CFA 2018 exam level 3 CFA level III quick sheet

PRIVATE WEALTH MANAGEMENT INVESTMENT POLICY STATEMENT • Return calculation • To maintain real value of portfolio, the required real aft er-tax return is calculated as: Annual after-tax w

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CFA ® LEVEL III SMARTSHEET

FOR THE CFA EXAM

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ETHICAL AND

PROFESSIONAL STANDARDS

STANDARDS OF PROFESSIONAL CONDUCT

• Thoroughly read the Standards, along with related

guidance and examples

ASSET MANAGER CODE OF

PROFESSIONAL CONDUCT

• Firm-wide, voluntary standards

• No partial claim of compliance

• Compliance statement: “[Insert name of ﬁ rm] claims

compliance with the CFA Institute Asset Manager Code of

Professional Conduct This claim has not been veriﬁ ed by

CFA Institute.”

• Firms must notify CFA Institute when claiming

compliance

• CFA Institute does not verify manager’s claim of

compliance

• Standards cover:

• Loyalty to clients

• Investment process and actions

• Trading

• Risk management, compliance, and support

• Performance and valuation

• Disclosures

BEHAVIORAL FINANCE

BEHAVIORAL FINANCE PERSPECTIVE

• Prospect theory

• Assigns value to changes in wealth rather than levels

of wealth

• Underweight moderate- and high-probability

outcomes

• Overweight low-probability outcomes

• Value function is concave above a wealth reference

point (risk aversion) and convex below a wealth

reference point (risk seeking)

• Value function is steeper for losses than for gains

• Cognitive limitations

• Bounded rationality: deciding how much will be done

to aggregate relevant information and using rules of

thumb

• Satisﬁ cing: ﬁ nding adequate rather than optimal

solutions

• Traditional perspective on portfolio construction

assumes that managers can identify an investor’s

optimal portfolio from mean-variance eﬀ icient portfolios

• Consumption and savings

• Mental accounting: wealth classiﬁ ed into current

income, currently owned assets, PV of future income

• Framing: source of wealth aﬀ ects spending/saving

decisions (current income has high marginal

propensity to consume)

• Self-control: long-term sources unavailable for current

spending

• Behavioral asset pricing models

• Sentiment premium included in required return

• Bullish (bearish) sentiment risk decreases (increases)

required return

• Behavioral portfolio theory

• Strategic asset allocation depends on the goal

assigned to the funding layer

• Uses bonds to fund critical goals in the domain of

gains

• Uses risky securities to fund aspirational goals in the

domain of losses

• Adaptive markets hypothesis

• Must adapt to survive (bias towards previously successful behavior due to use of heuristics)

• Risk premiums and successful strategies change over time

BEHAVIORAL BIASES

• Cognitive errors (belief persistence biases)

• Conservatism: overweight initial information and fail to update with new information

• Conﬁ rmation bias: only accept belief-conﬁ rming information, disregard contradictory information

• Representativeness: extrapolate past information into the future (includes base-rate neglect and sample-size neglect)

• Illusion of control: believe that you have more control over events than is actually the case

• Hindsight bias: only remember information that reinforces existing beliefs

• Cognitive errors (information-processing biases)

• Anchoring and adjustment: develop initial estimate and subsequently adjust it up/down

• Mental accounting: treat money diﬀ erently depending

on source/use

• Framing: make a decision diﬀ erently depending on how information is presented

• Availability bias: use heuristics based on how readily information comes to mind

• Emotional biases

• Loss aversion: strongly prefer avoiding losses to making gains (includes disposition eﬀ ect, house-money eﬀ ect and myopic loss aversion)

• Overconﬁ dence: overestimate analytical ability

or usefulness of their information (prediction overconﬁ dence and certainty overconﬁ dence)

• Self-attribution bias: enhancing and self-protecting biases intensify overconﬁ dence

• Self-control bias: fail to act in their long-term interests (includes hyberbolic discounting)

• Status quo bias: prefer to do nothing than make a change

• Endowment bias: value an owned asset more than if you were to buy it

• Regret aversion: avoid making decisions for fear of being unsuccessful (includes errors of commission and omission)

• Goals-based investing

• Base of pyramid: low-risk assets for obligations/needs

• Moderate-risk assets for priorities/desires; speculative assets for aspirational goals

• Behaviorally modiﬁ ed asset allocation

• Greater wealth relative to needs allows greater adaptation to client biases

• Advisor should moderate cognitive biases with high standard of living risk (SLR)

• Advisor should adapt to emotional biases with a low SLR

INVESTMENT PROCESSES

• Behavioral biases in portfolio construction

• Inertia and default: decide not to change an asset allocation (status quo bias)

• Nạve diversiﬁ cation: exhibit cognitive errors resulting

from framing or using heuristics like 1/n diversiﬁ cation.

• Company stock investment: overallocate funds to company stock

• Overconﬁ dence bias: engage in excessive trading (includes disposition eﬀ ect)

• Home bias: prefer own country’s assets

• Mental accounting: portfolio may not be eﬀ icient due

to goals-based investing as each layer of pyramid is optimized separately

• Behavioral biases in research and forecasting

• Representativeness: due to excessive structured

information

• Conﬁ rmation bias: only accept supporting evidence

• Gamblers’ fallacy: overweight probability of mean reversion

• Hot hand fallacy: overweight probability of similar returns

• Overconﬁ dence, availability, illusion of control, self-attribution and hindsight biases also possible

• Market behavioral biases

• Momentum eﬀ ects due to herding, anchoring, availability and hindsight biases

• Bubbles due to overconﬁ dence, self-attribution, conﬁ rmation and hindsight biases

• Value stocks have outperformed growth stocks; small-cap stocks have outperformed large-small-cap stocks

PRIVATE WEALTH MANAGEMENT INVESTMENT POLICY STATEMENT

• Return calculation

• To maintain real value of portfolio, the required real aft er-tax return is calculated as:

Annual after-tax withdrawal from the portfolio / Asset base

• To convert aft er-tax withdrawal to a pre-tax withdrawal

Pre-tax withdrawal = After-tax withdrawal / (1 – Tax rate on withdrawals)

• Nominal return = Real return + Inﬂ ation rate

• If investor wishes to grow portfolio, use TVM worksheet

to compute I/Y over investment horizon

• Risk tolerance

• Above-average ability if longer time horizon or large asset base compared with needs

• Willingness based on psychological proﬁ le

• Overall tolerance is a combination of ability and willingness

• Time horizon constraint: length and number of stages

• Liquidity constraint: ongoing needs, one-time expenditures, emergencies

• Tax constraint: diﬀ erent rates may apply to diﬀ erent sources of income and capital gains

• Legal and regulatory constraint: less of a concern for individuals, restricted trading periods may apply to corporate insiders

• Unique constraint: client-imposed restrictions, e.g socially responsible investing, client-directed brokerage

• Psychological proﬁ ling

• More risk averse: methodical (thinking), cautious (feeling)

• Less risk averse: individualist (thinking), spontaneous (feeling)

• Strategic asset allocation

• Return: eliminate portfolios that do not meet return objective May need to convert a pre-tax nominal return to an aft er-tax real return

After-tax real return = Pre-tax nominal return × (1 – Tax rate) – Inflation rate

• Risk: eliminate portfolios that do not meet shortfall or other risk objectives

• Constraints: eliminate portfolios that do not meet constraints, e.g cash holding for liquidity

• Of the remaining portfolios, select portfolio with highest risk-adjusted performance, usually on Sharpe ratio

Sharpe arpe ar ratio is:(expected return – rturn – rturn – riskn – risk-free rate)

expected standard ndard nda deviation

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TAXES AND PRIVATE WEALTH

MANAGEMENT

• Future value factor with accrual taxes

pre-tax

after-tax pre-tax

FVIF F Fpr pre-tax e-tax r r r

FVIF r

FVI

FVIF F F F F Fafte after- r-tax tax [1 [1 r r r r r rpr pr

FVIF r

FVI

n

(1 )

(1 pr )

( pre-tax)

( e-tax)

F ( r )

F 1 r

F (1 1 r )

F 1 rpr

F ( rpr pr )

F rpr

(1 )]

(1 1 1 t)] ] ]

(1 1 t I)] ]

(1 1 I I)] ]

(1 1 I)] ]

F = +r

F r

F ( r )

F = +r

F ( r )

F 1 r

F (1 1 r )

F = + 1 1 r

F (1 1 r )

F 1 r

F = +r

F [1 r

F = + [1 [1 r

F [1 r ((1 1 1 1 − ))] ] ] ]

• Future value factor when deferring taxes on capital gains

(B is cost basis as a proportion of current market value)

FVIF CG = (1 + r r rpre‐tax pre‐tax )n (1 − t CG ) + t CG CG CG B B

• Future value factor with annual wealth tax

FVIF r

FVI F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F F W W W W W W W W W W W W W W W W W W W W W W W W W W W W W W W W W W W W W W W W W W W W W W W W W W W W W W W W W= = = = = = = = = = = = = = = ==== = = =           ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( (1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 + + + + + + + + + + + + + + + ++++ + + +r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r rpr prprprpr prprprprprprprprprprprprpre-taxe-taxe-tax e-taxe-taxe-taxe-taxe-tax) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) )((((((((1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 11 t1 1 11 t1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 −t t t t W W W W W W W W W W W W W W W W W W W W W W W W W W W W W W W W W W W W W W W W W W W W W W W W W W W W W W W W W))))))))n

• Eﬀ ective annual aft er-tax return aft er taxes interest,

dividends and realized capital gains

*

r* r

r* r T I

r r T I

r =r T T T T T T(((((((((((((((11 P t1 1 11 P t−P t P t P t P t I I I I I I I I I I P t P t P t P t P t P t D D D D D D D D P t P t P t P t P t P t P t P t P t P t C C C C G C G C G C G C G G)))))))))))))))

r =r −

r =r T T − I I

r r T I

r =r −

r r T I

r = = = =r T T T T T T T T((((((((((((1 1 1 1 1 1 1 1 1 1 1 1 − − − − I I I I I I I I − −P t P t P t P t − − ))))))))))))

