2020

CFA® EXAM REVIEW

Critical
concepts
for the
CFA EXAM

Wiley’s CFA ®

Program Level III

Smartsheets
Fundamentals For CFA Exam Success
WCID184
 Wiley’s CFA Program Exam Review
®
ETHICAL AND
PROFESSIONAL STANDARDS
Standards of Professional Conduct
• Thoroughly read the Standards, along with related
guidance and examples.
Asset Manager Code of
Professional Conduct
• Firm-wide, voluntary standards
• No partial claim of compliance.
• Compliance statement: “[Insert name of firm] claims
compliance with the CFA Institute Asset Manager Code of
Professional Conduct. This claim has not been verified by
CFA Institute.”
• Firms must notify CFA Institute when claiming
compliance.
• CFA Institute does not verify manager’s claim of
compliance.
• Standards cover:
• Loyalty to clients
• Investment process and actions
• Trading
• Risk management, compliance, and support
• Performance and valuation
• Disclosures
GLOBAL INVESTMENT PERFORMANCE
STANDARDS
• Focus on required disclosures, and presentation and
reporting requirements and recommendations of GIPS.
• Be able to identify and correct errors in a performance
presentation that claims to be GIPS compliant.
BEHAVIORAL FINANCE
Behavioral Finance Perspective
• Prospect theory
• Assigns value to changes in wealth rather than levels
of wealth.
• Underweight moderate- and high-probability
outcomes.
• Overweight low-probability outcomes.
• Value function is concave above a wealth reference
point (risk aversion) and convex below a wealth
reference point (risk seeking).
• Value function is steeper for losses than for gains.
• Cognitive limitations
• Bounded rationality: deciding how much will be done
to aggregate relevant information and using rules of
thumb.
• Satisficing: finding adequate rather than optimal
solutions.
• Traditional perspective on portfolio construction
assumes that managers can identify an investor’s
optimal portfolio from mean-variance efficient portfolios.
• Consumption and savings
• Mental accounting: wealth classified into current
income, currently owned assets, PV of future income.
• Framing: source of wealth affects spending/saving
decisions (current income has high marginal
propensity to consume).
• Self-control: long-term sources unavailable for current
spending.
• Behavioral asset pricing models
• Sentiment premium included in required return.
• Bullish (bearish) sentiment risk decreases (increases)
required return.
• Behavioral portfolio theory
• Strategic asset allocation depends on the goal
assigned to the funding layer.
• Uses bonds to fund critical goals in the domain of
gains.
• Uses risky securities to fund aspirational goals in the
domain of losses.
• Adaptive markets hypothesis
• Must adapt to survive (bias towards previously
successful behavior due to use of heuristics).
• Risk premiums and successful strategies change over
time.
Behavioral Biases
• Cognitive errors (belief persistence biases)
• Conservatism: overweight initial information and fail to
update with new information.
• Confirmation bias: only accept belief-confirming
information, disregard contradictory information.
• Representativeness: extrapolate past information into
the future (includes base-rate neglect and sample-size
neglect).
• Illusion of control: believe that you have more control
over events than is actually the case.
• Hindsight bias: only remember information that
reinforces existing beliefs.
• Cognitive errors (information-processing biases)
• Anchoring and adjustment: develop initial estimate
and subsequently adjust it up/down.
• Mental accounting: treat money differently depending
on source/use.
• Framing: make a decision differently depending on
how information is presented.
• Availability bias: use heuristics based on how readily
information comes to mind.
• Emotional biases
• Loss aversion: strongly prefer avoiding losses to
making gains (includes disposition effect, house-
money effect and myopic loss aversion).
• Overconfidence: overestimate analytical ability
or usefulness of their information (prediction
overconfidence and certainty overconfidence).
• Self-attribution bias: self-enhancing and self-
protecting biases intensify overconfidence.
• Self-control bias: fail to act in their long-term interests
(includes hyberbolic discounting).
• Status quo bias: prefer to do nothing than make a
change.
• Endowment bias: value an owned asset more than if
you were to buy it.
• Regret aversion: avoid making decisions for fear of
being unsuccessful (includes errors of commission and
omission).
• Goals-based investing
• Base of pyramid: low-risk assets for obligations/needs.
• Moderate-risk assets for priorities/desires; speculative
assets for aspirational goals.
• Behaviorally modified asset allocation
• Greater wealth relative to needs allows greater
adaptation to client biases
• Advisor should moderate cognitive biases with high
standard of living risk (SLR).
• Advisor should adapt to emotional biases with a low
SLR.
Investment Processes
• Behavioral biases in portfolio construction
• Inertia and default: decide not to change an asset
allocation (status quo bias).
• Naïve diversification: exhibit cognitive errors resulting
from framing or using heuristics like 1/n diversification.
• Company stock investment: overallocate funds to
company stock.
• Overconfidence bias: engage in excessive trading
(includes disposition effect).
• Home bias: prefer own country’s assets.
• Mental accounting: portfolio may not be efficient due
to goals-based investing as each layer of pyramid is
optimized separately.
• Behavioral biases in research and forecasting
• Representativeness: due to excessive structured
information.
• Confirmation bias: only accept supporting evidence.
• Gamblers’ fallacy: overweight probability of mean
reversion.
• Hot hand fallacy: overweight probability of similar
returns.
• Overconfidence, availability, illusion of control, self-
attribution and hindsight biases also possible.
• Market behavioral biases
• Momentum effects due to herding, anchoring,
availability and hindsight biases.
• Bubbles due to overconfidence, self-attribution,
confirmation and hindsight biases.
• Value stocks have outperformed growth stocks; small-
cap stocks have outperformed large-cap stocks.
Capital Market
Expectations
CME frameworks and Macro
Considerations
• Good forecasts are:
• Objective and unbiased
• Internally consistent
• Efficient with low errors
• Uncertainty and errors stem from choosing incorrect
model, errors in underlying data, or errors in
estimated parameters
• Errors can also stem from behavioral biases such as
anchoring bias, availability bias, confirmation bias,
status quo bias, overconfidence bias, and prudence
bias
• Aggregate equity market value:
• Three distinct approaches to forecasting economic
change:
• Econometrics
• Economic indicators
• Checklist approach
• Yield curve over the business cycle
• Initial recovery – Steep yield curve with low short-term
rates that start to rise
• Early expansion – Rising curve with steep short
maturities and flat long maturities
• Late expansion – Slowly rising and flattening curve
• Slowdown – Flat or inverted curve that is falling
• Contraction – Falling curve that begins to steepen
Forecasting Asset Class Returns
• Expected returns on fixed income securities can be
determined using:
• A DCF approach, whereby current price and future cash
flows infer a yield to maturity (YTM). Realised return
differ from YTM due to gains/losses from pre-maturity
transactions and reinvestment effects
• A building block approach, whereby expected return
is based on the short-term nominal default-free rate
plus risk premiums such as a term premium, credit
premium and liquidity premium
• Expected returns on equities can be determined using:
• Historical statistics
Wiley © 2020
 Wiley’s CFA Program Exam Review
®

Asset AllocAtion with ReAl-woRld

Asset Allocation with Real-World Constraints

• A DCF/dividend discount approach, such as the asset allocations results in an overall strategic asset characteristics
After-tax Portfolio of different asset classes.
Optimization
Grinold-Kroner model: allocation). • Time horizon: asset allocation decisions evolve
Asset AllocAtion Optimizing a portfolio subject to taxes requires using the after-tax returns and risks on an
with changes in time horizon, human capital, utility
Principles of Asset Allocation ex-ante basis.
function, financial market conditions, characteristics of
AA ratliability
Asset rpt (1 − t )and
=allocation the asset
decisions shouldowner’s priorities.
be made on an after-tax basis.
• Mean variance optimization (MVO)
• A building block approach, whereby expected return • Taxes• Regulatory:
and portfolio financialrebalancing:markets As marketand regulatory
conditions change over entities
time, asset class
is based on either the short-or-long-term nominal
PrinciPles of Asset AllocAtion
• Produces an efficient frontier based on returns, where: weights often in aimpose
portfolio additional
change and tend constraints.
to move away from previously set target
default-free rate plus risk premiums such as those used standard deviation of returns and pairwise rat = expected after-tax return
levels. Portfolio rebalancing is needed to return actual allocation to the strategic
for fixed income securities as well as an equity risk correlations. • asset
Taxes
rpt = expected pre-tax return
allocation (SAA). However, discretionary portfolio rebalancing can trigger
Principles of Asset Allocation t = expected taxcapital
rate gains and losses and the associated tax liabilities that could have been
premium • Finds optimal asset allocation mix that maximizes • Place
realized less tax-efficient assets in tax-advantaged
otherwise deferred or even avoided.
• An equilibrium approach, whereby expected return forRisk Objectives client’s utility. Extending this accounts
to a portfolio to achieve
with both incomeafter-tax and portfolio
capital gains:optimization.

an equity market is based on its sensitivity (   ) to global Taxable asset owners should consider the trade-off between the benefits of tax
U p = E ( R p ) − 0.005 × A × σ 2p rat = pd rpt (1 −
minimization and + pmerits
td )the a rpt (1 −of )
tcgmaintaining the targeted asset allocation by rebalancing.
market returns and its level of integration ( ) with
global markets (Singer-Terhaar model):
where: where: Because after-tax volatility is smaller than pre-tax volatility, it takes a larger
U is the • investor’s
MVO limitations utility.
• Rebalancing
movement
pd = proportion of in a taxable
return from range forincome
portfolio
dividend toachange
taxable the portfolio
risk profile of (Rthe ) can
portfolio.
taxable
Consequently,
be wider rebalancing
than priceranges
from those of anfor aotherwise
taxable portfolio (R taxable)tax-
identical can be wider than
E(Rp) is the • Asset
portfolio allocations
expected return. are highly sensitive to small changes pa = proportion those of
of return
an otherwise identical
appreciation
tax-exempt
(i.e., capital
portfolio (
gain)
R ).
td = tax rateexempt on dividend income (R exempt).
portfolio tax exempt
A is the investor’sin input variables.
risk aversion. tcg = tax rate on capital gain
tax

σ 2p is the• variance of the portfolio.

Asset allocations can be highly concentrated. This formula R taxable = R taxthe
ignores / (1 − t) benefit from compounding capital gains rather than
multi-period
exempt
Roy’s Safety • Only Firstfocuses
Ratio (SFon Ratio)mean and variance of returns. recognizing the annual capital gain.
• SourcesE (of risk may not be well diversified.
R p ) − RL Taxes • Taxaffect
also loss harvesting
Revision expected
to asset is another
standard commonly used strategy related to portfolio rebalancing
an deviation.
allocation
and Ratio = and taxes.
• SFAsset-only σstrategy.
p • σ atChanges in goals
= σ (1 − t )
• Single-period framework and ignores trading/ Strategic ptasset location refers to placing less tax-efficient assets into tax-deferred or
• Changes in constraints
where: rebalancing costs and taxes. tax-exempt accounts such as pension and retirement accounts. For example, equities
should in generally
RL is the lowest acceptable return over a period of time. Taxes result
• lower highs
Changes inbeinvestment
heldhigher
and in taxable
lows,accounts,
effectivelyand
beliefs taxablethe
reducing bonds
meanand high-turnover
return and
• Does not address evolving asset allocation strategies, muting trading dispersion. assets should be placed in tax-exempt or tax-deferred accounts to maximize
• Expected returns on real estate can be determined using:E(Rp) is the path-dependent portfolio’s expected return.
decisions, non-normal distributions. • Tactical
the tax benefits asset of allocation
those accounts. (TAA) approaches
σp is the portfolio’s standard deviation. Equivalent After-Tax Rebalancing Range
• Capitilization rates: • Approaches to improve quality of MVO asset allocation Asset allocation • Discretionary
decisions are aTAA: uses market
dynamically changingtiming skillsprocess.
and adjusting to avoid or
Market
Including International Assets
• Use reverse optimization conditions Rand hedge negative
asset owner
at = R pt (1 − t )
returnsoften
circumstances in down
requiremarkets
revising anand enhance
original asset allocation
• The Sharpe ratio of the proposed new to asset compute
class: SR[New] implied returns
• Theand Sharpe improve
ratio of the quality
existing of inputs,
portfolio: e.g. Black-Litterman allocation policy:
SR[p]
decision. There positive
are basicallyreturns threeinelements
up markets.that may trigger a review of an existing asset

