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Quantitative
Methods

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1-90

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2-90

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Topic Weightings in CFA Level II
Session NO. Content Weightings

Study Session 1-2 Ethics & Professional Standards 10-15

Study Session 3 Quantitative Methods 5-10

Study Session 4 Economic Analysis 5-10

Study Session 5-6 Financial Statement Analysis 15-20

Study Session 7-8 Corporate Finance 5-15

Study Session 9-11 Equity Analysis 15-25

Study Session 12-13 Fixed Income Analysis 10-20

Study Session 14 Derivative Investments 5-15
Study Session 15 Alternative Investments 5-10

Study Session 16-17 Portfolio Management 5-10
3-90

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¾ SS3 Quantitative Methods for
Framework Valuation
• R9 Correlation and
Quantitative Methods regression
• R10 Multiple regression and
issues in regression analysis
• R11 Time-series analysis
• R12 Excerpt
from ’’Probabilistic
Approaches: Scenario
Analysis, Decision Trees, and
Simulation’’

4-90

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Reading
9

Correlation and regression

5-90

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1. Scatter Plots
2. Covariance and Correlation
Framework 3.
4.
Interpretations of Correlation Coefficients
Significance Test of the Correlation
5. Limitations to Correlation Analysis
6. The Basics of Simple Linear Regression
7. Interpretation of regression coefficients
8. Standard Error of Estimate & Coefficient of
Determination (R2)
9. Analysis of Variance (ANOVA)
10. Regression coefficient confidence interval
11. Hypothesis Testing about the Regression
Coefficient
12. Predicted Value of the Dependent Variable
13. Limitations of Regression Analysis

6-90

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Scatter Plots
¾ A scatter plots is a graph that shows the relationship between the
observations for two data series in two dimensions.

7-90

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Sample Covariance and Correlation
¾ Covariance:
z Covariance measures how one random variable moves with
another random variable. ----It captures the linear relationship.

n
z Cov( X , Y ) ¦(X
i 1
i  X )(Yi  Y ) /( n  1)

z Covariance ranges from negative infinity to positive infinity

Cov( X , Y )
¾ Correlation: r
sx s y
z Correlation measures the linear relationship between two
random variables
z Correlation has no units, ranges from –1 to +1

8-90

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Interpretations of Correlation Coefficients
¾ The correlation coefficient is a measure of linear association.
¾ It is a simple number with no unit of measurement attached, so the
correlation coefficient is much easier to explain than the covariance.

Correlation coefficient Interpretation
r = +1 perfect positive correlation
0 < r < +1 positive linear correlation
r=0 no linear correlation
−1 < r < 0 negative linear correlation
r = −1 perfect negative correlation

9-90

5.CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www.net Example ¾ The covariance between X and Y is 16.t critical z Conclusion: the correlation between the population of two variables is significantly different from zero. So we can say that the correlation coefficient between X and Y is significantly different from zero.101.net Significance Test of the Correlation ¾ Test whether the correlation between the population of two variables is equal to zero.45 is larger than the critical value of 2. Test the significance of the correlation coefficient at the 5% significance level. z H0: ρ=0. df = n-2 1-r 2 1-r 2 n-2 z Decision rule: reject H0 if t>+t critical. The sample size is 20. HA: ρ≠0 (Two-tailed test) z Test statistic: r-0 r n-2 t= .net Interpretations of Correlation Coefficients 10-90 www.101.45 1  0. 11-90 www. Since the test statistic of 2. two-tailed test with df=18 is 2. The t- statistic can be computed as: 20  2 t 0.gfedu.gfedu. or t<.25 The critical t-value for α=5%. ¾ Solution : z The sample correlation coefficient r = 16/(4˜8) = 0.5 u 2. The standard deviation of X is 4 and the standard deviation of Y is 8. we have sufficient evidence to reject the null hypothesis. 12-90 .gfedu.

or that there is no relationship when. 9 correlation between two variables arising not from a direct relation between them but from their relation to a third variable. z For example. 9 correlation induced by a calculation that mixes each of two variables with a third (two variables that are uncorrelated may be correlated if divided by a third variable. z Outlier can result in apparent statistical evidence that a significant relationship exists when. so it dose not capture strong nonlinear relationships between variables. in fact. the value of an outlier may be extraordinarily large or small. there is no economic explanation for the relationship.gfedu.net Limitations to Correlation Analysis ¾ Outliers z Outliers represent a few extreme values for sample observations. CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www. Certain data items may be highly correlated purely by chance.gfedu.net Limitations to Correlation Analysis ¾ Nonlinear relationships z Correlation only measures the linear relationship between two variables. 15-90 . 9 correlation between two variables that reflects chance relationships in a particular data set. 13-90 www. in fact. That is to say. which is a limitation of correlation analysis. Relative to the rest of the sample data. there is none. which would be considered a spurious correlation. there is a relationship. in fact.net Limitations to Correlation Analysis ¾ Spurious correlation z Spurious correlation refers to the appearance of a causal linear relationship when. (height may be positively correlated with the extent of a person's vocabulary) 14-90 www.gfedu. there is no relation. two variables could have a nonlinear relationship such as Y= (1-X) 3 and the correlation coefficient would be close to zero.

or the predicting variable. z The dependent variable is the variable whose variation is explained by the independent variable.gfedu.net Interpretation of regression coefficients ¾ Interpretation of regression coefficients z The estimated intercept coefficient ( b̂0 ) is interpreted as the value of Y when X is equal to zero.The estimated slope coefficient ( b̂1 ) equals covariance divided by variance of X. n ¾ Where Yi = ith observation of the dependent variable.. The dependent variable is also refer to as the explained variable.net The Basics of Simple Linear Regression ¾ The simple linear regression model Yi b0  b1 X i  H i .. i 1. ¾ Linear regression assumes a linear relation between the dependent and the independent variables. and quantify the strength of the relationship between the two variables.CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www. ¾ Example z An estimated slope coefficient of 2 would indicate that the dependent variable will change two units for every 1 unit change in the independent variable. or the predicted variable. Y Xi = ith observation of the independent variable. the dependent variable is 2%.gfedu. X b0 = regression intercept term b1 = regression slope coefficient εi= the residual for the ith observation (also referred to as the disturbance term or error term) 17-90 www. the endogenous variable. The independent variable is also refer to as the explanatory variable.gfedu. z The estimated slope coefficient ( b̂1 ) defines the sensitivity of Y to a change in X . 16-90 www.net The Basics of Simple Linear Regression ¾ Linear regression allows you to use one variable to make predictions about another. the exogenous variable. 18-90 .. z The intercept term of 2% can be interpreted to mean that the independent variable is zero.. test hypotheses about the relation between two variables. z The independent variable is the variable whose variation is used to explain the variation of the dependent variable.

The following table shows recent annual sales (in millions of Canadian dollars) and the average exchange rate for the year (expressed as the units of foreign currency needed to buy one Canadian dollar)..42 16 4 0. CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www.net The assumptions of the linear regression ¾ The assumptions z A linear relationship exists between X and Y z X is not random.e. E(εi)=0 ) z The variance of the error term is constant (i.33 35 6 0. Y ) is on the regression line.gfedu.net Calculation of regression coefficients ¾ Ordinary least squares (OLS) z OLS estimation is a process that estimates the population parameters Bi with corresponding values for bi that minimize the squared residuals (i.. is a Canadian company that sells forestry products to several Pacific Rim customers. and the condition that X is uncorrelated with the error term can substitute the condition that X is not random. the error terms are homoskedastic) z The error term is uncorrelated across observations (i.e.40 20 2 0..e. Year i Xi = Exchange Rate Yi = Sales 1 0. 21-90 . 20-90 www. Bouvier’s sales are very sensitive to exchange rates.36 25 3 0. error terms).gfedu. z the OLS sample coefficients are those that: n Cov( X . Y ) ¦(X i  X )(Yi  Y ) b1 Var ( X ) i 1 n b0 Y  b1 X ¦(X i 1 i  X )2 z The estimated intercept coefficient ( b̂0) : the point ( X .. z The expected value of the error term is zero (i. 19-90 www.31 30 5 0.e. E(εiεj)=0 for all i≠j) z The error term is normally distributed.gfedu.34 30 ¾ Calculate the intercept and coefficient for an estimated linear regression with the exchange rate as the independent variable and sales as the dependent variable.net Example: calculate a regression coefficient ¾ Bouvier Co.

gfedu.36 25 0 1 0 3 0.08 Sum 2.009 250 -1.36 ¾ The sample mean of sales is: n Y ¦Y / n i 1 i 156 / 6 26 ¾ We want to estimate a regression equation of the form Yi = b0 + b1Xi +εi.0004 16 -0.CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www.0016 36 -0.0009 81 -0.33 35 0.34 30 0.27 6 0.gfedu.0025 16 -0.net Example: calculate a regression coefficient ¾ The following table provides several useful calculations: Year i Xi = Exchange Rate Yi = Sales (Xi -X)2 (Yi -Y)2 (Xi -X)(Yi -Y) 1 0.0036 100 -0.6 4 0. Then estimates of the slope coefficient and the intercept are ¦ Yi -Y .16 / 6 0.16 156 0.net Example: calculate a regression coefficient ¾ The sample mean of the exchange rate is: n X ¦X i 1 i / n 2.4 20 0.24 2 0.2 5 0.42 16 0.31 30 0.39 22-90 www.

Xi -X .

44.009 ¦ Xi -X . -1. and 0.39 bˆ 1 = i=1 n = = -154.

2 i=1 bˆ 0 Y  bˆ 1 X 26  154.444 .

0.36 .

26  55.gfedu.net Analysis of Variance(ANOVA) Table ¾ Components Y š š Yi b0  b1 X i (Yi  Yi ) o SSE __ š _ (Yi  Y ) o SST (Yi  Y ) o RSS __ Y b0 X 24-90 .6 81.6 ¾ So the regression equation is Yi = 81.6 – 154.444Xi 23-90 www.

63 indicates that the variation of the independent variable explains 63% of the variation in the dependent variable. the better the fit. ¾ The SEE gauges the “fit” of the regression line. It is interpreted as a percentage of variation in the dependent variable explained by the independent variable.e. ¾ SEE will be low (relative to total variability) if the relationship is very strong and high if the relationship is weak. CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www. R² = r² ) ¾ The Different between the R2 and Correlation Coefficient z The correlation coefficient indicates the sign of the relationship between two variables. z Example: R2 of 0.gfedu. ¾ The SEE is the standard deviation of the error terms in the regression.net Standard Error of Estimate ¾ Standard Error of Estimate (SEE) measures the degree of variability of the actual Y-values relative to the estimated Y-values from a regression equation. whereas the coefficient of determination does not. Its limits are 0≤R2≤1.gfedu. 27-90 . ¾ For simple linear regression.net Coefficient Determination (R2) ¾ A measure of the “goodness of fit” of the regression.net ANOVA Table ¾ ANOVA Table df SS MSS Regression k=1 RSS MSR=RSS/k Error n-2 SSE MSE=SSE/(n-2) Total n-1 SST - SSE ¾ Standard error of estimate: SEE n2 MSE ¾ Coefficient of determination (R²) z RSS SSE R2 1 SST SST explained variation unexplained variation =1- total variation total variation 25-90 www.gfedu. R² is equal to the squared correlation coefficient (i. and it implies a explanatory power. while the correlation coefficient only applies to two variables and does not imply explanatory between the variables. z The coefficient of determination can apply to an equation with several independent variables. SSE SEE MSE n2 26-90 www. The smaller the standard error..

00 <0.net Example ¾ An analyst ran a regression and got the following result: Coefficient t-statistic p-value Intercept -0.t critical z Rejection of the null means that the slope coefficient is different from the hypothesized value of b1.18 Slope 2 12.91 0. and the coefficient is said to be statistically different from zero.net Regression coefficient confidence interval ¾ Regression coefficient confidence interval bˆ1 r t c sbˆ 1 ¾ If the confidence interval at the desired level of significance dose not include zero. ¾ sb̂ is the standard error of the regression coefficient. 1 z As SEE rises. 30-90 . ¾ What is the standard error of estimate? ¾ What is the result of the slope coefficient significance test? ¾ What is the result of the sample correlation? ¾ What is the 95% confidence interval of the slope coefficient? 28-90 www.5 -0. and the more variable the data. df=n-2 sbˆ 1 z Decision rule: reject H0 if +t critical <t. the less confidence there is in the regression model to estimate a coefficient.CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www.gfedu.001 ANOVA Table df SS MSS Regression 1 8000 ? Error ? 2000 ? Total 51 ? - ¾ Fill in the blanks of the ANOVA Table. sb̂ also increases.net Hypothesis Testing about Regression Coefficient ¾ Significance test for a regression coefficient z H0: b1=The hypothesized value(usually 0) z Test Statistic: bˆ1  b1 t . or t<. the null is rejected.gfedu. 29-90 www. and the confidence interval widens 1 because SEE measures the variability of the data about the regression line.gfedu.

net Predicted Value of the Dependent Variable ¾ Predicted values are values of the dependent variable based on the estimated regression coefficients and a prediction about the value of the independent variable. CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www.gfedu. ¾ Point estimate Yˆ bˆ0  bˆ1 X ' ¾ Confidence interval estimate Yˆ r t c u s f .

¾ Regression assumptions are violated z For example. t c = the critical t-value with df=n−2 sf = the standard error of the forecast 1 ( X '  X )2 1 ( X '  X )2 sf SEE u 1   SEE u 1   n (n  1) s X2 n ¦ ( X i  X )2 31-90 www.gfedu. This is referred to as parameter instability.gfedu.net Reading 10 Multiple regression and issues in regression analysis 33-90 .net Limitations of Regression Analysis ¾ Regression relations change over time z This means that the estimation equation based on data from a specific time period may not be relevant for forecasts or predictions in another time period. the regression assumptions are violated if the data is heteroskedastic (non-constant variance of the error terms) or exhibits autocorrelation (error terms are not independent). 32-90 www. ¾ The usefulness will be limited if others are also aware of and act on the relationship.

