CFA level 2 secret sauce 2014

Study Sessions 1 & 2Ethical and Professional Standards Professor’sNote:Theprohibitionagainst acceptinggifts, benefits,compensation, orotherconsideration thatmightcompromise yourindepende

LEVEL II SCHWESER’S SECRET SAUCE®

Foreword

Ethicaland Professional Standards:SS1&2

Quantitative Methods: SS3

Economics:SS 4

Financial ReportingandAnalysis: SS5,6, &7

Corporate Finance:SS8& 9

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118137157177

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SCHWESER’S SECRETSAUCE®:2014CFALEVELII

©2013 Kaplan, Inc Allrightsreserved

Publishedin2013byKaplan Schweser

Printed inthe UnitedStatesof America

ISBN:978-1-4277-4936-9/1-4277-4936-1

PPN:3200-4037

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Certain matcri.’ls contained within this text are the copyrighted property of CFA Institute.

The following is thc»copyright disclosure for these materials: “Copyright, 2013, CFA Institute.

Reproduced and republished from 2014 Learning Outcome Statements, Level I, II, and III questions fromCFA®Program Materials, CFA Institute Standards of Professional Conduct, and

CFA Institute’s Global Investment Performance Standards with permission from CFA Institute All Rights Reserved.”

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Disclaimer: Schweser study tools should be used in conjunction with the original readings as set

forth by CFA Institute in their 2014 CFA Level II Study Guide The information contained in

these materials covers topics contained in the readings referenced by CFA Institute and is believed

to be accurate However, their accuracy cannot be guaranteed nor is any warranty conveyed as to

your ultimate exam success The authors of the referenced readings have not endorsed or sponsored

SecretSauce®is avaluable additiontothestudytoolsofany CFAexamcandidate

Itoffersveryconciseandveryreadable explanations ofthemajorpartsofthe

Level II CFA curriculum

Thisbook doesnot coverevery Learning Outcome Statement (LOS) and,asyou

are aware,anyLOSis“fairgame”for theexam.Wefocus hereonthose LOS thatare core conceptsinfinance andaccounting,have applicationtootherLOS, are

complexand difficult forcandidates, orrequirememorizationof characteristicsor

relationships

Secret Sauceis easytocarrywith you and will allowyoutostudy these key

concepts,definitions,andtechniquesoverandover,animportantpartof mastering

thematerial When youget totopicswhere thecoverage here appearstoobriefor raisesquestionsin yourmind,thisis your cuetogobacktoyourstudynotes tofill

inthe gapsin your understanding.Thereisnoshortcuttolearningtheverybroad

arrayof subjectmattercoveredby the Level IIcurriculum,but this volume should

beavaluabletoolfor learningandreviewingthematerialasyouprogressin yourstudies overthe months leadingupto examday

Passratesremainaround40%,andreturningLevelII candidatesmakecomments

suchas,“Iwassurprisedathowdifficult theexamwas.”You should notdespairbecauseofthis,butyoushould alsonotunderestimate thischallenge.Ourstudy

materials,practiceexams,question bank,videos, seminars,andSecret Saucearealldesignedtohelpyoustudyasefficientlyaspossible,graspandretainthematerial,and applyitwith confidenceon examday

Bestregards,

Dr BijeshTolia,CFA,CA

VicePresident of CFA Education

and LevelIIManager

KaplanSchweser

KentWestlund,CFAContentSpecialist

ETHICAL AND PROFESSIONAL

STANDARDS

Study Sessions 1 & 2

Topic WeightonExam

SchweserNotes™Reference

10%

Book1,Pages 13—137

For manycandidates,ethicsisthemostdifficultmaterialto master.Eventhough

youare anethical person, you willnotbe preparedtoperformwellonthis portion

of the Level IIexamwithoutacomprehensiveknowledgeof the Standards ofProfessional Conduct

Tenpercentof the pointscomefrom theethics material,soyoushouldviewthistopicas an areawhereyoucan setyourselfapartfrom the person sittingnext to

you intheexam room.CFAInstitutehas indicatedthatperformanceontheethics

materialserves as a“tie-breaker”forexam scores veryclosetotheminimumpassingscore.Thisisreferredto asthe “ethics adjustment.”

What’s the point? The ethicsmaterialisworth taking seriously.With10%of thepointsandthepossibility of pushingamarginalexamintothe passcolumn(not

tomentionthefact thatas acandidateyouareobligatedtoabide byCFA Institute

Standards),it isfoolhardynot todevote the neededtimetoethics

A STUDY PLAN FORETHICS

The big questionis,“WTrat do I needtoknow?” Theansweristhatyoureally need

toknow all the ethics material You simplymustspendtimelearningtheStandards

anddevelopingsome intuitionabouthowCFAInstituteexpectsyoutorespondon

theexam.Hereareseveral quick guidelinestohelpin yourpreparation:

• Focusonthe Standards The Standards of Professional Conductarethe keytothe

ethics material TheCodeof Ethicsisapoeticstatementof objectives, buttheheartofthe testingcomesfromtheStandards

StudySessions 1 & 2

Ethical and Professional Standards

• Broad interpretation.Abroad definition ofmoststandardsisneededfortestingpurposesevenifit seems toobroadtoapplyin your “real world”situation.For

instance, akeycomponentof theprofessional standardsistheconceptof

disclosure(e.g.,disclosure of conflicts ofinterest,compensationplans,and softdollar arrangements) On theexam,youneedtointerpretwhatneedstobedisclosed very broadly.Agood guidelineisthat if thereisany questioninyourmind about whetheraparticularbitofinformation needstobedisclosed,then

itmostcertainly needs disclosing Erron thesideofmassivedisclosure!

• Always side with theemployer.Manyviewthe Code and Standardstobean

employer-orienteddocument.Thatis,formanyreaders the employer’sinterests

seem tobe moreamply protected If thereis apotential conflict between theemployeeandemployer,always side with the employer

• Defendthe charter.CFAInstituteviewsitselfas theguardian of the industry’s

reputation and,specifically,theguardian of theCFA®designation.Onthe

exam,beverysuspicious ofactivitythat makes industryprofessionalsandCFA

charcerholders look bad

• Assumeallinvestorsareinexperienced.Many differentscenarioscanshow upontheexam(e.g.,amoneymanagercontemplatingatradeforalargetrust fund) However,whenyou study thismaterial,viewthe Standards from the perspective

ofamoneymanager with fiduciary responsibility forasmallaccountbelonging

toinexperiencedinvestors.Assumingthat the investorsareinexperiencedmakessomeissues moreclear

Now,how shouldyouapproach this material?Thereare twokeys here

• First,you needtoreadthe materialverycarefully.Wesuggestthat you underlinekey words andconceptsandcommitchemtomemory.It’s probablyagoodideato startyourstudy effort withacareful readof ethics and thengooverthematerial againinMay

* Second,youshouldanswereverypractice ethicsquestion youcangetyourhandson to

developsomeintuition.Thetruthisthatontheexam, you aregoingto encounter

anumberofethicsquestions thatyou don’timmediately knowtheanswer to.

Answeringalotofpractice questions willhelpyoudevelopsomeintuitionabouthow CFAInstituteexpectsyoutointerprettheethicalsituationsonthe exam.Also,study every exampleinthe StandardsofPracticeHandbook and bepreparedfor questionsontheexam thattestsimilarconcepts.