• Eﬀ ective capital gains tax rate

1

T* * t t P P P

P t P t P t

CG P P I I P P D D P P CG CG

P t I D

P t P t I P t D D D P t P t P t P t C C G C G C G

T =t

T t − − − −P P P P−

−P t−

−P t− −

















• Future value factor with blended tax regime

after-tax

FVIF F F F Fafte after- r-tax tax (1 (1 r r r r r

FVIF r

FVI F F F F = + = + (1 (1 (1 (1 r r r r) ( ) (n n − − − −T T T T T T* *) * * * *) ) ) ) ) + + + +T T T T T T T T T − − −t t t t t t t t CG CG(1 (1 (1 (1 (1 (1 − − −B B B B B B B B

• Accrual equivalent aft er-tax return

1

0

V V

r V

V0

V n V A

V V0

V n V0 0 A

V V0

n

AE

r AE

r V V n n

n

(1 )

(1 r )

( r )

n ( r r A)

n= = 0 0(+ +r A E E)

V=V +

V V0

V=V0 0 +

V n n n n= =V0 0 0 0 0 + +A A A A

V n V A

V=V +

V n V A

V V0

V n V0 0 A

V=V0 0 +

V n V0 0 A

V n n n n n n n n= = = =V0((((((((1 1 1 1 1 1 1 1 1 1 1 1 + + + +A A A A A A A A))))))))

=n −

• Accrual equivalent tax rate

( )

= −

r =r −

r =r((−T ))

T r

r

AE

r AE r

r r(((((( T T AE AE))))))

AE

T AE

T r r AE AE

(1 )

( )

= ((1 − ))

1

= − 1

= −

• Measure of tax drag = Diﬀ erence between accrual

equivalent aft er-tax return and the actual return of the

portfolio

• Tax-deferred accounts (TDAs): contributions from

untaxed ordinary income, tax-free growth during the

holding period, taxed at time of withdrawal

FVIF TDA = (1 + r)n (1 – t n)

• Tax-exempt accounts (TEAs): aft er-tax contributions,

tax-free growth during the holding period, no future tax

liabilities

FVIF F F F = + = + = + = +(((((( r r r r))))))

FVIF r

FVI F F F F F F F F F F F F TE TE TEA TE TE TE A A A= + = + = + = +((((((((((((((1 1 1 r r r r r r r r r r r r))))))))))))))n

• TDA oﬀ ers aft er-tax return advantage over TEA if tax

rate at withdrawal is lower than tax rate at initial

contribution

• Investor’s shared of investment risk on a taxed return

σAT= σ − σ −(((( t))))

σAT=

σ = σ − σ −((((((1 1 ))))))

ESTATE PLANNING

• Core capital

• Assets for maintaining lifestyle, funding desired

spending goals and providing emergency reserve

• Joint survival probability for a couple

p s l p al p s l

p s l p al

l J p H

l H p W

l p

p s( )

p sur( ( ( ( (urviva urviva ur urviva ur viva l l l l l l J J J J J J J J J J) ) ) ) ) p p p p p p( ( ( ( ( ( (su su su surviv rviv rvival rviv rviv rvival al al al al H H H H H H H H H H) ) ) ) ) ) ) p s p sur( ( ( ( ( ( (urviva urviva ur urviva ur viva l l W W) ) ) ) ) ) )

( viva )

( vival ) p

p s( )

p sur( ( ( ( (urviva urviva ur urviva ur viva l l l l l l H H H H H H H H H H) ) ) ) ) p p p p p p( ( ( ( ( ( ( (su surviv su su su surviv rvival rviv rviv rvival al al al al W W W W W W W W W W) ) ) ) ) ) ) )

l =p +

l J J=p H H+

l J p H

l =p +

l J p H

l J J J J J J J J J J J J J J J J= = = = = = = =p( ( ( ( ( ( ( ( ( ( ( ( ( ( ( (su su su surviv su su su su su su su surviv rviv rviv rvival rviv rviv rviv rviv rviv rviv rvival al al al al al al al al al al H H H H H H H H H H H H H H H H) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) + + + + + + + +

l p

− l l l H×p p p W

−p s( ) ×

−p s p s( ( ) ) ×

−p s p sur( (ur ) ) ×

− ( (ur urviva viva ) ) ×

− ( (urviva ur urviva ur viva viva ) ) ×

− ( (urviva ur urviva ur l l ) ) ×p p

− ( ( l l l l l l H H) ) ×p p p p p p W W

− ( l l l l H H) ×p p p p W W

• PV of joint spending needs

(1 ) 1

PV sp( ( ( (sp ending ending) ) ) ) p s p s((((((((((((ur ur ur viva viva l l l l l l l)))))))))))) ((((s s s spending s s s pending pending pending))))))))

r

J

( ) ( ( ( ( ( ( l l l l l l l l l l J J J J J J J J J) ) ( ) ) ) ) ( ( ( ( ( ( ( ( ( ( (s s s s s s s s s s pending pending pending pending pending pending J J J J J J J J J) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) )

t t

N

∑

= l l l l l l J J××s s s s s s J J

+

=

• Relative aft er-tax value of a tax-free gift

[1 (1 )] (1 )

RV FV FV

r(1 t

r t

r(1 t

r(1 t T

ta

RV ta

RV tax f ta x f x fr x f eeGift r reeGift r G

FV G

FV ift Bequest

FV Bequest

FV

g(1 i

r g t i

r(1 t

r g(1 (1 t i

r(1 t g

e(1 i

r e t i

r(1 t

r e(1 (1 t i

r(1 t e T T e e

= = ++++ +r r r r r r r r r r r r g g g g(1(1(1(1(1 (1 (1 (1 (1 (1 (1 (1−−−− −t t t t t t t t t t t t i i i i

+r −t

+r r(1 (1 −t t

+r r r e(1 (1 −t t t i

+r r r r e e(1 (1 (1 (1 −t t t t i i

+r r e(1 (1 (1 (1 −t t i −

x f−

x f

• Relative aft er-tax value of a gift taxable to the recipient

RV FV FV

r(1 t

r(1 t T

r(1 t

r(1 t T

taxabl

RV taxabl

FV G

FV ift

Bequest

FV Bequest

FV

g(1 i

r g t i

r(1 t

r g(1 (1 t i

r(1 t g T T g g

e(1 i

r e t i

r(1 t

r e(1 (1 t i

r(1 t e T T e e

= = ++++ +r r r r r r r r r r r r g g g g(1(1(1(1(1 (1 (1 (1 (1 (1 (1 (1−−−− −t t t t t t t t t t t t i i i i −

+r −t

+r r(1 (1 −t t

+r r r e(1 (1 −t t t i

+r r r r e e(1 (1 (1 (1 −t t t t i i

+r r e(1 (1 (1 (1 −t t i −

• Trusts

• Revocable: owner (settlor) retains right to assets and can use trust assets to settle claims against settlor

• Irrevocable: owner forfeits right to assets and cannot use trust assets to settle claims against settlor

• Double taxation

• Credit method: residence country provides a tax credit for taxes paid in source country

t CM CM CM =Max =Max (t t t , t RC RC RC RC , t , t , t SC SC)

• Exemption method: residence country exempts foreign source income from tax

t EM t

t t SC

t =t

t t

• Deduction method: residence country allows deduction for tax paid in source country

t DM t t t t

t DM t

t =t RC+t t SC SC t t RC SC

t =t +

t =t RC RC+t t −t t

CONCENTRATED SINGLE-ASSET POSITIONS

• Objectives: risk reduction (diversiﬁ cation), monetization, tax optimization, control

• Considerations: illiquidity, triggering taxable gains

on sale, restrictions on amount and timing of sales, emotional and cognitive biases

• Monetization strategies

• Monetization by (1) hedging the position, and (2) borrowing against hedged position

• Hedging for monetization strategies can be achieved by: (1) short sale against the box (least expensive); (2) total return equity swap; (3) short forward or futures contract; (4) synthetic short forward (long put and short call)

• Hedging strategies

• Buy puts (protect downside and keep upside while deferring capital gains tax)

• Use zero-premium collars (long put and short call with

oﬀ setting premiums) to reduce costs vs buying puts

• Use prepaid variable forward (combine hedge and margin loan in same instrument), with number of shares delivered at maturity dependent on share price

at maturity

• Yield enhancement strategies:

• Write covered calls to generate income

• Does not reduce downside risk

• Tax optimized equity strategies

• Index-tracking separately managed portfolio: designed

to outperform benchmark from an investment and tax perspective

• Completeness portfolio: tracks index given concentrated portfolio characteristics and new investments

• Exchange fund: investors with concentrated positions contribute these positions in exchange for a share in a diversiﬁ ed fund (non-taxable event)

• Monetization strategies for concentrated private shares

• Strategic buyers: gain market share and earnings growth

• Financial buyers: acquire and manage companies using private equity fund

• Leveraged recapitalization: private equity ﬁ rm uses debt to purchase majority of owner’s stock for cash

• Management buyout: management borrow money to purchase owner’s stock

• Divestiture of noncore assets: owner uses proceeds to

diversify asset pool

• Sale or gift to family members

• Personal line of credit secured by company shares

• Initial public oﬀ ering

• Employee share ownership plan (ESOP) exchange: company buys owner’s shares for ESOP distributions

• Monetization strategies for real estate

• Mortgage ﬁ nancing (no tax consequences and can use proceeds to diversify)

• Donor-advised funds (contribute property now for tax deduction)

• Sale and leaseback (frees up capital for diversiﬁ cation but sale triggers taxable gain)

RISK MANAGEMENT FOR INDIVIDUALS

• Financial capital: includes all tangible assets including family home

• Human capital: PV of future expected labor income (higher income volatility requires higher discount rate)

• Income volatility risk can be diversiﬁ ed by appropriate

ﬁ nancial capital, e.g if human capital is equity-like,

ﬁ nancial capital should contain more bonds

• Economic (holistic) balance sheet

• Assets: ﬁ nancial capital, personal property, human capital, pension value

• Liabilities: total debt, lifetime consumption needs, bequests

• Net wealth is the diﬀ erence between total assets and total liabilities

• Young family has high % of economic assets in human capital As the household ages, weight of human (ﬁ nancial) capital will decrease (increase)

