countries, industries, and styles: industry factors have grown in importanceo currency hedging: publicly available market indexes are generally not hedged against currency

movements

Reading 48: Global Investment Performance Standards

GIPS governance: GIPS Executive Committee (formerly Investment Performance Council)

i. Four standing subcommittees:


GIPS Council: works w/ Country Sponsors in development, promotion and maintenance of standards

Interpretations Subcommittee: provides guidelines for new issues Practitioners/Verifiers Subcommittee: forum for 3rd-party service providers who apply

and implement GIPS Investors/Consultants Subcommittee: forum for end-users of GIPS info

GIPS:Preface: Background of the GIPS Standards

I. Introductiona. Preamble: Why Is a Global Standard Needed?b. Vision Statementc. Objectivesd. Overviewe. Scopef. Complianceg. Implementing a Global Standard

II. Provisions of the Global Investment Performance Standards0. Fundamentals of Compliance1. Input Data2. Calculation Methodology3. Composite Construction4. Disclosures5. Presentation and Reporting6. Real Estate7. Private Equity

III. Verificationa. Scope and Purpose of Verificationb. Required Verification Proceduresc. Detailed Examinations of Investment Performance Presentations

Appendix A: Sample GIPS-Compliant PresentationsAppendix B: Sample List and Description of CompositesAppendix C: GIPS Advertising GuidelinesAppendix D: Private Equity Valuation PrinciplesAppendix E: GIPS Glossary

GIPS:Preface: Background of the GIPS Standards

IV. Introductiona. Preamble: Why Is a Global Standard Needed?b. Vision Statementc. Objectivesd. Overview

i. Firms required in include “all actual fee-paying, discretionary portfolios in aggregates, known as composites, defined by strategy or investment objective.

ii. Show history for min of 5 yrs or since inception, and then add on yrs to build 10-yr recorde. Scopef. Complianceg. Implementing a Global Standard

V. Provisions of the Global Investment Performance Standards


0. Fundamentals of Compliancei. Must be firm-wide basis; the firm: “an investment firm, subsidiary, or division held out to

clients or potential clients as a distinct business; a distinct business entity is a “unit, division, department, or office that is organizationally and functionally segregated from other units, divisions, departments, or offices and retains discretion over the assets it manages and should have autonomy over the investment decision-making process.

ii. Must document in writing policies and procedures used in establishing and maintaining compliance w/ GIPS

iii. Compliance statement: “[Name of firm] has prepared and presented this report in compliance with the Global Investment Performance Standards (GIPS®).”

iv. Must “make every reasonable effort” to provide all prospective clients w/ a compliant presentation

v. Must provide a list and description of all composites to any prospective client asking, and must provide upon request compliant presentation for any composite listed. Discontinued must stay on list for 5 yrs.

vi. Recommends verification (which must be firm-wide). Verification language: “[Name of firm] has been verified for the periods [dates] by [name of verifier]. A copy of the verification report is available upon request.”

1. Input Datai. All data and info necessary … captured and maintained

ii. Portfolio valuations: market rather than cost or bookiii. Trade-date accounting req’d: the “transaction is reflected in the portfolio on the date of the

purchase or sale, and not on the settlement date.”iv. Accrual accounting req’d for fixed-income securities and other assets that accrue interestv. Frequency and timing of portfolio valuations: beginning 1/1/10: on the date of all large external

cash flows; and as of the calendar month-end or the last business day of the month2. Calculation Methodology

i. Time-Weighted Total Return adjusted from cash flows req’d:

1. simplest form:

2. when external cash flows: “value portfolio whenever an external cash flow occurs, compute a subperiod return, and geometrically chain-link subperiod returns expressed in relative form: ; rt,1 through rt,n are subperiods.