CODEOFETHICS

Cross-Referenceto CFA InstituteAssignedTopic Review #1

Members of theCFAInstitute andcandidatesforthe CFAdesignationmust:

• Actwithintegrity,competence,diligence,respect,andinanethicalmannerwith

thepublic,clients,prospectiveclients,employers, employees,colleaguesin the

investmentprofession,andother participantsin theglobalcapitalmarkets

StudySessions 1 & 2

Ethical and Professional Standards

• Place theintegrity ofthe investmentprofessionand theinterestsofclientsabovetheirownpersonalinterests

• Usereasonablecareand exerciseindependent professional judgmentwhen

conductinginvestmentanalysis,makinginvestmentrecommendations,talcing

investmentactions,and engaginginother professionalactivities

• Practiceand encourage otherstopracticeinaprofessionaland ethicalmannerthat will reflectcreditonthemselves and the profession

• Promotetheintegrityof, andupholdtherules governing, capital markets

• Maintainand improve theirprofessionalcompetenceandstrivetomaintain and

improve thecompetenceof otherinvestmentprofessionals

STANDARDSOFPROFESSIONAL CONDUCT

Cross-Reference toCFAInstituteAssignedTopic Review #2

Thefollowingis asummary of the Standardsof Professional Conduct Focuson

thepurpose ofthestandard,applicationsof the standard,andproperprocedures ofcompliance for eachstandard

_Standard1: Professionalism1(A) Knowledge oftheLaw.Understandandcomplywith laws,rules,

regulations, and CodeandStandardsof anyauthority governingyouractivities.In theeventofa conflict,follow themorestrictlaw, rule, orregulation.Donotknowinglyparticipateorassistin violations,and

dissociatefromany knownviolation

Professor’sNote:Therequirementtodisassociatefromany violationscommitted by othersisexplicitin theStandard This mightmeanresigningfromthefirminextremecases Theguidancestatementalsomakes clearthat you aren’trequiredto reportpotentialviolationsof

the Code and Standardscommittedby other membersorcandidates

toCFAInstitute,aithoughitisencouraged Compliance withanyapplicablefiduciary dutiestoclients wouldnowbecovered under thisstandard

1(B) IndependenceandObjectivity.Usereasonablecare toexercise

independenceandobjectivityinprofessionalactivities.Don’toffer,

solicit, or acceptanygift,benefit,compensation,orconsideration thatwould compromiseeither yourownorsomeoneelse’s independenceand

objectivity

Study Sessions 1 & 2

Ethical and Professional Standards

Professor’sNote:Theprohibitionagainst acceptinggifts, benefits,compensation, orotherconsideration thatmightcompromise yourindependenceand objectivity includesall situationsbeyondjust

those involving clients andprospects, includinginvestmentbankingrelationships,publiccompanies the analystisfollowing, pressureonsell-side analysts bybuy-sideclients,and issuer-paid research

1(C) Misrepresentation.Donotknowingly misrepresentfactsregarding

investmentanalysis,recommendations, actions, orotherprofessional

overreachorregulateone’spersonalbehavior

Professor’sNote:ThisStandardaddressinginsider tradingstates

that members and candidatesmust not act orcauseothersto act

on materialnonpublicinformation until thatsameinformationis

madepublic Thisisastrictstandard—itdoesnot matterwhethertheinformation isobtainedinbreachofaduty,ismisappropriated,

orrelatesto atenderoffer. The“mosaic theory"stillapplies,and

ananalystcan takeaction basedonher analysisofpublicand

nonmaterialnonpublicinformation.

11(B) MarketManipulation Donotengagein anypractices intendedtomislead

marketparticipantsthroughdistortedpricesorartificially inflated tradingvolume

]

Standard III:DutiestoClients111(A) Loyalty,Prudence,and Care.Alwaysactforthebenefitofclients andplace

clients’interestsbeforeyouremployer’soryourown interests.Youmustbe

loyalto clients, usereasonablecare,andexerciseprudent judgment

Study Sessions 1 & 2

EthicalandProfessional Standards

Professor’sNote:Applicabilityofanyfiduciarydutiestoclients andprospectsisnowcovered underStandard1(A)KnowledgeoftheLaw.III(B) FairDealing.Youmustdealfairly and objectively with all clients and

prospectswhenprovidinginvestmentanalysis,makinginvestment

recommendations,takinginvestment action, orinother professional

activities

Professor’sNote:This Standard includesprovidinginvestmentanalysis

andengaginginotherprofessionalactivities aswellasdisseminating

investmentrecommendationsandtakinginvestmentaction

III(C) Suitability

1. Wheninanadvisory relationshipwithaclientor prospect,youmust:

• Makereasonable inquiryinto aclients investment experience,

risk andreturnobjectives,and constraintspriortomaking

anyrecommendationsortakinginvestment action.Reassessinformationandupdateregularly

• Besure investments aresuitableto aclient’sfinancialsituationand

consistentwith client objectives beforemakingrecommendations

ortakinginvestment action

• Makesureinvestmentsaresuitablein thecontextofaclient’s totalportfolio

2 Whenmanagingaportfolio,your investmentrecommendationsandactionsmustbeconsistentwith the statedportfolio objectivesand

constraints.

Professor’sNote: The client’swrittenobjectives andconstraintsare

requiredtobe reviewed andupdated“regularly.“The seconditem

AGfl appliesthe suitability standardto managedportfoliosand requiresyou

tostickto themandatedinvestmentstyleasoutlined in the portfolioobjectivesandconstraints.

III(D) PerformancePresentation.Presentationsofinvestmentperformance

informationmustbefair, accurate,and complete

III(E) PreservationofConfidentiality All informationaboutcurrentandformer

clients andprospects mustbekeptconfidential unlessitpertainstoillegalactivities,disclosureisrequired bylaw,ortheclientor prospectgivespermission fortheinformationtobedisclosed

Professor’sNote: This Standardcoversall clientinformation, notjust

information concerningmatterswithin thescopeoftherelationship.Also notethat the languagespecificallyincludes notonlyprospects

StudySessions 1 & 2

Ethical and Professional Standards

[ Standard IV:DutiestoEmployers

IV(A) Loyalty.Youmustplaceyouremployersinterestbeforeyourownandmust

notdepriveyouremployerofyourskills andabilities,divulgeconfidential

information,orotherwiseharmyouremployer

Professor’sNote: Thephrase “in mattersrelatedtoemployment”means

that youarenotrequiredtosubordinateimportantpersonal and

family obligationstoyourjob.TheStandardalso addresses theissueof

“whistle-blowing”by stating that therearecircumstances in whichtheemployer’sinterests aresubordinatedto actionsnecessarytoprotecttheintegrityofthecapitalmarketsorclientinterests

IV(B) Additional Compensation Arrangements.Nogifts,benefits,compensation,

orconsiderationthatmaycreate aconflict ofinterestwith the employersinterest are tobeaccepted,unlesswrittenconsentisreceivedfrom all

parties

Professor’sNote: “Compensation”includes “gifts, benefits,

compensation,orconsideration.”