Qualitative Dependent Variables 34-90 www.CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www.gfedu.gfedu. Multiple Regression Assumptions 9.net 1. Regression Coefficient F-test 5. holding the other independent variables constant. Model Misspecification 11. Coefficient of Determination (R2) 6. The Basics of Multiple Regression Framework 2.net Interpreting the Multiple Regression Results ¾ The intercept term is the value of the dependent variable when the independent variables are all equal to zero. Dummy variables 8.gfedu. Hypothesis Testing about the Regression Coefficient 4. Multiple Regression Assumption Violations 10.net The Basics of Multiple Regression ¾ Multiple regression is regression analysis with more than one independent variable ¾ The multiple linear regression model Yi b0  b1 X 1i  b2 X 2i  /  bk X ki  H i Xij = ith observation of the jth independent variable N = number of observation K = number of independent variables ¾ Predicted value of the dependent variable Yˆ bˆ0  bˆ1 Xˆ 1  bˆ2 Xˆ 2  /  bˆk Xˆ k 35-90 www. ¾ Each slope coefficient is the estimated change in the dependent variable for a one unit change in that independent variable. Analysis of Variance (ANOVA) 7. That’s why the slope coefficients in a multiple regression are sometimes called partial slope coefficient. 36-90 . Interpreting the Multiple Regression Results 3.

gfedu.net Multiple Regression Assumptions ¾ The assumptions of the multiple linear regression z A linear relationship exists between the dependent and independent variables z The independent variables are not random ( OR X is not correlated with error terms).gfedu. quarter 1. 0 and 1 ¾ If we want to distinguish between n categories.e.e. CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www. the error terms are homoskedastic) z The error term is uncorrelated across observations (i.e. represents the average value EPS08Q4 0 0 0 of EPS for the fourth quarter. Q3t EPS09Q2 0 1 0 =0 otherwise EPS09Q1 1 0 0 z The intercept term.. Q1t EPSt Q1 Q2 Q3 =0 otherwise EPS09Q4 0 0 0 9 Q2t =1 if period t is the second quarter.net Dummy variables ¾ Interpreting the coefficients z Example: EPSt = b0 + b1Q1t + b2Q2t + b3Q3t + ϵ 9 EPSt = a quarterly observation of earnings per share y x1 x2 x3 9 Q1t =1 if period t is the first quarter. or 3) and the omitted quarter (the … … … … fourth quarter in this case). 37-90 www. we need n−1 dummy variables 38-90 www. E(εiεj)=0 for all i≠j) z The error term is normally distributed. There is no exact linear relation between any two or more independent variables z The expected value of the error term is zero (i. Q2t =0 otherwise EPS09Q3 0 0 1 9 Q3t =1 if period t is the third quarter. 39-90 . E(εi)=0 ) z The variance of the error term is constant (i.. 2. EPS08Q3 0 0 1 z The slope coefficient on each dummy variable EPS08Q2 0 1 0 estimates the difference in earnings per share EPS08Q1 1 0 0 (on average) between the respective quarter (i.e.net Dummy variables ¾ To use qualitative variables as independent variables in a regression ¾ The qualitative variable can only take on two values..gfedu..

z Function of adjusted R2 SSE n  k  1 ª§ n  1 · 2 º adjusted R 2 1 1  «¨ ¸ u 1  R .net Adjusted R2 ¾ R2 and adjusted R2 z R2 by itself may not be a reliable measure of the explanatory power of the multiple regression model.gfedu.net Analysis of Variance (ANOVA) ¾ ANOVA Table df SS MSS Regression k RSS MSR=RSS/k Error n-k-1 SSE MSE=SSE/(n-k-1) Total n-1 SST - ¾ Standard error of estimate SSE SEE MSE n  k 1 ¾ Coefficient of determination (R²) RSS SSE z Is R2 still reliable? R2 1 SST SST 40-90 www. even if the marginal contribution of the new variables is not statistically significant.gfedu.CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www. This is because R2 almost always increases as variables are added to the model.

net Hypothesis Testing about Regression Coefficient ¾ Significance test for a regression coefficient z H0: bj=0 bˆ j z Test statistic: t df = n-k-1 sbˆ j ¾ p-value: the smallest significance level for which the null hypothesis can be rejected z Reject H0 if p-value<α z Fail to reject H0 if p-value>α ¾ Regression coefficient confidence interval j z bˆ r t u s ˆc bj .gfedu. » SST n  1 ¬© n  k  1 ¹ ¼ 9 adjusted R² ≤ R² 9 adjusted R² may be less than zero 41-90 www.

z Estimated regression coefficient r(critical t-value) (coefficient standard error) 42-90 .

gfedu. ¾ The test assesses the effectiveness of the model as a whole in explaining the dependent variable 44-90 www.net Unbiased and consistent estimator ¾ An unbiased estimator is one for which the expected value of the estimator is equal to the parameter you are trying to estimate. which is interpreted to mean that at least one of the independent variables in the regression model makes a significant contribution on the explanation of the dependent variable. called as unreliable. z If not. CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www. explains the variation in the dependent variable. ¾ A consistent estimator is one for which the accuracy of the parameter estimate increases as the sample size increases.gfedu.gfedu.net Regression Coefficient F-test ¾ An F-statistic assesses how well the set of independent variables.net Regression Coefficient F-test ¾ Decision rule z Reject H0 : if F (test-statistic) > F c (critical value) z Rejection of the null hypothesis at a stated level of significance indicates that at least one of the coefficients is significantly different than zero. as a group. ¾ An F-test is used to test whether at least one slope coefficient is significantly different from zero ¾ Define hypothesis: z H0: b1= b2= b3= … = bk=0 z HA: at least one bj≠0 (j = 1 to k) ¾ F-statistic: SSR MSR k F MSE SSE (n  k  1) 43-90 www. ¾ The F-test here is always a one-tailed test. 45-90 .

It usually causes no major problems with the regression.net Multiple Regression Assumption Violations ¾ Detecting Heteroskedasticity z Two methods to detect heteroskedasticity 9 residual scatter plots (residual vs. which means that it dose not systematically increase or decrease with the change in the value of the independent variables. one-tailed test ‹Chi-square test: BP = n˜Rresidual².net Multiple Regression Assumption Violations ¾ Heteroskedasticity ‫ݱڐ‬ٚ z Heteroskedasticity refers to the situation that the variance of the error term is not constant (i.e. df=k ‡ ࡨ۞͹љનٛாsqured residualsչXҟ֛‫ͫڡ‬Rresidual²ީ࠴֛ ‫ڡ‬ङӐؔ঩‫ރ‬ ‹Decision rule: BP test statistic should be small (χ²⳷⤝⢎᷊ ¾ Correcting heteroskedasticity z robust standard errors (also called White-corrected standard errors) z generalized least squares 48-90 . z The coefficient estimates (the bˆ j ) are not affected. the t-statistics will be too large and the null hypothesis of no statistical significance is rejected too often (▲ ঝ୪ન).gfedu. that is.gfedu. 9 If the standard errors are too small. but the coefficient estimates themselves are not affected.CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www. independent variable) 9 the Breusch-Pagen χ² test ‹H0: No heteroskedasticity. z Conditional heteroskedasticity is heteroskedasticity. z The standard errors are usually unreliable estimates. 46-90 www. the lower probability of error. (иঝ୪ ન) z The F-test is also unreliable.gfedu.. 47-90 www.net Multiple Regression Assumption Violations ¾ Effect of Heteroskedasticity on Regression Analysis z Not affect the consistency of regression parameter estimators 9 Consistency: the larger the number of sample. 9 Conditional heteroskedasticity dose create significant problems for statistical inference. the error terms are not homoskedastic) z Unconditional heteroskedasticity occurs when the heteroskedasticity is not related to the level of the independent variables. 9 The opposite will be true if the standard errors are too large. variance of error term is related to the level of the independent variables.

CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www. negative serial correlation typically causes the standard errors that are too large. 50-90 www.gfedu. 9 Negative serial correlation occurs when a positive error in one period increases the probability of observing a negative error in the next period. 9 Because of the tendency of the data to cluster together from observation to observation.gfedu.net Multiple Regression Assumption Violations ¾ Effect of Serial correlation on Regression Analysis z Positive serial correlation → Type I error & F-test unreliable 9 Not affect the consistency of estimated regression coefficients.net Multiple Regression Assumption Violations ¾ Detecting Serial correlation z Two methods to detect serial correlation 9 residual scatter plots 9 the Durbin-Watson test ‹H0: No serial correlation ‹DW ≈ 2˜(1−r) ‹Decision rule Reject H0. Reject H0. so we focus our attention on its effects. which leads to the computed t-statistics too small. z Negative serial correlation → Type II error 9 Because of the tendency of the data to diverge from observation to observation. 9 Positive serial correlation is much more common in economic and financial data.net Multiple Regression Assumption Violations ¾ Serial correlation (autocorrelation)‫ٽ‬Ӧࣼһͧ১ࣼһ z Serial correlation (autocorrelation) refers to the situation that the error terms are correlated with one another z Serial correlation is often found in time series data 9 Positive serial correlation exists when a positive regression error in one time period increases the probability of observing regression error for the next time period. conclude conclude positive serial Do not negative serial Inconclusive Inconclusive correlation reject H0 correlation 0 d1 dU 4-dU 4-d1 4 51-90 .gfedu. 49-90 www. which will cause the computed t-statistics to be larger. positive serial correlation typically results in coefficient standard errors that are too small.

z Improve the specification of the model: The best way to do this is to explicitly incorporate the time-series nature of the data (e.net Multiple Regression Assumption Violations ¾ Detecting Serial correlation z Two methods to detect serial correlation 9 residual scatter plots 9 the Durbin-Watson test ‹H0: No positive serial correlation ‹DW ≈ 2˜(1−r) ‹Decision rule Reject H0.g.7 (i. conclude positive serial Inconclusive Fail to reject null hypothesis of no correlation positive serial correlation 0 d1 dU 52-90 www.CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www. 9 The White-corrected standard errors are preferred if only heteroskedasticity is a problem. 53-90 www.7). multicollinearity is often a matter of degree rather than of absence or presence.gfedu. while the F-test indicates overall significance and the R² is high.net Multiple Regression Assumption Violations ¾ Multicollinearity z Multicollinearity refers to the situation that two or more independent variables are highly correlated with each other z In practice.e. 烮r烮>0. 54-90 . z Methods to correct multicollinearity: omit one or more of the correlated independent variables. 9 the absolute value of the sample correlation between any two independent variables is greater than 0. z Two methods to detect multicollinearity 9 t-tests indicate that none of the individual coefficients is significantly different than zero.. Hansen method): the Hansen method also corrects for conditional heteroskedaticity.gfedu.net Multiple Regression Assumption Violations ¾ Methods to Correct Serial correlation z adjusting the coefficient standard errors (e..g.. include a seasonal term).gfedu.

similar to a regression equation. CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www. or default.gfedu. each with several subcategories: z 1.g. 57-90 . R² is high error rity ĸ High correlation among independent variables 55-90 www. which can then be used to create an overall score.. z 2. 9 Important variables are omitted.net Summary of assumption violations Assumption Impact Detection Solution violation ķ Residual scatter plots ķrobust standard errors Conditional Type I ĸ Breusch-Pagen χ²-test (White-corrected standard Heteroskeda /II error (BP = n×R²) errors) sticity ĸ generalized least squares ķ Residual scatter plots ķrobust standard errors Positive Type I ĸ Durbin-Watson test (Hansen method) serial error (DW≈2×(1−r)) ĸImprove the specification correlation of the model ķ t-tests: fail to reject H0. 9 These coefficients relate the independent variables to the likelihood of an event occurring. z 3. 9 Both models must be estimated using maximum likelihood methods ͧߢ‫ם‬ѷࣀѳઋͨ. The functional form can be misspecified. 9 Data is improperly pooled. probability of default). bankruptcy. or ranking. (Explanatory variables are correlated with the error term in time series models. while a logit model is based on the logistic distribution. or ways in which the regression model can be specified incorrectly.gfedu. ¾ Effects of the model misspecification: regression coefficients are biased and/or inconsistent 56-90 www. Time series misspecification. z Discriminant models yields a linear function. for an observation. Other time-series misspecifications that result in nonstationarity. an observation can be classified into the bankrupt or not bankrupt category.) 9 A lagged dependent variable is used as an independent variable with serially correlated errors. 9 Independent variables are measured with error. 9 A function of the dependent variable is used as an independent variable ("forecasting the past"). 9 Variables should be transformed.net Qualitative Dependent Variables ¾ Qualitative dependent variable is a dummy variable that takes on a value of either zero or one z Probit and logit model: Application of these models results in estimates of the probability that the event occurs (e. 9 A probit model based on the normal distribution.net Model Misspecification ¾ There are three broad categories of model misspecification.gfedu. ķRemove one or more Type II independent variables Multicollinea F-test: reject H0. Based on the score. such as a merger.

gfedu. Random Walks 4.net 1.0 E Where: A = WC / TA B = RE / TA C = EBIT / TA D = MV of Equity / BV of Debt E = Revenue / TA z If Z<1. Regression with More Than One Time Series 6.gfedu.6 D + 1. Autoregressive Conditional Heteroskedasticity (ARCH) 5.3 C + 0.2 A + 1.net Credit Analysis ¾ Z – score Z = 1.CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www.4 B + 3.net Reading 11 Time-series analysis 59-90 www. Steps in Time-Series Forecasting 60-90 .8 Æ Bankruptcy 58-90 www.gfedu. Trend Models Framework 2. Autoregressive Models (AR) 3.