• A building block approach, whereby expected return is • Themodel. correlation between asset class return and portfolio return: where: • Systematic TAA: uses signals to capture asset-class-
based on risk premia that incorporate those used for Corr (R[New], R[p])
• Adding constraints to incorporate short-selling and Ratpt 1.= Pre-tax
R = After-tax
Changes level rebalancing
goals: range
inreturn anomalies that have been empirically
both fixed income securities and equities a. As rebalancing
a result of changesrange in business conditions and changes in expected future cash
other real-world restrictions into optimization. demonstrated as producing abnormal returns.
SR[ New] > SR[ p] × Corr ( R[ New], R[ p]) flows over time, a mismatch may arise between the original intended goal and the
• An equilibrium approach, with adjustments for • Resampled MVO technique combining MVO and Monte Portfolio • Behavioral
Value
current AftergoalTaxable
biases
of the fundDistributions
intoasset allocation
best serve the fund’s needs.
illiquidity and smoothed returns b. Changes in an asset owner’s personal circumstances may alter risk appetite or
Portfolio Risk Carlo approaches to seek the most efficient and
Budgeting • VAllocAtion
Asset Loss
= V aversion:
(1
atrisk capacity. − t ) mitigate by framing
i Life events such as marriage, having riskchildren,
in terms andofbecoming ill
• Expected returns for foreign exchange can be determined consistent optimization. may
pt
shortfall
all haveprobability
an impact on the or needs
funding high-priority
and goals of an individual goals with from an
benefiting
using: Marginal contribution to total risk identifies the rate at which risk changes as asset i is
added • Monte
3. toItthe
canportfolio: Carlo simulation and scenario
incorporate trading costs and costs of rebalancing a portfolio. It may also analysis low-risk
where:Asset AllocAtion
investment
AA
assets.
portfolio.
• A monetary approach, whereby exchange rate vat =2.after-tax
Changes
• Illusion
portfolio value Any material change in constrains, including asset size,
in constraints:
movements reflect the expected differences in inflation 4. It can
• Used
incorporate taxes.
in a multiple-period framework to improve
model non-normal multivariate return distributions, serial and cross-sectional vpt = pre-tax
liquidity, time of
portfolio value control:
horizon, mitigate
regulatory, byexternal
or other using constraints,
the globalshould markettrigger a
MCTR2.single-period
The =
correlations, βi ,P σ P approach
two-portfolio
i distribution MVO.
requirements, or hedging/return-seeking portfolio approach
an evolving asset allocation strategy,partitions
path- rateportfolio
ti = taxreexamination
on distributions
AA of asexisting
aasstarting
income point and
asset allocation using a formal asset
decisions.
• Capital flows, whereby expected changes in exchange dependent assets into two groups: a hedging portfolio and a return-seeking portfolio. The
decisions, nontraditional investments, non-tradable assets, and human 3. Changes allocation process based on long-term return and risk many
in beliefs: Investment beliefs change with market conditions, among
rates is based on differences between countries in
• Provides
capital.
hedging portfolioa realistic
is managedpicture so that its assetsof distribution
are expected to produce of potential
a good hedge
other factors. TheyAny areunauthorized
a set of guiding
where: to cover required cash outflows from the liabilities. The return-seeking portfolio © wiley 2018 Allforecasts,
Rights Reserved. optimization copying orprinciples
constraints that
distribution will govern
anchored
constitute anthe asset owner’s
around
infringement of copyright.
future outcomes.
can be managed independently of the hedging portfolio. Portfolio managers and investment decisions. Investment beliefs include expected returns, volatilities, and
default-free rates and risk premiums asset class
βAi,Prisk
= beta of isasset i returns with canrespect to portfolio returns
amongweights in the
in theglobal market set. portfolio, and
budget a particular
investment allocation
advisors of portfolio
potentially risk.
treat theAn optimal riskportfolio
return-seeking budget as is an
oneasset-
to
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• Can
σP = portfolio
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return
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as standard
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Portfolio taxes.
risk
i returns
process. The can be
two-
strict policy ranges.
total risk, marketportfolio
risk, active risk,isormost
approach residual risk. Here
appropriate are three statements
for conservative investors who thatwish
are directly
to reduce
related to • Can model non-normal distributions, toserial and cross-
Absolute the risk
or budget
contribution eliminate process:
to the
totalriskriskof not being able
identifies to pay
the future liabilities.
contribution Variants
total risk of
fortheasset
two- i
• Mental accounting: goal-based investing incorporates
• A building block approach, whereby expected return is 1. The sectional correlations, evolving asset allocations, path-
portfolio approach include:
riska.budget
Partialidentifies
hedge: Capital allocated
the total amount to the hedging
of risk and portfolio
allocatesisthereduced
risk toin different
order to this bias directly into the asset allocation solution by
based on risk premia that incorporate those used for dependent generate decisions,
higher expected returns non-traditional
from the return-seekinginvestments,
194
portfolio. © 2018 Wiley
i = wi × MCTRi aligning each goal with a discrete sub-portfolio.
asset
ACTR classes in a portfolio.
both fixed income securities and equities human
2. An optimal b. risk capital.
Dynamic
the
hedge: The investor increases the allocation to
budget allocates risk efficiently, which is to maximize return per unit
funding ratio ACTR
increases.
the hedging portfolio as
of% risk
ACTRtaken. to total risk = i
• Recency or representativeness bias: mitigate by using
• Expected return for emerging market securities is likely 3. • The Risk budget
The i two-portfolio approach has its limitations.
process of finding the optimal σ risk budget is risk budgeting.
a. It cannot be used when Pthe funding ratio is less than 1. c09.indd 194 a formal asset allocation policy with prespecified 7 March 2018
to include considerations for ability and willingness to The concept • Identifies
b. It cannot be
of marginal totaluse when amounta true hedging
liabilities are related to portfolio
contribution to payments risk
offorrisk is anand
portfolio
damages
allocates
is unavailable;
important risk
for example,
one because
due to hurricanes
tothe
it allows
or earthquakes. allowable ranges.
pay (fixed income) and risks to shareholder protections us to (1) track 3.different
the
Thechange
integratedasset
in portfolio classes.
risk due
asset-liability to a change
approach is used byin portfolio holding,investors
some institutional (2) determine
to
24 © Wileypositions
which 2018 All rights reserved.
are optimal,
jointly optimize Any
and unauthorized
(3)and
asset create a copying or distribution
riskdecisions.
liability budget. will constitute
Banks, long/short hedgean infringement
funds, insurance of copyright. • Framing bias: mitigate by presenting the possible asset
(equities) • Asset allocation is optimal when must ratio of excess return
companies, and reinsurance companies often render decisions regarding the allocation choices with multiple perspectives on the
• Expected variance of returns and covariances can be In a risk budget tocomposition
MCTR
setting, weishave
the thesame
of liabilitiesfollowing for all
relations:
in conjunction
assets.
with their asset allocation. The process is
called asset-liability management (ALM) for banks and dynamic financial analysis risk-reward tradeoff.
determined using: (DFA) for insurance companies. The approach is often implemented in the context
Marginal contribution
of multiperiod to total
models viarisk (MCTR)
a set of projected = Asset beta ×The
scenarios. Portfolio standard
integrated deviation
asset-liability • Familiarity or availability bias: mitigate by using the
• Historical statistics Absolute approach provides
contribution toatotal risk ( ACTR
mechanism ) = Asset
to discover the weight
optimal×mix MCTRof assets and liabilities. It
global market portfolio as the starting point in asset
is the most comprehensive approach among the three liability-relative asset allocation
• Factor models, that seek to reduce problems Ratio of excess return to MCTR = (Expected return − Risk-free rate)/ MCTR
approaches. allocation and carefully evaluating any potential
associated with historical statistics. Shrinkage Characteristics of liability-relative asset allocation approaches are summarized in the deviations.
estimation, using historical statistics and factor model An asset • following
Liability-relative
allocation is
table. optimal when asset
the ratio allocation
of excess return approaches
(over the risk-free rate) to
MCTR is the same for all assets.
outputs can provide further precision
• Smoothing, especially in the case of illiquid markets: Factor-based
Surplus optimization two-Portfolio
asset allocation utilizes investment risk factors instead of asset classes to
Simplicity Simplicity
Integrated Asset-liability
Increased complexity
make asset allocation decisions. These factors are fundamental factors that historically have
EQUITY PORTFOLIO
producedLinear

1.
returncorrelation
All levels of risk
Size (small cap
Linear or
premiums or anomalies to nonlinear
investors.correlation
These factorsLinear
Conservative level of risk
ratioversus large
or nonlinear
include,

cap). funding ratio for

correlation
but not limited to:
All levels of risk MANAGEMENT
2.
Any funding
Valuation (value stock versus
Positive
basicgrowth
approachstock).
Any funding ratio
• Approaches to managing equity portfolios
3. Momentum
Single period(winners versus losers).
Single period Multiple periods • Passive management: try to match benchmark
4. Liquidity (low liquidity versus high liquidity).
5. Duration (long
It’s important term versus
to examine short term).
the robustness of asset allocation strategies. Four commonly used
performance.
• ARCH models, that seek to account for volatility 6. • Goal-based
Credit (low-rated
robustness asset
tests are:bonds allocations
versus high-rated bonds). • Active management: seek to outperform benchmark
7. Volatility (low-volatility stocks versus high-volatility stocks).
clustering of returns • 1.Creation of differentiated
Simulation based portfolio
on historical return and risk data. modules based on by buying outperforming stocks and selling
2. seven
Sensitivity
capital
Note that these analysis
market
factors
resulting
where the level
expectations.
are implemented asofa zero-cost
one underlying risk factor
investment is changed and the
or self-financing underperforming stocks.
investment, in which theasset allocation
underperformer outcomes are investigated.
is short-sold and outperformer is bought. By
•
construction,3.Identifying
Scenario
clients’
analysis where
goals
the levels
and low matching
of multiple risk factors are
thethegoals
changed
to with
in a correlated • Semiactive management (enhanced indexing): seek
ASSET ALLOCATION
they are often market neutral and carry correlations with market and
manner and the resulting asset allocation outcomes are investigated. Stress testing is
other factors.
appropriate
one such case. sub-portfolios and modules. to outperform benchmark with limited tracking risk
(highest information ratio).
Asset Allocation Approaches Asset
© 2018 Wiley
Allocation with Real-World • Approaches
185 to constructing an indexed portfolio
Constraints • Full183replication: minimal tracking risk but high costs.
• Asset-only: does not explicitly model liabilities © 2018 Wiley
• Stratified sampling: retains basic characteristics of
• Liability-relative (liability-driven investing): aims at an • Constraints on asset allocation due to:
c08.indd 185 7 March 2018 3:34 PM

index without costs associated with buying all the

asset allocation that can pay off liabilities when they c08.indd 183
• Asset size: more acute issue for individual rather than stocks.
7 March 2018 3:34 PM

come due. institutional investors. • Optimization: seeks to match portfolio’s risk exposures
• Goals-based investing: specifies sub-portfolios • Liquidity: liquidity needs of asset owner and liquidity (including covariances) to those of the index but can
aligned with a specific goal (sum of all sub-portfolio be misspecified if historical risk relationships change

Wiley © 2020
 Wiley’s CFA Program Exam Review
®

over time.
• Value style investing: low P/E, contrarian, high yield.
selling parent and buying subsidiary) and multi-class
trading (e.g. selling class A shares in company X, while PRIVATE WEALTH
• Growth style investing: consistent growth, earnings buying their class B shares). MANAGEMENT
momentum. • Event driven:
• Market-oriented (blend or core style) investors: market- • Merger arbitrage – Seek returns from the price volatility Advising Private Clients
oriented with a value bias, market-oriented with a accompanying takeover bids of acquiring company’s
growth bias, growth at a reasonable price, style rotators. • Compared to institutional clients, private clients tend
stock and target company’s equity and debt securities to have:
• Market cap approach: small-cap, mid-cap, large-cap • Distressed securities – Buying securities of companies
investors.
• objectives that are goals-based, less-defined and less
in financial distress and facing bankruptcy to take stable
• Investment style analysis advantage of low price and the restructuring of the • multiple, finite time horizons
• Holdings-based: analyses characteristics of individual company • informal/limited governance structure
security holdings. • Relative value: • - Private wealth manager skills include:
• Returns-based: regressing portfolio returns on • - technical skills such as financial planning
returns of a set of securities indices (betas are the
• Fixed income arbitrage – Exploiting various aspects
of mispricing of risk premiums between securities. knowledge, capital market proficiency and portfolio
portfolio’s proportional exposure to the particular style construction ability
Strategy managers will tend to hedge/immunize
represented by index). • soft skills such as communication, social, coaching and
against market risks such as duration, sovereign risk,
• Price inefficiency on the short side currency risk, credit risk and prepayment risk business development skills
• Restrictions to short selling. • Private clients can be segmented into mass affluent,
• Convertible bond arbitrage – Seek returns from delta high-net-wealth (HNW), and ultra-high-net-wealth
• Management’s tendency to deliberately overstate hedging and gamma trading short equity hedges
profits. segments
against the potential long equity exposure within
• Sell-side analysts issue fewer sell recommendations. convertible bonds
• - Private client objectives are likely to include return
objectives, retirement goals, funding priorities,
• Sell-side analysts are reluctant to issue negative • Opportunistic: investment preferences and risk tolerance
opinions.
• Global macro – Seek returns through trading • Tax for private clients might be based on level of income,
• Sell disciplines wealth and/or consumption
of currencies, bonds and derivatives based on
• Substitution: opportunity cost sell and deteriorating expectations of the relative economic health of • Tax strategies employed by private clients might include:
fundamentals sell. countries and potential economic policy changes • tax avoidance - utilizing tax mechanisms/concessions
• Rule-driven: valuation-level sell, down-from-cost sell, • tax reduction - investing in tax-effective assets
up-from-cost sell, target price sell.
• Managed futures – Systematically seek returns from
technical analysis of markets and signals of expected • tax deferral - preference for capital gains over income
lio ManagEMEnt
lio ManagEMEnt • Semiactive equity strategies movements in futures prices across all global markets. • Capital sufficiency for a private client assessed by using:
• Derivative-based semiactive equity strategies: • deterministic forecasting, which uses expected returns
exposure to equity market through derivatives and
• Specialist:
Core–Satellite and cashflows to determine the expected level of
Core–Satellite
enhanced return through non-equity investments, e.g. • Volatility – Seeks returns through the implied volatility capital over time
A fixed
A core–satellite
core–satellite income.
portfolio
portfolio is constructed
is constructed when
when applying
applying the the optimization
optimization to to aa group
group of equity captured in option prices by buying cheap volatility
of equity • Monte Carlo simulation, which utilises probability
Equity Portfolio ManagEMEnt
managers• that
managers that includes indexers,
Stock-based
includes indexers, enhancedindexing
enhanced
enhanced indexers, and
indexers, and active managers,
strategies:
active managers, judged by
portfolio
judged by their
their and selling expensive volatility distributions of returns and cashflows to produce a
information ratios.
information ratios. Index
Index and
and semiactive
semiactive managers
managers constitute
constitute the
the core
core holding,
holding, andand active
active
managers looks like
represent the benchmark
opportunistic ringexcept
of in those
satellites around areas
the onsowhich
core, as
managers represent the opportunistic ring of satellites around the core, so as to achieve an to achieve an • Insurance-linked – Seeks returns from investing and range of possible outcomes over time
Enhanced-index
acceptable the manager
acceptable level
level portfolio
of
of explicitly
managers
active return
active return while
while wishessome
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essentially
mitigating to bet
active
some of onactive
the
the (within
of managers
active who
risk. riskcore
risk. build
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portfolios
should • Retirees exhibit four main behavioral tendencies in their
aresemble
high degree of risk
thelimits) control. Their
to benchmark
investor’s generatefor
benchmark information
alpha.
for the asset ratio
asset class, can
class, while be explained
while the in
the satellite terms
satellite portfoliosof Grinold
portfolios may
may also andbe or life settlements (i.e. purchasing of life policies
also be financial planning being:
resemble the investor’s the
Kahn’s Fundamental
benchmarked to the Law ofasset
the overall
overall Active Management.
class benchmark The or aa law
stylestates that:
benchmark.
• Information
benchmarked to asset
ratioclass benchmark
(Grinold andorKahn) style benchmark. with attractive surrender values and mortality 1. heightened loss aversion
To evaluate such managers, it is useful to divide their total active return into two components: characteristics)
To evaluate IR such
≈ IC managers,
Breadth it is useful to divide their total active return into two components:
2. consumption gap
• Multi-manager: 3. annuity puzzle
1. Manager’s
1. Manager’s “true”“true” active
active return
return = = Manager’s
Manager’s return
return −− Manager’s
Manager’s normal
normal benchmark
benchmark
2. • Manager’s
Core-satellite
Manager’s “misfit” portfolio:
active return index and semiactive
= Manager’s
Manager’s normal benchmark managers
− Investor’s
Investor’s • Multistrategy – Combination of the above strategies in 4. income preference Taxes and PrivaTe WealTh ManageMenT in a glo
The2. information “misfit”
ratio (IR) isactive
equalreturn
to what = you know aboutnormal benchmark
a given −
investment (the
constitute
benchmark
benchmark core holding while active managers
information coefficient [IC]) multiplied by the square root of the investment discipline’s
represent the one fund • The Investment Policy Statement (IPS) for a private client
satellites.
breadth, which is defined as the number of independent, active investment decisions made Taxes and Private Wealth Management in a Global Context 
includes:
The manager’s normal benchmark (normal portfolio) represents the universe of securities from • Fund of funds – A manager that invests in other hedge
each
which • manager
The manager’s
year. Total normal
active
Therefore, benchmark
return
a lower-breadth and (normal
riskportfolio)
strategy represents
necessarily themore
requires universe of securities
accurate insightfrom
investor’s benchmark
benchmark
about
funds that will generally have multiple layers of
• Background and investment objectives
Annual Accrual with a Single, Uniform Tax Rate
givenaa investment
awhich normally
manager normally might
might
to produce select
select
the securities
samesecurities for the
for the portfolio.
IR as a strategy portfolio. The breadth.
The
with higher investor’s
refers to
refers • Manager’s
to the
the benchmark the
benchmark thetrue active
investor
investor toreturn
uses to
uses evaluate=performance
evaluate Manager’s
performance of aareturn
of –
given portfolio
given portfolio or asset
or asset class.
class. management and fees • Investment parameters
A semiactive Manager’s
stock-selection normal
approach benchmark
has limitations: r• Portfolio
after-tax (1 − tI ) allocation
= rpre-tax asset Taxes and PrivaTe WealTh ManageMenT in a glo
manager’s “true”
The manager’s “true” active
active risk
risk isis the
the standard
standard deviation
deviation of
of true
true active
active return.
return. The
The
The
manager’s
manager’s
• Any
• Manager’s
“misfit”
“misfit” risk is
risk that
technique
misfit
the
is the the active
standard
the standard
generates
return
deviation
deviation
positive
=ofManager’s
“misfit”
of “misfit”
alpha may become
normal
active
active return.
return.
obsolete The manager’s
The manager’s
as other investors
Asset Allocation to Alternatives • Portfolio management
Taxes and Private
• FVIF Wealth Management in a Global Context 
try benchmark
total active
active risk, it. –both
reflecting Investor’s
both true and benchmark
and misfit
misfit risk, is:
is: Duties and responsibilities
pre-tax = (1 + rpre-tax )
n
total torisk, reflecting
exploit true risk,
• Total active
• Quantitative modelsrisk derived from analysis of historical returns may be invalid in the • Private equity • IPS appendix
Annual Accrual with a Single, Uniform Tax Rate
FVIF = [1 + r (1 − tI )]n
future. Markets undergo secular changes, lessening the effectiveness of the past as a
Manager’s total
Manager’s total active
active risk
risk == • Limited diversification benefits but can provide • Theafter-tax
two mainpre-tax portfolio construction approaches for
guide to the future.
additional return via the liquidity risk premium rprivate (1 − tare:
clients
after-tax = rpre-tax I)
(Manager’s “true”
(Manager’s “true” active risk)22 +
active risk) + (Manager’s
(Manager’s “misfit”
“misfit” active risk)22
active risk) where:
Managing a Portfolio of Managers 1. Tvalue
raditional approach, which starts with finding
• Hedge funds FVIF = Future interest (i.e., accumulation) factor
r = return the efficient frontier (based on asset classes and
FVIFpre-tax = (1 + rpre-tax )
n
When
The
developing
most• accurate
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Information
accurate asset
measure of
measure
allocation
ratio
of policy,
as measure
the manager’s
the manager’s the investor seeks
of manager’s
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risk-adjusted
an allocation
performance
performance riskis
is theto a group
the IR computed of
computed as: • Role in a portfolio will
EQ
depend on strategy but might t = tax rate capital market expectations) and ends with portfolio
equity managers within the equity allocation who maximize active return for aIRgiven level ofas: help to trade-off between equity market alpha and n = number allocations
of periods
FVIFafter-tax (1 − tI )]non investment constraints,
(based
= [1 + rpre-tax
adjustedbyperformance
active risk determined the investor’s level of aversion to active risk:
beta or provide a source of uncorrelated returns preferences and asset location)
Manager’s “true”
Manager’s “true” active
active return
return Deferral Method with a Single, Uniform Tax Rate (Capital Gain)
MaximizeIR IRby== choice of managers: • Real assets
where: 2. Goals-based approach, which can also start with
Manager’s “true” active risk FVIF = Future finding
value interest
Manager’s “true” active risk then(i.e., accumulation)
efficient factor
frontier but ends up with
• Provide portfolios with inflation hedging FVIFCG = (1 + rCG ) (1 − tCG ) + tCG
r = return
multiple portfolios, each with different objectives Taxes and PrivaTe WealTh ManageMenT in a glo
U A = rA − λ A σ 2A t = tax rate
Completeness fund
Completeness fund • Low correlation to equities n = numberbased of periodson the various goals of the client