3. (used to be able to use from 1/1/05 until 1/1/10 the Original Dietz method reflecting

midpoint assumption:

4. daily weighted CFs required after 1/1/05 but not after 1/1/10:

a. Modified Dietz: ; where CD is total

calendar days in month and D is the # of days from beginning of month that CF occurs (so 5 for CF on the 5th).

b. Modified or Linked IRR: solve for r:

5. returns from cash and cash-equivalents must be included in total return calculations6. returns must be calculated after deduction of actual—not estimated—trading expenses

(but not custody fees)a. if bundled fees (all-in fees and wrap fees) and not extricable, then deduct entire

fee7. recommendation: calculate returns net of nonreclaimable withholding taxes on

dividends, interest and capital gains (but accrue reclaimable withholding taxes)document.doc

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8. Composite return calc standards: “Composite returns must be calculated by asset-weighting the individual portfolio returns using beginning-of-period values or a method that reflects both beginning-of-period values and external cash flows.”

a. Denominator of method using beginning-value plus external CFs:

b. So, composite return using just beginning:

c. composite return using beginning and external CFs:

d. after 1/1/10, composite returns must be calculated monthly using monthly asset-weighting.

3. Composite Construction: “All actual, fee-paying, discretionary portfolios must be included in at least one composite. Although non-fee-paying discretionary portfolios may be included in a composite (with appropriate disclosures), nondiscretionary portfolios are not permitted to be included in a firm’s composites.”

i. Discretionary: if the manager is able to implement the intended investment strategy. Restrictions that impede investment process to extent that strategy cannot be implemented as intended: presumed nondiscretionary.

ii. Defining investment strategies: must be defined according to similar investment objectives and/or strategies, and the full composite definition as documented in the firm’s policies and procedures must be made available upon request.

1. suggested hierarchy: Investment Mandate | Asset Classes | Style or Strategy | Benchmarks | Risk/Return Characteristics

iii. including and excluding portfolios: must include new portfolios on a timely and consistent basis after the portfolio comes under management unless specifically mandated by the client. Preferably, beginning of next full performance measurement period. Must include terminated portfolio in historical record of the appropriate composite up to last full measurement period.

1. cannot be switched from one composite to another unless documented changes in client guidelines or the redefinition of the composite make it appropriate. Historical record must remain in composite.

2. recommendation: event of significant external CFs, use temporary new accounts rather than temporarily removing portfolios from composites. May be compelled to temporarily remove portfolios from composites when large external CFs occur.

3. if minimum asset level threshold for inclusion, must strictly follow that policy: none below can be included. May require time threshold so that temporarily devalued portfolios don’t go in and out of composite. Any changes to minimum threshold: cannot be applied retroactively. Firm should not market composite to prospective clients falling below minimum threshold.

iv. Carve-Outs: cannot exclude cash; “When a single asset class is carved out of a multiple asset class portfolio and the returns are presented as part of a single asset composite, cash must be allocated to the carve-out returns in a timely and consistent manner.” 2 acceptable cash allocation methods: “Beginning of period allocation” and “Strategic asset allocation” (for strategic: the cash amount is the deviation for the target: so 2.5% when target is 37.5% and actual is 35%.). From 1/1/10, carve-out returns cannot be included in single-asset-class composite returns unless the carve-out is actually managed separately with its own cash balance.

4. Disclosuresi. Def of “firm”; if re-defined, disclose date and re-def

ii. All significant events that help interpret performance record


iii. Use of subadvisors and periods for which usediv. Make available complete list (last 5 yrs) and description of all compositesv. Recommended: disclose firms w/I parent company

vi. Recommended: if verified, disclose and periods verified if not allvii. Currency to express performance; disclose and describe exchange rate inconsistencies among

composites and b/w composite and benchmarkviii. Treatment of withholding tax

ix. Tax basis of benchmark vs. composite (Lux vs. U.S.)x. Disclose availability of add’l info on calc and reporting returns (e.g., methodology, valuation

sources, treatment of large external CFs)xi. Recommended: disclose when change of calc methodology or valuation sources has material

impactxii. Fees: clearly label returns gross of or net of; for gross of, also disclose whether anything other

than direct trading expenses deducted; for net of, also disclose whether anything other than direct trading expenses and investment management fee deducted; disclose appropriate fee schedules; if bundled-fee, present % of portfolios for each annual period that are such and disclose various types of bundled fees.

