CFA 2024 Level III Module Videos Workbook Secured

Module Videos
Workbook
2024 Level III CFA®
00_CFA2024_L3_VideoWB_FM.indd 1 7/25/23 6:54 AM

2024 LEVEL III CFA® MODULE VIDEOS WORKBOOK
©2023 Kaplan, Inc. All rights reserved.
Published in 2023 by Kaplan, Inc.
10 9 8 7 6 5 4 3 2 1
These materials may not be copied without written permission from the author. The unauthor-
ized duplication of these notes is a violation of global copyright laws and the CFA Institute
Code of Ethics. Your assistance in pursuing potential violators of this law is greatly appreciated.
Required CFA Institute Disclaimer: “Kaplan Schweser is a CFA Institute Prep Provider. Only
CFA Institute Prep Providers are permitted to make use of CFA Institute copyrighted materials
which are the building blocks of the exam. We are also required to create / use updated materials
every year and this is validated by CFA Institute. Our products and services substantially cover
the relevant curriculum and exam and this is validated by CFA Institute. In our advertising,
any statement about the numbers of questions in our products and services relates to unique,
original, proprietary questions. CFA Institute Prep Providers are forbidden from including CFA
Institute official mock exam questions or any questions other than the end of reading questions
within their products and services.
CFA Institute does not endorse, promote, review or warrant the accuracy or quality of the prod-
uct and services offered by Kaplan Schweser. CFA Institute®, CFA® and “Chartered Financial
Analyst®” are trademarks owned by CFA Institute.”
Certain materials contained within this text are the copyrighted property of CFA Institute. The
following is the copyright disclosure for these materials: “© Copyright CFA Institute”.
Disclaimer: The Schweser study tools should be used in conjunction with the original read-
ings as set forth by CFA Institute. The information contained in these study tools covers topics
contained in the readings referenced by CFA Institute and is believed to be accurate. However,
their accuracy cannot be guaranteed nor is any warranty conveyed as to your ultimate exam suc-
cess. The authors of the referenced readings have not endorsed or sponsored these study tools.

Contents
Capital Market Expectations (Readings 1 and 2)............................................ 1
Asset Allocation (Readings 3–5)................................................................... 65
Derivatives and Currency Management (Readings 6–8).............................. 127
Fixed Income (Readings 9–12)................................................................... 255
Equity (Readings 13–16)............................................................................ 367
Alternative Investments (Readings 17 and 18)........................................... 423
Private Wealth Management, Institutional Investors (Readings 19–22)...... 463
rading, Performance Evaluation, and Manager Selection; and
T
Case Studies (Readings 23–28)..................................................................655
Ethical and Professional Standards (Readings 29–33)................................. 917
iii

Capital Market
Expectations
01_CFA2024_L3_VideoWB_R1-2.indd 1 7/25/23 6:54 AM

2 Capital Market Expectations
Fixed Income Investments
Capital Market Expectations

Capital Market Expectations, Part 1:
Framework and Macro Considerations

Part 1
Formulating Capital Market Expectations

1. Determine the capital market expectations (CME) that
are needed given the investor’s time horizon, allowable
asset classes, and other relevant factors.
2. Determine the historical performance and driving
factors of the asset classes.
3. Identify the valuation models and methods that will be
used.
4. Identify the best sources of data possible to make
better investment decisions.
© Kaplan, Inc. 2

Capital Market Expectations 3

Part 1
Formulating Capital Market Expectations (cont.)

5. Use experience and judgment to interpret current
investment conditions.
6. Formulate and document the necessary CME.
7. Monitor results and refine the process.
The focus is macroeconomics and beta research to
determine asset class expectations. Alpha research is used
to add value within an asset class.
© Kaplan, Inc. 3

Part 1

Forecasts should be as follows:
◼ Consistent
◼ Unbiased
◼ Objective
◼ Well supported
◼ Accurate, with minimal forecasting errors
© Kaplan, Inc. 4


Part 1
Challenges to Forecasting
Limitations in the economic data
◼ Data is available with time lags and is subject to
revision.
◼ Inconsistent data definitions and methodology
calculation methods change among sources.
◼ Indices are rebased (i.e., the base upon which they are
calculated can change).
© Kaplan, Inc. 5

Part 1
Challenges to Forecasting (cont.)

Data measurement errors and biases in the data
◼ Transcription errors—numbers are entered wrong
◼ Survivorship bias—overstating return and
understating risk
◼ Appraisal (smoothed) data for illiquid assets
© Kaplan, Inc. 6


Part 1
Smoothing Consequences
◼ Illiquid assets are infrequently traded and priced.
Price
Time
◼ Resulting analysis implicitly assumes a continuous price
change between the two pricing points.
◼ Risk calculations are understated, and correlation is closer to 0.
© Kaplan, Inc. 7

Part 1
◼ Ex post may understate ex ante risk
◼ Future can always be worse than the past—lower return
and higher risk
◼ Limitations of using historical-based estimates
◼ Future can be different from the past
◼ Can be subject to regime change when fundamental
driving factors change, leading to nonstationarity
(statistical characteristics differ by time period)
© Kaplan, Inc. 8


Part 1
Selecting the Time Period

◼ Longer time periods or more frequent observations (e.g., daily
rather than quarterly) increase the quantity of the data
point.
◼ Data may only exist for shorter time periods.
◼ Shorter periods are less likely to include regime changes.
◼ Use the longer periods unless (1) there is a reason to believe
fundamentals have changed, or (2) statistical analysis of
subperiods reveals nonstationarity.
© Kaplan, Inc. 9

Part 1
◼ Analyst biases
◼ Data mining—keep analyzing the data until a pattern
emerges, even if it is not real
◼ Time-period bias—relationship holds in one period but
not another
© Kaplan, Inc. 10


Part 1

◼ Failure to condition data
◼ Example—using past nominal return without regard to
change in the level of inflation
◼ Mistaking correlation for causation, does:
◼ A→B
◼ B→A
◼ C → A and B
© Kaplan, Inc. 11

Part 1

Psychological biases
◼ Anchoring bias
◼ Status quo bias
◼ Confirming evidence bias
◼ Overconfidence bias
◼ Prudence bias
◼ Availability bias
© Kaplan, Inc. 12


Part 1

Model risk
◼ Model uncertainty—selecting the wrong model
◼ Input uncertainty—using the wrong inputs
© Kaplan, Inc. 13

Part 1
Setting Capital Market Expectations

1. Statistical tools
2. Discounted cash flow models
3. Risk premium approach
4. Financial equilibrium models
5. Surveys, panels, and judgment
© Kaplan, Inc. 14


Part 1
The Trend Rate of Economic Growth

◼ Exogenous shocks are unanticipated events outside the
normal course of the economy; these events are not
predicted or built into current market prices.
◼ Exogeneous shocks be caused by several factors:
1. Changes in government policy—can encourage long-term
growth, including sound fiscal policy, minimal government
interference, and sound tax policy
© Kaplan, Inc. 15

Part 1
The Trend Rate of Economic Growth (cont.)

2. Political events—geopolitical tensions divert resources to
less productive uses, which may decrease growth
3. Technological progress—new, innovative technology has
potential to increase growth
4. Natural disasters—likely reduce short-term growth but
could encourage long-term growth if more efficient
capacity replaces previous capital
© Kaplan, Inc. 16


Part 1
The Trend Rate of Economic Growth (cont.)

5. Discovery of natural resources—new supply of natural
resources or more efficient production can increase
growth
6. Financial crisis—shocks to the financial system (i.e., 2007
and 2008) can lead to decrease in consumer confidence;
can also lead to reduction in economic output in the short
term and decrease the long-term trend rate of growth
© Kaplan, Inc. 17

Part 1
Pro-Growth Governmental Policies

◼ Minimal interference with free markets
◼ Support infrastructure and human capital development
◼ Promote competition, free trade, and capital flows
◼ Sound tax policy; lower and predictable
◼ Sound fiscal policy; countercyclical, but balanced over the
economic cycle
◼ Avoid the twin deficit problem
© Kaplan, Inc. 18


Part 1
Key Factors for Economic Growth Trends

◼ Forecasting returns with DCF models incorporates the
trend rate of growth and acts as an anchor for long-term
bond and equity returns.
◼ Higher trend growth rates may lead to higher stock returns.
◼ Higher trend growth means that the economy can grow at a
faster pace before inflation becomes a major concern.
◼ Higher trend growth rates generate higher bond yields.
© Kaplan, Inc. 19

Part 1
Forecasting the Economic Growth Rate

The following is a basic model for forecasting the economic
growth rate:
◼ Labor input, based on the growth in the labor force and
labor participation
◼ Capital per worker, which increases labor productivity
◼ Total factor productivity, reflected in technological progress
and changes in governmental policies
© Kaplan, Inc. 20


Part 1
Economic Forecasting: Econometrics

Quantitative models base on theoretical relationships.
Pros: Cons:
▪ Many variables can be ▪ Complex and time-consuming to
incorporated build
▪ Once specified, the ▪ Finding the data and stable
model can be reused relationships
▪ Output is quantified ▪ Output can be unreasonable
and internally ▪ Poor record forecasting recessions
consistent
© Kaplan, Inc. 21

Part 1
Economic Forecasting: Economic Indicators

Leading indicators turn before the economy, lagging after.
Pros: Cons:
▪ Simple and intuitive ▪ Poor record for predicting
▪ Uses readily available data turning points in the
economy
▪ Can be tailored to meet
needs
Note that stock prices are
▪ Supported by academic often used as a leading
research economic indicator.
© Kaplan, Inc. 22


Part 1
Economic Forecasting: Checklist

This is a list of factors the forecaster considers—essentially, a
series of questions to consider in forming conclusions.
Pros: Cons:
▪ Straightforward and ▪ Time-consuming
simple
▪ Subjective
▪ Flexible: mixes objective
▪ Relies on manual
statistical analysis with
interpretation of the
judgment regarding
information
changing relationships
© Kaplan, Inc. 23

Part 1
The Business Cycle and Growth

The slope represents the
Real GDP
trend rate of growth over

time.
There is variation around
Time the trend due to the
business cycle.
Additional shorter-term
variations can be caused
by the inventory cycle.
© Kaplan, Inc. 24


Part 1
The Business Cycle

◼ As mentioned, the trend rate of growth provides guidance
on setting long-term expectations.
◼ Fluctuations in economic growth over short to intermediate
time horizons are often associated with the business cycle.
◼ A fundamental reason why economic activity is cyclical is
the nature of business decisions.
◼ Decision makers allocate resources to their highest valued
uses, but can only do so with imperfect information.
© Kaplan, Inc. 25

Part 1
The Business Cycle (cont.)

It is important to form capital market expectations (CME), but
understanding the business cycle is difficult for various reasons:
◼ Business cycles vary in duration and intensity, and their
turning points are difficult to predict.
◼ It is difficult to tease out shorter-term factors that will affect
the longer-term trend rate of economic growth.
◼ Returns in capital markets are strongly related to activity in
the real economy, but they are also affected by investors’
attitudes toward risk and return. 26
© Kaplan, Inc.


Part 1
The Business Cycle and Growth

Inflection points when
Real GDP
growth turns from + to –

or – to +
An output gap with GDP
Time is below potential and
generally declining
An overheated economy with
inflation
GDP above potential and
generally increasing inflation
© Kaplan, Inc. 27

Part 1
The Business Cycle: Initial Recovery

The economy exits
Real GDP
recession; government
policy stimulative; improving
consumer confidence;
inflation initially declining
Time
◼ ST rates low or declining
◼ LT rates bottoming and bond prices peaking
◼ Stocks do well in anticipation of economic recovery
© Kaplan, Inc. 28


Part 1
The Business Cycle: Early Expansion

Economy grows faster than
Real GDP
trend and the output gap

shrinks; policy less stimulative;
increasing consumer
confidence; inflation low
◼ ST rates increasing
◼ LT rates bottoming or increasing; bond prices begin declining
◼ Stock prices increasing
© Kaplan, Inc. 29

Part 1
The Business Cycle: Late Expansion

GDP above trend but growth
Real GDP
slowing; policy becoming

restrictive; consumer
confidence excessive; inflation
increasing
◼ ST rates increasing
◼ LT rates increasing with bond prices declining
◼ Stock prices volatile and topping out
© Kaplan, Inc. 30


Part 1
The Business Cycle: Slowdown

GDP is still above trend but
Real GDP
growth rate is below trend and

turning negative; policy turning
neutral; consumer confidence
peaking; inflation still increasing
◼ ST rates peaking and then declining
◼ LT rates high and then declining; bond returns favorable
◼ Stock prices declining in anticipation of recession
© Kaplan, Inc. 31

Part 1
The Business Cycle: Recession/Contraction

Previously defined as two
Real GDP
consecutive quarters of negative

real growth; output gap increasing;
policy easing; consumer
confidence weak; inflation peaking
◼ ST and LT rates declining; bonds do well
◼ Stock prices generally turn up later in the recession
◼ Duration of 12–18 months
© Kaplan, Inc. 32


Part 1
Inflation Implications
◼ Inflation means too much money chasing after not enough
products; this results in generally rising prices.
◼ Inflation typically accelerates late in the business cycle.
◼ Disinflation means a deceleration in the inflation rate and
frequently occurs as an economy enters a recession.
◼ Deflation means generally falling prices.
© Kaplan, Inc. 33

Part 1
Quantitative Easing and Negative Inflation

◼ With negative inflation, interest rates decline to near zero,
and this limits the ability of central banks to lower interest
rates to stimulate the economy.
◼ Following the financial crisis of 2007–2009, and the very
low interest rates, several central banks attempted a new
monetary policy called quantitative easing (QE) to stimulate
the economy.
◼ QE was different because it was very large in scale, and
purchases by central banks included troubled MBS.
© Kaplan, Inc. 34


Part 1
Inflation Expectations and Asset Classes
© Kaplan, Inc. 35

Part 1
Inflation Expectations and Asset Classes (cont.)
© Kaplan, Inc. 36


Part 1
Government: Monetary Policy

◼ Increase/decrease the money supply to lower/increase ST
rates and stimulate/slow the economy.
◼ ST rates then affect LT rates.
◼ Deflation (generally declining prices) is a serious problem.
◼ May produce economic collapse—why buy anything?
Wait, and the price will fall.
◼ “Zero” interest rates—how do you stimulate the
economy from there?
© Kaplan, Inc. 37

Part 1
The Taylor Rule
◼ This can be used by central banks to implement

countercyclical monetary policy:
ntarget = rneutral + iexpected + [0.5(GDPexpected – GDPtrend) + 0.5(iexpected –

itarget)]
◼ This can be used as an active management tool to anticipate

changes in central bank policy and interest rates.
© Kaplan, Inc. 38


Part 1
The Taylor Rule: Example

Neutral rate 3.00%
Inflation target 2.00%
Expected Target nominal short-term rate:
4.00%
inflation 3 + 4 + [0.5(0 – 2) + 0.5(4 – 2) = 7%
GDP long-term
2.00%
trend
Expected GDP 0.00%
© Kaplan, Inc. 39

Part 1
Negative Interest Rates

◼ Negative interest rates were generally considered a
hypothetical curiosity before the 2007–2009 financial crisis.
◼ A negative rate is defined as a net payment made to keep
money on deposit at a financial institution or payment of a
net fee to invest in short-term investments.
◼ Consumers, investors, and businesses now have to believe
the risk of spending is worth it. Negative rates signal
uncertainty about the future.
© Kaplan, Inc. 40


Part 1
Negative Interest Rates (cont.)

Negative interest rates complicate the process of forming
capital market expectations (CME).
◼ The risk-free rate is the starting point for buildup models
used to estimate long-run returns for asset classes, and
throws off normal valuation methods.
◼ Analysts must now estimate when negative rates will
converge to a long-run sustainable risk-free rate.
© Kaplan, Inc. 41

Part 1
Negative Interest Rates (cont.)

◼ Some forecasting methods interpret negative risk-free rates
as being consistent with contraction or early recovery
stages of the business cycle.
◼ It is not generally possible to use historical data, as few
comparable periods exist—and the negative rates suggest
significant structural economic changes are occurring.
© Kaplan, Inc. 42


Part 1
Government: Fiscal Policy

◼ Another tool at the government’s disposal for managing the
economy is fiscal policy.
▪ Stimulate the economy—Congress can implement loose fiscal
policy by lowering taxes and/or increasing spending.
◼ If Congress wants to reign in growth, the government does the opposite to
implement fiscal tightening.
◼ It is the change in fiscal deficits that is believed to really matter.
◼ Only changes in the deficit directed by government policy will influence
growth, as deficits change naturally during cycles.
© Kaplan, Inc. 43

Part 1
The Yield Curve as an Economic Predictor

◼ Both fiscal and monetary policy are expansive.
◼ Yield curve is sharply upward sloping.
◼ The economy is likely to expand.
◼ Both fiscal and monetary policy are restrictive.
◼ Yield curve is downward sloping.
◼ The economy is likely to contract.
© Kaplan, Inc. 44


Part 1
The Yield Curve as an Economic Predictor (cont.)

◼ Monetary policy expansive, fiscal policy restrictive
◼ Yield curve mildly upward sloping
◼ Monetary policy restrictive, fiscal policy expansive
◼ Yield curve more or less flat
© Kaplan, Inc. 45

Part 1
International Considerations
◼ Business cycles tend to converge with globalization.
◼ Larger, more diversified economies are less affected.
Macroeconomic linkage—economies are linked by
international trade and capital flows. A recession in one
country causes the following:
◼ Imports decline, reducing exports from trading partners
◼ Investment spending in trading partners declines
© Kaplan, Inc. 46


Part 1
International Considerations (cont.)

◼ A useful relationship for understanding how the current
account influences economic activity is the following
formula:
net exports = net private saving + government surplus
© Kaplan, Inc. 47

Part 1

Interest rate/currency linkages
◼ Countries that peg their currency value must generally follow
the economic policies of the country to which they peg.
◼ Pegging country interest rates typically exceed those of the
country to which they peg.
◼ The interest rate differential fluctuates with the market’s
degree of confidence in the peg.
© Kaplan, Inc. 48


Part 1

◼ In the absence of currency pegs, the following occur:
◼ If a currency is perceived as overvalued and expected to
decline, interest rates will be higher to compensate
investors for the expected decline.
◼ Relative nominal and real bond yields are increased by
strong economic activity.
◼ The theory that real rates converge is not well
supported.
© Kaplan, Inc. 49


Capital Market Expectations, Part 2:
Forecasting Asset Class Returns

Part 2
Forecasting Capital Market Expectations (CME)

▪ Forecasting returns requires not only assessing expected
returns, variances, and correlations, but also understanding
that time horizons are important.
There are three approaches to forecasting CME:
1. Surveys
2. Judgments
3. Formal tools
© Kaplan, Inc. 2


Part 2
Surveys and Judgment

▪ CME can be formed using surveys, which can be the most
useful ways to gauge consensus.
▪ Judgment can also be applied to project CME by using
qualitative information based on experience.
▪ Although quantitative models provide objective
numerical forecasts, there are times when an analyst
must adjust those expectations using experience and
insight.
© Kaplan, Inc. 3

Part 2
Formal Tools
Statistical methods
▪ Using sample statistics—sample mean, variance, and
correlations
▪ Applying a shrinkage estimate to historical data—take
weighted average (e.g., 60% of historical return and 40% of
a model estimated return)
▪ Applying time series analysis—based on lagged values of
the variable being forecast and selected other lagged
variables
© Kaplan, Inc. 4


Part 2
Formal Tools (cont.)

▪ Discounted cash flow (DCF)
▪ Gordon growth model (DDM) at Level II and
Grinold-Kroner model at Level III
▪ Risk premium model
▪ Can be used for both equities and fixed income
▪ Starts with risk-free rate and then adds compensation
for risks (i.e., CAPM, factor model, building blocks)
© Kaplan, Inc. 5

Part 2
Forecasting Fixed-Income Returns

Forecasting fixed-income returns can be done through the
following:
▪ Discounted cash flow (DCF) method
▪ Risk premium (building block) approach
© Kaplan, Inc. 6


Part 2
DCF Analysis
◼ For bonds, use yield to maturity (YTM).
◼ YTM is an IRR, which implicitly assumes the
reinvestment rate on all cash flows is at the initial IRR.
◼ Reinvest at a rate higher/lower than the initial YTM and
the return will be higher/lower than that YTM.
For the exam, remember that the Macaulay duration can
be calculated by multiplying modified duration by the
bond’s YTM.
© Kaplan, Inc. 7

Part 2
Risk Premium (Building Block) Approach

◼ The building block approach starts with a risk-free rate and
then adds compensation for additional risks.
◼ The required return will include the one-period
default-free rate, a term premium, a credit premium,
and a liquidity premium.
© Kaplan, Inc. 8


Part 2
Risk Premium (Building Block) Approach (cont.)

1. Short-term default-free rate
◼ The short-term default-free rate matches the forecast
horizon and uses the most liquid asset.
◼ As a result, it is the closest to the government
zero-coupon yield, and is closely tied to the central
bank policy rate.
© Kaplan, Inc. 9

Part 2

2. Term premium
◼ Rates implied from the spot yield curve give us useful
information about the term premium.
◼ The real term premium cannot be derived from the
yield curve alone. It is driven by the following: inflation
uncertainty, recession hedge, supply and demand,
and business cycles.
© Kaplan, Inc. 10


Part 2

3. Credit premium
◼ Compensates for the expected level of losses and for
the risk of default losses, both of which are components
of the credit spread
◼ Yield spread is typically not a good predictor of future
default rates because premiums earned tend to be
uneven and subject to significant clustering of persistent
high and low spreads
© Kaplan, Inc. 11

Part 2

4. Liquidity premium
Generally, liquidity is higher for bonds that are as
follows:
◼ Newly issued at close-to-par or market rates
◼ Large in size and issued by a well-known issuer
◼ Simple in structure and of high credit quality
© Kaplan, Inc. 12


Part 2
Emerging Market Bond Risk

▪ They offer higher return and risk as they “catch up.”
▪ Many emerging countries are dependent on foreign
borrowing, which can later create crisis situations in their
economy, currency, and financial markets.
▪ Many emerging countries have unstable political and social
systems.
© Kaplan, Inc. 12

Part 2
Emerging Market Economies

▪ Key issues and warning signs:
1. Irresponsible fiscal and monetary policies
Government deficit/GDP ratio > 4%
2. Insufficient real economic growth to satisfy the
expectations of the population
Growth < 4%
© Kaplan, Inc. 13


Part 2
Emerging Market Economies (cont.)

3. An overvalued currency supporting a twin deficit problem
financed by foreign borrowing (a budget and current
account deficit)
Current account deficit > 4% of GDP
4. Excessive foreign-denominated debt
Foreign debt/GDP ratio > 50%
© Kaplan, Inc. 14

Part 2
Emerging Market Economies (cont.)

5. Inadequate short-term liquidity to service foreign debt
Foreign currency reserves/ST foreign currency debt
ratio < 100%
6. Risky political situation
Policies not supportive of growth
© Kaplan, Inc. 15


Part 2
Forecasting Equity Returns

▪ When looking at a very long time horizon—over 100 years—
mean real returns of equity markets in various countries do
not show statistically meaningful differences.
▪ Sample averages tend to be imprecise, unless the volatility
of the data is small.
▪ Shrinkage estimators are typically more reliable as
predictors of equity returns.
© Kaplan, Inc. 16

Part 2
Discounted Cash Flow Approach (DCF)

▪ A tool for setting CME is DCF models.
▪ These models calculate the intrinsic value of an asset as
the PV of future cash flows.
▪ Any DCF model (from Level II) can be adapted to project
return.
▪ The most common application of DCF models is the
Gordon growth model, or constant growth model.
© Kaplan, Inc. 17


Part 2
Forecasting Equity Returns

▪ Grinold-Kroner is a key model on the exam, and it is an
adaptation of the Gordon growth DCF model:
where:
◼ E(Re) = expected equity return
◼ D/P = dividend yield
◼ %ΔE = expected percentage change in total earnings
◼ %ΔS = expected percentage change in shares outstanding
(share repurchases)
◼ %ΔP/E = expected percentage change in the P/E ratio
© Kaplan, Inc. 18

Part 2
Grinold-Kroner Model
▪ The model can be regrouped into three components:
▪ The expected cash flow return (income return):
D/P – %ΔS = income return
▪ The expected nominal earnings growth is the real growth
in earnings plus expected inflation: %ΔE
▪ The expected repricing return is the expected

change in the P/E ratio: %ΔP/E
E(Re) ≈ (D/P − %ΔS) + (%ΔE) + (%ΔP/E)

© Kaplan, Inc. 19


Part 2
The Risk Premium Approach

◼ The equity risk premium is generally defined as the amount
by which the equity return exceeds the risk-free rate.
◼ Alternatively, the equity risk premium is the amount by
which the equity return exceeds the expected return on a
default-free bond.
◼ The approach relative to the risk-free rate looks at a single
premium for equity; the approach relative to bonds uses a
building block approach.
© Kaplan, Inc. 21

Part 2
The Risk Premium Approach—Forecasting

◼ Forecasting the equity premium is quite challenging,
regardless of the approach selected.
◼ An analyst must therefore supplement her forecasts with
other methods of analysis.
© Kaplan, Inc. 22


Part 2
The Equilibrium Approach

◼ The financial equilibrium approach assumes that financial
models will value securities correctly.
◼ The Singer-Terhaar model is based on two versions of the
international capital asset pricing model (CAPM):
1. One in which global asset markets are fully integrated
2. One in which markets are fully segmented
◼ The model then looks at the expectations of actual
segmentation/integration and takes a weighted average.
© Kaplan, Inc. 23

Part 2
Financial Equilibrium Approach

◼ Estimate the equity risk premium for a market using its
correlation with the global portfolio, its standard deviation,
and the Sharpe ratio for the global portfolio.
◼ Rearranging the CAPM, we arrive at the expression for the
risk premium for asset i, RPi:
 RP 
RPi = ρi,Mσi  M 
 σM 
© Kaplan, Inc. 24


Part 2
Financial Equilibrium Approach (cont.)

 RP 
RPi = ρi,Mσ i  M 
 σM 
RPi = equity risk premium for market i
ρi,M = correlation (market i, global market)
σi = standard deviation of market i
RPM
= Sharpe ratio for global market
σM
© Kaplan, Inc. 25

Part 2
The Equilibrium Approach

◼ The Singer-Terhaar model then adjusts the CAPM for
market imperfections, such as segmentation.
◼ When markets are segmented, capital does not flow freely
across borders (opposite is integrated markets, where
capital flows freely).
◼ Government restrictions on investing are a frequent cause
of market segmentation, and they increase the risk
premium for securities in segmented markets.
© Kaplan, Inc. 26


Part 2
The Equilibrium Approach (cont.)

◼ In reality, most markets are neither fully segmented nor
fully integrated.
◼ Investors tend to have a home bias for equities that
prevents them from fully exploiting investment
opportunities overseas.
◼ Developed world equity markets—75%–90% integrated
◼ Emerging market equity markets—50%–75% integrated
© Kaplan, Inc. 27

Part 2
The Equilibrium Approach (cont.)

◼ Under the full segmentation assumption, the relevant
global portfolio is the individual asset as its own market
portfolio.
◼ This means that the asset is perfectly correlated with itself:
(βi,M = ρi,M = 1)
© Kaplan, Inc. 28


Part 2
Financial Equilibrium Approach
◼ Calculate the risk premium for asset i assuming a fully

segmented market:
if ρi,M = 1 → RPiS= σi (RPiS / σi)
© Kaplan, Inc. 29

Part 2
Financial Equilibrium Approach (cont.)

◼ Finally, take a weighted average of the two risk premiums
(calculated under full integration and full segmentation) to
calculate the asset’s risk premium:
RP = ФRPG + (1 – Ф) RPS
◼ This is where Ф measures the degree of the asset’s
integration with the global markets, and the superscripts
are G (globally integrated) and S (segmented).
© Kaplan, Inc. 30


Part 2
Singer-Terhaar Model Example

◼ Suppose an analyst is valuing two equity markets:
◼ Market A—developed market
◼ Market B—emerging market
◼ Investor’s time horizon is five years
◼ Calculate the risk premiums and expected returns for each
market.
© Kaplan, Inc. 31

Part 2
Calculate Risk Premium—Singer-Terhaar Model

Sharpe Ratio of the Global Market = .29 Market A Market B
Sharpe ratio 0.29 0.40
Volatility (standard deviation) 17% 28%

Correlation with global market 0.82 0.63
Degree of integration 80% 65%
Illiquidity premium 0% 2.3%
Risk-free rate = 5%
© Kaplan, Inc. 32


Part 2
Step 1
◼ Calculate the risk premium for both markets assuming full
integration.
◼ Note that for the emerging market, the illiquidity risk
premium is included.
◼ RPi = ρi,Mσi (market Sharpe ratio)
◼ RPA = (0.82)(0.17)(0.29) = 4.04%
◼ RPB = (0.63)(0.28)(0.29) + 0.0230 = 7.42%
© Kaplan, Inc. 33

Part 2
Step 2
◼ Next, we calculate the equity risk premium for both markets
assuming full segmentation.
◼ Rpi = σi (market Sharpe ratio)
◼ RPA = (0.17)(0.29) = 4.93%
◼ RPB = (0.28)(0.40) + 0.0230 = 13.50%
◼ Note that under full segmentation, the correlation between
the local market and itself is 1.0.
© Kaplan, Inc. 34


Part 2
Step 3
◼ We then take a weighted average of the integrated and
segmented risk premiums by the degree of integration and
segmentation in each market to arrive at the weighted
average risk premium.
© Kaplan, Inc. 35

Part 2
Step 3 (cont.)
◼ RPi = (degree of integration of i)(ERP assuming full
integration) + (degree of segmentation of i)(ERP
assuming full segmentation)
◼ RPA = (0.80)(0.0404) + (1 – .80)(0.0493) = 4.22%
◼ RPB = (0.65)(0.0742) + (1 – 0.65)(0.1350) = 9.55%
© Kaplan, Inc. 36


Part 2
Final Step
◼ Finally, the expected return in each market also

incorporates the risk-free rate:
◼ RA= 5% + 4.22% = 9.22%
◼ RB = 5% + 9.55% = 14.55%
© Kaplan, Inc. 37

Part 2
Emerging Market Equity Risk

Emerging markets (EM) are often characterized as follows:
◼ Fragile economies
◼ Political and policy instability
◼ Weak property rights
◼ Weak disclosure and enforcement standards
◼ Tend to exhibit idiosyncratic risks
◼ Tend to be less fully integrated than developed markets
© Kaplan, Inc. 38


Part 2
Forecasting Real Estate (RE) Returns

▪ Unlike traditional asset classes (i.e., stocks, bonds, cash),
RE is generally immobile and illiquid, and each property is
part of a heterogeneous group with unique characteristics.
▪ Managing RE also requires maintenance and operating
costs, which can be significant.
▪ Calculating returns often involves appraisals, which are
subject to time lags and data smoothing problems.
© Kaplan, Inc. 39

Part 2
Forecasting Real Estate (RE) Returns (cont.)

When looking at RE and business cycles, we observe the
following characteristics:
▪ Boom—Increased demand will drive up property and lease
rates, which induces construction activity and stronger
economic activity.
▪ Bust—Falling demand leads to overcapacity and
overbuilding, driving values and lease rates down, which
weakens economic activity.
© Kaplan, Inc. 40


Part 2
Capitalization (Cap) Rates

The capitalization rate (cap rate) is a commercial RE
property’s earnings yield calculated by dividing current net
operating income (NOI) by the property value.
▪ During infinite time periods, the cap rate can be calculated
as follows:
cap rate = E(Rre) – NOI growth rate
E(Rre) = cap rate + NOI growth rate
© Kaplan, Inc. 41

Part 2
Capitalization (Cap) Rates (cont.)

▪ During stable periods, the long-run NOI growth rate should
be similar to GDP growth. This is if an investor has a finite
time period:
E(Rre) = cap rate + NOI growth rate – %∆cap rate
▪ Similar to the expected return net of growth rate for
equities, the cap rate is used as a long-term discount rate
for RE properties and is positively related to interest rates
and vacancy rates.
© Kaplan, Inc. 42


Part 2
Risk Premiums on Commercial RE

RE assets require several risk premiums to compensate for
their higher risk:
▪ A term premium for holding long-term assets
▪ A credit premium to compensate for the risk of tenant
nonpayment
▪ An equity risk premium above corporate bonds for the
fluctuations in RE values, leases, and vacancies
▪ A liquidity premium estimated to be 2%–4%
© Kaplan, Inc. 43

Part 2
Public vs. Private RE

Wealthy individuals and institutional investors can create
diversified RE portfolios.
▪ Investors with less wealth can choose between publicly
traded RE, including REITs, for diversification.
▪ REITs are highly correlated with equities in the short term,
while direct RE shows low correlation (appraisal data).
▪ Long-term, REITs have a high correlation with direct RE.
© Kaplan, Inc. 44


Part 2
Residential RE Returns
Residential RE is the largest class of developed properties,
accounting for 75% of global values.
▪ Overall, residential RE outperformed equities on an
inflation-adjusted basis with lower volatility.
▪ Residential RE had comparably weaker returns during
1980–2015.
▪ Residential RE returns were uncorrelated across countries
after WWII, while equity returns showed rising correlations.
© Kaplan, Inc. 45

Part 2
Exchange Rate Forecasting

Currency exchange rate forecasting is particularly complex,
causing the portfolio manager to either fully hedge currency
exposure or accept the volatility. Trade in goods and services
affects exchange through the following:
1. Trade flows
2. Purchasing power parity (PPP)
3. Competitiveness and sustainability of the current
account
© Kaplan, Inc. 46


Part 2
Exchange Rate Forecasting (cont.)