A
ALTERNATIVE INVESTMENTS
where:
completeness fund
A completeness fund establishes an
UA = expectedestablishes
an overall
overall portfolio
utility of the active
portfolio with
with the
return of the
the same
manager
same risk
mix
risk exposures
exposures as the • Private real estate
as the
Taxes
Taxable and
Gains Private
When Wealth
the Cost Management
Basis Differs
Taxes and Private Wealth
inValue
from Current a Global Context 
Deferral Method with a Single, Uniform Tax Rate (Capital Gain)
Annual Taxable
Accrualgain
with=aVSingle, Uniform Tax Rate
mix managers’ positions. For example,• Can provide additional inflation protection (as well as
investor’s overall
overall equity
equity benchmark
benchmark whenwhen added
added to
to active
active managers’ positions. For example,
investor’srA = expected active return of
Hedge Fund Strategies
the completeness
completeness fundfund may
may be
the manager
be constructed
constructed with
with the
the objective
objective of
of making
making the
the overall
overall portfolio
portfolio Management T − Cost basis
the access to illiquidity premium) FVIFCG = (1 + rCG ) (1 − tCG ) + tCG
n
λA = the investor’s trade-off between active risk and active
style neutral
style neutral with respect
with respect to
to the
return; measures
the benchmark
benchmark while attempting
risk aversionwhile
attempting toto retain
in active risk terms
retain the
the value
value added
added from
from where: rafter-tax = rpre-tax (1 − tI )
the active managers’
the activeσ2managers’ stock selection ability.
stock selection ability. • Private credit • VFuture
T = terminal value
valuefactor with accrual taxes
• Equity:
A = variance of the active return Cost basis = amount paid for an asset
seeking• Low correlation to equities Taxable Gains When the Cost Basis Differs from Current Value
• Long-short ( )
One drawback
drawback of completeness
completeness portfolios is from
that they
they seekand
to eliminate
eliminate misfit risk.
risk. In
In seeking n
One of – Seek alphais
portfolios that longseek to short misfit FVIFpre-tax = 1 + rpre-tax
to eliminate
eliminate misfit riskspecified
throughby aa completeness
completeness fund, aa fund
fund sponsor is giving
giving upand
some of the
the
to
The
value added
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misfit
from
risk
efficientopportunities
frontier
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through
stock
(as
selection
well
this as
objective
of the
the
fund,
beta from
function
active managers.
managers.
sponsor
isnet
drawn in is
long active riskup
exposure). some of
active • Provides access to less liquid debt FVIF CG =
Taxable (1 += rVpre‐tax
gain − )n (1 basis
Cost − tCGn) + tCGB
FVIFafter-tax = [1 + rpre-tax (1 − tI )]
T
value
return from
Oncethe
space.Alpha stock
active andselection of
semiactive active
managers
might also be chased byare in the mix, the investor’s
“beta-tilting” and risktrade-off • Alternatives might be classified based on:
becomes one of active return versus active risk. The amount of active risk an investor wishes where:
where:
factor exposures
to assume determines will bemanagers.
the mix of specific influenced by strategy
For example, focus,
an investor wishing to where:• VFuture
T = terminal valuefactor when deferring taxes on capital gains
over a high • Traditional asset class counterparts (equities, fixed
value
use of
assume no active riskleverage,
at all wouldandholdwillingness
an index fund. to hold positions
In contrast, investors desiring FVIFCost
Cost basis basis
= Future valuepaid
= amount interest (i.e.,
for an accumulation) factor
asset
risk and active return may find their mix skewed toward some combination of income, real estate)
B= (B is cost basis as a proportion of current market value)
time
level of active r =Vreturn
0
higher-active-risk managers with little or no exposure to index funds.
• Dedicated short-selling and short-bias – Dedicated • Macroeconomic performance (normal economy, t = tax rate
V0 = valueFVIF
of an
CGasset
= (1 when purchased
+ rpre‐tax)n (1 − tCG) + tCGB
© 2018
© 2018 Wiley
Wiley n = number of periods
short-selling strategies seek returns from short inflationary economy, deflationary economy)
positions only, whereas short-bias strategies may • Exposure to risk factors (equity market, size, value, where:• Future
Accumulation
Deferral Method value
Factor factor
withwith Annual
a Single, with annual
Wealth
Uniform wealth
TaxRate
Tax (Capitaltax
Gain)
balance their portfolios with long positions liquidity, duration, inflation, credit, currency)
7 March 2018 3:51 PM Cost basis
B=
( )
n
(1−−tCG
tW ) + tCG
7 March 2018 3:51 PM
FVIFWCG= = (11++ rrpre-tax
CG ) (1
n
VFVIF
• Market neutral – This includes pairs trading (e.g. selling 267
0
© 2018 Wiley
company A, buying company B), stub trading (e.g. V0 = value of an asset when purchased
Effective Annual
Taxable Gains After‐Tax
When Return
the Cost BasisinDiffers
a Blended
fromTax Regime
Current Value
Accumulation Factor with Annual Wealth Tax
.indd 267 7 March 2018 3:51 PM
Taxable gain = V − Cost basis Wiley © 2020
r* = rT (1 − PI tI −TPD t D − PCG tCGn )
( )
where: FVIFW =  1 + rpre-tax (1 − tW ) 
 
where: VT = terminal value
 FVCharitable Gift (1 + rg )n + Toi [1 + re (1 − tie ) ]n (1 − te )
Gift = FVCharitable Gift = (1 + rg ) + Toi [1 + re (1n− tie ) ] (1 − te )
Relative Value of Charitable
RVCharitable Gratuitous Transfers n
FVIFCG = (1 + rpre‐tax)n (1 − tCG) + tCGB RVCharitable Gift = FVBequest = [1 + re (1 − tie )] (1 − Te )
vaTe WealTh ManageMenT in a global ConTexT 
FVBequest [1 + re (1 − tie )]n (1 − Ten)

Wiley’s CFA Program Exam Review

where: ® FVCharitable Gift (1 + rg )n + Toi [1 + re (1 − tie ) ] (1 − te )
where: RVCharitable Gift = =
Costin basis
vaTe WealTh ManageMenT a global ConTexT  Toi = tax on ordinary income FV
where: (donor
Bequestcan increase the [1 +charitable
re (1 − tie ) ]gift
n
(1 −amount)
Te )
B=
Effective Capital Gains Tax Rate Toi = tax on ordinary income (donor can increase the charitable gift amount)
V0
Tax Code Relief
V0 = value of an asset when purchased where:
Tax Code Relief
 1 −Tax
Effective Capital Gains PD − PCG 
PI −Rate Toi = tax on ordinary income (donor can increase the charitable gift amount)
T * = tCG  Credit Method
Accumulation Factor 1 − with
PI t − P D t D − PCG
Annual tCG  Tax
Wealth Credit Method
Tax Code Relief
 1 − PI − PD − PCG  tCM =Max (tRC, tSC)
T * = tCG  n  tCM =Max (tRC, tSC)
The after-tax
FVIFfuture1value (
W =  1 + rIpre-taxD(1
− P tmultiplier
WCG )
)tCG this
− P t D −−tPunder  blended tax regime then becomes: Credit Method
where:
• Effective
FVIF
annual after-tax return after taxes, interest,
= (1 + r*)n (1 − T *) + T * − t (1 − B) where: tCM =Max
tRC = applicable tax(trate
RC, tin ) residence country
SCthe
family home
The after-tax future
after-taxvalue multiplier under this blended
CG tax regime then becomes:
Effectivedividends,
Annual After‐Tax and Return
realized in acapital
Blendedgains
Tax Regime ttRC = applicable tax rate in the residence country
SC = applicable tax rate in the source country • Human capital: PV of future expected labor income Risk Mana
tSC = applicable tax rate in the source country
FVIFafter-tax
If the portfolio isConTexT  = (1 + r*)npaying
non‐dividend (1 − T *)equity
+ T * −securities
tCG (1 − Bwith
) where:
no turnover (i.e., PD = PExemption
I=0
• Method
Exemption method: residence country exempts foreign (higher income volatility requires higher discount rate).
vaTe
vaTe WealTh
WealTh ManageMenT
ManageMenT in
in aa global
and PCG =r*1)=held
global (1to− Pthe
rT ConTexT  − PDof
I t I end CG tCG ) the formula reduces to:
− Phorizon,
t Dthe source
tRC = applicable
Exemption Method income
tax rate from tax.
in the residence country
• Income volatility risk can be diversified by appropriate
tSC = applicable tax rate in the source country The international shift away from defined-benefit (DB) pension plans has caused a shift
If the portfolio is non‐dividend paying equity securities with no turnover (i.e., P = P = 0 tEM = tSC financial capital, e.g. if human capital is equity-like,
toward annuities. At the individual level, there are five factors that would likely increase
where:
• Effective
D I
Effective Capital =capital
Gains (1from r )of
Tax
− (gains
nRate
− tCG
1the )dividends,
tax
+ tCGrate Exemption = tSC
tEMMethod financial for capital should contain more bonds.
and
P=P CG =FVIF
Effective 1) held
Capital
proportion to the
Gains
of return
after-tax end
Tax Rate
income, horizon, the formula reduces
and realized to: gains during the period
capital demand any annuity:
Deduction• Method
Deduction method: residence country allows • Economic (holistic) balance sheet
1. Longer-than-average life expectancy
DeductiontEM = tSC
Method
 = 1 I (P )equity
tCG securities
−−any
1(1− −nunauthorized
PrI )− −P
P1paying
PCG deduction 5 for tax paid in source country.
© Wiley
If 2018Tall
the portfolio
FVIF
T *=
* =rights
tis reserved.
non‐dividend
after-tax
tCG 
P D−−
D tCG CG +copying