• Risks to human and ﬁ nancial capital

• Earnings risk: protect against earnings risk related to injury with disability insurance

• Premature death (mortality risk): protect with life insurance

• Longevity risk: protect with annuities

• Property risk: protect with homeowner’s insurance

• Liability risk: protect with liability insurance

• Health risk: protect with health insurance

• Risk management techniques

High severity Low severity

Risk avoidance Risk reduction

Risk transfer Risk retention

• Adequacy of life insurance

• Human life value method: estimates the PV of earnings that must be replaced

• Needs analysis method: estimates ﬁ nancial needs of dependents

INSTITUTIONAL INVESTORS DEFINED BENEFIT PENSION PLAN

• Risk tolerance: greater ability to assume risk if

• Plan surplus

• Lower sponsor debt and/or higher current proﬁ tability

• Lower correlation of plan asset returns with company proﬁ tability

• No early retirement and lump sum distributions options

• Greater proportion of active versus retired lives

• Higher proportion of younger workers

• Risk objective: usually related to shortfall risk of achieving funding status

• Return objective: to achieve a return that will fully fund liabilities (inﬂ ation-adjusted), given funding constraints

• Liquidity: to meet required beneﬁ t payments

• Time horizon: usually long-term and could be multi-stage

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• Tax: investment income and capital gain usually

tax-exempt

• Legal/regulatory: plan trustees have a ﬁ duciary

responsibility to beneﬁ ciaries under ERISA (US)

• Unique: limited resources for due diligence, ethical

constraints

FOUNDATIONS

• Risk tolerance/objective: higher risk tolerance due to

noncontractually committed payout

• Return objective: to cover inﬂ ation-adjusted spending

goals and overheads not countable toward required

spending minimum

r % spend % management % inflation

or

(1 % spend)(1 % management)(1 % inflation) 1

= % spend +

= + (1

= + (1 1 % 1 % management + + + + + management)( )(1 % 1 % + + + + + −

• Liquidity: to quickly fund spending needs (including

noncountable overheads) greater than current

contributions

• Time horizon: usually inﬁ nite

• Tax: investment income and capital gain taxable

• Legal/regulatory: UPMIFA (US)

• Unique: May use swap agreements or other transactions

to diversify returns if funding is primarily via large blocks

of stocks

ENDOWMENTS

• Risk tolerance/objective

• Greater ability to take risk due to inﬁ nite time horizon

and if adopting spending rules based on smoothed

averages of return and previous spending

• Lower ability to take risk if high donor contributions as

a % of total spend

• Lower ability to take risk if contributing a signiﬁ cant %

to a company’s annual spending or if company relies

on endowment to cover high ﬁ xed costs

• Return objective: same as for foundations Annual spend

may be calculated in a number of ways

Spendingt= Spending rate × Ending market valuet−1

Spendingt= Spending rate × 1 1 1 ⁄ ⁄ ⁄ ⁄ [Ending market value 3 t−3

+ Ending market valuet−2 + Ending market valuet−1 ]

Spendingt= Smoothing rate × [Spendingt−1 × (1 + Inflationt−1 )]

+ [(1 − Smoothing rate) × (Spending rate × Beginning market valuet−1 )]

• Liquidity: to fund gift s and planned capital distributions

for construction projects as well as to allow portfolio

rebalancing No minimum spending requirement

• Time horizon: usually inﬁ nite (maintain principal in

perpetuity)

• Tax: not taxable unless they are unrelated business

taxable income

• Legal/regulatory: UPMIFA (US)

• Unique: types of investments constrained by size or

board member sophistication

LIFE INSURANCE COMPANIES

• Liquidity risk: arises from changes in investment

portfolio that aﬀ ects reserves

• Interest rate risk: reinvestment risk and valuation

risk (due to duration mismatch between assets and

liabilities)

• Credit risk of bond investments

• Cash volatility risk: relates to timely receipt and

reinvestment of cash

• Disintermediation risk: policy owners withdraw

funds to reinvest with other intermediaries in

higher-returning assets

• Return objective: minimum return requirement (based

on rate initially speciﬁ ed to fund life insurance contract)

and net interest spread

• Liquidity: limited liquidity needs since cash inﬂ ows exceed cash outﬂ ows, but need to consider disintermediation risk (when interest rates are rising) and asset marketability risk

• Time horizon: diﬀ erent product lines have diﬀ erent time horizons and will be funded by duration-matched assets

• Tax: pay corporate tax

• Legal/regulatory: regulations on eligible investments, prudent investor rule, NAIC risk-based capital (RBC) and asset valuation reserve (AVR) requirements

• Unique: look out for restrictions on illiquid investments

NON-LIFE INSURANCE COMPANIES

• Policyholder reserves use lower-risk assets due to unpredictable operating claims

• Maintaining surplus during high-volatility markets reduces ability to accept higher risk

• Risk measured against premiums-to-capital and premiums-to-surplus ratios

• Return objective

• Investment earnings on surplus assets must be suﬀ icient to oﬀ set periodic losses and to maintain policyholder reserves

• Larger companies use active management strategies for total return rather than yield or investment income strategies

• Liquidity: to meet policyholder claims

• Time horizon: generally shorter duration than life insurance companies

• Legal/regulatory: regulations on eligible investments, risk-based capital (RBC) requirements

• Unique: look for restrictions on illiquid investments

BANKS

• Below-average risk tolerance

• Leverage-adjusted duration gap (LADG) measure overall interest rate exposure

LADG D D D kD kD k

k V V

D A k L

D A kD D L

D kD

D A k L

D kD

k V L A

k V L L L/ /V V A A A

=D−k

=D D D A−k k k L

=D D A−k k L

k V=

k V

• Value at risk (VAR) measures minimum loss expected over a speciﬁ ed time period at a given level of probability

• Credit risk in the bank’s loan portfolio

• Return objective: interest income allocation focuses on positive spread over cost of funds, with the remaining allocation focusing on higher total return

• Liquidity: driven by demand for loans and net outﬂ ows

of deposits

• Time horizon: duration spread of assets over liabilities constrains time horizon for securities portfolio to an intermediate-term

• Legal/regulatory

• Large % of securities portfolio in government securities

as pledge against reserves

• Regulators restrict allocation to common shares and below-investment-grade bonds

• Risk-based capital requirements

• Unique: Lending activities may be inﬂ uenced by community needs and historical banking relationships

ECONOMIC ANALYSIS CAPITAL MARKET EXPECTATIONS

• Expected return on equity from Gordon growth model

E R D g

P g D

P g

( )

E R( )

E R=D D D D D D D D0 0((((+g g g g g g + = g g))))+ =g g + 0

P0

P

1 0

P0

P

( 1 )

D( g)

D1 g

D( g)

D g

• Expected return on equity from Grinold-Kroner model

E R( )

E R( ) D

P %%%%%%%%%%%%%%% %S I S I S INF S I S I S I NF NF NF NFL g NF NF NF L g L g L g r r %%%%%%%%%%%%%% PE% %

≈ − ∆ + % % % % % % % % % % % % % % % % ∆ + ∆ +S I S I L g L g+ + + + + +r r % % % % % % % % % % % % % % % %∆PE

• Risk premium (buildup) approach

• Fixed income buildup model

( )

E R( )

E R( ) ( ) ( )b b b b b b= = = =rr rr rr rr rr rr F F F F F F+ + + +RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP IN IN INFL IN IN IN FL FL FL+ + + +RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP Default D D efaul efaul t t t+ + + +RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP L L L L iquidity iquidity+ + +RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP Maturity Ma Ma turity turity+ + +RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP RP Ta Ta Tax Ta x

• Equity buildup model

E R( )e R F ERP YTM year Tre r Tre r T asury asury asur ERP

E R( )

E R( )e e F F

E R e F

E R( )

E R e F

E R e e e e= = = =R R R R R R F F F F+ + + + = = = = = = = = = = =YTM YTM 10 10−yea year T r Tre r Tre r T r Tre r T asur re asury asury asur asury asur y+ + + + + + + + + + +

• ICAPM (Singer-Terhaar)

• Expected return

E R ( ) R( ) ( )i i i i i i= = = =R R R R R R R R R R R R R R R R R R F F F F F F+ + + + β β β β β β β β β β β β β β βi i i i i i i i i i i[ ( [ ( [ ( [ ( [ ( [ ( [ ( [ ( [ ( [ ( [ ( [ ( [ ( [ ( [ ( [ ( [ ([ (R E E E E E E E E E E E E E E E E E E E R R R R R R R R M M M M M M M M M M M) ) ) ) ) ) ) ) ) ) ) ) − − − − − − − − − − − − − − −R R R R R R R R R F F] ] ] ] ] ] ] ] ] ] ] ]

• Asset class risk premium in a 100% fully integrated market

COV

COV i M

COV

M

i M i M M i

M i M

,

i M,

i M

2 ,

i M,

i M

2 i M i M, ,

β =i

σ σi M

σ σi Mρ















ρ

RP i RP

RP i

RP RP RP M M

M i i M

=σ σ ρ σ ρi i i i,

• Asset class risk premium in a completely segmented market

RP i i RP

RP i i

RP RP RP M M M

= σ

i= σi

















• Expected return with less than 100% integration and

a liquidity risk premium (where RP i * is the weighted average of perfectly integrated and completely segmented asset class risk premiums)

E R ( ) R( ) ( )i i i i i i= = = =R R R R R R F F F F F F+ + + +RP R R R R R RP P P P P P P P P i i i i i* * + +R R R RP R R R R R R P P L L L L L iquidity

• Taylor rule

= + [0.5 ( × × × × × ( GDP GDP − − − − − GDP GDP ) 0 ) 0 + + + + + 5 5 × × × × × ( )]

R Op =R + × × × × GDP GDP GDP GDPg g g − − − − GDP GDP GDP GDPg g g ( ( ( (I I − − − −I I ) ) ) )