Exchange rates are determined by factors influenced by the
following:
▪ Trading
▪ Governments, financial systems, and laws
▪ Regulations
▪ Country customs
© Kaplan, Inc. 47

Part 2

1. Trade flows—impact of net trade flows (gross trade flows
less exports) tends to be relatively small on exchange
rates assuming they can be financed
2. Purchasing power parity (PPP)—implies that the prices of
goods and services in different countries should reflect
changes in exchange rates and follow the expected
inflation rate differentials among countries
© Kaplan, Inc. 48


Part 2

▪ PPP doesn’t work well in predicting short-term
exchange rates, but it is a more accurate predictor in
the long term.
▪ Actual real exchange rates may differ from those predicted
through PPP (i.e., due to trade barriers or certain goods
may be restricted from trading).
▪ PPP also does not account for capital flows, which may
exert significant influence on exchange rates.
© Kaplan, Inc. 49

Part 2

▪ With current account and exchange rates, when restrictions
are placed on capital flows, exchange rate sensitivity tends
to increase relative to the current account (trade) balance.
▪ Research has found that it is not the size of the current
account balance that matters as much as the length of the
imbalance.
© Kaplan, Inc. 50


Part 2

Structural imbalances in the current account can exist from
the following:
1. Fiscal imbalances that persist over time
2. Demographics and trade preferences
3. The scarcity or abundance of resources
4. Viable investment opportunity availability
5. The terms of trade
© Kaplan, Inc. 51

Part 2
Capital Flow Impacts on Exchange Rates

1. Capital mobility—The expected percentage change in the
exchange rate is the difference between nominal short-term
interest rates and the risk premiums of the domestic
portfolio over the foreign portfolio.
▪ When there is a relative improvement in investment
opportunities in a country, the currency initially tends to
see significant appreciation but “overshoots.”
© Kaplan, Inc. 52


Part 2
Capital Flow Impacts on Exchange Rates (cont.)

1. Capital mobility (cont.):
▪ The exchange rate will initially significantly appreciate.
▪ Following an extended level of stronger exchange rates in
the intermediate term, investors will start to expect a
reversal.
▪ The exchange rate in the long run will tend to start
reverting once the investment opportunities have been
realized.
© Kaplan, Inc. 53

Part 2

2. Uncovered interest rate parity (UIP)—UIP states that
exchange rate changes should equal differences in nominal
interest rates.
▪ In contrast to UIP, carry trades involve borrowing in a
low-rate currency and lending in a high-rate currency.
▪ Carry trades are considered to be successful because
they include a risk premium, confirming the validity of the
risk premiums in the equation.
© Kaplan, Inc. 54


Part 2

3. Portfolio balance and composition:
Strong economic growth in a country tends to correspond
to an increasing share of that country’s currency in the
global market.
▪ Investors tend to have a strong home bias, which leads
them to absorb a larger share of new assets.
▪ Countries that experience high trend rates tend to be
smaller, emerging markets.
© Kaplan, Inc. 55

Part 2

3. Portfolio balance and composition (cont.):
Large current account deficits also weaken exchange rates,
but several mitigating factors exist:
▪ Current account deficits due to large investment spending
are easier to finance if thought to be profitable
▪ Small current account deficits in global reserve currencies
help provide global liquidity and are beneficial
© Kaplan, Inc. 56


Part 2
Volatility Forecasting
▪ Estimating the variance for a single asset is relatively easy.
▪ However, estimating variances for a portfolio with many
assets is much more complex and requires the use of a
variance-covariance (VCV) matrix or other forecasting
tools.
© Kaplan, Inc. 57

Part 2
Volatility Forecasting (cont.)

▪ There are a large number of formulas in the CFA Institute
reading for this section; some can be very complex.
▪ They are included in the SchweserNotes™ to help
explain the underlying concepts.
▪ However, it is unlikely that you would be required to do
these calculations on the exam since the LOS only asks
you to do the following:
▪ Discuss methods of forecasting volatility.
© Kaplan, Inc. 58


Part 2
Sample VCV Matrix

▪ Estimating a constant VCV matrix can be done from
deriving variances and covariances from sample statistics.
▪ However, choosing the appropriate sample size for large
portfolios is imperative to avoid meaningless outcomes
(e.g., the VCV matrix may show that a large portfolio is
riskless).
▪ It is recommended that the number of observations
should be at least 10 times larger than the number of
assets.
© Kaplan, Inc. 59

Part 2
Factor-Based VCV Matrices

▪ Using multifactor models for VCV matrices significantly
reduces the number of needed observations.
▪ Correlations can be estimated from a few common factors,
while variances require factors related to specific assets.
© Kaplan, Inc. 60


Part 2
Factor-Based VCV Matrices (cont.)

▪ A VCV matrix needs (N(N – 1) / 2) covariances.
▪ A factor model would only need (N × K) factor sensitivities
and (K(K + 1) / 2) factor elements.
For N = 50 and K = 6:
▪ VCV matrix would need (50(49) / 2) = 1,225 sensitivities
▪ Factor model would need only (50 × 6) = 300 sensitivities
and (6(7) / 2) = 21 elements
© Kaplan, Inc. 61

Part 2
Factor-Based VCV Matrices Weaknesses

▪ The matrix is biased and is not a good predictor of the true
returns. Matrix inputs need to be estimated and will be
misspecified.
▪ The matrix is inconsistent, as the sample size increases in
the factor-based VCV matrix; the model does not converge
to the true matrix.
▪ In contrast, the sample VCV matrix will be both
consistent and unbiased.
© Kaplan, Inc. 62


Part 2
Shrinkage Estimates
▪ Combining information in the sample VCV matrix with a
target matrix (i.e., factor-based VCV matrix) can result in
more precise data and reduced estimation error.
▪ If conditions selected by the analyst for both the model and
weights are well chosen, the shrinkage estimate
covariances are likely to be more accurate.
© Kaplan, Inc. 63

Part 2
Shrinkage Estimates (cont.)

Suppose that the sample covariance between two assets is
180 and the target (from a factor-based model) estimated
covariance is 220.
▪ The analyst weights the historical covariance by 60% and
the target by 40%.
▪ The shrinkage estimate would be 196 (= 180 × 0.60 + 220
× 0.40).
© Kaplan, Inc. 64


Part 2
Smoothed Returns to Estimate Volatility

▪ Smoothing of data can lead to underestimating risk and
overstating returns (overstate diversification benefits).
▪ However, not adjusting for smoothing can lead to distorted
investment analysis and suboptimal portfolios.
▪ It is recommended that the analyst adjust the data for the
impact of smoothing by taking a weighted average of the
current “true” returns and previously observed returns.
© Kaplan, Inc. 65

Part 2
Smoothed Returns to Estimate Volatility (cont.)
Rt = (1 – λ)r1 + λRt–1 where λ is a weight between 0 and 1

The portfolio variance is then calculated as:
var(r) = (1 + λ) / (1– λ) var(R) > var(R)
▪ The true current return is not directly observable and can
be estimated using common asset indices.
© Kaplan, Inc. 66


Part 2
ARCH Models
▪ Historically, asset returns show periods of high and low
volatilities, leading to volatility clustering.
▪ These volatilities can be modified through autoregressive
conditional heteroskedasticity (ARCH) models.
▪ ARCH models can be used for large portfolios in VCV
matrix estimations.
© Kaplan, Inc. 67

Part 2
Global Portfolio Adjustments

◼ In this section, candidates apply what they have learned and
make adjustments to portfolio allocations.
◼ It is recommended that candidates focus on the big picture
and not get “bogged down” in the minute details of the case.
◼ Candidates must use the taught material from the CFA
Institute curriculum to make asset allocation decisions,
not what they have learned from their practitioner
experience.
© Kaplan, Inc. 68


Part 2
Global Portfolio Adjustments (cont.)

It is recommended that candidates keep in mind the
following questions when making asset allocation
decisions:
1. Have the drivers of trend growth changed significantly?
2. Are markets becoming more or less integrated?
3. Where is the country positioned within the business cycle,
and are fiscal and monetary policies consistent with the
current phase of the business cycle?
© Kaplan, Inc. 69

Part 2

4. What is the trend in current account balances?
5. Are currencies strong or weak, and how are currencies
affecting economic growth and competitiveness?
© Kaplan, Inc. 70


Part 2

There are a few things to remember:
▪ Trend growth is thought to be more beneficial to equities
since it focuses on long-term earnings growth.
▪ Trend growth is unfavorable to bonds because it typically
results in higher interest rates.
▪ Analysts can use country-specific and CME expectations
through VCV matrices to allocate between equities and
bonds.
© Kaplan, Inc. 71

Part 2

▪ As markets become more globally integrated, required
returns will decrease (Singer-Terhaar).
▪ Analysts should increase allocations to emerging markets
that are expected to become more integrated and move
away from those markets that are already integrated.
© Kaplan, Inc. 72


Part 2

▪ When the economy is at the trough of the business cycle,
equities perform well and valuation ratios and earnings
growth are expected to increase.
▪ At this stage, the yield curve is steep with high credit and
term premiums.
▪ However, the expectation of rising interest rates means that
bonds tend to underperform; the analyst should reduce the
allocation to bonds.
© Kaplan, Inc. 73

Part 2

▪ Understanding monetary and fiscal policy changes should
be considered by the analyst.
▪ However, the analyst should not focus on changes
already reflected in current asset prices, but instead,
focus on any fundamental structural changes (i.e.,
quantitative easing).
▪ Also, changes in tax code or central bank goals can also
influence the appropriate asset allocation.
© Kaplan, Inc. 74


Part 2

▪ Current account balances tend to fluctuate with the
business cycle.
▪ Analysts should focus on the long-term trend in current
account balances when forming CME.
▪ Rising current account balances tend to be associated with
rising required returns and increased capital flows.
▪ Capital flows also can influence currencies.
© Kaplan, Inc. 75

Asset Allocation

66 Asset Allocation
Asset Allocation
Overview of Asset Allocation
Warm-Up
Capital market expectations: Client IPS:
▪ Expected return, E(R) ▪ Objectives and
▪ Standard deviation, σ constraints
▪ Correlation, ρ
SAA: Based on TAA: Seeks to add

long-term capital value based on
market expectations shorter-term views
© Kaplan, Inc. Investment governance 2

Asset Allocation 67
Investment Governance Elements

Most models share six elements:
▪ Establish long-term and short-term objectives.
▪ Allocate rights and responsibilities.
▪ Specify processes for creating an IPS.
▪ Specify processes for creating an SAA.
▪ Apply a reporting framework to monitor progress toward
the stated goals and objectives.
▪ Periodically perform a governance audit.
© Kaplan, Inc. 3
Investment Governance Considerations

Functions: Hierarchy:
▪ Clarifies the mission ▪ Investment committee
▪ Creates a plan ▪ Investment staff
▪ Reviews progress ▪ Third-party resources
toward achieving
objectives
▪ Long- and short-term
© Kaplan, Inc. 4

68 Asset Allocation
Economic Balance Sheet

Adds extended portfolio of assets and liabilities to the
financial assets and liabilities of the traditional B/S
◼ Extended portfolio assets could include the following:
◼ For individuals:
◼ PV of expected earnings (human capital)
◼ PV of pension income
◼ For institutions:
◼ PV of royalties and exploitable resources
© Kaplan, Inc. 5
Economic Balance Sheet

◼ Extended portfolio of liabilities could include the
following:
◼ For individuals:
◼ PV of expected future consumption
◼ For institutions:
◼ PV of expected payouts
◼ E.g., grants made out of a foundation
© Kaplan, Inc. 6

Asset Allocation 69
Economic Balance Sheet—Example

Assets Liabilities and Net Worth
Financial assets Financial liabilities
Domestic equity 400 Short-term borrowings 100
Real estate 250 Mortgage obligations 200
650 300
Extended assets Extended liabilities
PV of expected royalties 150 PV of expected payouts 300
Economic assets 800 Economic liabilities 600
Net worth
Economic assets –
economic liabilities 200
Total 800 Total 800
© Kaplan, Inc. 7
Approaches to Asset Allocation (AA)

Asset-only: Liability-relative: Goals-based:
▪ Manage ◼ Manage the assets ◼ Manage
the risk in relation to subportfolios

and meeting the of assets to
return of liabilities meet specific
the ◼ Consider the risk goals (quasi
assets and return to the liabilities)
surplus
S = PVA – PVL
© Kaplan, Inc. 8

70 Asset Allocation
AA: Asset-Only
◼ Used when liabilities are not quantified:
◼ Liabilities not explicitly modeled
◼ But required return is set to meet needs
◼ Risk:
◼ Standard deviation of asset return or downside
deviation
◼ Monte Carlo models used to simulate what can
happen over time with a given AA

◼ Deviation from assigned benchmark
© Kaplan, Inc. 9
AA: Liability-Relative
◼ Liabilities are explicitly modeled:
◼ Fixed-income management techniques are often used
◼ More common for institutional portfolios with legal

liabilities
◼ Risk:
◼ Insufficient assets to meet liabilities, shortfall risk
◼ Need for additional contributions
◼ Volatility of surplus
© Kaplan, Inc. 10

Asset Allocation 71
AA: Goals-Based Investing (GBI)

◼ Goals are quantified and treated as quasi liabilities:
◼ Generally used for individual investors
◼ Subportfolios are constructed for each goal
◼ Time horizon typically varies by goal
◼ Total portfolio is the sum of the granular subportfolios
◼ Risk:
◼ Probability of failing to meet the goal
© Kaplan, Inc. 11
Asset Classes and Systematic Risk

◼ Asset class: This is a group of assets with similar
investment characteristics.
◼ Asset class weights in the portfolio are the fundamental
determinant of the portfolio’s systematic risk exposures.
◼ Managing asset class weights controls those risks.
© Kaplan, Inc. 12

72 Asset Allocation
Criteria for Defining Asset Classes

◼ Assets within the class are relatively homogenous.
◼ They have similar descriptive and statistical
attributes.
◼ Classes are mutually exclusive.
◼ They don’t overlap—e.g., U.S. equity and
international (non-U.S. equity).

◼ An asset does not fit in more than one class.
© Kaplan, Inc. 13
Criteria for Defining Asset Classes

◼ Classes are not highly correlated.
◼ Providing diversification
◼ Classes cover the majority of (world) investable

assets.
◼ Classes are sufficiently liquid.
◼ Useless if classes are not investable
© Kaplan, Inc. 14

Asset Allocation 73
Asset Classes
Super classes: Typical exam asset classes:
◼ Capital assets that can be ◼ Domestic equity
valued as the PV of future ◼ International equity

cash flow ◼ Domestic fixed income
◼ Consumable/transformable ◼ International fixed income
assets such as ◼ Alternative investments
commodities ◼ RE
◼ Store of value assets such ◼ PE

as currencies ◼ Commodities
© Kaplan, Inc. 15
Asset Class Granularity

How subdivided are the classes? E.g.:
Large cap More granular
Domestic Small cap subclasses are
Equity usually less distinct
International Developed
in characteristics:
Emerging
Increasing granularity ◼ More relevant to
policy
◼ SAA focus is on the distinctly implementation
different, broader asset classes and TAA
© Kaplan, Inc. 16

74 Asset Allocation
Risk Factors
Asset classes could reflect a few underlying risk drivers
(e.g., volatility, liquidity, inflation, interest rates, duration,
foreign exchange, default risk).
◼ Risk factors earn risk premiums and control risk exposure.
Underlying risk factors

driving return:
Asset class: Foreign exchange
◼ Domestic equity
Volatility
◼ Domestic fixed income
Liquidity
© Kaplan, Inc. 17
Factor-Based Asset Allocation

◼ Most risk factors are not directly investable.
◼ But multifactor models can be used to allocate by risk
factor.
◼ Portfolios are formed from factor portfolios rather than
traditional asset classes.

◼ Factor portfolios isolate systematic risk exposures.
◼ For example, long Treasuries plus short inflation-

linked Treasuries isolate inflation risk.
© Kaplan, Inc. 18

Asset Allocation 75
Factor-Based vs. Traditional Asset Classes

◼ MVO can be applied to either.
◼ Neither has been proven as clearly superior.
◼ The approach used should reflect how the client and
manager think about the portfolio management

process.
Primary focus of the CFA readings is on asset classes.
© Kaplan, Inc. 19
Illustration: Strategic Asset Allocation

◼ Nathan Tillman is a 50-year-old entrepreneur who plans
to retire in five years. He:
◼ Plans to purchase an annuity at retirement.
◼ Has a $5 million portfolio.
◼ Also has $1 million in real estate with $700,000 in
mortgage debt.
◼ He would like to eliminate all mortgage debt before
retirement.
© Kaplan, Inc. 20

76 Asset Allocation
Illustration: More Case Facts

◼ His son, David, is 18 years old and starting college this
year with eventual plans for medical school.
◼ Tillman estimates he will contribute $500,000 to his
son’s education.
◼ Tillman is generally conservative with his investments; he
does not like portfolio volatility.
◼ He has no social or environmental investment
constraints.
© Kaplan, Inc. 21
Illustration: Proposed Allocations

Two portfolio allocations have been proposed:
Global Global Fixed Diversifying
Allocation Cash Equity Income Strategies
A 45% 15% 35% 5%
B 5% 50% 20% 25%
© Kaplan, Inc. 22

Asset Allocation 77
Illustration: Questions
For each asset allocation (A and B):
◼ State and justify why it is most consistent with (1)
an asset-only, (2) a liability-relative, or (3) a goals-
based approach to asset allocation.
◼ Give one reason based on Tillman’s situation that
the approach is appropriate for Tillman.

Do not draw any conclusion as to the optimal overall
approach to allocation for Tillman.
© Kaplan, Inc. 23
Illustration: Solution
Allocation A, state and justify: Goals-based
• More than sufficient cash for liquidity needs of $1.2
million to pay the mortgage and education expenses
Give one reason the approach is appropriate for Tillman:

• The high allocation to cash would reduce portfolio
volatility. It fits his conservative investment views.
© Kaplan, Inc. 24

78 Asset Allocation
Illustration: Solution
Allocation B, state and justify: Asset-only
• Emphasis on higher-growth equity
• Avoids cash drag and lower return
Give one reason the approach is appropriate for Tillman:

It provides diversification with alternative investments and
some fixed income.
© Kaplan, Inc. 25
The Global Market Portfolio (GMP)

◼ Contains all available risky assets
◼ The market portfolio in capital market theory
◼ The most diversified portfolio possible
◼ Mitigates investor biases such as home country or

value vs. growth
◼ Can serve as a starting point for asset-only allocation
approaches
◼ Weights can be tilted for specific investors
© Kaplan, Inc. 26

Asset Allocation 79
Challenges in Using the GMP

◼ Establishing relative size of each asset class
(nonpublicly traded assets)
◼ Practicality of investing in residential real estate
◼ Liquidity and size challenges to investing in
commercial real estate and private equity
◼ Proxies (e.g., ETFs) to GMP often use only traded

assets
© Kaplan, Inc. 27
Implementing the AA
Most Passive: Most Active:
◼ Implement
• Tracking error ◼ Vary the SAA
• Expected return
SAA using and value added
weight by asset
index funds • Costs class using:
◼ TAA
◼ Shorter-term deviations from the SAA,
◼ Dynamic AA
seeking to add value
◼ Defined here as deviations from SAA ◼ Use active
based on longer-term views management within
each asset class
© Kaplan, Inc. 28

80 Asset Allocation
Factors Driving Implementation

Most Passive Most Active
◼ Are passive index vehicles available?
◼ Large investments can suffer diseconomies of scale.
◼ Is passive consistent with the investor’s O&C?
◼ Is the market efficient?
◼ Incremental benefit vs. cost of active decisions
◼ Tax issues: Taxation tips the scale toward more
passive/lower turnover.
© Kaplan, Inc. 29
Risk Budgeting and Rebalancing

Risk budgeting: Defining how
much and where to take risk These concepts are
covered in more
Rebalancing: A disciplined depth in Principles of
process of restoring portfolio Asset Allocation.
weights to the SAA
© Kaplan, Inc. 30

Asset Allocation 81
Asset Allocation
Principles of Asset Allocation
Mean-Variance Optimization (MVO)

Inputs: Mean Output:
• E(R) variance • Efficient
• Correlations optimizer frontier (EF)
• Standard (computer • Asset
deviations software) allocations
◼ The optimization is usually subject to constraints:

Budget: Non-negativity: Client:
Weights must Only + weights, Min return/max risk
sum to 100% no short positions Min/max asset weights
© Kaplan, Inc. 2

82 Asset Allocation
MVO: Input
Data:
------------Correlation coefficients----------------
Domestic Non-dom Domestic Real
Asset class Exp. rtn. Std. dev. equity equity bonds estate
Domestic equity 10.0% 11.0% 1 0.7 0.4 –0.18
Non-dom equity 14.0% 16.0% 0.7 1 –0.02 –0.05
Domestic bonds 6.0% 8.0% 0.4 –0.02 1 0.14
Real estate 16.0% 19.0% –0.18 –0.05 0.14 1
Constraints: 100% allocation and only + or 0 weights
© Kaplan, Inc. 3
MVO Output: EF
The resulting efficient frontier (EF):
Points 4, 3, 2, and 1 are 1
2
referred to as corner
3
portfolios (CPs)
Asset allocations for points between the CPs can be calculated as

a linear interpolation of the two bracketing CPs, which produces
the same weighted average return
© Kaplan, Inc. 4

Asset Allocation 83
MVO Output: Weights

Weights
4
along the EF: 1
4 3 2 1
domestic real
bonds estate
non-
domestic domestic
equity equity
© Kaplan, Inc. 5
MVO Output: Select Points

---------------------Weighting---------------------
Std. Domestic Non-dom. Domestic Real
Allocation Exp. rtn. dev. equity equity bonds estate
1 16.00% 19.00% 0.00% 0.00% 0.00% 100.00%
2 14.97% 12.05% 0.00% 51.50% 0.00% 48.50%
3 13.21% 9.62% 38.91% 22.77% 0.00% 38.32%
4 8.58% 6.84% 3.99% 17.64% 68.28% 10.09%
When selecting the optimal mix for any given investor,

various approaches can be taken.
© Kaplan, Inc. 6

84 Asset Allocation
Utility Maximization Approach

Expected return and variance of asset allocation z
Investor’s
utility from Uz = E(Rz) – (0.005  l  sz2 )
asset
allocation z Multiplier * Investor’s risk aversion
coefficient (“lambda”)
▪ Lambda ranges from 1 to 10
▪ 0 is treated as risk-neutral in that the investor ignores risk
▪ In practice it is very difficult to determine an investor’s
lambda
* With 0.005; E(R) and s are in % terms—e.g., 15 and 20
* Or use 0.5; E(R) and s are in decimal terms—e.g., 0.15 and 0.20
© Kaplan, Inc. 7
Safety-First Approach
◼ Client specifies a minimum acceptable return
◼ Maximizing safety-first minimizes the probability of violating
the MAR
E(Rm) – RMAR
◼ Also called Roy’s safety-first: RSFz =
sm
◼ The Sharpe ratio is essentially a variation on safety-first

◼ Treating rf as the client’s MAR
© Kaplan, Inc. 8

Asset Allocation 85
Other Approaches
◼ Determine the required return and select the portfolio
from the EF that provides it
◼ Determine the (maximum) standard deviation and select
the portfolio from the EF that provides it
© Kaplan, Inc. 9
Cash Equivalents
In portfolio theory, risk-free means a known return with 0
standard deviation and 0 correlation to other assets
◼ Over shorter discrete single periods, ◼ In ongoing portfolio situations,
risk-free exists, leading to the capital cash is just another asset class
allocation line (with low, not 0, risk)
Optimal tangent portfolio
(T) for all investors
Borrow at rf and
invest in T
Select the optimal
rf portfolio from the EF
Allocate between T and rf
© Kaplan, Inc. 10

86 Asset Allocation
Criticisms: Sensitivity and Concentration

1) The output is highly sensitive to small changes in the
inputs
◼ Particularly to changes in estimates of return, E(R)
◼ The EF generally does not shift significantly
◼ The asset allocation for any point on the EF may
change significantly
2) The allocations are often concentrated in a few asset
classes
◼ Mathematical diversification is not practical diversification
© Kaplan, Inc. 11
Solutions
Solutions: The first two criticisms can be addressed by
modifications to the MVO process:
◼ Reverse optimization: start with the market portfolio and
let the market dictate E(R)s
◼ Black-Litterman: selectively view adjust those market
E(R)s
© Kaplan, Inc. 12

Asset Allocation 87
Reverse Optimization and Black-Litterman

Reverse optimization: First Black-Litterman: The
solve for and then use world manager then view
market (WM) E(R) data to adjusts the WM E(R)s
select the client’s portfolio. and reruns the MVO.
Inputs: Output:
• WM asset weights Mean variance • E(R) by asset class
• Correlations optimizer • Consensus
• Standard deviations expectations
© Kaplan, Inc. 13
Recommending an Asset Allocation Using MVO

Recommend which of the three strategic asset allocations is
appropriate for Bronsten.
Case Facts:
◼ Marsha Bronsten’s risk tolerance is average (λ = 4).
◼ She wants to minimize the chance of earning less than 3%.
Allocation Expected return Variance

Caution—some of the #1 8% 0.0225
data is in % and some #2 6% 0.0144
is in decimal form! #3 4% 0.0025
© Kaplan, Inc. 18

88 Asset Allocation
Recommending an Asset Allocation Using MVO

Recommend which of the three strategic asset allocations is
appropriate for Bronsten.
Um = E(Rm) − 0.5 × λ × Varm
U1 = 0.08 − 0.5 × 4 × 0.0225 = 0.0350 = 3.50%
U2 = 0.06 − 0.5 × 4 × 0.0144 = 0.0312 = 3.12%
U3 = 0.04 − 0.5 × 4 × 0.0025 = 0.0350 = 3.50%
Roy’s safety first: (RP − RL) / σP
#1 = (0.08 − 0.03) / 0.02250.5 = 0.33 Select #1
#3 = (0.04 − 0.03) / 0.00250.5 = 0.20
© Kaplan, Inc. 19
Another Example, Different Facts

The risk-free rate is 3%. If the client and manager believe a true
risk-free asset exists and can be used to construct the SAA,
identify the appropriate asset allocation for Plowshare and
calculate the risk of the optimal allocation.
Case Facts:
◼ Plowshare University Endowment’s return objective is 9%, which
covers the spending rate, inflation, and investment expenses.
◼ They seek to minimize standard deviation of return while meeting
the return objective, subject to a non-negativity constraint.
© Kaplan, Inc. 20

Asset Allocation 89

Allocation Expected Standard
choices return deviation ◼ All returns exceed the
required 9%
AA 15% 24%
◼ No borrowing (a negative
BB 18% 27% weight) is needed
CC 12% 20% ◼ Select the best Sharpe
DD 10% 14% ratio
AA: (15 − 3) / 24 = 0.50 CC: (12 − 3) / 20 = 0.45
BB: (18 − 3) / 27 = 0.56 DD : (10 − 3) / 14 = 0.50
© Kaplan, Inc. 21

BB: (18 − 3) / 27 = 0.56
What is the allocation between BB and rf to earn the required 9%?

9 = 18(w) + 3(1 − w) 9 = 18w + 3 − 3w 6 = 15w
Allocate 40% to BB and 60% to rf
What is the risk (standard deviation) of this allocation?
0.40(27%) + 0.60(0%) = 10.8%
© Kaplan, Inc. 22

90 Asset Allocation
Incorporating the Economic Balance Sheet

MVO can be adapted to include:
◼ Human capital
current % allocation
◼ For low-risk stable wages increasing with
Constrained to
inflation: model as an inflation-linked bond
◼ Otherwise model as mix of inflation-linked and
corporate bonds, plus equity
◼ Residential real estate
◼ Use property index for investor location
© Kaplan, Inc. 23
Liquidity Issues
◼ Less-liquid asset classes require a liquidity premium
◼ E.g., direct real estate, private equity, infrastructure
◼ Are more difficult to model for MVO

◼ Lack of indexes providing reliable return
characteristics
◼ Lack of low-cost passive investment options
◼ Often create concentrated (idiosyncratic) risk exposure
◼ Hard to diversify within the asset class
© Kaplan, Inc. 24

Asset Allocation 91
Modeling Illiquid Asset Classes

◼ Exclude from MVO, but retain existing positions as part of
the total portfolio
◼ Include in MVO:
◼ Modeling the characteristics of the specific assets held
by the investor
◼ Modeling the characteristics of such asset classes
using reported alternative investment indexes

◼ Such indexes may overlap with other asset classes,
biasing correlations upwards
© Kaplan, Inc. 25
Incorporating Client Issues

Approaches include:
◼ Specify additional constraints
◼ Limits on allocations to risky assets
◼ Set a ceiling on portfolio risk
◼ Specify a risk aversion factor (l)
◼ Use Monte Carlo simulation
◼ Project wealth outcome for different risk levels (i.e.,

asset allocation choices)
© Kaplan, Inc. 26

92 Asset Allocation
Monte Carlo Simulation (MCS)

◼ MCS is a statistical modeling tool, complementing MVO
◼ Multiple simulations of a specific asset allocation over
time
◼ Assumptions have to be made regarding the
distributions of asset returns—normal, non-normal, etc.