or distributionwith
will constitute an infringement
100 percent turnoverofand
copyright. • Assets:
2. Greater financial
preference capital, personal
for lifetime income property, human
taxed annually, theformula
CG 1−−P −reduces
PI tt − PD tt D −−P CG tCG 
Pto:  t DM = t RC + tSC − t RC tSC
1 I P D D CG tCG 
= +
capital, pension
3. Less concern for value.
leaving money to heirs
t
DeductionDM t
MethodRC t SC − t RC t SC 4. More conservative investing preferences
If the portfolio is non‐dividend paying equity securities with 100 percent turnover and • Liabilities: total debt, lifetime consumption
sources (such asneeds,
(1 − tCGwith
)under 5. Lower guaranteed income from other pensions)
n
The
The • Future
after-tax
taxedafter-tax
annually,
FVIF future
thevalue
future
after-tax = 1 +multiplier
value
formula
value multiplier
rreduces
factor  blended
under
to: this blended
this blended taxtaxregime
tax regime then
regime then becomes:
becomes:
t DM = t RC + tSC − t RC tSC bequests.
n Concentrated Single-Asset Positions Lesson 7: IMpLeMentatIon oF RIsK ManageMent FoR IndIVIduaLs
• Net wealth 9 is the difference between total assets and
= (1 (1n−(1
+ rr*) − T) *)
*) + *− (1 − B) © Wiley 2018 all Rights Reserved. any unauthorized copying or distribution will constitute an infringement of copyright.
n
FVIFafter-tax =Return −T +TT* − ttCG
FVIFafter-tax = 
Accrual Equivalent 1+
(1 *) (1tCG CG (1 − B) 9
after-tax © Wiley 2018 all Rights Reserved. any unauthorized copying or distribution will constitute an infringement of copyright. total liabilities.
• Objectives: risk reduction (diversification), monetization, Los 12j: analyze and critique an insurance program. Vol 2, pp 431–440
• Young family has high % of economic assets in human
0 (non‐dividend
AE )
n
If the portfolio
Accrual
If the portfolio is
Vn = Vis
• =Equivalent
Accrual
non‐dividend
1 +equivalent
rReturn paying equity equity securities with
after-taxsecurities
paying return
with no
no turnover
turnover (i.e.,
(i.e., P =P
PD =
©
= 00
PI =
I Wiley tax
2018 optimization,
all Rights control.
Reserved. any unauthorized copying or distribution will constitute an infringement of copyright. 9
and
and P 1) held to the end of the horizon, the formula reduces to:
D
capital.
Los 12l:As the
Recommend household ages,appropriate
and justify weight of humanstrategies for asset allocation
CG = 1) heldVto the end of the horizon, the formula reduces to:
PCG
• Considerations: illiquidity, triggering taxable gains
rAE = n n − 1 n and risk reduction
(financial) capitalwhen given an investor
will decrease profile of key inputs.
(increase).
Vn = V0 (V10+ rAE ) on sale, restrictions on amount and timing of sales, Vol 2, pp 440–443
after-tax = (1 − r )nn (1 − tCG ) + tCG • Risks to human and financial capital
V = (1 − r ) (1 − tCG ) + tCG
FVIF
FVIFafter-tax emotional and cognitive biases.
where:
rAE = n n − 1
V0 • Monetization strategies
• Earnings
The decision torisk:
retainprotect
risk or buyagainst
insuranceearnings risk
is determined byrelated to risk tolerance.
a household’s
Ifnthe
V the portfolio
= value isn non‐dividend
afteris non‐dividend
compoundingpaying paying
periodsequity equity securities
securities with
with 100
100 percent
percent turnover
turnover and
and At injury
the samewith
level disability insurance.
of wealth, a more risk-tolerant household will prefer to retain more
If portfolio
taxed
taxed annually,
annually, thethe formula
formula reduces
reduces to: • Monetization by (1) hedging the position, and (2) risk, either through higher insurance deductibles or by simply not buying insurance. A
Accrual
where: Equivalent Tax Rate
to: • Premature death (mortality
have lower risk): protect with life
• Accrual equivalent tax rate
Vn = value after n compounding periods
borrowing against hedged position. risk-averse
all insurance.
household would deductibles and purchase more insurance. For
households, insurance products that have a higher load (expenses) will encourage a
+ rr ((1 − ttCG ))  n •
n
FVIFafter-tax =
r (1 − TTax
= 1
1+ 1− Hedging for monetization strategies can be achieved household to retain more risk. Finally, as the variability of income increases, the need for
AE) Rate CG  • Longevity risk: protect with annuities.
FVIF
AE = after-tax
Accrual rEquivalent
by: (1) short sale against the box (least expensive); (2) life insurance decreases because the present value of future earnings (human capital) will
Accrual
rAE
TAE = 1 − Return total return equity swap; (3) short forward or futures • Property
be lower with arisk:higherprotect
discount with
rate. homeowner’s insurance.
Accrual rEquivalent
= r (1 −rTReturn
Equivalent )
AE AE contract; (4) synthetic short forward (long put and • Liability
Table 7-1 showsrisk:
the protect withofliability
appropriateness insurance.
the four risk management techniques depending on
rAE n short call).
• TMeasure
Tax‐Deferred
VAE
V ==Accounts
n = V10 −((1
V 1+ AE ))
+r rrof tax
n drag = Difference between accrual • Health
the risk:
severity of lossprotect with health
and the frequency of loss. insurance.
n
equivalent
0
Vn
AE
after-tax return and the actual return Taxes and ofPrivaTe • Hedging
theWealTh ManageMenT strategies
in a global ConTexT 
• table 7-1:
Risk management
Risk Management techniques
techniques
V
= nn n − −1 n
Tax‐Deferred rrAE
portfolio.
AE =Accounts
FVIF V=0 (1 1+ r ) (1 − t ) tCG B • Buy puts (protect downside and keep upside while
TDAV Private Wealth ManageMent
0 Loss Characteristics High Frequency Low Frequency
Tax‐Exempt• Tax-deferred
Accounts accounts (TDAs): contributions from deferring capital gains tax).
High severity Risk avoidance Risk transfer
where: FVIF
where: untaxed TDA = (1 ordinary
+ r ) (1 − t )income,
n
tCG B tax-free growth during the • Private
UseWealthzero-premium
ManageMent collars (long put and short call with
Survival Probability
holding Approach periodsat time of withdrawal Low severity Risk reduction Risk retention
Vn =
V n
= value
valueFVIF after n
after TEA = (period,
1 + r )n taxed
compounding
n compounding periods offsetting premiums) to reduce costs vs buying puts.
Accrual
Joint
Accrual Equivalent
survival
Equivalent probability Tax Rate
Tax Rate
for a couple is: • Use prepaid variable forward (combine hedge and • Adequacy of life insurance
Exhibit 10, Volume 2, CFA Curriculum CFA 2017
Survival Probability
FVIFTDA = Approach (1 + r)n (1 – tn)
FVIF TDA = FVIF (1 − t ) ) + p(survival ) margin loan in same instrument), with number of • Human
An investmentlife value
advisor willmethod: estimates
often be asked how muchthe
life PV of earnings
insurance is enough. There are
) = pTEA
r ((1 −reserved.AE )) for a couple is:
p(survival
= − (survival Taxes and PrivaTe WealTh ManageMenT in a global ConTexT 
r
Joint survival
rAE
© Wiley• 2018
r
AE =probability
all rights
1 J T
TAE any
H
unauthorized copying
W
orafter-tax
distribution willcontributions,
constitute an infringement of copyright.
shares delivered at maturity dependent on share price twothat
techniques
mustthat
beyou will be responsible for on the exam:
replaced.
Tax-exempt − accounts
p ( survival )(TEAs):
× p ( survival )
rrAE
H W
at maturity.
Value FormulaT
tax-free
T =
=1
(survival
pAE
AE 1for−
− JAE agrowth
r ) Tax
= p(Exemptsurvivalduring Account
H ) + pthe holding
(survival W) period, no future tax • Needs analysis
1. Human method:
life value method:estimates financial
This technique needs
estimates the ofvalue of earnings
present
Tax‐Exempt
Based
© Wileyon2018 joint Accounts
liabilities. survival
all rights
r
reserved. probability,
− pany unauthorized
(survival present
) × value
copying
p ( survivalor of )joint will
distribution spending
constituteneeds
an is:
infringement of copyright. • Yield enhancement
IMPORTANT:
A more conserva- strategies: dependents.
that must be replaced.
H W
• Write
tive approach as-
covered 2. needs analysis method: This technique estimates the financial needs of the
Tax‐Deferred V0 (1 − t0)(1n+ r)n
Vn = Accounts sumes both spousescalls to generate income.
Tax‐Deferred FVIFAccountsTEA = (1 + r )
N IMPORTANT: dependents.
p(survival J ) × value
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live through the
Based onPV joint =∑
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INSTITUTIONAL INVESTORS
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t
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IMPORTANT:
rate because contribution.
they are nonsystematic (i.e., unrelated to market-based risk inherent in the as-
to outperform
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sets).
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IMPORTANT: • SWF types include:
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are nonsystematic (i.e.,
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exporting countries)
usually sufficient for planning. return on a portfo-
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liabilities considers the shortfall risk ofoffunding investments.
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σ = standardsufficient
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The Monte Carlo approach examines many paths, with outcomes based on random values within Private Wealth ManageMent
Monte • Core
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PWM event). • pension reserve funds (similar to private sector defined
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a feeling of funding
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on random values within• Monetization strategies for concentrated private shares
desiredrisk as a funding portfolio.
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Inter vivos gifting bypasses the estate tax on a bequest at death. Local jurisdictions have • savings funds (used for multi-generational national
where:
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implemented
σ = standard p(survivalgift
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implemented gift and donation taxes to minimize the revenue loss from inter vivos gifting. • Leveraged
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IMPORTANT:
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for either life.
life.
at death. In this scenario, t 1
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companythe tax rate buys
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to the recipient (no tax consequences and can use
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ranges for each variable (i.e., portfolio FV [1 + r
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emergency experiences, tax changes, etc.). proceeds PWM

© Wiley •
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Trusts
2018 alltherights reserved.
Gift
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than the estate
to diversify).
(numerator) is less
7 tax • Liquidity: generally related to time horizon
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• Donor-advised
rate (denominator).
funds (contribute property now for tax • Time horizon:
© 2018 Wiley
transferring excess Capital deduction). 107 • budget stabilization funds - short-term
can use trust assets to settle claims against settlor.
Inter • gifting • Sale and leaseback (frees up capital for diversification • development funds - medium to long-term
© 2018vivos
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at death. andjurisdictions
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implemented gift and donation taxes to minimize the revenue loss from inter vivos gifting. but sale 7triggers taxable gain).
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use trust assets to settle claims against settlor. March 2018 3:49 PM
• pension reserve funds - long-term
Tax-Free • Double
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.indd 107 7 March 2018 3:49 PM

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• allCredit
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 Wiley’s CFA Program Exam Review
®

• Tax: SWFs generally enjoy tax-free status in their • Tax: not taxable unless they are unrelated business • Time horizon: duration spread of assets over liabilities
jurisdictions taxable income. constrains time horizon for securities portfolio to an
• Legal/regulatory: SWF’s are generally established by • Legal/regulatory: UPMIFA (US). intermediate-term.
way of legislation. Many have adopted the Santiago • Unique: types of investments constrained by size or • Tax: pay corporate tax.
Principles that addresses governance and best-practice board member sophistication. • Legal/regulatory
• Large % of securities portfolio in government securities
Defined benefit pension plan Life insurance companies as pledge against reserves.
• Risk tolerance: greater ability to assume risk if • Risk tolerance/objective • Regulators restrict allocation to common shares and
below-investment-grade bonds.
• Plan surplus • Liquidity risk: arises from changes in investment
• Lower sponsor debt and/or higher current profitability portfolio that affects reserves.
• Risk-based capital requirements.
• Lower correlation of plan asset returns with company • Interest rate risk: reinvestment risk and valuation • Unique: Lending activities may be influenced by
community needs and historical banking relationships.
profitability risk (due to duration mismatch between assets and
• No early retirement and lump sum distributions liabilities).
options • Credit risk of bond investments. Derivatives and currency
• Greater proportion of active versus retired lives • Cash volatility risk: relates to timely receipt and
reinvestment of cash.
management
• Higher proportion of younger workers
• Risk objective: usually related to shortfall risk of • Disintermediation risk: policy owners withdraw Options
achieving funding status. funds to reinvest with other intermediaries in higher-
nvestors • Return objective: to achieve a return that will fully fund returning assets. • Option strategies
liabilities (inflation-adjusted), given funding constraints. • Return objective: minimum return requirement (based Strategy Construction using Motivation
on rate initially specified to fund life insurance contract)
• Liquidity: to meet required benefit payments.
foundations
European options
and net interest spread. Covered Own underlying share and Earn premium to
• Time horizon: usually long-term and could be multi-
Types stage. • Liquidity: limited liquidity needs since cash inflows call sell call on share. cushion losses.
• Independent (private or family): Funded by donor, donor’s family, or independent exceed cash outflows, but need to consider Protective Own underlying share and Downside protection
• trustees
Tax: investment income and capital gain usually
to further educational, religious, or other charitable goals tax- disintermediation risk (when interest rates are rising) put buy put on share. with upside potential.
exempt.
• Company-sponsored: Same as independent foundation, but a legally independent and asset marketability risk.
organization sponsored by a profit-making corporation Bull Buy call at lower strike and Speculation on stock
• Legal/regulatory: plan trustees have a fiduciary
• Operating: Funded same as independent foundation, but conducts specific research• orTime horizon: different product lines have different time spread sell call at higher strike (can price increase in a
responsibility
provides to beneficiaries
a special service (e.g., operates aunder
private ERISA (US).
park or museum) horizons and will be funded by duration-matched assets. use puts instead of calls) range
• • Community:
Unique: limited resources
Multiple donors for due
or publicly diligence,
funded ethical
to make grants for purposes similar Bear Buy call at higher strike and Speculation on stock
to independent foundation; no spending requirement as with the others • Tax: pay corporate tax.
constraints. spread sell call at lower strike (can price decrease in a
• Legal/regulatory: regulations on eligible investments, use puts instead of calls) range
Risk Objectives prudent investor rule, NAIC risk-based capital (RBC) and
Foundations Butterfly Buy call at lower strike, Bet on low volatility
Higher risk tolerance due to noncontractually committed payout. asset valuation reserve (AVR) requirements. spread buy call at higher strike, sell
• Risk tolerance/objective: higher risk tolerance due to • Unique: look out for restrictions on illiquid investments. two calls at strike halfway
Return Objectives between strikes of long calls
noncontractually committed payout.
• Return objective:
Asset management fees cannot betoused
cover
towardinflation-adjusted
the spending requirement spending
(although grant-
Non-life insurance companies (can use puts instead of calls)
Collar Buy stock, buy put and sell Downside protection
goals and
making expenses overheads
can count notFoundations
toward that). countable toward
seek returns required
to cover at least inflation-
adjusted spending goals and overhead not countable toward the required spending minimum:
spending minimum.
• Risk tolerance/objective call. (zero-cost collar if and with limited
call and put premiums are upside
• Policyholder reserves use lower-risk assets due to the same)
r = % spend + % management + % inflation
unpredictable operating claims.
or Straddle Buy call and put with same Bet on high volatility
= (1 + % spend)(1 + % management)(1 + % inflation) − 1
• Maintaining surplus during high-volatility markets strike
reduces ability to accept higher risk. Strap Buy two calls and one put Bet on high volatility
Liquidity• Liquidity:
Requirementto quickly fund spending needs (including
• Risk measured against premiums-to-capital and with same strike (stock price rise more
noncountable overheads) greater than current premiums-to-surplus ratios. likely)
Foundations contributions.
must be able to quickly fund spending needs (including noncountable overhead) • Return objective Strip Buy one call and two puts
InstItutIonal Investors
Bet on high volatility
greater than current contributions. with same strike (stock price fall more
• Time horizon: usually infinite. • Investment earnings on surplus assets must be likely)
Private • andTax: investment
family foundations income
must spendand capital
percentage of gain average in the fiscal year, sufficient to offset periodic losses and to maintain
taxable.
12-month
Banks Strangle Buy call and put, put has Bet on high volatility
so they typically have 10% to 20% of assets in reserve to make sure they can make grants policyholder reserves.
equal to• atLegal/regulatory:
least 5% of assets. UPMIFA (US). different exercise price
• Unique: May use swap agreements or other transactions Liabilities• Larger
of banks companies
consist primarilyuse
of activeand
demand management
time deposits, strategies
but may include publicly Box Bull call spread and bear Replicate risk-free
Time Horizon traded debt forand total return rather
funds purchased than
from other yield
banks orFederal
or the investment
Reserve income
to satisfy regulatoryspread put spread return or make
to diversify returns if funding is primarily via large blocksrequirements.
strategies. arbitrage profit
Risk ManageMent applications of DeRivative
of stocks.
Usually the time horizon is infinite, but this depends on the purpose of the foundation. A
longer horizon implies greater risk-taking ability.
• Liquidity:
Bank surplus consists to meetless
of assets policyholder claims.
liabilities, the cash portion of which is invested in • Interest rate options
Risk ManageMent applications of DeRivatives

