Professional Documents
Culture Documents
GIPS:
- Firms must make every reasonable effort to provide a compliant presentation to all prospective
clients, at least once in the last 12 months. It is a recommendation, not a requirement that all clients
receive a compliant presentation on an annual basis.
- Firms must provide investors with a comprehensive view of their performance in terms of risk and
returns, not just returns.
- To claim compliance, firms must meet all GIPS requirements.
- A composite must include all actual fee-paying, discretionary portfolios managed in accordance
with the same investment mandate, objective or strategy. Non fee-paying and nondiscretionary
portfolios must not be included in composites.
- The current GIPS standards include new provisions related to risk to provide investors with a more
comprehensive view of a firm’s performance.
- After a firm presents a minimum of five year of GIPS-compliant performance, the firm must present
an additional year of performance each year, building up to a minimum of 10 years of GIPS-compliant
performance.
Standards
Violation of SI(A) Knowledge of the Law is likely to occur unless the (wrong) asset base information is
corrected.
Violation of SII(A) Material Non-public Information is likely to occur when using information that is
selectively disclosed by corporations to a small group of investors, analysts, or other market
participants.
If a member or candidate determines that a falsified information is material, he must make
reasonable efforts to achieve public dissemination of the information. If dissemination of the
information is not possible, he must communicate the information only to the designated
supervisory and compliance personnel within it firm and must not take investment action on the
basis of the information.
Using the mosaic theory to combine nonmaterial, non-public information with material public
information is not a violation of the standard.
Violation of SIII (C) Suitability if an analysis based on each individual client’s return and risk objectives
was not done.
Violation of SIV(A) Loyalty by taking proprietary trading software from a former employer (created
during the period he was an employee).
Violation of SIV(A) Loyalty if a contradictory research recommendation reports to clients is released
(confusion among clients and embarrassment to the firm).
SIV(A) Loyalty requires that, in matter related to their employment, members and candidates must
act for the benefit of their employer and not deprive their employer of the advantage of their skills
and abilities, divulge confidential information, or otherwise cause harm to their employer. If no non-
competing agreement is signed, a former employee is not restricted to recruit former colleagues of
his former employer.
SIV (B) Additional Compensation Arrangements dictates member to disclose any source of conflict of
interest. Members and candidates must obtain permission from their employer before accepting
compensation of other benefits from third parties or services that might create a conflict with their
employer’s interests.
A board position in a business independent of the financial services industry don’t lead to violation of
the standard.
Violation of SV(A) Diligence and Reasonable Basis if no reasonable and diligent efforts are made to
determine if the third party’s research is sound, or if at least external adviser’s adherence to strategy
is not reviewed.
Violation of SV(C) Record Retention if members and candidates don’t develop and maintain
appropriate records to support their investment analysis.
Standard VI (B) Priority of Transactions dictates members and candidates give their clients and
employer priority when making personal investment transactions. Even when clients allow or insist
the manager invest alongside them, the manager’s transactions must never adversely affect the
interest of the clients. A popular or “hot” IPO is likely to be oversubscribed, in that case the manager
should not participate in this event.
Standard VI (C) Referral Fees states that referral arrangements should be disclosed to potential
clients “before entry into any formal agreement for services” and not after the fact.
Punishing abuse in the financial market is not one of the six component of the Code of Ethics.
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Quantitative Methods
Bank Discount yield: 360 days
EAY: 365 days
Position of a percentile
L=( n+ 1 ) × ( 100y ) where y is the percentage point at which we are dividing the distribution (y =20
for first quintile for ex)
In Eliott Wave theory, Wave 2 commonly exhibits a pattern best describe as a Fibonacci ratio
percentage retracement composed of the three smaller waves.
Time weighted rate of return is found by taking the geometric mean of the different HPR.
Test errors
Type I error: rejection of the null when actually true
Type II error: failure to reject the null when actually false
Power of a test = 1 – Type II error: reject the null when false.
P-value: smallest level of significance at which the null hypothesis can be rejected. If p-value < α, the
null hypothesis will be rejected.