◼ Rules for rebalancing can be built in
◼ Taxes, inflation, and spending can be incorporated
◼ Each simulation can be regarded as a scenario
© Kaplan, Inc. 27
Illustration: MCS
◼ The following chart shows a client, aged 50
◼ They want to retire at 65 and have the portfolio be worth
no less than its current value, in real terms
◼ The output is per $1 million initial value
◼ 300 simulations of the asset allocation’s results were
ranked to display portfolio real value at the 10, 25, 50, 75,
and 90th percentile over time
© Kaplan, Inc. 28

Asset Allocation 93
Illustration: MCS Output

Percentiles: 10% 25% 50% 75% 90%
6,000,000
Investor is currently aged 50, with $1m to $5,303 ,854

5,000,000 invest. This simulation shows a range of
outcomes from a proposed investment strategy.
4,000,000
90% of time portfolio does not
exceed these values $3,268 ,892
3,000,000
Median values,
2,000,000 exceeded 50% of time
$1,887 ,064
1,000,000 $1,032 ,485
$545 ,573
-
50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65
© Kaplan, Inc. 29
Age
Criticisms: Diversifies by Asset Class

4) Allocations may be diversified by asset class but not by
risk factors
◼ See earlier discussion of risk factors driving asset class
returns
Solution:
◼ Factor-based allocation
© Kaplan, Inc. 30

94 Asset Allocation
Factor-Based Allocation
Multi-factor regression is used to derive factors that drive
asset class return
◼ Typical risk factors used include market risk premium,
size (market cap), valuation (value vs. growth), momentum

(vs. mean reversion), liquidity, duration, credit, and
volatility
◼ Correlation among risk factors is typically lower than
among asset classes
© Kaplan, Inc. 31
Build a Factor-Based Portfolio

◼ Each risk factor has a risk premium (E(R) – rf), standard
deviation, and set of correlations
◼ MVO generates an EF of risk factors and associated
allocations to risk factors
◼ Long/short factor portfolios can be used to obtain
desired exposures, e.g.:
◼ Credit exposure: long position in credit risky and short
position in credit risk-free bonds

◼ Valuation: long value and short growth stocks
© Kaplan, Inc. 32

Asset Allocation 95
Risk Budgeting
◼ Define risk in ways relevant to the portfolio
◼ Active risk budgeting refers to deviations from the
portfolio’s benchmark
◼ At the overall allocation level: deviation from the SAA
◼ At each asset class level: deviation from the assets in
that asset class in the benchmark
I.e., another way of discussing the passive/active spectrum
© Kaplan, Inc. 33
Risk Budgeting
◼ The process: specify the total acceptable risk and
allocate it
◼ The goal: maximize return per unit of risk
◼ Marginal contribution to risk is a powerful tool in risk
budgeting
◼ Allows determination of whether the allocation is
optimal
© Kaplan, Inc. 34

96 Asset Allocation
MCTR
◼ Marginal contribution to portfolio risk: change in
total portfolio risk for a small change in allocation to
asset class i
MCTRi = beta of asset class i with respect to
portfolio  total portfolio s
◼ Absolute contribution to portfolio risk: asset class
i’s contribution to portfolio volatility (s)
ACTRi = weighti  MCTRi
© Kaplan, Inc. 35
Optimal Allocations
◼ Return to risk can be measured as:
Excess return / MCTR
Excess return = Ri – rf
When the optimal portfolio is reached,
◼ all excess return / MCTR ratios are equal and
◼ they equal the portfolio’s Sharpe ratio
© Kaplan, Inc. 36

Asset Allocation 97
Illustration: Risk Budgeting

Portfolio data: Weight Excess Return Beta
US equities 60% 6.50% 1.300
US bonds 30% 3.66% 0.732
Cash 10% 0% 0
Total portfolio 100% 5.00% 1.000
◼ Betas are asset class with respect to the portfolio
◼ Portfolio standard deviation is 12%
Demonstrate the portfolio is optimal:
© Kaplan, Inc. 37
Illustration: It’s Optimal

MCTRequities: 1.3  12% = 15.60%
Excess return / MCTR = 6.50% / 15.60% = 0.417
MCTRbonds: 0.732  12% = 8.78%
Excess return / MCTR = 3.66% / 8.78% = 0.417
Portfolio Sharpe ratio:

Total excess return / total risk = 5.00 / 12.0 = 0.417
© Kaplan, Inc. 38

98 Asset Allocation
Illustration: Final Points

Excess % Contribution Ratio of Excess
Weight Return Beta MCTR ACTR to Total Risk Return to MCTR
US equities 60% 6.50% 1.300 15.60% 9.36% 78% 0.417
US bonds 30% 3.66% 0.732 8.78% 2.64% 22% 0.417
Cash 10% 0% 0 0% 0% 0%
Total portfolio 100% 5.00% 1.000 12.00% 100%
For instance:
ACTRequities = wequities  MCTRequities = 0.6  15.6% = 9.36%
Equities’ contribution to total risk = 9.36% / 12% = 78%
And 9.36 + 2.64 = 12.00% = portfolio σ
© Kaplan, Inc. 39
Criticisms: Single Period Analysis

5) MVO is a single period model
◼ Ignoring trading/rebalancing costs and taxes
Solution: Use a more complex multi-period model

◼ Can be applied to asset-only or liability-relative portfolios
◼ MCS also takes a multi-period perspective
© Kaplan, Inc. 40

Asset Allocation 99
Criticisms: Asset Only

6) Explicit liabilities and consumption needs are not directly
incorporated in basic MVO
Solution: Develop a lability-relative asset allocation (also
called asset-liability management and liability-driven
investment)
◼ Surplus optimization
Three approaches
◼ Hedging/return-seeking approach
to liability-relative,
◼ Integrated asset-liability approach but first
© Kaplan, Inc. 41
Characteristics of Liabilities
Generally essential needs
◼ Fixed versus contingent rate and have a higher PV

require a lower discount
◼ Legal versus quasi-legal

◼ Their duration and convexity
◼ Liability size relative to size of the sponsor
◼ Drivers affecting the liabilities, such as inflation,
the economy, interest rates, and risk premiums
◼ Timing issues, such as longevity risk
◼ Regulations affecting calculations
© Kaplan, Inc. 42

100 Asset Allocation
Illustration: Liability-Relative
◼ A pension plan has assets of 550 million
◼ Regulations formerly allowed discounting liabilities at the
high-quality corporate bond rate for a PVL of 475 million
◼ Recent changes require discounting at the long-term
government bond rate for a PVL of 585 million

Demonstrate that the plan is underfunded:
Surplus = 550 – 585 = –35 million
Funding ratio = 550/585 = 0.94
© Kaplan, Inc. 43
Surplus Optimization
Applies basic MVO math Expected surplus
PVA – PVL
◼ Inputs must also include:
◼ Estimated liability return

(discount rate) Current portfolio;
◼ Correlations of liability to selected using
asset classes asset-only MVO
◼ Additional client
constraints σ of surplus
Demonstrate that the current portfolio is not optimal:
© Kaplan, Inc.
Not on the surplus EF 44

Asset Allocation 101
Hedging/Return-Seeking Approach
A “two portfolio” approach:
◼ A hedge portfolio that best mimics the liabilities is funded
◼ E.g., has the same risk factor weights as the liabilities
◼ A second return-seeking portfolio focuses on generating

excess return
Complications:
◼ No surplus
◼ No true hedging portfolio exists
© Kaplan, Inc. 45
Variations on Hedging/Return Seeking

◼ Conservative: fully fund the hedge
◼ Limit return seeking to the surplus
◼ Aggressive: underfund the hedge

◼ Allows more funds for return seeking
◼ Adopt a “glide path”: increase funding of the hedge as

liability payout approaches
© Kaplan, Inc. 46

Integrated Asset-Liability Approach

◼ Some institutions (banks, insurance companies, long/short
funds) simultaneously determine their assets and liabilities
◼ They often use multi-period models to project and
maximize expected return/surplus

◼ Regulators frequently require stress testing to estimate
worst case outcomes

E.g.: A bank can lend at 6.0% (asset return) and issue deposits
or borrow at 3.5% and 5.5% (liability costs)
◼ Volatility (duration) and correlations of all factors must be
estimated
© Kaplan, Inc. 47
Summary: Comparing Liability-Relative Approaches

Surplus Hedging/Return Integrated A/L
Optimization Seeking Approach
◼ Simple extension ◼ Simple; can ◼ More complex;
of MVO, adding assume linear can assume
return, risk, and and nonlinear linear and
correlation of the relationships nonlinear
liabilities ◼ Focus is low relationships
◼ High to low risk risk ◼ High to low risk
application ◼ Single period application
◼ Single period ◼ Multi-period
© Kaplan, Inc. 48

Goals-Based Approach
◼ Total portfolio is the sum of sub-portfolios (modules)
◼ Each module meets specific investor goals, time
horizon, and probability of success
◼ Often advisors design and select from predefined
modules, designed to meet common situations
Modules are E(R)
◼
◼
created using ◼
MVO
◼
Modules selected
◼
from EF by advisor
© Kaplan, Inc.
σ 49
The Modules
◼ Modules should:
◼ Cover a wide range of the investment universe
◼ Be sufficiently different from each other
◼ Recognize some assets have non-normal return
distributions
◼ Provide sufficient liquidity
◼ Anticipate potential panic sales by clients who want to

liquidate during crisis periods
© Kaplan, Inc. 50

Illustration: Goals-Based
◼ Three modules are available:
Module: A B C
Expected return 5% 6% 8%
Standard deviation 4% 7% 14%
◼ The investor has 2 goals:
◼ $500,000 to fund his daughter’s education beginning in
10 years with a 90% required probability of success

◼ Transfer $6,000,000 to his daughter in 30 years with a
required probability of success of 75% 51

© Kaplan, Inc.
Illustration: Probabilities
Estimated annual minimum expectation returns and
probabilities by portfolio:
Over a 10-year horizon:
Required success A B C
90% 3.0% 2.4% –2.2%
75% 3.6% 3.8% 1.7%
90% 4.0% 4.3% 4.7%
75% 4.1% 4.8% 5.2%
© Kaplan, Inc. 52

Illustration: Education Goal

Goal: $500,000 in 10 years with 90% probability
90% 3.0% 2.4% –2.2%
75% 3.6% 3.8% 1.7%
Use Portfolio A for best return
Required funding: 500,000 / 1.0310 = 372,047
© Kaplan, Inc. 53
Illustration: Transfer Goal

Goal: $6,000,000 in 30 years with 75% probability
90% 4.0% 4.3% 4.7%
75% 4.1% 4.8% 5.2%
Use Portfolio C for best return
Required funding: 6,000,000 / 1.05230 = 1,311,231
© Kaplan, Inc. 54

Illustration: Conclusions
◼ Total portfolio funding: 372,047 + 1,311,231 = 1,683,278
◼ Portfolio asset allocation and return are a weighted
average of the module allocations and return
Generalizations:
◼ Approach is best suited to individuals with multiple goals
◼ Complex to implement in a business setting
◼ Must be able to determine the client’s true goals
◼ Must periodically revisit and rebalance
© Kaplan, Inc. 55
Other Approaches
Heuristic (ad hoc “rules of thumb”) are experience-based
rules that often work; they are often reasonable, if not
optimal:
◼ Allocation to equity = 120 – client’s age
◼ 60/40 equity/FI for the average investor
© Kaplan, Inc. 56

Other Approaches, Less Common

◼ The endowment (Yale) model: overweight alternative
investments to capture manager skill and liquidity
premiums
◼ Problem: complex investments, not suitable for many investors
◼ Risk parity: allocation so each asset class’s contribution to
total portfolio risk is the same
◼ Problem: ignores expected returns
◼ 1/N rule: equal weight all asset classes
◼ Empirical evidence, performs better than might be expected
© Kaplan, Inc. 57
Rebalancing
◼ A process of buying and selling assets to restore the
desired SAA
◼ The rebalancing policy must address the following:
◼ Who should rebalance and how frequently?
◼ How wide should the target ranges be?
◼ Are deviations partially or fully corrected?
◼ Benefits vs. costs
◼ Method of rebalancing
© Kaplan, Inc. 58

Benefits vs. Costs

Empirical evidence indicates disciplined rebalancing tends
to reduce risk and enhance return:
+ Riskier assets generally rise in value and portfolio weight;
thus, selling reduces portfolio risk
+ Earns a diversification effect and is akin to “shorting
volatility” (selling calls and puts) to earn premiums and
enhance return
◼ To rebalance you sell the appreciated asset (equivalent to it
being called) and buy the depreciated asset (as if it were put to
you)
© Kaplan, Inc. 59
Benefits vs. Costs

+ Maintains the desired risk factor exposures
◼ Riskier assets tend to rise in value and portfolio weight
– Costs: transaction, tax, and monitoring
© Kaplan, Inc. 60

Strategic Considerations in Rebalancing

Wider ranges are appropriate for:
◼ Higher transaction costs
◼ Taxable portfolios Wider

◼ To avoid taxes (and consider ranges
asymmetric ranges to realize losses) reduce
◼ Greater investor risk tolerance transaction
◼ The investor will take the risk and other
◼ Higher correlation between asset classes costs
◼ Further divergence from target weight
is unlikely
© Kaplan, Inc. 61

Narrower ranges are appropriate for:
◼ Greater volatility in the rest of the portfolio
◼ Increases the risk of rapid divergence from target
weights
© Kaplan, Inc. 62


Additional considerations:
◼ Asset volatility increases both risk and cost
◼ Illiquidity makes rebalancing difficult
◼ Derivatives may allow synthetic rebalancing
◼ Momentum markets favor wider ranges
◼ Let the winner run
◼ Mean-reverting markets favor narrower ranges
◼ Sell high, before it declines
© Kaplan, Inc. 63
Rebalancing Methods
Calendar: rebalance after every “X” time period
+ Less costly to monitor the portfolio
– Ignores interim fluctuations in value and risk exposure
Percentage range: rebalance if the deviation exceeds “Y%”
from target
+ Better risk control
– Theoretically requires continuous monitoring
© Kaplan, Inc. 64

Asset Allocation
Asset Allocation with Real-World Constraints
Asset Allocation with Real-World

Constraints
Constraints: Asset Size

◼ Small portfolios may lack the expertise and governance
structure to implement complex strategies
◼ Legislation/regulations may limit access
◼ Defining qualified investors based on size of investor
assets and experience—e.g., limited partnerships
◼ Smaller investors may be able to use commingled accounts
and funds to gain access—e.g., private equity
© Kaplan, Inc. 2


Constraints
Constraints: Large Portfolios

◼ Large portfolios don’t have the limitations of small portfolios
◼ They can benefit from economies of scale when investing
and achieve higher levels of diversification
◼ But their size can exhaust the capacity of niche strategies
and managers to accept funds—e.g., distressed debt
© Kaplan, Inc. 3

Constraints
Constraints: Liquidity
◼ Some assets provide insufficient liquidity to meet the
investor’s requirements—e.g., some hedge funds
◼ Liquidity needs are affected by the total resources of the
investor, including those outside the portfolio
◼ Investors may panic in periods of crisis—e.g., 2008–09
◼ Liquidity declines and investors:
◼ liquidate at the worst time or
◼ discover liquidation is not allowed
© Kaplan, Inc. 4


Constraints
Constraints: Time Horizon

◼ Asset allocation must be adjustable as time passes
◼ Portfolio objectives and constraints change
◼ The allocation between human and financial capital
shifts
◼ Longer time horizons typically allow for greater risk
◼ Time diversifies risk
© Kaplan, Inc. 5

Constraints
Constraints: Regulatory
Portfolio Regulatory or Other Considerations
Insurance companies • Risk-based capital requirements
• Requirement to invest in assets with certain liquidity and credit
rating
• Specific accounting/reporting requirements
Pension funds • Restriction to invest in certain asset classes
• Specific funding and reporting requirements
Endowments and • Minimum required annual distribution or socially responsible
foundations investment required to maintain a tax-exempt status
Sovereign wealth • Minimum investment requirements in socially or ethically
funds acceptable assets
• Limits on the investment allowed in certain currencies
© Kaplan, Inc. 6


Constraints
Tax Considerations
◼ Taxable investors should base asset allocation on after-tax
risk and return
◼ Typical considerations:
◼ Capital gains are taxed at lower rates and can be
deferred
◼ Tax-advantaged locations may exist
◼ TDA: tax-deferred accounts

◼ TEA: tax-exempt accounts
◼ Dividends are taxed at lower tax rates
© Kaplan, Inc. 7

Constraints
Tax Considerations: Results

Effective tax rates differ by asset
rAT = rPT (1 – t)
◼
class
σAT = σPT (1 – t)
◼ Tax effects are not consistent by
ρAT = ρPT asset classes
Therefore, the after-tax efficient frontier and asset allocation
of a taxable and tax-exempt investor will differ
Note: Correlations are a market-level issue and not investor specific;
therefore, they are unaffected by the investor’s tax situation
© Kaplan, Inc. 8


Constraints
Complications: URG/L
◼ If the cost basis (for tax purposes) of an investment is
different than the current market value, there is an existing
unrealized capital gain/loss (URG/L) and tax liability/asset
MV > Cost basis Unrealized gain Tax liability
MV < Cost basis Unrealized loss Tax asset
© Kaplan, Inc. 9

Constraints
Adjusting for URG/L

1) Assume that the asset will be sold today—subtract the
value of the embedded capital gains tax from the current
market value of the asset; or
2) Assume that the asset is to be sold in the future—discount
the tax liability to its present value using one of the following
discount rates:
A. Asset’s after-tax return or
B. After-tax risk-free rate
© Kaplan, Inc. 10


Constraints
Complications: Widen the Rebalancing Range

Reduce the frequency of rebalancing to defer realizing gains
◼ Increase the allowed deviation (Dev) from target allocation
weight (wT)
DevAT = DevPT / (1 – t)
where:
Allowed range = wT (Dev)
© Kaplan, Inc. 11

Constraints
Complications: Tax Locations

Locate in:
Assets subject to lowest
◼ Taxable accounts*
effective tax rates
Assets subject to highest ◼ Tax-advantaged

effective tax rates TDA and TEA
* Because governments rarely allow unlimited investing in

tax advantaged accounts
© Kaplan, Inc. 12


Constraints
Tax Locations Multiply the Choices

◼ Optimization should consider both the available classes
and locations
◼ 2 asset classes + 2 locations = 4 allocation choices:
1. Equity in taxable 2. Equity in tax-deferred

account account
3. Fixed income in 4. Fixed income in tax-
taxable account deferred account
© Kaplan, Inc. 13

Constraints
Complications: Harvest Losses

◼ Tax loss harvesting: realize losses to offset gains taxed
elsewhere
© Kaplan, Inc. 14


Constraints
Changing the SAA

◼ The SAA is not static; review and possible changes can be
triggered by material changes in:
◼ Client objectives and constraints
◼ Longer-term expected (beliefs about) market conditions
Examples include:
◼ Economic prospects of the sponsor’s business change
◼ The individual investor ages or starts a family
◼ The investor has specific expenses to fund
© Kaplan, Inc. 15

Constraints
Changing the SAA

More examples include:
◼ A large inheritance
◼ Loss of job or retirement benefits
◼ New regulations/tax laws
◼ Change in investment committee personnel
◼ Regime change such as the decline in inflation post-
1984
◼ Regime change such as 2008–09
© Kaplan, Inc. 16


Constraints
Illustration: The Portal Endowment

◼ The Portal Endowment Fund operates in perpetuity to
support projects to improve third world living conditions
◼ The risk and return objectives are aggressive because the
founder (Will Portal) has committed to leaving his estate to
the fund
◼ This would conservatively quadruple the fund and is
expected in 5 years
◼ Annual fund distributions are 10% of market value and met
by annual contributions to the fund from Portal
© Kaplan, Inc. 17

Constraints
Illustration: New Circumstances

◼ The fund’s asset allocation is very aggressive, focusing on
high return and earning liquidity premiums
◼ A devastating economic depression has just destroyed
Portal’s wealth and he will leave nothing to the fund
Discuss how the new situation will change the fund’s:
Risk and return objectives?
Liquidity needs?
Asset allocation?
© Kaplan, Inc. 18


Constraints
Illustration: Resulting Changes

How will the fund’s risk and return objectives change?
◼ Lower risk and return due to the loss of major inflows
from Portal in the future

Its liquidity needs?
◼ Higher needs due the lack of inflows and high annual
10% distributions
Its asset allocation?
◼ Shift to a more conservative asset mix and more liquid
assets
© Kaplan, Inc. 19

Constraints
Tactical Asset Allocation

Objective: Shorter-term deviations from the SAA to increase
return or risk-adjusted returns
◼ Exploit short-term economic or market conditions
◼ Size of deviations must be consistent with portfolio risk and

other constraints
◼ TAA can increase trading and tax costs plus increase
concentration of risk in specific assets in the portfolio
© Kaplan, Inc. 20


Constraints
TAA: Performance Evaluation

◼ Compare the Sharpe ratio under the TAA and the SAA
◼ Calculate the information ratio or t-stat of the excess
realized returns relative to the SAA
◼ Compare the realized risk and return of the TAA to
portfolios lying on the SAA’s efficient frontier
◼ Perform attribution analysis on the excess return to identify
the contribution of specific under- or over-weightings
© Kaplan, Inc. 21

Constraints
Approaches to Tactical Asset Allocation
Discretionary
TAA
Value
Approaches
Systematic
Momentum
© Kaplan, Inc. 22


Constraints
TAA: Discretionary
Relies on the skill of the manager in qualitative interpretation
of variables
◼ Possible inputs to discretionary TAA:
Economic Variable Indicators

Macroeconomic data Bond yields, credit spreads, monitory policy, GDP
growth, etc.
Fundamental data Deviation in P/E, P/B, and dividend yield from their
historic means, etc.
Market sentiment Margin borrowing, short interest, and volatility
indexes, etc.
© Kaplan, Inc. 23

Constraints
TAA: Systematic
Uses quantitative signals to dictate shifts in weightings
◼ Two main approaches:
1. Value investments
2. Momentum strategy
© Kaplan, Inc. 24


Constraints
Systematic: Value Indicators

Type of Asset Value Indicators
Equity Dividend or cash flow yield
Fixed income Yield spread over risk-free rate
Currency Short-term interest rate differentials
Commodity Roll yield in backwardation and
contango, F0 versus S0
© Kaplan, Inc. 25

Constraints
Systematic: Momentum Indicators

◼ Commonly used indicators include:
◼ Most recent 12-month trend: trend will persist for the
next 12 months
◼ Moving-average crossover: shorter-term moving
averages crossing above longer-term moving averages
indicate an uptrend (and crossing below indicates a
downtrend)
© Kaplan, Inc. 26


Constraints
Behavioral Biases in Asset Allocation

Behavioral Bias Implications on Asset Allocation Countermeasures
Loss aversion • Irrational behavior when • Goals-based investing

is a bias in returns are negative and use of sub-
which investors • Investors have a strong portfolios
dislike losses temptation to alter the asset • High-priority goals are
more than they allocation when returns are funded with less risky
like gains negative assets and vice versa
I would use these tables as an indication that behavioral

issues are inescapable in the investment business
© Kaplan, Inc. 27

Constraints

Illusion of • Frequent trading and tactical • The market portfolio
control is a allocation shifts derived from the
tendency to • Above average use of short basic CAPM mean-
overestimate the selling and leverage variance framework
ability to control • Concentrated positions that should be used as the
events expose the portfolio to starting point for the
diversifiable risk allocation
• Use of biased risk and return • Any change in
forecasts in the asset allocation should be
allocation framework made after a formal
review process
© Kaplan, Inc. 28


Constraints

Mental accounting Suboptimal asset allocation— Use of goals-based
involves separating e.g., maintaining a low-interest investing
assets and savings account while paying
liabilities into high interest on a credit card or
different “buckets” individuals spending their tax
based on subjective refund on luxury goods even
criteria when their savings are
inadequate
© Kaplan, Inc. 29

Constraints

Representative Allocating more to the assets Strong governance
(recency) bias that have performed well and objective asset
overemphasizes recently allocation
the importance of
the most recent
events
© Kaplan, Inc. 30


Constraints

Framing bias Biased decision making—e.g., Provide a full range
occurs when the use of standard deviation leads of relevant
way information is to lower risk preference by the information to the
presented affects investors and downside risk investors and do not
the resulting measures (e.g., VAR) may lead selectively frame
decision to better decisions in certain only some pieces of
situations the information
© Kaplan, Inc. 31

Constraints

Availability bias Two offshoots of availability bias: Start the allocation
occurs when process with the
personally • Familiarity bias: familiar or global market
experienced or easy to recall event is given portfolio
more easily too much importance in the
recalled events decision process
disproportionately • Home bias: overallocation to
influence decisions domestic assets and lack of
diversification
© Kaplan, Inc. 32

Derivatives and
Currency Management

128 Derivatives and Currency Management
Derivatives and Currency

Management
Option Strategies
Option Strategies
Options Terminology Refresher

▪ Call (= c): Right to buy the underlying asset (= S)
▪ Put (= p): Right to sell the underlying asset
▪ T = option expiration
▪ Exercise (strike = X): Price at which right can be exercised
▪ L, M, H: subscripts denoting lower, medium, or higher strike prices
▪ Expiration (expiry): date and time at which right can be
exercised
▪ European style: Can only be exercised at expiration
▪ American style: Can be exercised any time up until expiration
© Kaplan, Inc. 2

Derivatives and Currency Management 129
Option Strategies
Options Terminology Refresher

▪ Premium: Value of the option to the seller; amount that buyer
pays
▪ Buyer: Takes long position; owns the right
▪ Short: Takes short position, receives premium; has obligation
▪ Short a call: Must deliver underlying if buyer exercises
▪ Short a put: Must buy underlying if buyer exercises
© Kaplan, Inc. 3
Option Strategies
Intrinsic Value and Time Value

Key determinants of an option’s value:
◼ Strike price
◼ Price/level of underlying (e.g., stock price, currency rate)
◼ Time to expiration
◼ Volatility of the underlying (standard deviation)
◼ Risk-free interest rate (annual) over the period to expiration
◼ Annualized yield/return from the underlying
◼ Whether option is European or American style
© Kaplan, Inc. 4

Option Strategies

◼ Implied volatility: Estimating the volatility of the underlying
from the current option value
◼ Estimate of volatility should be forward looking (not the same as
stock price movement)
◼ Intrinsic (in the money) value = value of immediate exercise
◼ Time value = additional potential value until expiration
◼ Higher volatility = higher call and put option premiums
◼ Less time to expiry = lower call and put option premiums
© Kaplan, Inc. 5
Option Strategies

Calls:
◼ In the money (ITM) if current underlying price > strike price
◼ Out of the money (OTM) if current underlying price < strike
price
Puts:
◼ ITM if the current underlying price < strike price
◼ OTM if current underlying price > strike price
© Kaplan, Inc. 6

Option Strategies
The Calculations
◼ For all option positions, know the payoff pattern and be
prepared to calculate the following:
◼ Initial cost
◼ Profit at expiration
◼ Maximum gain
◼ Maximum loss
◼ Breakeven price(s)
© Kaplan, Inc. 7
Option Strategies
Our Recommended Approach

◼ The CFA text (and our SchweserNotes) have dozens of
formulas and graphs.
◼ All formulas are based on the payoff graph shape, initial
investment, and intrinsic values.
◼ A more fundamental approach to problem solving based on
these underlying factors is recommended and used in the
following slides.
© Kaplan, Inc. 8

Option Strategies
Calls: Example
◼ Consider a long (buy) position in XYZ MAY 50 calls.
◼ Option premium (cost) is $6.26
◼ At expiration, if XYZ stock > $50, option is ITM
◼ At expiration, if XYZ < $50, option is OTM (0 intrinsic value)
Example:
◼ XYZ stock at expiration is $40: option expires OTM, worthless
(zero intrinsic value)
◼ XYZ stock at expiration is $60: option expires ITM with an
intrinsic value = $60 – $50 = $10
© Kaplan, Inc. 9
Option Strategies
Calls: Example
◼ Profit at expiration (long call):
◼ If XYZ stock price = $40, profit = $0 – $6.26 = loss of $6.26
◼ If XYZ stock price = $60, profit = $10 – $6.26 = profit of $3.74
◼ Profit at expiration (short call):
◼ If XYZ stock price = $40, profit = $6.26 – $0 = profit of $6.26
◼ If XYZ stock price = $60, profit = $6.26 – $10 = loss of $3.74
◼ Breakeven at expiration (both long and short call):
◼ Sum of the strike price and the premium: $50 + $6.26 = $56.26
© Kaplan, Inc. 10

Option Strategies
Calls: Example
◼ Maximum profit:
◼ Long call: Payoff diagram shows there is no maximum profit
(unlimited) since there is no upper limit to the stock price
◼ Short call: Premium received ($6.26)
◼ Maximum loss:
◼ Long call: Premium paid ($6.26)
◼ Short call: Has no maximum loss (unlimited) since there is no
upper limit to the stock price
© Kaplan, Inc. 11
Option Strategies
Puts: Example
◼ Consider a long (buy) position in XYZ JUN 50 puts
◼ Option premium (cost) is $4.88
◼ At expiration, if XYZ stock < $50, option is ITM
◼ At expiration, if XYZ > $50, option is OTM (0 intrinsic value)
Example:
◼ XYZ stock at expiration is $60: option expires OTM, worthless
(zero intrinsic value)
◼ XYZ stock at expiration is $40: option expires ITM with an
intrinsic value = $50 – $40 = $10
© Kaplan, Inc. 12

Option Strategies
Puts: Example
◼ Breakeven at expiration (both long and short put):
◼ Strike price less the premium: $50 – $4.88 = $45.12
◼ Maximum profit:
◼ Long put: When stock is worthless: $50 – $4.88 = $45.12
◼ Short put: Premium received ($4.88)
◼ Maximum loss:
◼ Long put: Premium paid ($4.88)
◼ Short put: When stock is worthless: $50 – $4.88 = $45.12
© Kaplan, Inc. 13
Option Strategies
Synthetic Positions: Long Call + Short Put

▪ We can combine a long call with a short put to create a
synthetic long forward position
◼ On the same underlying, same strike price and same expiration
◼ Only one of the options can be ITM at expiration (other is OTM)
◼ If stock price at expiration > strike price: call is ITM, put is OTM,
and position generates a profit
◼ If stock price at expiration < strike price: put is ITM, call is OTM,
and position generates a loss
© Kaplan, Inc. 14

Option Strategies
Synthetic Positions: Long Call + Short Put

▪ Consider a long XYZ MAY 50 call and short XYZ MAY 50 put
▪ Call premium = $6.26, put premium = $3.87
▪ Net initial payment: $6.26 – $3.87 = $2.39
▪ Breakeven at expiration: $50 + $2.39 = $52.39 (stock is up
$2.39, call is ITM by $2.39, put is OTM with $0 value)
▪ Maximum profit: unlimited
▪ Maximum loss: $50 + $2.39 = $52.39
© Kaplan, Inc. 15
Option Strategies
Synthetic Positions: Put-Call Parity

▪ An identical payoff pattern to the long call + short put position
= buying the stock and borrowing the PV of the strike price
▪ These two positions have identical values, regardless of
the stock price at expiration.
◼ Call premium (paid initially) – put premium (received initially) =
initial stock price paid – PV(X) received
◼ In symbols: c0 – p0 = S0 – PV(X) or S0 + p0 = c0 + PV(X)
◼ This is the (dreaded) put-call parity relationship.
© Kaplan, Inc. 16

Option Strategies
Synthetic Positions: Put-Call Parity

▪ In our example, c0 – p0 = $6.26 – $3.87 = $2.39.
▪ Assume the risk-free interest rate is 3%.
▪ Therefore, PV($50) = $50 / (1.03)61/365 = $49.75.
▪ And S0 – PV(X) = $52.14 – $49.75 = $2.39.
▪ We can also substitute PV(F0(T)) for S0.
▪ F0(T) is the forward price for a contract that matures at the
same time as the options expire.
▪ This is called put-call forward parity.
© Kaplan, Inc. 17
Option Strategies
Covered Calls
◼ Covered call is long the underlying stock and short a call
◼ Limited upside, but risk of the short option position is hedged
by ownership of the stock
◼ Example: Buy XYZ stock on 20 March for $52.14, and sell
XYZ APR 55 call for $2.52 (per share)
◼ At expiration, if XYZ > $55, call is ITM and exercised
◼ At expiration, if XYZ < $55, call is OTM and is worthless
© Kaplan, Inc. 18

Option Strategies
Covered Calls: Example

◼ Maximum profit (when stock is $55 or higher):
◼ At $55, the stock rose by $2.86, and any further appreciation has
been given away because of short call
◼ Profit: ($55 – $52.14) + $2.52 = $5.38
◼ Maximum loss:
◼ Stock can fall to zero, but loss is mitigated by premium received
◼ $52.14 – $2.52 = $49.62
◼ Breakeven:
◼ Same as maximum loss
© Kaplan, Inc. 19
Option Strategies
Covered Calls: Investor Motivations

There are 3 primary motivations for covered call positions:
1. Extra yield: OTM strike price
◼ Doesn’t expect large price appreciation; premium adds income
2. Reducing a position at a favorable price: ITM strike price
◼ Option provides income and will be exercised if stock price >
strike price (risk is stock price decreases)
3. Realize a target price: Slightly OTM strike price
◼ Similar to selling stock at a limit price
◼ Risk is foregoing large price appreciation or opportunity to sell at
current high prices
© Kaplan, Inc. 20

Option Strategies
Protective Puts
◼ Protective put is long the underlying stock and long a put
◼ Put protects against stock price falling, but retains upside
◼ Example: Buy XYZ stock on 20 March for $52.14, and buy
XYZ MAY 50 put for $3.87 (per share)
◼ At expiration, if XYZ > $50, put is OTM and is worthless
◼ At expiration, if XYZ < $50, put is ITM
© Kaplan, Inc. 21
Option Strategies
Protective Puts: Example

◼ Maximum profit:
◼ Unlimited because stock price can rise without limit
◼ Maximum loss:
◼ Stock can fall, but decline below $50 is mitigated by put
◼ ($52.14 – $50) + $3.87 (premium) = $6.01
◼ Breakeven:
◼ Initial stock price + put premium
◼ $52.14 + $3.87 = $56.01
© Kaplan, Inc. 22

Option Strategies
Hedging Short Positions With Options

A short position in a stock allows an investor to benefit from a
price decline, but risk is that stock price rises
◼ Can combine a short position with a long call to mitigate risk
◼ Similar in function to a protective put
◼ Keeps upside
◼ Conversely, can sell a put to give extra income (premium)
◼ But removes benefit of stock price falling below put strike
price
© Kaplan, Inc. 23
Option Strategies
Collars
◼ Think of a collar as a combination of a protective put and a
covered call.
◼ In other words, buy a stock, buy a put, sell a call.
◼ It limits the upside but protects on the downside.
© Kaplan, Inc. 24

Option Strategies
Collars: Example
◼ Consider holding XYZ stock on March 20 priced $52.14
◼ Buy XYZ JUN 50 put for $4.88, and sell XYZ JUN $55.87 call
for $4.88
◼ Put cost offsets premium received from call (zero cost collar)
◼ Stock price is hedged beyond both strike prices
◼ Maximum profit: $55.87 – $52.14 = $3.73
◼ Maximum loss: $52.14 – $50 = $2.14
© Kaplan, Inc. 25
Option Strategies
Straddles
▪ A straddle is a volatility play
▪ No position in underlying, only through options
▪ Long straddle: Buy a call and put, same expiry date and
strike
▪ Profits from high volatility
▪ Short straddle: Sell a call and put, same expiry date and
strike
▪ Profits from low volatility (neutrality play)
© Kaplan, Inc. 26