¾ Limitations of Trend Model z Usually the time series data exhibit serial correlation. ……) yt t 61-90 www. 2.gfedu.gfedu. 3. z A log-linear model may be more appropriate if the data plots with a non-linear (curved) shape. except for that the independent variable is time t (t=1.net Trend Models ¾ Factors that Determine Which Model is Best z A linear trend model may be appropriate if the data points appear to be equally distributed above and below the regression line (inflation rate data). CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www. 63-90 . which means that the model is not appropriate for the time series. then the residuals from a linear trend model will be persistently positive or negative for a period of time (stock indices and stock prices).net Trend Models ¾ Linear trend model z yt=b0+b1t+εt z Same as linear regression.gfedu.net Trend Models ¾ Log-linear trend model z yt=e(b0+b1t) z Ln(yt ) =b0+b1t+εt z Model the natural log of the series using a linear trend z Use the Durbin Watson statistic to detect autocorrelation 62-90 www. causing inconsistent b0 and b1 z The mean and variance of the time series changes over time.

z For example.gfedu.net Autoregressive Models (AR) ¾ An autoregressive model uses past values of dependent variables as independent variables z AR(p) model xt b0  b1 xt 1  b2 xt 2  . a model with two lags is referred to as a second-order autoregressive model or an AR (2) model.gfedu. a two-step-ahead forecast for an AR (1) model is calculated as: š š š xt 2 b0  b1 xt 1 65-90 www.  bp xt  p  H t z AR (p): AR model of order p (p indicates the number of lagged values that the autoregressive model will include)..gfedu.net Autoregressive Models (AR) ¾ Forecasting With an Autoregressive Model ¾ Chain rule of forecasting z A one-period-ahead forecast for an AR (1) model is determined in the following manner: š š š xt 1 b0  b1 xt z Likewise..CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www.net Autoregressive Models (AR) ¾ Forecasting With an Autoregressive Model. we should prove: z No autocorrelation z Covariance-stationary series z No Conditional Heteroskedasticity 66-90 . 64-90 www.

z Using the information in Table 1.H t k t  statistics = Sr 1/ n z If the residual autocorrelations differ significantly from 0.g. rH t .net Autocorrelation ¾ Seasonality – a special question z Time series shows regular patterns of movement within the year z The seasonal autocorrelation of the residual will differ significantly from 0 z We should uses a seasonal lag in an AR model z For example: xt=b0+b1 xt-1+ b2 xt-4+εt 68-90 www. so we estimate Equation: z (ln Salest – ln Salest–1) = b0 + b1(ln Salest–1 – ln Salest–2) + b2(ln Salest–4 – ln Salest–5) + εt. we mean autocorrelation of time series itself rxt .gfedu. seasonality) z Correction: add lagged values 67-90 www. so we may need to modify it (e. use the model to predict the sales growth for this quarter.H t k -0 rH t .H t k . determine if the model is correctly specified.net Example ¾ Suppose we decide to use an autoregressive model with a seasonal lag because of the seasonal autocorrelation in the previous problem. z If sales grew by 1 percent last quarter and by 2 percent four quarters ago. xt k rather than autocorrelation of the error term rH t . ¾ Detecting autocorrelation in an AR model z Compute the autocorrelations of the residual z t-tests to see whether the residual autocorrelations differ significantly from 0.gfedu. CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www. 69-90 .gfedu. We are modeling quarterly data. the model is not correctly specified.net Autocorrelation ¾ Autocorrelation in an AR model z Whenever we refer to autocorrelation without qualification.

0318 Observations 68 Durbin–Watson 1. 72-90 .gfedu.net Covariance-stationary ¾ Covariance-stationary series z Statistical inference based on OLS estimates for a lagged time series model assumes that the time series is covariance stationary.CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www. The absolute value of the t-statistic for each autocorrelation is below 0.0121 – 0. this model has 65 degrees of freedom.0839 0.gfedu.0065 0.0958 6.0121 0.01) + 0.Log Differenced Sales ¾ Table 1 Regression Statistics R-squared 0.1213 0.02) = e0.4220 Standard error 0.0572 0.1213 –0.1213 –0.0700 0.6292 ln(1.6292 0.60 (less than 2.0.0839 ln(1.0053 2.net Table 1.8784 Coefficient Standard Error t-Statistic Intercept 0. We have determined that the model is correctly specified. z Three conditions for covariance stationary 9 Constant and finite expected value of the time series 9 Constant and finite variance of the time series 9 Constant and finite covariance with leading or lagged values z Stationary in the past does not guarantee stationary in the future z All covariance-stationary time series have a finite mean-reverting level. then the model predicts that sales growth this quarter will be 0.8757 Lag 4 0. 71-90 www.0532 4 –0.05 significance level. z If sales grew by 1 percent last quarter and by 2 percent four quarters ago.02372 – 1 = 2.3033 70-90 www.40%. with 68 observations and three parameters. so we cannot reject the null hypothesis that each autocorrelation is not significantly different from 0.3055 Lag 1 –0.5693 Autocorrelations of the Residual Lag Autocorrelation Standard Error t-Statistic 1 0.4720 2 –0.1213 –0.gfedu. The critical value of the t-statistic needed to reject the null hypothesis is thus about 2.0).0368 0.5771 3 0.0958 –0.net Example ¾ Answer z At the 0.

with or without a drift. (1  b1 ) b0 and if xt  the model predicts that x t+1 will be higher than x t (1  b1 ) Ṹֻ ˈ 73-90 www.gfedu. the mean reverting level is: 1  b1 b0 z If xt ! the model predicts that x t+1 will be lower than x t. CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www.net Covariance-stationary ¾ Mean reversion z A time series exhibits mean reversion if it has a tendency to move towards its mean b0 ٬ xt z For an AR(1) model.net Covariance-stationary ¾ Instability of regression coefficients z Financial and economic relationships are dynamic z Models estimated with shorter time series are usually more stable than those with longer time series ¾ So we need to check Covariance stationary 74-90 www. is not covariance stationary 75-90 . b1=1) 9 The time series is expected to increase/decrease by a constant amount ¾ Features z A random walk has an undefined mean reverting level z A time series must have a finite mean reverting level to be covariance stationary z A random walk.gfedu.net Random Walks ¾ Random walk z Random walk without a drift 9 Simple random walk: xt =xt-1+εt (b0=0 and b1=1) 9 The best forecast of xt is xt-1 z Random walk with a drift 9 xt=b0+xt-1+εt (b0≠0.gfedu.

where b0=b1=0 z The first-differenced variable yt is covariance stationary 77-90 www. 76-90 www.net Autoregressive Conditional Heteroskedasticity ¾ Heteroskedasticity refers to the situation that the variance of the error term is not constant. the time series is ARCH(1). ¾ If ARCH exists.gfedu. then the variance of the errors in period t + 1 can be predicted in period t. 78-90 .gfedu. If a time-series model has ARCH(1) errors. ‫ך‬ҫ֛‫ڡ‬ИऀBP test ¾ Test whether a time series is ARCH(1) z H t2 a0  a1H t21  ut z If the coefficient a1 is significantly different from 0. z the standard errors for the regression parameters will not be correct. it is not often the case.CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www.gfedu. Generalized least squares must be used to develop a predictive model.net Unit root correction ¾ If a time series appears to have a unit root z One method that is often successful is to first-difference the time series (as discussed previously) and try to model the first-differenced series as an autoregressive time series. however.net Unit root test ¾ The unit root test of nonstationarity z The time series is said to have a unit root if the lag coefficient is equal to one z A common t-test of the hypothesis that b1=1 is invalid to test the unit root. z we can predict the variance of the errors if we have it modeled. the time series does not have a unit root and is stationary. ¾ First differencing z Define yt as yt = xt .xt-1 =εt z This is an AR(1) model yt = b0 + b1 yt-1 +εt . z Dickey-Fuller test (DF test) to test the unit root 9 Start with an AR(1) model xt=b0+b1 xt-1+εt Subtract xt-1 from both sides xt-xt-1 =b0+(b1 –1) xt-1+εt xt-xt-1 =b0+g xt-1+εt 9 H0: g=0 (has a unit root and is nonstationary) Ha: g<0 (does not have a unit root and is stationary) 9 Calculate conventional t-statistic and use revised t-table 9 If we can reject the null.

we can use multiple regression 81-90 . 80-90 www. we compare how accurate a model is in forecasting the y variable value for a time period outside the period used to develop the model. we cannot use multiple regression z If we can reject the null. 9 If conintegrated. if any time series contains a unit root. In other words. OLS may be invalid ¾ Use DF tests for each of the time series to detect unit root..e. which for a time series is known as the sample or test period. time period) used to estimate the model. CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www.gfedu.net Compare forecasting power with RMSE ¾ Comparing forecasting model performance z In-sample forecasts are within the range of data (i. 9 Root mean squared error (RMSE): the model with the smallest RMSE is most accurate for out-of-sample 79-90 www.net Regression with More Than One Time Series ¾ In linear regression. z Out-of-sample forecasts are made outside. we will have 3 possible scenarios z None of the time series has a unit root: we can use multiple regression z At least one time series has a unit root while at least one time series does not: we cannot use multiple regression z Each time series has a unit root: we need to establish whether the time series are cointegrated.gfedu.gfedu. can estimate the long-term relation between the two series (but may not be the best model of the short-term relationship between the two series).net Regression with More Than One Time Series ¾ Use the Dickey-Fuller Engle-Granger test (DF-EG test) to test the cointegration z H0: no cointegration Ha: cointegration z If we cannot reject the null.

CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www.gfedu.gfedu.OXYZ*OLLKXKTIKY ࠆֹࣩѲਗ਼ ১ ֚ ‫ڠ‬ ࠜٚ‫ފ‬ժ১ࣼһ Yes টড‫׌‬ԅ১֚‫ݤڠ‬ଞոঃ‫ݤ‬ ࠆ ֹ 9KXOGR)UXXKRGZOUT% 'JJOTM2GMY ঐ ‫ڎ‬ No ષ ঎ ‫ފ‬ժ‫ৼ؃֧؁‬㓬֛ॹ Yes ‫׌‬ԅࣼ‫ࣩڀ‬১֚‫ڠ‬ঃ‫ݤ‬ ֢ 9KGYUTGROZ_6XKYKTZ 'JJOTM2GMY  No ࣐'8).net Steps in Time-Series Forecasting ‫ٽ‬ӦԢ‫ݱ‬ٚ‫ފ‬ժ֠ؓ /YYKXOKY)U\GXOGTIK9ZGZOUTGX_% No Yes јٚ஛ࡄଜ‫ݰ‬ঐ‫ٽڎ‬Ӧ ј'8ࠆֹ‫׶ڏ‬ :GQK.YKGZXKTJSUJKR . Decision Trees.net Reading 12 Excerpt from“Probabilistic Approaches: Scenario Analysis.KZKXUYQKJGYZOIOZ_% ‫ֹࠆݦ‬Зࣩହ੷ No ঐ‫ֹࣩࠆੰֹ࡚ͧࠆۉ؎ڎ‬ஓ࡚ৗԂ 83-90 www.ࠆֹ࡚߳‫ފ‬ժ‫ڐ֧؁‬ઔ㓬 Yes ૹ૚‫ٹ‬Тࣩ‫سޣ‬зЪࡄ޼ઁ .YKGT'8SUJKR 82-90 www. and Simulation” 84-90 .net Steps in Time-Series Forecasting ࣗӞ‫ݢ‬䎯֢ͧӭ‫ٽݮ‬Ӧ‫ފ‬ժ‫ޥ‬મԍ Does series have a trend? Yes No ࠆ ֹ ঐ ‫ڎ‬ ঎㓬મԍ ‫ݤܗ‬મԍ ӭ‫ފݮ‬ժ‫ৼ؃ޥ‬㓬֛ॹ ঎ a linear trend GTK^VUTKTZOGRZXKTJ 9KGYUTGROZ_% ષ ֢  ࣐҄*=߳யӭ‫ࠜݮ‬ٚ‫ފ‬ժ১ࣼһ Yes 9KXOGRIUXXKRGZOUT% No Yes ࣐҄મԍࠆֹ ࣐҄১֚‫ֹࠆڠ‬ .gfedu.

z Run the simulation 86-90 www.net Simulation ¾ Steps in Simulation z Determine “probabilistic” variables z Define probability distributions for these variables 9 Historical data 9 Cross sectional data 9 Statistical distribution and parameters z Check for correlation across variables 9 When two variables are strong correlated.gfedu.gfedu. 87-90 . one solution is to pick only one of the two inputs. Simulation Framework 2.net Simulation ¾ Advantage of using simulation in decision making z Better input estimation z A distribution for expected value rather than a point estimate ¾ Simulations with Constraints z Book value constraints 9 Regulatory capital restrictions „ Financial service firms 9 Negative book value for equity z Earnings and cash flow constraints 9 Either internally or externally imposed z Market value constraints 9 Model the effect of distress on expected cash flows and discount rates.gfedu.net 1. CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www. the other is to build the correlation explicitly into the simulation. Comparing the Approaches 85-90 www.

gfedu. ࣿո਴िͫ‫ߧײ‬҂߄▲Зߑѫ૦சਘٜङࢬ‫ە‬Ծҟ҂ઍО୍੽ङзͫ଻Т଑ Зߑѫ‫֨࣫ީؼ‬澞 90-90 .net It’s not the end but just beginning.gfedu. Life is short. that moment is now. or simulations z Selective versus full risk analysis z Type of risk 9 Discrete risk vs. Continuous risk 9 Concurrent risk vs. decision trees.gfedu.net Comparing the Approaches ¾ Choose scenario analysis.CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www. If there was ever a moment to follow your passion and do something that matters to you.net Simulation ¾ Issues in using simulation z GIGO z Real data may not fit distributions z Non-stationary distributions z Changing correlation across inputs 88-90 www. Sequential risk z Correlation across risk 9 Correlated risks are difficult to model in decision trees Risk type and Probabilistic Approaches Discrete/ Correlated/ Sequential/ Risk approach Continuous Independent Concurrent Discrete Correlated Sequential decision trees scenario Discrete Independent Concurrent analysis Continuous Either Either simulations 89-90 www.

and Trading • R50 Economics and investment markets • R51 Analysis of active portfolio management • R52 Algorithmic Trading and High-Frequency Trading 3-145 . Active Management. and Risk Management Portfolio • R47 The portfolio Management Management Process and the Investment Policy Statement • R48 An introduction to multifactor models • R49 Measuring and Managing Market Risk ¾ SS17: Economic Analysis.gfedu. Asset Allocation. CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www.net 6UXZLUROU 3GTGMKSKTZ ‫)ٵ‬.gfedu. Content Weightings Study Session 1-2 Ethics & Professional Standards 10-15 Study Session 3 Quantitative Methods 5-10 Study Session 4 Economic Analysis 5-10 Study Session 5-6 Financial Statement Analysis 15-20 Study Session 7-8 Corporate Finance 5-15 Study Session 9-11 Equity Analysis 15-25 Study Session 12-13 Fixed Income Analysis 10-20 Study Session 14 Derivative Investments 5-15 Study Session 15 Alternative Investments 5-10 Study Session 16-17 Portfolio Management 5-10 2-145 www.net Topic Weightings in CFA Level II Session NO.gfedu.net ¾ SS16: Portfolio Management: Framework Process.'зঃ‫׀‬੟஍ࣹ  ઔ٤͹յ䛬 1-145 www.