xiii. Investment objectives, style, and strategy of composite (more than broadly indicative name)xiv. Composite creation datexv. Measure of dispersion and which measure

xvi. If minimum asset level for inclusion in composite, disclose minimum and any changes theretoxvii. Presence, use and extent of leverage or derivatives, if material, including use, frequency and

characteristics of instrumentsxviii. Whether conforms to local laws and regs that differ from GIPS, and disclosure of such conflict

5. Presentation and Reportingi. Show at least 5 yrs and extend thereafter until 10 yrs

ii. Annual returns (calendar yr unless noncalendar fiscal yr); number of portfolios; amount of assets in composite; % of total firm assets composite represents or total firm assets; measure of dispersion of individual portfolio returns if >=6 portfolios (high/low, interquartile range, standard deviation)

iii. Can link to prior-to-1/1/00 non-GIPS-compliant performance if disclosediv. Cannot annualize partial-year returnsv. “portability”

1. Prior affiliation performance must be linked if: 1. substantially all the investment decision-makers are employed by the new firm; 2. staff and decision-making process remain intact and independent w/ the new firm; and 3. new firm has records that document and support the reported performance.

2. linking must be disclosed3. can be linked if: substantially all of the assets from past firm’s composite transfer to the

new firm4. one yr to comply if GIPS-compliant firm acquires noncompliant firm

vi. single-asset-class carve-outs from multiple-asset-class portfolios: presentation must include % of composite that is composed of carve-outs from 1/1/06 forward.

vii. Benchmarks: benchmarks reflecting composite’s investment strategy or mandate must be presented for each annual period; if none shown, must explain why; dates and reasons for changes of benchmarks must be presented; for custom benchmarks, describe benchmark creation and rebalancing process; once established, rebalancing must be consistently applied

viii. If composite includes any non-fee-paying portfolios, must present % of composite.ix. Recommended: present composite performance gross of investment management and

administrative fees and before taxes except for nonreclaimable withholding taxes.x. Recommended: present cumulative composite and benchmark returns


xi. Recommended: present equal-weighted mean and median returns for each compositexii. Recommended: present composite-level country and sector weightings

xiii. Recommended: present charts and graphsxiv. Recommended: present risk measures: beta, tracking error, modified duration, information

ratio, Sharpe ratio, Treynor ratio, credit ratings, value at risk and volatility or variability of composite and benchmark

6. Real Estatei. Publicly traded real estate securities, securities issued by public companies, CMBSs and private

debt investments (including commercial and residential loans for which the expected return is solely related to contractual interest rates w/o any participation in the economic performance of the underlying real estate) are treated under the regular GIPS standards and not the real estate standards. Portfolio holding both must carve out.

ii. Despite regular GIPS, must be valued quarterly internally or externally, valued every 12 months externally and “Real estate investments must be valued by an external professionally designated, certified or licensed commercial property valuer/appraiser at least once every 36 months.”

iii. Must present methods, sources, and frequency of valuations; also asset-weighted % of composite real estate assets valued by an external valuation for each period as well as frequency w/ which real estate investments are valued by external valuers.

iv. Must describe definition of discretion; generally: if manager has sole or primary responsibility for major investment decisions.

v. Must present total return w/ income and capital appreciation breakdown; and calculation methodology (e.g., whether chain-linked time-weighted; or adjusted to make the capital return and income return equal total return); adjust for time-weighted cash flows

1. capital employed:

2. capital return: ; where E is capital expenditures and S is sale

proceeds

3. income return: ; INC is income accrued, E is

nonrecoverable expenditures, INT is interest on debt and T is property taxes4. total return: rT = rC + rI

vi. recommended: present capital and income segments of the appropriate real estate benchmarkvii. recommended: annual/annualized since-inception IRR for composite: SI-IRR; should disclose

time period and frequency of cash flows; should use quarterly cash flows at minimum.viii. Recommended: present time-weighted rate of return and SI-IRR gross and net of fees, and

reflecting ending market value and also reflecting only realized cash flows excluding unrealized gains.