Option Strategies
Long Straddle: Example

◼ Buy a June $52.5 call and buy a June $52.5 put
◼ Call premium = $6.22; put premium = $6.19
◼ Total premium = $6.22 + $6.19 = $12.41 = maximum loss
◼ At expiration, either the call or put is ITM, but not both
◼ Breakeven call: $52.50 + $12.41 = $64.91
◼ Breakeven put: $52.50 – $12.41 = $40.09
© Kaplan, Inc. 27
Option Strategies
Spreads
◼ Spreads: Equal numbers of long options on one strike and
short options on a second strike
◼ Spreads have limited upside and downside
◼ Bull spreads (bullish) profit if underlying increases in price
◼ But less bullish than call option only
◼ Bear spreads (bearish) profit if underlying decreases in price
◼ But less bearish than put option only
◼ Both can be constructed with only calls or only puts
© Kaplan, Inc. 28

Option Strategies
Bull Call Spread: Example

Investor buys XYZ June 50 call for $7.40 on March 20
Investor also sells XYZ June 55 call for $5.20
Also called debit spread because of net cash outlay
Calculate:
◼ Net outlay
◼ Maximum value
◼ Maximum profit/maximum loss
◼ Breakeven
© Kaplan, Inc. 29
Option Strategies
Bull Call Spread: Example

Net outlay = net premium paid
◼ Net outlay = $7.40 – $5.20 = $2.20
Maximum value is when the stock closes at 55
◼ Further upside to the long call is hedged away by short call
Maximum profit: maximum value of $5 less the net premium =
$5 – $2.20 = $2.80
Maximum loss: net premium paid = $2.20
Breakeven: $2.20 above the lower strike = $50 + $2.20 = $52.20
© Kaplan, Inc. 30

Option Strategies
Bear Put Spread: Example

Investor buys XYZ May 55 put for $6.61 on March 20
Investor also sells XYZ May 50 put for $3.87
Calculate:
◼ Net outlay
◼ Maximum value
◼ Maximum profit/maximum loss
◼ Breakeven
© Kaplan, Inc. 31
Option Strategies
Bear Put Spread: Example

Net outlay = net premium paid
◼ Net outlay = $6.61 – $3.87 = $2.74
Maximum value is when the stock closes at 50
◼ Further upside to the long put is hedged away by short put
Maximum profit: maximum value of $5 less the net premium =
$5 – $2.74 = $2.26
Maximum loss: net premium paid = $2.74
Breakeven: high strike – net premium = $55 – $2.74 = $52.26
© Kaplan, Inc. 32

Option Strategies
Bear Call Spread

Buy a call option at a higher strike price, and sell a call option at
a lower strike price
Called a credit spread because of net cash inflow
◼ Maximum profit = net premium received
◼ Breakeven = lower strike + net premium received
◼ Maximum loss = difference between strikes – net premium
received
© Kaplan, Inc. 33
Option Strategies
Bull Put Spread

Buy a put option at a lower strike price, and sell a put option at a
higher strike price
Also called a credit spread because of net cash inflow
◼ Breakeven = higher strike + net premium received
◼ Maximum loss = difference between strikes – net premium
received
© Kaplan, Inc. 34

Option Strategies
General Spread Formulas for Exam

◼ For debit spreads (bull call and bear put):
◼ Maximum loss = net premium paid
◼ Maximum profit = difference between strikes – net premium paid
◼ For credit spreads (bear call and bull put):
◼ Maximum loss = difference between strikes – net premium received
◼ For call spreads, breakeven = lower strike + net premium
◼ For put spreads, breakeven = higher strike – net premium
© Kaplan, Inc. 35
Option Strategies
The Greeks
◼ Greeks refers to an option’s relationship with other variables
◼ We will look at: delta, gamma, theta, vega
◼ Delta (Δ) = change in option price for $1 change in stock price
◼ Positive (0 to +1) for long calls; negative (–1 to 0) for long puts
◼ The more ITM an option, the higher is its absolute delta (closer to 1)
◼ The more OTM an option, the lower is its absolute delta (closer to 0)
◼ Delta of long position in one unit of the underlying is +1
◼ Delta of short position in one unit of the underlying is –1
© Kaplan, Inc. 36

Option Strategies
The Greeks: Example

◼ Consider a MAY 55 call with a delta of 0.47:
◼ If the stock price rose by $1, the call should rise by $0.47.
◼ We say “should” because other factors are assumed constant.
◼ In reality, the option price may rise by more than $0.47 because
the option price line is not a straight line.
◼ Now consider that the MAY 55 call has a gamma of 0.031:
◼ This means for a $1 rise in the share price, the call’s delta would
be 0.031 higher: 0.470 + 0.031 = 0.501.
◼ Note that gamma is only an approximation.
© Kaplan, Inc. 37
Option Strategies
The Greeks
◼ Gamma (Γ) = change in delta for $1 change in stock price
◼ Positive for long calls and for long puts
◼ Gamma is greatest for ATM options close to expiration
◼ Theta (θ) = daily change in option price due to change in time
◼ Negative for long calls and long puts
◼ Vega (ν) = change in option price per +1% change in volatility
◼ Positive for long calls and for long puts
◼ Exam tip: Theta is ‘t’ for time, vega is ‘v’ for volatility
© Kaplan, Inc. 38

Option Strategies
Position Deltas
◼ Delta for combination of options and positions: Add up
individual deltas (be careful with signs!)
◼ Consider a long position of 1,000 shares in XYZ, plus a long
position in 10 XYZ put contracts with a delta = –0.6
◼ Portfolio has a position delta of (1,000 × +1) + (10 × 100 × –0.6)
= 1,000 – 600 = 400
◼ Therefore, negative exposure in puts offsets some of positive
exposure in stock
◼ Conversely, if share price falls $1, position loses $400
© Kaplan, Inc. 39
Option Strategies
Protective Put Pre-Expiry

◼ Recall that a protective put = long stock + long put
◼ Net exposure of protective put = long call (delta of 0 to +1)
◼ At expiration, it fully retains upside above strike price but
completely hedges below the strike price
◼ Pre-expiry: If stock price rises significantly:
◼ Put is substantially OTM, and position delta moves close to +1
◼ Pre-expiry: If stock price falls significantly:
◼ Put is substantially ITM, and position delta moves close to 0
© Kaplan, Inc. 40

Option Strategies
Covered Call Pre-Expiry

◼ Recall that a covered call = long stock + short call
◼ Net exposure of covered call = short put (delta of 0 to +1)
◼ At expiration, it gives away upside above strike price but
retains downside below the strike price
◼ Pre-expiry: If stock price rises significantly:
◼ Short call is substantially ITM, and position delta is close to 0
◼ Pre-expiry: If stock price falls significantly:
◼ Short call is substantially OTM, and position delta is close to +1
© Kaplan, Inc. 41
Option Strategies
Collar Pre-Expiry
◼ Recall that a collar = long stock + long put + short call
◼ At expiration: It gives away upside above short call strike price
and hedges below the long put strike price, with unhedged
exposure between put and call strike prices
◼ Pre-expiry: Collar considerably dampens the variability of the
position
© Kaplan, Inc. 42

Option Strategies
Bull Call Spread Pre-Expiry

◼ Recall that a bull call spread = long call with lower strike +
short call with higher strike
◼ At expiration: It gives away upside above short call strike price
and hedges below the long call strike price, with unhedged
exposure between the two strike prices
◼ Pre-expiry: Delta is close to zero, but positive
© Kaplan, Inc. 43
Option Strategies
Theta
◼ Recall that theta measures how quickly an option loses value
over time:
◼ It is always negative.
◼ Theta changes simply from the passage of time.
◼ ATM options have the highest (absolute value) thetas.
◼ One way to profit from thetas is through a calendar spread.
© Kaplan, Inc. 44

Option Strategies
Long Calendar Spread

◼ Buy a longer-dated option and sell a shorter-dated option with
the same strike price and underlying
◼ Only example where options have different expirations
◼ Motivation is to benefit from theta from different expiry options
◼ Premium on shorter-dated option should fall faster than the
premium on longer-dated option
◼ Gains more value on short than loss on long
◼ Benefits from stable market or increase in implied volatility
© Kaplan, Inc. 45
Option Strategies
Short Calendar Spread

◼ Sell a longer-dated option and buy a shorter-dated option with
the same strike price and underlying
◼ Motivation is to benefit from theta from different expiry options
◼ Premium on longer-dated option should fall faster than the
premium on shorter-dated option
◼ Gains more value on short than loss on long
◼ Benefits from large move in underlying or decrease in implied
volatility
© Kaplan, Inc. 46

Option Strategies
Vega
◼ Recall that vega is change in option price for 1% change in
volatility:
◼ Always positive
◼ ATM options have the highest (absolute value) thetas
© Kaplan, Inc. 47
Option Strategies
Straddle Pre-Expiry
◼ Recall that straddle involves a long call option and a long put
option with same underlying, strike and expiry
◼ Volatility is straddle’s best friend
◼ Because an investor buys both a call (positive delta) and a put
(negative delta), the position can be created to have near-zero
delta (a zero delta is called a delta neutral position)
◼ However, two long options have negative theta, so value falls
over time
© Kaplan, Inc. 48

Option Strategies
Volatility Skew and Smile

◼ In practice, option prices for different expirations and strike
prices have different volatilities.
◼ There are two relationships between implied volatility and
strike price:
1. Volatility smile: The further away an option is from being ATM,
the higher the implied volatilities, so we would see a U-shaped
(smiling) curve when plotting implied volatility vs. strike price.
2. Volatility skew: Implied volatility increases for more OTM puts
and decreases for more OTM calls.
© Kaplan, Inc. 49
Option Strategies
Volatility Skew and Smile

◼ Bearish sentiment: Large increase in skew, large (absolute)
increase in implied volatility
◼ Bullish sentiment: High implied volatilities for OTM calls
© Kaplan, Inc. 50

Option Strategies
Risk Reversal
◼ Risk reversal: long (short) call + short (long) put on the same
underlying
◼ A risk reversal with a delta of 0.3 would imply that a $1 fall in the
stock price would result in a loss of $1 × 0.3 × 1,000 = $300.
◼ The goal is to profit when implied volatilities return to a normal
state.
◼ Risk reversal creates net long stock position
© Kaplan, Inc. 51
Option Strategies
Risk Reversal
◼ An investor can offset this long exposure by selling 300 shares (this
is called a delta hedge).
◼ In a delta hedge, the size of the position of the hedge is adjusted for
the delta of the position on the other side.
◼ Because the delta in a risk reversal changes over time, the size of
the delta hedge also needs to be constantly adjusted (this is called
dynamic hedges).
© Kaplan, Inc. 52

Option Strategies
Two Additional Terms

◼ Term structure of volatility: Implied volatilities differ across
option maturities (e.g., contango)
◼ Implied volatility surface: Examines joint influence of
maturity (x-axis) and strike price (y-axis) on implied volatility
on the z-axis
© Kaplan, Inc. 53
Option Strategies
Applications
◼ Follow along in your SchweserNotesTM as we look at these
examples that illustrate a particular option strategy:
▪ Covered call ▪ Calendar spread

▪ Put writing ▪ Hedging excepted volatility
▪ Long straddle ▪ Long calls as proxy for underlying
▪ Collar ▪ Protective put
© Kaplan, Inc. 54

Option Strategies
Strategy 1: Covered Call

◼ Investor owns stock but has bearish outlook for next 6 months
◼ Covered calls can be used to generate extra premium income
◼ Reduces delta of stock holding
◼ Stock is worth $169 ➔ sell 44-day calls with $170 strike
◼ OTM option works better than ITM because ITM option can be
called away immediately
◼ Risk: Investor foregoes potential stock price rise above $170
© Kaplan, Inc. 55
Option Strategies
Strategy 2: Put Writing

◼ Investor wants to buy stock but finds it too expensive
◼ Can write puts to generate premium income and offset cost
◼ Stock is $169, but investor wants to pay max $165
◼ Write OTM puts at $165 strike
◼ Risk 1: Stock price may rise, and investor missed out on
buying at $169 (slightly mitigated by premium income)
◼ Risk 2: Stock price may fall below ($165 – premium), in which
case investor must buy at $165 instead of ($165 – premium)
© Kaplan, Inc. 56

Option Strategies
Strategy 3: Long Straddle

◼ Investor believes stock price will rise or fall by more than 10%
but is unsure of direction
◼ Straddle is optimal strategy under high price volatility
◼ Following a news story, volatility rises and straddle price rises
◼ Investor now needs 12% movement to reach new breakeven
points, so straddle is no longer worthwhile
◼ Investor can use vega and implied volatility to determine
straddle’s price change
© Kaplan, Inc. 57
Option Strategies
Strategy 4: Collar
◼ Investor owns stock with low cost basis, so does not want to
sell (e.g., for tax reasons) but is worried about price decline
◼ Can use a zero-cost collar by selling call and buying put
◼ Short call minimizes potential large gains
◼ Long put protects against potential large losses
© Kaplan, Inc. 58

Option Strategies
Strategy 5: Calendar Spread

◼ Investor has moderately bearish long-term outlook in Euro
Stoxx 50 index but little movement over next month
◼ Current index level is 3,500
◼ Sell 3-month ATM 3,500 puts, buy 6-month ATM 3,500 puts
◼ This is a long calendar spread
◼ If index stays flat, short put expires worthless, long put
declines in value but is still worth more than net premium paid
© Kaplan, Inc. 59
Option Strategies
Strategy 5: Calendar Spread (cont.)

◼ Why use puts: Because once near term put expires, investor
is left with longer term put, so keeps bearish exposure
◼ Puts will always have same intrinsic value (because same
strike), but long put will have more time value
◼ Risk: Entire net premium being lost
© Kaplan, Inc. 60

Option Strategies
Strategy 6: Hedging Expected Volatility

◼ Investor owns stock but worries about higher short-term
volatility
◼ Can buy ATM call on VIX futures and sell OTM put on VIX
futures
◼ Premium income from OTM put reduces cost of call
◼ Equivalent to a collar against a short exposure
◼ Can regress portfolio’s historic profits/losses against changes
in volatility to determine option price
© Kaplan, Inc. 61
Option Strategies
Strategy 7: Long Calls as Proxy for Underlying

◼ Investor expects share price to rise from £60 to £70 over the
next three months with no change in option volatility
◼ Investor can use a formula to find a three-month (long) call
that will maximize profits given expected price change
profit at expiration if stock = £70 70 – (X + c 0 )

=
premium c0
◼ Call with breakeven (X + c0) above £70 will not work

© Kaplan, Inc. 62

Option Strategies
Strategy 8: Protective Put

◼ Investor expects share price to fall by up to 10% rom €42 to
€37.80 over the next week
◼ Investor can use a formula to find a one-month (long) put that
will maximize profit given expected price change
profit at expiration if stock = €37.80 (X – p0 ) – 37.8

=
premium p0
◼ Put with breakeven (X – p0) below €37.80 will not work

© Kaplan, Inc. 63


Management
Swaps, Forwards, and Futures Strategies
Interest Rate Swaps

▪ Interest rate swaps are contracts that convert fixed-rate to
floating-rate, or floating-rate to fixed-rate obligations.
▪ A payer swap makes (pays) fixed-rate payments and
receives floating-rate payments on a notional amount.
▪ A receiver swap receives fixed-rate payments and makes
floating-rate payments on a notional amount.
▪ The other side to a payer swap is a receiver swap.
▪ The floating-rate payment for the first settlement date is
known upfront (at contract initiation).
© Kaplan, Inc. 2

Interest Rate Swaps
Interest Rate
Existing Exposure Converting Beneficial When
Swap Required
Floating-rate liability Floating to fixed Payer swap Floating rates expected
to rise
Fixed-rate liability Fixed to floating Receiver swap Floating rates expected
to fall
Floating-rate asset Floating to fixed Receiver swap Floating rates expected
to fall
Fixed-rate asset Fixed to floating Payer swap Floating rates expected
to rise
© Kaplan, Inc. 3
Interest Rate Swap: Example

◼ ABC, Inc. issued a $30M, semiannual-pay, four-year floating-
rate note (FRN) with coupon of 180-day LIBOR + 25 bp.
◼ After one year, the firm expects interest rates to rise.
◼ The firm enters into a 3-year payer swap with a 2% fixed
rate of semiannual payments on $30M notional principal.
◼ At swap initiation, 180-day LIBOR was 1.5%.
© Kaplan, Inc. 4


◼ Settlement date 1 (180 days after swap initiation)
◼ Swap:
◼ Fixed payment = $30M × 2% × 180 / 360 = $300,000
◼ Floating payment = $30M × 1.5% × 180 / 360 = $225,000
◼ Net cash flow = $225,000 – $300,000 = –$75,000
◼ FRN: floating payment = $30M × (1.5% + 0.25%) × 180 / 360

= $262,500
◼ ABC: total payment = $262,500 + $75,000 = $337,500
© Kaplan, Inc. 5

◼ 180-day LIBOR at settlement date 1 = 3%
◼ Settlement date 2 (360 days after swap initiation)
◼ Swap:
◼ Fixed payment = $30M × 2% × 180 / 360 = $300,000
◼ Floating payment = $30M × 3% × 180 / 360 = $450,000
◼ Net cash flow = $450,000 – $300,000 = $150,000
◼ FRN: floating payment = $30M × (3% + 0.25%) × 180 / 360 =

$487,500
◼ ABC: total payment = $487,500 – $150,000 = $337,500 6
© Kaplan, Inc.


◼ Note: regardless of the level of LIBOR, the cash payments
by ABC will always be $337,500 = swap fixed rate + the
margin above the reference rate on the FRN:
◼ $30M × (2% + 0.25%) × 180 / 360 = $337,500
© Kaplan, Inc. 7
Modifying Portfolio Duration

▪ Receiver swap is equal to issuing a FRN and buying a fixed-
rate note.
▪ Note that fixed-rate duration is greater than floating-rate
duration.
▪ Therefore, payer swap has a negative duration.
▪ Increases in value when interest rates increase
▪ Receiver swap has a positive duration.
▪ Decreases in value when interest rates increase
© Kaplan, Inc. 8

Modifying Portfolio Duration

▪ The basic hedging formula for bond contracts can be adapted
to calculate the notional principal of a swap necessary to
modify portfolio duration.
 MDT − MDP 
NPS =   (MVP )
 MDS 
© Kaplan, Inc. 9
Target Duration Using Swaps: Example

▪ A fund manager with a portfolio of £120 million fixed-rate U.K.
bonds believes interest rates will fall over the next 3 years.
▪ The manager wants to increase duration from 4.5 to 6.
▪ A payer swap is available with a duration of –2, and a receiver
swap with a duration of +2.
▪ State the appropriate swap and calculate the notional
principal.
© Kaplan, Inc. 10

Target Duration Using Swaps: Example

▪ The manager should enter into a receiver swap with a £90M
notional principal:
 6 − 4.5 
NPS 
=   £120 million = £90 million
 2 
© Kaplan, Inc. 11
Forward Rate Agreements (FRAs)

▪ FRAs are (short-term) derivatives that hedge the uncertainty
of future borrowing or lending rates.
▪ Long position in FRA receives payment at settlement if market
rate of interest rate is higher than FRA (forward) rate.
▪ If market rate of interest rate is greater than FRA (forward)
rate, a payment must be made to settle the FRA.
▪ For the exam, remember the following:
▪ Long FRA increases in value when interest rates rise.
▪ Short FRA increases in value when interest rates fall.
© Kaplan, Inc. 12

Forward Rate Agreements (FRAs)

▪ Consider an FRA that settles in 60 days and is based on
future 120-day borrowing rate.
▪ This is known as a long 2×6 FRA.
▪ Each number is a multiple of 30 days.
▪ 2 = 2 × 30 days = 60 (days FRA expiry)
▪ 6 – 2 = 4 × 30 days = 120 (days borrowing period)
▪ Payoff in FRA at the end of the 120-day borrowing period
days is discounted to FRA expiry.
© Kaplan, Inc. 13
Timeline of the Long 2×6 FRA
© Kaplan, Inc. 14

FRA: Example
◼ Smithies Plc (Smithies) wants to borrow £1M for 180 days, 90
days from now, at LIBOR + 50 bps.
◼ Smithies is worried that interest rates will rise, raising its cost.
◼ Solution: Take a long position in a £1M notional FRA on 180-
day LIBOR, 90 days in the future with a fixed rate of 5%.
◼ Calculate the borrowing costs if 180-day LIBOR values are
7% and 3% 90 days from now.
© Kaplan, Inc. 15
FRA: Example
LIBOR is 7% at FRA expiry:
◼ Cost of loan: (7% + 0.5%) × 180 / 360 × £1M = £37,500

◼ Long FRA receipt: (7% – 5%) × 180 / 360 × £1M = £10,000
◼ Net cost: £37,500 – £10,000 = £27,500
◼ Note that the £10,000 payoff at the end of the borrowing
period is typically discounted and exchanged between FRA
counterparties at FRA expiry at day 90.
© Kaplan, Inc. 16

FRA: Example
LIBOR is 3% at FRA expiry:
◼ Cost of loan: (3% + 0.5%) × 180 / 360 × £1M = £17,500

◼ Long FRA receipt: (3% – 5%) × 180 / 360 × £1M = –£10,000
◼ Net cost: £17,500 + £10,000 = £27,500
© Kaplan, Inc. 17
Short-Term Interest Rate (STIR) Futures

▪ STIR futures are similar in concept to FRAs.
▪ But, standardized for specific maturities only, they require a
margin deposit and are marked-to-market.
▪ Users often need offsetting transaction to close out positions.
▪ An example of STIR futures is Eurodollar futures, which are
quoted as 100 − annualized forward rate.
▪ Forward rate is calculated from current LIBOR rates.
▪ Futures prices will rise when forward rates fall (vs. a long FRA
which rises when forward rates rise).
© Kaplan, Inc. 18

STIR Futures: Example

◼ Allan Luard expects to receive a $20M inheritance in 120
days.
◼ Luard wants to invest the $20M at LIBOR – 25bps but is
worried about interest rates falling.
◼ He takes a long position in 20 Eurodollar futures contracts
expiring in 120 days and trading at 95 .
◼ Calculate his return if in 120 days LIBOR is 3.5% and 6.5%.
© Kaplan, Inc. 19

LIBOR is 3.5% at futures expiry:
◼ Interest on deposit: $20M × (3.5% − 0.25%) × 90 / 360 =

$162,500
◼ Number of futures contracts: $20M / $1M = 20
◼ Futures price at settlement: 100 − 3.5 = 96.5
◼ Profit on futures: 96.5 − 95 = 150 bps; 150 bps × $25 × 20
contracts = $75,000
◼ Total return: $162,500 + $75,000 = $237,500
© Kaplan, Inc. 20


LIBOR is 6.5% at futures expiry:
◼ Interest on deposit: $20M × (6.5% − 0.25%) × 90 / 360 =

$312,500
◼ Number of futures contracts: $20M / $1M = 20
◼ Futures price at settlement: 100 − 6.5 = 93.5
◼ Loss on futures: 93.5 − 95 = −150 bps; 150 bps × $25 × 20
contracts = −$75,000
◼ Total return: $312,500 − $75,000 = $237,500
© Kaplan, Inc. 21
Fixed Income Futures

▪ Interest rate futures are useful interest rate hedges of short-
maturity bonds (2–3 years).
▪ Longer maturity bonds are best hedged with fixed income
futures (i.e., bond futures).
▪ Exchange traded with good liquidity
▪ Can be traded on CBOE, CME, Eurex or ICE exchanges
© Kaplan, Inc. 22


▪ Futures are usually closed out before settlement.
▪ If held to maturity, short has delivery options.
▪ For example, for U.S. Treasury bonds, short can select bonds
between 15 and 25 years maturity.
▪ Treasury bond futures are based on a notional value bond
with 6% coupon.
▪ Each bond that can be delivered by the short is assigned a
conversion factor (CF).
© Kaplan, Inc. 23

▪ Process to compute CF is not perfect because it assumes a
flat term structure of interest rates at 6%.
▪ But, term structure does affect bond’s value.
▪ This results in a bias because one of the eligible bonds will
generate the greatest gain (or smallest loss) to the short.
▪ Known as the cheapest-to-deliver (CTD) bond
© Kaplan, Inc. 24

Fixed Income Futures Calculations

▪ Settlement price is quoted with a par of $100.
▪ Short party will receive:
invoice price = (futures settlement price / 100) × $100,000 × CF
▪ Short party also receives accrued interest (AI):
total invoice amount = principal invoice price + accrued interest
▪ Overall profit / loss on deliver at time T:
profit/(loss) on delivery = [(settlement price × CF) + AIT] − (CTD
clean price + AIT)
© Kaplan, Inc. 25
Fixed Income Futures: Example

Bond 1 Bond 2
Coupon 5.5% 5.75%
Time to maturity 20 yrs 19 yrs
Bond price $141.13 $145.10
AI at delivery $0 $0
CF 0.9422 0.9719
Settlement price $148.75 $148.75
Identify which bond is the CTD.
© Kaplan, Inc. 26

Fixed Income Futures: Example

Bond 1 Bond 2
Settlement price × CF $148.75 × 0.9422 $148.75 × 0.9719
Total invoice amount $140.15 + $0 $144.57 + $0
Bond dirty price $141.13 + $0 $145.10 + $0
Loss (per $100,000) $0.98 $0.53
Therefore Bond 2 is the CTD because it results in the smaller

loss.
© Kaplan, Inc. 27
Hedging Interest Rate Risk with Treasury Futures

▪ A fund manager can use Treasury bond futures to hedge the
interest rate risk of a long bond portfolio.
▪ Treasury bond futures are useful in altering portfolio duration.
▪ Short futures reduce portfolio duration.
▪ Long futures positions increase duration.
▪ Treasury futures prices correlate most closely with the CTD
bond.
▪ Change (Δ) in futures price = ΔCTD / CF
© Kaplan, Inc. 28

Treasury Futures
▪ To fully immunize portfolio value against interest rate
changes, change in portfolio value must be offset by change
in futures value:
∆P = HR × ∆ futures price = HR × ΔCTD / CF
▪ Where:
∆P = change in portfolio value
HR = hedge ratio = number of futures contracts
© Kaplan, Inc. 29
Treasury Futures
▪ But, hedging with derivatives is subject to basis risk.
▪ Basis risk (or spread risk) is the mismatch between the
change in portfolio value and the change in derivative value
used to hedge it.
▪ For example, if the portfolio does not only contain the CTD
bond, then it is subject to basis risk.
▪ A duration-based hedge ratio (BPVHR) can be used to
determine the number of futures contracts required for a
hedge.
© Kaplan, Inc. 30

Treasury Futures
BPVT arget − BPVPortfolio
=BPVHR  CF
BPVCTD
◼ BPVHR = number of short futures
◼ BPVPortfolio = MDPortfolio × 0.0001% × MVPortfolio
◼ BPVTarget = MDTarget × 0.0001% × MVPortfolio
◼ BPVCTD = MDCTD × 0.0001% × MVCTD
◼ MD = modified duration
◼ MV = CTD price / 100 × $100,000
© Kaplan, Inc. 31
Treasury Futures: Example

▪ A fixed-income manager has a £60M portfolio and wants to
fully hedge against parallel movements in the yield curve.
▪ Portfolio modified duration is 10.75.
▪ The manager will sell U.K. Government Long Gilt futures to
hedge the portfolio.
▪ Compute the number of U.K. Government Long Gilt futures to
be sold to immunize the portfolio.
◼ Compute the number of Gilt futures that need to be sold to
achieve a target duration of 8.7.

© Kaplan, Inc. 32


U.K. Government Long Gilt Futures Specifications
Futures price £130.21

Futures contract size £100,000
CTD 4.75% coupon, 12 yrs to redemption
CTD Price £139.56
CTD CF 1.0709
CTD modified duration 9.7
© Kaplan, Inc. 33

Answer (to immunize portfolio):
Step 1: Compute BPVportfolio = 10.75 × 0.0001 × £60 million = £64,500
Step 2: Compute BPVCTD = 9.7 × 0.0001 × [(£139.56 / 100) × £100,000] = £135.37
Step 3: Compute BPVHR = −BPVPortfolio =
 CF
−£64,500
 1.07009
BPVCTD £135.37
= –509.87, or short 510 contracts to fully hedge portfolio
© Kaplan, Inc. 34


Answer (to achieve a target duration of 8.7):
Step 1: Compute BPVtarget = 8.7 × 0.0001 × £60 million = £52,200
BPVT arget − BPVPortfolio £52,200 − £64,500
Step 2: Compute BPVHR = BPVCTD
 CF =
£135.37
 1.07009
= –97.30, or short 97 contract to fully hedge portfolio
◼ Selling 97 Long Gilt futures will achieve target modified

duration of 8.7.
© Kaplan, Inc. 35
Currency Swaps
◼ A currency swap can be used to convert debt in one
currency to debt in another currency.
◼ A firm can borrow at lower cost in one currency and use
a currency swap to convert to a desired currency.
◼ Parties to a currency swap may exchange notional
amounts of each currency or only interest payments.
◼ If notional amounts are exchanged, it is known as cross-
currency basis swap.
© Kaplan, Inc. 36

Currency Swaps: Example

◼ A euro-based company needs USD.
◼ The company borrows euro from a bank and exchanges it for
USD.
◼ Euro borrowing is at 90-day Euribor and USD borrowing is at
90-day USD LIBOR.
◼ Company enters into two-year, €50M notional cross-currency
basis swap (exchange of principals) with quarterly settlement.
◼ The $/€ exchange rate at initiation is $1.1236/€.
◼ Calculate the payments at each settlement.
© Kaplan, Inc. 37

At initiation, euro company:
◼ Borrows €50M and delivers it to swap dealer
◼ Receives €50M × 1.1236 = $56.18M
At each settlement, euro company:

◼ Pays $56.18M × quarterly $ Libor to swap dealer
◼ Receives €50M × quarterly Euribor from swap dealer
◼ Pays €50M × quarterly Euribor interest on bank loan
© Kaplan, Inc. 38


At swap maturity (in 2 years), euro company:
◼ Exchanges back $56.18M notional for €50M with swap dealer
◼ Repays €50M bank loan
◼ Has effectively converted €50M floating rate obligation to
$56.18M floating rate obligation
© Kaplan, Inc. 39
Cross-Currency Basis
◼ Using a cross-currency basis swap violates the covered
interest rate parity (CIRP) relationship.
◼ If CIRP holds:
◼ The cost of borrowing directly in USD has the same cost
as borrowing in a foreign currency and hedging exchange
rate risk with a currency swap.
◼ If CIRP does not hold, arbitrage profits are possible.
© Kaplan, Inc. 40

Cross-Currency Basis
◼ CIRP has not held since 2008/2009 due to the following:
◼ Market friction (i.e., taxes and transaction fees)
◼ Stricter capital adequacy requirements and rules resulting in higher
interest costs
◼ High demand for USD loans resulting in higher premiums
◼ Cross-currency basis is the incremental cost of borrowing
USD through a swap rather than directly in the USD cash
market.
◼ Currencies typically show negative basis against the dollar.
© Kaplan, Inc. 41
Cross-Currency Basis Swap: Example

◼ Boivis is a French patisserie (bakery), which needs $50M to
set up shop in the U.S. and to cover working capital
requirements.
◼ Borrowing in USD is too expensive at $LIBOR + 100 bps.
◼ A decision is made to borrow in France at Euribor + 60 bps.
◼ Boivis then enters into a 4-year, variable interest quarterly pay
currency swap with a –20 basis points basis.
◼ $/€ exchange rate is $1.1815.
© Kaplan, Inc. 42


◼ At initiation, 3-month Euribor is 1.5% and $LIBOR is 2.0%.
◼ Three months later (first settlement date), 3-month Euribor is
1.6% and $LIBOR is 1.9%.
◼ Compute the principal amounts exchanged at initiation and
end of the swap.
◼ Calculate the interest payments at the first and second
settlement dates and Boivis’ cost for the synthetic dollar loan.
© Kaplan, Inc. 43

Principals at swap initiation and maturity:
◼ Boivis needs to borrow $50M / $1.1815 = €42,319,086 and
exchange it for $50M.
◼ Swap back principals at swap maturity.
© Kaplan, Inc. 44


Interest payment at first settlement date:
◼ Pays interest on loan: €42,319,086 × (0.015 + 0.006) × 90 /
360 = €222,175
◼ Pays interest on swap: $50M × 0.02 × 90 / 360 = $250,000
◼ Receives interest on swap: €42,319,086 × (0.015 − 0.002) ×

90 / 360 = €137,537
◼ Equivalent to paying $50M × (0.02 + 0.006 – (–0.002) × 90 /
360 = $350,000
© Kaplan, Inc. 45