Investment Objectives and Constrains 3.net 1. Portfolio Perspective Framework 2.net Portfolio Perspective ¾ Portfolio Perspective: focus on the aggregate of all the investor’s holdings the portfolio ¾ Harry Markowitz → Modern Portfolio Theory (MPT) ¾ Some pricing models z such as CAPM. IPS 4.gfedu. ICAPM.CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www.net Reading 47 The portfolio Management Process and the Investment Policy Statement 4-145 www. Management investment portfolios 5-145 www.gfedu.gfedu. etc → these pricing models are all based on the principle that systematic risk is priced → should analyze the risk-return tradeoff of the portfolio 6-145 . APT.

net Investment Objectives and Constrains ¾ Some specific factors that affect the ability to accept risk z Required spending needs z Long-term wealth target z Financial strengths/Liabilities z Health/Age ¾ Some specific factors that affect the willingness to accept risk z Return objective z Habit z Historical Trading z Character 9-145 . CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www.net Investment Objectives and Constrains ¾ Investment objectives z Investment objectives relate to what the investor wants to accomplish with the portfolio z Objectives are mainly concerned with risk and return considerations ¾ Risk objective Risk Tolerance Ability to Take Risk Willingness to Take Risk Below Average Above Average Below-average risk Below Average Resolution needed tolerance Above-average risk Above Average Resolution needed tolerance z Risk measurement .gfedu.net Portfolio Management ¾ Steps z the planning step 9 Identifying and Specifying the Investor’s Objective and Constraints 9 Creating the Investment Policy Statement 9 Forming Capital Markets Expectations 9 Creating the Strategic Asset Allocation z the execution step 9 Tactical Asset Allocation 9 Security Selection/Composition z the feedback step 9 Monitoring and Rebalance 9 Performance Evaluation 7-145 www.Value at risk (VaR) 8-145 www.gfedu.gfedu.

pretax returns. an individual investor’s portfolio choices may be constrained by circumstances focusing on health needs. return relative to the benchmark’s. including how much the investor wishes to receive from the portfolio 9 required return represents some level of return that must be achieved by the portfolio. 9 Unique circumstances: internal factors.CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www. long term. 11-145 www. 9 Tax concerns: tax payments reduce the amount of the total return. support of dependents. and other circumstances unique to the particular individual. absolute Return. z Promote long-term discipline for portfolio decisions. real returns inflation-adjusted returns. or a combination of the two). at least on an average basis to meet the target financial obligations 10-145 www.net Investment Objectives and Constrains ¾ Investment constrains z Investment constrains are those factors restricting or limiting the universe of available investment choices. or oversight authorities to constrain investment decision- making.gfedu. z Types 9 Liquidity requirement: a need for cash of new contributions or savings at a specified point in time. regulatory. 9 Legal and regulatory factors: external factors imposed by governmental. return nominal returns.net IPS ¾ Definition z a written planning document that governs all investment decisions for the client ¾ Main roles z Be readily implemented by current or future investment advisers. 9 Time horizon: the time period associated with an investment objective (short term.gfedu. 12-145 . z Help protect against short-term shifts in strategy when either market environments or portfolio performance cause panic or overconfidence. post-tax returns z Return desire and requirement 9 desired return is that level of return stated by the client.net Investment Objectives and Constrains ¾ Return objective z Return measurement 9 such as: total Return.gfedu.

z Guidelines for portfolio adjustments and rebalancing. restrictions. z The purpose of the IPS with respect to policies. ¾ Strategic Asset allocation z the final step in the planning stage. combines the IPS and capital market expectations to formulate weightings on acceptable asset classes 15-145 . CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www. objectives. an example in indexing z Active approach: involves holding a portfolio different from a benchmark or comparison portfolio for the purpose of producing positive excess risk-adjusted returns z Semiactive approach: an indexing approach with controlled use of weights different from benchmark 14-145 www. z Identification of duties and responsibilities of parties involved.gfedu. z The formal statement of objectives and constrains. 13-145 www. Long-run forecasts of risk and return characteristics for various asset classes form the basis for choosing portfolios that maximize expected return for given levels of risk. and portfolio limitations. goals.net CME and Strategic Asset allocation ¾ Capital market expectations z The manager’s third task in the planning process is to form capital market expectations. z Asset allocation ranges and statements regarding flexibility and rigidity when formulating or modifying the strategic asset allocation.net IPS ¾ Elements z A client description that provides enough background so any competent investment adviser can give a common understanding of the client’s situation.gfedu. or minimize risk for given levels of expected return.net IPS ¾ Three approaches for investment strategy z Passive investment strategy approach: portfolio composition does not react to changes in expectations.gfedu. z A calendar schedule for both portfolio performance and IPS review.

Arbitrage Pricing Theory (APT) Framework 2.net Management investment portfolios ¾ Justify ethical conduct as a requirement for managing investment portfolios z the investment professional who manages client portfolio well meets both standards of competence and standards of conduct z the appropriate standard of conduct is embodied by the CFA Institute Code and Standards 16-145 www.gfedu. Application: Portfolio Construction 18-145 .net 1.CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www. Statistical Factor models 4. Multifactor Model • Macroeconomic Factor Model • Factor Sensitivities for a Two-Stock Portfolio • Fundamental Factor • Standardized beta 3.net Reading 48 An introduction to multifactor models 17-145 www. Application͹Return Attribution 5.gfedu.gfedu.

net Arbitrage Pricing Theory (APT) ¾ APT z asset pricing model developed by the arbitrage pricing theory ¾ Assumptions z A factor model describes asset returns z There are many assets. ¾ The parameters of the APT equation are the risk-free rate and the factor risk-premiums (the factor sensitivities are specific to individual investments). λj) represents the expected return in excess of the risk free rate for a portfolio with a sensitivity of 1 to factor j and a sensitivity of 0 to all other factors.net Arbitrage Pricing Theory (APT) ¾ The factor risk premium (or factor price.  E P. 20-145 www.k (Ok ) 19-145 www. 2 (O2 )  . so investors can form well-diversified portfolios that eliminate asset-specific risk z No arbitrage opportunities exist among well-diversified portfolios ¾ Exactly formula E ( RP ) RF  E P. Such a portfolio is called a pure factor portfolio for factor j.. CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www.gfedu.gfedu..1 (O1 )  E P.net Arbitrage Pricing Theory (APT) ¾ Arbitrage Opportunities z The APT assumes there are no market imperfections preventing investors from exploiting arbitrage opportunities 9 extreme long and short positions are permitted and mispricing will disappear immediately 9 all arbitrage opportunities would be exploited and eliminated immediately 21-145 .gfedu.

0λ1 +1.5λ 2 E ( RK ) 0.gfedu.3 1. 23-145 www. 24-145 . z multifactor models explain asset returns better than the market model does.2 E ( RL ) 0. According to the APT.net Types of Multifactor Models ¾ Macroeconomic Factor ¾ Fundamental factor models ¾ Statistical factor models ¾ Mixed factor models z Some practical factor models have the characteristics of more than one of the above categories.1 E ( RJ ) 0.0λ 2 E ( RP ) 0.14 RF  1.5 K 0.1λ 2 22-145 www. Portfolio Expected return Sensitivity to Sensitivity to GDP inflation factor factor J 0.14 1.12 RF  0.2 (λ2 ) ¾ Well-diversified portfolios.11 RF  1.5λ1 +1. and L. explain returns.Arbitrage Pricing Theory (APT) ¾ Suppose that two factors.02βp.07  0.net Example.12 0.3λ1 +1. surprise in inflation (factor 1) and surprise in GDP growth (factor 2).0 1. We can call such models mixed factor models.1 (λ1 )+βp.5 1. J.net Multifactor Model ¾ Multifactor models have gained importance for the practical business of portfolio management for two main reasons. z multifactor models provide a more detailed analysis of risk than does a single factor model. K.CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www.gfedu.1 +0. an arbitrage opportunity exists unless E ( RP ) RF  βp.06βp.0 L 0.11 1.gfedu. given in table.

For a stock. it might represent the return from an unanticipated company-specific event. holding all other factors constant.1 percent.net Macroeconomic Factor model ¾ Suppose our forecast at the beginning of the month is that inflation will be 0. we find that inflation was actually 0.net Macroeconomic Factor Model ¾ Macroeconomic Factor z assumption: the factors are surprises in macroeconomic variables that significantly explain equity returns Regression (time z exactly formula for return of asset i series) bi1.4 = 0.5 .gfedu. At the end of the month. the surprise in inflation was 0. z A factor sensitivity is a measure of the response of return to each unit of increase in a factor.gfedu.gfedu. Surprise = actual value – predicted (expected) value 25-145 www.0. actual inflation was 0. Therefore. During any month. then εi must represent an asset-specific risk.4 percent during the month. bi2 Return FGDP FQS Ri E ( Ri )  bi1FGDP  bi 2 FQS  H i … … … Where: Ri = return for asset i E(Ri )= expected return for asset i … … … FGDP = surprise in the GDP rate … … … FQS = surprise in the credit quality spread … … … bi1 = GDP surprise sensitivity of asset i … … … bi2 = credit quality spread surprise sensitivity of asset i εi = firm-specific surprise which not be explained by the model.5 percent during the month. 27-145 . CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www.5 percent and predicted inflation was 0.4 percent. If we have adequately represented the sources of common risk (the factors). 26-145 www. z Actual inflation = Predicted inflation + Surprise inflation z In this case.net Macroeconomic Factor model ¾ Slope coefficients are naturally interpreted as the factor sensitivities of the asset. ¾ The term εi is the part of return that is unexplained by expected return or the factor surprises.

01) + 3(0) + (1/3)(0.gfedu.gfedu. respectively.net Factor Sensitivities for a Two-Stock Portfolio ¾ Suppose that stock returns are affected by two common factors: surprises in inflation and surprises in GDP growth.average attribute value … … … bij V (attribute value) … … … (P/E)1 . Fsize No economic Regression (cross interpretation sectional data) Return bi1 bi2 … … … Asset i's attribut value .5 percent 29-145 www.12) + [(1/3)(. and two- thirds is invested in Nextech stock. ¾ Calculate the return on the portfolio given that the surprises in inflation and GDP growth are 1 percent and 0 percent.P/E … … … e. A portfolio manager is analyzing the returns on a portfolio of two stocks. Manumatic (MANM) and Nextech (NXT).09  1FINFL  1FGDP  H MANM RNXT 0.005) = 0. ¾ State the expected return on the portfolio. Formulate an expression for the return on the portfolio.005) + (2/3)(0. ¾ Correct Answer 3 : z Rp = 0.CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www.g.net Factor Sensitivities for a Two-Stock Portfolio ¾ Correct Answer 1 : z The portfolio's return is the following weighted average of the returns to the two stocks: Rp = (1/3)(0.125 or 12. where the factors FINFL. represent the surprise in inflation and GDP growth.11 + 1 FINFL+ 3FGDP + (1/3) εMANM + (2/3) εNXT = 0. The following equations describe the returns for those stocks.gfedu.net Fundamental Factor ¾ ЉգҸ՛ङRչ‫ځث‬ङbi1ͫbi2 Ri a i  bi1FP/E  bi2 FSIZE  Hi ¾ ࡌӟFP/E.09) + (2/3)(0 .11 + 1(0. the value of the intercept in the expression obtained in Part 1. bi1 V P/ E … … … 30-145 .5 percent. and FGDP.I) + (2/3)(2)] FINFL+ [(1/3)(1) + (2/3)(4)]FGDP + (1/3) εMANM + (2/3) εNXT = 0.11 + 1 FINFL+ 3FGDP + (1/3) εMANM + (2/3) εNXT ¾ Correct Answer 2 : z The expected return on the portfolio is 11 percent.12  2 FINFL  4 FGDP  H NXT ¾ One-third of the portfolio is invested in Manumatic stock. respectively: RMANM 0. assuming that the error terms for MANM and NXT both equal 0. 28-145 www.

31-145 www.net Statistical Factor models ¾ Statistical factor models z In a statistical factor model. ¾ The exception to this interpretation is factors for binary variables such as industry membership. z Two major types of factor models are factor analysis models and principal components models. 32-145 www. or one-half standard deviation above average. despite differences in units of measure and scale in the variables. the factors are actually portfolios of the securities in the group under study and are therefore defined by portfolio weights. statistical methods are applied to historical returns of a group of securities to extract factors that can explain the observed returns of securities in the group.gfedu. z The investment's sensitivity to dividend yield is (3. CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www.net Standardized beta ¾ The scaling permits all factor sensitivities to be interpreted similarly.1 dummy variables.5 percent and that the average dividend yield across all stocks being considered is 2. z Advantage and Disadvantage 9 Major advantage: it make minimal assumptions. 9 Major weakness: the statistical factors do not lend themselves well to economic interpretation 33-145 . 9 Principal components models best explain the historical return variances. 9 Factor analysis models best explain historical return covariances. that an investment has a dividend yield of 3. z In statistical factor models. z in models that recognize that companies frequently operate in multiple industries. A company either participates in an industry or it does not.5 percent.50. suppose that the standard deviation of dividend yields across all stocks is 2 percent.5%)/2% = 0.gfedu.net Standardized beta ¾ Suppose.2. z The industry factor sensitivities would be 0 .gfedu. Further. for example. the value of the sensitivity would be 1 for each industry in which a company operated.5% .