R Op R

R timal R

R = = = = = =R Neut Neut ra ra l l l l l l l l l l l l l l l l l l l l+ + + + + + [0 [0.5 5 ( × × × × × × × × × × × × × × × × × × × × × × × × × × × × × × × × × × × × × × × × × × × × × × × × × × × × × × × × × × × × × × × × × × ( ( ( GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDPg g g g g g g g g g g g g g g g g g g g g g g g g g g g g g g g g g g g g g g g g g F F F F F F F F F F F F For F F F F F F F or or or or or or or orecast or or or or or or or ecast ecast ecast ecast ecast ecast ecast− − − − − − − − − − − − − − − − − − − − − − − − − − − − − − − − − − − − − − − − − − − − − − − − − − − − − − − − − − − − − − − − − − GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDP GDPg g g g g g g g g g g g g g g g g g g g g g g g g g g g g g g g g g g g g g g g g g Trend d d d d d d d d d d d d d) 0 ) 0 ) 0 ) 0 + + + + + + + + + + 5 5 5 5 × × × × × × × × × × ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( (I I I I I I I I I I I I I I F F F F F F F F For F F F F F or or or or or orecast or or or or or ecast ecast ecast ecast ecast I I I I I I I I I I I I I I Ta Ta rg rg et et) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) )

• Exchange rate forecasting

• Relative PPP: exchange rates off set infl ation diff erentials

%∆ ∆ ∆ ∆ ∆ ∆ ∆ ∆FX f d f d f d f d/ / / / ≈≈ INFL≈ ≈ ≈ ≈ ≈ ≈INFL IN f f f f INFL IN IN INFL INFL IN INFL IN FL d d d d

• Relative economic strength: increasing growth attracts portfolio investment capital, increasing short-term demand for domestic currency

• Capital ﬂ ows forecasting: higher relative direct and long-term portfolio investment causing currency appreciation

• Savings-investment imbalance: current account defi cits must be met with capital account surplus as foreign investors provide funds to off set domestic savings defi cit

EQUITY MARKET VALUATION

• Cobb-Douglas economic growth with constant returns

to scale

(1 )

Y Y A A K K L L

∆ ≈ ∆A ∆A +α ∆ + −+ − (1 (1 α ∆∆L L

• H-model for equity market valuation

2

V0

V0 D

r g

N

L ((((11 g g L L L L L L L L)))) 2 2(((((g g g g g g S S S S S S S S g g g g g g L L)))))

=r g r g− ((((((+ + + + +g g g g L L L L L L))))))+ + + + + ((g g g g S S S S S S−g g g g))





• Relative value models

• Fed model: equity market undervalued if S&P earnings yield > 10-year Treasury note yield (but ignores equity risk premium and earnings growth)

• Yardeni model: equity markets undervalued if model’s justiﬁ ed earnings yield < market’s earnings yield

1 0

E

P0

y B d LTEG

y B d

y d

=y−d

=y y y B−d d d

=y y B−d d×

• Cyclically adjusted P/E (CAPE) ratio

• 10-year moving average CAPE ratio controls for business cycle eﬀ ects and is mean reverting

Trang 5

• CAPE value is current-year real S&P 500 index value

divided by average real earnings over previous 10

years

• Asset-based models

• Tobin’s q: market value of debt and equity capital

divided by replacement cost of assets (undervalued if q

ratio < 1 assuming mean reversion)

• Equity q: market value of equity divided by

replacement cost of net assets (undervalued if q ratio <

1 assuming mean reversion)

ASSET ALLOCATION

ASSET ALLOCATION APPROACHES

• Asset-only: does not explicitly model liabilities

• Liability-relative (liability-driven investing): aims at an

asset allocation that can pay oﬀ liabilities when they

come due

• Goals-based investing: speciﬁ es sub-portfolios

aligned with a speciﬁ c goal (sum of all sub-portfolio

asset allocations results in an overall strategic asset

allocation)

PRINCIPLES OF ASSET ALLOCATION

• Mean variance optimization (MVO)

• Produces an eﬀ icient frontier based on returns,

standard deviation of returns and pairwise

correlations

• Find optimal asset allocation mix that maximizes

client’s utility

U p p E R( ( ( (R R R p p) ) 0.00 ) ) 0.005 5 A A A A

U p E p

U p= =E( ( ( ( ( (R R p) ) ) ) ) ) − − A A p

U = =E R( ( ( (R R R R R) ) ) ) − − × × × ×A A A A A A σ

• MVO limitations

• Asset allocations are highly sensitive to small changes

in input variables

• Asset allocations can be highly concentrated

• Only focuses on mean and variance of returns

• Sources of risk may not be well diversiﬁ ed

• Asset-only strategy

• Single-period framework and ignores trading/

rebalancing costs and taxes

• Does not address evolving asset allocation strategies,

path-dependent decisions, non-normal distributions

• Approaches to improve quality of MVO asset allocation

• Use reverse optimization to compute implied returns

and improve quality of inputs, e.g Black-Litterman

model

• Adding constraints to incorporate short-selling and

other real-world restrictions into optimization

• Resampled MVO technique combining MVO and Monte

Carlo approaches to seek the most eﬀ icient and

consistent optimization

• Monte Carlo simulation and scenario analysis

• Used in a multiple-period framework to improve

single-period MVO

• Provides a realistic picture of distribution of potential

future outcomes

• Can incorporate trading/rebalancing costs and taxes

• Can model non-normal distributions, serial and

cross-sectional correlations, evolving asset allocations,

path-dependent decisions, non-traditional investments,

human capital

• Risk budget

• Identiﬁ es total amount of risk and allocates risk to

diﬀ erent asset classes

• Asset allocation is optimal when ratio of excess return

to MCTR is the same for all assets

= × Marginal contri contri cont bution to total risk (MCTR) A = = = = = = = = = = A sse sse t b t b et et a P a P × × × × × × × × × × ortf ortf or olio tfolio tf standard ndard nda deviation

Absolute contribution to total risk Asset weight MCTR

Ratio of excess return t eturn t etur o MCTR (Expected return Risk-free rate)/MCTR

( AC ) ( ACTR ) ( TR ) = = = = = = A Asse sset w t weigh eight M t M × × × × × ×

= −

R ( = −

R (Expected = = = = Expected re retu turn rn − − − −

• Liability-relative asset allocation approaches

Surplus optimization two-Portfolio t Integrated Asset-liability

basic approach

Any funding ratio

• Goal-based asset allocations

• Creation of diﬀ erentiated portfolio modules based on capital market expectations

• Identifying clients’ goals and matching the goals to appropriate sub-portfolios and modules

ASSET ALLOCATION WITH REAL-WORLD CONSTRAINTS

• Constraints on asset allocation due to:

• Asset size: more acute issue for individual rather than institutional investors

• Liquidity: liquidity needs of asset owner and liquidity characteristics of diﬀ erent asset classes

• Time horizon: asset allocation decisions evolve with changes in time horizon, human capital, utility function, ﬁ nancial market conditions, characteristics of liability and the asset owner’s priorities

• Regulatory: ﬁ nancial markets and regulatory entities oft en impose additional constraints

• Taxes

• Place less tax-eﬀ icient assets in tax-advantaged accounts to achieve aft er-tax portfolio optimization

r at p r t p r

r at p

r = = =p d p d p r r r r r r r r r r r r r r r r t t t t t t t t(1 (1 (1 (1 − − −t t t t t t t t t t t t t t t t d d d d d d d d) ) ) ) ) p r p r p r p r p r p r p r p r a p a p a p a p a p a p t t t t t t t( ( ( ( ( 1 1 1 1 1 t t t t t t cg c c c c c c g g) ) ) ) )

r =p −

r = = = = = =p r d p d p d p d p r r r r r r r r r r r r r r r r r r r r r t t t t t t(1 (1 (1 (1 − − − − − −t t t t t t t t t t t t t t t t t t t t t t d d d d d d) ) ) ) ) ) ) ) ) ) + + + + + + + + +p r p r p r p r p r p r p r p r p r p r p r p r a p a p a p a p a p a p a p a p t t t t t t t t t t( ( ( ( ( ( ( ( ( ( 1 1 1 1 − − − − − − − − −c c c c c c c c c c) ) ) )

• Rebalancing range for a taxable portfolio (R taxable) can

be wider than those of an otherwise identical

tax-exempt portfolio (R tax exempt)

R taxable = = = = = R / ( / ( 1 t 1 t − − − − − )

Rtaxable R

R = = = = Rtaxtax exempt exempt − − − −

• Revision to asset an allocation

• Changes in goals

• Changes in constraints

• Changes in investment beliefs

• Tactical asset allocation (TAA) approaches

• Discretionary TAA: uses market timing skills to avoid or hedge negative returns in down markets and enhance positive returns in up markets

• Systematic TAA: uses signals to capture asset-class-level return anomalies that have been empirically demonstrated as producing abnormal returns

• Behavioral biases in asset allocation

• Loss aversion: mitigate by framing risk in terms of shortfall probability or funding high-priority goals with low-risk assets

• Illusion of control: mitigate by using the global market portfolio as a starting point and using a formal asset allocation process based on long-term return and risk forecasts, optimization constraints anchored around asset class weights in the global market portfolio, and strict policy ranges

• Mental accounting: goal-based investing incorporates this bias directly into the asset allocation solution by aligning each goal with a discrete sub-portfolio

• Recency or representativeness bias: mitigate by using

a formal asset allocation policy with prespeciﬁ ed allowable ranges

• Framing bias: mitigate by presenting the possible asset allocation choices with multiple perspectives on the risk-reward tradeoﬀ

• Familiarity or availability bias: mitigate by using the global market portfolio as the starting point in asset allocation and carefully evaluating any potential deviations

CURRENCY MANAGEMENT

• Domestic return on global asset (where exchange rate is expressed as SDC/FC)

R (1 R

R DC (1 R 1 1 R ) )

R DC R

R R FC FC FC)( )(1 1 FX FX FX) )

R = +R

R (1 R

R = + (1 (1 R

R (1 R FC FC FC FC 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 + + + + +R R R R R R FX FX FX FX) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) − − − − −

• Portfolio return in domestic currency terms

[ 1 (1 1 1 ) ) 1 1 ) w ) w 2 2 2 2 1 1 2 2 ) )

R [w (

R DC [w ( 1 1 R R R ) )(1 (1 R R R R R R R 2 2 )( )(1 1 1 1 1 1 R R R R 2 2 ) ) ) ) ) )