Endowments • Time
marketable horizon: generally shorter duration than life
securities. interest Rate option Strategies
• Buy interest rate call option to protect a future
interest Rate option Strategies
Tax Concerns insurance companies. The payoff of an interest rate call option is:
Banks use U.S. government securities as collateral to cover the uninsured portion of deposit borrowing against interest rate increases.
DE

• Risk tolerance/objective
Excise tax on dividends, interest, and realized capital gains is equal to about 2%, but is •
liabilitiesTax:
(e.g., pay
the corporate
pledging tax.
requirement). The payoff of an interest rate call option is:
Risk ManageMent applications of DeRivatives
Interest rate call option payoff = Notional principal × max (Underlying rate at
reduced to• 1% Greater ability
if charitable to takeexceed
distributions risk due to infinite
the minimum time horizon
percentage of assets required• Legal/regulatory: regulations on eligible investments, Interest rate call option payoff = Notional principal × max (Underlying Days inatunderlying rate
rate
Risk Objectives expiration − Exercise rate,0) ×
for the year and andthe if five-year
adopting spending
average rules
payout plus 1%based on smoothed
of investment income.
risk-based capital (RBC) requirements. Days in underlying 360 rate
expiration − Exercise rate,0) ×
averages of return and previous spending. Banks,• due
DE option greeks and Risk Management Strategies 360
Unique: look for
to risk relative restrictions
to primarily on illiquid
fixed liabilities, investments.
have below-average risk tolerance. • Buy interest rate put option to protect a future lending
The payoff of an interest rate put option is:
• Lower ability to take risk if high donor contributions as
stitutional investor Portfolios
A bank’s asset–liability risk management committee (ALCO) closely monitors: it. To hedge (or investing) transaction against interest rate declines.
Options
The payoff areofrisky positions.
an interest rate putAn optionoptionis: trader does not hold an option positon without hedging
titutional investor Portfoliosa % of total spend.
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=
= Notionalratio, also known
principal
×
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• Lower
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Managing Institutional
ability to take risk Investor Portfolios
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− Underlying rate at expiration,0)
rate
×
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toManaging
a company’s Institutional
annual spending Investor or ifPortfolios
company relies • • Interest
Risk tolerance/objective
spread: Average yield on earning assets less average percentage cost of
Change−in option price
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rate at expiration,0) 360
rate
Simple Spending Rule Option delta = = 360
Change in underlying stock price ∆ S
Simple Spending
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to cover high fixed
Institutional Investor Portfolios costs. © 2018 interest-bearing liabilities
• Below-average risk tolerance.
Wiley
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same as for foundations. Annual spendLeverage-adjusted
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using interest
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Borrowing
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7 March 2018 3:50 PM
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To reduce
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Rolling Three-year Average Spending Rule
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To implement the strategy,
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If the
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generates
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that stocks.
the ofastock
an at-the-
payoff that will
price.
interest
Leverage-adjusted Smoothing = D A ×− kD
gap rate) × Beginning market valueBanks
t−1)] buy or sell marketable securities to adjust interest rate risk, manage liquidity, offset rate
be delivered at the end of atthe loan repayment date. Noteit that the payoff one of an interest
rebalancing.
Leverage-Adjusted No minimum
Duration Gap spending
L
requirement. allocation
loan portfolio focusing
credit risk, on income
and produce higher(up
total return.
to a quarter or more of revenue).
money
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rate option
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is not delivered
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is delivered
it is delivered
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∆Vcall
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perpetuity). Return Objectives Change

L of deposits. not need
3. We in March at option
to consider both the callinoption
expiration). underlying
premium stock price
as well as the time value
k=
where: Leverage-adjusted duration gap = D A − kDL 3. (opportunity cost/financing
We need to consider
∆c both cost) of the
the call call option
option premium premium.
as wellWeas should
the timereduce
valuefrom
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k = ratio of liabilities to assets, both at market value The interest income allocation focuses on positive spread over cost of funds. the = − Nwe
N Samount
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c cost/financing day ofofborrowing by the future
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premium. of should
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of borrowing byofthe
option anfuture
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in-the-money
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allcalloption
option moves
k=
where: A The remaining allocation focuses on higher total return. toward 1; the delta
interest
premium. theofcall
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bothoption
reflectsbetween thethe moves
option
call option toward
purchase
premium –1;
and the
loan
and delta
initiation
any and all of an out-of-the-
(option
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optionafter considering hedging
k = ratio of liabilities to assets, both at market value Because delta movies
interest isona the toward
call
function of zero.
premiumthe accrued
underlyingbetweenasset thevalue, purchase
as the value
costs. Using the previous example, in March, we should reduce the call option
andchanges,
loan initiation
delta changes
where: Liquidity Requirements (option expiration). The net amount is the funds we receive after considering hedging
with it. Consequently, a previously
premium and financing constructed
cost (interest delta-hedged
accrued) between portfolio
January and is nothelonger hedged
March from
 Cross-Reference to CFA Institute Assigned Reading #28 +−EE(Credit
( Currency gains/losses )
losses)
E ( R) ≈+Yield
E(Currency
incomegains and losses)

Wiley’s CFA Program Exam Review

The goal of this reading is to understand how to use forward®and futures contracts to achieve a +Rolldown return
This model for fixed-income returns can help investors better understand the assumptions
particular level of risk exposure of an underlying risk factor. Risk factors include market risk, Assuming in notheir ∆P based
reinvestment income, (aka yield) is computed
nt applications of DeRivatives embedded +E(return expectations yield
on investor’s income
acrossyield and
virtually current
spread
any view)
fixed-income security. as:
sector risk, interest rate risk, currency risk, and others. We may either reduce our existing risk
–E(Credit losses)
exposure (hedging) or increase our existing risk exposure (speculation).
Expectedcredit
Expected returnlosses
+E(Currencyyield
due torepresent income
Annual the
gains represents
orloss
coupon coupon
probability
payment
losses) (i.e.,income
expected plusdefault
any reinvestment
rate) multiplied by
The numberequity of stock index futures interest Current
relative yield
losstoseverity = (i.e.,
a bond’s price. Ingiven
the absence of reinvestment income, yield income is
Managing Market Risk contracts needed to achieve the goals is given by the the expected loss
Bond default):
price
following expression: simply the bond’s annual current yield.
where:
Market risk is measured by beta, so our risk management of an equity Risk portfolio isapplications
all around Yield income = Annual
equalscoupon payment/Current
ManageMentapplications
Risk ManageMent ofof DeRivatives
DeRivatives Roll-down
Rolldown E(Credit
return
return losses)
recognizes =the
E(Default
bond’s
the rate)
valuepercentage
change abond
× E(Losss
aspricebond price =asCurrent
everity)
change
approachesthe bond yield
approaches
maturity (“pull to par”)
beta measures. The current stock T portfolio has a beta β S , the stock index futures have a beta Rolldownassuming
return = (B − B0) / B1 =yield % change in
Inbond price due of to changing
 V (1 + r )  maturity,
under an assumption anof1unchanged
zero rate volatility curve.(i.e., the absence
unchanged yield curve).the time
default, bond’sto price
maturity
β f , and the N *ftarget
= Round beta of the stock  portfolio is βT . We have the following relation: E(ΔP basedpar
approaches on value
investor’s
as theyield
time and
to spread view)
maturity M × the
= (− D(i.e.,
decreases ΔY%) ×C×
+ (0.5 pull
so-called to ΔY%)
maturity).
 fq  Expected currency gains or losses in reporting currency terms must also be considered.
DEDE
RiSk MAnAgeMent
MAnAgeMent ApplicAtionS ApplicAtionSof ofSwAp SwApStRAtegieS
StRAtegieS
Forward and Futures risk-free rate, T is the • Hedging strategies
Cross-Reference to ofCFA Institute Assigned Reading #30
Currency
Note: Creditlosses
Rolling occur
losses return
and =currency
when the asset
Yield income
gains + Rolldown
currency
or lossesdepreciates
are return
discussed against the reporting currency.
elsewhere.
βT SCross-Reference
where = βVS isS +the β f f to
N famount CFA Institute
money to be Assigned
invested, Reading
r is the#30 B − B0
investment horizon, q is the futures contract price multiplier, f is the stock index • Passive hedging: manager protects portfolio with full Limitations Roll-down return = 1
* Effect of of the
Leverage model
on theinclude:
Portfolio
B 0
• Managing
A swap isfuturesa financialprice,
thereading
and
contract
contract
equity
covers
in
inN f is
which
which an
twointeger
two
market
oftoapplications
representing
counterparties
counterparties
risk andagree the number
agreetotoexchange
exchange
changing of long
aasequence
sequence
equity ofof stock index
asset hedging. Expected price change due to change in the yield or spread depends on the bond’s modified
Wecashsolve
flows. forThis
futures number
contracts covers futures
applications aof
convertcontractsof interest
interest
cash rate
rateswaps,
needed
position to
swaps, ancurrency
to reach theswaps,
currency
equity target
swaps, equity
positionbeta:
equity
or the number duration and convexity,
• Reinvestment at or effective duration and convexity in the case of bonds with options:
swaps, andallocation by beta adjustment • Discretionary hedging: manager reduces risk with • Expected bond
price yield to
change maturity
due (YTM).
to
[ofr1 yield VBchange
rB ) ] inreturn.
yield or spread
swaptions.
of short stock index futures contracts to convert an existing equity position into Rolling yield isPortfolio
• Duration: the return
combination
Considers only × (VE income
−yield
VB ) −curve
(and ×roll-down
a cashRate position. hedging but has discretion to make currency bets for rP = = parallel shifts.
using interest Swaps
 βT − β S  to to convert
 Sconvert
 a floating-Rate loan to a fixed-Rate
a floating-Rate loan to a fixed-Rate loan loan • Excludes
E(% ∆
Portfolio
P) = ( − D
equity
richness/cheapness× ∆Y) + effects:
(C × 0.5
VDeviations
∆ EY 2 ) from the fitted yield curve at certain
(and
Ment applications of DeRivatives f =
ViceNVersa)   return enhancement. The expected return fromMod
maturities. V
the price change that results from the change in yield and yield
 βf  f  r1 + B (r1 in
spread can be= measured − rone
B ) formula using duration and convexity:
A pay fixed, receive floating interest interest raterate swap
swap can
canbe beviewed
viewedas asaaportfolio
portfolioofofaalong
longfloating-
floating- • Active currency management: manager seeks alpha by • Expected VE
credit losses
Asset and a short
Allocation withfixed-rate
futures bond.
bond. Similarly,
Similarly, aa paypayfloating,
floating,receive
receivefixed
fixedinterest
interestrate
rateswap Leverage
rate bond
The • viewed
number Creating
of stock
if theastarget
fixed-rate
synthetic
index
a portfolio
beta of βfutures
a long stock
contracts
fixed-rate index
needed
bond beand
toafund
aachieve
short or
theconverting
goals is
shortfloating-rate given
bond. Based
swap
byequity
the
on
making currency bets.
Clearly,
can be of Ta islongzero, N f will
fixed-rate bond negative,
and which means
floating-rate bond. we need
Based onto sell stock E ( ∆ P due to yield change and spread ) = ( − D × ∆Y ) +  0.5 × C × ( ∆Y )2 
into cash betais βT is • Currency overlay: currency management outsourced Leverage
following
this insight,
this insight, expression:
we have
wecontracts
have the
the following:
following: where: involves using borrowed capital to enhance return. Leverage improves return when
index
Futures futures
contracts can be toused
neutralize
to adjust ourasset
existing long equity
allocation amongposition. If the The
asset classes. targetidea
smaller For (or greater) than the portfolio,
current beta useβstock to specialists. r =
portfolioReturn
return on isthe unlevered
greater than portfolio
borrowing cost. Portfolio return using leverage is calculated as:
simple. a given existing S , N f index
will be negative
futures (or positive),
contracts to adjust which means
the beta 1
we need
of the portfolio
Floating-rate
Floating-rate
to sell (or bond
bond
buy)
to its target
== Fixed-rate
Fixed-rate
stock T index bond
bond ++[Pay
futures[Pay fixed,
fixed,
contracts receive
receive
to floating
floating
reduce interest
interest
(or
)  level and use bond futures contracts to adjust the modified
V (1 + rbeta
rate
rate
increase)swap]
swap]our existing
• Active currency management 220
r = • Effect
Borrowing of
costs leverage on portfolio return
effective duration must be used for bonds with embedded options; otherwise, modified
B
© 2018 Wiley
N * = Round   VE = Equity
equity exposure. duration is used in this variation
duration of fthe portfolio  to fq its target modified duration. Stock index futures and bond futures  Portfolio return  ofrIthe (VEformula.
+ VB ) − rB VB
allow us to Fixed-rate bond == Floating-rate
bond
synthetically
Fixed-rate lever up/down
Floating-rate bond++equity
bond [Pay
[Payfloating,
beta as
floating, receive
wellfixed
receive interest
as bond
fixed interest rate
rateswap]
modified swap]duration. The • Economic fundamentals: real exchange rate will VB = Borrowed
rP =  amount  =
 Portfolio equity  VE
creatingwhere
technique is notVnew.
equity isout
theItof
amount
iscash of money toof
a combination bewhat
invested, r is the risk-free
we covered rate, T istwo
in the previous the sections, eventually converge to fair market values, with short- The remainder of the equation indicates the return effect of leverage such that r1 > rB
where
These we twoinvestment
independently horizon,
the handle
q isfor the
the futures
equitycontract
component price andmultiplier, f is the stock
fixed-income index
component. V
These two equations are
equations
futures price,
are the
and
recipe
recipe
N *
is
for
an
converting
converting
integer
aafloater
floatertotoaafixed-rate
representing
fixed-rate
the number
bond
bondororconverting
of long
converting
stock
aa
index term increases in the domestic currency due to (1)
c10.indd 220
©results
2018 Wiley
in a = rI + Bcontribution
positive (rI − rB ) from leverage.
7 March 2018