Asset returns Assumptions To control risk.net Arbitrage Pricing Theory (APT) ¾ Comparison CAPM and APT CAPM APT All investors should hold some APT gives no special role to the combination of the market market portfolio. flexible than CAPM.. hedge or speculate on multiple risk factors.gfedu. 35-145 www. we can analyze a portfolio manager’s active return as the sum of two components.gfedu. and is far more portfolio and the risk-free asset.gfedu. less risk averse follow a multifactor process. rather than risk-free asst. investors simply hold more of the allowing investors to manage market portfolio and less of the several risk factors.net Arbitrage Pricing Theory (APT) ¾ The relation between APT and multifactor models APT Multifactor models cross-sectional equilibrium time-series regression that pricing model that explains the Characteristics explains the variation over time in variation across assets’ returns for one asset expected returns ad hoc (i. Investor’s unique circumstances may drive the investor to hold The risk of the investor’s portfolio portfolios titled away from the conclusions is determined solely by the market portfolio in order to resulting portfolio beta. 36-145 . z Active return = Rp − RB ¾ With the help of a factor model. the factors are Assumptions assumes no arbitrage identified empirically by looking opportunities for macroeconomic variables that best fit the data) expected return derived from the Intercept risk-free rate APT equation in macroeconomic factor model 34-145 www. we call that component security selection. we call that component the return from factor tilts.CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www.net Application͵Return Attribution ¾ Multifactor models can help us understand in detail the sources of a manager’s returns relative to a benchmark. z The first component is the product of the portfolio manager’s factor tilts (overweight or underweight relative to the benchmark factor sensitivities) and the factor returns. rather than being derived directly from an equilibrium-pricing model that equilibrium theory.e. just one. z The second component of active return reflects the manager’s skill in individual asset selection (ability to overweight securities that outperform the benchmark or underweight securities that underperform the benchmark).

gfedu. CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www.net Application͵Return Attribution ¾ Active return=factor return + security selection return z Factor return: k factor return ¦ E i 1 pk .

E bk u Ok . .

E pk=factor sensitivity for the kth factor in the active portfolio E =factor sensitivity for the kth factor in the benchmark portfolio bk Ok =factor risk premium for factor k z Security selection: 9 Security selection return=active return – factor return 9 The security selection return is then the residual difference between active return and factor return.gfedu.net Example: Information ratio ¾ To illustrate the calculation. 39-145 .gfedu.7. and the portfolio's tracking risk was 6 percent.net Application͵Risk Attribution ¾ Active risk z Definition: the standard deviation of active returns z Exactly formula: active risk s( RP  RB ) ¦ (R Pt  RBt ) 2 t 1 ¾ Information Ratio z Definition: the ratio of mean active return to active risk z Purpose: a tool for evaluating mean active returns per unit of active risk z Exact formula: RP  RB IR s(R P  R B ) 38-145 www. we would calculate an information ratio of (9% . if a portfolio achieved a mean return of 9 percent during the same period that its benchmark earned a mean return of 7.25. 37-145 www.5%)/6% = 0. ¾ Setting guidelines for acceptable active risk or tracking risk is one of the ways that some institutional investors attempt to assure that the overall risk and style characteristics of their investments are in line with those desired.5 percent.

11 17.20 0.net Application͵Risk Attribution ¾ We can separate a portfolio's active risk squared into two components: Active risk squared = s2 (R P  R B ) ¾ Active factor risk is the contribution to active risk squared resulting from the portfolio's different-than-benchmark exposures relative to factors specified in the risk model.00 12.85 0.net Example ¾ Correct Answer : z The table below shows the proportional contribution of various resources of active risk as a proportion of active risk squared. Active Factor Active Active Fund Size Factor Style Factor Total Factor Specific Risk Alpha 29% 56% 85% 15% 4.gfedu.25 12.1%). Note that active risk is the square root of active risk squared(as given).0% Gamma 47% 0% 48% 52% 6. CFA.1% z The Gamma fund has the highest level of active risk(6.gfedu. 42-145 .7 37.22 Gamma 17.22 16. z The Alpha fund has the highest exposure to style factor risk as seen by 56% of active risk being attributed to differences in style.net Example ¾ Steve Martingale.80 4.22 21.22 18.96 19. is analyzing the performance of three actively managed mutual funds using a two-factor model. z The Alpha fund has the lowest exposure to active specific risk(15%)as a proportion of total active risk. The results of his risk decomposition are shown below: Active Factor Active Active Risk Fund Size Factor Style Factor Total Factor Specific Squared Alpha 6.47 3.69 Beta 3.gfedu.66 ¾ Questions: z Which fund assumes the highest level of active risk? z Which fund assumes the highest percentage level of style? z Which fund assumes the lower percentage level of active specific risk? 41-145 www. ¾ Active specific risk or asset selection risk is the contribution to active risk squared resulting from the portfolio's active weights on individual assets as those weights interact with assets' residual risk.CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www.7% Beta 20% 5% 25% 75% 4. ¾ Active risk squared = Active factor risk + Active specific risk 40-145 www.

net Application: Portfolio Construction ¾ The Carhart four-factor model (four factor model) z ERP=RF+β1RMRF+ β2SML+ β3HML+ β4WML z According to the model. HML (BV/P) 9 Stocks whose prices have been rising.net Reading 49 Measuring and Managing Market risk 45-145 . z In evaluating portfolios. ¾ Rules-based active management (alternative indexes). 43-145 www. value. or momentum when constructing portfolios. These strategies routinely tilt toward factors such as size. commonly referred to as “value” stocks.net Application: Portfolio Construction ¾ Passive management.gfedu. analysts use multi-factor models to understand the sources of active managers' returns and assess the risks assumed relative to the manager's benchmark (comparison portfolio). commonly referred to as “momentum” stocks: WML=Return of Winner – return of Loser 44-145 www.gfedu.gfedu. there are three groups of stocks that tend to have higher returns than those predicted solely by their sensitivity to the market return: 9 Small-capitalization stocks: SMB=Return of Small – Return of Big 9 Low price-to book-ratio stocks. Many quantitative investment managers rely on multifactor models in predicting alpha (excess risk-adjusted returns) or relative return (the return on one asset or asset class relative to that of another) as part of a variety of active investment strategies. CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www. ¾ Active management. quality. Analysts can use multifactor models to match an index fund's factor exposures to the factor exposures of the index tracked.

z A measure in either currency units (in this example. and so on? In other words. The left side displays the low or negative returns. z A statement references a time horizon: losses that would be expected to occur over a given period of time.CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www. The loss can be stated as a percentage of value or as a nominal amount.gfedu.net Understanding VaR ¾ VaR states at some probability (often 1 % or 5%) the expected loss during a specified time period.gfedu. Analytical (variance-covariance) method 4. 47-145 www. Historical Method 5. But suppose the 5% VaR is losing $ 1.net Understanding VaR ¾ Analysis should consider some additional issues with VaR: z The VaR time period should relate to the nature of the situation. z The left-tail should be examined. Extensions of VaR 7. A 1% VaR would be expected to show greater risk than a 5% VaR.gfedu. z A minimum loss.37 million.net 1. how much worse can it get? 48-145 . The Confidence Intervals 3. 1%. what happens at 4%. Other Key Risk Measures 8. Left-tail refers to a traditional probability distribution graph of returns. VaR always has a dual interpretation. Using Constraints in Market Risk Management 46-145 www. A traditional stock and bond portfolio would likely focus on a longer monthly or quarterly VaR while a highly leveraged derivatives portfolio might focus on a shorter daily VaR. the euro) or in percentage terms. Understanding VaR Framework 2. Monte Carlo Simulation Method 6. z The percentage selected will affect the VaR. which is what VaR measures at some probability. Applications of Risk Measures 9.

There is a 95% chance that the expected loss over the next month is less than $12.5 million over one month. 50-145 www.net Estimating VaR ¾ 3 methods to estimate VaR: z Analytical method (variance-covariance/delta normal method) z Historical method z Monte Carlo method 51-145 . which of the following statements is correct? A.gfedu. C.net Example ¾ Given a VaR of $12. There is a 5% chance of losing $12.net Understanding VaR 49-145 www.5 million. The minimum loss that would be expected to occur over one month 5% of the time is $12.5 million. CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www. B.gfedu.gfedu.5 million at 5% for one month.

P  1. P  2. This will make the VaR estimate worse as no return is considered.58σ μ-1. ¾ VaR for periods less than a year are computed with return and standard deviations expressed for the desired period of time.65 u12% u $100. the 5% annual VaR is: VaR R p  z u V u Vp 6%  1.96σ μ-2. z For monthly VaR.800.gfedu.e. 54-145 .000 portfolio is 6.58σ 68% 95% 99% 53-145 www. divide the annual return by 12 and the standard deviation by the square root of 12. z A CFA candidate would know that 5% in a single tail is associated with 1. 000 $13.65V ] 95% confidence interval is [ P  1. ¾ 1% VaR is 2.gfedu. Then.645. divide the annual return by 52 and the standard deviation by the square root of 52. 000.96σ μ-σ μ μ+σ μ+1.33 standard deviations below the mean.65V .gfedu. Therefore. ¾ Example: Analytical VaR z The expected annual return for a $1 00. standard deviations from the mean expected return. compute monthly VaR. but over one day the expected return should be small. 000 52-145 www. ¾ For a very short period (1-day) VaR can be approximated by ignoring the return component (i.65 standard deviations below the mean.96V . compute weekly VaR.000.65..net For the Exam: ¾ 5% VaR is 1. Then.58V ] Probability μ-2.CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www. enter the return as zero). z For weekly VaR.0% and the historical standard deviation is 12%.net The Confidence Intervals ¾ 68% confidence interval is [P  V .58V . or approximately 1.net Understanding VaR ¾ The analytical method (or variance-covariance method) is based on the normal distribution and the concept of one-tailed confidence intervals. P  V ] 90% confidence interval is [ P  1. P  1.96V ] 99% confidence interval is [P  2. Calculate VaR at 5% significance.

gfedu. z The difficulty of estimating standard deviation in very large portfolios.0% and the historical standard deviation is 12%. z The number of standard deviations for a 1% VaR will be 2. z Many assets exhibit leptokurtosis (fat tails).1154%. ¾ The primary disadvantage of the historical method is the assumption that the pattern of historical returns will repeat in the future (i. 9 Some securities have skewed returns. The weekly standard deviation will be 12%/521/2 = 1 . A 1% VaR implies a downward move of 1%.7620% ¾ Which of the following statements is not correct? A. 57-145 . z Can be applied to shorter or longer time periods as relevant.6641%) = -3. A one standard deviation downward move is equivalent to a 16% VaR.33 below the mean return.1154% -2. ¾ Disadvantages of the analytical method include: z Assumes normal distribution of returns. 56-145 www. z The weekly return will be 6%/52 = 0.. z Does not assume a returns distribution.000 portfolio is 6. z Can be applied to different time periods according to industry custom. 55-145 www. Calculate weekly VaR at 1%. CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www. 9 Variance-covariance VaR has been modified to attempt to deal with skew and options in the delta-normal method.net Historical Method ¾ Advantages of the historical method include: z Very easy to calculate and understand.33(1 .6641% z VaR = 0.e. C. it is indicative of future returns). A 5% VaR implies a move of 1.net Analytical (variance-covariance) method ¾ Advantages of the analytical method include: z Easy to calculate and easily understood as a single number.net Example ¾ The expected annual return for a $1 00.gfedu.gfedu.000. z Allows modeling the correlations of risks.65 standard deviations less than the expected value. B.

000.0034. and other factors the analyst believes are relevant.net Monte Carlo Simulation Method ¾ The primary advantage of the Monte Carlo method is also its primary disadvantage. you identify the lower five returns: -0. correlations.000 portfolio.gfedu.net Example ¾ You have accumulated 100 daily returns for your $100. and z an assumed probability distribution for each variable of interest ¾ A Monte Carlo output specifies the expected 1-week portfolio return and standard deviation as 0.0019. they represent the 5% lower tail of the “distribution” of 100 historical returns.0019) is the 5% daily VaR.CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www.500 59-145 www. 000) 0.0096.19%.00188 and 0. -0. We should ay there is a 5% chance of a daily loss exceeding 0.874. -0.gfedu.65(0.00188  1. For some portfolios it may be the only reasonable approach to use.0025.000. 60-145 . ¾ Answer: Since these are the lowest five returns. VaR RP  ( z )(V ) u VP = 0. The fifth lowest return (- 0. -0.net Monte Carlo Simulation Method ¾ A computer program simulates the changes in value of the portfolio through time based on: z a model of the return-generating process.000. 000) $1. This complexity can lead to a false sense of overconfidence in the output among the less informed. -0. z It can incorporate any assumptions regarding return patterns. respectively. ¾ Calculate the 1-week value at risk at 5% significance. After ranking the returns from highest to lowest.0125.gfedu. 000.0125) ($100. It is data and computer intensive which can make it costly to use in complex situations (where it may also be the only reasonable method to use). or $190.0101 Calculate daily VaR at 5% significant using the historical method. z That leads to its downside: the output is only as good as the input assumptions. 58-145 www.018745($100.

z Failure to take into account liquidity.net Extensions of VaR ¾ Conditional VaR (CVaR):the average loss that would be incurred if the VaR cutoff is exceeded. 61-145 www. z Facilitates capital allocation decisions. ¾ Marginal VaR (MVaR): it is conceptually similar to incremental VaR in that it reflects the effect of an anticipated change in the portfolio.net Advantages and Limitations of VaR ¾ Limitation z Subjectivity. ¾ ex ante tracking error. z Can be used for performance evaluation. z Reliability can be verified. z Widely accepted by regulators. z Vulnerability to trending or volatility regimes.gfedu.gfedu. 62-145 www. CVaR is also sometimes referred to as the expected tail loss or expected shortfall. z Misunderstanding the meaning of VaR.gfedu. z Sensitivity to correlation risk.net Advantages and Limitations of VaR ¾ Advantages z Simple concept. z Oversimplification. z Easily communicated concept. 63-145 . CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www. ¾ Incremental VaR (IVaR): how the portfolio VaR will change if a position size is changed relative to the remaining positions. z Provides a basis for risk comparison. z Disregard of right-tail events. z Underestimating the frequency of extreme events. also known as relative VaR : a measure of the degree to which the performance of a given investment portfolio might deviate from its benchmark. but it uses formulas derived from calculus to reflect the effect of a very small change in the position.