Estimators
Unbiased : expected value equal to the true value of the population parameter
Consistent : more accurate, the greater the sample size
Efficient: has a sampling distribution that is less than any other unbiased estimator.
Chebyshev's inequality states that the proportion of observations within k standard deviations of an
arithmetic mean is at least 1−1 /k 2, for all k > 1.
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Test statistic
Mean (n.d.)
x −¿0
t n−1= ¿
o Unknown variance : s
√n
x−❑0
o Known variance (or unknown variance and large sample size) : z=
❑
√n
Difference in means (population n.d., independent): t-statistic
( X 1− X 2 )−( ❑1 −❑2 )
t= 0,5
s 2p s2p , if variances unknown but assumed equal
( +
n1 n 2 )
( X 1− X 2 )−( ❑1 −❑2 )
t= 0,5
s 21 s 22 , if variances unknown and assumed not equal
( +
n1 n 2 )
Paired comparison test : Means of the differences (2 dependent, n.d.) : t-statistic
d sd
t= , with sd = , Df = n-1
sd √n
Population variance (n.d.) : chi-square test statistic
( n−1 ) s2
χ 2= , sigma 0 the hypothesized value of the pop variance, Df = n-1
❑20
The balance at any time of an amortizing loan is the present value of the remaining payments.
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Economics
Demand surplus:
Starting with the function: P = 9 – 0,2*Q
Use the demand function: Q = 45 – 5*P to determine Q given P (4). Q =25.
The consumer surplus can be charged: area under the demand curve above P (4) for Q=25.
Consumer surplus = ½ * (9-4)*25 = 62,5.
Elasticities
Use demande function Q= a + bP
% change∈quantity demanded P0 Q Q
Price elasticity : = × ,b=
% change∈ price Q0 P P
|own price elasticity| > 1: demand is elastic
|own price elasticity| < 1 : demand is inelastic|
% change∈quantity demanded I 0 Q Q
Income elasticity : = × ,b=
% change∈income Q0 I I
Income elasticity < 0 : good is an inferior good
Income elasticity > 0 : good is a normal good
% change∈quantity demanded
Cross price elasticity :
% change∈ price of related good
cross price elasticity > 0 : related good is a substitute
cross price elasticity < 0 : related good is a complement
An increase in capacity utilization will cause an increase in aggregate demand through higher
investment and will increase GDP.
In first-degree price discrimination, then entire consumer surplus is captured by the producer, the
consumer surplus falls to zero.
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1
Fiscal multiplier =
1−MPC ( 1−T )
Consumption
With MPC =
Disposableincome
GDP /Accounts
Current account: Merchandises & Services / Income receipts (foreign income from dividends on
stock, interest on debt debentures) / Unilateral transfer (one way transfer of assets).
Current account = (X-M) = (S-I) – (G + R –T)
Capital account: Capital transfers / Sales and purchases of non-financial assets
Financial account: government owned assets abroad (gold, currency, foreign securities) / Foreign
owned assets in the country
Purchase of machinery is an import and affects the Current Account, not the capital account.
The purchase of a non-produced, non-financial asset (such as a patent) affects the capital account.
Expenditure approach:
GDP = C + I + G + (X-M)
Income approach:
GDP = National income + Capital consumption allowance + Statistical allowance
Using both approaches :
Gross GDP = Consumer spending + Business gross fixed investment + Change in inventories +
Government spending on goods and services + Government gross fixed investments + Exports –
Imports + Statistical discrepancy.
Giffen/Veblen goods:
Giffen good is an inferior good for which negative income effect > positive substitution effect when
price falls. It has a positively sloped individual demand curve.
Veblen good is a good for which a higher price make it more desirable. This is not an inferior good
but a high-status good. It violate the fundamental axioms of demand theory.
Both types demonstrate the possibility of a positively sloping demand curve.
Inflation Indices
Laspeyres index: based on the cost of a specific basket of goods and services that represents
actual consumption in a base period. Biased upward because of new goods, quality
improvements…
Cost of basket at current prices
CPI= ×10 0
Cost of basket at base period price
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Hedonic pricing is a technique used to adjust a price index for product quality
Chain-weighted price indices address the bias of substitution, such as Fischer Index.