R DC w

R = = [ [ [ [ [ [w1 1 1 1 1 1 × × ( ( ( ( ( ( 1 1 1 1 1 1 R R FC FC FC FC FC FC1 1 1 1 1 1 ) )(1 ) ) ) ) (1 R R FX FX FX FX FX FX R R FC FC FC FC FC2 2 2 2 2 2 2 2 2 2 )( )( )( )(1 1 1 1 1 1 1 1 1 1 1 1 R R FX FX FX FX FX2 2 2 2 2 2 2 2 2 2 ) ) ) ) ) ) ) ) ) ) ) )

R =w×

R [w (

R = [ [w× ( (

R [w1 1 1 1 1 1 1 1 1 1 1 1 1 1 (1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 + + + + + + + + + +R R R R R R R R R R R R R R R R R R R R R R R R FC FC FC FC FC FC FC FC1 1 1 1 1 1 1 1 1 1 1 1 1 1 ) ) ) ) ) ) ) ) ) )(1 ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) )(1 ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) (1 (1 (1 (1 (1 (1 (1 (1 (1 (1 + + + + + + + + + +R R R R R R R R R R R R R R R R R R R R R R R R FX FX FX FX FX FX FX FX1 1 1 1 ) w ) w ) w ) w ) w ) w + + + + 2 2 2 2 × × × × + + + + + + + + + + +R R R R R R R R R R R R R R R R R R R R R R R R R R R R FC FC FC FC FC FC FC FC2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 )( )( )( )(1 )( )( )( )( )( )( )( )(1 )( )( )( )( )( )( )( )( )( )( )( )( )( )( )( )(1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 + + + + + + + + + + +R R R R R R R R R R R R R R R R R R R R R R R R R R R R FX FX FX FX FX FX FX FX2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) )] 1 ] 1 −

• Variance of the domestic return

2 (R R ) 2 ( (R R ) ) 2

2 ( (R ) ) 2R

2 ( ( (DC DC) ) ) 2 ( (FC FC FC) ) ( ( ( (R R R R FX FX FX) ) [2 ) ) [2 ( ( ( (R R R R FC FC FC FC FC FC FC FC) ) ) ) ( ( ( ( ( ( ( (R R R R R R R R R FX FX FX FX FX FX FX FX) ) ) ) ) ) ) ) ( ( ( ( ( ( ( (R R R R R R R R R FC FC FC FC FC FC FC FC,, R, , , , ,, R R FX FX FX FX FX FX FX FX

σ 2 ( ) ≈ 2

σ 2 2 ( ( ) ) ≈ 2 2

σ 2 ( (R ) ) ≈ 2R

σ ( (R R ) ) ≈ R R

σ 2 2 ( (R R ) ) ≈ 2 2R R

σ 2 2 2 2 ( ( ( (R R ) ) ) ) ≈ 2 2 2 2R R

σ 2 2 ( ( ( ( ( (R DC) ) ) ) ) ) ≈ 2 2R

σ ( ( ( ( ( (R R DC DC) ) ) ) ) ) ≈ R R

σ 2 2 2 2 ( ( ( (R R R R R R R R DC) ) ) ) ≈ σ σ σ σ σ 2 2 2 2 ( ( ( ( ( (R R R R R R R R ) ) ) ) ) ) + + + + +

σ ( (FC FC) ) + FX FX

σ ( (FC FC FC FC FC FC FC) ) + σ σ σ σ σ σ σ σ 2 2 ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( (R R R R R R R R R R R R FX FX FX FX FX FX FX) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) + + + + + + + + × σ × σ × σ × σ × σ × σ ( ( ( ( ( ( ( ( ( (R R R R R R R R R R R R FC FC FC FC FC FC FC FC) ) ) ) ) ) ) ) ) ) × σ × σ × σ × σ × σ × σR R R R R R FX FX FX FX FX FX FX FX × ρ × ρ × ρR R R R R R FC FC FC FC FC FC FC FC FX FX FX FX FX FX FX FX

• Factors favouring more currency hedging

• Signiﬁ cant short-term objectives, e.g income/liquidity requirements

• Global ﬁ xed-income investments

• Markets with high currency or asset volatility

• High risk aversion

• Doubt about value of currency return potential

• Lower possibility of regret if the hedge is not proﬁ table

• Low costs of hedging

• Hedging strategies

• Passive hedging: manager protects portfolio with full hedging

• Discretionary hedging: manager reduces risk with hedging but has discretion to make currency bets for return enhancement

• Active currency management: manager seeks alpha by making currency bets

• Currency overlay: currency management outsourced

to specialists

• Active currency management

• Economic fundamentals: real exchange rate will eventually converge to fair market values, with short-term increases in the domestic currency due to (1) increase in domestic currency’s real purchasing power, (2) higher domestic interest rates, (3) higher expected foreign inﬂ ation, and (4) higher foreign risk premiums

• Technical analysis: based on belief that historical currency patterns will repeat over time and those repetitions are predictable

• Carry trade: borrow in lower interest rate (or forward premium) currencies and invest in higher interest rate (or forward discount) currencies, based on assumption that uncovered interest rate parity does not hold

• Roll yield: positive when trading the forward rate bias (buying base currency at forward discount or selling base currency at forward premium); negative when trading against the forward rate bias (selling base currency at forward discount or buying base currency

at forward premium)

FC

DC

PC

BC

F C C = S F F ×

F = = = S C/ C/DC C/DC C/ C/DC C/ DC × × × 1 ( 1 (i + + + + i i i i iFCFC× × × × ) ) ) ) ) )

1 ( + ×

1 (i + + i i i i i DC DC × × ) ) ) ) ) )

F C C = S P P ×

F = S C/BC C/BC × 1 ( 1 (i + + + + i i i i iPCPC× × × × ) ) ) ) ) )

1 ( + ×

1 (i + + i i i i i BC BC × × ) ) ) ) ) )

• Volatility trade: long (short) straddle or strangle if volatility expected to increase (decrease)

• Currency management tools

CurrenCy ManageMent: an IntroduCtIon

options expire within that range The “short” position comes from the fact that the out-of-the-money put and call in the seagull spread have been shorted.

Exotic Options

Exotic options are those that are creative in nature and cannot be categorized as being

“plain.” Exotic strategies provide the lowest cost investment to achieve a specific outcome

in the investment policy statement or who have specific income needs that cannot be produced by traditional financial securities.

One commonly used exotic option is a knock‐in option in which the option does not actually exist until a barrier spot rate is realized Keep in mind that the barrier rate is not the same as the strike price For example, consider a call option with an exercise rate of CAD1.15/USD and a barrier rate of CAD1.12/USD If the spot rate is currently CAD1.10/

USD, the option does not even exist until the spot rate rises to CAD1.12/USD It works like a regular option, but if the barrier rate is never realized, it’s as if the option never existed A knock-out option ceases to exist when the exchange rate touches the barrier

If the base currency appreciates above the barrier, then the option no longer exists These exotics are cheaper than regularly traded options and offer less protection.

Exhibit 5‐1: Select Currency Management Strategies Forward Contracts Over‐/under‐hedging Profit from market view

Option Contracts OTM options Cheaper than ATM

Exotic Options Put/call spreads Write options to earn premiums

A digital option, which might also be called an “all‐or‐nothing” or binary option, earns a predetermined, fixed payout if the underlying reaches the strike price at any time during the life of the option It does not have to cross the strike price, nor does it have to remain in‐the‐money until expiration to earn the payoff amount This feature makes the option more appropriate for currency speculation than hedging.

• Minimum variance hedge ratio for a cross-hedge

• Obtained from a regression of change in value of underlying asset in domestic currency terms against change in value of the hedging security

• Beta (slope coeﬀ icient) of the regression equation is the optimal hedge ratio

• Basis risk occurs due to imperfect correlation between currency price movement and hedging instrument

Trang 6

MARKET INDEXES

• Market cap weighted index: weight of each security

is security’s capitalization value as a % of total index

market cap

• Advantages: broad acceptance; requires less

rebalancing as index remains properly weighted aft er

a price change

• Disadvantages: overly inﬂ uenced by overpriced

securities; price movements overly concentrated in a

few large companies

• Price weighted index: weight of each security is

proportional to its price (represents portfolio holding

one share of each security)

• Advantages: simple; long track record

• Disadvantages: not relevant to most strategies;

inﬂ uenced by highest priced securities; must be

rebalanced aft er stock splits

• Equal weighted index: all securities are held in equal

weights at rebalancing (represents portfolio holding an

equal $ amount of each security)

• Advantages: more diversiﬁ ed away from highest-priced

companies

• Disadvantages: must be rebalanced frequently to

maintain weighting; price movements of smaller

companies may be overrepresented

• Fundamental weighted index: uses accounting data or

other valuation metrics to weight the securities

• Advantages: better representation of economic

importance

• Disadvantages: rely on creator’s subjective judgment;

restrictive valuation screens may result in less

diversiﬁ cation; investability constraints of smaller

companies; not transparent because of proprietary

valuation weightings

FIXED INCOME PORTFOLIO

MANAGEMENT

INTRODUCTION

• Fixed-income returns model

• Expected return decomposition

≈

+

∆

−

+

E(R) Yield income

Roll down return

+ E( P ( P ∆ ∆ rice due to yields and spread read r s)

E(Credit losses)

E(Currency gains and losses)

• Yield income equals current yield assuming no

reinvestment income

Current yield =Annual coupon payment

Bond pric pric pr e

• Rolldown return: value change as bond approaches

maturity (pull to par)

=

Roll-down return eturn etur 1 0

0

B−B

B1 −B0

B1 B0

B

• Expected price change due to change in yield or spread

E(% P % P ∆ = ∆ = ∆ = ∆ = D ) ( ) ( − − − − − − − − − − D D D D D D D D D D Mo Mo Mo d d d × × ∆ + × × × × × × × × ∆ + ∆ + ∆ + C 0 Y Y Y Y Y Y Y Y Y Y Y ) ( ) ( C 0 × × × × 5 5 ∆ ∆ ∆ ∆Y ) Y ) Y ) 2 2

• Expected credit losses

• Eﬀ ect of leverage on portfolio return

r Portfolio return

Portfolio equity

r (V V ) r V

V V

V(r r )