IV(C) Responsibilitiesof Supervisors.Youmustmake reasonableeffortsto

detectandpreventviolationsoflaws,rules,regulations, and the Code and

Standardsbyanypersonunder yoursupervisionorauthority

Professor’sNote:Thefocusis onestablishingandimplementing

reasonablecomplianceproceduresinorderto meetthis Standard.Notice also thatinformingyouremployerofyourresponsibilityto

abideby the Code and Standardsisonlya recommendation

I Standard V: InvestmentAnalysis,Recommendations,andActionsV(A) Diligenceand Reasonable Basis

1. Whenanalyzinginvestments,makingrecommendations,andtaking

investmentactions, usediligence,independence, andthoroughness

2 Investment analysis,recommendations,andactionsshould havea

reasonableandadequatebasis,supported by research and investigation

Professor’sNote: ThisStandardexplicitly requires that youexercise

KzjgW diligenceand havea reasonable basisforinvestmentanalysis,as well

asformakingrecommendationsortakinginvestmentaction

Study Sessions 1 & 2

Ethical and Professional Standards

V(B) CommunicationWith Clients andProspectiveClients

1. Disclosetoclients andprospectsthe basicformat andgeneral principles

ofinvestmentprocessesusedtoanalyze and selectsecuritiesand

constructportfolios Promptlydiscloseanyprocess changes

2 Usereasonablejudgmentinidentifyingrelevantfactors importantto investmentanalyses,recommendations, or actions,and include chosefactorswhencommunicating with clientsandprospects.

3 Investment analysesand recommendationsshouldclearly differentiatefacts from opinions

Professor’sNote:ThisStandardcoverscommunication inanyform

with clientsandprospectiveclients, including researchreportsandrecommendations

V(C) RecordRetention.Maintainall recordssupportinganalysis,

recommendations, actions,and all otherinvestment-related

communications withclients andprospects.

Professor’s Note:Theissueofrecordretention is aseparateStandard,

emphasizingitsimportance Itincludes records relatingto investmentanalysisaswellas investmentrecommendations andactions Theguidancestatementsaysyou shouldmaintain recordsforsevenyearsinthe absenceofotherregulatory guidance

StandardVI:Conflicts ofInterest

VI(A) Disclosure ofConflicts.Youmustmake full and fair disclosureofall

mattersthatmayimpair yourindependenceorobjectivityorinterferewithyourdutiestoemployer,clients,a'ndprospects.Disclosuresmustbe

prominent,inplain language,andeffectivelycommunicatethe information

Professor’sNote:Theemphasisis onmeaningfuldisclosurein

prominent andplain language;impenetrable legalprosethatno one can understandis notsufficient.

VI(B) PriorityofTransactions.Investmenttransactionsfor clients andemployers

musthave priorityoverthose in whichyou areabeneficialowner.

Professor’sNote: Thelanguageisintendedtoheclear—transactionsfor

clients and employers alwayshave priorityoverpersonaltransactions.

StudySessions 1 & 2 Ethical andProfessional Standards

StandardVII:ResponsibilitiesasaCFAInstituteMemberor

CFACandidateVII(A) ConductasMembersandCandidatesintheCFAProgram.Youmust not

engageinconductthatcompromises the reputationorintegrityof

CFAInstitute,theCFAdesignation,orthe integrity, validity,or securityof

theCFAexams.

Professor’sNote: TheStandardisintendedtocoverconduct suchascheatingon the CFA exam orotherwiseviolatingrulesof

CFA InstituteortheCFAprogram.Itis notintendedtoprevent

anyonefromexpressingany opinionsorbeliefsconcerning

CFAInstituteortheCFAprogram. Violations also includediscussingthe questions(or even broad subjectareas)thatweretestedor not

testedon theexam.

VII(B) ReferencetoCFAInstitute,the CFADesignation, andtheCFA Program

Youmust notmisrepresentor exaggeratethe meaningorimplications ofmembershipin CFAInstitute,holdingthe CFA designation,orcandidacy

intheprogram

Professor’sNote: This Standardprohibitsyoufrom engagingin

any conduct that may “misrepresentor exaggeratethe meaningorimplicationsofmembership in CFAInstitute, holdingthe CFA

designation, orcandidacy inthe CFAprogram.” Youcannotreferenceany “partial”designation, sincethis also misrepresentsorexaggerates

credentials

OTHER LEVEL II ETHICS TOPIC REVIEWS

The Code and Standardsaretheheartof the Level II ethicscurriculum, so werecommend spending about 60% ofyourethicsstudytimeonthem.However,

someadditional ethics topicreviewsatLevelII maybetested,includingthe CFA

InstituteSoft DollarStandards,theCFAInstituteResearch ObjectivityStandards,and theNew Prudent Investor Rule.Spendtheother40% of yourtime onthesetopicsandfocusonthekey points discussedinthefollowingsections.Rememberthat the Research ObjectivityStandardsareapplicableonlytofirms(asopposedto

individuals)who claim compliance

CFA INSTITUTE SOFT DOLLAR STANDARDS

Cross-Reference to CFA InstituteAssigned TopicReview #3

“Soft dollars”(or“clientbrokerage”)referstoinvestment research,products andservices,andcash credits giventotheinvestmentmanager by brokersinreturn

Study Sessions 1 & 2

Ethical and Professional Standards

forclientbusiness.Thesoft dollarcreditistheclient’sasserbecausehe pays the

commission.Fiduciariesowetheirclientstwobasicduties:to act intheclient’sbest

interestandrodisclose conflictsofinterest.The cardinal ruleisthat soft dollarsare

an assetof theclient,andsoftdollarsmaynotbeusedfor any purpose thatdoes

notbenefitthat client

Knowthetwokeyprinciplesof theSoftDollarStandardsand apply themto any

questioninwhich youare unsureof thespecificdetailsoftheStandards

• Principle#1:Brokerageisthepropertyof the client

• Principle#2:Investmentmanagers haveadutytoobtainbestexecution, minimizetransactionscosts,anduseclientbrokeragetobenefitclients

Youshould befamiliarwithsomeofthekeyrequirements of theSoftDollar

Standards, asoutlinedinFigure1

Study Sessions 1 & 2

Ethical and Professional StandardsFigure1:Key Requirementsof the CFAInstituteSoftDollarStandards

General • Place client interests above all else.

• Don’t allocate client brokerage based on client

referrals from brokers.

Relationships With Clients • Disclose potential participation in soft dollar

arrangements.

Selection of Brokers • Consider brokers’ trade execution capabilities

when selecting brokers,

Evaluation of Research • Use clientbrokerageonly for products and services

that meet the definition of “research”:productsand

services that assist die investment manager in the

investmentdecision-makingprocess.

• Document basis for determining why it meets the definition.

• Research must benefit the client.

• Allocate research cost based on expected usageformixed-use research.

Client-Directed Brokerage • Don’t usebrokeragefrom one client to pay

for research purchased for another client who

is operating under aclient-directedbrokerage

agreement.

Disclosure • Disclose policies in planlanguage

• Send clients annual statement that soft dollar

practices conform to Soft Dollar Standards.

• Disclose to clients that more information on policies is available upon request.

Record Keeping • Meet all regulatory and legal requirements.

• Document any specific arrangement with clients,

including client-directedbrokerageagreements.

• Document the basisformixed-useallocations

• Documenthow products and services assist the

manager in the investment decision-making process.

• Document compliance with the Soft Dollar Standards.