convexity z Options Risk Measures: Delta. 64-145 www. ‹for example.net Advantages and Limitations of Other Measures ¾ Sensitivity z Advantage 9 address some of the shortcomings of position size measures.gfedu. 9 overcome any assumption of normal distributions. z Hypothetical scenarios—extreme movements and co-movements in different markets that have not necessarily previously occurred. and it is difficult to assess their probability. 9 allowing liquidity to be taken into account. 9 can be tailored to expose a portfolio’s most concentrated positions to even worse movement than its other exposures. Vega ¾ Scenario Risk Measures z Historical scenarios are scenarios that measure the hypothetical portfolio return that would result from a repeat of a particular period of financial market history. The scenarios used are somewhat difficult to believe.net Other Key Risk Measures ¾ Sensitivity z Equity Exposure Measures: Beta from (CAPM) z Fixed-income Exposure Measure: Duration. they may get the magnitude of movements wrong. 9 Hypothetical scenarios can be very difficult to create.net Advantages and Limitations of Other Measures ¾ Scenario Risk Measures z Advantage 9 do not need to rely on history.gfedu. but they represent the only real method to assess portfolio outcomes under market movements that might be imagined but that have not yet been experienced. 66-145 . 9 Hypothetical scenarios may incorrectly specify how assets will co- move.gfedu. z Limitations 9 Historical scenarios are not going to happen in exactly the same way again. gamma. z Limitations 9 do not often distinguish assets by volatility. which makes it less comparable. 9 It is very difficult to know how to establish the appropriate limits on a scenario analysis or stress test. duration addresses the difference between a 1- year note and a 30-year note. it measures the level of interest rate risk.CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www. 65-145 www.

glide path. surplus at risk. VaR. scenario analysis. active share. economic capital. ex post versus ex ante tracking error. asset and liability matching. VaR .net Applications of Risk Measures ¾ Banks: Liquidity gap. sensitivities. liability hedging exposures versus return generating exposures. scenarios.gfedu. ¾ Stop-loss Limits sets an absolute dollar limits for losses over a certain period. VaR. scenario analysis. redemption risk. scenario analysis z Life Insurers: sensitivities.gfedu.g. ¾ Position limits place a nominal dollar cap on positions. z Hedge Funds: sensitivities. 67-145 www. ¾ Asset Managers: z Traditional Asset Managers: position limits.net Using Constraints in Market Risk Management ¾ Risk Budgeting: process of determining which risks are acceptable and how total risk is allocated across business units/portfolio managers.gfedu. Economic Capital 68-145 www. dollar position limits are set according to frequency of trading volume. ¾ Risk Measures and Capital Allocation z Capital allocation is the practice of placing limits on each of a company’s activities in order to ensure that the areas in which it expects the greatest reward and has the greatest expertise are given the resources needed to accomplish their goals. sensitivities. CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www. beta sensitivity . ¾ Insurers: z Property and casualty insurers: sensitivities and exposures. liquidity. VaR. ¾ Pension Fund: z interest rate and curve risk. scenario analysis. gross exposure .leverage. economic capital. ¾ Liquidity limits are related to position limits. drawdown.net Reading 50 Economics and investment markets 69-145 . 9 E.

¾ The discount rates applied to the cash flows of financial assets will almost certainly vary over time as perceptions of expected economic growth.gfedu.gfedu. Short-term nominal interest rate 4. s  T t . Credit premiums and the business cycle 6. may rise because investors in general may be less willing and able to take on heightened default risk during such periods. inflation. the risk premium that investors demand on financial assets.net 1.gfedu. Framework for the analysis of financial Framework markets 2. ¾ In particular during recessions. The yield curve and business Cycle 5.s = expected inflation rate between t and t + s ρit. The discount rate on real default-free bonds 3.CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www. and cash flow risk change. Commercial real estate 70-145 www. s periods in the future 72-145 . which pays one unit of currency s periods in the future θt. nominal cash flow paid s periods in the future i ± CF ts ± it  s ]= the expectation of the random variable CF conditional on the Et [CF information available to investors today (t) lt.net Framework for the analysis of financial markets ¾ The present value model N Et [CF± it  s ] Pti ¦ s 1 (1  lt . s ) i s z where: Pit = the value of the asset i at time t (today) N = number of cash flows in the life of the asset = the uncertain.net Framework for the analysis of financial markets ¾ Effects of the economy on asset prices are transmitted through some combination of influence on the asset’s expected cash flows and the discount rate(s) applied to the asset’s expected cash flows. especially those that are not default-free.s= the risk premium required today (t) to pay the investor for taking on risk in the cash flow of asset i. s  U t . Equities and the Equity Risk Premium 7. 71-145 www.s = yield to maturity on a real default-free investment today (t).

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The discount rate on real default-free bonds
¾ What sort of return would investors require on a bond that is both
default –free and unaffected by future inflation?
z The choice to invest today involves the opportunity cost of not
consuming today.
z In this case, the investor can:
9 Pay price P today, t, of a default –free bond paying 1 monetary
t ,s
unit of income s periods in the future, or
9 Buy goods worth Pt , s dollars today.
¾ The tradeoff is measured by the marginal utility of consumption s
periods in the future relative to the marginal utility of consumption
today (t).
9 the marginal utility of consumption of investors diminishes as their
wealth increases because they have already satisfied fundamental
needs.

73-145

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The discount rate on real default-free bonds
¾ Inter-temporal rate of substitution
z The ratio of these two marginal utilities - the ratio of the marginal utility
of consumption periods s in the future (the numerator) to the marginal
utility of consumption today (the denominator).
9 For a given quantity of consumption, investor always prefer current
consumption over future consumption and m<1.
9 The rate of substitution is a random variable because an investor
will not know how much she has available in the future from other
sources of income.
9 The Inter-temporal rate of substitution was lower at good state of
the economy, because individuals may have relatively high levels of
current income so that current consumption is high.

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The discount rate on real default-free bonds
¾ The investor must make the decision today based on her expectations of
future circumstances.
° t ,s º E ªm
Pt , s Et ª¬1m ° º
¼ t ¬ t ,s ¼

¾ If this price of the bond was less than the investor’s expectation of the
inter-temporal rate of substitution, then she would prefer to buy more of
the bond today.
z As more bonds are purchased, today’s consumption falls and marginal
utility of consumption today rises, so that expectations conditional on
current information of the inter-temporal rate of substitution, Et ª¬ m
° t ,s º ,
¼
fall. This process continues until the rate of substitution is equal to the
bond.

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The discount rate on real default-free bonds
¾ If the investment horizon for this bond is one year, and the payoff then is $1,
the return on this bond can be written as the future payoff minus the current
payment relative to the current payment.

1  Pt ,l 1
The return on this bond lt , s 1
Pt ,l ª ° t ,s º
Et ¬ m ¼
¾ The one-period real risk-free rate is inversely related to the inter-temporal
rate of substitution. That is, the higher the return the investor can earn, the
more important current consumption becomes relative to future
consumption.

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The discount rate on real default-free bonds
¾ The link between the bond price and the consumption/investment
decision:
z Consider the market price of the bond is “too” low for an individual
investor. The investor with a higher initial inter-temporal rate of
substitution would buy more of the bond the investor will consume
less today leading to an increase in today’s marginal utility expect
to have more consumption and thus lower marginal utility in the future
the inter-temporal rate of substitution would fall.
¾ In sum, the one-period real risk-free rate is inversely related to the
inter-temporal rate of substitution
¾ Uncertainty and risk premiums:
z An investor’s expected marginal utility associated with a given expected
payoff is decreased by any increase in uncertainty of the payoff; thus,
the investor must be compensated with a higher expected return

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The discount rate on real default-free bonds
¾ Pricing a s-period Default-Free Bond
° t 1, s 1 º
E ª¬ P
Pt , s ¼ ° t 1, s 1, m
 covt ª¬ P ° t ,1 º
1  lt ,l ¼
z The first term is the asset’s expected future price discounted at the risk-
free rate. It may be called the risk neutral present value because it
represents a risky asset’s value if investors did not require compensation
for bearing risk
¾ The covariance term is the discount for risk. Note that with a one-period
default-free bond, the covariance term is zero because the future price is a
known constant ($1)
z In general with risk-averse investors, the covariance term for most risky
assets is expected to be negative. Because the price of bond at time t+1
is uncertain, so the price of bond at time t should be lower than a risk-
free bond, which indicates that the covariance term is negative.

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The discount rate on real default-free bonds
¾ However, the covariance term can be positive in some circumstances
such as economy goes bad.
z When economy goes bad, treasury bond is of high demand because it
can be treated as a safe-haven assets to gain a risk-free return. In that
case, the price of the bond will increase.
z In the meantime, future income is decreased as bad economy indicates
and in turn the marginal utility of future consumption is increased. In
that case, the inter-temporal rate of substitution will also increase.

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The discount rate on real default-free bonds
¾ Default-Free Interest Rates and Economic Growth
z An economy with higher trend real economic growth, other things being
equal, should have higher real default-free interest rates than an
economy with lower trend growth.
z Again, other things being equal, the real interest rates are higher in an
economy in which GDP growth is more volatile compared with real
interest rates in an economy in which growth is more stable.
N
CFt i s
Pti ¦ (1  l s
s 1 t ,s )

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Example
¾ What financial instrument is best suited to the study of the relationship
of real interest rates with the business cycle?
A. Default-free nominal bonds
B. Investment-grade corporate bonds
C. Default-free inflation-indexed bonds
¾ The covariance between a risk-averse investor’s inter-temporal rates of
substitution and the expected future price of a risky asset is typically:
A. Negative
B. Zero
C. Positive
¾ The prices of one-period, real default-free government bonds are likely
to be most sensitive to changes in:
A. investors’ inflation expectations.
B. The expected volatility of economic growth
C. The covariance between investors’ inter-temporal rates of
substitution and the expected future prices of the bonds
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s. We denote this risk premium by πt. 82-145 www. z the central bank’s policy rate. s ) s z Investors will want to be compensated by this bond for the inflation that they expect between t and t + s. θt. 84-145 . should fluctuate around the neutral policy 9 Taylor rule: Policy ratet =lt +ιt +0. investors are unlikely to be very confident in their ability to forecast inflation accurately. which. s ) s s 1 ¾ Short-term default-free interest rates tend to be very heavily influenced by: z the inflation environment and inflation expectations over time z real economic activity.gfedu.CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www.gfedu. z But unless the investment horizon is very short. N CFt i s Pti ¦ (1  l t . 9 It will also vary with the level of real economic growth and with the expected volatility of that growth. s  S t . plus 9 a risk premium that will be required by investors to compensate them predominantly for uncertainty about future inflation. which. s  T t .s. z It should be clear from the discussion earlier that this break-even inflation rate will incorporate: 9 the inflation expectations of investors over the investment horizon of the two bonds. is influenced by the saving and investment decisions of households. Because we generally assume that investors are risk averse and thus need to be compensated for taking on risk as well as seeking compensation for expected inflation. s  Tt .net Short-term nominal interest rate ¾ The pricing formula for a default-free nominal coupon-paying bond N CFt i s Pti ¦ s 1 (1  lt .net Short-term nominal interest rate ¾ Treasury bills (T-bills) are very short-dated nominal zero-coupon government bonds: their yields are also usually very closely related to the central bank’s policy rate. in turn. they will also seek compensation for taking on the uncertainty related to future inflation.s.net The yield curve and business Cycle ¾ Break-even inflation rates z The difference between the yield on.5(ιt −ι‫כ‬t )+0. for example. a zero-coupon default-free nominal bond and on a zero-coupon default-free real bond of the same maturity is known as the break-even inflation (BEI) rate.5(Yt −Y‫כ‬t ) 83-145 www.gfedu. which we define as θt. in turn. πt.

z The premium demanded would tend to rise in times of economic weakness.net Example ¾ The yield spread between non-inflation-adjusted and inflation- indexed bonds of the same maturity is affected by: A. both a risk premium for future inflation uncertainty and investors’ inflation expectations over the remaining maturity of the bonds. B.net Credit premiums and the business cycle ¾ Credit spread: the difference between the yield on a corporate bond and that on a government bond with the same currency denomination and maturity. and Curvature of the Yield Curve z The shape of yield curve 9 Upward sloping 9 Downward sloping 9 Hump 9 Flat z An inverted yield curve is often read as being a predictor of recession.gfedu. ¾ Yield Curve z Level. ¾ If we assume that investors are risk neutral͵ z Expected loss = Probability of default ˜ (1 – Recovery rate) z Recovery rates tend to be higher 9 for secured as opposed to unsecured debt holders 9 when the economy is expanding and lower when it is contracting 87-145 . investors’ inflation expectations over the remaining maturity of the bonds. expectations of increasing or decreasing short-term interest rates might be connected to expectations related to future inflation rates and/or the maturity structure of inflation risk premiums. 86-145 www. a risk premium for future inflation uncertainty only. Slope. 85-145 www.net The yield curve and business Cycle ¾ Referring to government yield curves. z The yield on a corporate bond and that on a government bond are both subject to interest rate risk. CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www. C.gfedu.gfedu.