This section
fixed-rate
fixed-rate bond
bondfocuses
to a on the following two pieces of logic:
floater.
to a floater. f VE
futures contracts to convert a cash position to an equity position or the number increase in domestic currency’s real purchasing power,
of short
using Swaps
using Swaps to stock
to Adjust index
βT − βthe
Adjust the  futures
Duration
S  of
S Duration ofcontracts to convert
aa fixed-income
fixed-income an existing equity position into
portfolio
portfolio (2) higher domestic interest rates, (3) higher expected Leverage • where
Leverage
Using Futures with futures
rI = investment asset return, rB is the cost of funds, and VE and VB are
aN Sf = risk-free
cash
Long position.
   +Long futures = Long stock index
bond
 βcan
An interest rate swap  fS  as a portfolio of a long floating/fixed-rate bond and a
f beviewed
An interest rate swap can be viewed as a portfolio of a long floating/fixed-rate bond and a foreign inflation, and (4) higher foreign risk premiums.
r21.indd 135
the values of equity and borrowing, respectively. Therefore, the numerator
11 Au

short
changes.
• Consequently,
short fixed/floating-rate
fixed/floating-rate bond.
Changingan bond
bond. The
The value
interest
value of
asset
rate swap
of an interest
interestrate
allocation
an
has duration,
rateswap
swapisissensitive
just like a
sensitivetotointerest
bond does.
interestrate
rate • Technical analysis: based on belief that historical the first line=ofNotional
inLeverage
Futures
valuerepresents
the equation – Margin the return on portfolio assets less
changes. Consequently,
Long stock an interest+ Short rate futures
swap has=duration, just like bonda bond does. Margin IntroductIon to FIxed-Income PortFolIo m
Asset Allocation withindex futures Long risk-free currency patterns will repeat over time and those borrowing costs.
Now we we need
need to  MDUR
make two − MDURS  B
two Tassumptions:
Now N
Futures contractsBf
to
= make assumptions:
 can be used to adjust asset allocation β y among asset classes. The idea is
repetitions are predictable.
The first equation  demonstratesMDUR f bond howisto75% fsynthetically create a stock
(e.g.,toaindex
10-yearfund: holding cash (a Securities Lending
long
1. The
simple.
1. For
duration
The aduration
of a fixed-rate
given existing
of a fixed-rate portfolio,bonduse
B of its maturity
stock
is 75% ofindex futures
its maturity
in contracts
years
in years (e.g., aadjust
10-yearthefixed-
beta
fixed- • Carry trade: borrow in lower interest rate (or forward Methods of Leverage
Liability-Driven
Total Return Analysis Strategies
of therisk-free
rate bond
portfolio bond)
tohas and
its aatarget
duration buying
betaof stock index futures. The second equation demonstrates how to
7.5).
oflevel
7.5).and use bond futures contracts to adjust the modified
create 2.
rate bond
The
2. cash
duration
out
has
of
of equity:
duration
a floating-rate
holding bond
a stock is 50%index of coupon
andStock resetting
selling period
stock in
index years (e.g.,
futures. a premium) currencies and invest in higher interest rate Futures contracts allow large positions to be controlled with little rate
margin (i.e., equity).
duration of the
The
The first7-year portfolio
duration
expression of a to its target modified
floating-rate
is thebond number bond is 50%
of stock index duration.
of coupon
couponfutures
index
resetting
paymentcontracts
futures
period inand bond
years
usedofto (e.g.,futures
a
lever up (if N Sf Rebate rate = Collateral earnings rate − Security lending
Swaps
7-year
floating-rate
floating-rate bond
with semiannual
with semiannual
allow us to synthetically lever up/down equity beta as well as bond modified duration.coupon payment
has a duration
has a duration of
0.25).
0.25). The (or forward discount) currencies, based on assumption Leverage • isImmunization:
the exposure (i.e., reducesposition size orgreater
eliminates
than margin) the
1
risks to liability
normalized for the margin
istechnique
positive) or lever down (if N Sf is negative) thecovered
portfolio’s existing equity CurrenCy
market ManageMent:
risk toan IntroduCtIon  Total future dollars  n
The duration
achieve
is not new.
of an interest
a synthetic
It is
targetrate
a combination
swap is
equity
of
the differencewhat webetween in the
theexpression previous
long bond’s duration two sections,
and that uncovered interest rate parity does not hold. amount: funding arising from
Semiannual total return = interest
 Full price ofrate volatility

− 1 over the
The duration
where we of an interest
independently rate swap allocation.
is the difference The second
between the long bond’sis the number
duration and of Treasury the bond
duration. handle the equity component and fixed-income component.
the short
bond
the short
bond’s
• bond’s
futures
Duration contracts
duration.of used to lever rate
interest up (if swaps N Bf is positive) or lever down (if N Bf is negative) • Roll yield: positive when trading the forward rate bias
options expire within that range. The “short” position comes from the fact that the out-of-
planning horizon.
the portfolio’s existing interest rate risk to achieve a synthetic target bond allocation. (buying put andbase currency athaveforward discount or selling Dollar• Duration Notional amount − Margin
Duration  β[Pay fixed and S  receive floating interest rate swap] = Duration(Floating-rate bond)An intRoduction the-money call in the seagull spread been shorted. LImmunizing
Futures = a single liability
S  and
Duration T − βfixed
[Pay receive floating interest rate swap] = Duration(Floating-rate cuRRency MAnAgeMent: bond)
N =    − Duration (Fixed-rate bond) base currency at forward premium); negative when Margin
• Market value of assets is greater
Sf
Similarly,
nt applications we can
of DeRivatives  use β f futures   fS contracts to adjust allocations between − Duration one(Fixed-rate
bond class bond)and anotherExotic Options than or equal to PV of
(e.g., long-term bonds and short-term bonds), or to adjust allocations between one equity class trading against the forward rate bias (selling base Dollar duration = Duration × Bond value1 × 0.01
Exotic options Currency
are those that Management:
are creative in nature and AncannotIntroduction
be categorized as being liability
and another Duration
(e.g., [pay
Duration [pay
floatingand
large-cap and receive fixedstocks,
floating andsmall-cap
interest rate S&P
receive fixed interestthe
swap] = Duration
rate swap]500 Index,(Fixed-rate
= Duration
bond)
and the Nasdaq-100
(Fixed-rate bond) Index).
“plain.”currency
Exotic strategiesat forward
provide
309 the discount
lowest cost or
investmentbuyingto achievebase
a currency
specific outcome.
Swaps allow conversion to a long/short portfolio for minimal collateral required by the
© 2018 Wiley
nAgeMent: An With these  MDURin T − MDUR  B ready to use interest −rate Duration (Floating-rate bond)
− Duration These atoptions
forwardare
32
helpful for clients with significant unique circumstance constraints counterparties
quitepremium). • all
© Wiley 2018 Macaulay
rights
or, reserved.duration
increasinglyany unauthorized
since the offinancial
assets
copying matches
or distribution
crisis of 2008, liability’s
will constitute
a clearinghouse.due Aof copyright.
an infringement manager
intRoduction N Bfproperties
= mind, we S are
 gain βy swaps(Floating-rate
to lever upbond) or lever
Forward Exchange Rates 1
Note:
swapBond value is in market valuetonot par value
down • Usecontracts,
Using duration
futures pay
of an floating
MDUR
existing we fcan bond also
and f Breceive
 portfolio exposure
to afixed to an
target asset class
interest
duration. Torate in advance
achieveswap of actually
to
a target portfolioin the investment policy statement or who have specific income needs that cannot be can date
a position long bonds avoid rising rates by paying the fixed rate and receiving a
committing funds to that asset class. Essentially we produced by traditional financial securities. floating rate. This effectively results in a long/short portfolio.
duration, we
increase may use an interest
duration rate
of bond swap based portfolio.on buy futures contracts
the following relation:on that asset class 1 + (i FC × Actual 360) • Convexity of asset portfolio is minimized.
Spread Duration
indd 309 Currency Management: An Introduction OneFFC/DC = SFC/DC
commonly used × 2018 3:52
7 March
exotic PM
option
The first expression is the number of stock index futures contracts used to lever up (if N Sf 1 + (i ×isActual
a knock‐in option in which the option does not
• Portfolio
•
is positive)
Use or
pay
lever down
fixed (if N
and receive
Sf is negative) the
floating
portfolio’s
interest rate swap
existing equity market risk to
to actually exist until a barrier DC rate
spot 360 )
is realized. Keep in mind that the barrier rate is not Three major types of spreads:needs rebalancing as time passes.
Forward V ( MDUR
Exchange ) +
P Rates NP ( MDUR ) = V ( MDUR ) 1 + (i × Actual )
a reduce duration of bond P portfolio. the same as the strike price. For PCexample,360 consider a call option with an exercise rate of
achieve
© 2018 Wiley
P
synthetic target equity allocation. S
The secondTexpression is the number of Treasury 317 = SPC/BC
FPC/BC
CAD1.15/USD
317
and a ×barrier
1 + (i rate × ofActual
CAD1.12/USD.
) If the spot rate is currently CAD1.10/ • Risk: non-parallel shifts in yield curve (risk is reduced
bond Wiley contracts used to lever up (if N Bf is positive) or lever down (if N Bf is negative)
© 2018futures • Nominal spread is the difference between the portfolio yield and the treasury yield
• or:
Duration
the portfolio’s management
existing interest + (i FC
1rate risk× to using
achieve
Actual an interest rate swap
360 ) a synthetic target bond allocation.
USD, the option does not evenBC exist until 360 the spot rate rises to CAD1.12/USD. It works
like a regular option, but if the barrier rate is never realized, it’s as if the option never
by minimizing convexity).
for the same maturities.
FFC/DC = SFC/DC ×
c15.indd 317
 MDUR
1 + (i DC × Actual 360)
 allocations between one bond class and anotherwhere:
7 March 2018 3:52 PM
existed. A knock-out option ceases to exist when the exchange rate touches the barrier. • Zero-volatility
© 2018• Wiley Cash flow spread matching for multiple
(Z-spread) is the constant liabilities
spread over all the Treasury spot
AgeMent: An intRoduction
Similarly, we can use futures Tcontracts− MDUR to Padjust © 2018 Wiley • theVolatility
Think of a put option trade: long (short) straddle or strangle if
of the base currency with a barrier slightly below the strike price. rates at all maturities that forces equality between the bond’s price and the present
c15.indd 317
NP = bonds VP and short-term 1 + (i PCbonds),
× Actual or360to) adjust allocations between one equity class FFC/DC =Ifforward
7 March 2018 3:52 PM

• Portfolio hascash
cash flows matching the amount and
FPC/BC =SPC/BC
(e.g., long-term
×
MDUR S
rate forappreciates
base currency
volatility
domesticabove
expected
currency
to increase
in terms
the barrier, then oftheforeign
option nocurrency;
(decrease).
longer exists. same as “base
These
value of the bond’s flows.
and another (e.g., large-cap and1 small-cap + (i BC × Actual stocks, 360 )
the S&P 500 Index, and the Nasdaq-100 Index). exotics
currency are cheaper
in terms than ofregularly traded
price currency” options and offer less protection.
timing of liabilities.
Currency Management: An Introduction • Option-adjusted spread (OAS) is the spread over the treasury or the benchmark
• where
Uses of currency swap SFC/DC • Currency
=Exhibit
spot rate management
for domestic currency in tools
terms of foreign currency c10.indd 221
Using futures contracts,
MDURwe S iscan
the also gain exposure
modified duration to an
of asset
an class inrate
interest advanceswap, of and
actually 5‐1: Select Currency Management
iFC = interest rates in foreign currency country
7 March 2018 3:52 PM
Strategies • after incorporating
Duration the effects
matching forofmultiple
any embedded options in the bond.
liabilities
committing
Forward
where: NP • Exchange
funds
Convert to that
is the required Rates asset class.
loannotional Essentially
in oneprincipal currency we buy futures
into the
to change
contracts
a loanduration
on that
in another
of the
asset class
iDC =Forward
interestContracts
rates in domestic currency country Profit from market view
Over‐/under‐hedging
Economic • Surplus
Market value of assets is greater than or equal to the
FFC/DC = existing
forwardcurrency. rate for domestic currency in
portfolio duration MDURP to the target duration of MDURT . terms of foreign currency; same as “base
currency in terms of 1 +price
(i FC ×currency”
Actual
Option Contracts OTM options Cheaper than ATM market value of liabilities.
360 ) Forward Premium/DiscountRisk reversals
SFC/DC = spot • FFC/DC
Convert
rate=S forFC/DCdomestic×
foreign cash
1 + (icurrency
DC ×
Actual receipts
in terms
360 )
ofinto
foreign domestic
currency currency. Write options to earn premiums Economic Surplus = MVAssets − PVLiabilities
• Asset basis point value (BPV) equals the liability BPV.
iFC = interest rates in foreign currency country Exotic Options Put/call spreads Write options to earn premiums
using • = Uses
iDCSwaps to of equity 1+ swap
(i PC × Actual ) of Structured notes
FC − i DC ) ×
 (ispreads Actual
 options to earn premiums where: • Dispersion of cash flows and convexity of assets are
interest
FPC/BC =create
rates
SPC/BC inand×
domesticManage currency the360 Risk
country FFC/DC − SFC/DC = SFC/DC Seagull 360
Write
• Diversify a concentrated 1 + (i BC × Actual 360)portfolio.  1 + (i × Actual )  MVAssets =greater
market value than of those
assets of the liabilities.
© 2018 Wiley Knock‐in/out DC
features 360Reduced downside/upside exposure
PVLiabilities = present value of liabilities
Interest rate swaps can be used to create and manage leveraged floating-rate notes (leveraged
Forward• Premium/Discount
Achieve
floaters) and inverse floaters. international diversification. FPC/BC − SPC/BC = SPC/BC 
Digital  − i BC ) × Actual 360
(ioptions
PC 
Extreme payoff strategies • Derivatives overlay
where: Fixed income
Fixed income  1 + (i BC × Actual 360)  Derivatives Overlay
• Change asset allocation between stocks and bonds. • Uses bond futures contracts to immunize liabilities.
to FC − i DC )× 
FFC/DC = forward rate (iissue Actualof foreign
A for firmdomestic currency ain terms currency; sameprincipal
as “base of FPA digital option, which might also be called an “all‐or‐nothing” or binary option, earns a
•
7 March 2018 3:52 PM
Leveraged Ffloaters: − S = intends
S leveraged 360floater with a notional Minimum variance hedge ratio for a cross-hedge
• currency
and a floating Swaptions
FC/DC inFC/DC
rate of terms kL, where ofFC/DC
price  1 + (i × Actual ) 
k iscurrency”
the leverageDC factor
360 (e.g., 2.5) and L is the LIBOR rate. predetermined, fixed payout if the underlying reaches the strike price at any time during Liability portfolio BPV – Asset portfolio BPV
SFC/DCare
There = spot
• Fthree rate
Payer
for to
steps domestic
the process.
swaption:
currency in termsActual
holder has
of foreign currency
) × right  enter interest rate Lower liquidity
Domestic
Lower • Obtained
the Return
liquidity
life of with:
the
with:on Global
option. from a regression of change in value of
It Assets
does not have to cross the strike price, nor does it have to remain Nf =
 (i PC − icountry BC 360 to in‐the‐money until expiration to earn the payoff amount. This feature makes the option Futures BPV
iFC = interest rates in foreign currency
PC/BC − SPC/BC = SPC/BC   underlying asset in domestic currency terms against
DC =To
i1. swap
interest rates as fixed-rate
theingoal, domestic  1payer
currency+ (i × (in-the-money
BCcountry
Actual
into an 360
)  when interest • more
• TimeTime appropriate
since
RDC since
for
issuance
= (1 +issuance
currency speculation
(because
RFC )(1 + (because
RFX ) − 1 dealers
than
dealers have hedging.
have supply
supply right right after
after issuance,
issuance, but but buyers
buyers ofof Futures BPV ≈ BPVCTD
achieve the firm enters interest rate swap with a notional principal change in value of the hedging security.
of k(FP).ratesThe gofirm up).chooses to be the fixed rate (FS) payer and floating rate receiver. those bonds those bonds
= RFC may may hold
+ RFXhold them
+ Rthem to maturity).
FC RFXto maturity).
CF CTD
Forward
Domestic • Premium/Discount
The firm pays
Receiver
Return (FS)k(FP)
on Global swaption: Assets and receives
holder(L)k(FP), has right where FS is the
to enter fixed rate in the•
interest
• Lower• Beta
Lower credit
≈credit
(slope
quality.
RFC +quality.
RFX
coefficient) of the regression equation is
• Lower
Lower the acceptance
optimal ashedge
collateral in repo
ratio. repo market
market (sovereigns
(sovereigns are are more
more liquid
liquid than
than lower-
lower-
interest rate swap to make the interest rate swap have a zero value at swap initiation.
rate as fixed-rate receiver (in-the-money when interest
• acceptance
quality corporates).
corporates).
as collateral in where:• Contingent immunization
FS is the price of the swap. quality
2. The DCrates
FRFC/DC = (1S+go
firm−now
RFCdown).
FC/DC passes
RFX )−(i1FC − i DC ) ×
= S+FC/DC
)(1
through  1 the cash Actual
Actual
inflow from
360 
 the interest rate swap (L)k(FP) •
where: • Basis
• Smaller
Smaller issue
issue
risk sizeoccurs
size (becausedue
(because smaller
to imperfect
smaller issues will
issues will notnotcorrelation
be included
be included in inbetween
index/benchmark).
index/benchmark).
Nf = number of futures contract to immunize portfolio
• Active management if surplus (assets less liabilities) is
as interest = RFC + RFX +of
payments RFC the