Cost of USD financing at first settlement date:
◼ Borrowing USD direct at LIBOR + 100 bps would have cost:
◼ $50M × (0.02 + 0.01) × 90 / 360 = $375,000
◼ Borrowing USD synthetically at LIBOR + 80 bps actually cost:
◼ $50M × (0.02 + 0.006 + 0.002) × 90 / 360 = $350,000
◼ Net benefit of swap: $375,000 − $350,000 = $25,000
© Kaplan, Inc. 46


Interest payment at second settlement date:
◼ Pays interest on loan: €42,319,086 × (0.016 + 0.006) × 90 /
360 = €232,755
◼ Pays interest on swap: $50M × 0.019 × 90 / 360 = $237,500
◼ Receives interest on swap: €42,319,086 × (0.016 − 0.002) ×

90 / 360 = €148,117
◼ Equivalent to paying $50M × (0.019 + 0.006 – (–0.002) × 90 /
360 = $337,500
© Kaplan, Inc. 47

Cost of USD financing at second settlement date:
◼ Borrowing USD direct at LIBOR + 100 bps would have cost:
◼ $50M × (0.019 + 0.01) × 90 / 360 = $362,500
◼ Borrowing USD synthetically at LIBOR + 80 bps actually cost:
◼ $50M × (0.019 + 0.006 + 0.002) × 90 / 360 = $337,500
◼ Net benefit of swap: $362,500 − $337,500 = $25,000
◼ Boivis has locked into a cost of $LIBOR + 80 BP
© Kaplan, Inc. 48

Currency Forwards and Futures

◼ Currency forwards and futures allow the exchange of one
currency for another currency at a future date.
◼ It allows an entity to hedge the risk of exchange rate
movements and lock in a specific currency amount.
◼ Currency forwards are customized, while currency futures
are standardized for quantity and delivery dates.
◼ Because futures are standardized, a futures hedge may not
exactly match the requirements of a hedger.
© Kaplan, Inc. 49
Currency Forwards and Futures
© Kaplan, Inc. 50

Currency Forwards and Futures: Example

◼ Consider a U.S. firm that will receive €20M in 90 days for
goods sold
◼ The firm will sell EUR futures contracts with a maturity closest
to 90 days, at a rate of 1.3150 USD per EUR
◼ EUR-USD FX future contract size is €125,000
◼ Compute the number of futures contracts required to hedge
the liability and the amount of USD received at contract
settlement
© Kaplan, Inc. 51
Currency Forwards and Futures: Example

Answer:
€20,000,000
=
◼ HR = 160 EUR-USD futures
€125,000
◼ At settlement, the U.S. firm will deliver €20M and receive 20M × 1.3150 =
$26.33M.
◼ If the futures settle before the euros are received, the firm will have exchange
rate risk between settlement and euros receipt.
◼ If the futures settle after the euros are received, the futures position will be
closed prior to the futures settlement.
© Kaplan, Inc. 52

Equity Swaps
▪ Equity swaps create synthetic exposures to stocks.
▪ They allow share ownership without the expense of
ownership.
▪ Three main types of swaps:
▪ Pay fixed, receive equity return
▪ Pay floating, receive equity return
▪ Pay another equity return, receive equity return
▪ Equity return can be based on a single stock, basket of

stocks, or an equity index.
© Kaplan, Inc. 53
Equity Swaps
▪ A typical swap has periodic settlement dates, although some
swaps require single payment at end.
▪ Main advantages:
◼ Allows exposure to equity when owning in physical market
is restricted
◼ Avoids tax (i.e., stamp duty) and custody fees on physical
ownership
◼ Avoids the cost of monitoring physical positions
© Kaplan, Inc. 54

Equity Swaps
▪ Main disadvantages:
▪ Typically requires collateral
◼ Generally illiquid
◼ No equity voting rights
© Kaplan, Inc. 55
Equity Swaps: Example

▪ German fund manager has €200M portfolio of German stocks.
▪ Portfolio passively tracks DAX 30 stock market index.
▪ Manager expects index to rise over the next year and wants to
synthetically increase stock exposure by 40%.
▪ Enters into semiannual equity swap with €80M notional.
▪ Manager pays floating interest at 6-month Euribor + 30 bps.
▪ Manager receives equity index return.
▪ DAX 30 index at swap initiation is 12,400 points.
© Kaplan, Inc. 56


Scenario 1:
◼ Euribor reference rate for first settlement date is 6%.
◼ DAX 30 at the first settlement date is 13,020.
Scenario 2:
◼ Euribor reference rate for first settlement date is 6%.
◼ DAX 30 at the first settlement date is 11,780.
Compute for each scenario: (1) the portfolio gain/loss, (2) the
swap cash flows, and (3) the net position for the fund manager.
© Kaplan, Inc. 57

Scenario 1:
◼ Return on DAX 30 = (13,020 / 12,400) − 1 = 5%
◼ Portfolio gain = €200M × 0.05 = €10M
◼ Swap equity payment = €80M × 0.05 = €4M
◼ Swap floating payment = €80M × (0.06 + 0.003) × 180 / 360 =
€2.52M
◼ Swap net cash flow = €4M − €2.52M = €1.48M
◼ Fund manager’s position = €10M + €1.48M = €11.48M
© Kaplan, Inc. 58


Scenario 2:
◼ Return on DAX 30 = (11,780 / 12,400) − 1 = − 5%
◼ Portfolio loss = €200M × − 0.05 = −€10M
◼ Swap equity payment = €80M × − 0.05 = −€4M
◼ Swap floating payment = €80M × (0.06 + 0.003) × 180 / 360 =
€2.52M
◼ Swap net cash flow = −€4M − €2.52M = −€6.52M
◼ Fund manager’s position = −€10M − €6.52M = −€16.52M
© Kaplan, Inc. 59
Equity Forwards and Futures

◼ Both equity forwards and futures allow tactical asset allocation
and synthetically gain or reduce equity exposure.
◼ Selling (short) forwards / futures reduces equity exposure.
◼ Buying (long) forwards / futures increases equity exposure.
◼ Helps with portfolio diversification.
◼ Provides exposure to international markets.
◼ Make directional bets on the market.
© Kaplan, Inc. 60

Equity Forwards
◼ The main advantage is that forwards can be customized.
◼ Forwards do not have mark-to-market margin adjustments.
◼ But, they are typically illiquid and exposed to counterparty risk.
◼ There is no clearinghouse.
© Kaplan, Inc. 61
Equity Futures
◼ Exchange traded and standardized
◼ Require margin and subject to mark-to-market adjustments
◼ Have low transaction costs
◼ Can be available on indexes and single stocks
◼ Have a multiplier (e.g., $250 for S&P 500 Index futures, £10
for FTSE 100 Index futures)
◼ Multipliers should be given to you on the exam.
© Kaplan, Inc. 62

Equity Futures: Example

◼ A fund manager has a £200M equity portfolio, which passively
tracks the FTSE 100 Index.
◼ The manager wants to hedge against equity market risk.
◼ Compute the number of contracts needed to hedge 30% of
the portfolio’s equity position.
◼ Compute the profit or loss if the FTSE 100 rises 5% and the
futures price is 7,665.
◼ Compute the profit or loss if the FTSE 100 falls 5% and the
futures price is 6,935.
© Kaplan, Inc. 63

Contract Details for FTSE 100 Index Futures
◼ Quotation Index points
◼ Multiplier £10 per point
◼ Delivery dates March, June, September, December
◼ Settlement price FTSE 100 cash price on last day of trading
◼ Futures price 7,300 (September delivery)
© Kaplan, Inc. 64


Calculating number of futures contracts needed:
◼ Hedging against equity exposure requires selling futures:
◼ Number of futures contracts needed = 822 short futures
© Kaplan, Inc. 65

Calculating portfolio gain (FTSE 100 up 5% at price of 7,665):
◼ Change in index: 7,665 − 7,300 = 365 points (5% increase)
◼ Futures gain: 365 points × £10 × −822 = −£3,000,300
◼ Portfolio value: (1 + 0.05) × £200,000,000 = £210,000,000
◼ Net position: £210,000,000 − (£3,000,300) = £206,999,700
◼ (Note: The −£3,000,300 is essentially the same as 5% ×
£60,000,000, which is 30% hedge of portfolio).
© Kaplan, Inc. 66


Calculating portfolio loss (FTSE 100 down 5% at price of 6.935):
◼ Change in index: 6,935 − 7,300 = − 365 points (5% decline)
◼ Futures loss: − 365 points × £10 × −822 = £3,000,300
◼ Portfolio value: (1 − 0.05) × £200,000,000 = £190,000,000
◼ Net position: £190,000,000 + £3,000,300 = £193,000,300
◼ (Note: The £3,000,300 is essentially the same as −5% ×
£60,000,000, which is 30% hedge of portfolio).
© Kaplan, Inc. 67
Modifying Portfolio Beta

◼ Long futures can be used to increase portfolio beta, while
short futures can be used to decrease beta.
 desired change in beta   MVP 

# contracts =   
 beta of the futures contract   F 
Target beta Current beta
 β – βP   MVP 
Nf =  T  
 βF  F 
Futures beta
© Kaplan, Inc. 68

Modifying Portfolio Beta: Example

A manager of a $60M portfolio with a beta of 1.2 wants to reduce
beta to 0.8 over the next 6 months using S&P 500 futures.
◼ Beta of the S&P 500 futures is 1, and the futures price is
2,984 with a $250 multiplier.
◼ Calculate the number of futures contracts.
◼ Determine the most appropriate strategy using futures.
◼ Compute the effectiveness of the strategy.
© Kaplan, Inc. 69

◼ Futures contract value = 2,984 × $250 = $746,000
◼ To reduce beta, sell futures contracts
 0.8 − 1.2   $60,000,000 

number of futures =   $746,000  = −32.17
 1  
◼ Value of portfolio in six months:

$60,000,000 × [1 − (0.015 × 1.2)] = $58,920,000
© Kaplan, Inc. 70


◼ Futures in six months: 2,984 × (1 − 0.015) = 2,939.24
(rounded to 2,939)
◼ Futures profit: (2,984 − 2,939) × $250 × 32 = $360,000
◼ Net position: $58,920,000 + $360,000 = $59,280,000
◼ Return (loss) = $59,280,000 / $60,000,000 – 1 = –1.2%
© Kaplan, Inc. 71
Cash Equitization
◼ Large cash balances reduce portfolio return because of low
yield on cash.
◼ This can increase risk of underperforming benchmark.
◼ Cash equitization (or cash securitization or cash overlay)
refers to buying index futures to synthetically invest cash and
earn portfolio’s return.
◼ Advantages include high liquidity and low transaction costs.
© Kaplan, Inc. 72

Cash Equitization: Example

A fund manager holds $8M in cash but is worried that the
portfolio will underperform the S&P 500 because of cash drag.
◼ Beta of the S&P 500 futures is 1, and the futures price is
2,780 with a $250 multiplier.
◼ Calculate the number of futures contracts needed to equitize
cash.
© Kaplan, Inc. 73
Cash Equitization: Example

◼ To equitize cash, buy futures contracts (create long
exposure).
◼ Cash has a beta of 0; S&P 500 Index has a beta of 1.
◼ Futures contract value = futures price × multiplier = 2,780 ×
$250 = $695,000
 1 − 0   $8,000,000 
number of futures =
=   11.51,therefore buy 12 futures
 1  $695,000 
© Kaplan, Inc. 74

Volatility Derivatives Overview

▪ Volatility = magnitude of price movements over time.
▪ The best known measure of volatility is the CBOE Volatility
Index (VIX, or “fear index”).
▪ VIX is a measure of expected, not actual, volatility of S&P 500
traded options with an average 30-day expiry.
▪ VIX Index value is the annualized standard deviation of the
expected +/− % moves in the S&P 500 Index over 30 days.
© Kaplan, Inc. 75
Volatility Derivatives Overview
© Kaplan, Inc. 76

Volatility Derivatives: VIX Futures

▪ Investment in VIX Index can be done through VIX futures.
▪ VIX futures will price the expected S&P 500 Index volatility
following the 30-day period after contract expiration.
▪ For example, long VIX futures can protect an equity portfolio
during rising volatility given their negative correlation with
equities (equities down, VIX futures up).
▪ Short VIX futures imply short volatility but will have losses if
volatility increases.
© Kaplan, Inc. 77

▪ The term structure of VIX futures indicates expectations of
volatility.
▪ The expected change in volatility will determine whether
futures markets are in contango or backwardation.
▪ Upward slowing VIX futures curve indicates normal state,
rising volatility (contango market: futures price > spot price).
▪ Downward sloping VIX futures curve indicates abnormal state,
falling volatility (backwardated market: futures price < spot
price).
© Kaplan, Inc. 78


▪ VIX futures prices converge to the VIX Index at maturity as
their price converges to the spot price.
▪ For markets in contango, the futures price declines to the spot
price.
▪ For markets in backwardation, the futures price increases to
the spot price.
▪ Roll yield refers to the profit or loss as the basis moves
toward zero during the contract’s life.
▪ Basis refers to the spot price minus futures price.
© Kaplan, Inc. 79

The term structure of futures determines the level of roll yield:
Position Term Structure Roll Yield

Long futures position Contango Negative
Short futures position Contango Positive
Long futures position Backwardation Positive
Short futures position Backwardation Negative
© Kaplan, Inc. 80

Other Volatility Indexes and Derivatives

▪ Volatility indexes also exist on other U.S. and European stock
markets.
▪ Other derivatives also exist, including VIX options and
variance swaps.
▪ VIX options are cash-settled European options.
▪ For example, VIX call options gain value if volatility
expectations rise at maturity.
© Kaplan, Inc. 81
Variance Swaps
▪ Variance swaps are derivatives based on variance (standard
deviation).
▪ One counterparty makes fixed payments, other counterparty
makes variable payments.
▪ The fixed payment is known at initiation and is based on
implied volatility.
▪ The variable payment is only known at swap maturity and
is based on actual (realized) variance.
© Kaplan, Inc. 82

Variance Swaps
▪ At initiation, no principals are exchanged, and there are no
interim settlement periods.
▪ When realized variance > implied variance → fixed gains
▪ When realized variance < implied variance → variable gains
▪ Variance swap is therefore a pure play on whether realized
variance will be higher/lower than expected variance.
▪ Payoff at expiration time T is a single payment:
settlement amountT =
(variance notional)(realized variance − variance strike)
© Kaplan, Inc. 83
Variance Swaps
▪ Therefore, the profit/loss can also be stated based on realized
volatility relative to the strike price:
▪ Realized volatility > strike → long (swap buyer) gains
▪ Realized volatility < strike → long (swap buyer) loses
▪ Realized volatility (realized variance) is the natural log of the
daily price relatives, which is the ratio of closing price on day t,
divided by the closing price on day t−1:
Ri = ln(Pt / Pt–1)
© Kaplan, Inc. 84

Variance Swaps
▪ The daily variance can be calculated as a function of the price
relatives (R) and the number of days traded (N):
 N−1 2 
  Ri 
daily variance =  i=1
( N − 1) 
 
 
▪ Annualized variance = daily variance × 252 (where 252 =
assumed trading days in a year).
© Kaplan, Inc. 85
Variance Swaps
▪ The notional of a variance swap can be expressed either as
variance or vega.
▪ Variance notional or NVAR
▪ Vega notional or NVEGA
▪ NVAR represents the profit or loss per point difference between
realized variance (σ2) and implied variance (K2):
profit/(loss) = NVAR × (σ2 − K2)
© Kaplan, Inc. 86

Variance Swaps
▪ However, market convention is to use vega notional.
◼ Vega: change in option premium per 1% change in volatility.
◼ The profit or loss on a variance swap using NVEGA is similar to
using NVAR, but divided by implied volatility × 2:
  2 − K2 
= NVEGA   
 2K 
© Kaplan, Inc. 87
Convexity of Variance Swaps

▪ Convexity is useful in hedging tail risk of large equity declines.
▪ If volatility rises significantly, equity values fall but variance
swap profits rise at an accelerating rate.
▪ Variance swap payoffs are convex with respect to volatility.
▪ Relative to volatility derivatives with linear payoffs:
▪ If realized volatility < strike → variance swap losses are
smaller
▪ If realized volatility > strike → variance swap gains are
larger
© Kaplan, Inc. 88

Mark to Market of Variance Swaps

▪ Variance swaps have zero value at initiation.
▪ Profit or loss after initiation as volatility changes.
▪ Expected variance at maturity =
▪ Time-weighted average of the variance realized over the
time since swap inception + implied variance over the
remaining time to maturity
▪ Marking to market of a variance swap uses the expected
variance at maturity and has three steps.
© Kaplan, Inc. 89

Step 1:
▪ Calculate the expected variance at maturity (time-weighted
average of the variance realized over the time since swap
inception).
 t   2 T -t 
expected variance =  σ t2 ×  +  K (T -t ) × T 
 T   
▪ Note: Don’t get discouraged by this formula; once you apply

it, it will feel less complex (see following example).
© Kaplan, Inc. 90


Step 2:
◼ Compute expected payoff at swap maturity:
◼ payoff = NVAR × (expected variance to maturity – original

strike2)
Step 3:
◼ Discount the expected payoff at maturity back to valuation
date.
© Kaplan, Inc. 91
Mark to Market of Variance Swaps: Example

◼ Luke Amos, an equity fund manager, purchases a one-year
variance swap on the S&P 500.
◼ Swap has vega notional of $100,000 and a strike of 20%.
◼ Nine months later the S&P has a realized volatility of 21%.
◼ The strike price for a 3-month variance swap is quoted at
22%, and the annual interest rate is 2%.
◼ Compute the current value of the swap.
© Kaplan, Inc. 92


Step 1: Compute the expected variance at maturity:
◼ (212 × 9 / 12) + (222 × 3 / 12) = 330.75 + 121 = 451.75
Step 2: Compute the expected payoff at maturity:

◼ Expected payoff at maturity = (σ2 − K2) × variance notional
◼ K2 = 202 = 400
◼ Variance notional = vega notional / 2K = $100,000 / (2 ×
20) = $2,500
© Kaplan, Inc. 93

Step 2: (cont.)
◼ Expected payoff at maturity = (451.75 − 400) × $2,500 =
$129,375
Step 3: Discount the expected payoff back to valuation date:

◼ First, unannualize the interest rate = 2% × 3 / 12 = 0.5%
◼ Then discount the payoff = $129,375 / 1.005 = $128,731
◼ Long swap side gains, short side loses
© Kaplan, Inc. 94

Derivatives in Portfolio Management

▪ We now turn to the practical application of this reading’s
material on how to use derivatives in portfolio management,
through the following examples:
1. Using equity swaps to change equity exposure
2. Using index futures for cash equitization
3. Using futures to change asset class allocations
4. Using swaps to change asset class allocations
© Kaplan, Inc. 95
Example 1: Using Equity Swaps

▪ Jennifer Seago has 80,000 shares in ABC Gmbh (ABC).
▪ ABC is trading at €6.00 with an annual dividend of €0.05.
▪ She does not want to sell the shares for tax reasons but is
worried that the share price will fall due to restructuring.
▪ One-year Euribor is 0.95%.
▪ Suggest a swap strategy that addresses her concerns.
▪ Evaluate this strategy assuming that ABC share price either
increases by 5% or decreases by 5%.
© Kaplan, Inc. 96


▪ Assume a 1-year annual-pay total return swap.
▪ Interest paying side is tied to Euribor.
▪ Notional is 80,000 shares × €6.00 = €480,000.
Scenario 1: ABC pays €0.05 dividend but share price falls 5%

▪ €6.00 × (1 − 0.05) = €5.70
▪ Total return on ABC = (€5.70 + €0.05) / €6.00 − 1 = −4.1667%
▪ Seago receives:
[0.0095 − (−0.041667)] × €480,000 = €24,560
© Kaplan, Inc. 97

Scenario 2: ABC pays €0.05 dividend and share price rises 5%
▪ €6.00 × (1 + 0.05) = €6.30
▪ Total return on ABC = (€6.30 + €0.05) / €6.00 − 1 = 5.8333%
▪ Seago receives:
(0.0095 − 0.058333) × €480,000 = −€23,440 (receives
negative amount, i.e., pays €23,440)
© Kaplan, Inc. 98

Example 2: Cash Equitization

▪ Yoann Barbet manages an equity fund tied to the FTSE 100.
▪ The fund holds £60M in cash and £300M in equities with a
beta of 1.2 relative to the FTSE 100.
▪ Six-month cash rate is 0.86% (annualized).
▪ Six-month FTSE 100 futures are 7,348.50 with a beta of 1, a
multiplier of £10, and a contract tick size of 0.5 index points.
▪ Barbet is worried about cash drag, without buying equities.
▪ Determine his best strategy, and calculate his return
assuming the FTSE 100 rises by 6% and futures rise to 7,642.
© Kaplan, Inc. 99

Solution:
 T   MVP   1.2   £60,000,000 
▪ # of futures needed =    =  1   £73,485 
 F   F    
▪ # of futures contracts needed to buy = 979.8 (rounded to 980)

◼ Value of equity portfolio if the FTSE 100 rises by 6%=
£300M × [1 + (0.06 × 1.2)] = £321.6M

◼ $ return on equity portfolio = £321.6M − £300M = £21.6M
© Kaplan, Inc. 100


Barbet receives:
▪ Interest on cash = £60M × 0.0086 × 180 / 360 = £258,000
▪ Profit on futures contract = (7,642 − 7,348.50) = 293.5 points
▪ 293.5 points × £10 × 980 contracts = £2,876,300
▪ Barbet’s $ return = £21,600,000 + £258,000 + £2,876,300 =
£24,734,300
▪ Barbet’s % return = £24,734,300 / (£300M + £60M) = 6.87%
▪ 5.87% < 6% because of rounding of # of futures contracts
© Kaplan, Inc. 101
Example 3: Asset Allocation Using Futures

▪ Mathieu Chausset manages an €800M portfolio invested in
▪ 80% equities, split 50/50 in German and French stocks,
and
▪ 20% in French fixed-income securities.
▪ For the next 6 months, Chausset wants to increase the fixed-
income portion to 40% and reduce the equity portion to 60%.
▪ He also wants to reduce the German equity allocation to 30%
and increase the French equity allocation to 70%.
▪ Chausset wants to use index and government bond futures.
© Kaplan, Inc. 102


Additional information:
▪ German stock portfolio beta = 1.2 (relative to the DAX 30)
▪ French stock portfolio beta = 0.95 (relative to the CAC 40)
▪ French government bond (OAT) portfolio modified duration is
8.5.
▪ Also refer to the following slides for additional information.
▪ Calculate the number of long and short futures positions
Mathieu needs to use to implement his strategy.
© Kaplan, Inc. 103

Additional details on futures contracts (equity index)
Index name French CAC 40 German DAX 30

Futures price 5,500 12,200
Multiplier €10 €25
Beta 1 1
© Kaplan, Inc. 104


Additional details on futures contracts (French OATs)
Futures price €163.84

Contract size €100,000
CTD €127.72
CF 0.7768
© Kaplan, Inc. 105

Solution:
Original New Change

Equity €640M €480M
German €320M = 50% €144M = 30% ↓ €176M
French €320M = 50% €336M = 50% ↑ €16M
Fixed Income
French OATs €160M = 20% €320M = 40% ↑ €160M
© Kaplan, Inc. 106


German equities: decrease exposure by €176M
▪ # of futures needed:
  T − P   MVP   0 − 1.2   €176,000,000 



F  =  1   €305,000  = −692.45
 F     
▪ Chausset needs to sell 692 DAX 30 futures contracts

(rounded).
© Kaplan, Inc. 107

French equities: increase exposure by €16M
  T − P   MVP   0.95 − 0   €16,000,000 



F = 1   €55,000  = −276.36
 F      
▪ Chausset needs to buy 276 CAC 40 futures contracts

(rounded).
© Kaplan, Inc. 108


French OTAs: increase exposure by €160M
▪ BPVtarget = MDtarget × 0.0001 × MVportfolio =
8.5 × 0.0001 × €160M = €136,000
▪ BPVCTD = MDCTD × 0.0001 × (price / 100 × contract size) =
8.89 × 0.0001 × [(€127.72 / 100) × €100,000] = €113.54
▪ BPVHR = [(€136, 000 − €0) / €113.54] × 0.7768 = 930.46
▪ Chausset needs to buy 930 French OATs futures contracts
(rounded).
© Kaplan, Inc. 109

Summary of futures positions:
Security Futures position # of contracts

German equities Short DAX 30 futures –692
French equities Long CAC 40 futures +276
French fixed income Long OATs futures +930
© Kaplan, Inc. 110


Scenario 1: Now assume equity portfolio values will change:
▪ German stock portfolio declines 4% over next 6 months.
▪ French stock portfolio rises 2% over next 6 months.
▪ CAC 40 futures price is 5,616 at the end of 6 months.
▪ DAX 30 futures price is 11,793.5 at the end of 6 months.
▪ Calculate the impact on Chausset’s portfolio assuming the
portfolio adjustments in the previous scenario were made.
© Kaplan, Inc. 111

Solution: German equities decline by 4%:
▪ Decline in original equity holding = €320M × −0.04 = −€12.8M

▪ Gain in short DAX futures = (11,793.5 − 12,200) × €25 × −692
= €7,032,450
▪ Net loss = −€12,800,000 + €7,032,450 = −€5,767,550
© Kaplan, Inc. 112


Solution: French equities rise by 2%:
▪ Increase in original equity holding = €320M × 0.02 = €6.4M

▪ Gain in CAC futures = (5,616 − 5,500) × €10 × 276 =
€320,160
▪ Net gain = €6,400,000 + €320,160 = €6,720,160
© Kaplan, Inc. 113

Scenario 2: 50 bps parallel decline in French yield curve
▪ Gain in original fixed income holdings = −8.5 × −0.005 ×
€160,000,000 = €6,800,000
▪ Gain/loss on bond futures gain = BPVF × change in yield ×
number of futures contracts
▪ BPVF = BPVCTD / CF = €113.54 / 0.7768 = €146.16
▪ Gain on bond futures = €146.16 × 50 × 930 = €6,796,440
▪ Net gain = €6,800,000 + €6,796,440 = €13,596,440
© Kaplan, Inc. 114

Example 4: Rebalancing Using Futures

▪ Josh Birmingham manages an €200M portfolio with a target
asset allocation of 70% equities and 30% government bonds.
▪ Over the last month, the portfolio increased in value to €210M
and the portfolio allocations are now misaligned.
▪ Equity portfolio beta = 0.8.
▪ Fixed-income portfolio modified duration = 9.5.
▪ Birmingham wants to use futures to hedge his position.
▪ Calculate the number of futures positions needed.
© Kaplan, Inc. 115

Asset Current Target Change

U.S. large cap $140M $147M +$7M
(66.67%) (70%)
U.S. Treasury bonds $70M $63M –$7M
(33.33%) (30%)
Total $210M $210M
© Kaplan, Inc. 116


Additional information: Equity and Treasury futures contract
details
S&P 500 futures U.S. Treasury futures

Futures price 2,930 Futures price $135,000
Multiplier 250 Contract size $100,000
Beta 1 CTD $110.25
CF 0.8140
© Kaplan, Inc. 117

Solution 1: Increase U.S. large cap exposure by $7M
▪ Birmingham needs to buy 8 S&P 500 futures contracts

(rounded).
▪ Exam note: you should round up if the fraction is > 0.50.
© Kaplan, Inc. 118


Solution 2: Decrease U.S. Treasury bond exposure by $7M
▪ BPVportfolio = MDportfolio × 0.0001 × MVportfolio =
9.5 × 0.0001 × $7M = $6,650
▪ BPVCTD = MDCTD × 0.0001 × (price / 100 × contract size) =
8.5 × 0.0001 × [($110.25 / 100) × $100,000] = $93.71
▪ BPVHR = [($0 − $6,650) / $93.71] × 0.8140 = −57.76
▪ Birmingham needs to sell 58 U.S. Treasury futures contracts
(rounded).
© Kaplan, Inc. 119
Example 5: Asset Allocation Using Swaps

▪ Akasuki Weber manages the Cross Bright Helper fund (CBH).
▪ CBH value is ¥21,580,000,000, invested in Japanese equities
and fixed income.
▪ Equities are split into growth and value stocks.
▪ Fixed income are split into government and corporate bonds.
▪ Weber wants to alter the allocation between fixed income and
equity and alter the allocation of subfunds using futures.
▪ Calculate the number of futures contracts needed.
© Kaplan, Inc. 120


◼ Weber wants to avoid transaction costs.
◼ He decides to use equity and fixed-income swaps.
◼ These indexes share characteristics with the subportfolios:
◼ MSCI Japan Value Index
◼ MSCI Japan Growth Index
◼ S&P Japanese Government Bond Index
◼ S&P Japanese Corporate Bond Index
© Kaplan, Inc. 121

Additional information: Equities:
Current Target Change
Value ¥9,063.6M ¥3,884.4M – ¥5,179.2M
(60%) (30%)
Growth ¥6,042.4M ¥9,063.6M + ¥3,021.2M
(40%) (70%)
Total equity ¥15,106.0M ¥12,948.0M – ¥2,158.0M

(70% total) (60% total)
© Kaplan, Inc. 122


Additional information: Fixed income:
Current Target Change
Government ¥3.237.0M ¥5,179.2M + ¥1,942.2M
(50%) (60%)
Corporate ¥3.237.0M ¥3,452.8M + ¥215.8M
(50%) (40%)
Total bonds ¥6.474.0M ¥8,632.0M + ¥2,158.0M

(30% total) (40% total)
© Kaplan, Inc. 123

Solution: Use four swaps
▪ Swap 1: Pay return on MSCI Japan Value Index, receive
floating reference rate, on ¥5,179.2M notional principal
▪ Swap 2: Pay reference rate, receive return on MSCI Japan
Growth Index, on ¥3,021.2M notional principal
▪ Swap 3: Pay reference rate, receive return on S&P Japanese
Government Bond Index, on ¥1,942.2M notional principal
▪ Swap 4: Pay reference rate, receive return on S&P Japanese
Corporate Bond Index, on ¥215.8M notional principal
© Kaplan, Inc. 124

Market Expectations
▪ Market expectations refer to current expectations based on
market prices.
▪ If there is a market shock, expectations can change quickly.
▪ Applications:
Inferring expectations about Derivative to use
FOMC* moves Fed funds futures
Inflation CPI swaps
Future volatility VIX futures and options
*Federal Open Market Committee
© Kaplan, Inc. 125
Market Expectations
▪ Federal funds rate: interest rate that deposit institutions
charge other deposit institutions for loans in the overnight
interbank markets
▪ Deposit institutions include banks and credit unions.
▪ Federal funds effective (FFE) rate is the weighted
average of interest rates charged on overnight interbank
loans.
© Kaplan, Inc. 126

Market Expectations
▪ Federal funds target rate: rate set by governors of the
Federal Reserve System in FOMC meetings
▪ The FOMC meets eight times a year to set the target rate.
▪ The most important considerations are inflation rates and GDP
growth rates.
▪ The target rate is typically set as a range (e.g., 2.25%–2.50%).
▪ Note that the Fed does not directly control the FFE rate, but
influences it through monetary policy (e.g., open-market
operations and bank reserves).
© Kaplan, Inc. 127
Using Fed Funds Futures

▪ Fed funds futures are used to infer the expected probabilities
of upcoming Fed interest rate changes.
▪ Price reflects the market expectation of the FFE rate at the
time of contract maturity.
▪ In other words, the price reflects market expectations about
future changes in the Fed funds target rate.
▪ Traded on the CME with maturities up to 36 months.
© Kaplan, Inc. 128

Using Fed Funds Futures

◼ The probability of a change in the Fed funds target rate can
be determined through the following equation:
▪ % probability of rate change
effective rate implied by futures − current Fed funds target rate
=
Fed funds rate assuming a rate change − current Fed funds target rate
implied Fed funds effective rate − current target rate

=
expected size of rate change
© Kaplan, Inc. 129
Using Fed Funds Futures: Example

◼ Joe Stokes works at a bank where the interest received on
loans made is linked to the FFE rate, and he has been asked
to compute the likelihood that the FOMC will increase the rate
by 25 bps at its next meeting.
◼ Stokes has collected the following market data:
◼ Fed funds future price = 98.1625
◼ Current Fed funds target rate = 1.50%–1.75%
◼ Calculate the expected average FFE rate at futures maturity,

and the probability of a 25 bps increase in the target rate.
© Kaplan, Inc. 130

Using Fed Funds Futures: Example

Solution:
1. Expected average FFE rate at contract expiration:
100 − 98.1625 = 1.8375%
2. Current target rate midpoint: (1.50% + 1.75%) / 2 = 1.625%
3. Target rate assuming 25 bps rise: 1.625% + 0.25% = 1.875%
4. % probability of a rate change =
(1.8375% − 1.625%) / (1.875% − 1.625%) = 0.85 or 85%
© Kaplan, Inc. 131