Study Sessions 1 & 2

Ethical and Professional Standards

CFA INSTITUTE RESEARCH OBJECTIVITY STANDARDS

Cross-Referenceto CFA InstituteAssignedTopic Review#4

The Research Objectivity Standardsarevoluntary standardsintendedto

complement and facilitate compliancewith the StandardsofPractice.Theyareintendedtobeauniversalguideforall investmentfirms byprovidingethicalstandards and practices regarding fullandfairdisclosureofanyconflictsor

potential conflicts relatingto thefirm’s research andinvestmentrecommendations.However,firmsare notrequiredtocomplywith the Research Objectivity

Standards

ProfessorsNote:Ifyou havean understandingofthe basic

requirements, you should be abletohandlemostofthe questionsonthe topic thatmight appearon the LevelIIexam We alsosuggest that

youreview the Recommended Proceduresfor Compliance

StudySessions 1 & 2

Ethical and Professional StandardsFigure2:Key Requirements of theCFA InstituteResearch Objectivity Standards =

Research Objectivity

Policy

Have a formal, writtenpolicyanddistributeit to clients,

prospective clients, andemployees

Seniorofficemust attest annually thatfirm complieswith

policy

Discloseconflicts of interest whendiscussingresearch and

recommendations inpublicforums.

PublicAppearances

Allreports and recommendations must have areasonable

andadequatebasis.

Reasonableand

Adequate Basis

InvestmentBanking Separate researchanalystsfrom investmentbanking

Don’t let analysts report to, orbe supervisedby, investment

Linkanalyst compensation toqualityof analysis, not

amount of investmentbanking businessdone with client.

Don’tengage in front running ofclienttrades.

Don’t let employees and immediate family members trade ahead of clients, trade contrary tofirmrecommendations,

or participate inIPOsof companies covered by the firm.

Disclosure Disclose conflicts of interest.

Rating System Have a rating system that investorsfinduseful and

providethem with informationtheycan use to determine suitability.

Study Sessions 1 & 2

Ethical and Professional Standards

THE NEW PRUDENT INVESTOR RULE

Cross-Reference to CFA InstituteAssignedTopic Review #10

Differences BetweentheOld Prudent Man Rule and theNewPrudentInvestorRule

ThenewPrudent Investor Rulemakesfive key changestothetraditional rules

governing investmenttrust management.

• Useoftotalreturn.ThenewRulemeasuresreasonable portfolioreturn astotal

return (incomepluscapitalgrowth) andemphasizesthat thetrustee’sdutyis

to notonlypreserve thepurchasing power of thetrust but,in certaincases, to

realizeprincipal growthinexcessofinflation

• Riskmanagement.UnderthenewRule,thetrusteehas the obligationtoassessthe risk andreturnobjectives of thetrustbeneficiariesandmanage thetrustinaprudentmannerconsistent withthoseobjectives,ratherthantoavoid allrisk

• Evaluationinaportfoliocontext.WhilethenewRule callsfor theavoidanceofundue speculationandrisk,it alsoencouragestrustees to viewrisk inaportfolio

context.

• Securityrestrictions.Nosecuritiesare“off-limits” becauseof theirriskinesswhenheldinisolation Forexample,under the oldRule,optionswere not allowed,

butunderthenew Rule,theyare, aslongasthe manager takes theportfolio

perspectivetoanalyzing risk

• Delegationofduty.TheoldRuledidnotpermittrustees todelegateinvestment

authority.Infact,investinginmutual fundsor evenindexfundswasdeemed

improper ThenewRulegoessofaras tosay thatitmaybethedutyofa trustee (this is strongerlanguagethan justauthority)todelegate, justas aprudent

investor would

Professor’sNote: Theseprinciplesareconsistentwith theguidelinesoutlinedinthe topicreviewoftheportfoliomanagementprocessinStudySession18, where the LOSask you toexplain the importance

oftheporfolioperspectiveanddefineinvestmentobjectives andconstraints.

StudySessions 1 & 2

Ethical and Professional StandardsKey Factors That Trustees Should Consider

ThenewPrudentInvestor Rule includeseightkeyfactors that thetrusteeshouldconsider when investingandmanagingtrust assets:

1. Economicconditions

2 Effectsofinflation and deflation

3 Impact ofinvestmentdecisionsonthe beneficiary’staxliability

4 How each individualinvestmentcontributestothe risk andreturnof theoverallportfolio

5 Expectedtotalreturnfrom capital appreciationand income

6 Otherresourcesof the beneficiary

7 Thebeneficiary’s liquidity,income,and capital preservationrequirements

8 Whetheranyassetshaveaspecialrelationshiptothe requirements of thebeneficiaryorthetrust.

QUANTITATIVE METHODS

Study Session 3

'.v • / • :

SchweserNotes™Reference Book1 ,Pages138-263

Quantitativeanalysisisoneoftheprimary toolsused intheinvestmentcommunity,

soyoucan expectCFAInstituteto testthis sectionthoroughly.Bothlinear

regression(withonlyoneindependentvariable) andmultipleregression(withmorethanoneindependentvariable)arecoveredintheLevelII Quant readings The

LevelII curriculum also includesatopicreviewon time seriesanalysis

Akeytopic in the LevelII Quant materialismultiple regression Ifyouhaveasolidunderstanding of simplelinearregression,youcanhandle multiple regression andanythingyoumightsee on theLevel IIexam.Alltheimportantconceptsinsimple

linearregressionarerepeatedin thecontextof multiple regression (e.g.,testing

regressionparametersandcalculating predicted valuesof thedependentvariable),

andyou’remostlikelyto seethese testedas partofamultipleregressionquestion

Forthetime series material,theconceptsofnonstationarity,unit roots (i.e.,randomwalks),and serialcorrelation,will be important,aswellasbeing abletocalculate

the mean-reverting levelofanautoregressive(AR) time-seriesmodel Understandthe implications of seasonality and howtodetect andcorrect it, aswellastheroot meansquarederror (RMSE) as amodel evaluationcriterion.

CORRELATIONAND REGRESSION

Cross-Referenceto CFA Institute Assigned Topic Review #11

Becauseeverythingyoulearnfor simplelinearregressioncanbeappliedtomultiplelinear regression,youshouldfocusonthe materialpresentedin thenextsection.Theonly topics uniquetosimple linear regressionare (1) the correlationcoefficient,

(2) regressionassumptions,and(3)formingapredictionintervalfor the dependent(Y)variable

CorrelationCoefficient

Thecorrelationcoefficient, r,forasample andpforapopulation,is a measureofthe

StudySession 3

Quantitative Methods(perfectpositivecorrelation),avalue of—1indicates thatthevariablesmove

exactly opposite(perfect negative correlation),andavalueof0indicatesnolinear

relationship

H

Theteststatisticforthesignificanceofacorrelation coefficient(nullisp=0)hasa

r-distributionwithn - 2degreesoffreedom andiscalculatedas:

iJn —2

Regression Assumptions

• A linearrelationshipexistsbetween thedependentandindependentvariables

• Theindependentvariableisuncorrelated with the residualterm.

• The expected value oftheresidualterm is zero.

• Thereis a constantvarianceof the residualterm.

• The residualterm isindependentlydistributed;thatis,theresidualtermforone

observationisnotcorrelated with that ofanotherobservation(aviolationofthis

assumptioniscalledautocorrelation).

• Theresidualterm isnormally distributed

Notethat five of thesixassumptionsarerelatedtothe residual.term.The residual

terms areindependently(ofeach otherandtheindependentvariable),identically,

andnormallydistributed witha zero mean.