RFX + (i DC × 360 ) 
leveraged floater with a notional principal of FP R and
DC a= returncurrency
in domesticprice currency movement
terms and hedging instrument. BPV = Basisabove point value
a designated threshold.
CTD = Cheapest to deliver
Currency
floating≈ rate R of
FPC/BC − SFCPC/BC FX
+R kL. Management
=S
 PC BC
(i − i ) × Actual
360 
Using exchange-traded
RFC = exchange-traded
Using return in foreign currency options
options (e.g., (e.g., futures and options on futures)
termsfutures and options on futures) may provide a more may provide a more
rateCF • If the surplus
and= Conversion factor falls below threshold, revert to a pure
3. Now the issuer may PC/BC sell aleveraged
1 + (i BC ×floater Actual with )  a notional principal of FP and

liquid
R
liquid
FXa = alternative. change
percentage
alternative. Using over-the-counter
Using over-the-counter
in S DC/FC (i.e., (OTC)-traded
foreign currency
(OTC)-traded instruments
in terms
instruments of (e.g., interest
domestic
(e.g., interest
currency)
rate and

FIXED INCOME PORTFOLIO

360
floating rate of kL and use the funds to buy a fixed-rate bond to (partly) offset credit
credit default swaps)
the default swaps) may may alsoalso helphelp reduce
reduce risk.risk. immunization strategy.
where:• fixed-rate
Domestic return on global asset (where FI exchange rate is
may purchase• Use gains on actively managed funds to reduce cost of
payments in the interest rate swap (FS)k(FP). FI The leveraged floater is Portfolio Return in Domestic Currency Terms
expressed ascurrency
SDC/FC ) terms
MANAGEMENT
RDC = return
Domestic in domestic
Return onengineered.
Global Assets Exchange-traded funds
Exchange-traded funds (ETFs)
(ETFs) may may provide
provide aa liquidliquid option.
option. Portfolio
Portfolio managers
managers may
successfully 108 © 2018 Wiley purchase meeting liabilities.
RFC = return in foreign currency terms ETF shares
ETF shares and and then redeemredeem them for for thethe underlying
underlying bonds bonds using using authorized
authorized participants
participants
RDC = then [ w1 × (1 + RFCthem 1 )(1 + RFX 1 ) + w 2 × (1 + RFC 2 )(1 + RFX 2 )] − 1
RFX = percentage
Inverse floaters:
RDC = A (1change
+firmRFCintends in+SRDC/FC
)(1 (i.e.,an
to issue
FX ) − 1
foreign
inverse currency
floater in withterms of domestic
a notional principalcurrency) (e.g.,
of(e.g.,
FP and qualified
qualified
a banks and
banks and other
other institutions)
institutions) as as intermediaries
intermediaries with with ETF ETF sponsors.
sponsors. • Horizon matching: cash flow matching for short-term
floating rate of=(bR– L), + Rwhere b isRa constant rate (e.g., 8%) and L is the LIBOR rate. ThereIntroduction are liabilities (< 5anyyears), duration matching for long-term
FX + RCurrency
r19.indd 108 12 August 2017 11:54 PM
Fixed-Income Returns Model © Wiley 2018 all rights reserved. unauthorized copying or distribution will constitute an infringement of copyright.
Portfolio
three steps• Portfolio
Return in
FCDomestic
to the process.
≈ RFC + RFX
return
FC FX
in domestic Terms currency terms where:
Fixed-Income Returns Model IntroductIon to FIxed-Income PortFolIo management
liabilities.
cuRRency
wn =MAnAgeMent:
weight ofAnasset intRoduction
in the portfolio
1. ToRachieveDC = [ w1the × (1goal,+ RFCthe 1 )(1 + RFX
firm 1) + w
enters 2 × an
into (1 +interest
RFC 2 )(1rate + RFX swap2 )] −with
1 a notionalPortfolio • Fixed-income expected returns returns model
principalmanagers use expected returns to position assets for risk and return properties • Interest rate swap overlay to reduce duration gap
Portfolio managers use to position assets for risk and return properties
desired for the
where: of FP. The firm chooses to be the fixed rate (FS) receiver and floating rate payer. desired The • the
for portfolio:
Expected
portfolio: return decomposition
Risk on Global
issuer Assets
pays in Domestic
and receives Currency
(FS)(FP), Terms
where is the fixed rate in the interest Liability portfolio BPV – Asset portfolio BPV
where:• Variance of the domestic return
RDC = return L(FP)
in domestic currency terms FS
NP = × 100
rate swap
RFC = return to make
in foreign the interest
currency terms rate swap have a zero value at swap initiation. FS is theE(R) E(R) ≈≈ Yield
Yield income
income Swap BPV
wn = weight
price of
ofasset
the in the portfolio
RFX σ2 (R
= percentage ) ≈swap.
DC changeσ 2 ( RinFCS)DC/FC
+ σ 2 ((i.e., + [2 × σcurrency
RFX )foreign ( RFC ) × σin( Rterms
FX ) × of
ρ( R
domestic
FC , RFX )]currency) ++ Roll
Roll down
down return
return
2. The firm now issues an inverse floater with a notional principal of FP and a floating
rate of (bin– Domestic
L). InterestCurrency
paymentTerms is (b – L)FP. Cash inflow from the interest rate swap ++ E(
E(∆ ∆ Price
Price due
due to
to yields
yields and
and spreads)
spreads) where:
• Factors
Portfolio
Roll Yield
Return favoring more currency hedging
−− E(Credit
E(Credit losses)
losses) • Risksprincipal
NP = Notional when of managing
the swap portfolio against a liability
28
• RDCSignificant
= [ w1 × (1 + Rshort-term objectives, e.g. income/liquidity © wiley 2018 All Rights
FC1 )(1 + RFX 1 ) + w 2 × (1 + RFC 2 )(1 + RFX 2 )] − 1
Reserved. Any unauthorized copying or distribution will constitute an infringement of copyright. structure: model risk, spread risk, counterparty credit
++ E(Currency
E(Currency gainsgains and
and losses)
losses)
Index Matching to a Fixed-Income Portfolio
requirements.
( F − SP / B ) © 2018 Wiley risk.
YRoll = P / B • noYield incomeincome,equals current yield assuming no
• Global fixed-income
SP / B investments. Assuming reinvestment yield income (aka current
Assuming no reinvestment income, yield income (aka current yield) is computed as: yield) is computed as:
where:
• All
Markets in with high currency
reinvestment income Index-Based Strategies
Active return = Portfolio return – Benchmark index return
= weight
w©n wiley 2018 ofRights
assetReserved.
the Anyportfolio
unauthorized copying or or assetwillvolatility.
distribution constitute an infringement of copyright. 7 March 2018 3:52 PM
Annual coupon payment
• Highabsolute
where || indicates value. Positive roll yield occurs when a trader buys base
risk aversion. Current yield
Current yield = = Annual coupon payment • Total return mandates
currency at a forward discount or sells it at a forward premium. Bond price
Bond price
• Doubt about value of currency return potential. • Pure indexing (full replication): match benchmark
• Variance
Lower possibility of regret if the hedge is not profitable.Rolldown return recognizes the value change as a bond approaches maturity (“pull to par”) weights and risk factors by owning all bonds in the
Rolldown• return
Minimum Hedge Rolldown return: value change asapproaches
bond approaches
recognizes the value change as a bond maturity (“pull to par”)
• Low costs of hedging. under an
under an assumption
assumption
maturityof zero
of zero rate
(pullrate volatility
tovolatility (i.e., unchanged
par) (i.e., unchanged yield
yield curve).
curve). index with the same weighting.
yt = α + βxt + εt
Rolling return = Yield income + Rolldown return
© wiley 2018 All Rights Reserved. Any unauthorized copying or distribution will constitute an infringement of copyright. Rolling return = Yield income + Rolldown return
where: Wiley © 2020
yt = percentage change in asset to be hedged Expected price
price change
change due
due to
to change
change in
in the
the yield
yield or
or spread
spread depends
depends onon the
the bond’s
bond’s modified
modified
xt = percentage change in hedging instrument Expected
duration and
duration and convexity,
convexity, or
or effective
effective duration
duration and
and convexity
convexity in
in the
the case
case of
of bonds
bonds with
with options:
options:
β = hedge ratio for minimum variance hedge
 Wiley’s CFA Program Exam Review
®

• Enhanced indexing: sampling approach to match conditions, market impact, execution risk and trade
primary risk factors; slight mismatch with benchmark benchmark
weights to achieve a higher return compared to full • Trading strategies include:
replication.
• Short-term alpha
• Active management: aggressive mismatches with • Long-term alpha
benchmark weights and primary risk factors to achieve • Using butterflies: long the wings (barbell) and short the
outperformance. body (bullet) if flattening curve, volatile interest rates,
• Risk rebalance trade
• Laddered bond portfolio buying convexity or parallel yield curve increase; short • Cash flow-driven trade
• Maturities and par values spread evenly along the yield the wings and long the body if steepening curve, stable • Trading algorithm classes include:
curve. interest rates or selling convexity. • scheduled execution algorithms based on percentage
• Protection from yield curve shifts and twists by • Using options: sell convexity bonds (30-year maturity) of volume, colume weighted average price or time
balancing the position between cash flow reinvestment and purchase call options to outperform in both rising weighted average price
and market price volatility. and falling rate scenarios. • liquidity seeking algorithms that execute trades quickly
• Suited to stable, upwardly sloped yield curve across all available venues
Credit Strategies
environments. • arrival price strategies which look to trade as closes
• Higher convexity and liquidity. • Risk considerations as possible to the market price at the time the order is
received
• High yield bonds: credit risk (includes default risk and
Yield Curve Strategies loss severity). • dark strategies that use dark pools to trade in low
liquidity or low urgency orders
• Stable yield curve strategies • Investment grade bonds: interest rate risk, credit
migration risk, spread risk. • smart order routers that find the best market price for
rategieS • Buy and hold: choose parts of curve where yield the order across venues
changes will not affect return or purchase longer- • Spread duration (measure of spread risk): percentage
increase in bond price for a 1% decrease in spread. • Implementaion shortfall (expanded):
duration/higher-yield securities.
Portfolio duration generally can be increased by reallocating cash (which has duration at • Credit spread measures
• Rolldown: riding the yield curve when yield curve
or close to zero) to duration assets, or by replacing shorter-duration securities with longer- is
upward-sloping.
duration securities. Decreasing duration involves selling securities for cash. If the manager
• G-spread: bond’s yield to maturity less interpolated
prefers to• continue yield of correct maturity benchmark bond.
Sellingholding certain securities,
convexity: however, the same
sell lower-yielding types of duration altering
higher-convexity Fixed-inCome aCtive management: Credit StrategieS
may be accomplished via derivatives.
bonds if expecting low interest rate volatility. • I-spread: uses swap rates rather government bond
altering •
yields.
Fixed-Income Active Management: Credit Strategies
Carry duration
portfolio trade: buy withlonger-maturity,
derivatives higher-yielding
• Z-spread: spread added to each yield-curve point so • Market-adjusted cost:
securities and finance them with shorter-maturity, Excess Return on Credit Securities
LoS 23d:lower-yielding
explain how derivatives may be used to implement yield curve that PV of bond’s cash flows equals price.
securities.
strategies. vol 4, pp 137–141 • Option-adjusted spread (OAS) for bonds with
• Changing yield curve strategies XR ≈ (s × t ) − ( ∆s × SD)
embedded options: spread added to one-period Fixed-inCome aCtive management: Credit StrategieS
• Durationportfolio
A derivatives-overlay management:
makes duration shorten
management(lengthen)
a separateduration if
decision from forward rates that sets arbitrage-free value equal to
expect
security selection andyield
can avoidincreases
the costly(decreases).
capital gain component present for a securities where: Fixed-Income Active Management: Credit Strategies
price Performance evaluation
sale. For this discussion, the overlay consists of puts and calls on bonds and interest rates = spread at the beginning of the measurement period
• Buying
futures (which are alsoconvexity: with falling
a form of derivative). yields,
Other types portfolios
of derivatives withstructured
include • Return
Excess
t = holding
Excess onreturn
period and expected
(i.e., fractional
Credit Securities portion ofexcess
the year)return on credit
greater
notes, interest-only convexity
strips (IOs) and will increase
principal-only more
strips (POs)inused
value than of MBS
for portfolios securities
SD = spread duration of the bond • Return attribution and risk attribution analyses the
portfolios mortgage
assets, and collateralized with less convexity;
obligations with rising
(i.e., securities basedyields,
on underlying MBS sources of return and risk respectively
assets). ExpectedXR ≈ (s ×Return
Excess t ) − ( ∆s on
× SD )
Credit Securities
portfolios with greater convexity will decrease less. Fixed income
• Macro and micro return attribution evaluates how
• Bullet
Fixed-income futuresand barbell
contracts may structures
be used to adjust duration without any cash outlay where: EXR ≈ (s × t ) – ( ∆s × SD) − (t × p × L ) decision of asset owners and portfolio managers
other than initial margin and the mark-to-market cash flows required to maintain margin.s = spread at the beginning of the measurement period respectively affect returns
Managers can findRelative
the correct Outperformance
number of futures Given Scenario
contracts to buy or sell as a function oft = holding period (i.e., fractional portion of the year)
the money duration or, more specifically, the price value of a basis point (PVBP). Recall where: • Bottom-up approach to credit strategy (security • Attribution analysis may be returns-based (most
Yield Curve Scenarios Structure SD = spread duration of the bond
that money duration is the currency change in portfolio market value for a 1% changepin= annual selection):
probability of for two issuers with similar credit risks,
default common - using total returns only), holdings-based
rates: Level change Parallel shift Barbell L = expected
Expected severity
purchase
Excess Returnof loss
bond with greater
on Credit Securitiesspread to benchmark rate. (using end of day data) or transactions-based (least
Slope change Flattening Barbell
• Top-down approach to credit strategy: macro approach common – using weights and returns of all transactions)
DModified Steepening Bullet
DMoney = VP × EXR ≈ (s × t ) – ( ∆sand × SDoverweight
) − (t × p × L ) sectors with better relative • Equity return attribution
100 to determine
Curvature change Less curvature Bullet
More curvature Barbell value. • Brinson-Hood-Beebower approach:
PVBP, then, is money duration divided by 100 yet again: where:• Managing liquidity risk
Volatility change Decreased volatility Bullet p = annual probability of default
DMoney increased
D volatility Barbell • Cash
L = expected severity of loss
PVBP = VP × = VP × Modified
• Duration management 100 10,000
methods • Liquid, non-benchmark bonds FI (higher incremental
Formulating a Portfolio Positioning Strategy for a Market View return vs cash). (Allocation effects – performance difference from the
• Buy (sell)
That information can thenbond be used futures
along withto desired
increase (decrease)
additional PVBP and duration.
PVBP of the
futures contract
Parallel to determine
Upward Shiftthe number of contracts to be purchased or sold:
• Credit default swaps index derivatives (more liquid benchmark due to allocation decisions – Note: The
than credit markets). Brinson-Fachler approach that is used for macro and
Bonds Additional
with forward impliedPVBPyield change greater than forecast yield change will enjoy • ETFs
higher (liquid but unpredictable price movements in micro attribution replaces Bi with [Bi – B])
# Contracts =
return in a magnitudeFutures based
PVBP on duration as they roll down the yield curve. volatile markets).
The leverage (i.e., value of bonds to be purchased to reach the desired additional PVBP) • Tail risk
Yield Curve StrategieS