Management
Currency Management: An Introduction
Currency Management:
An Introduction
A Foreign Investment
◼ A domestic investor in a foreign asset has two sources of
return and risk:
◼ The return on the foreign asset (RFC) that would have
been earned by an investor in that country, and its
standard deviation [σ(RFC)]
◼ The return on the foreign currency (change in value of
the foreign currency, RFX), and its standard deviation
[σ(RFX)]
© Kaplan, Inc. 2

An Introduction
A Foreign Investment: Return

◼ The return to a domestic investor (RDC) is:
RDC = (1 + RFC)(1 + RFX) – 1
= RFC + RFX + (RFC )(RFX )
≈ RFC + RFX
◼ If an investor holds multiple foreign assets, the investor’s
return is the weighted average of the RDCs
◼ The weights are based on the beginning of period portfolio
allocation
© Kaplan, Inc. 3
An Introduction
A Foreign Investment: Risk

◼ The standard deviation of return to a domestic investor is
the square root of the variance, where:
σ2(RDC) ≈ σ2(RFC) + σ2(RFX) +
2σ(RFC )σ(RFX)ρ(RFC,RFX )
◼ The standard deviation of a risk-free asset is a special

case:
σ(RDC) = σ(RFX)(1 + RFC )
© Kaplan, Inc. 4

An Introduction
Strategic Choices in Currency Management

◼ Be consistent with the client’s IPS
◼ Maximize return for risk
◼ Neither academic nor empirical evidence support a clear
decision on the optimal approach to currency management
◼ The choices:
◼ Do nothing or do something
◼ Fully passive to fully active
© Kaplan, Inc. 5
An Introduction
The Choices
◼ Do nothing:
◼ Avoid the time and cost of currency trading
◼ A zero-sum game, if one currency appreciates, then
another depreciates
◼ In the long run, currencies are fairly valued
◼ Do something:
◼ In the short run, currency movements can be extreme
◼ Misvaluations of currency caused by central banks and
international trade can be exploited

© Kaplan, Inc. 6

An Introduction
The Choices
◼ Passive: Match the portfolio’s currency exposures to the
portfolio’s benchmark exposures
◼ A rule-based approach designed to eliminate active
return and risk due to currency
◼ Discretionary: Allow small deviations from the benchmark
to add modest value
◼ Allowable deviations are defined (e.g., +/– 5%)
◼ The primary goal is risk reduction
© Kaplan, Inc. 7
An Introduction
The Choices
◼ Active: Wider deviations from the benchmark are allowed
◼ The goal is adding incremental return
(+ alpha) not risk reduction

◼ Overlay: A separate manager makes currency decisions
after the asset manager selects the asset exposures
◼ Allows for specialization of labor
◼ Treats RFC and RFX as separate sources of return
© Kaplan, Inc. 8

An Introduction
The Choices
The overlay manager’s mandate can range from:
◼ An aggressive approach treating currency as an asset
class, focused on pure value added

◼ For example, the asset manager for a U.K.- based
portfolio holds multiple foreign currency exposures (but

none in the CHF), the overlay manager is long CHF
◼ Alternatively, the mandate can be passive, discretionary, or
active (but restricted to asset positions in the portfolio)
© Kaplan, Inc. 9
An Introduction
The Choices
Factors that favor a passive (match the benchmark) approach
or narrower discretionary bands:
◼ Shorter-term investment objectives
◼ Higher risk aversion
◼ Shorter-term income and liquidity needs
◼ Fixed-income assets
◼ Low hedging costs
◼ A client skeptical of the manager’s ability to add value

and/or a manager with no views
© Kaplan, Inc. 10

An Introduction
Active Currency Management

◼ Discretionary deviations from the benchmark can be based
on:
1. Economic fundamentals
2. Technical rules
3. The carry trade
4. Volatility trading
◼ These tactical deviations require the manager to have
views
◼ No one approach works consistently
© Kaplan, Inc. 11
An Introduction
1. Economic Fundamentals
◼ Long-term currency values are determined by purchasing
power parity and short-term deviations can be exploited
◼ Short-term increases are associated with:
◼ Greater undervaluation relative to long-term value
◼ A faster rate of increase in long-term value
◼ Lower relative inflation
◼ Higher real (and nominal) interest rates
◼ A decreasing currency risk premium
© Kaplan, Inc. 12

An Introduction
2. Technical Rules
◼ Past price action predicts future price movement:
◼ Overbought or oversold markets mean revert
◼ Prices reverse at support or resistance levels
◼ Unless they pierce the level in which case they will
continue in the same direction

◼ A shorter-term moving average moving above (below) a
longer-term moving average signals prices will continue

to rise (fall) further
© Kaplan, Inc. 13
An Introduction
3. The Carry Trade

◼ The higher interest rate currency will either appreciate
or depreciate less than predicted by UCIRP
◼ Borrow in the lower interest rate currency
◼ Convert to and invest in the higher interest rate currency
◼ Typically, this means borrow in a developed market

currency to invest in an emerging market currency
© Kaplan, Inc. 14

An Introduction
3. The Carry Trade

◼ The carry trade is trading the forward rate bias
◼ F0 is not an unbiased prediction of ST
◼ It is a reflection of the interest rate difference
FP/B = SP/B[(1 + iP)/(1 + iB)]

where: iP and iB are periodic interest rates
◼ While usually profitable, it has generated significant losses
in periods of market crisis
◼ Volatility spikes
© Kaplan, Inc. 15
An Introduction
3. The Carry Trade

◼ To implement the carry trade:
◼ Borrow in and then sell in the spot market the lower
interest rate currency
◼ Which means selling spot the currency trading at a
forward premium
◼ To buy and invest in the higher interest rate currency
◼ Which means buying spot the currency trading at a
forward discount
© Kaplan, Inc. 16

An Introduction
4. Volatility Trading
◼ Vol trading is designed to profit from changes in volatility
◼ Use delta hedging to take a delta-neutral position. The
value of the position should be unaffected by changes in
value of the currency
◼ Delta measures change in value of an option for change
in value of the underlying

◼ Long call and short put positions have +delta
◼ Short call and long put positions have –delta
© Kaplan, Inc. 17
An Introduction
Option Payoff Patterns
Long call Long put
Short call Short put
© Kaplan, Inc. 18

An Introduction
◼ Vega measures the change in value of an option for
change in volatility
◼ Both call and put values change directly with volatility
◼ If volatility is expected to increase:

◼ Use a long straddle: Buy at-the-money calls and puts
on the currency
◼ Use a long strangle: Buy out-of-the-money calls and
puts on the currency (reduces initial cost and upside)
© Kaplan, Inc. 19
An Introduction
◼ If volatility is expected to decrease:
◼ Use a short straddle: Sell at-the-money calls and puts
on the currency
◼ Use a short strangle: Sell out-of-the-money calls and
puts on the currency (lower premium inflow and risk)
◼ If volatility is expected to be low, use the carry trade
© Kaplan, Inc. 20

An Introduction
Active Trading Rules

◼ Expectation: Relative currency appreciation
◼ Reduce the hedge on or increase the long position in
the currency
◼ Expectation: Relative currency depreciation
◼ Increase the hedge on or decrease the long position in
the currency
◼ Expectation: Volatility increasing
◼ Long straddle (or strangle)
© Kaplan, Inc. 21
An Introduction
Active Trading Rules

◼ Expectation: Volatility decreasing
◼ Short straddle (or strangle)
◼ Expectation: Stable market

◼ A carry trade
◼ Expectation: Market crisis and spike in volatility

◼ Discontinue the carry trade
© Kaplan, Inc. 22

An Introduction
Currency Management: Hints

◼ Determine which currency exposure needs to be increased
or decreased
◼ It is easier to work with the foreign currency as the base
currency in P/B
◼ Assume statements refer to the base currency unless
otherwise indicated
◼ Be explicit in your answer and state which currency
you are referring to
© Kaplan, Inc. 23
An Introduction

◼ Buying futures, forwards, or calls on B; increases exposure
to B
◼ Selling futures or forwards, or buying puts on B; decreases
exposure to B
◼ A call on B is a put on P
◼ A put on B is a call on P
© Kaplan, Inc. 24

An Introduction

◼ Hedging is not free:
◼ Forwards have no initial cost but high opportunity cost
(loss of upside)
◼ Buying options has high initial cost but low opportunity
cost (a protective put)
© Kaplan, Inc. 25
An Introduction

◼ Reducing the initial option cost requires reducing the
downside protection or upside potential:
◼ Write options to generate initial premium inflow
◼ Adjust the option strike price
◼ Adjust the notional amount of the option
◼ Add exotic features to the option
© Kaplan, Inc. 26

An Introduction

◼ Currency forwards are generally preferred to futures
because they:
◼ Can be customized by date and amount
◼ Are available on any currency pair
◼ Avoid the cost and operational complexity of margin

cash flows
◼ Are far more liquid than futures
© Kaplan, Inc. 27
An Introduction
Static vs. Dynamic Hedging

◼ A static hedge is held to expiration and a dynamic hedge
is adjusted
◼ Example: A U.S.-based manager must hedge EUR
5,000,000 of assets for three months.
1- and 3-month contracts are available. One month after
initiation of the hedge, the assets are worth EUR
4,500,000.
◼ Approach 1: Sell EUR 5,000,000 forward for one month.
When the contract expires, sell EUR 4,500,000 forward.
© Kaplan, Inc. 28

An Introduction
Rolling the Hedge: Details

◼ To roll over the 1-month contract, the manager would execute
an FX swap. Two days prior to the initial contract’s expiration,
the manager will:
◼ Buy EUR 5,000,000 to offset the initial forward sale of
EUR, which expires in two days, the near leg of the swap
◼ Sell EUR 4,500,000 one month forward, the far leg is
different in size, making this a mismatched FX swap

◼ There will be a cash flow gain (loss) if the EUR has decreased
(increased) in value
© Kaplan, Inc. 29
An Introduction

◼ Approach 2, a dynamic hedge: Sell EUR 5,000,000
forward for three months. One month later, buy EUR
500,000 forward for two months to adjust the size of the
hedge.
◼ No cash flows until contract expirations
◼ Approach 3, a static hedge: Sell EUR 5,000,000 forward

for three months. One month later, do nothing.
◼ No cash flows until contract expirations
© Kaplan, Inc. 30

An Introduction

◼ Choosing the approach:
◼ Shorter-term contracts or dynamic hedges improve the
hedge results but increase cost
◼ Rolling shorter-term contracts creates interim cash
flows
◼ Higher risk aversion suggests more frequent
rebalancing
◼ Lower risk aversion and strong manager views
suggests discretionary hedging
© Kaplan, Inc. 31
An Introduction
Roll Yield and Hedging Costs

◼ Roll yield (roll return): Change in forward minus change
in spot price: (Ft – F0) – (St – S0)
◼ Convergence dictates that at contract expiration: Ft = St
◼ If the contract is held to expiration, roll yield and % roll
yield are:
S0 – F0 and (S0 – F0) / S0
◼ Roll yield can be considered a cost of hedging as hedging
locks in the differential between S0 and F0
© Kaplan, Inc. 32

An Introduction

If: FP/B > SP/B: F0
◼ the forward price curve is
S0
upward-sloping
◼ iP > iB Time to settlement
◼ A short forward position in B earns positive roll yield,
decreasing hedging cost and encouraging hedging
◼ A long forward position in B earns negative roll yield,
increasing hedging cost and discouraging hedging
© Kaplan, Inc. 33
An Introduction

If: FP/B < SP/B: S0
◼ the forward price curve is
downward-sloping F0
◼ iP < iB Time to settlement

◼ A short forward position in B earns negative roll yield,
increasing hedging cost and discouraging hedging
◼ A long forward position in B earns positive roll yield,
decreasing hedging cost and encouraging hedging
© Kaplan, Inc. 34

An Introduction

As time passes, FT converges to ST at contract expiration
FT FT decreases in price resulting in
negative/positive roll return if
ST
long/short the forward
S0
FT increases in price resulting in
ST
positive/negative roll return if
FT long/short the forward
Applies to forwards and futures on any asset class
© Kaplan, Inc. 35
An Introduction
Trading Strategies
◼ Perfect hedging with forward contracts has no initial explicit
cost:
◼ It locks in F0 and symmetrically modifies risk and return
◼ It has opportunity cost by eliminating upside potential
◼ Discretionary hedging allows the manager to:

◼ Hedge more of the currency if it is expected to
depreciate
◼ Hedge less of the currency if it is expected to appreciate
© Kaplan, Inc. 36

An Introduction
Trading Strategies
Option-based hedging can asymmetrically modify risk:
▪ Buy ATM put options: Removes
all downside risk and retains all
upside potential; highest initial cost
▪ Buy OTM put options: Removes

downside risk below the lower
strike price and retains all upside
potential; lower initial cost
© Kaplan, Inc. 37
An Introduction
Trading Strategies
▪ Buy a higher strike price and
sell a lower strike price put
option (a put spread): Provides
downside protection only
between the two strike prices
and retains all upside potential;
lower initial cost
© Kaplan, Inc. 38

An Introduction
Trading Strategies
▪ Sell a call option and buy a put
option (collar): Provides
downside protection below the put
strike price and retains upside
potential to the call strike price;
lower initial cost
▪ A zero-cost collar if the two
option premiums are equal
▪ A risk reversal: Buy the call
and sell the put
© Kaplan, Inc. 39
An Introduction
Trading Strategies
▪ Buy a higher strike price and
sell a lower strike price put
option, plus sell an OTM call
option (a seagull spread):
Provides downside protection
between the two put strike prices
and upside potential to the call
strike price; lower initial cost
© Kaplan, Inc. 40

An Introduction
Trading Strategies
◼ Other modifications to lower initial cost include:
◼ Mismatch the size of the option position (e.g., buy fewer
puts and sell more calls)
◼ Use exotic options such as knock-in or knock-out
options or binary options that pay a fixed amount or

nothing
◼ Candidate hint: Focus on what each piece of the
transaction does to understand the effect on initial cost,
downside protection, and upside potential
© Kaplan, Inc. 41
An Introduction
Direct Hedges
◼ Long exposure to a currency is hedged by selling it forward
◼ Short exposure to a currency is hedged by buying it
forward
◼ If the size and expiration of the contract perfectly match
the hedging goals, this can be a perfect hedge, locking

in F0 as the ending value
◼ The hedged item (the currency) and the hedging vehicle
(the forward contract) are perfectly correlated
© Kaplan, Inc. 42

An Introduction
Hedging Direct Currency Risk

◼ A U.S. investor has a CHF 2,000,000 equity portfolio. The
investor sells CHF 2,000,000 forward when:
◼ S0 = $1.10/CHF; F0 = $1.05/CHF
◼ In one year, the portfolio has increased 10.00% to CHF
2,200,000 and:
◼ S1 = $1.16/CHF; F1 = $1.16/CHF
◼ Calculate the net portfolio return
© Kaplan, Inc. 43
An Introduction
Answer
▪ V0 = $1.10/CHF × CHF 2,000,000 = $2,200,000
▪ V1 = $1.16/CHF × CHF 2,200,000 = $2,552,000
RDC no currency hedge = $352,000
▪ Loss on futures position = (–F1 + F0):
CHF 2,000,000 × (–1.16 + 1.05) = –$220,000
▪ Net gain on the hedged portfolio:
$352,000 – $220,000 = $132,000
RDC with currency hedge = $132/$2,200 = 6.00%
© Kaplan, Inc. 44

An Introduction
Cross Hedges
◼ A perfect hedge may be unavailable or expensive
◼ In a cross hedge, the hedged item and hedging vehicle
are highly but not perfectly correlated
◼ Example: Two currencies are highly correlated with
each other and the portfolio is long one and short the
other
◼ A cross hedge is riskier because the correlation can
change
© Kaplan, Inc. 45
An Introduction
Macro Hedges
◼ Macro hedges are designed to hedge portfolio-wide risk as
opposed to a single-currency risk
◼ The correlation will not be perfect
◼ Therefore, these are also cross hedges
© Kaplan, Inc. 46

An Introduction
Macro Hedge: Example

Example: A portfolio is long multiple foreign currencies and
shorts a contract based on a fixed basket of currencies similar
to what is owned. The hedge is:
◼ Not perfect
◼ Less expensive and more expedient than hedging each

individual currency exposure
© Kaplan, Inc. 47
An Introduction
Minimum Variance Hedge Ratios (MVHR)

◼ A MVHR is a regression-based approach to determining
the hedge ratio that will minimize risk
◼ When the portfolio has only one foreign currency
exposure, a joint optimization to minimize the volatility

of RDC is possible
◼ It minimizes the joint volatility of RFX and RFC
◼ It’s a cross hedge and a macro hedge
© Kaplan, Inc. 48

An Introduction
MVHR: Joint Optimization Example

Example: A German manager is long JPY 10,000,000 of
assets and wishes to minimize the volatility of the portfolio’s
return measured in EUR (RDC)
◼ The manager regress RFX and RDC
◼ RFX is the change in value of the JPY (EUR/JPY)
◼ RDC is the dependent variable and the change in value

of the foreign asset measured in EUR
◼ The slope coefficient between the two variables is 0.81 with
an R2 of 87%
© Kaplan, Inc. 49
An Introduction
MVHR: Joint Optimization Example

◼ Determine the MVHR and discuss expectations for how
the hedge will perform:
JPY 10,000,000 × 0.81 = JPY 8,100,000
Sell forward JPY 8,100,000
The historical R2 is high, indicating it should work well, but
future results could be better or worse than past results
© Kaplan, Inc. 50

An Introduction
MVHR
◼ A MVHR is designed to directly minimize the volatility of
RDC
◼ It considers the interaction of RFC and RFX:
◼ Positive correlation between RFC and RFX, increases the
volatility of RDC, MVHR > 1

◼ Negative correlation between RFC and RFX, decreases
the volatility of RDC, MVHR < 1
© Kaplan, Inc. 51
An Introduction
Emerging Market Currencies

Transactions pose additional challenges:
▪ Lower trading volume and wider bid-ask spreads
▪ An economic crisis can make trades even more costly
▪ Bid-ask between two emerging market (EM) currencies
can be particularly wide as dealers execute individual
trades between each EM currency and a developed market
currency
▪ Return distributions have negative skew and fat tails, while
many trading strategies assume a normal distribution
© Kaplan, Inc. 52

An Introduction
Emerging Market Currencies

More challenges:
▪ Contagion is a problem with correlations converging
towards 1.0 in crises
▪ Higher interest rates produce negative roll yield for sellers
of EM currencies
▪ Tail risk is common as EM governments artificially support
the currency value, followed by periodic severe currency
corrections
© Kaplan, Inc. 53
An Introduction
Nondeliverable Forwards (NDFs)

◼ Some EM governments restrict transactions in their own
currency
◼ NDFs settle in a single exchange of gain or loss using the
developed currency
◼ Example: A portfolio manager sells CNY 2,000,000 forward
using an NDF when the initial spot exchange rate is
CNY/USD 6.117 and the forward points are +6.7. At
contract settlement, the spot exchange rate is USD/CNY
0.1672.
© Kaplan, Inc. 54

An Introduction
NDF Example
Compute the cash flows at settlement
◼ The NDF contracted exchange rate in CNY/USD is 6.117 +
0.0067 = 6.1237. In USD/CNY, this is 1/6.1237 = USD/CNY
0.1633.
◼ The manager committed to sell CNY 2,000,000 at
USD/CNY 0.1633 and the CNY closes higher at a spot
exchange rate of USD/CNY 0.1672; a loss for the short
position of: (USD/CNY 0.1672 – 0.1633) × CNY 2,000,000
= USD 7,800 loss
© Kaplan, Inc. 55

Fixed Income

256 Fixed Income
Fixed Income
Overview of Fixed-Income
Portfolio Management
The Role of Fixed Income

1) Risk reduction:
▪ Low correlation to equity; portfolio diversification benefits
▪ Lower standard deviation; FI is generally lower than for equity
2) Regular cash flow:
▪ Useful to pay obligations
3) Potential inflation hedge:
▪ Nominal bond: no inflation protection
▪ Floating-rate coupon: coupon adjusted
▪ Inflation-linked bond: par value adjusted
© Kaplan, Inc. 2

Fixed Income 257
Fixed Income Mandates

Liability based: Total return (indexing):
Lowest
◼ Cash-flow matching tracking error ▪ Pure indexing
and value
◼ Duration matching added ▪ Enhanced indexing
◼ Derivative overlays
◼ Contingent ▪ Active management
immunization Highest
© Kaplan, Inc. 3
Managing Interest Rate Risk

▪ Matching Portfolio D to its benchmark (or liability)
removes interest rate risk (from small, immediate parallel
yield curve shifts)
▪ Matching duration contributions (a form of cell
matching) removes interest rate and yield curve risk
(from nonparallel shifts)
▪ The durations will match, removing interest rate risk
(the primary risk)
▪ Will also remove yield curve risk (a secondary risk)
© Kaplan, Inc. 4

258 Fixed Income
Duration: Basics Overview of Fixed-Income

Duration
Bond managers continually refer to duration:
▪ Changing interest rates is the dominant factor in
bond price fluctuation
▪ Duration allows quick estimates of price change
▪ Duration extends to multiple permutations and uses at
Level III (and in the investment business)
© Kaplan, Inc. 5

The Duration Family Tree

Macaulay duration: Modified duration Money duration:
the PV weighted (MD): Macaulay / 1 + change in value
average of when the periodic discount for a given change
cash flows are to be rate; measures % Δ in in interest rates
received value
Price value of a
Spread duration: basis point
measures % Δ in Effective duration: (PVBP) and basis
relative value if takes into account point value
spread changes embedded options (BPV); the Δr is
0.0001
© Kaplan, Inc. 6

Fixed Income 259

More Offshoots
Empirical duration: calculated Key rate duration: price
from regression of historical sensitivity to specific points on
price and interest rate changes the yield curve
Duration Times Spread (DTS): adjusts spread

duration to give a higher sensitivity to ΔS when
spreads themselves are higher (R14)
▪ More details to come as we apply the material in class

▪ Exam questions often say duration is “X”
▪ So, that is the D you needed in that question 7
© Kaplan, Inc.
Convexity and Effective Convexity

◼ Convexity measures the second order, nonlinear effects
of a yield change on a bond price.
◼ Positive convexity leads to more of a price rise, and
less of a price fall (than predicted by duration).
◼ Effective convexity measures the secondary effect of a
change in a benchmark yield curve.
◼ Used with bonds with uncertain cash flows, such as
bonds with embedded options.
© Kaplan, Inc. 8

260 Fixed Income
Using Duration in Active Management

Manager expects interest rates to fall:
◼ Increase portfolio duration; tilt portfolio holdings to
longer maturities
◼ Use derivative overlays such as futures, swaps, and
swaptions to increase portfolio duration
Manager expects credit spreads to narrow:
◼ Increase portfolio credit risk, tilt to portfolio to lower-rated
bonds, or use credit derivatives (e.g., sell CDS [in R14]) 9
© Kaplan, Inc.
FI Liquidity Issues
Liquidity is significantly lower than in the equity market,
particularly since the 2008–2009 Great Recession:
◼ Trading volume lower than previous to 2008–2009
◼ Dealers must charge higher bid–ask spreads and hold
smaller inventories
◼ A reaction to reduced inventory turnover
◼ What is the bond worth?
◼ A simple question that is now harder to answer
© Kaplan, Inc. 10

Fixed Income 261
More Liquidity Issues

◼ A large number of bond issuers with multiple issues
per issuer
◼ Each issue can be made up of fairly unique set of
features
◼ Over time, each issue tends to become held by
investors with little desire to sell
Derivative instruments may provide more liquid access to

the FI markets.
© Kaplan, Inc. 11
Liquidity by Subsectors
Highest liquidity: Lowest liquidity:
▪ Recent issue ▪ Older (off-the-run),
(on-the-run), high low quality, smaller,
quality, sovereign corporate debt
government debt
Active traders seek Buy-and-hold
out these bonds for investors seek out
ease of subsequent these to earn a
trading. liquidity premium.
© Kaplan, Inc. 12

262 Fixed Income
Fixed Income Correlations

Investment grade (IG): have a lower probability of default;
highly correlated with interest rate changes
High yield (HY): have a higher probability of default; more
impacted by Δ spread than Δ rates; increased equity
correlations
Economic cycle:
◼ Upturn: PD and LGD ↓ (rates ↑, spreads ↓)
◼ Downturn: PD and LGD ↑ (rates ↓, spreads ↑) 13
© Kaplan, Inc.
Alternatives to Investing Directly in Fixed Income

Indirect investments in bonds
◼ ETFs, mutual funds, exchange-traded derivatives, and
OTC derivatives
Exchange-traded funds (ETFs) and mutual funds
◼ Both ETFs and mutual funds are more liquid than
underlying bonds (ETFs most liquid)
◼ Ongoing fees, up-front load, economies of scale benefit
the smaller investor, benefit from diversification 14
© Kaplan, Inc.

Fixed Income 263
Illustration: Components of Return

Par value (notional principal) in millions 50
Average coupon rate of portfolio 3%
Coupon frequency semiannual
Horizon analysis 1-year
Average bond price of portfolio 101.500
Projected bond price in 1-year (unchanged yield) 102.419
Average bond duration and convexity 5.60, 28
Expected Δ in benchmark yields –0.54%
Expected Δ in credit spread –0.06%
Expected currency gains or losses (40% allocation) +3.925%
© Kaplan, Inc. 15

1) Coupon income: coupon / price
3.00 / 101.50 = 2.956%
2) Rolldown return: (projected ending / beginning price) – 1
with projected price based on no change in the yield
curve
(102.419 / 101.500) – 1 = 0.905%
Rolling yield is: 2.956 + 0.905 = 3.861%
© Kaplan, Inc. 16

264 Fixed Income

3) Expected price change due to change in benchmark yield
%Δ value = (–MD × Δy) + (1 / 2)(C)(Δy2)
%Δ value = (–5.6)(–0.0054) + (1 / 2)(28)(–0.00542)
= 3.065%
4) Expected price change due to change in credit spreads

%Δ value = (–MD × ΔS) + (1 / 2)(C)(ΔS2)
%Δ value = (–5.6)(–0.0006) + (1 / 2)(28)(–0.00062)
© Kaplan, Inc.
= 0.337% 17

5) Expected gains or losses vs. investor’s currency
▪ Portfolio is invested 40% in foreign bonds
▪ Expected to appreciate 3.925%
▪ Expected gain = 3.925% × 0.40 = 1.570%
Overall projected return:

2.956 + 0.905 + 3.065 + 0.337 + 1.570 = +8.833%
© Kaplan, Inc. 18

Fixed Income 265
Leverage
◼ Leverage means using borrowed funds to purchase
assets
◼ Leveraged return is net return amount / net portfolio
value (i.e., the investor’s equity)
rp = rI + [(VB / VE) × (rI – rB)]
where:
rp = return on portfolio rB = rate paid on borrowings
rI = return on invested assets VB = amount of leverage
VE = amount of equity invested
© Kaplan, Inc.
Leverage: The Risks

rp = rI + [(VB / VE) × (rI – rB)]
◼ If rI < rB, there is negative carry, and leveraged portfolio
return will be below the unlevered return on portfolio
assets.
◼ If the collateral value declines, lenders may demand
repayment, leading to forced liquidations:
◼ Widespread forced liquidations can contribute to a
market collapse.
© Kaplan, Inc.

266 Fixed Income
Explicit Leverage
◼ Borrow the money
◼ Often done with a repurchase agreement (repo)
where portfolio assets are collateral for the loan
Receive cash Collateral value normally
Party A Party B exceeds loan amount
Deliver collateral
Repayment and collateral
Repay P and I return date are specified in
the initial transaction
Return collateral
Loan interest = principal
amount × rate × (days / 360)
© Kaplan, Inc.
Equivalent Results
◼ Buy a futures contract and post margin
◼ leverage = (notional value of contract – margin
amount) / margin amount
◼ Use a swap
Receive desired return
Portfolio Dealer
Pay fixed or floating
Traditionally, OTC swaps did not require mark to market or margin, but
these provisions are now written into many contracts.
© Kaplan, Inc.

Fixed Income 267
Repo and Securities Lending

◼ Different underlying motivation
◼ Repo: borrow/lend the money
◼ Securities lending: borrow/lend the collateral assets

Securities lending is often
Receive cash
Party A Party B used to borrow specific
Deliver collateral assets (the collateral) to
execute a short sale
Repay P and I
The return of collateral is
Return collateral often open ended, when
demanded by one
counterparty
© Kaplan, Inc.
Taxation Issues
◼ CFA material and the exam are focused on taxation
issues and not the code of any one country.
◼ These issues are covered more comprehensively in the
Private Wealth Management section of the curriculum.
▪ Be prepared to understand a situation as presented,

rather than try to memorize exact tax rules that are not
covered.
▪ Remember, taxes do not affect tax-exempt investors.
© Kaplan, Inc.

268 Fixed Income
Relatively Common Tax Features

◼ Tax is imposed on income received
◼ Exception: imputed income may be taxed annually on
zero-coupon bonds
© Kaplan, Inc.
Relatively Common Tax Features

◼ Tax is imposed on realized (not unrealized) gains.
◼ Capital gains may be taxed at lower rates, with the lowest
rate applied to assets held for longer periods.
◼ Capital losses may be used to offset realized gains (but
not always other income sources):
◼ This makes tax-loss harvesting beneficial.
◼ Realized loss may be carried forward to offset gains in
future years (or back to offset past gains).
© Kaplan, Inc.

Fixed Income 269
Taxation of Collective Investment Funds

Example—mutual and collective investment funds:
◼ Tax events are reported and are taxable to each investor,
and generally not to the fund.
◼ Investors are taxed on interest income, regardless of
whether it is paid out of the fund or reinvested.

◼ Taxation of realized gains varies by country.
© Kaplan, Inc.
Collective Investment Fund: Capital Gains Taxation

Tax on the sale of an asset held within the fund:
Pass-through taxation: Deferred taxation:
◼ Each fund investor is taxed on his ◼ No tax initially
share of realized gain in the period ◼ When the
in which the fund realizes the gain investor sells his
◼ Reducing taxes due when the fund shares,
investor sells his fund shares (e.g., gains are taxed
the U.S.) (e.g., the U.K.)
© Kaplan, Inc.

270 Fixed Income
Fixed Income
Liability-Driven and Index-Based Strategies
Liability-Driven and
Index-Based Strategies
Comparison
Asset-liability management Index-based
(ALM): investing:
◼ Liability-driven investing ▪ Manage assets in
(LDI): manage assets in relation to index
relation to liability characteristics
characteristics
◼ Asset-driven investing (ADI):
manage liabilities in relation to
asset characteristics
© Kaplan, Inc. 2

Fixed Income 271
Immunization
◼ Within LDI, immunization refers to a group of
techniques where assets are dedicated and used solely
to meet future definable liabilities:
◼ All cash flows are reinvested until needed.
◼ Variability of cumulative total return over the period

until payout is minimized.
◼ For a single liability, we are replicating the return of a
zero-coupon bond that would provide a pure cash-

flow match for the liability.
© Kaplan, Inc. 3
Immunization Techniques
Cash-flow match: Duration match: Contingent

asset cash flows match asset and immunization:
directly fund liability duration actively manage
liability payouts the portfolio as
long as the
surplus is
▪ E(R) Both increasing positive
▪ Structural risk
© Kaplan, Inc. 4

272 Fixed Income
Portfolio Structures
Varying distribution of cash flow, but same total duration
Bullet • Highest yield (if yield
curve concave)
• Natural periodic liquidity
Ladder • Diversification: across the
yield curve and of price vs.
reinvestment risk
Barbell • Maximum cash-flow
dispersion and convexity
© Kaplan, Inc.
CF Matching Using Laddered Portfolios

Laddered portfolios can be used in cash-flow matching
multiple liabilities:
◼ Laddered portfolio has roughly equal par amount
across different maturities
Advantages of laddered portfolios:
◼ Regular liquidity as bonds mature each period, also
diversification across maturities, and diversification of
price and reinvestment risks
© Kaplan, Inc.