P

rP

r r ( r (V I I I V V V E E E V VB VB V ) r B ) r B B B VB V B

E

VE V

VB

V

E

VE

V (r (r III r ) r ) BBB

=  = VVV V V V++++ + +VV ) rVB V VB V ) r B B B B) r) r ) r ) r−−−− − − B B B B B B

= + r

= + rI

= + r r II

= + r rI −

• Leverage with futures

Leverage =Notional value – Margin

Margin

Futures

LIABILITY-DRIVEN STRATEGIES

• Immunization: reduces or eliminates the risks to liability funding arising from interest rate volatility over the planning horizon

• Immunizing a single liability

• Market value of assets is greater than or equal to PV of liability

• Macaulay duration of assets matches liability’s due date

• Convexity of asset portfolio is minimized

• Portfolio needs rebalancing as time passes

• Risk: non-parallel shift s in yield curve (risk is reduced

by minimizing convexity)

• Cash ﬂ ow matching for multiple liabilities

• Portfolio has cash ﬂ ows matching the amount and timing of liabilities

• Duration matching for multiple liabilities

• Market value of assets is greater than or equal to the market value of liabilities

• Asset basis point value (BPV) equals the liability BPV

• Dispersion of cash ﬂ ows and convexity of assets are greater than those of the liabilities

• Derivatives overlay

• Uses bond futures contracts to immunize liabilities

Liability portfolio portfolio por BPV – Asset portfolio portfolio por BPV

Futures BPV Futures BPV

N BPV CF

f CT

BPV CT BPV CTD CT D

CT

CF CT

CF CTD CT D

=

≈

• Contingent immunization

• Active management if surplus (assets less liabilities) is above a designated threshold

• If the surplus falls below threshold, revert to a pure immunization strategy

• Use gains on actively managed funds to reduce cost of meeting liabilities

• Horizon matching: cash ﬂ ow matching for short-term liabilities (< 5 years), duration matching for long-term liabilities

• Interest rate swap overlay to reduce duration gap

NP Liability portfolio BPV – Asset portfolioportfoliopor BPV

• Risks when managing portfolio against a liability structure: model risk, spread risk, counterparty credit risk

INDEX-BASED STRATEGIES

• Total return mandates

• Pure indexing (full replication): match benchmark weights and risk factors by owning all bonds in the index with the same weighting

• Enhanced indexing: sampling approach to match primary risk factors; slight mismatch with benchmark weights to achieve a higher return compared to full replication

• Active management: aggressive mismatches with benchmark weights and primary risk factors to achieve outperformance

• Laddered bond portfolio

• Maturities and par values spread evenly along the yield curve

• Protection from yield curve shift s and twists by balancing the position between cash ﬂ ow reinvestment and market price volatility

• Suited to stable, upwardly sloped yield curve environments

• Higher convexity and liquidity

YIELD CURVE STRATEGIES

• Stable yield curve strategies

• Buy and hold: choose parts of curve where yield changes will not aﬀ ect return or purchase longer-duration/higher-yield securities

• Rolldown: riding the yield curve when yield curve is upward-sloping

• Selling convexity: sell lower-yielding higher-convexity bonds if expecting low interest rate volatility

• Carry trade: buy longer-maturity, higher-yielding securities and ﬁ nance them with shorter-maturity, lower-yielding securities

• Changing yield curve strategies

• Duration management: shorten (lengthen) duration if expect yield increases (decreases)

• Buying convexity: with falling yields, portfolios with greater convexity will increase more in value than portfolios with less convexity; with rising yields, portfolios with greater convexity will decrease less

• Bullet and barbell structures

Relative Outperformance Given Scenario

Slope change Flattening

Steepening

Barbell Bullet Curvature change Less curvature

More curvature

Bullet Barbell Volatility change Decreased volatility

increased volatility

Bullet Barbell

• Duration management methods

• Buy (sell) bond futures to increase (decrease) duration

= −

# Contracts required PVBP PVBP

PVBPT P

BPT P

BPTT PV PVBP BPPP

F

BPF BP

where the subscripts on PVBP indicate the target value T, actual portfolio value P, and futures value F.

• Use leverage to increase duration

Additional PVBP

of bonds 10,000 Leveraged

Modified odified odif

VLeve

VLeve D

New Old Equity Leveraged

Equity

DNe D

DNew DO

D w DO

VEquity V

VEquity VLeve

V VLeve

VEquity

w = O ×

w = Old ld ×

D =D ×

D w DO

D w w =DO O ×

D w DO

V +V

V V

• Use interest rate swaps: receive-fi xed, pay-fl oating swaps increase duration; pay-fi xed, receive-fl oating swaps reduce duration

• Convexity management methods

• Shift bonds in portfolio (diﬀ icult with large portfolios)

• Buying callable bonds and MBS (equivalent to selling convexity)

• Portfolio positioning strategy

• Parallel upward shift : bonds with forward implied yield change greater than forecast yield change will enjoy higher return as they roll down the yield curve (upward sloping)

• Parallel yield change of uncertain direction: increase convexity by using barbell strategy

• Using butterﬂ ies: long the wings (barbell) and short the body (bullet) if ﬂ attening curve, volatile interest rates, buying convexity or parallel yield curve increase; short the wings and long the body if steepening curve, stable interest rates or selling convexity

• Using options: sell convexity bonds (30-year maturity) and purchase call options to outperform in both rising and falling rate scenarios

CREDIT STRATEGIES

• Risk considerations

• High yield bonds: credit risk (includes default risk and loss severity)

• Investment grade bonds: interest rate risk, credit migration risk, spread risk

Trang 7

• Spread duration (measure of spread risk): percentage

increase in bond price for a 1% decrease in spread

• Credit spread measures

• G-spread: bond’s yield to maturity less interpolated

yield of correct maturity benchmark bond

• I-spread: uses swap rates rather government bond

yields

• z-spread: spread added to each yield-curve point so

that PV of bond’s cash ﬂ ows equals price

• Option-adjusted spread (OAS) for bonds with

embedded options: spread added to one-period

forward rates that sets arbitrage-free value equal to

price

• Excess return and expected excess return on credit

securities

XR≈ × ≈ × ≈ × ( ( ( ( ( (s t s t s t s t s t s t) ) ) ) ) ) − ∆ − ∆ ( ( ( ( ( ( ( (s S s SD s SD s S s SD s S s S s S s S s S× D) ) ) ) ) ) ) )

EXR≈ × ≈ × ≈ × ( ( ( ( ( (s t s t s t s t s t s t) ) ) ) ) ) – ( ∆ × ∆ ×s SD s SD s S s S s S D D D D D D D D) ( ) ( ) ( ) ( − × − × − ×t t t t t t t t t t p L p L p L× )

• Bottom-up approach to credit strategy (security

selection): for two issuers with similar credit risks,

purchase bond with greater spread to benchmark rate

• Top-down approach to credit strategy: macro approach

to determine and overweight sectors with better relative

value

• Managing liquidity risk

• Cash

• Liquid, non-benchmark bonds (higher incremental

return vs cash)

• Credit default swaps index derivatives (more liquid

than credit markets)

• ETFs (liquid but unpredictable price movements in

volatile markets)

• Tail risk

• Assess tail risk by modelling unusual return

patterns and using scenario analysis (historical and

hypothetical)

• Manage tail risk using (1) diversiﬁ cation strategies and

(2) hedges using options and credit default swaps

• Advantages of using structured ﬁ nancial securities such

as ABSs, MBS, CDOs and covered bonds

• Higher returns vs other types of bonds

• Improved portfolio diversiﬁ cation

• Diﬀ erent exposures to investment grade and high yield

bonds

EQUITY PORTFOLIO MANAGEMENT

• Approaches to managing equity portfolios

• Passive management: try to match benchmark

performance

• Active management: seek to outperform benchmark

by buying outperforming stocks and selling

underperforming stocks

• Semiactive management (enhanced indexing): seek

to outperform benchmark with limited tracking risk

(highest information ratio)

• Approaches to constructing an indexed portfolio

• Full replication: minimal tracking risk but high costs

• Stratiﬁ ed sampling: retains basic characteristics of

index without costs associated with buying all the

stocks

• Optimization: seeks to match portfolio’s risk exposures

(including covariances) to those of the index but can

be misspeciﬁ ed if historical risk relationships change

over time

• Value style investing: low P/E, contrarian, high yield

• Growth style investing: consistent growth, earnings

momentum

• Market-oriented (blend or core style) investors:

market-oriented with a value bias, market-market-oriented with a

growth bias, growth at a reasonable price, style rotators

• Market cap approach: small-cap, mid-cap, large-cap

investors

• Investment style analysis

• Holdings-based: analyses characteristics of individual

security holdings

• Returns-based: regressing portfolio returns on returns of a set of securities indices (betas are the portfolio’s proportional exposure to the particular style represented by index)

• Price ineﬀ iciency on the short side

• Restrictions to short selling

• Management’s tendency to deliberately overstate proﬁ ts

• Sell-side analysts issue fewer sell recommendations

• Sell-side analysts are reluctant to issue negative opinions

• Sell disciplines

• Substitution: opportunity cost sell and deteriorating fundamentals sell

• Rule-driven: valuation-level sell, down-from-cost sell, up-from-cost sell, target price sell

• Semiactive equity strategies

• Derivative-based semiactive equity strategies:

exposure to equity market through derivatives and enhanced return through non-equity investments, e.g

ﬁ xed income

• Stock-based enhanced indexing strategies: portfolio looks like benchmark except in those areas on which the manager explicitly wishes to bet on (within risk limits) to generate alpha

• Information ratio (Grinold and Kahn)

IR IC Breadth ≈

• Core-satellite portfolio: index and semiactive managers constitute core holding while active managers represent satellites

• Total active return and risk

• Manager’s true active return = Manager’s return – Manager’s normal benchmark

• Manager’s misﬁ t active return = Manager’s normal benchmark – Investor’s benchmark

• Total active risk

Manager’s totalactiveris eris er k (Manager’s “tru “tru “t e” active ris e ris e r k) 2 2 2 2 2 2 2 2 2 2 2 2 2 (Manager’s “misfit” active ris (M (Manager anager’s ’s “m “mis isfi fit” t” activ active r e ris e r k) e ris e ris e r e ris e r k) is k) 2 2 2 2 2 2 2 2 2 2 2 2 2