¾ Company-specific factors: z Issuers that are profitable. C. ¾ the basic reason for the increase in the credit risk premium was a reassessment by investors of these sovereign issuers’ ability to pay and the likelihood that they might default. B. This sensitivity can be related to the types of goods and services that they sell or to the indebtedness of the companies in the sector.gfedu. ¾ The category of bonds whose spreads can be expected to widen the most during an economic downturn are bonds from the: A.gfedu. 89-145 www. 90-145 . cyclical sector with high credit ratings.net Credit premiums and the business cycle ¾ Industry sector and credit quality: z Credit spreads between corporate bond sectors with different ratings will often have very different sensitivities to the business cycle z Some industrial sectors are more sensitive to the business cycle than others. uncorrelated with the level of cyclicality in the company’s business. negatively correlated with the level of cyclicality of the company’s business.gfedu. have low debt interest payments. 88-145 www.CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www. non-cyclical sector with low credit ratings. B. C.net Example ¾ The sensitivity of a corporate bond’s spread to changes in the business cycle is most likely to be: A. positively correlated with the level of cyclicality in the company’s business.net Sovereign Credit Risk ¾ The credit risk embodied in bonds issued by governments in emerging markets is normally expressed by comparing the yields on these bonds with the yields on bonds with comparable maturity issued by the US Treasury. and that are not heavily reliant on debt financing will tend to have a high credit rating because their ability to pay is commensurately high. cyclical sector with low credit ratings.

s  S t.gfedu.gfedu. z The P/B tells investors the extent to which the value of their shares is “covered” by the company’s net assets 9 The higher the ratio. 9 P/Es tend to rise during periods of economic expansion. 93-145 . We would thus expect the equity risk premium to be positive. ¾ Sharp falls in equity prices are associated with recessions—bad times z it is difficult to argue that equities are a good hedge for bad consumption outcomes. relative to large.net Investment strategy ¾ Investment styles z Growth stocks 9 Strong earnings growth 9 High P/E and a very low dividend yield 9 Have very low(or no) earnings z Value stocks 9 Operates in more mature markets with a lower earnings growth 9 Low P/E and a very high dividend yield ¾ Company size z Generally speaking. stocks. s  kt . it implies that investors are not willing to pay a high price for a dollar’s worth of the company’s earnings. i ¾ kt .s  Tt .gfedu. f Et [CF± it  s ] Pt i ¦ s 1 (1  lt . Small stock companies will tend to have less diversified businesses and have more difficulty in raising financing. s  J t . One might expect investors to demand a higher equity premium on small. the greater the expectations for growth but the lower the safety margin if things do not turn out as expected 92-145 www. and will thus be less able to weather an economic storm. a relatively high P/E valuation level should be associated with a lower return premium to bearing equity risk going forward. s is essentially the equity premium relative to credit risky bonds. one might expect small stocks to underperform large stocks in bad times. s ) i i s 91-145 www.s  J t . Holding all else constant.s  S t. CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www.net Equities and the Equity Risk Premium ¾ lt .s is the return that investors require for investing in i credit risky bonds.net Equities and the Equity Risk Premium ¾ Valuation multiples: z P/E ratio tells investors the price they are paying for the shares as a multiple of the company’s earnings per share 9 if a stock is trading with a low P/E relative to the rest of the market. s  T t . particularly during recessions.

gfedu. illiquidity acts to reduce an asset class’s usefulness as a hedge against bad consumption outcomes. s  S t. z property investment is both bond-like and stock-like ¾ Most of the asset classes are liquid relative to an investment in commercial property. i f ± ts ] Et [CF Pt i ¦ s 1 (1  lt .net Commercial real estate ¾ Regular Cash Flow from Commercial Real Estate Investments z When investors invest in commercial real estate.CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www. C. z The added liquidity premium provides additional compensation for the risk that the real estate investment may be very illiquid in bad economic times. the cash flow they hope to receive is derived from the rents paid by the tenants. a liquidity premium is added to the discount rate applicable to equity investments. These rents are normally collected net of ownership costs. B. s  kt .gfedu.s. The key difference in the discount rates applied to the cash flows of equity investments and commercial real estate investments relate to liquidity.net Reading 51 Analysis of active portfolio management 96-145 .gfedu.net Example ¾ Which of the following statements relating to commercial real estate is correct? A. 95-145 www. s  T t . ϕt. ¾ Other things being equal. Commercial real estate investments generally offer a good hedge against bad consumption outcomes. ¾ Correct Answer : C z To arrive at an appropriate discount rate to be used to discount the cash flows from a commercial real estate investment. Because of this. s  J t . Rental income from commercial real estate is generally unstable across business cycles. s ) i i i s 94-145 www. investors will demand a liquidity risk premium. s  It .

Decomposition of value added 3. Active Security Returns 7. but the complete set of active weights sums to zero.net 1. j RP. CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www. Information Coefficient 9. j .gfedu.net Decomposition of value added ¾ The common decomposition: value added due to asset allocation and value added due to security selection.net Value added ¾ The value added or active return is defined as the difference between the return on the manage portfolio and the return on a passive benchmark portfolio. The Sharpe ratio 4.gfedu. N RA ¦ 'w R i 1 i Ai 98-145 www. ¾ The total value added is the difference between the actual portfolio and the benchmark return: M M RA ¦ wP. Size Active Weights 8. The full fundamental law of active management 97-145 www. RA RP  RB ¾ Value added is related to active weights in the portfolio. The basic fundamental law 10. defined as differences between the various asset weights in the managed portfolio and their weights in the benchmark portfolio. Individual assets can be overweighed (have positive active weights) or underweighted (have negative active weights). Information ratio 5. j  RB. Value added Framework 2. Constructing Optimal Portfolios 6.gfedu.

j .  ¦ wP. j  wB.

RB. j j 1 j 1 Security Selection Asset Allocation 99-145 .

7%. 101-145 www.40(–2.68(3.0%) = 2.1%) = 2.gfedu.net Example-Decomposition of value added ¾ Consider the fund returns for the calendar year 2013 in the following table.0 0. Using the actual weights of 68% and 32% in the Fidelity and PIMCO funds.net Example-Decomposition of value added ¾ Correct Answer : z As shown in the table.3%) + 0. so the value added by the active asset allocation decision was 0. the combined value added from security selection was 0.1% + 2. with 68% of the total portfolio in Fidelity and 32% in PIMCO. Fund Return Benchmark Value Fund (%) Return (%) Added (%) Fidelity Magellan 35.08(32.1 Return Portfolio Return 23.4% and the return on the policy portfolio was 0.gfedu.0%) + 0. note that the return on the investor’s portfolio was 0.1%.8%.6%.4 18.4% – 18.8 ¾ Consider an investor who invested in both actively managed funds.32(–1. 100-145 www. Fidelity Magellan added value of RA = RP – RB = 35.0% and PIMCO Total Return Fund Fidelity Magellan added value of RA = RP – RB = –1.6 = 4.9% – (–2. ¾ Assume that the investor’s policy portfolio (strategic asset allocation) specifies weights of 60% for equities and 40% for bonds.net Example-Decomposition of value added z The total value added by the investor’s active asset allocation decision and by the mutual funds through security selection was 2. z To confirm this total value added.9 −2.3 32.CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www.gfedu.9%) = 23.32(0. for a difference of 23.60(32.7% = 4.0%) = 0.1%.3% – 32.68(35.3%) + 0.0%) = 18.3% = 3.3%) – 0.0 PIMCO Total −1.8%. 102-145 . z The active asset allocation weights in 2013 were 68% – 60% = +8% for equities and –8% for bonds.3 3.08(–2.6 4.

RP  RF SR P STD(R P ) ¾ An important property is that the Sharpe ratio is unaffected by the addition of cash or leverage in a portfolio. RC  RB wR  1  w.net Information ratio ¾ The information ratio measures reward per unit of risk in benchmark relative returns. z Of course. RC  RF w P (R P  R F ) SR C SR P STD(Rc) w PSTD(R P ) 103-145 www.net The Sharpe ratio ¾ The Sharpe ratio measures reward per unit of risk in absolute returns. an outside investor can hardly adjust the active risk of an existing fund by changing the individual asset active weight positions. RP  RB RA IR STD( RP  RB ) STD( RA ) ¾ However. but the same objective can be met by taking positions in the benchmark portfolio.gfedu. CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www.gfedu. the information ratio of an unconstrained portfolio is unaffected by the aggressiveness of active weights.

RB  RB wRA RA IR = P STD RC  RB .

z the squared Sharpe ratio of an actively managed portfolio is equal to the squared Sharpe ratio of the benchmark plus the information ratio squared: SR 2P SR 2B  IR 2 105-145 .gfedu. wSTD( RP  RB ) wSTD( RA ) STD( RA ) 104-145 www. the overriding objective is to find the single risky asset portfolio with the maximum Sharpe ratio. given the opportunity to adjust active risk and return by investing in both the actively managed and benchmark portfolios. ¾ A similarly important property in active management theory is that.net Constructing Optimal Portfolios ¾ Given the opportunity to adjust absolute risk and return with cash or leverage. whatever the investor’s risk aversion.

” In addition.CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www.1% 7.2% 17.net Constructing Optimal Portfolios ¾ The preceding discussion on adjusting active risk raises the issue of determining the optimal amount of active risk. 107-145 www.4% return Return standard 15.5% 0.0% 8. We use historical values in this problem for convenience. values for both the benchmark portfolio and the active funds would be subjectively determined by the investor. suppose that the historical performance of the S&P 500 benchmark portfolio shown in Exhibit 1 is indicative of expected returns and risk going forward.9% 17. or expected.6% 10. V2 RP V 2 +V 2 RB RA 106-145 www.8%) S&P Fidelity Magellan Vanguard Windsor 500 (Fund I) (Fund II) Average annual 10.gfedu.4% Information ratio −0. Sharpe ratio 0. but in practice the forecasted.net Example͵Constructing Optimal Portfolios ¾ Suppose that the historical performance of the Fidelity Magellan and Vanguard Windsor mutual funds in Exhibits 2 and 3 are indicative of the future performance of hypothetical funds “Fund I” and “Fund II.gfedu.gfedu.32 0. the total risk of the actively managed portfolio is the sum of the benchmark return variance and active return variance.25 0. without resorting to utility functions that measure risk aversion.4% Active risk 6.net Example͵ Constructing Optimal Portfolios Excerpted from Exhibits 1 and 2 (based on a risk-free rate of 2.05 Benchmark S&P 500 S&P 500 108-145 . as shown below.3% dev. the level of active risk that leads to the optimal portfolio is: IR VR VR A SR B B ¾ By definition. For unconstrained portfolios.44 Excerpted from Exhibit 3 Fidelity Magellan Vanguard Windsor (Fund II) (Fund I) Active return –1.47 0.

because Fund II has the higher expected information ratio: 0.0% = −30%. The benchmark portfolio weight needed to adjust the active risk in Fund III is 1 − 6. Fund III has the potential to increase the expected Sharpe ratio from 0.5%/5.net Example-3 ¾ Again.25. ¾ Correct Answer 3: z The optimal amount of active risk is (0. ¾ Correct Answer 2: z Properly combined with the S&P 500 benchmark portfolio.net Active Security Returns ¾ The Correlation Triangle 111-145 .5%.472 + 0. Determine the weight of the benchmark portfolio required to create a combined portfolio with the highest possible expected Sharpe ratio. ¾ Correct Answer 1: z Fund II has the potential to add more value as measured by the Sharpe ratio.05 compared with –0. Fund I or Fund II. ¾ Calculate the possible improvement over the S&P 500 Sharpe ratio from the optimal deployment of a new fund.0%.47)15.20.” which has an expected information ratio of 0.gfedu. 110-145 www.gfedu. 109-145 www.net Example-1&2 ¾ State which of the two actively managed funds.202)1/2 = 0.20/0.51.2% = 6.gfedu. called “Fund III. CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www.47 for the passive benchmark portfolio to an expected Sharpe ratio of (0. would be better to combine with the passive benchmark portfolio and why. suppose Fund III comes with an active risk of 5.

in the left corner. Pi V i . RAi. and forecasted active returns. μi. To be more accurate. μi.net Active Security Returns ¾ Signal quality is measured by the correlation between the forecasted active returns. but only to the extent that those forecasts are exploited in the construction of the managed portfolio. called the transfer coefficient (TC).CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www. μi. at the right corner. 112-145 www.e. at the top of the triangle. IC=COR RAi V i . z Investors with higher IC. measures the degree to which the investor’s forecasts are translated into active weights. and the N realized active returns. IC is the ex ante risk-weighted correlation. at the top of the triangle. and the realized active returns. RAi. Δwi. or ability to forecast returns. will add more value over time.net Information Coefficient ¾ Assume IC is the ex ante (i. ¾ The correlation between any set of active weights. commonly called the information coefficient (IC).gfedu. anticipated) cross-sectional correlation between the N forecasted active returns..gfedu.

'wiV i ) 113-145 www.” Scores with a cross-sectional variance of 1 are used to ensure the correct magnitude of the expected active returns. is basically the cross-sectional correlation between the forecasted active security returns and actual active weights. z sponsible screens generally require the use of a numerical optimizer. 114-145 . sometime called “scores.net Size Active Weights ¾ In addition to employing mean–variance optimization. proofs of the fundamental law generally assume that active return forecasts are scaled prior to optimization using the Grinold (1994) rule: Pi ICV i Si z IC is the expected information coefficient z σi is separate for individual securities z Si represents a set of standardized forecasts of expected returns across securities. TC. TC COR(Pi / V i .gfedu. ¾ The transfer coefficient.

gfedu. is the sum product of active security weights and forecasted active security returns: N E RA .net Size Active weights ¾ mean–variance-optimal active security weights for uncorrelated active returns. or expected active portfolio return. proofs of the fundamental law generally assume that active return forecasts are scaled prior to optimization using the Grinold (1994) rule. Pi VA 'w i V i IC u BR 2 115-145 www.gfedu. subject to a limit on active portfolio risk. CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www. are given by Pi VA 'w i V i2 N Pi2 ¦ i 1 Vi 2 ¾ In addition to employing mean–variance optimization.net The basic fundamental law ¾ The anticipated value added for an actively managed portfolio.

¦ 'w P i 1 i i ¾ Using the optimal active weights and forecasted active security returns talked before. the expected active portfolio return is: E RA .

0% 117-145 .net Example ¾ Consider the simple case of four individual securities whose active returns are defined to be uncorrelated with each other and have active return volatilities of 25.0% #2 1.0 25.0% #4 –1. an active investor believes the first two securities will outperform the other two over the next year.gfedu. respectively.0 50.0%. IC BRV A IR =IC u BR 116-145 www. and thus assigns scores of +1 and –1 to the first and second groups.0% and 50.0% #3 –1.0 50. After some analysis.0 25. The scenario is depicted in the following exhibit: Security Score Volatility #1 1.