ConfidenceIntervalforaPredicted Y-Value

In simplelinearregression,you havetoknowhowtocalculateacojifidenceinterval

forthepredictedYvalue:

predictedY value±(critical t-value)(standard errorofforecast)

Calculatingaconfidence intervalforthepredicted yvalue isnot partofthe multiple

regressionLOS,however, because the multiple regressionversion istoocomplicated

andnot partoftheLevel IIcurriculum

MULTIPLE REGRESSIONAND ISSUESIN REGRESSION ANALYSIS

Cross-Reference to CFA InstituteAssigned TopicReview #12

Multipleregressionis themostimportantpartof thequantmaterial Youcanfully

expectthat multiple regression will beontheexam,probablyinseveral places

StudySession 3

Quantitative Methods

Theflow chartinFigure1willhelpyouevaluateamultiple regressionmodelandgrasp the“bigpicture”inpreparation for theexam.

Figure1:Assessment ofaMultiple Regression Model

No Correctthemodel

misspecification

Is themodel correcdy

specified?

Yes, Yes

Areindividualcoefficients

.Yes No

Dropone of the correlated variables Use the model!

Youshouldknow thata f-test assessesthe statisticalsignificanceofthe individual

regressionparameters,andanT-testassessesthe effectivenessof themodelas awholeinexplainingthedependentvariable You should understand the effect

thatheteroskedasticity, serialcorrelation,andmulticollinearity haveonregressionresults Focusoninterpretationofthe regression equation and thetest statistics.

avaluefor the dependentvariable,youuseestimated valuesfor all the independentvariables, even thoseindependentvariables whose slope coefficientisnot

statistically different fromzero.

MultipleRegression:Testing

Tests forsignificanceinmultiple regressioninvolvetesting whether:

• Each independentvariableindividuallycontributestoexplainingthe variation in

the dependentvariableusing thef-statistic

• Someorall of the independent variables contributetoexplainingthevariation

in thedependent variableusing the F-statistic

Testsforindividualcoefficients.Weconducthypothesis testingontheestimated

slope coefficientstodetermine if the independent variables makeasignificant

contributiontoexplainingthevariationin thedependentvariable.With multipleregression, thecriticalt-stat isdistributed with n—k—1degreesoffreedom,where n is

the numberof observations and kisthenumberof independent variables

estimated regressionparameter

•with ri—k—1df

t=

standarderrorof regressionparameter

ANOVAis astatisticalprocedurethatattributes thevariationin thedependentvariableto oneoftwo sources:the regression modelortheresiduals(i.e.,theerror term).ThestructureofanANOVAtableisshowninFigure2

n—k—1 SST

NotethatRSS+SSE=SST The informationinanANOVAtablecanbe usedto

calculateR2,theT-statistics,and thestandarderrorofestimate(SEE).

Thecoefficient ofdetermination (R2)isthepercentageof thevariation inthedependent variable explained bytheindependent variables

_ regressionsumof squares(RSS)

totalsumof squares(SST)

SST—sumofsquarederrors(SSE)

SST

Inmultipleregression, you alsoneedtounderstandadjustedR2.The adjusted

R2providesa measureofthegoodnessof fit thatadjusts forthenumberof

independent variablesincludedinthemodel

The standarderrorofestimate (SEE) measurestheuncertainty of the valuesofthe

dependentvariablearoundtheregressionline Itisapproximatelyequaltothestandard deviationofthe.residuals.If the relationshipbetween thedependent andindependent variablesisverystrong,theSEEwill below.

standarderrorofestimate(SEE)= ymeansquarederror (MSE)

Testsofallcoefficientscollectively.Forthistest,the null hypothesisisthat all theslope coefficients simultaneously equalzero.Therequiredtest isaone-tailedFriest

andthe calculatedstatistic is:

„ regression mean square (MSR) , , , , , ,

-F= — -5 -- -: withkandn-k- 1df

meansquarederror (MSE)

The F-statistichastwodistinct degreesoffreedom, oneassociatedwith the

StudySession 3 QuantitativeMethodsrulefortheF-testis rejectHQif F>Fcriticaj.Remember that thisisalwaysaone-tailed

test.

Rejection of the null hypothesisat astated levelof significance indicatesthatat

leastoneofthecoefficientsissignificantly different thanzero,whichisinterpreted

to meanthatatleastoneof the independentvariables in theregression modelmakesasignificantcontributiontothe explanation of the dependentvariable

Confidence Intervals

The confidenceintervalforaregression coefficientinamultiple regressioniscalculatedandinterpreted exactlythesame aswithasimple linear regression:regression coefficient±(criticalt-value)(standard errorof regressioncoefficient)

Ifzero iscontainedin theconfidenceinterval constructedforacoefficientat adesired significancelevel, weconcludethat theslopeis notstatistically differentfromzero.

Potential ProblemsinRegression Analysis

You should be familiar withthe threeviolationsoftheassumptions ofmultipleregressionand theireffects

Figure3: Problems inRegression Analysis

Conditional

Heteroskedasticity SerialCorrelation Multicollinearity

What is it? Residualvariance

positive correlation)

ToomanyType II

errorsModelMisspecification

Therearesixcommonmisspecificationsof the regressionmodelthatyoushouldbe

awareofand beabletorecognize:

1 Omittingavariable

2. Transformingvariable

Study Session 3

Quantitative Methods

3 Incorrectly poolingdata

4 Usingalaggeddependent variableas anindependent variable

5 Forecastingthepast.

6 Measuring independent variables witherror.

Theeffects ofthemodelmisspecificationonthe regressionresultsarebasicallythe

samefor allthemisspecifications:regressioncoefficientsarebiased andinconsistent,whichmeans we canthaveanyconfidenceinourhypothesistestsofthecoefficients

orin thepredictions ofthe model

TIME-SERIESANALYSIS

Cross-Reference to CFA InstituteAssignedTopic Review #13

Typesof TimeSeries

Linear TrendModel

The typicaltime series uses time asthe independent variableto estimatethevalue

oftimeseries(thedependentvariable) inperiodP.

yt= b0 +bj(t)+£t

Thepredicted changeinyisbjandt=1,2, T

Trend modelsarelimitedinthat theyassume timeexplainsthedependentvariable.Also,they tendtobeplagued byvariousassumption violations.TheDurbin-Watson

test statistic canbe usedtocheckforserial correlation A linear trend model may

beappropriate ifthe datapointsseem tobeequally distributed aboveandbelow

thelineand themean is constant.GrowthinGDPand inflation levelsarelikelycandidatesfor linear models

Log-Linear Trend Model

Log-linear regressionassumesthedependent financialvariablegrowsat some constant rate:

—ebo+b](t)

Yt

ln(yt)= ln(eb°+blW)=>ln(yt)= b0 +bL(t)

Study Session 3

Quantitative MethodsThe log-linear modelisbestforadataseriesthat exhibitsatrendorforwhich theresidualsarecorrelatedorpredictableor themeanisnon-constant.Mostof the datarelatedtoinvestmentshavesome typeoftrendand thus lend themselvesmore toa

log-linear model Inaddition,anydatathathave seasonalityarecandidatesforalog-linear model Recall thatanyexponential growth data call foralog-linearmodel

Theuseof the transformed data producesalinear trend line withabetterfitforthedataandincreases thepredictive ability ofthemodel.Because thelog-linearmodelmoreaccuratelycapturesthebehaviorof the timeseries,theimpact of serial

correlation intheerror termsisminimized

Autoregressive(AR)Model

InARmodels,the dependent variableisregressedagainstprevious valuesof itself

An autoregressive model of orderpcanbe representedas:

Xc = b0+blxt-l+b2Xt-2+ • + bpXt-p+et

Thereis nolongeradistinctionbetweenthedependent andindependent

variables(i.e., x istheonlyvariable).AnAR(p) modelisspecified correctly if theautocorrelationsof residuals from the modelare notstatistically significantatany

lag

Whentesting forserialcorrelationinanARmodel,don’tusetheDurbin-Watson

statistic.Usea£-test todetermine whether any ofthecorrelationsbetweenresiduals

atanylagarestatistically significant

Ifsome aresignificant,the modelisincorrectlyspecifiedandalaggedvariableattheindicated lag shouldbeadded

Chain RuleofForecasting

Multiperiodforecastingwith ARmodels isdoneoneperiodat a time,where riskincreaseswith each successiveforecast becauseit isbasedonpreviouslyforecastedvalues The calculationofsuccessiveforecastsinthismannerisreferredto as

thechain ruleofforecasting.Aone-period-ahead forecast foran AR(1)modelisdeterminedinthe followingmanner:

xt+l=bo+bixt

Oneof the assumptionsunderlyinglinear regressionisthat theresiduals

uncorrelatedwitheach other.Ifa time seriesmodel’s residuals exhibit serial

correlation,the modelis notappropriateforthetime seriesandweshouldnot use

it topredictfutureperformancewithoutmakingappropriatecorrections.

are

CovarianceStationary

Statisticalinferences basedon alaggedtime seriesmodelmaybe invalid unless

we canmakethe assumption that thetime seriesbeingmodeledis covariance

stationary Atime series is covariance stationaryifitsatisfies thefollowingthreeconditions:

1 Constant and finiteexpectedvalue

2. Constantandfinitevariance.

3 Constant and finitecovariancewithleadingorlaggedvalues

Todetermine whethera time series is covariance stationary, we can:

• Plot the datato seeifthemeanandvariance remain constant (oftendetects

seasonality)

8 Runan ARmodel andtestcorrelations

e Perform theDickey-Fullertest (which is a testfora unit root, orifbj—1 isequalto zero).

Ifthetimes seriesdoesnotsatisfytheseconditions, wesayit is not covariance stationary, orthat thereis nonstationarity.Mosteconomicandfinancialtime seriesrelationshipsare notstationary Thedegreeofnonstationaritydependsonthe

lengthoftheseriesand theunderlyingeconomicand marketenvironmentandconditions

Foran AR(1)modelto becovariance stationary,themeanreverting levelmustbe

defined.Stateddifferently,b, mustbe lessthan.one.

If the AR modelis not covariancestationary,we canoftencorrect itwith first

differencing

Study Session 3

Quantitative Methods

MeanReversion

Atime series is meanrevertingifittends towardsits mean over time.Themean

reverting level foran AR(1)model is bo

(1-bj)*

Thevalueofthedependentvariable tendstofall when aboveits meanandrise

when below itsmean.

Unit Root

Ifthe valueof thelagcoefficientisequalto one,thetime series issaidtohavea

unit rootand willfollowarandom walkprocess Aserieswitha unit root is not

covariancestationary Economicand financetime seriesfrequentlyhaveunit roots.

Firstdifferencingwillofteneliminate theunit root.Ifthereis a unit root,this

period’svalueisequal tolastperiod’svalueplusarandomerror termandthemean

revertinglevelisundefined

Random Walk

Arandom walktime series is onefor which the value inoneperiodisequalto

the valueinanotherperiod, plusarandom(unpredictable) error.Ifwebelievea

time series is a random walk(i.e.,hasa unit root), we cantransform the datato a covariancestationarytime seriesusingaprocedurecalled firstdifferencing

Random walk withoutadrift:x =x j + e

Random walk withadrift: x£=bQ+x£ _j +8

0 Ineithercase,themeanrevertinglevelisundefined(bj=1), sotheseries is not covariancestationary

0 Needto usefirstdifferencing,and thenewdependentvariableisthechange

in xfromoneperiodtothenext.

FirstDifferencing

The firstdifferencingprocess involvessubtractingthe value of thetime series (i.e.,thedependentvariable) intheimmediately preceding period fromthecurrent

valueof thetime series todefinea newdependentvariable,y.Iftheoriginaltime

serieshasa unit root,thismeans we candefine y as:

Yt=A-N-1=>yt=et

Thistransformedtime serieshasafinitemean-revertinglevelof — =0 andis,

Firstdifferencingcan remove atrend'in the data and resultin a covariance

stationaryseries.

Professor’sNote:By takingfirstdifferences,you model thechange

in the valueofthedependent variable rather than the valueofthe

dependentvariable

Seasonality

Seasonalityina time series istestedbycalculatingthe autocorrelationsoferror

terms Astatistically significant laggederror term mayindicateseasonality.To

adjustforseasonalityin anARmodel, anadditionallagof theindependentvariable

(correspondingtothestatistically significant laggederror term) isaddedtothe

originalmodel.Usually,if quarterlydataare used,the seasonallagis4;if monthly

dataare used,the seasonallagis 12.Ifaseasonallagcoefficientisappropriate and

correctstheseasonality,arevised modelincorporatingthe seasonallagwill showno

statisticalsignificanceof thelaggederror terms.

Assessing ForecastAccuracyWith Root MeanSquaredError(RMSE)

Rootmeansquarederror (RMSE) is usedto assessthepredictiveaccuracyof

autoregressivemodels.Forexample,you couldcomparetheresultsofan AR(1)and

an AR(2) model The RMSEisthe squarerootof the average(or mean)squarederror.The model with the lower RMSEisbetter

Out-of-sampleforecastspredictvalues usingamodelfor periods beyondthetime seriesusedto estimatethe model The RMSE ofamodel’sout-of-sampleforecasts

shouldbe usedtocompare the accuracy of alternative models

Study Session 3

Quantitative MethodsStructuralChange(CoefficientInstability)

Estimated regressioncoefficients change fromone timeperiodtoanother.There

is atradeoffbetweenthestatisticalreliability ofalongtime seriesand thestability

ofashorttime series.You needto ask,has the economic processor environmentchanged?

Astructural changeisindicatedbyasignificantshift intheplotteddataat apoint

in timethatseems todivide the datainto twodistinctpatterns.When thisisthecase,you haveto run twodifferentmodels, oneincorporating the data before and

oneafter thatdate,andtestwhether thetime series hasactuallyshifted.Ifthetime serieshasshifted significantly,asingletime seriesencompassingtheentireperiod(i.e.,bothpatterns)willlikely produce unreliableresults, sothemost recentmodelmay bemoreappropriate

Cointegration

Cointegrationmeansthattwo time series areeconomically linked (related tothe

same macro variables) orfollowthesametrend and thatrelationshipis notexpected

tochange Iftwo time series arecointegrated,theerror termfrom regressingone on

the otheris covariancestationary and thet- tests arereliable

Totestwhethertwo time series arecointegrated,weregressonevariableon theother using thefollowingmodel:

yt=bo+b1xt+ e

where:

yt=valueoftime seriesyat time t

x(= value.oftime series x at time t

The residualsaretestedfora unit rootusing theDickey-Fullertestwith criticalt-values calculated by EngleandGranger (i.e.,the DF-EGtest).Ifthetest rejectsthenullhypothesisofa unit root, wesay theerror termsgenerated bythetwo time series arecovariance stationary and thetwo series arecointegrated Ifthetwo series

arecointegrated,we can usethe regressiontomodel theirrelationship

Occasionally,ananalystwillrun aregression usingtwo time series (i.e., two time serieswithdifferentvariables).Forexample,to usethe market modelto estimate

Study Session 3

Quantitative Methods

the equity beta fora stock,theanalystregressesa time seriesof thestock’sreturns

on atimeseriesofreturnsfor themarket

• Ifbothtime series are covariancestationary, modelisreliable

0 If onlythedependentvariabletime series oronlytheindependenttime series is covariancestationary, the modelis notreliable

• Ifneithertimeseriesiscovariance stationary, you needtocheckfor

cointegration

Autoregressive ConditionalHeteroskedasticity(ARCH)

ARCHdescribes theconditionwhere thevarianceof the residuals inone timeperiodwithina time series isdependentonthevarianceof the residuals inanotherperiod.When this conditionexists,the standard errorsof the regression coefficients

inAR models and thehypothesistestsof these coefficientsareinvalid

TheARCH(l)regression modelisexpressedas:

If thecoefficient,aÿ,isstatisticallydifferentfromzero,the time series is ARCH(l).