Fixed Income 273
ETF Laddered Portfolios

Bond ETFs are an alternative to buying individual bonds:
◼ Create a laddered approach using fixed maturity,
target-date ETFs
◼ ETFs passively replicate bond performance; have cost
advantages and increased liquidity
Disadvantages of ETF laddered portfolios:
◼ Mutual funds providing single diversified laddered portfolio
may be easier to purchase/maintain
© Kaplan, Inc.
How Duration Matching Works

Consider a liability due in 10 years, Macaulay D = 10
Use a cash-flow match:
◼ Buy a 10-year zero-coupon bond
◼ Hold to expiration; no price or reinvestment risk
Use a duration match: Interest Sale Reinvested Total

◼ Buy a 12-year Rates Price Cash Flows FV
coupon bond with ↓ ↑ ↓ Stable*
Macaulay D of 10 ↑ ↓ ↑ Stable*
*Assumes only one small immediate parallel shift in the yield curve
© Kaplan, Inc. 8

274 Fixed Income
Duration Matching: The Rules

To deal with real-world interest rate changes:
Single liability: Multiple liabilities:
◼ PVA ≥ PVL ▪ PVA ≥ PVL
◼ Match Macaulay D
DA = DL ▪ BPVA = BPVL
◼ Minimize portfolio convexity (the
single liability has minimum C) ▪ CA slightly exceeds CL

Both require continual monitoring and rebalancing to
maintain the D match!
© Kaplan, Inc. The two sets of rules end up meaning the same thing. 9
Technical Issues
▪ The rules assume portfolio IRR = liability discount rate
▪ In more complex situations where the portfolio IRR is higher, you
can start with lower asset value, as you may see in examples
▪ No defaults or spread change
▪ Portfolio statistics such as IRR, D, and C are based on portfolio-level
cash-flow analysis and not simpler weighted average calculations from
individual bond data
▪ Expect portfolio statistics to be given
▪ See the SchweserNotesTM if interested in more detail on calculations
▪ Nevertheless, simpler weighted average calculations are
sometimes used as approximations
© Kaplan, Inc. 10

Fixed Income 275
Structural Risk
◼ Structural risk means failing to meet the liability payouts,
specifically due to nonparallel twists and shifts in the yield
curve.
◼ The rules minimize, but may not eliminate, structural risk.*
◼ The portfolio may fail to replicate the return of a pure
cash-flow match, using a zero-coupon bond.
◼ Parallel shifts are a sufficient (but not necessary)
condition to minimize structural risk.
© Kaplan, Inc. *Cash-flow matching does eliminate structural risk. 11
Why Match Durations?

Matching asset and liability D
controls risk due to small
immediate parallel shifts in the
curve
%Δ value = –D(Δr) + (1/2)(C)(Δr2)
◼ If the D match, the % change in value of assets
and liabilities match
◼ Surplus is stable, and immunization should work
◼ All else the same, but C matters, too

© Kaplan, Inc. 12

276 Fixed Income
Why Set CA > CL?

◼ If asset convexity exceeds
liability convexity, the surplus
–D(Δr) + (1/2)(C)(Δr2)
will improve for large parallel
shifts in the curve, and
immunization should work.
◼ But there is more—do not exceed liability convexity by

too much.
© Kaplan, Inc. 13
Why Only a Little CA > CL?

◼ DA and DL are matched, so the higher C is due to wider
dispersion of asset cash flows along yield curve
Macaulay duration2 + Macaulay duration + dispersion
convexity =
(1+ periodic IRR)2
◼ Therefore, nonparallel shifts may hurt

◼ Assets and liabilities will respond to shifting rates at
different points on yield curve

◼ Surplus may decline, and immunization may be at risk
© Kaplan, Inc. 14

Fixed Income 277
Structural Risk: Flattening Twist

▪ DA = DL ▪ No change in value of
▪ DA allocated to L* and H* liability; ΔyMedium = 0
▪ DL allocated only to M* ▪ Value of assets increases
as gain on higher exceeds
loss on shorter duration
assets; surplus ↑
▪ Immunization is likely not at
risk, but check:
New portfolio IRR?
Vs. liability discount rate?
© Kaplan, Inc. *L, M, H refer to lower, medium, and higher duration 15
Structural Risk: Positive Butterfly

▪ Value of liability increases
as ΔyMedium declines
▪ Value of assets decreases
from losses on longer and
shorter duration assets;
surplus ↓
▪ Immunization may well be at
risk, but check:
New portfolio IRR?
New liability discount rate?
© Kaplan, Inc. 16

278 Fixed Income
A Duration Gap
The surplus is directly at risk if there is a duration gap:
BPVA ≠ BPVL
◼ BPVA < BPVL: a negative gap; if r↓, the S↓
◼ BPVA > BPVL: a positive gap; if r↑, the S↓
The gap can be adjusted:

◼ By changing the assets
◼ By using derivatives on fixed income
◼ Futures, swaps, swaptions
© Kaplan, Inc. 17
Adjusting the Duration Gap

Partial rather than full adjustment (hedging) of the gap is
common:
◼ Changing assets = expensive
◼ Using derivatives is less costly, but it creates practical

issues:
◼ Client may lack an understanding of derivatives
◼ Accounting and reporting requirements
◼ Margin cash-flow requirements
© Kaplan, Inc. 18

Fixed Income 279
The Calculations
◼ Duration gap = BPVA – BPVL
◼ BPV = MD × V × 0.0001
◼ Closing the gap using futures:

◼ Nf = desired ΔBPV / BPVfutures
◼ BPVfutures ≈ BPVCTD / CFCTD
◼ Closing the gap using a swap:

◼ NP = desired ΔBPV / BPVswap
◼ BPVswap = +BPVreceived – BPVpaid

© Kaplan, Inc. 19
Illustration: Comprehensive
◼ A U.S. company has ample cash and wishes to reduce
balance sheet leverage (reduce debt).
◼ Here is data for the specific bonds (liabilities) to retired:
◼ Market value: 150 million
◼ Modified duration (MD): 7.26
◼ Convexity (C): 125.82
◼ BPVL: 150,000,000(7.26)(0.0001) = 108,900
© Kaplan, Inc. 20

280 Fixed Income
Illustration: Choices
◼ Buy bonds (liabilities) in the open market
◼ Bonds are held by buy-and-hold investors who
demand high prices
◼ Construct a cash-flow match portfolio using
government bonds
◼ This qualifies for defeasance, with the debt and
government bonds removed from balance sheet
◼ But using government bonds is too expensive
© Kaplan, Inc. 21
Illustration: Duration Match Choices

◼ Three corporate bond portfolios are considered:
◼ All have a market value of 150 million or more
◼ Are sufficient to pay the bond liabilities when due
Able Baker Charlie Baker is selected:

MD 7.01 7.40 7.26 ◼ All the BPV are very
C 120.34 131.25 115.38 close to the liability BPV

BPV 108.85 108.95 108.90 ◼ Only Baker’s C slightly
(thousands) exceeds Cliability

© Kaplan, Inc. 22

Fixed Income 281
Illustration: Rebalancing
◼ Sometime later, the hedge is reviewed for its first
rebalancing.
◼ New data is collected:
BPVL: 98,750
BPVA: 101,370
BPVfutures: 99.65 per contract
BPVswap: 0.0951 per 100 notional principal
Swap terms are 4.6% fixed vs. 90-day
© Kaplan, Inc.
Market Reference Rate (MRR) 23
Illustration: Futures and Swaps

◼ Sell futures contracts to reduce BPVA:
Sell: (101,370 – 98,750) / 99.65
= 26 contracts
◼ Or, enter a pay-fixed swap to reduce BPVA:

(101,370 – 98,750) / (0.0951 / 100)
= 2.755 million notional principal
© Kaplan, Inc. 24

282 Fixed Income
Illustration: Practical and Other Considerations

◼ The company is unfamiliar with derivatives reporting and
is concerned with the size of the rebalancing positions.
◼ Market conditions make it impractical to adjust the
portfolio assets.
◼ The manager is directed to hedge only 60% of the
duration gap.
◼ The manager also decides to compare option strategies
(swaptions) to the swap.
© Kaplan, Inc. Illustration continues in Part 3 25
Background on Swaptions
◼ An option to enter a swap; swap terms are set when
swaption is purchased
◼ Receiver and payer refer to the fixed side of the swap
from the swaption buyer’s perspective
◼ Swaption value and exercise decision are determined by
comparing the swap fixed rate (SFR) in the swaption with
new SFR in the marketplace
Payer swaption SFRswaption < SFRnew; buyer will exercise
Receiver swaption SFRswaption > SFRnew; buyer will exercise
© Kaplan, Inc. 26

Fixed Income 283
Illustration
Recommended
The illustration will describe:
study focus
◼ How to use each approach to hedge the duration
gap
◼ The subsequent market conditions that would

determine which approach turns out to be optimal
© Kaplan, Inc. 27
Illustration: Swaptions and Collars

◼ The swap terms are unchanged: 4.6% fixed vs. 90-day
MRR
BPVswap: 0.0951 per 100 notional principal
◼ Available swaptions and collar include:
◼ A payer swaption on a 5.1% swap
◼ A zero-cost collar composed of the payer swaption and
a receiver swaption on a 4.2% swap
© Kaplan, Inc. 28

284 Fixed Income
Illustration: The Swap

Enter a pay-fixed swap to decrease BPV of assets:
(0.6) (101,370 – 98,750) / (0.0951 / 100)
= 1.653 million notional principal (NP) for 60% hedge
MRR ◼ The swap is optimal if SFRnew is
The
company 4.6% more than 4.6% when the
swaption expires.
◼ Paying 4.6% is a good deal.
© Kaplan, Inc. 29
Illustration: The Swaption

Buy the payer (5.1%) swaption to decrease BPV of assets:
MRR ◼ Company can choose to pay

The
5.1% 5.1%; beneficial if new SFR
company
are above 5.1%
© Kaplan, Inc. 30

Fixed Income 285
Illustration: The Collar

Buy the payer (5.1%) and sell the receiver (4.2%)
swaption
MRR ◼ Company can choose to pay 5.1%
5.1% if SFRnew are above 5.1%

The
company 4.2% ◼ The company will be forced to
MRR
pay 4.2% if SFRnew are below
4.2%
© Kaplan, Inc. 31
Summary Comparison
BPVA > BPVL: BPVA < BPVL*:
Enter a pay 4.6% swap Enter a receive 4.6% swap
◼ Best if rates will be high ◼ Best if rates will be low
Collar, buy a 5.1% payer and Collar, buy a 4.2% receiver and
sell a 4.2% receiver swaption sell a 5.1% payer swaption
◼ Decreasing rates make ◼ Increasing rates make
collar more attractive collar more attractive

Buy a 5.1% payer swaption Buy a 4.2% receiver swaption
◼ Best if rates fall below a ◼ Best if rates rise above a
threshold threshold
© Kaplan, Inc. *The CFA text and class slides have comparable examples. 32

286 Fixed Income
Contingent Immunization (CI)

A hybrid active/passive strategy requiring you start with a
positive surplus (S): PVA > PVL
◼ Monitor the surplus:
◼ Use active management as long as S is positive.
◼ Revert to immunization if S drops to 0.
◼ If CI succeeds, the surplus will grow and the ultimate

return will exceed an initially immunized return.
◼ If CI fails, the surplus is lost, but the liabilities are still
funded.
© Kaplan, Inc. 33
CI: Approaches
◼ Actively manage the total assets:
◼ Risk: if the surplus declines to 0, assets must be
quickly liquidated to fund an immunized portfolio
◼ Immunize the liabilities and only actively manage the
surplus amount:
◼ Risk: less, but liquidity risk can still exist
◼ Example: derivative positions like a short call may

be used and downside risk is unlimited
© Kaplan, Inc. 34

Fixed Income 287
Liability-Driven and Index-Based

Strategies
LDI: Additional Risks

◼ Calculations depend on duration, and duration is an estimate
that changes.
◼ Duration assumes parallel shifts and ignores convexity effects.
◼ Models are used in estimating the characteristics of the assets and
liabilities (e.g., for callable bonds and pension liabilities).
◼ Weighted average YTM, D, and C might be used instead of portfolio
characteristics based on aggregate portfolio cash flows.
◼ Futures BPV is the following:
◼ Based on a CTD, and the CTD can change
◼ An approximation
© Kaplan, Inc. 35

Strategies
LDI: Additional Risks

◼ Spread risks examples:
◼ The relationship of liability discount rate to asset IRR can change.
◼ Rebalancing may require selling an asset where the spread has
widened and buying where the spread has narrowed.

◼ Swaps are based on the money market rates, but liability discount
rates are not.

◼ OTC instruments introduce counterparty risk.
◼ Exchange-traded (and collateralized OTC) instruments introduce
cash-flow risk (meeting margin requirements).
© Kaplan, Inc. 36

288 Fixed Income

Strategies
Fixed-Income Mandates
Liability based: Total return (indexing):
Lowest
◼ Cash-flow matching tracking error ▪ Pure indexing
and value
◼ Duration matching added ▪ Enhanced indexing
◼ Derivative overlays
◼ Contingent ▪ Active management
immunization Highest
© Kaplan, Inc.

Strategies
Total Return (Index-Based) Strategies

Full replication is rarely practical due to large number of
bond issues, their variability, and illiquidity
Pure Enhanced Pure
indexing indexing active
Matching risk Allow modest deviations in Unrestricted
characteristics is risk characteristics, but
generally used generally match duration
instead
Fully passive Fully active
© Kaplan, Inc. 38

Fixed Income 289

Strategies
Controlling Primary Risk Factors

▪ Match modified duration (MD)
%Δ value = –MD Δy
▪ Match key rate durations
Cell matching
%Δ value = –Dkey rate n Δyn
can also control
▪ Match exposures subject to spread these risks
change (e.g., sectors, quality, issuer)
%Δ relative value = –DS Δs
spread = yhigher yield – ygovernment
© Kaplan, Inc. 39

Strategies
Example: Cell Approach

Maturity
Benchmark Coupon: 1–3 +3–5 +5–10
weights: < 2% 15% 15% 15%
2%–4% 10% 15% 15%
> 4% 5% 10% 0%
◼ If cell weights for the portfolio match those of the
benchmark, the two returns will track closely
◼ If the manager selected relevant factors to match
© Kaplan, Inc. 40

290 Fixed Income

Strategies
Controlling Yield Curve Risk

Match portfolio and benchmark: key rate duration, present
value distribution of cash flows, or duration contributions
PV distribution of cash flows Duration
Cash Flow Cash w, % of Years contribution
in Years Flow Discounted PV Total PV ×w for CF 1
1 6 5.6604 0.0566 0.0566
2 6 5.3400 0.0534 0.1068 Key rate
3 106 88.9996 0.8900 2.6700 duration 3
Bond price = 100.0000 1.0000 2.8334
Macaulay
duration
© Kaplan, Inc. 41

Strategies
Methods of Establishing Passive Bond Exposure

▪ Full replication
▪ Stratified sampling (cell approach)
▪ Bond market index funds
▪ Open ended: trading once per day at NAV
▪ ETFs: continuous trading near NAV
▪ Synthetic strategies (derivatives)
▪ Total return swaps
© Kaplan, Inc. 42

Fixed Income 291

Strategies
Criteria in Benchmark Selection

◼ Benchmark should reflect specific goals and objectives of
the portfolio
▪ Complicating the selection process:
▪ Bonds have finite maturity and duration declines
over time
▪ New issuance and bond retirement change nature
of the index
▪ Rules-based ‘smart beta’ strategies are increasingly being
used on well-known fixed income excess return strategies
© Kaplan, Inc. 43

292 Fixed Income
Fixed Income
Yield Curve Strategies
Changes in the Yield Curve

◼ Active management requires a view of how the yield curve will
change or remain stable over time.
◼ Changes in the yield curve

◼ Δ in the level: parallel shift of all yields
◼ Δ in the slope: curve becomes flatter or steeper
◼ Δ in the curvature: measured via butterfly spread
◼ This reading will focus on short-term, medium-term, and

long-term yield curve maturities.
© Kaplan, Inc. 2

Fixed Income 293

◼ Upward parallel shift where all yields shift up (or down) by
the same amount
◼ Steepening: LT yields rise more than ST yields

◼ Flattening: LT yields fall more than ST yields
© Kaplan, Inc. 3

◼ Increased curvature if medium-term yields rise more than
ST and LT yields
◼ The butterfly spread is a measure of curvature:

◼ BS = (2 × MT yield) – ST yield – LT yield
© Kaplan, Inc. 4

294 Fixed Income
Portfolio Structures
Varying distribution of cash flow
◼ Same total duration
• Maximum yield
Bullet
• Natural periodic liquidity
• Diversification:
Ladder • Across the yield curve
• Of price vs.
reinvestment risk
Barbell
• Maximum cash flow
dispersion and
convexity
© Kaplan, Inc. 5
Example: Barbell vs. Bullet

◼ Maturity Coupon Mod Duration Convexity
2-yr 2.25% 1.86 5.2
10-yr 0.25% 9.52 104.8
20-yr 1.25% 16.23 292.8
◼ Portfolio 1 is a bullet with 100% weight in the 10-yr

◼ Portfolio 2 is a barbell with 46.68% in 2-yr and 53.32%
in the 20-yr
◼ Calculate change in values of both portfolios assuming an
upward parallel shift of 50 bps
© Kaplan, Inc. 6

Fixed Income 295
Solution: Barbell vs. Bullet

Using the duration and convexity formula (from R11)
◼ %ΔP = (–MD × Δy) + (0.5 × C × Δy )
2
Portfolio 1—bullet portfolio

◼ %ΔPP1 = (–9.52 × 0.0050) + (0.5 × 104.8 × 0.0050 )
2
= –0.0476 + 0.00131
= –0.04629 i.e., –4.63%
© Kaplan, Inc. 7
Solution: Barbell vs. Bullet

◼ Portfolio 2—barbell portfolio
◼ %ΔP2yr = (–1.86 × 0.005) + (0.5 × 5.2 × 0.0052)
◼ = –0.00925 + 0.000065 = –0.92%
◼ %ΔP20yr= (–16.23 × 0.005) + (0.5 × 292.8 × 0.0052)
= –0.08115 + 0.00366 = –7.75%
◼ %ΔP2 = (0.4668 × –0.92%) + (0.5332 × –7.75%)

= –4.56%
◼ Barbell outperforms bullet due to higher convexity

◼ Note: both portfolio durations equal 9.52 8
© Kaplan, Inc.

296 Fixed Income
Static Yield Curve Strategies

Buy and hold: upward sloping
Yield ◼ Extend D to add yield
◼ Low turnover
Roll down, ride the curve:

Maturity ◼ Buy at higher yield
◼ Sell as the yield drops and
Repo carry trade: price increases

◼ Borrow at a lower rate to invest at a higher rate
◼ In a stable upward sloping curve, borrow at lower
shorter-term rates to invest in higher long-term

assets
© Kaplan, Inc. 9
Static Yield Curve Strategies

Stable curve:
Yield
◼ Use derivative overlay
◼ Synthetically Δ duration
◼ Assuming upward sloping
Maturity curve, increase duration
Derivatives-based static yield curve strategies:

◼ Long futures positions synthetically increase
◼ Receive-fixed swap portfolio duration
◼ BPVfutures = BPVCTD / conversion factorCTD

© Kaplan, Inc. 10

Fixed Income 297
Extending Duration (Bond vs. Swap)

Example:
◼ An active manager has the view that the yield curve will
remain static over the next six months.

◼ Consider two trades, A and B:
◼ Trade A: buy a 10-yr 3% semiannual coupon U.K. Treasury
bond yielding 2.5%; price 104.3998

◼ Trade B: enter a 10-yr semiannual receive-fixed swap at
3%; current market reference rate (MRR) is 0.5%

◼ Assume a 6-month horizon, £50m par value, and a 25 bps
fall in Treasury yields and swap rates
© Kaplan, Inc. 11
Extending Duration (Bond vs. Swap)
1. Calculate the coupon income and price appreciation for

Trade A. Break the price appreciation down into rolldown and
the change in price due to the change in rates.
2. Calculate the swap carry and MtM gain/loss on the swap.
© Kaplan, Inc. 12

298 Fixed Income
Solution: Extending Duration

1. Trade A coupon income: £50m × 0.03 / 2 = £750,000
Working with £100 of par, and scaling to £50m later
Price of bond in 6 months (with new yield)

N = 19, I/Y = 1.125 (2.25 / 2), PMT = 1.5, FV = 100
CPT PV = £106.3828
Price of bond in 6 months (due to rolldown, no Δy)

N = 19, I/Y = 1.25 (2.5 / 2), PMT = 1.5, FV = 100
CPT PV = £104.2048
© Kaplan, Inc. 13

Price change due to rolldown (assumes no Δy)
= (104.2048 – 104.3998) / 100 × £50 million
= –£97,500 (rolls down toward 100 par)
Price appreciation (above rolldown price* due to Δy)

= (106.3828 – 104.2048*) / 100 × £50 million
= £1,089,000
Net ΔP: –£97,500 + £1,089,000

= £991,500
© Kaplan, Inc. 14

Fixed Income 299

2. 10-year GBP swap
Swap carry = fixed leg income – floating leg outflow
= [(0.03 – 0.005) / 2] × £50,000,000 = £625,000
Swap value in 6 months (view the swap as 2 bonds)

▪ Receive-fixed leg: long a 3% fixed-coupon bond
▪ Pay-floating leg: short a floating-rate note (FRN)
Value of fixed leg (per £1 par, and 25 bps Δy)

N = 19, I/Y = 1.375 (2.75 / 2), PMT = 0.015 (3 / 2), FV = 1
CPT PV = £1.020776346 15
© Kaplan, Inc.

Value of fixed leg (par value £50 million)
= £1.020776346 × £50 million = £51,038,817
Value of floating leg

▪ At a payment date, FRN value will reset to par
▪ FRN par value £50 million
Swap value in 6 months

= PV fixed – PV floating
= £51,038,817 – £50,000,000 = £1,038,817
© Kaplan, Inc. 16

300 Fixed Income
Trades for a Dynamic Yield Curve

Divergent rate level view
◼ An active manager has bullish view that the benchmark
curve will shift down
◼ Strategy: increase portfolio duration
◼ Overweight longer-dated bonds
◼ Long futures contracts; receive fixed swap
◼ An active manager has bearish view that the benchmark

curve will shift up
◼ Strategy: reduce portfolio duration
◼ Overweight ST bonds; short futures, pay fixed 17

© Kaplan, Inc.

Divergent yield curve slope view
◼ An active manager expects steepening curve with long-term
rates rising and short-term rates falling

◼ Strategy: sell long-dated bonds, buy short-dated bonds
◼ An active manager expects flattening curve with long-term

rates falling and short-term rates rising
◼ Strategy: buy long-dated bonds, sell short-dated bonds
© Kaplan, Inc. 18

Fixed Income 301
Divergent Yield Curve Slope View

Flatten Steepen
Yield
Maturity
◼ Expect flattening
◼ Buy long-dated, sell short-dated bonds
◼ Expect steepening
◼ Buy short-dated, sell long-dated bonds
© Kaplan, Inc. 19

◼ Bull steepener is the view that ST rates will fall
by more than long-term rates

◼ Strategy: buy ST bonds, short sell LT bonds
◼ Portfolio duration: positive
◼ Bear steepener is the view that long-term rates will rise

by more than short-term rates
◼ Strategy: buy ST bonds, short sell LT bonds
◼ Portfolio duration: negative
© Kaplan, Inc. 20

302 Fixed Income

◼ Bull flattener is the view that long-term rates will fall by
more than short-term rates

◼ Strategy: buy LT bonds, short sell ST bonds
◼ Portfolio duration: positive
◼ Bear flattener is the view that short-term rates will rise by

more than long-term rates
◼ Strategy: buy LT bonds, short sell ST bonds
◼ Portfolio duration: negative
© Kaplan, Inc. 21
Example: Bull Steepening

2-yr 2.25% 1.86 5.2
10-yr 0.25% 9.52 104.8
◼ Manager expects the yield curve to steepen

◼ She wishes to take a long position with market value of
£100 million and an appropriately sized short position
◼ No expectation of a change in the level of rates
© Kaplan, Inc. 22

Fixed Income 303
Example: Bull Steepening

2-yr 2.25% 1.86 5.2
10-yr 0.25% 9.52 104.8
1. Describe the trades the manager should make to profit

from their view.
2. Calculate the total profit or loss of the portfolio if there is an
immediate 20 bps decline in 2-yr yields and a 20 bps rise in
10-yr yields.
3. Discuss how the manager would adjust the portfolio
© Kaplan, Inc.
positions, assuming a bull steepening. 23
Solution: Bull Steepening

1. Steepening curve, no change in level
▪ Strategy: sell LT 10-yr bonds, buy ST 2-yr bonds
▪ Keep BPV neutral, as no Δ in level of rates
Calculate BPV of the long position in 2-yr bonds

BPV2-yr = 1.86 × 0.0001 × £100 million = £18,600
Calculate MV of the short position in 10-yr bonds

£18,600 = 9.52 × 0.0001 × market value
Market value = £18,600 / 0.000952 = £19,537,815
© Kaplan, Inc. 24

304 Fixed Income

2. Immediate 20 bps decline in 2-yr yields and 20 bps rise
in 10-yr yields
▪ ΔPlong 2-yr = (–1.86 × –0.002) + (0.5 × 5.2 × –0.0022)
= 0.0037304 or 0.37304%
= 0.0037304 × £100m = £373,040 gain
▪ ΔPshort 10-yr = (–9.52 × 0.002) + (0.5 × 104.8 × 0.0022)

= –0.01883 or –1.883%
= –0.01883 × –£19,537,815 = £367,897
Net position: £373,040 + £367,897 = £740,937 25

© Kaplan, Inc.

3. If the manager expected a bull steepening, what adjustments
would be made (no calculation required)
Bull steepening:
▪ Manager expects short-term rates to fall more than long-term
rates (falling rate environment)
▪ Buy the 2-yr bond, sell the 10-yr bond
▪ Increase portfolio duration / BPV
▪ Increase the long position in the 2-yr bond or short sell less of
the 10-yr bond
© Kaplan, Inc. 26

Fixed Income 305

Divergent yield view: change in curvature
◼ Butterfly strategy if a manager has the view that the curvature
of the yield curve is likely to change

◼ Butterfly is a long–short combination of a bullet (body) and
a barbell (wings)
◼ Butterfly spread = (2 × MT yield) – ST – LT yields
◼ Positive butterfly
◼ Short barbell, long bullet (expect curvature ↓)
◼ Negative butterfly
◼ Long barbell, short bullet (expect curvature ↑)
© Kaplan, Inc. 27
Butterfly Trades (Long–Short)

Bullet Long–short trades allow 0
Yield
net D and investment, but
still profit from curve
Barbell
reshaping
Duration
Positive butterfly: Negative butterfly:
• Long the bullet • Short the bullet
• Short the barbell • Long the barbell
• Expect curvature ↓ • Expect curvature ↑
© Kaplan, Inc. 28

306 Fixed Income
Example: Butterfly Strategy

2-yr 2.25% 1.86 5.2
10-yr 0.25% 9.52 104.8
20-yr 1.25% 16.23 292.8
A manager wishes to construct a portfolio to profit from a

positive butterfly view.
The market value of the long position is £100 million, and they
wish the wings of the trade to be of equal market value.
© Kaplan, Inc. 29
Example: Butterfly Strategy

1. Explain how a manager should construct a duration-neutral
portfolio. Show your calculations.
2. Calculate the profit on the portfolio if 2- and 20-yr yields rise

by 10 bps and the 10-yr yield falls 25 bps.
3. Discuss the convexity exposure of the resulting portfolio and

the impact on portfolio performance, should the manager’s
view be correct.
© Kaplan, Inc. 30

Fixed Income 307
Solution: Butterfly Strategy

1. Positive butterfly strategy
▪ Expect MT yields ↓, ST & LT yields ↑, curvature ↓
▪ Strategy: long bullet (MT), short barbell (ST and LT)
▪ Overall strategy to be duration neutral
Long bullet position in 10-yr bond (the body)

BPV = 9.52 × 0.0001 × £100 million = £95,200
Short barbell position (the wings) BPV must equal £95,200

to create duration-neutral position
© Kaplan, Inc. 31

Solve to find the market value in the wings
£95,200 = (MVw × 1.86 × 0.0001) + (MVw × 16.23 × 0.0001)
£95,200 = 0.000186 MVw + 0.001623 MVw

£95,200 = 0.001809 MVw
£95,200 / 0.001809 = MVw
MVw = £52,625,760
Manager should buy £100m of the 10-yr bond and short sell
£52,625,760 of both the 2-yr and 20-yr bonds
© Kaplan, Inc. 32

308 Fixed Income

2. Portfolio profit if 2-yr and 20-yr yields rise by 10 bps and the
10-yr yield falls by 25 bps
Change in the price of each bond

ΔP2-yr = (–1.86 × 0.001) + (0.5 × 5.2 × 0.0012)
= –0.0018574 or –0.18574%
P/L = –0.001857 × –£52,625,760 = £97,747
ΔP10-yr = (–9.52 × –0.0025) + (0.5 × 104.8 × –0.00252)

= 0.0241275 or 2.41275%
P/L = 0.0241275 × £100 million = £2,412,750 33
© Kaplan, Inc.

2. Portfolio profit if 2-yr and 20-yr yields rise by 10 bps and the
10-yr yield falls by 25 bps
ΔP20-yr = (–16.23 × 0.001) + (0.5 × 292.8 × 0.0012)

= –0.0160836 or –1.60836%
P/L = –0.0160836 × –£52,625,760 = £846,412
Net position:
£97,747 + £2,412,750 + £846,412 = £3,356,909
(The short barbell wins as LT and ST yields ↑, long bullet wins
as MT yields ↓)
© Kaplan, Inc. 34

Fixed Income 309

3. Discuss the convexity exposure of the resulting portfolio and
the impact on portfolio performance, should the manager’s view
be correct.
The portfolio is short a high-convexity barbell and long a

lower-convexity bullet. In this example, the convexity impact of
the long bullet is greater than that of the short barbell due to the
larger yield change. This can be seen by comparing the
convexity adjustments calculated in (2). If the yield changes had
been the same, the convexity would have been negative.
© Kaplan, Inc. 35
Yield Curve Volatility Strategies

Bonds with embedded options, stand-alone options
◼ A callable bond gives issuer the right to buy the bond back
from the investor before maturity

◼ Option-free bond and a short call
◼ Negative convexity at low yields
◼ A putable bond gives investor the right to sell the bond back
to the issuer before maturity
◼ Option-free bond and a long put
◼ Effective bond price floor at high yields
© Kaplan, Inc. 36

310 Fixed Income

Options on bond prices and bond futures
◼ Call option on a bond price or bond futures contract increases
the duration of a fixed-income portfolio
◼ Put option on a bond price or bond futures contract decreases

the duration of a fixed-income portfolio
© Kaplan, Inc. 37

Swaptions can also alter duration and convexity
◼ Payer swaption is the right to enter a pay fixed receive
floating swap
◼ Wins if rates rise
◼ Negative swap duration = floating – fixed
◼ Receiver swaption is the right to enter a receive-fixed

pay-floating swap
◼ Wins if rates fall
◼ Positive swap duration = fixed – floating
© Kaplan, Inc. 38

Fixed Income 311
Key Rate Duration

Key rate duration (a.k.a. partial duration) measures sensitivity
of a portfolio to a movement in a key maturity while other rates
remain constant
◼ Assess exposure to nonparallel Δ yield curve
◼ Sum of key rate durations equals the effective duration of

the portfolio
Interpreting key rate durations

◼ High positive key rate duration at a maturity
◼ Expecting the yield at this maturity to fall
◼ High negative key rate duration, expecting a rise

© Kaplan, Inc. 39
Using Key Rate Durations

Key rate (partial) durations
Yield measure sensitivity to one
point on the yield curve:
n %Δ value = –Dn Δrn
◼ Comparing partial durations of two portfolios

can indicate relative performance given
expected change in yield curve
◼ Partial, key rate, and duration contribution are
all the same thing
© Kaplan, Inc. 40

312 Fixed Income
Example: Key Rate Duration

◼ Maturity Annualized Yield Position ($m)
2-yr 2.0% 250
10-yr 3.0% –50
20-yr 5.0% 100
An active fixed income manager takes the positions in the zero-

coupon bonds shown above. The manager’s benchmark is
equally weighted across the three zero-coupon bonds.
© Kaplan, Inc. 41
Example: Key Rate Duration

1. Calculate the key rate durations and overall modified
durations for both the manager and the benchmark.
2. Determine the most likely view of the manager on the next

change in yield curve level, slope, and curvature.
© Kaplan, Inc. 42

Fixed Income 313
Solution: Key Rate Duration

1. Calculate the key rate durations and overall modified
durations for both the manager and the benchmark.
First, compute the modified durations:

▪ Modified duration = Macaulay duration / 1 + yield
▪ Macaulay duration of a ZCB is its maturity
MD2-yr = 2 / 1.02 = 1.961

MD10-yr = 10 / 1.03 = 9.7087
MD20-yr = 20 / 1.05 = 19.0476
© Kaplan, Inc. 43

Calculate the key rate durations of the portfolio and the
benchmark (a.k.a. duration contributions).
Key rate duration = modified duration × weight
Portfolio key rate durations:

▪ 2-yr KRD = 1.961 × (250 / 300) = 1.634
▪ 10-yr KRD = 9.7087 × (–50 / 300) = –1.618
▪ 20-yr KRD = 19.0476 × (100 / 300) = 6.349
▪ Total portfolio duration = 6.365
© Kaplan, Inc. 44

314 Fixed Income

Calculate the key rate durations of the portfolio and the
benchmark (a.k.a. duration contributions).
Benchmark key rate durations (equally weighted across

all three bonds):
▪ 2-yr KRD = 1.961 × (100 / 300) = 0.654
▪ 10-yr KRD = 9.7087 × (100 / 300) = 3.236
▪ 20-yr KRD = 19.0476 × (100 / 300) = 6.349
▪ Total portfolio duration = 10.239
© Kaplan, Inc. 45

◼ Maturity Portfolio Index Active
2-yr KRD 1.634 0.654 0.980
10-yr KRD –1.618 3.236 –4.854
20-yr KRD 6.349 6.349 0.000
Mod duration 6.365 10.239 –3.874
Interpreting the strategy: bear steepener / –butterfly

▪ Portfolio level: lower overall duration is bearish, believing
medium-term rates are going to rise
▪ Slope: believe 2-yr rates will fall (or rise less) than 20-yr rates
(i.e., the curve is going to steepen) 46
© Kaplan, Inc.