= +

• Information ratio as measure of manager’s risk adjusted performance

IR Manager’s “truetruetr ” active returneturnetur Manager’s “true true tr ” active ris e ris e r k

=

ALTERNATIVE INVESTMENTS

• Common features of alternative investments

• Relative illiquidity

• Diversifying potential

• High due diligence costs

• Diﬀ icult performance appraisal

• Informationally less eﬀ icient markets

• Real estate

• Direct investment: ownership in residences, commercial real estate, agricultural land

• Indirect investment: real estate companies, REITs, ETFs, mutual funds, CREFs, infrastructure funds

• Benchmarks: NCREIF (sample of commercial properties), NAREIT

• Private equity

• Direct private equity investment is structured as convertible preferred stock: provides priority for dividends and liquidation claims over common shares;

buyout or acquisition of the common equity will trigger conversion of convertible prefs into common shares

• Indirect investment primarily through private equity funds (venture capital and buyout funds)

• Formative-stage investment: seed, start-up, ﬁ rst stage capital

• Expansion-stage investment: second stage, third stage, pre-IPO (mezzanine) capital

• Buyout funds seek to add value by: restructuring operations and improving management; purchasing

companies at a discount to intrinsic value; capturing gains from debt structuring

• Compensation to fund manager of private equity fund consists of management fee plus incentive fee (carried interest)

• Benchmarks: IRR, benchmarks for VC funds and buyout funds provided by Cambridge Associates and Thomson Venture Economics

• Commodities

• Direct investment: purchase of physical commodities and commodity derivatives

• Indirect investment: companies specializing in commodity production

• Energy and precious metals provide signiﬁ cant inﬂ ation hedge

• Benchmarks: RJ/CRB, S&P GSCI, DJ-AIGCI and S&P CI are indices based on futures prices

• Hedge funds

• Broad range of strategies

• Compensation structure consists of management fee plus incentive fee and may include high-water mark and hurdle rate

• Diff erences in hedge fund indices due to: selection criteria, style classifi cation, weighting scheme, rebalancing scheme, investability, survivorship bias, backfi ll bias

• Hedge fund performance appraisal measures

• Sharpe ratio (inappropriate with illiquid holdings and when returns are asymetrical/skewed or serially correlated)

• Sortino ratio

Sortino ratio = (Annualized rate of return - Minimum

acceptable return)/Downside deviation

• Gain-to-loss ratio

Gain-to-loss ratio (Number months with positive retur e retur e r eturns etur / Number months ns

with negative returns eturns etur ) (Average up-month r month r mont eturn / eturn / etur Average down-month r month r mont eturn) eturn) etur

=

) ( × ) (

• Distressed securities

• Hedge fund structure or private equity fund structure

• Risks: event risk, market liquidity risk, market risk, J-factor risk (past judicial precedents on bankrupt proceedings)

RISK MANAGEMENT

• Financial risks: market, credit, liquidity, asset price, exchange rate, interest rate

• Non-ﬁ nancial risks: operational, model, settlement (Herstaat), regulatory, legal/contract, tax, accounting, sovereign/political

• VaR

• Minimum amount we expect to lose in a given reporting period with a given level of probability

• Analytical (variance-covariance) method: assumes normality in asset return distributions

Miniumum $ VaR V= = =V V V V V V V V V V V V V V P P P P P P P P P P P P× × ×[[[[[[[[[[[[[[[[[[[[E E E E E R E E E E E E E E E E( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( (R R R R R R R R R R R P P P P P P P P P P P P) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) − σ − σ − σ − σZ Z Z Z Z Z Z Z Z Z Z Zα α αP P]]]]]]]]]]]]]]]]]]]]

• Historical method: VaR estimates based on historical realizations of past returns

• Monte Carlo method: uses a probability distribution for each variable to randomly generate portfolio returns and to compute VaR based on the simulated returns

• Limitations: can be diﬀ icult to estimate; considers only downside risk; may be based on invalid distributional assumptions

• Stress testing as a complement to VaR

• Used to identify unusual conditions that would lead to losses in excess of a threshold

• Can be based on stylized scenarios (historical or hypothetical), stressing models, maximum loss optimization and worst-case scenario analysis

• Credit risk

• Current credit risk (jump-to-default): risk of ongoing or pending default in the immediate future

• Potential credit risk: risk of possible default in the future

Trang 8

• Credit VaR: minimum expected loss due to a negative credit

event with a given probability during a period of time

• Forwards: counterparty with positive value has credit risk

• Interest rate and equity swaps: potential credit risk is

highest during the middle of swap’s life

• Currency swap: potential credit risk is highest between

the middle and end of swap’s life

• Options: option buyers hold credit risk

• Managing risk: apply eﬀ ective risk governance model; use

ERM system; use risk budgeting; reduce or transfer risk

• Performance evaluation

• Sharpe ratio

• Risk-adjusted return on capital (RAROC)

• Return over maximum drawdown (RoMAD)

• Sortino ratio

RISK MANAGEMENT

APPLICATION OF DERIVATIVES

FORWARD AND FUTURES

• Managing equity market risk and changing equity asset

allocation by beta adjustment

=β − ββ





















 

f

f β − β − βT T T βS S S

f

• Creating synthetic stock index fund or converting equity

into cash

Round (1 )

*

N V V(1(1 r r

fq

f

T

= V V +r r















where V is the amount of money to be invested, V V is the amount of money to be invested, r r r is the risk-free rate, is the risk-free rate, T T T is the is the

investment horizon, q is the futures contract price multiplier, f is the stock index f f is the stock index

futures price, and N*fis an integer representing the number of long stock index

futures contracts to convert a cash position to an equity position or the number

of short stock index futures contracts to convert an existing equity position into

a cash position.

• Changing bond asset allocation













N MDUR M MDUR M

MDUR

M

B f

M

T MDUR S

T MDUR M DUR S

T MDUR M S

DUR f f f B y

OPTIONS

• Option strategies

Strategy Construction using

Covered

call Own underlying share and sell call on share Earn premium to cushion losses

Protective

put Own underlying share and buy put on share Downside protection with upside potential

Bull

spread Buy call at lower strike and sell call at higher strike (can

use puts instead of calls)

Speculation on stock price increase in a range Bear

spread Buy call at higher strike and sell call at lower strike (can

use puts instead of calls)

Speculation on stock price decrease in a range Butterﬂ y

spread Buy call at lower strike, buy call at higher strike, sell

two calls at strike halfway

between strikes of long calls

(can use puts instead of calls)

Bet on low volatility

Collar Buy stock, buy put and sell

call (zero-cost collar if

call and put premiums are

the same)

Downside protection and with limited upside Straddle Buy call and put with same

Strap Buy two calls and one put

with same strike Bet on high volatility (stock price rise more

likely) Strip Buy one call and two puts

with same strike Bet on high volatility (stock price fall more

likely) Strangle Buy call and put, put has

different exercise price Bet on high volatility

Box

spread Bull call spread and bear put spread Replicate risk-free return or make

arbitrage proﬁ t

• Interest rate options

• Buy interest rate call option to protect a future borrowing against interest rate increases

Interest rate call option payoff ayoff ayof N N otional principal max (Underlying rate at

expiration Exercise rate,0) Days in underlying rate

360

= ×

f = N ×

f = = = = Notiona otional p l pri rincipal ncipal × × × ×

− ×

n E − ×

n Exe − − − − − − − xerc rcis ise r e rat ate, e,0) 0) × × × × × × ×

• Buy interest rate put option to protect a future lending (or investing) transaction against interest rate declines

360

f = = = = Notiona otional p l pri rincipal ncipal × × × ×

• Cap: series of interest rate call options

• Floor: series of interest rate put options

• Interest rate collar to protect a future borrowing: buy interest rate cap and sell interest rate ﬂ oor

• Option Greeks

• Option delta: positive for long call; negative for long put

Option delta Change in option price Change in underlying stock price

c S

• Option gamma: greatest for options that are at-the-money and close to expiration

= Option gamma Change in option delta

Change in underlying stock price

SWAPS

• Duration of interest rate swaps

Duration (Fixed-rate bond)

= Duration [pay floatin y floatin y f g and receive fixed interes nteres nter t rate swap] wap] wa Duration (Fixed-rate bond)

Duration (Floating-rate bond)

=

• Use pay ﬂ oating and receive ﬁ xed interest rate swap to increase duration of bond portfolio

• Use pay ﬁ xed and receive ﬂ oating interest rate swap to reduce duration of bond portfolio

• Duration management using an interest rate swap

=  − 

NP V MDUR M MDUR M

MDUR M P

V P

V T T T T M MDUR MDUR M MDUR M DUR P P P P

S

• Uses of currency swap

• Convert loan in one currency into a loan in another currency

• Convert foreign cash receipts into domestic currency

• Uses of equity swap

• Diversify a concentrated portfolio

• Achieve international diversiﬁ cation

• Change asset allocation between stocks and bonds

• Swaptions

• Payer swaption: holder has right to enter interest rate swap as ﬁ xed-rate payer (in-the-money when interest rates go up)

• Receiver swaption: holder has right to enter interest rate as ﬁ xed-rate receiver (in-the-money when interest rates go down)

TRADING, MONITORING AND REBALANCING EXECUTION OF PORTFOLIO DECISIONS

• Eﬀ ective spread

Effectiv ffectiv ff e spread 2 Execution price (Bid pricpricpr e Ask pricpricpr e)

2

= × 2 E

= × 2 22  E EE − e Ae A+



2  E

2  E

2  E

2  E





2  E









• Market quality

• Liquidity: resilience, quote depth, narrow bid-ask spreads

• Transparency: pre-trade and post-trade

• Assured completion: trade completion is guaranteed

• Execution costs

• Explicit: commissions, exchange fees, duties and taxes

• Implicit: bid-ask spread, market impact, missed trade opportunity cost, delay (or slippage) costs

• Volume-weighted average price (VWAP)

• Advantages: easy to compute/understand; useful for comparing smaller trades in nontrending markets

• Disadvantages: Does not include costs of delayed/ cancelled trades; misleading for large trades; can be gamed by delaying trades; not sensitive to trade size or market conditions