0% 9.0%.0% 118-145 www.net Example-2 ¾ Given the assumption that the four securities’ active returns are uncorrelated with each other. 119-145 www.0% 25.0% #2 1.20(25.0% –10.0% 5.net Example-1 ¾ Assume that the anticipated accuracy of the investor’s ranking of securities is measured by an information coefficient of IC = 0.252 0.0% 10.0 25.0% μ 18.0 25. What are the forecasted active returns to each of the four securities using the scaling rule μi = ICσiSi? ¾ Correct Answer 1: z The forecasted active return to Security #1 is 0. and forecasts are independent from year to year.0% 50.0 50.0%)(1.0% 25.gfedu.0% –5.net Example-3 ¾ Suppose the investor wants to maximize the expected active return of the portfolio subject to an active risk constraint of 9.05 0.0% #3 –1.0% #3 μ 5. then the investor has made four separate decisions and breadth is BR = 4.09 'w i =18% 0.0 50. what is the breadth of the investor’s forecasts? ¾ Correct Answer 2: z If the active returns are uncorrelated with each other and the forecasts are independent from year to year. the number of securities. Security Score Active Return Volatility Expected Active Return #1 1.0% #2 10.0% #4 –1.0) = 5.0% #4 μ 10.0% μ 9. Security Expected Active Return Active Return Volatility Active Weight #1 5.20 u 4 z Similar calculations for the other four securities are shown in the following exhibit.20.0% 50.CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www. Similar calculations for the other three securities are shown in the following exhibit. Calculate the active weights that should be assigned to each of these securities using the formula: 'w i Pi VA 2 V i IC u IB ¾ Correct Answer 3: z The size of the active weight for Security #1 is 0.0%.gfedu.0% 18.0% 120-145 .gfedu.

0% –9% –17% 123-145 . limits on turnover.0% 50. Expected Active Return Optimal Active Actual Active Security Active Return Volatility Weight Weight #1 5. a number of practical or strategic constraints are often imposed in practice.net The full fundamental law of active management ¾ Although we were able to derive an analytic (i. socially re 121-145 www.gfedu. For Exampleͫ z if the unconstrained active weight of a particular security is negative and large. formula-based) solution for the set of unconstrained optimal active weights. active risks.0% 25. also comes into play in calculating the optimal amount of active risk for an actively managed portfolio with constraints.0% –18% 7% #4 –10. The active return forecasts.0% 9% 4% #3 –5. TC.e. z many investors are constrained to be long only. the full fundamental law is expressed in the following equation: E ( RA ) (TC )( IC ) BRV A IR (TC )( IC ) BR ¾ We close this sub-section by noting that the transfer coefficient. and the active weights for each security are shown in the exhibit below.0% 50. z for quantitatively oriented investors. z Specifically.gfedu.net The full fundamental law of active management ¾ Including the impact of the transfer coefficient. that might lead to short sell of the security.0% 25.0% 18% 6% #2 10.. either by regulation or costs of short selling. with constraints and using notation consistent with expressions in the fundamental law: IR VA TC VB SR B 2 SR 2P = SR 2B +( TC) (IR * )2 122-145 www.net Example ¾ Consider the simple case of four individual securities whose active returns are uncorrelated with each other and forecasts are independent from year to year. CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www.gfedu.

04)2 (50.0)2 + (0. ICR.0) = 2.58 and breadth of BR = 4.17)2 (50. is E(R A̮IC R ) (TC)(IC R ) BRV A z We can represent any difference between the actual active return of the portfolio and the conditional expected active return with a noise term R A =E(R A̮ICR ) + Noise z an ex post (i.net Example-2 ¾ Verify the full fundamental law of active management using the active portfolio return.e.net Ex post Performance Measurement ¾ Most of the fundamental law perspectives discussed up to this point relate to the expected value added through active portfolio management.0)2]1/2 = 9.58 u 0.0% 9 Information ratio=2.1% IR (TC )( IC ) BR 0.1%. realized) decomposition of the portfolio’s active return variance into two parts: variation due to the realized information coefficient(T2) and variation due to constraint-induced noise(1-T2) 126-145 . ¾ Correct Answer : z The full fundamental law states that E ( RA ) (TC )( IC ) BRV A 0. ¾ Correct Answer: z The forecasted active return of the optimal portfolio is the sum of the active weights times active returns for each security. ¾ Actual performance in any given period will vary from its expected value in a range determined by the benchmark tracking risk.20 u 4 0.CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www.gfedu.07(–5.gfedu.0)2 + (– 0.232 125-145 www. The active risk of the optimal portfolio is the square root of the sum of active weights squared times the active volatility squared for each security.0) + 0.233 124-145 www.gfedu. The individual active return forecasts and optimal active weights were sized using an information coefficient of IC=0.0) + 0. an transform coefficient of TC=0.1%/9%=0..06(5.04(10.net Example-1 ¾ Calculate the forecasted active return and active risk of the managed portfolio using the actual active weights.0)2 + (0. and transfer coefficient calculations before.0) + (–0.06)2(25. active portfolio risk.17)(– 10.20. 9 Active risk = [(0. z Using actual active weight 9 Active return = 0.20 u 4 u 9.07)2 (25.0% 2.58 u 0. z Expected value added conditional on the realized information coefficient.

2% z In other words. and annualized active risk of σA = 4.0%.10. the investor should expect an active return that is negative because the realized information coefficient is negative.gfedu.6%. how much of the forecasted active return was offset by the noise component? ¾ Correct Answer 3: z The noise portion of the active return is the difference between the actual active return and the forecasted active return: –2.05 u 100 u 4.gfedu.6%.. and annual rebalancing). Given the –0. z In other words.2) = 0.gfedu. 128-145 www. Calculate the expected value added according to the fundamental law. 100 individual stocks whose active returns are uncorrelated. instead of the expected value of IC = 0.05. In the absence of constraint-induced noise. without including constraint-induced noise (which has an expected value of zero) is E ( RA̮ICR ) (TC )( ICR ) BRV A -3. conditional on the actual information coefficient. 129-145 .6 – (–3.80. CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www. ¾ Correct Answer 1: E( RA ) (TC)( IC) BRV A 0.05.net Example-3 ¾ Suppose that the actual return on the active portfolio was –2. an expected information coefficient of IC = 0.6% 127-145 www. the noise component helped offset the negative value added from poor return forecasting. a transfer coefficient of TC = 0.net Example-1 ¾ Consider an active management strategy that includes BR = 100 investment decisions (e.g.10 realized information coefficient.80 u 0.0% 1.net Example-2 ¾ Suppose that the realized information coefficient in a given period is – 0. what would be the value added that period? ¾ Correct Answer 2: z The value added.

. Specifically. tracking risk squared) in this strategy over time is attributed to variation in the realized information coefficient (i..gfedu.net Applications of The Fundamental Law ¾ Global Equity Strategy(TC) z selection of country equity markets in a global equity fund. TC2 = 64%. individual stock) selection strategies are analytically and empirically confirmed to be 45%–91% of original estimates using the fundamental law. 132-145 .gfedu. z The increasing in BR is at the cost of decreasing IC. Furthermore.e. security (i..net Example-4 ¾ What percentage of the performance variance (i. leaving 36% due to constraint-induced noise.gfedu. z In that case. and what percentage of performance variance is attributed to constraint-induced noise? ¾ Correct Answer 4: z Given the transfer coefficient of TC = 0.CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www. forecasting ability probably differs among different asset segments and varies over time. z the constraints that are imposed on the portfolio should inform the decision of how aggressively to apply an active management strategy. 130-145 www. ¾ Fixed-Income Strategy(IC. forecasting success). 64% of the variation in performance over time is attributed to the success of the forecasting process.net Practical Limitations ¾ Ex Ante Measurement of Skill z Behaviorally. z The key impact of accounting for the uncertainty of skill is that actual information ratios are substantially lower than predicted by an objective application of the original form of the fundamental law. z Even if that bias did not exist. questions about assessing an accurate level of skill remain.80.e. 131-145 www. one might argue that investors tend to overestimate their own skills as embedded in the assumed IC.BR) z timing of credit and duration exposures in a fixed-income fund.e.

gfedu.net Practical Limitations ¾ Independence of Investment Decisions N BR 1  N  1. CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www.

Risk management and regulatory oversight 8.gfedu. Latency 7. Execution algorithms take various approaches 3. breadth can increase well beyond the number of securities. Define algorithmic trading Framework 2. z Similarly.gfedu.net 1. U z All the stocks in a given industry or all the countries in a given region because they are responding to similar influences cannot be counted as completely independent decisions. Market fragmentation and its effects 6. Data for High-frequency trading algorithms 4. HFT-statistical arbitrage 5.net Reading 52 Algorithmic Trading and High-Frequency Trading 134-145 www. 133-145 www. Impact of algorithmic on securities markets 135-145 . when fundamental law concepts are applied to hedging strategies using derivatives or other forms of arbitrage(ϱ<0). so breadth in these contexts is lower than the number of assets.

z HFT algorithms are about profit.gfedu. ¾ Implementation shortfall dynamically adjusts the schedule of the trade in response to market conditions to minimize the difference between the price at which the buy or sell decision was made and the final execution price. z Execution algorithms are about minimizing market impact and trying to ensure a fair price.gfedu.CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www. ¾ High-frequency trading algorithms add Ȕwhen to tradeȕ and even sometimes Ȕwhat to tradeȕ. Although all news offers value. some news is more relevant than other news. that event is likely to have a lesser impact than news Ȕsurprises.ȕ ¾ Execution algorithms are about automating Ȕhow to tradeȕ—that is. ¾ News events. is a new bid or offer in the market for a certain instrument at a certain price level and with a certain available quantity (volume) ¾ Trade events. contains news related to particular instruments or economic indicators. proportioned to this distribution.net Data for High-frequency trading algorithms ¾ Market data feeds stream directly from trading venues.gfedu.net Execution algorithms take various approaches ¾ VWAP uses the historical trading volume distribution for a particular security over the course of a day and divides the order into slices. ¾ Market participation slices the order into segments intended to participate on a pro-rata basis with volume throughout the course of the execution period.net Define algorithmic trading ¾ Algorithm is Ȕa sequence of steps to achieve a goal. 137-145 www. shows a new trade that has taken place at a certain price and a certain volume. 136-145 www. If the news contained in a news event merely confirms pre- existing expectations. ͧс‫֫ޣ‬۱ङ‫ͨ݇ރ‬ ¾ Quote events.ȕ and algorithmic trading is Ȕusing a computer to automate a trading strategy.ȕ 138-145 . how to place orders in the market.

it is important to act quickly on the liquidity opportunity seen in the market. soybean meal) z Mean reversion z Delta neutral strategies 139-145 www. This process is called a multi-legged trade. algorithms monitor instruments that are known to be statistically correlated with the goal of detecting breaks in the correlation that indicate trading opportunities. soybean oil futures. it is important not to get “legged out. z Pairs trading z Index arbitrage z Basket trading z Spread trading 9 Crack spread(crude oil. before a human trader can react. Low latency is important to get first mover advantage and to act on an opportunity before a competitor does. Over time. arb. ¾ Genetic tuning z The algorithms that have the most profitable theoretical P&L profile can be put into the market to trade live. CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www. or unexpected weather events.gfedu. ¾ Real-time pricing of instruments z High-frequency pricing can thus influence prices and spreads based on the up-to-millisecond view of the market and the tier of the customer. z First.” with one leg of the strategy executing but another leg being confronted with a market that has moved. petroleum products) 9 Spark spread(market price of electricity and its cost of production) 9 Crush spread(soybean futures.gfedu. in which each trade is a leg.net The “money machine” application areas ¾ Liquidity aggregation and smart order routing z Markets have become increasingly fragmented as the number of venues trading the same instruments has proliferated. which means the opportunity is lost. 141-145 .net Latency ¾ Latency is the time difference between stimulus and response.net HFT-statistical arbitrage ¾ Stat.gfedu. ¾ Trading on news z firms can trade automatically on news. This phenomenon is known as market fragmentation and creates the potential for price and liquidity disparities across venues. z Second. live algorithms may become less profitable and can be deactivated. 140-145 www. ¾ Low latency decision making is particularly relevant when placing multiple trades as part of a stat arb strategy. such as announcement of a war.

Brokers can also benefit from this kind of technology to prevent abuse in their trading operations and ensure their good reputations. some groups turned off their pre-trade risk management because it increased latency. However. it can also increase trading risk.net Risk management and regulatory oversight ¾ Several regulators around the world have recognized that real-time market monitoring and surveillance allows more rapid response to potential crises and market abuse.gfedu. ¾ Two approaches being successfully used to mitigate trading risk z Real-time pre-trade risk firewall z Back testing and market simulation. To complement high-frequency trading.net Impact of algorithmic on securities markets ¾ Positive z Minimized market impact of large trades z Lower cost of execution z Improved efficiency in certain markets z More open and competitive trading markets z Improved and more efficient trading venues ¾ Negative z Fear of an unfair advantage z Acceleration and accentuation of market movements(no emotion) z Gaming the market(fictitious orders) z Increased risk profile z Algorithms gone wild 144-145 . potentially allowing rapid action to prevent or minimize any market impact.net Risk management and regulatory oversight ¾ HFT can scale the capabilities of a trader hundreds or thousands of times. but there is a lack of consistency across the market.gfedu.CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www.gfedu. layering and spoofing from Flash Crash of American stock at May 6th . ¾ Many firms embraced this concept some time ago. 142-145 www. However.2010) z Wash trading z Trade collusion 143-145 www. ¾ Many trading venues have had real-time surveillance technologies for a long time. ¾ The kinds of patterns that can be detected include the following: z Insider trading z Front running orders z Painting the tape z Fictitious orders(quote stuffing. high-frequency pre-trade risk capabilities are needed.

If there was ever a moment to follow your passion and do something that matters to you. that moment is now. CFA FRM网课+纸质彩印notes 微信号:xxkj889 持续更新 www.net It’s not the end but just beginning.gfedu. Life is short. ࣿո਴िͫ‫ߧײ‬҂߄▲Зߑѫ૦சਘٜङࢬ‫ە‬Ծҟ҂ઍО୍੽ङзͫ ଻Т଑Зߑѫ‫֨࣫ީؼ‬澞 145-145 .