Ifa time-seriesmodel has been determinedto containARCHerrors,regressionprocedures thatcorrectforheteroskedasticity,suchasgeneralizedleast squares,

mustbe used in ordertodevelopapredictivemodel.Otherwise,the standarderrors

of the model’s coefficients will beincorrect,leadingtoinvalid conclusions

However,ifa timeserieshas ARCHerrors, anARCH modelcanbe usedtopredict

thevarianceof the residualsinfollowing periods.Forexample, ifthedata exhibit

canbe usedinperiodt topredictthe ARCH(l) pattern,theARCH(l)model

varianceof the residualsinperiodt + 1:

an

Oÿao+ajE?

Study Session 3 Quantitative Methods

Summary: The Time-SeriesAnalysis Process

Thefollowingstepsprovideasummaryof thetime-seriesanalysis process.Notethat you maynotneedtogothroughallnine steps.Forexample,noticethatbyStepC,ifthereis noseasonalityorstructuralchangeand the residuals donot

exhibitserialcorrelation,the modelisappropriate

StepA: Evaluatetheinvestment situationyouareanalyzingandselectamodel.If

you choosea time series model,followstepsBthroughI

Step B: Plotthedata and checkthatitis covariancestationarity.Signsof

nonstationarity include lineartrend,exponentialtrends,seasonality,or a

structuralchangein the data

StepC: Ifnoseasonalityorstructuralchange, decidebetweenalinearorlog-linear

model

• Calculatethe residuals

• Checkforserial correlationusing theDurbin-Watsonstatistic

• Ifnoserialcorrelation,modelisappropriateto use.

StepD:Ifyoufindserialcorrelation,prepareto use an autoregressive(AR) model

bymakingit covariancestationary This includes:

* Correcting foralinear trend—usefirstdifferencing

• Correcting foranexponentialtrend—take natural logand first

difference

• Correcting forastructuralshift—estimatethe models before and afterthechange

• Correcting forseasonality—addaseasonallag(seeStepG).

StepE: After theseries is covariancestationary,use an AR(1)modeltomodelthe

data

• Testresidualsforsignificantserial correlations

" Ifnosignificantcorrelation,modelisokayto use.

Step F: Iftheresidualsfrom theAR(1)exhibit serial correlation,use an AR(2)

model

° Testresiduals forsignificantserial correlations

• Ifnosignificantcorrelation,modelisokayto use.

0 If significantcorrelationfound,keep addingtothe ARmodeluntilthereis nosignificantserial correlation

StepG:Check for seasonality

• Plotdata

• Checkseasonalresiduals(autocorrelations)for significance

• Ifresidualsaresignificant,add the appropriatelag (e.g.,formonthlydata,add the12thlagof thetime series).

Step H: Checkfor ARCH

StepI: Testthemodelonout-of-sampledata

Economicswillmostlikelybetested by askingyoutoapplytheinvestmenttoolsyoulearninthissectiontothe analysisof equity, fixedincome,and derivative

securities.For example, thelessonslearnedfromeconomicgrowth modelscanbe

appliedtothecredit analysisofsovereigndebt inStudySession14.Asyouread

throughthe Level IIeconomics material,look for linkstosecurityvaluation and

thinkabout howtheconceptsmight be testedas partofabroader valuationitem set.

CURRENCY EXCHANGE RATES: DETERMINATIONANDFORECASTINGCross-Reference to CFA Institute Assigned Topic Review #14

Currency Cross Rates

Across rate istherateofexchangebetweentwo currenciesimplied bytheirexchange

rateswitha commonthirdcurrency.

Supposewe aregiven three currenciesA, B,andC.Wecanhave three pairsof

currencies(i.e.,A/B, A/C,andB/C)

To calculate the profits fromatriangular arbitrage,imagine thatthreecurrencies

eachrepresent a cornerofatriangle Beginwithafirstcurrency(usually given

inthequestion—wecallitthehome currency) and go aroundthetrianglebyexchangingthe home currencyfor thefirstforeigncurrency,then exchanging the

offer 'offer

Study Session4

Economics’second foreigncurrencybackintothe homecurrency.Ifweendup withmore

moneythanwestartedwith,we’veearnedanarbitrageprofit

Thebid-askspreadforcesus tobuyacurrencyat ahigherrategoingonewaythan

we cansellitfor going theother way

Followthe“up-the-bid-and-multiplyand down-the-ask-and-divide” rule

Example: Triangular arbitrage

Thefollowingquotes areavailable from your dealer

Quotes:

USD/EUR 1.271-1.272

EUR/GBP1.249-1.250

USD/GBP 1.600-1.601

Isanarbitrage profitpossible? Ifso, computethearbitrageprofitin USDifyou

startwithUSD1million

Answer:

Theimpliedcross rates:

-1,271x1.249=1.587x

GBP'bid EUR'bid GBP 'bid

jStudy Session 4

Economics

Thereare twopossible pathsaroundthe triangle(we aregiven thestartingposition in USD): *

Path1 USD-*ÿGBP->EUR USD

Path2:USD EUR—» GBP -»USD

Step 1: Convert 1 million USD into EUR G 1.27.2 -EUR 786,164

Sir/,.2: Convert MR 786, 164 imo C BP C 1.250 - (,BI> 628,931

-Step3 ConvertGBP628,931intoUSD@1.600=USD1,006,289

Arbitrageprofit= USD6,289

Note.Instep 1 , we aregoing fromUSDtoEUR(“down”the USD/EURquote),hencewedivide USD 1 ,000,000by the askrate of 1 272.Thesamelogicis used ;

forsteps 2and 3 Note alsothatwedidnothateto computetheimplied crossrate' tosolve thisproblem:wecould’ve simply computed the end resultusingboth

pathsto seeifeither would giveus anaibitrageprofit

Study Session 4

Economics

Mark-to-Market Value ofaForward Contract

Themark-to-marketvalueofaforwardcontractreflects theprofitthat would berealizedbyclosingoutthe positionat currentmarketprices, whichisequivalentto

offsettingthecontractwithanequalandoppositeforwardposition:

_ (FPt—FP)(contract size)

vt

360where:

Vt =valueof theforwardcontract attimet (tothepartybuying thebase

currency), denominatedinthepricecurrency.

FP( =forwardprice(tosell base currency)at time tinthemarketfora new

contractmaturingat timeT[t < T).

days=number ofdaysremainingtomaturity of the forwardcontract (T—t).

R = theinterest rateof the pricecurrency.