- Fischer index is the geometric mean of a Laspeyres index and a Paasche index.
- Paasche index uses the current consumption weights, prices from the base period and
prices in the current period.
In a monopolistic competition structure: many competitors, each of which follows its own product
differentiation, low pricing power, production of differentiated products (through advertising), and
some pricing power. The ease to entry results in zero economic profit in the long run.
In a perfect competition structure, the supply curve of a firm is its marginal cost curve above average
variable cost.
Inflation that is unexpected, or higher than expected, shifts wealth from lenders to borrowers,
because interest rates include a premium for expected inflation. Unexpected deflation has to
opposite effect.
The matching principle holds that expenses should be accounted for in the same performance
measurement period as the revenue the generate.
For publicly traded firms in the US, the auditor must express an opinion as to whether the company’s
internal control system is in accordance with the Public Accounting Oversight Board, under the
Sarbanes-Oxley Act.
The direct method CF statement presents specific operating CFs by source and use.
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Financial ratios alone are not sufficient to determine the creditworthiness of a company. Other
factors must be considered such as examining the entire operation of the company, meeting with
management, touring company facilities…
Operating profit = Revenue – COGS – SG&A– restructuring expenses (US GAAP) – Depreciation
EBITDA = Operating profit (EBIT) + DADP
Inventory costs
Inventory Costs = Raw materials + Transportation-in + Tax related duties – Trades discounts.
Abnormal waste, storage of finished goods and administrative overhead are expensed.
Measurement of inventories
IFRS :
o Lower of Cost or Net Realizable Value = Selling price – selling costs
o If cost > NRV : write down.
o If subsequent recovery in value, written up (limited to the amount of the original
write-down) and the gain is recognized in the IS by reducing COGS
US GAAP :
o Lower of Cost or Market
o NRV – normal profit margin < Market = replacement cost < NRV
o If Cost > Market : write down
o No write up allowed
Inventory methods
Special identification best matches the actual historical cost of the inventory sold with their
physical flow if a company is using perpetual inventory system. The costs remain in inventory
until the actual identifiable inventory is sold. Unit old is matched with unit’s actual cost.
Suitable for items not interchangeable, expensive, unique.
WAC method
LIFO: not allowed under IFRS. Recent purchases sold first.
FIFO: ending inventory includes most recent purchases, COGS earliest purchases.
When using the FIFO inventory method, the ending inventory, the COGS and the gross margin are
the same under either the perpetual or periodic methods. The use of a perpetual or periodic or
perpetual system makes a difference under weighted average and LIFO.
In a period of rising interest rates, the ending inventory would be lower under weighted average and
COGS will be higher compared to FIFO, resulting in a lower NI and retained earnings. There will be no
impact on the debt level. Therefore, the debt-to-equity ratio will increase due to the decrease in
retained earnings (and lower shareholders’ equity). Debt = LT debt + interest bearing ST debt.
Firms that report under LIFO must also report a LIFO reserve, the amount by which LIFO inventory is
less than FIFO inventory:
Add LIFO reserve to LIFO inventory on the BS
¿ V FIFO=¿ V LIFO + LIFO reserve
Increased the retained earnings component of shareholders’ equity by
LIFO reserve ×(1−t )
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It is also necessary, for comparison purposes to convert the LIFO firm’s COGS to the FIFO COGS.
FIFO COGS=LIFOCOGS−( ending LIFOreserve−beginning LIFO reserve )
The LIFO reserve will increase when prices are rising and inventories quantities are stable or
increasing. If a firm is liquidating its inventory, or if prices are falling, the LIFO reserve will decline.
LIFO liquidation occurs when a LIFO firm’s inventory quantities decline.
Compared to a situation in which inventory quantities are not declining:
Older, lower costs are included in COGS
LIFO liquidation results in higher profit margins, income taxes , net income.
Decreased cash expenses (from not producing inventory) will increase CFO, although higher
income taxes on higher earnings will partially offset this increase.
The extra profit reported with a LIFO liquidation inflates operating margins by recognizing
historical inflationary gains from increasing inventory prices as income in the current period.