7. Private Equityi. Open-end and evergreen funds subject to regular GIPS standards and not PE standards

ii. Private Equity Valuation Principals1. obligate firms to ensure that valuations are prepared w/ integrity and professionalism by

individuals w/ appropriate experience and ability under direction of senior management and in accordance w/ documented review procedures

2. valuation basis must be divulged3. clearly disclose methodologies and key assumptions4. logically cohesive and rigorously applied5. must recognize events that diminish an asset’s value6. present on consistent and comparable basis from one period to next; any change in

valuation basis or method must be disclosed


7. valuations at least annually, but quarterly recommended8. recommended: valuations on fair value basis; hierarchy:

a. market transactions (e.g., most recent arms-length financing)b. market-based multiplesc. risk-adjusted discounted expected cash flows

iii. must disclose net-of-fees (including net of carried interest, investment management fees and transaction expenses; net of investment advisors fees … if applicable) and gross-of-fees SI-IRR of composite for each year; use daily or monthly CFs and end-of-period valuation of unliquidated holdings remaining in composite; stock distributions valued at time of distribution

iv. all closed-end PE investments to be included in composite defined by strategy and vintage year; direct investments and investments made through other funds or p’ships must be in separate composites

v. must disclose: 1. vintage years, 2. composite investment strategy, 3. total committed capital for composite, 4. valuation methodologies and change thereof, 5. if also complies w/ local or regional guidelines, 6. that valuation review procedures are available upon request7. if fair value not used, why, number of investments not fair valued and their carrying

value in absolute amount and relative to total fund8. unrealized appreciation or depreciation of composite for most recent period9. whether using daily or monthly CFs for SI-IRR10. if benchmarks disclosed, disclose calc methodology for benchmark and cumulative

annualized SI-IRR; if no benchmark disclosed, explain why11. if not calendar, disclose period-end used12. for discontinued PE composites: final realization or liquidation date must be stated13. funding status: cumulative paid-in-capital (including paid-in but not yet invested), total

current invested capital, cumulative distributions paid out to investors in cash or stock, TVPI, DPI, PIC, RVPI

14. recommended: disclose average holding period of investments over lifeVI. Verification: review of performance measurement policies, processes, and procedures by an independent

third-party for purposes of establishing that a firm claiming compliance has adhered to the GIPS standarda. Scope and Purpose of Verification:

i. Verification can only be as to whole firm; may have a detailed Performance Examination conducted on a composite thereafter

ii. Minimum verification period is one yeariii. Verification report must confirm that firm has complied w/ all composite construction

requirements of GIPS on firmwide basis and that firm’s processes and procedures are designed to calculate and present performance results in compliance w/ GIPS

iv. Must have report to claim verificationv. If not fully compliant, verifier must provide report to firm stating why cannot issue verification

reportvi. Minimum knowledge-based qualifications for verifiers

b. Required Verification Proceduresi. Learn about firm, firm’s performance-related policies and valuation basis for performance

calculationsii. Obtain selected samples of investment performance reports and other available info

iii. Determine firm’s assumptions, policies and procedures for establishing and maintaining compliance including:

1. written def of investment discretion and guidelines therefor


2. list of composite definitions w/ written criterion for including account w/i3. policy regarding timeframe for including new accounts in and excluding closed

accounts from composite4. policies re input data: dividend and interest income accruals and market valuations,

portfolio and composite return calculation methodologies including assumptions on timing of CFs, presentation of composite returns

5. info on use of leverage and derivatives, investments in securities or countries not included in composite’s benchmark, timing of implied taxes on income and realized cap gains if firm reports on after-tax basis

6. “any other policies and procedures relevant to performance presentation”iv. Stuff to gather:

1. sample performance presentations and marketing materials2. all of firm’s performance-related policies, such as firm’s definition of discretion, the

sources, methods, and review procedures for asset valuations, the time-weighted rate-of-return calculation methodology, the treatment of external cash flows, the computation of composite returns, etc.