can be found by the rTotal = Y0 − D1 (Y1 − Y0 )

formula: • Assess tail risk by modelling unusual return
• Use leverage to increase duration (Selection effects – performance difference from the
where
The portfolio duration subscripts
is then in effectindicate beginning
multiplied or end
by the ratio of of
thethe
newperiod.
notional value patterns and using scenario analysis (historical and
Additional PVBP benchmark due to manager selection decisions)
after adding =
the overlay
VLeveraged × 10,000 value so that the PVBP of the combined
to the original portfolio hypothetical).
portfolio is as desired: D of bonds
Modified
A portfolio facing no constraints can position to maximize rTotal. • Manage tail risk using (1) diversification strategies and
VEquity + VLeveraged (2) hedges using options and credit default swaps.
DNew = D
Parallel Old × Changes of Uncertain Direction
Yield
VEquity • Advantages of using structured financial securities such
Increase convexity by using a barbell strategy when a yield change is certain, but the direction
of the change is not. Current portfolio duration is maintained by weighting the best bonds at
as ABSs, MBS, CDOs and covered bonds (Interaction effects – performance difference from the
The leveraged value
either end is assumed to be funded by overnight loans, which would have
by: • Higher returns vs other types of bonds. benchmark due to manager selection decisions)
• Useto interest
duration equal 0 and therefore ratehaveswaps: receive-fixed,
no effect on the equation.pay-floating
© 2018 Wiley • Improved portfolio diversification. S + I = Full selection effect
swaps increase duration; pay-fixed, receive-floating
If the manager were
swaps
= ws Dto
DPunable
reduce s +find
wL Dbonds
duration.
L with the same duration, bonds of different • Different exposures to investment grade and high yield A + S + I = Portfolio excess return (alpha)
duration could be added. = wFor + (1 − ws )D
s Ds example, it would take twice as many bonds if the manager bonds.
• Convexity
used those with duration management
L
equal to half thatmethods
of the current portfolio, or half as many bonds if 17 August 2017 12:35 AM
• Factor-based return attribution
• Shift
we used those withwhere
duration
bonds theintwice that ofindicate
subscripts
portfolio the current portfolio.
duration
(difficult with Clearly,
forlarge
the theseP,alternatives
portfolio the short-maturity
portfolios).
TRADING, PERFORMANCE
have different outcomessecurity forS,transaction costs and curve
and the long-maturity risk. L.
security
• Buying callable bonds and MBS (equivalent to selling © Wiley 2018 all rights reserved. any unauthorized copying or distribution will constitute an infringement of copyright. 37
convexity).
Using leverage in portfolios with credit risk amplifies both credit and liquidity risk. The • Fixed-income return attribution
Using Butterflies
higher duration
• The
Portfolio
of the leveraged portfolio amplifies interest rate risk.
appropriate positioning
long positionstrategy
depends on whether the manager expects flattening (i.e., long
EVALUATION, AND • Exposure decomposition (duration based):
Although • notParallel
barbell) as liquid upward
or steepening
as futures, shift:
(i.e.,
swaps bonds
longcould
bullet),
alsowith
just itforward
beasused adjustimplied
istooutside
have the advantage of being created for any maturity rather than being limited to standard
change greater than forecast yield change
the yield
butterfly
duration. structure:
Swaps
will enjoy repo
MANAGER SELECTION Top down approach which compares portfolio duration
and returns to that of the benchmark in order to
maturities as• areLong theAwings
futures. futures (barbell
contractstructure) and shortto
can be compared thea long
bodybond/short
(bullet structure):
position, andhigher
leverage○ return
can as they
Flattening
be comparedcurvetoroll down
ora volatile
long the yield
interest
bond/short rates curve
financing (upward
position. Receive- TRADING STRATEGY AND EXECUTION understand which decisions (e.g. duration bets, sector
© Wiley 2018 all rights reserved. any unauthorized copying or distribution will constitute an infringement of copyright. 37
sloping).
fixed, pay-floating ○ Buying
swaps convexitytoinaexchange
are comparable for lower
long bond/short yield debt security
short-term allocation, bond selection) contribute to excess returns
position. ○
• Parallel yield change of uncertain direction: increase
Parallel yield curve increase • Yield curve decomposition (duration based)
• Trading strategy will be based on order characteristics,
Because a newconvexity by using
futures position or newbarbell strategy.
swap position is initiated at a value of 0, there security characteristics, market conditions, user-based Top down or bottom up approach that identifies
is an undefined duration for the position itself. Portfolio duration, however, will still be
relatively easy to calculate using money duration or PVBP effects on the portfolio’s equity
value. Wiley © 2020
© 2018 Wiley 237
Sizing the swap position resembles sizing a futures position, but will be scaled to
USD1,000,000 in the absence of any standard contract size (such as with the standard
 Wiley’s CFA Program Exam Review
®

contributions to total return from changes in yield

to maturity and which can be used to determine
• Appraisal ratio
Case Studies
success of yield curve decisions based on yield curve
components (e.g. yield, roll, shift, slope, curvature,
Where:
Institutional Investor: Illiquid
spread) Investments, Ethics and Derivatives
• Yield curve decomposition (full repricing)
Bottom up approach that reprices constituent bonds • Illiquidity premium is likely to be based on the illiquidity
from zero-coupon curves. horizon. It might be calculated by way of put option costs
• Risk attribution or premiums offered by low-liquidity equities
• Sortino ratio
• Bottom up approach will look at each position’s • Illiquidity risk management tools include:
contribution to tracking risk (relative) or total risk • Liquidity profiling – classifying assets based on their
(absolute) level of liquidity and investing in line with a liquidity
• Top down approach will look to attribute tracking budget
risk to allocation and selection effects (relative) or at • Rebalancing strategies – managing asset allocation
each factor’s contribution to total risk and specific risk and transaction costs involved with rebalancing
(absolute)
• Commitment strategies – managing capital calls
• Factor-based approach will look at each factor’s
contribution to tracking risk and active specific risk • Stress testing – assessing liquidity under market stress
(relative) or at each factor’s contribution to total risk • Derivatives – altering liquidity levels through use of
and specific risk (absolute) • Capture ratios highly liquid derivatives and associated leverage
• Asset-based benchmarks include absolute return • The manager selection process can raise ethical
benchmarks, broad market indices, style benchmarks, considerations between stakeholders (researcher,
factor-based benchmarks, returns-based benchmarks, portfolio manager, external managers, end investors, etc)
manager metrics and custom security-based including Standard IV(A) Conflicts of Interest; Standard
Where:
valuation benchmarks I(B) Independence and Objectivity, and Standard III(E)
valuation
• Alternative asset benchmark issues include the Preservation of Confidentiality
following: • The use of derivative overlays can raise important
risk-adjusted Performance
risk-adjusted Performance measures measures
• Hedge funds will often use the risk-free rate plus a considerations between overlay types (ETFs, futures,
The following are five risk-adjusted
The following are five risk-adjustedor
spread (absolute performance measures:
relative)measures:
to account for respective
performance and swaps) including trading costs, cash usage, liquidity,
1. ExEx poststrategy
post alpha risks
Investment Manager Selection monitoring, and counterparty risk
1. alpha
• Unlisted real estate and private equity indices will • Type I error: Hiring/retaining a manager with no skill
− rr ft == α
RRtt − α ++ ββ((RRMt −− rr ft)) ++ εεt
likely
ft include Mt assets
ft t that are not investable
Private Wealth Clients: Ethics a
• Explicit cost
valuation 2. •
TreynorCommoditymeasure investment benchmarking is not able to
2. Treynor measure
use market-weighting as futures values offset to zero • Measured • Illiquidity premium is likely to be based on the illiquidity
•
RA − rf
TA == RA − rf measures used in comparing portfolios
Appraisal • Obvious to investors horizon. It might be calculated by way of put option costs
T
risk-adjusted 
Performance measures
ββAA • Type II error: Not hiring/firing a manager with skill
A
include: or premiums offered by low-liquidity equities
3. •
The following
Sharpe
are
Sharpe
3. Sharpe ratio ratio
fiveratio
risk-adjusted performance measures: • Opportunity cost • Illiquidity risk management tools include:
1. Ex post alpha
RA − rf
• Seldom measured • Liquidity profiling – classifying assets based on their
ratio A = RA − rf
Sharpe ratio • Not obvious to investors level of liquidity and investing in line with a liquidity
Rt − r ft = α +Aβ=( RMtσ
Sharpe −Ar ) + ε
σ ft t
• Quantitative metrics used to evaluate managers include budget
A

4.
2.
4. • Treynor
M22
Treynor
M ratio
measure analysis of style (returns-based or holdings-based), • Rebalancing strategies – managing asset allocation
active share, up/down capture, and drawdowns and transaction costs involved with rebalancing
RA − rfRA − rf 
TMA22== rf +  RA − rf  σ

• Qualitative metrics used to evaluate managers include
M = rf β+  σ
A
σM
 AA  M
σ • Commitment strategies – managing capital calls
analysis of philosophy, personnel, decision-making
• Information
5. Information
3. Information
Sharpe ratio ratio
ratio ratio process (idea generation and implementation; portfolio • Stress testing – assessing liquidity under market stress
5.
construction and monitoring), operations (trading • Derivatives – altering liquidity levels through use of
IR RRAA −− RRBB= RA − rf
A = ratio
Sharpe process, firm characteristics), investment vehicle and highly liquid derivatives and associated leverage
IR A =   A
σσAA−−BB σA
terms, and fee structure
Note4.that 2 Ex post alpha and Treynor measure provide the same conclusion about manager
thatMthe
the
Note Ex post alpha and Treynor measure provide the same conclusion about manager
rankings because
rankings because they
they are
are based
based on on systematic
systematic risk.
risk. The
The Sharpe
Sharpe ratio
ratio and
and MM22 also
also provide
provide the
the
same conclusion
same conclusion about manager
 RAmanager
about rankings because
− rf  rankings because they
they are
are based
based on
on total
total risk.
risk.
2
M = rf +  
σM
 
Performance Evaluation  σA 
Evaluation
Performance
5. Information
Quality control chartsratio
control charts are one
one effective
effective and
and visual
visual means
means ofof presenting
presenting the
the performance
performance
Quality are

Wiley’s CFA Program Exam Review

of an
an investment
investment manager
manager over time. It uses statistical methods to systematically evaluate ®
of RA − RB over time. It uses statistical methods to systematically evaluate
performanceIR =
data
performance data σ and assist in making retention or removal decisions.
A and
A− B
assist in making retention or removal decisions.
Manager continuation policies
Manager policies (MCPs):
Note thatcontinuation
the Ex post alpha and(MCPs):
Treynor measure provide the same conclusion about manager
rankings because they arewith
based on systematic 2
• Retain
• conclusion managers
Retain managers investment
with investment skills.risk. The Sharpe ratio and M also provide the
skills.
same• Remove about manager
managers without rankings because
investment theyand
skills, aredobased on total
so before
before risk.
they produce negative
negative

The secret is out.

• Remove managers without investment skills, and do so they produce
results.
results.
Performance
• Evaluation
Minimize manager turnover.
• Minimize manager turnover.
• Include
• Include relevant
relevant nonperformance
nonperformance information
information in in the manager
manager review process.
process.
Quality control charts are one effective and visual meansthe of presentingreview
the performance
of an investment
Reduce the manager
following two over
errors:time. It uses statistical methods to systematically evaluate

Wiley’s materials
Reduce the following
performance data and two errors:
assist in making retention or removal decisions.
• Type
•
Manager
•
Type II error:
error: keeping
continuation
Type II error:
keeping (or
policies
firing
(or hiring)
(or
hiring) managers
(MCPs):
managers who
not hiring)
hiring) managers
who do
managers who
do not
who do
not have
have investment
do have
investment skills.
have investment
skills.
investment skills.
skills.
Sign up
• Type II error: firing (or not
CFA® EXAM REVIEW

for your
are a better
MORNING
SESSION

• Retain managers with investment skills.

• Remove managers without investment skills, and do so before they produce negative
results. ©2018
2018Wiley
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©
LEVEL II CFA
®

• Minimize manager turnover.

• Include relevant nonperformance information in the manager review process.
MOCK EXAM
today
7 March 2018 3:53 PM
7 March 2018 3:53 PM
Reduce the following two errors:

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

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