Increases in profit margin from LIFO liquidation are not sustainable, however, because a firm
cannot continue forever to sell existing inventory without replenishment.
LIFO liquidation can be identified by reviewing the inventory footnotes for a decrease in the LIFO
reserve.
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Receivables
Allowance for doubtful accounts increases by the bad debt expense recognized for the year and
decreases by the amounts written off during the year.
Ending balance allowance for doubtful accounts=Beginning balance allowance+ Bad debt expense – Writ offs
Valuation of intangibles
Under US GAAP: historical cost
Under IFRS: at cost or revaluation
Re/valuation of assets
Investment properties :
o Under IFRS: amortized cost or fair value. When using the fair value model of
revaluing assets, all increases/decreases affect NI.
o Under US GAAP : no specific identification of investment properties
Identifiable intangible assets :
o IFRS: if purchased, on the BS using the cost model or revaluation model (i.e. at FV if
an active market exists).
Revaluation model :
Initial revaluation to FV below historical cost result in a loss reported
on the Income Statement, decreasing NI.
Subsequent upward revaluation is reported as a gain in the IS to the
extent that it reverses a previously reported loss from revaluation to
FV.
Regardless of prior revaluations, any increase in an asset’s value
above historical cost is not reported as a gain in the IS but as a
component of shareholders’ equity in an account called revaluation
surplus.
Subsequent declines in value first decrease this surplus, then result
in a loss reported on the IS to the extent that an asset’s fair value
decreases below its historical cost.
o US GAAP: only the cost model is allowed. Upward revaluation is generally prohibited
(exception : long-lived assets held for sale, for which prior impairment losses can be
reversed)
o If created internally (R&D costs) :
US GAAP : expensed as incurred
IFRS : identify research stage (expensed) and development stage (capitalized)
o Finite life intangible assets are amortized over their useful life and tested for
impairment in the same way as PP&E.
o Infinite lives intangible assets are not amortized but tested for impairment at least
annually.
Derecognition
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Sold : difference between sales proceeds and carrying (book) value is reported as a gain or
loss in the income statement
Abandoned : carrying value is removed from the BS and a loss is recognized in that amount
Exchanged: gain or loss is computed by comparing the carrying value of the old asset with
the fair value of the old asset (or fair value of the new asset if more clearly evident).
Impairment
IFRS : if carrying value > recoverable amount written down to recoverable amount
Recoverable amount = max [FV-selling costs; Value in use=PV of expected CF]
Loss recoveries are permitted but not above historical cost.
US GAAP : if carrying value > undiscounted future CF written down to FV
Subsequent recoveries are not allowed.
Capitalized interests
Interest cost is capitalized when an asset is constructed for own use or for resale under both
standards.
Interest rate is based either on debt acquired to specifically finance the asset’s construction
or the firm’s existing borrowings.
Interest cost is charged to I.S through depreciation or COGS.
In CF statement, cap. Interest is an outflow from investing activities.
Income earned by temporarily investing borrowed funds reduces borrowing costs available
for capitalization (IFRS).
No reduction under U.S. GAAP.
Securities
Reported at Unrealized G/L
Held-for-trading Fair value Income Statement
Held-for-sale Fair value Equity (OCI) but dividend in
Income statement
Held-to-maturity Amortized cost N/A
Derivatives Fair value Income Statement
Leases
If leases were capitalized, both assets and liabilities would increase by the present value of the lease
payments.
Sales vs Finance lease:
Sales : company report an account receivable classified as a current asset
Finance lease : company report a lease receivable, which is primarily long term
Current assets are lower under leasing.
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Corporate Finance
DOL/DFL/DTL
Contribution margin = Price – variable costs
% EBIT Q× ( P−VC ) Q× Contribution margin
DOL= = =
% Sales Q × ( P−VC )−¿ costs Q ×Contribution margin−¿ costs
% EPS EBIT
DFL= =
% EBIT EBIT−Interest
% EPS Q× ( P−VC )
DTL=DOL× DFL= =
% Sales Q × ( P−VC )−¿ costs−Interest
Switching from straight-line depreciation to accelerated depreciation will increase the DTL as it
increases the fixed costs!