• Implementation shortfall (IS)

• IS is the return diﬀ erence between the return on a notional portfolio and the actual portfolio’s return, expressed as a % of the investment in the notional portfolio

• Explicit costs (for purchases)

= Expicit costs Commissions, taxes, and feesfeesf

S ×P

S H×P H

S H P H

S ×P

S H× ×P H

S ×P

• Realized proﬁ t/loss (for purchases)

= ××(( −− ))

RPL S S S S× × × × × × ( ( ( ( ( (P P P P− − − − − −P) ) ) ) ) )

S ×P

S ×E P R

(E R)

× ( − )

× E− R

× ( − )

S ( (P E R) )

S× × ( (P− − ) )

S× × × × ( (P E− − − − R) )

S× × ( ( ( ( (P E− −P P R) ) ) ) )

S H P H

S ×P

S H× ×P H

S ×P

• Delay or slippage costs (for purchases)

= Delay S S S S× × × × × × × ×(( ( ( ( ( ( ( (P P P P− − − − − − − −P)) ) ) ) ) ) ) )

S ×P

(R H)

× ( − )

× R− H

× ( − )

S ( (P R H) )

S× × ( (P− − ) )

S× × × × ( (P R− − − − H) )

S× × ( ( ( ( (P R− −P P H) ) ) ) )

S H P H

S ×P

S H× ×P H

S ×P

• Unrealized proﬁ t/loss or missed trade opportunity cost (for purchases)

=(( − ×− ×− × ()) )

UPL

UP ((( (S S − × − × − × − × (S S))) ) ( ( (P P− − − −P P) ) ) )

S ×P

H− × L

( − × ) (H− × − × ) L

(H− × ( ) (L ) ) (S S)

(S S) ( − × ) (S − × − ×S) (H− × − × ) L

(S − × − ×S) (H− × ( ) ( ( ( ( ( ( ( ( (P P P P L P P P P H H H) ) ) ) ) ) ) ) ) )

S H P H

S ×P

S H× ×P H

S ×P

• IS is the sum of explicit costs, RPL, delay costs and UPL (for sales, reverse the prices used in the numerator)

• Advantages: relates execution costs to value of investment idea; recognizes tradeoﬀ between immediacy and price; attribution of execution costs; can be used to optimize turnover and improve performance; cannot be gamed

• Disadvantages: requires extensive data collection; unfamiliar framework

• Types of traders

trader

Information Unassimilated information Time Minutes/hours

Liquidity Divest securities, invest

cash, buy things

Dealers/Day traders Accommodate other traders Indifferent Minutes/hours

• Trading tactics

Focus Purpose costs Advantages Disadvantages

Liquidity at any cost Immediately execute large blocks

Upsetting supply/demand Guaranteed execution Information

market impact possible Need

trustworthy agent

Low level advertising on large trades;

possible hazardous situation

Higher commissions;

information leakage

Price improvement

to wait Lose trade control

Costs are not important Certain execution Spread; potential price impact Market‐ determined

price Lose trade control Advertise to

draw liquidity Large trades without information advantage

High (organizational and operational) cost

Market‐

determined price

Possible front running Low cost

whatever the liquidity

Indifferent to timing; non‐

informational trades

High search and monitoring costs;

low commission

Favorable price possible Execution uncertainty; possible movement away from price point results in

“chasing” the market with limit orders

• Algorithmic trading

• Simple logical participation strategies: VWAP strategy aims to match expected volume for the stock; TWAP strategy breaks order up for exposure at various time periods during the day; percentage of volume strategy makes trades as some % of overall market volume until completed

• Implementation shortfall (arrival price) strategies:

Trang 9

minimize execution costs by front-loading executions

into the early part of the trading day

• Opportunistic strategies: involve passive holdings and

opportunistically seizing liquidity

• Specialized strategies: smart routing, “hunter”

strategies and benchmark-based algorithms

MONITORING AND REBALANCING

• Rebalancing disciplines

• Calendar rebalancing: simple but unrelated to market

behavior

• Percentage-of-portfolio (or interval) rebalancing:

provides tighter control and triggers rebalancing

related to market performance

• Calendar and percentage-of-portfolio: rebalancing

occurs at calendar intervals only if corridors have been

exceeded (lower monitoring and rebalancing costs)

• Equal probability rebalancing: corridors are based on

a common multiple of asset class standard deviation;

does not address transaction costs or correlations

• Tactical rebalancing: less frequent rebalancing during

trending markets; more frequent rebalancing during

reversals

• Optimal corridor width of asset class

Higher transaction costs Wider corridor

Higher risk tolerance Wider corridor

Higher correlation with rest of

Higher volatility of asset class Narrower corridor

Higher volatility of remaining

• Rebalancing strategies

constant Mix buy‐and‐hold cPPI

Market conditions

DOWN — Momentums Underperform Outperform Outperform

Implications

Portfolio insurance Selling insurance None Buying insurance

PERFORMANCE EVALUATION

• Characteristics of a valid benchmark: unambiguous, investable, measurable, appropriate, reﬂ ective of current investment opinions, speciﬁ ed in advance, acknowledged

• Types of benchmarks: absolute return, manager universe, broad market index, investment style index, factor-model-based, return-based, custom security-based

• High quality benchmark: low systematic bias; minimal tracking error; similar risk exposure to portfolio;

signiﬁ cant overlap of holdings with portfolio; low turnover; positive active positions

• Macro attribution (fund sponsor level)

• Net contributions

• Risk-free rate

• Asset categories

• Benchmarks

• Investment managers

• Allocation eﬀ ects

• Micro attribution (investment manager level)

• Explains three components of value-added return (diﬀ erence between the returns on the portfolio and the benchmark)

[( ) ( )] [ ( )]

r v r P r w r r w w w w) ( ) (r r r r r)] )] [ [w w w ((r r

r v r P

r r r r B B w w P P

i S

Pi w w w w Bi Bi r r r r Pi Pi r r Bi Bi w w

S

Bi

[Bi ( [ (r r r r Pi Pi r r r r Bi Bi

i S

r B B B B ∑∑∑∑∑∑[( [( [( [(w P P P P w w w w ) ( ) ( ) ( ) (r r r r r r r r)] )] )] )] ∑∑∑∑∑∑w w w w

r B w P

r B [(w P

r ∑∑∑∑∑∑∑∑w i i i i w w w w w w w w w w w w B B B B i i i i i i i i) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) (r r r r r r r r r r r r B B B B B B B B i i i i r r r r B B B B ∑∑∑∑∑∑∑∑w w w w r r ∑∑w w

= − =

r= − =r

r v v= − = = − =r P P r r w w

r v r P

r= − =r

r v r P

r= − =r r r r r B B ∑∑∑∑∑∑∑∑∑∑∑∑∑∑∑∑∑∑∑∑∑∑∑∑∑∑∑∑w w w w P P i i i i i i i i− − − − − − − −w w w w w w w w w w w w w w w w w w w w w w w w w w w w w w w w B B B B B B B B i i i i i i i i) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( × × × × × × × ×r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r r B B B B B B B B i i i i i i i i− − − − − −r r r r r r r r r r r r r r r r B B B B B B B B)] )] )] )] )] )] )] )] )] )] )] )] + + + + + +∑∑∑∑∑∑∑∑∑∑∑∑∑∑∑∑∑∑∑∑∑∑∑∑∑∑∑∑w w w w w w w w w w w w w w w w − − − − −w w w w w w w w Bi Bi) ( ) ( ) ( ) ( ) ( ) ( × × × × ×r r r r r r r r− − − − −r r r r r r r r Bi Bi)] )] )] )] )] )] + + + + + [ [w w w w w w w w × × × × ((r r r r r r Pi Pi− − − −r r r r r r

• First term is pure sector allocation eﬀ ect

• Second term is allocation/selection interaction eﬀ ect

• Third term is stock selection eﬀ ect

• Fixed income micro attribution

• Decomposes total return of a ﬁ xed-income portfolio into two groups of components: eﬀ ect of external interest environment (out of manager’s control) and contribution of the investment manager

• Eﬀ ect of external interest environment: return on the default-free benchmark, assuming no change in forward rates; return due to changes in forward rates

• Contribution of the investment manager: return from interest rate management; return from sector/

quality management; return from selection of speciﬁ c securities; return from trading activities

• Risk-adjusted performance measures

• Ex post alpha

R t r f ( (R r) )

R t r f

R t t−r ft f t t t= ( ( ( ( ( ( ( ( ( ( ( (R R M M Mt M t t t t t t t r r f f f f ft f f f t t t) ) ) ) ) ) ) ) ) ) ) ) t t t t

R−r =

R t t−r f f=

R t r f

R−r =

R t r f

R t t t t− −r ft f ft f t t t t t t t t t t t t t t t t t t t t t t= = α + α + β β β β β β β β β β β β ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( ( (R R R R R R R R R R R R R R R R R R M M M M M M M M M M M M Mt M Mt M M M M M M M M M t t t t t t t t t t− − − − − − − − − − − −r r r r r r r r r r r r r r r r r r f f f f f f f f f f f f t t) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) ) )+ ε + εt t

• Treynor measure

T A R R r r

T A

T R R A A r r f f

A

=R Rβ−r r

• Sharpe ratio

Sharpe Shar ratio A R R A r r f

R A r f

R r

A

=R Rσ−r r

• M2

2

M r

M2 r

M2 r R R r r

R A r f

R r

= +

M = +r

M = +r f f

M r f

M = +r

M r f

M r R R −r r

σ















σ

conclusion on manager performance as they are based

on systematic risk

• Sharpe ratio and M2provide the same conclusion on manager performance as they are based on total risk

• Information ratio

IR A R R R A A R R R B B

A B

=R R −R R

σA B A B−

• Manager continuation policies

• Type I error: keeping (or hiring) managers who do not have investment skills

• Type II error: ﬁ ring (or not hiring) managers who do have investment skills

GLOBAL INVESTMENT PERFORMANCE STANDARDS

• Focus on required disclosures, and presentation and reporting requirements and recommendations of GIPS

• Be able to identify and correct errors in a performance presentation that claims to be GIPS compliant

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