Example:Mark-to-market valueofaforwardcontract

YewMun Yip hasenteredinto a90-dayforwardcontractlongCAD1million:against AUDat aforward rateof1.05358AUD/CAD.Thirty daysafter

i initiation,thefollowingAUD/CADquotes areavailable:

Maturity FX Rate

1.0612/1.0614Spot

*14.67+16.8

+42.37+48.3The followinginformation isavailable(at t=30)for AUDinterest rates:

Study Session 4

Economics

sj <v vt< g | cÿ |g tSÿ | *• n % i \ pH

Yip’scontractcalls forlongCAD (i.e.,conveningAID toCADYTo value the .

contractv.wewould lookto unwind the position.To unwind the position, Yip

can-'takeanoffsettingposition in a nowforward contractwith thesamematurity

Hence Yip.wotild.be sel-iing-CAD.-in exchangeforAUD- and',hence,goingup thehit!(i.e., usethe hid price) Note thatalter30days.OQ.moredaysremain in the

relativeto A l 'D since int option of the connect.Y ipcan close out the, contract on

that:d.r> and weaveAUD8,463.64.

International ParityConditions

Note: Exchangerates (whereapplicable) below follow theconventionofA/B.Covered interestarbitrage:

Coveredinterest rateparityholdswhen anyforwardpremiumordiscountexactlyoffsets differencesin interest rates so an investorwouldearnthesame return

investingineithercurrency Coveredin thiscontext means itholdsby arbitrage

I+RA|—360

|i+rb|days So

Study Session 4

EconomicsUncoveredinterest rateparity:

Uncoveredinterest rateparityrelates expectedfuturespotexchangerates (insteadofforward exchangerates) to interest ratedifferentials.Sincetheexpectedspotpriceis notmarkettraded, uncoveredinterest rateparity doesnot hold by arbitrage

!+ RA I

1+ RB J

E(St) =expectedspot rate at time t= (S0)

Comparing coveredand uncoveredinterestparity,we seethat covered interestrate

parity givesustheno-arbitrageforwardexchangerate,while uncoveredinterest rate

parity givesustheexpected futurespotexchangerate (which is notmarkettraded).

InternationalFisher relation:

Relativepurchasingpower parity(relative PPP) statesthatchangesinexchange

ratesshouldexactlyoffset the priceeffects ofanyinflationdifferential between two countries.

Relative PPP:

1+inflationÿ

St- S0 1

+inflationÿ

Study Session4

Economics

Figure1:The International ParityRelationshipsCombined

Uncovered Interest Rate ParityExchangeRate

Differentials

Inflation Rate

Covered Interest Parity

• Coveredinterestparity holdsby arbitrage.If forwardrates areunbiased

predictorsoffuturespot rates,uncoveredinterest rateparity also holds(and vice versa).

• Interestratedifferentialsshouldmirrorinflation differentials This holdstrueif

the internationalFisher relationholds.Ifthatis true, we canalsouseinflationdifferentialstoforecastfuture exchangerateswhichisthe premise of theex-ante versionof PPP

8 Bycombining relative purchasingpower parity with the international Fisher

relation, we getuncovered interestrateparity

RealExchangeRates

IfrelativePPPholdsatanypoint intime,the realexchangeratewill beconstant,

andiscalled theequilibriumrealexchangerate.However,sincerelativePPPseldomholdsover theshortterm,the realexchangeratefluctuates aroundthismean-revertingequilibriumvalue

realexchangerate (A/B) =equilibriumrealexchangerate

+ (real interestrateB-realinterestrateA)

Study Session 4

Economics

Severalobservationscanbe made about therelationshipidentified above:

• Thisrelationship should onlybe usedto assessthe directionofchange(i.e.,appreciate/depreciate)in realexchangeratesrather than preciseestimatesof

exchangerates.

• In theshortterm,therealvalueofa currencyfluctuatesarounditslong-term,equilibriumvalue

* The real valueofa currency ispositivelyrelatedto itsreal interestrateand

negativelyrelatedtothe risk premiuminvestorsdemandfor investing inassets

denominatedin thecurrency

8 The realinterest rateincreases when the nominalinterest rateincreases(keeping

inflation expectationsunchanged)orwhenexpected inflationdecreases(keeping

nominalinterest ratesunchanged)

TaylorRule

TheTaylorrule links the centralbanks policyrate to economicconditions

(employmentlevel andinflation)andcanbe usedtoforecast exchangerates.Under

theTaylorrule,the realinterest rate ispositivelyrelatedtobothinflationgap and

outputgap

realinterest rate=r = rn+ a(tt - IT*) +(3(y-y*)

where:

r =Taylorruleimpliedrealpolicyinterest rate

rn =Neutralrealpolicyinterest rate

=Current inflationrate

7t* = Central bank’stargetinflation rate

=logofcurrentlevelofoutput

y* =logof central bank’starget (sustainable)output

a, (3 =policyresponse coefficients(>0;Taylor suggesl-edavalueof0.5 forboth)

71

Y

TheTaylorrule advises that thepolicyrateshould be raisedin responsetopositiveinflation andoutputgaps

Becauseexchangerates arepositivelyrelated tothe realinterest rateina country

(due tocapital inflowsto countrieswith highrealinterest rates),exchangerates

should also bepositivelyrelatedtoinflationgaps andoutputgaps

TheFXCarry Trade

TheFXcarry trade seekstoprofitfrom the failure of uncoveredinterest rateparity

toholdin the shortrun.InanFXcarry trade,the investorinvests in ahigh-yield

Study Session 4

Economics

currencywhile borrowinginalow-yieldcurrency.Ifthehigher yieldcurrencydoes

notdepreciate bytheinterest ratedifferential, theinvestormakesaprofit

profitoncarry trade

=interestdifferential-changein thespotrateofinvestment currency

The carry trade isinherentlyaleveragedtrade thatisexposedtocrashrisk, asthe

underlyingreturndistributions of carry tradesarenon-normal (negativeskewnessandexcess kurtosis).Riskmanagementincarrytrade may beimplemented through

avaluationfilteror avolatilityfilter

BalanceofPayments(BOP)Analysis

BOPinfluenceonexchangerates canbeanalyzedbasedon current account

influenceandcapitalaccountinfluence

Currentaccountinfluences include:

• Flow mechanism: A current accountdeficit putsdownwardpressureonthe

exchangevalueofacountry’scurrency.The decreaseinthevalueof thecurrencymayrestorethecurrent accountdeficitto abalancedependingonthe initial

deficit,theinfluenceofexchangerates on exportand import prices, and thepriceelasticity ofdemand of tradedgoods

* Portfoliocomposition mechanism- Investorcountrieswithcapitalaccount

deficits(and current accountsurpluses)may find theirportfoliosdominated

byinvestmentsincountriespersistently running capitalaccountsurpluses(and current account deficits).If/when theinvestor countriesrebalance their

portfolios,theinvesteecountries’currenciesmaydepreciate

• Debtsustainability mechanism-.Acountryrunninga current accountdeficitmay

berunningacapitalaccountsurplus by borrowingfrom abroad When the level

of debtgets toohighrelative'to GDP, investorsmayquestion thesustainability

of this level ofdebt,leadingto arapid depreciationof the borrower’scurrency.Capitalaccountinflows(outflows) are oneof the majorcausesof appreciation

(depreciation) ofacountry’scurrency

ApproachestoExchangeRate Determination

1 Mundell-Fleming model

Figure2showsthe impact ofmonetaryand fiscal policiesin theshortrunundertheMundell-Fleming model