¿ operating costs
Operating breakeven quantity of sales=
P−VC
D
(
β Equity =β Asset × 1+ (1−tax rate )
E )
A Pull on liquidity occurs when disbursements are made too quickly (e.g. current liabilities are paid
instead of being held or when credit availability is reduced or limited). E.g.: reduction in a credit line
A drag on liquidity occurs when receipts lag (i.e. non-cash-current assets do not convert to cash
quickly).
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A banker's acceptance is a short-term debt instrument issued by a company that is guaranteed by a
commercial bank. Banker's acceptances are issued as part of a commercial transaction.
1
Nominal ×annual rate ×
Interest +Commission N
Effective annualized cost= ×N= ×N
Proceeds 1
(
Nominal × 1−annual rate×
N )
Capital structure
The company’s current capital structure, at book value weights, is the least appropriate method for
an external analyst to estimate a company’s target structure for determining WACC. He should rely
on market value (not book value) weights.
Financing costs are not included in a CF calculation but are considered in the calculation of the
discount rate (WACC).
Equity Investments
Expected growh rate :g=( retention rate ) ( ROE ) =(1− payout ratio )( ROE )
EV/EBITDA is the most useful multiple when comparing with significant differences in capital
structure. EBITDA is computed prior to payment to any of the company’s financial stakeholders and is
not impacted by the amount of debt leverage.
Margin transaction
1
Leverage ratio=
initial margin requirement
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Price appreciation+¿−Margin interest
TR ( on equity ) %=
Equity
Gain ¿ price appreciation=TR−¿+ Margin interest
Price at which investor sold the stock=Gain ¿ price appreciation per share + Purchase price
Preference shares have characteristics of both debt (dividends are fixed but not contractual
obligations) and equity (can be perpetual and pay dividends indefinitely) securities.
Puttable common shares provide benefits to both the issuing company and investors. The put option
feature facilitates raising capital because the shares are more appealing to investors. It also helps
investors limit their potential losses because they can sell the shares back to the issuing company if
the market price falls below the pre-specified put price.
FCF
FCF measures cash available for discretionary purposes. FCF=CFO−CapEx
FCFE=CFO−CapEx + Net borrowing=CFO−CapEx +(Debt issued−Debt repaid )
FCFF=¿+ Noncash charges−WC−CapEx + [ interest expenses × ( 1−t ) ]
FCFF=CFO−CapEx + [ interest expenses × ( 1−t ) ]
Cash Flows
CFO :
Direct method : present the firm’s operating cash receipt and payments
Indirect method: only present the net result of these receipts and payments. Focuses on the
differences in net income and CFO: this provides a useful link to income statement when
forecasting future CFO.
Step 1: Start with NI
Step 2: Subtract gains, add losses that resulted from financing or investing CF (gains from sale
of land)
Step 3: Add back all non-cash charge to income (DADP), subtract all non-cash components of
revenue
Step 4: Add or subtract changes to BS operating accounts as follows:
o Asset accounts : ↗ Assets (use of cash) ↘ Cash
o Operating liability accounts : ↗ Liabilities (source of cash) ↗ Cash
CFF :
o Determined by measuring the CFs occurring between the firm and its suppliers of
capital (new borrowings, debt principal repayments). Interest paid is included in CFO
under US GAAP!
Net CF ¿ creditors=New borrowings− principal amounts paid
o And CFs between the firm and its shareholders (equity issued, shares repurchased,
dividend paid)
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Net CF ¿ shareholders=New equity issued−Shares repurchased−cash dividends paid
Regulators act to level the playing field for market participants and help define minimum standards
of practice for agent. They impose minimum levels of capital that apply across the board to all
regulated firms, not the optimum level which is firm specific.
Diluted EPS
Diluted EPS=¿ ¿
Net increase in common shares from the potential exercise of stock options/warrants:
Exercise if Exercise price < Average Market Price :
AMP−EP
×N
AMP
Fundamentally weighted indices generally will have a contrarian “effect” in that the portfolio
weights will shift away from securities that have increased in relative value and towards securities
that have fallen in relative value whenever the portfolio is rebalanced.