3. complete list and description of composites4. composite definitions, including benchmarks and written criteria for including accounts5. list of all portfolios under management6. all investment management agreements or contracts, and clients’ investment guidelines7. list of all portfolios that have been in each composite during the verification period, the

dates they were in the composites, and documentation supporting any changes to the portfolios in the composites.

8. sample historical portfolio- and composite-level performance datav. Determinations:

1. determine has been and remains appropriately defined2. determine defined and maintained composites consistently in compliance3. determine benchmarks are appropriate4. determine list of composites is complete5. determine that all actual discretionary fee-paying portfolios are included in at least one

composite, and that all accounts are included in their respective composites at all times, and that none belonging is excluded

6. determine def of discretion has been consistently applied7. determine accounts consistently apply discretionary and non-discretionary8. obtain complete list of open and closed accounts; select appropriate sample9. confirm timing of inclusion and shifting of accounts conforms to definition10. recalculate sample of returns and dispersion measures and determine computations

conform 11. review sample of composite presentations for compliance

vi. must maintain sufficient info to support verification reportvii. firm must provide representation letter to verifiers of major policies and other reps

c. Detailed Examinations of Investment Performance Presentations

Appendix A: Sample GIPS-Compliant PresentationsAppendix B: Sample List and Description of CompositesAppendix C: GIPS Advertising Guidelines

1. mandatory if claim GIPS compliance2. any written or electronic materials addressed to more than one prospective or existing client (excludes one-on-

one advertisements!)3. all advertisements that claim compliance must include description of firm and info about how to obtain list

and description of all firm’s composites or a presentation that complies w/ GIPS


4. “[Name of firm] claims compliance w/ the Global Investment Performance Standards (GIPS®).”5. if further present performance, must describe strategy of advertised composite, indicate gross or net of fees,

currency. Must present period-to-date composite results. Less than year returns cannot be annualized. Must present 1, 3, and 5, or just 5 year composite returns, and indicate end-of-period; present compliant benchmark total return for same periods and described, if none, disclose why; disclose material leverage and derivatives

6. if presenting noncompliant info, must disclose such, reasons and periods of such7. supplemental info must not be more prominent

Appendix D: Private Equity Valuation PrinciplesAppendix E: GIPS Glossary

Other issues:i. After-Tax Return Calculation Methodology: not required by GIPS

ii. Guidance Statement for Country-Specific Taxation Issues Preliquidation return:

1. Consistent use of “anticipated tax rates”i. Anticipated income tax rate = Federal tax rate + [State tax rate x (1 –

Federal tax rate)] + [Local tax rate x (1 – Federal tax rate)]ii. if client’s tax rate unknown, then may use maximum federal tax rate for

specific category of investor etc.2. “realized taxes”:

3. Preliquidation after-tax Modified Dietz:

4. After-tax LIRR:

5. Preliquidation after-tax return with daily valuations:

; can then be chain-linked

6. Pre-tax returns for composites that hold tax-exempt securities must not be grossed up for taxes.

7. Full credit for net realized losses mark-to-liquidation return: use liquidation value in both numerator and denominator

1. may provide supplemental info regarding tax effects from nondiscretionary: adds back

2. gain ratio:

3. Adjustment factor: 4. Tcgr = should be weighted average of short-term and long-term cg5. Modified Dietz aftertax return calculation w/ adjustment factor (removes effect

of nondiscretionary realized taxes):

6. tax loss harvesting: recommended to disclose % benefit of tax-loss harvesting for composite if realized losses are greater than realized gains during period

i. Benefit of tax loss harvesting:

ii. Percent benefit of tax loss harvesting =

Objectives of GIPS:i. To obtain worldwide acceptance of a common standard for calculating and presenting

investment performancedocument.doc

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ii. To ensure accurate and consistent performance dataiii. To promote fair, global competition for all marketsiv. To foster the notion of industry self-regulation


CFA Level III Outline-Notes (2010)

Documents

investment info

investment actions

clients investment objectives

investment recommendations

investment style

investment analysis

investment needs

investment process