Disposition effect refers to the behavioural bias in which investors tend to avoid realizing losses but,
rather, seek to realize gain.
Derivatives
FRA payoff (long)
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Interest paid =Notional ×
( days ∈underlying
( Underlying rate at expiration−Forward contract rate )
360
rate
)
days∈underlying rate
1+underlying rate × ( )
360
Conversion factor
If the short delivers a bond with a coupon greater than the coupon of the hypothetical deliverable
bond, the conversion factor is greater than 1.
According to the put-call parity, a fiduciary call (long position in a call and in a risk-free asset)
generates a payoff equal to the market value of the asset if it expire in the money.
Fixed Income
For a CMO, the first tranche of bonds has the highest level of prepayment risk and lowest level of
interest rate risk. As it receives payments first, it has the lowest duration and therefore the lowest
interest rate risk. The first tranche absorbs all prepayments and therefore ha the highest prepayment
risk compared with the remaining tranches.
Callable bonds
Price(callable bond)=Value of an option free bond−Value of the embedded call option
A decrease in yield volatility will decrease the value of the call option and therefore increase the
value of the callable bond.
The yield on a US Treasury STRIPS is also known as the Treasury spot rate. A STRIPS security is a ZC
bond with no default risk and therefore represent the appropriate discount rate for a CF certain to be
received at the maturity date for the STRIPS.
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The full valuation approach to measuring IR risk relative to the duration/convexity approach is that it
increases the measurement approach. It allows modelling of the response to both parallel and not
parallel yield curve changes and will reflect CF that change when IR change, whereas the
duration/convexity approach assumes parallel yield curve changes and fixed CF.
Debentures are the actual financial instruments - an unsecured debt instrument e.g. debt that is not
collateralized like a corporate bond.
Indentures are the underlying contractual aspects such as coupon rates, payment dates, callability,
etc.
A sinking fund arrangement is a way to reduce credit risk by making the issuer set aside funds over
time to retire the bond issue.
Duration of a portfolio is the market value weighted average duration of the assets duration.
Market value = Price x Par amount
Price Value of a Basis Point
PVBP=intitial price−price if yiel ischanged by by one bps
Or
PVBP=¿ ¿ ¿
An original issue discount tax provision allows the investor to increase the cost basis of the bond, so
when the bond matures, the investor faces no capital gain or loss.
A positive duration gap (Macaulay duration – investment horizon) implies that the investor is
currently exposed to the risk of higher interest rates.
Option-adjusted spread (OAS) is used for bonds with embedded options. The OAS takes the option
yield component out of the Z-spread; the OAS is the spread to the government spot rate curve that
the bond would have if it were option-free.
OAS=Z spread−option value
The OAS for a callable will be less than the bond’s Z-spread. The difference is the extra yield required
to compensate bondholders for the call option.
Intangible assets that can be sold, such as trademarks, provide collateral of good quality. Low-quality
collaterals are any assets that are likely to be written down in value if a firm encounters financial
distress, such as goodwill and DTA.
Alternatives Investments
Commodity futures price
Futures price=spot ( 1+r ) + storage costs−convenience yield
Sources of commodity futures returns
Roll yield : yield due to a difference between the spot price and futures price, or a difference
between two futures prices with different expiration dates
o In backwardation : roll yield >0
o In contango : roll yield <0
Collateral yield: interest earned on collateral required to enter into a futures contract.
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Change in spot prices: total price return is a combination of the change in spot prices and the
convergence of futures prices to spot prices over the term of the futures contract.
Backwardation/Contango/Full carry
Backwardation: futures prices lower than spot price, high convenience yield
When a commodity market is in backwardation, the futures prices is below the spot price
because market participants believe the spot price will be lower in the futures.
Contango: futures prices higher than spot price, little or no convenience yield
Portfolio Management
Execution step includes asset allocation, security analysis and portfolio construction.
Feedback step includes performance measurement.
As one moves to the right along an investor’s efficient frontier, a set increase in risk lead to
sequentially smaller increases in expected return. The slope of the efficient frontier continues to
decrease.
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