Fixed Income 315
Active Management Across Currencies

Unhedged foreign bond position
◼ RDC = (1 + RFC)(1 + RFX) – 1
Example: unhedged foreign bond investment

An Australian portfolio manager invests in a 2-yr zero-coupon
U.S. Treasury bond for 1 yr:
◼ U.S. bond is trading at a price of 96.374
◼ USD/AUD exchange rate was 0.90 at the start of the year
and 0.80 at the end of the year

◼ U.S. bond ends the year at a price of 99.939
© Kaplan, Inc. 47
Example: Unhedged Foreign Bond

1. Calculate the return of the investor in domestic currency terms.
Foreign bond local return (RFC)
Currency return (RFX)
Domestic return (RDC)
© Kaplan, Inc. 48

316 Fixed Income
Solution: Unhedged Foreign Bond

Foreign bond local return (RFC)

RFC = (priceT1 / priceT0) – 1
= (99.939 / 96.374) – 1 = 3.70%
Currency return (RFX)

RFX = (spotT1 / spotT0) – 1
= (1.2500 / 1.1111) – 1 = 12.50%
(The quote must be in direct terms: AUD/USD)
1 / 0.8 = 1.2500, 1 / 0.9 = 1.1111 49
© Kaplan, Inc.
Solution: Unhedged Foreign Bond

Domestic return (RDC)

RDC = (1 + RFC) × (1 + RFX) – 1
= (1.037) × (1.125) – 1
= 16.66%
© Kaplan, Inc. 50

Fixed Income 317
Example: The Hedging Decision

The Australian portfolio manager holds the U.S. bond for 2 yrs to
its maturity when it redeems at par:
◼ Original price paid for the U.S. 2-yr ZCB was 96.374
◼ Original USD/AUD exchange rate was 0.90 at initiation of

the trade
◼ An equivalent 2-yr zero-coupon Australian government bond
was yielding 5% at initiation of the trade
1. Calculate the fair 2-yr forward rate.
2. Demonstrate that the manager would earn their domestic
risk-free rate if they hedged their position.
© Kaplan, Inc. 51
Solution: The Hedging Decision

1. Calculate the fair 2-yr forward rate.
Calculate the U.S. risk-free from the 2-yr ZCB:

Rfree = (100 / 96.374)1/2 – 1
= 1.864%
Calculate the forward rate using the IRP formula:

F = spot rateDC/FC × (1 + rDC) / (1 + rFC)
= 1/0.9 × (1.05)2 / (1.01864)2
= AUD/USD 1.1806
(Note that we use currency direct quotes)
© Kaplan, Inc. 52

318 Fixed Income
Solution: The Hedging Decision

2. Demonstrate that the manager would earn their domestic
risk-free rate if they hedged their position.
To hedge the receipt of USD 100 in 2 yrs:
▪ Sell forward at the fair rate of AUD/USD 1.1806
▪ Receive 100 × 1.1806 = AUD 118.06
Original AUD cost of the U.S. bond:

▪ 96.374 / 0.90 = 107.0822
RDC = (118.06 / 107.0822)1/2 – 1 = 5% (Rfree dom)

© Kaplan, Inc. 53
Hedging Foreign Coupon-Paying Bonds

Fixed-fixed cross-currency swap
▪ Exchange of principal at the start and at the end
Example: An Australian manager wishes to hedge an investment in

USD 100 million par of a 10-yr U.S. Treasury bond currently trading
at par:
▪ Current USD/AUD rate is 0.80
▪ Manager enters a fixed-fixed cross-currency swap to pay fixed
USD and receive fixed AUD
▪ Principal sizes of USD 100 million and 100 / 0.8 = AUD 125 million
© Kaplan, Inc. 54

Fixed Income 319

Position At Initiation Semiannual At the End
Payments
U.S. T bond Pay USD Receive fixed Receive USD

100m to buy USD bond 100m par at
the U.S. bond coupon bond maturity
Fixed-fixed Receive USD Pay fixed USD Pay USD
cross-currency 100m, pay leg, receive 100m, receive
swap AUD 125m fixed AUD leg AUD 125m
Net flow Pay Receive Receive

© Kaplan, Inc. AUD 125m fixed AUD AUD 125m 55

▪ Look again at overview of the strategy and net cash flows
for the Australian investor
▪ Invest in a U.S. Treasury bond

▪ Fixed-fixed cross-currency swap (pay USD / receive AUD)
◼ Question: what is the net position equivalent to?

◼ Answer: same as investing in a domestic AUD bond; manager
has hedged the foreign exposure
© Kaplan, Inc. 56

320 Fixed Income
The Carry Trade

Unhedged cross-currency trade
▪ Borrow in a low-interest currency
▪ Deposit in a high-interest currency
▪ Carry trade implies UCIRP does not hold
▪ Assumes the high-interest currency does not depreciate
reducing or removing all profits
Risks
▪ The high-interest currency depreciates
▪ Often, high-interest currencies are emerging markets with
additional volatility and liquidity risks
(Carry trades and UCIRP are covered in the LIII currency reading)
© Kaplan, Inc. 57
Example: The Carry Trade

A manager is considering executing a carry trade with a 1-yr
horizon borrowing U.S. dollars (USD) and investing in short-term
Indian rupee (INR) securities:
▪ Manager will borrow at 1-yr USD rate of 1%
▪ Manager will roll 90-day INR securities, which currently offer a
rate of 5% on an annualized basis
▪ Current INR/USD spot rate is 70
1. Calculate the return from the carry trade if interest rates and
exchange rates are stable.
2. Calculate the return if 90-day INR rates evolve to 5%, 6%,
4%, and 3%, and the final INR rate is 85.
© Kaplan, Inc. 58

Fixed Income 321
Solution: The Carry Trade

1. Calculate the return from the carry trade if interest rates and
exchange rates are stable.
INR 1-yr return from rolling over 90-day securities
r = (1 + 0.05/4)4
= 5.1%
USD cost of funds

= 1%
Net return (assuming stable exchange rates)

5.1% – 1% = 4.1% 59
© Kaplan, Inc.

INR 1-yr return from rolling over 90-day securities

= (1 + 0.05/4)(1 + 0.06/4)(1 + 0.04/4)(1 + 0.03/4) – 1
= 4.6%
FX return (must be direct quote, USD/INR)

= (spotT1 / spotT0) – 1 = (0.011765 / 0.014286) – 1
= –17.6%
(inverting quotes: 1 / 70 = 0.014286, 1 / 85 = 0.011765)
© Kaplan, Inc. 60

322 Fixed Income

Overall carry trade approximate return

▪ INR 1-yr return = 4.6%
▪ FX return = –17.6%
▪ Cost of borrowing = –1%
▪ Total return = –14%
© Kaplan, Inc. 61
Framework for Evaluating Strategies

Evaluating yield curve strategies—5-step process
▪ Coupon income = annual coupon / bond price
▪ Rolldown return = (priceT1 / priceT0) – 1
▪ ΔP Δ bmk yield = (–MD × Δy) + (0.5 × C × Δy2)
▪ ΔP Δ yield spread = (–MD × Δy) + (0.5 × C × Δy2)
▪ Currency G/L
Notes:
▪ Expected return model over a 1-yr horizon
▪ Rolldown assumes no Δ yield
▪ Rolling yield = coupon income + rolldown 62
© Kaplan, Inc.

Fixed Income 323
Example: CAD Bullet vs. Barbell

A U.S.-based portfolio manager is considering investing in
Canadian zero-coupon bonds. The expected 1-yr performance
data is shown below.
Bullet Barbell
▪ Average bond price 96.75 97.00
▪ 1-yr price (stable curve) 98.75 98.95
▪ Effective duration 4.89 4.92
▪ Expected convexity 28.50 43.00
▪ Expected Δbond yields 0.25% 0.25%
▪ Expected ΔCAD vs. USD –0.50% –0.50%
© Kaplan, Inc. 63
Example: CAD Bullet vs. Barbell

1. Calculate the components of expected return from the bullet
and barbell portfolios over the next year.
2. Discuss reasons for the difference in performance of the

bullet and barbell portfolios.
© Kaplan, Inc. 64

324 Fixed Income
Solution: CAD Bullet vs. Barbell

1. Calculate the components of expected return from the bullet
and barbell portfolios over the next year.
Step 1: coupon income—no income

Both portfolios only contain zero-coupon bonds.
Step 2: rolldown return

Bullet = (98.75 / 96.75) – 1 = 2.067%
Barbell = (98.95 / 97) – 1 = 2.010%
© Kaplan, Inc. 65

Step 3: impact of changes in benchmark yields
Bullet: ΔP = (–4.89 × 0.0025) + (0.5 × 28.5 × 0.00252) = –1.214%
Barbell: ΔP = (–4.92 × 0.0025) + (0.5 × 43 × 0.00252)
= –1.217%
Step 4: impact of changes in yield spread

There is no information provided regarding changes in spreads,
so we assume this is zero.
© Kaplan, Inc. 66

Fixed Income 325

Step 5: impact of currency
RDC = (1 + RFC) x (1 + RFX) – 1
Steps 1–3 provide the RFC

Bullet: RFC = 2.067% – 1.214% = 0.853%
Barbell: RFC = 2.010% – 1.217% = 0.793%
(RFX = –0.50%)
Bullet: RDC = (1.00853) × (1 – 0.0050) -1 = 0.35%
Barbell: RDC = (1.00793) × (1 – 0.0050) -1 = 0.29%
© Kaplan, Inc. 67

2. Discuss reasons for the difference in performance of the
bullet and barbell portfolios.
The bullet outperforms the barbell by 6 bps (0.35% vs. 0.29%).

This primarily comes from the higher expected rolldown return
of the bullet.
As the bullet is priced at a greater discount than the barbell
(96.75 vs. 97.00), the expected rolldown return in 1 yr is higher
(2.067% vs. 2.010%).
© Kaplan, Inc. 68

326 Fixed Income
Fixed Income
Fixed-Income Active Strategies:

Credit Strategies
Credit Strategies
Risk Considerations
Major risks
◼ Credit risk is the risk that the issuer fails to make
payments as promised
◼ Liquidity risk is the risk the investor is not able to trade
in the security at a reasonable price

◼ Components of credit risk
◼ Probability of default (PD)
◼ Loss given default (LGD) and recovery rate (RR)
◼ Expected exposure (EE)
◼ Expected credit loss (%) = PD × LGD
◼ Expected loss ($) = PD × LGD × EE

© Kaplan, Inc. 2

Fixed Income 327
Credit Strategies
Example: Credit Spread, PD, and LGD

A credit analyst notes that an issuer has first lien bonds
outstanding with a spread of 1.5%. The historical recovery rate
for similar first lien bonds is 50%. The issuer is preparing to
issue second lien bonds. The historical recovery rate of similar
second lien bonds is 40%.
Calculate the fair credit spread for the second lien bonds.
© Kaplan, Inc. 3
Credit Strategies
Solution: Credit Spread, PD, and LGD

Calculate the fair credit spread for the second lien bonds.
First and second lien bonds
▪ A lien is a legal claim. First lien creditors rank ahead of
second lien creditors.
Solve for PD, then credit spread2-lien

PD = credit spread1-lien / LGD1-lien
= 0.015 / 0.50 = 0.03 or 3%
credit spread2-lien = PD × LGD2-lien
= 0.03 × (1 – 0.40) = 0.018 or 1.8%
© Kaplan, Inc. 4

328 Fixed Income
Credit Strategies
Credit Risk and the Economic Cycle

Early Late Peak Contraction
Expansion Expansion (Recession)
Corporate Peak Falling Stable Rising

defaults
Credit Stable Falling Rising Peak

spread
level
Credit IG: stable IG and HY IG and HY IG: flat
spread HY: inverted upward upward HY: inverted
slope sloping sloping
© Kaplan, Inc. 5
Credit Strategies
Risk Considerations for IG and HY

Interest rate risk: Credit risk:
◼ A general ◼ Narrowly defined as loss
increase in due to default
(credit) risk-free ◼ More generally, it refers to
rates relative price deterioration
◼ The parallel shift due to spread widening
%Δ value = –D Δr %Δ relative value = –DS Δs
Typically: (normal economy)
◼ Investment grade (IG) are more affected by interest
rate risk, and high yield (HY) by credit risk

© Kaplan, Inc. 6

Fixed Income 329
Credit Strategies
Why Managers Focus on Spread

%Δ V = –D Δy ◼ If Δs ↑, the Δy of the
two bonds cannot be
equal
s = yhy – rrf ◼ Δy must shift in a way
that is relatively
detrimental to the price
%Δ rel. V = –DS Δs
of the higher yield
(credit risky bond)
This assumes the higher-yield and credit risk–free

bond have equal duration.
© Kaplan, Inc. 7
Credit Strategies
Why Δs Is So Important for HY

◼ Δs for HY often exceeds Δr, the reverse for IG
◼ Δs and Δr often move in opposite directions
◼ Economy improves: r↑, and s↓
◼ Empirical duration is calculated by regressing

actual bond price Δ with Δrrisk-free
Duration Effective
Duration
Empirical Duration
0
AAA AA A BBB BB B CCC
Credit Quality –Empirical
Duration
© Kaplan, Inc. 8

330 Fixed Income
Credit Strategies
Measuring Spread
Yield . Bond F yield: 4.23%
. Benchmark spread:
= 4.23 – 2.47 = 176 bp
On-the-run government bond
Maturity yield: 2.47%
What if no comparable maturity on-the-run

government bond exists?
© Kaplan, Inc. 9
Credit Strategies
Benchmark, G-, and I-Spread

All three compare nominal yields:
YTMbond – YTMbenchmark
◼ Benchmark spread compares to on-the-run
(OTR) government bond (credit risk free)

◼ G-spread compares to interpolated yield of the
two bracketing OTR government bonds

◼ I-spread compares to interpolated yield of
swap fixed rates
© Kaplan, Inc. 10

Fixed Income 331
Credit Strategies
Benchmark, G-, and I-Spread

◼ Benchmark spread:
– Maturity of the benchmark probably differs
from the bond being analyzed
◼ G-spread:
+ Matches maturity
+ The E(R) of the position is hedged
◼ Long the bond, short the benchmark
◼ I-spread:
+ Yields available for many points on the curve
– Not truly risk free
© Kaplan, Inc. 11
Credit Strategies
Example: G-Spread
Maturity Coupon Yield Mod Dur
Corporate bond 12 4.30% 4.5% 11.1
Government 10 2.75% 3.0% 9.2
Government 20 5.25% 5.0% 17.5
1. Calculate the yield spread and the G-spread for the

corporate bond.
2. Calculate, using both the yield spread and the G-spread, the
estimated change in price of the corporate bond, assuming the
20-yr bond yield falls by 10 bps, and the 10-yr yield and G-spread
© Kaplan, Inc.
are unchanged. 12

332 Fixed Income
Credit Strategies
Solution: G-Spread
1. Calculate the yield spread and the G-spread for the
corporate bond.
Yield spread
▪ Yield spread = corporate bond yield – nearest dated
government bond yield
= 4.5% – 3.0% = 1.5%
G-spread
▪ G-spread = corporate bond yield – interpolated maturity
matched government bond yield
© Kaplan, Inc. 13
Credit Strategies
Solution: G-Spread
Interpolate between government bond maturities
▪ Corporate bond maturity is 12 yrs
▪ 10-yr and 20-yr government bond maturities
Solve to find the weights needed to match 12 yrs

12 = (1 – w) × 10 + (w × 20)
12 = 10 – 10w + 20w
2 = 10w
w = 0.20
Matching maturity: (0.2 × 20-yr) + (0.8 ×10-yr) = 12
© Kaplan, Inc. 14

Fixed Income 333
Credit Strategies
Solution: G-Spread
Weighted average government yield
= (0.2 × 5%) + (0.8 × 3%)
= 3.40%
G-spread
= Corporate bond yield – weighted average government yield
= 4.50% – 3.40%
= 1.1%
© Kaplan, Inc. 15
Credit Strategies
Solution: G-Spread
2. Calculate, using both the yield spread and the G-spread, the
estimated change in price of the corporate bond, assuming
the 20-yr bond yield falls by 10 bps, and the 10-yr yield and
G-spread are unchanged.
Recalculate the 12-yr govt benchmark yield
▪ 10 bps fall in 20-yr yield, from 5% to 4.9%
= (0.2 × 4.9%) + (0.8 × 3%) = 3.38%
New corporate bond yield (constant G-spread)

= Bmk yield + G-spread = 3.38% + 1.1% = 4.48%
© Kaplan, Inc. 16

334 Fixed Income
Credit Strategies
Solution: G-Spread
Calculate the expected price change of the corporate
▪ Initial YTM 4.50%
▪ New YTM 4.48%
▪ Yield change –0.02%
%ΔP = –MD × Δy
= –11.11 × –0.02%
= 0.222% expected increase in price
© Kaplan, Inc. 17
Credit Strategies
Asset Swap Spread (ASW)

Asset swap spread is a bond’s fixed coupon minus
the maturity interpolated swap rate
◼ Represents the spread the bond is offering over
the floating market reference rate (MRR)

Example:
◼ Manager purchases a bond with a coupon of 6%
◼ Equivalent maturity swap fixed leg is 4%
◼ ASW = 6% – 4% = 2%
◼ Manager buys the bond, and a pay-fixed swap
◼ Net = floating +2%
© Kaplan, Inc. 18

Fixed Income 335
Credit Strategies
OAS
Embedded options make nominal yield misleading
Use OAS: (think option-REMOVED spread)
◼ The single constant spread that if added to the
interest rate tree of forward rates will, on
average, equate the expected future cast flows
of the bond to its current price
Translation:
◼ Output from a computer program
◼ The average expected excess return
◼ Return in any one period likely differs from

the OAS 19
© Kaplan, Inc.
Credit Strategies
Floating-Rate Note Spread Measures

A floating-rate note (FRN) pays a periodic coupon
equal to a floating MRR plus a quoted margin
◼ Quoted margin (QM)
◼ A fixed spread above MRR representing the

credit risk of the issuer at issuance
◼ At issuance, QM = discount margin
◼ Discount margin (DM)
◼ Current market credit spread above the MRR
◼ Over time, credit spreads (and DM) change
© Kaplan, Inc. 20

336 Fixed Income
Credit Strategies
Quoted Margin and Discount Margin

Example:
◼ A corporate FRN pays MRR + 50 bps
◼ The fixed 50 bps spread is the QM
◼ At issuance DM = QM, priced at par
If issuer credit quality declines:

▪ DM widens, DM > QM, FRN priced at a discount
If issuer credit quality improves:

▪ DM narrows, DM < QM, FRM priced at premium
© Kaplan, Inc. 21
Credit Strategies
Example: Discount Margin

A 1-yr FRN pays 3-mth MRR +1.25% on a quarterly
basis. The MRR is 0.55% and is assumed to stay
constant over time. The discount margin is 1.55%.
1. State whether the FRN will be trading below,

equal to, or above par. Justify your response.
2. Calculate the value of the $1 million par value of

the FRN.
© Kaplan, Inc. 22

Fixed Income 337
Credit Strategies
Solution: Discount Margin

1. State whether the FRN will be trading below,
equal to, or above par. Justify your response.
FRN trading at a premium, discount or at par

▪ Compare DM (1.55%) vs. QM (1.25%)
▪ DM has widened, credit risk has increased
▪ FRN will trade at a discount to par
© Kaplan, Inc. 23
Credit Strategies
Solution: Discount Margin

2. Calculate the value of the $1 million par value of the FRN.
Value the FRN as a bond using the calculator
▪ N = 4 quarterly payments
▪ FV = $1m
▪ I/Y = 0.525 (0.55% + 1.55%) / 4 = 0.525%
▪ PMT = 4,500 (0.55% + 1.25%) / 4 = 0.45%
× $1m = 4,500
▪ CPT PV = $997,039
Note: helpful to think of MRR + QM as the coupon, and MRR + DM as

the YTM
© Kaplan, Inc. 24

338 Fixed Income
Credit Strategies
Impact of Spreads on Portfolio Return

Recall the 5-step return decomposition process
1. Coupon income = annual coupon / bond price
2. Rolldown return = (priceT1 / priceT0) – 1
3. ΔP Δ bmk yield = (–MD × Δy) + (0.5 × C × Δy2)
4. ΔP Δ yield spread = (–MD × Δy) + (0.5 × C × Δy2)
5. Currency G/L
▪ Step 4 of the process captures the impact of

changes in spread on a manager’s returns.
▪ Steps 1–3 are also important in explaining excess
returns of corporate bonds vs. benchmark bonds.
© Kaplan, Inc. 25
Credit Strategies
Example: Excess Rolling Yield

Maturity Coupon Yield
Corporate bond 5 4.00% 2.25%
Government bond 4.5 2.00% 1.20%
Both bonds have a semiannual coupon.
1. Calculate the annualized excess rolling yield earned by the

manager holding the corporate bond vs. the government
bond over the next 6 months.
© Kaplan, Inc. 26

Fixed Income 339
Credit Strategies
Solution: Excess Rolling Yield

Price the corporate bond
Starting price: N = 10, PMT = 2, I/Y = 1.125, FV = 100
CPT PVT0 = 108.232
Price 6 mths: N = 9, PMT = 2, I/Y = 1.125, FV = 100
CPT PV6mth = 107.450
Rolldown return = (107.45 / 108.232) – 1 = –0.723%

Coupon income = 0.5 × 4% / 108.232 = 1.848%
Annualized rolling yield = (1.848% – 0.723%) × 2
= 2.25%
© Kaplan, Inc. 27
Credit Strategies
Solution: Excess Rolling Yield

Price the government bond
Starting price: N = 9, PMT = 1, I/Y = 0.6, FV = 100
CPT PVT0 = 103.494
Price 6 mths: N = 8, PMT = 1, I/Y = 0.6, FV = 100
CPT PV6mth = 103.115
Rolldown return = (103.115 / 103.494) – 1 = –0.366%

Coupon income = 0.5 × 2% / 103.494 = 0.966%
Annualized rolling yield = (0.966% – 0.366%) × 2
= 1.20%
Excess rolling yield = 2.25% - 1.20% = 1.05%
© Kaplan, Inc. 28

340 Fixed Income
Credit Strategies
Effective Spread Duration

Effective spread duration is the sensitivity of bond
price with respect to changes in yield spreads
▪ %ΔP = (–EffSpreadDur × ΔSpread) + (0.5 ×
EffSpreadCon × ΔSpread2)
Option adjusted spread

▪ ΔSpread is typically defined as the ΔOAS
Proportionate change in spread (%ΔS)

▪ Assume a widening of 10 bps, OAS is 100 bps
▪ %ΔSpread = +10 / 100 bps = +10% widening
© Kaplan, Inc. 29
Credit Strategies
Duration Times Spread (DTS)

Duration times spread adjusts spread duration to
give higher sensitivity to spread changes when
spreads themselves are higher
▪ DTS = EffSpreadDur × Spread
▪ OAS is often used as the Spread
Expected change in portfolio value

▪ %ΔSpread = ΔSpread bps / OAS bps
▪ Estimated ΔPortfolio = DTS × %ΔSpread
© Kaplan, Inc. 30

Fixed Income 341
Credit Strategies
Example: DTS
Issuer OAS EffSpreadDur Weight
A rated 180 bps 9.0 70%
C rated 400 bps 9.5 30%
The current benchmark index OAS is 200 bps.
1. Calculate the DTS of the portfolio.
2. Calculate the expected change in portfolio value for a 20 bps

increase in benchmark spread.
© Kaplan, Inc. 31
Credit Strategies
Solution: DTS
1. Calculate the DTS of the portfolio.
Calculate the DTS of each bond and of the portfolio.
DTS A rated bond = 9 × 180 = 1,620
DTS C rated bond = 9.5 × 400 = 3,800
DTS portfolio = (0.7 × 1,620) + (0.3 × 3,800) = 2,274
2. Calculate the expected ΔP (+20 bps in spread).

Proportionate spread widening = ΔS / OASportfolio
= +20 bps / 200 bps = +10% widening
Expected bps Δ Portfolio = DTS × %ΔS
= 2,274 × 0.1 = 227.4 bps 32
© Kaplan, Inc.

342 Fixed Income
Credit Strategies
Expected Excess Spread (ES)

ES = Spread – (EffSpreadDur × ΔSpread) – (PD × LGD)
◼ PD: probability of default (%)

◼ LGD: loss given default (%)
◼ PD × LGD: expected credit loss (%)
Expected excess returns

▪ Earn excess returns by finding mispriced securities
▪ Credit losses occur both from the spread widening and
from expected credit losses
© Kaplan, Inc. 33
Credit Strategies
Example: Excess Spread

A credit analyst collects the following information regarding a
corporate bond:
▪ Effective spread duration: 4.5 yrs
▪ Current credit spread: 250 bps
▪ Annualized probability of default: 1.5%
▪ Expected loss severity: 55%
▪ Expected credit spread in 6 months: 270 bps
1. Evaluate this corporate bond based on the estimates

provided by the analyst and the bond’s expected excess
spread over a 6-mth time horizon. 34
© Kaplan, Inc.

Fixed Income 343
Credit Strategies
Solution: Excess Spread

1. Evaluate this corporate bond based on the estimates
provided by the analyst and the bond’s expected
excess spread over a 6-mth time horizon.
ES = Spread – (EffSpreadDur × ΔSpread) – (PD × LGD)
= (0.025 × 0.5) – (4.5 × 0.002) – [(0.5 × 0.015) × 0.55]
= 0.0125 – 0.009 – 0.004125
= –0.000625 or –0.0625% or –6.25 bps
The bond is expected to earn a negative excess return

over the next 6 months and so it is currently overvalued.
© Kaplan, Inc. 35
Credit Strategies
Bottom-Up Credit Strategies

Bottom-up approaches focus on individual security selection to
attempt to earn excess return:
▪ Finding the best issuers and bond investments
▪ Identify the universe of bonds (relevant to mandate)
▪ Divide the universe into industry sectors/location
▪ Identify misvaluations within/between sectors
Credit analysis is the assessment of the likelihood of the issuer

making scheduled payments:
▪ Operating history and competitive position
© Kaplan,▪Inc.Financial ratios: profitability, leverage, and liquidity 36

344 Fixed Income
Credit Strategies
Credit Risk Models

Structural models estimate the future value of the assets,
liabilities, and equity of a company. The size of the equity
cushion and volatility of the assets is used to estimate the
distance to default (DtD).
▪ Default: assumed to occur when A = L (E = 0)
▪ Higher equity cushion, higher DtD, lower PD
▪ Example: Moody’s Expected Default Frequency (EDF)
Reduced-form models look for relationships between

macroeconomic conditions and borrowers.
▪ Estimate PD or spreads: PD ≈ credit spread / LGD 37
© Kaplan, Inc.
Credit Strategies
Reduced Form Model: Altman’s Z-Score

Uses key financial ratios to calculate a Z-score
▪ Working capital / total assets
▪ Retained earnings / total assets
▪ EBIT / total assets
▪ Market value of equity / total liabilities
▪ Sales / total assets
Interpretation of the Z-score

▪ Z-score > 3.0 low chance of default
▪ Z-score 1.8–3.0 some risk of default
▪ Z-score < 1.8 likely to default 38
© Kaplan, Inc.

Fixed Income 345
Credit Strategies
Example: Relative Value Analysis

Maturity Coupon YTM
A corporate issuer 2 0.5% 0.9%
has these option-free 5 2.0% 1.5%
bonds 15 3.5% 3.5%
Maturity YTM
On-the-run 2 0.2%
Benchmark bonds 5 0.8%
10 2.0%
30 4.0%
© Kaplan, Inc. 39
Credit Strategies
Example: Relative Value Analysis

The company plans on issuing a new bond with a maturity of 10
years. Expectations are that the new bond will offer 5 bps more
than the credit spread derived from interpolating the existing
credit spread curve for the issuer.
1. Calculate the fair credit spread for the new 10-yr bond issue.
© Kaplan, Inc. 40

346 Fixed Income
Credit Strategies
Solution: Relative Value Analysis

5-yr credit spread
= 1.5% – 0.8% = 0.7%
15-yr benchmark yield

▪ No 15-yr benchmark yield; interpolate 10-yr and 30-yr
▪ 15 = 10w + (1 – w)30
▪ 15 = 10w + 30 – 30w
▪ W10-yr = 75%, W30-yr = 25%
▪ Yield 15-yrbmk = (0.75 × 2%) + (0.25 × 4%) = 2.5%
15-yr credit spread = 3.5% – 2.5% = 1% 41

© Kaplan, Inc.
Credit Strategies
Solution: Relative Value Analysis

10-yr credit spread
▪ Interpolate between the 5-yr and 15-yr spreads to find the
10-yr credit spread
▪ 10 yrs is exactly halfway implying 50% weights
Alternatively, using algebra:
10 = 5w + (1 – w)15
10 = 5w + 15 – 15w
5 = 10w w = 0.5
10-yr credit spread (using 5- and 15-yr spreads):
= (0.5 × 0.7%) + (0.5 × 1.0%) + 0.05% = 0.90%
(Remember to add the 5 bps new issue premium)
© Kaplan, Inc. 42

Fixed Income 347
Credit Strategies
Top-Down Credit Strategies

Top-down approaches focus on macro factors that are likely to
affect the credit portfolio. Here are factors:
▪ Strength of economic growth and corporate profits
▪ Stronger growth, narrower spreads, take more CR
▪ When to focus on IG vs. HY
▪ Identify improving and worsening sectors
Historical patterns
▪ Credit cycle and credit spread changes
▪ Inverse relationship between growth and default
▪ Consider a weighted rating system (nonlinear) 43
© Kaplan, Inc.
Credit Strategies
Other Top-Down Considerations

Determining average credit quality: normally done
by assigning a numeric value to each rating
Risk of
A
default nonlinear
scale
better
Rating: AAA AA A BBB BB B CCC CC reflects
Simple the risks
score 1 2 3 4 5 6 7 8
Better
score 1 20 120 360 1350 2720 6500 10000
© Kaplan, Inc. 44

348 Fixed Income
Credit Strategies
Factor-Based Credit Strategies

Style-based factors (used by active fixed-income and active
equity portfolio managers)
▪ Carry: E/R with unchanged conditions (the OAS)
▪ Defensive: empirically lower risk assets, higher
risk-adjusted returns
▪ Momentum: buy recent winners, sell recent losers
▪ Value: low market value vs. fundamental value
Environmental, social, and governance factors

▪ Negative screening (exclude firms), ESG ratings
▪ Green bonds to directly fund ESG-specific initiatives 45
© Kaplan, Inc.
Credit Strategies
Liquidity Risk
Liquidity levels in fixed income vary from extremely high for
large issues of on-the-run bonds in developed markets to very
low for smaller, corporate off-the-run securities:
▪ Liquid on-the-run for ST strategies, less liquid for LT
▪ Liquid overlay strategies (e.g., CDSs and ETFs)
Effective spread (ES) is a measure of transaction costs and

execution quality:
▪ ES (buy) = trade size × (trade price – midquote)
▪ ES (sell) = trade size × (midquote – trade price)
© Kaplan, Inc. 46

Fixed Income 349
Credit Strategies
Tail Risk
Tail risk refers to the risk of losses due to infrequent but high
negative-impact events.
Value at risk is a measure of unexpected loss over a given time

frame with a specified probability:
▪ Example: the 1% daily VaR of a portfolio is $7 million
▪ 99% confidence level that the max loss is $7 million
▪ 1% significance level (error), loss could be higher
Tail risk lies beyond VaR (catastrophic losses):

▪ Explored via stress testing and scenario analysis
© Kaplan, Inc. 47
Credit Strategies
Value at Risk (VaR) Methods

The parametric method assumes returns are normal and uses
the mean and standard deviation to calculate a loss estimate at
a given confidence level:
▪ 95% confidence level (z-value is 1.65)
▪ 99% confidence level (z-value is 2.33)
Historical simulation uses empirical data for a chosen time

period to generate a return distribution:
▪ No distributional assumptions
▪ Will the future be like the past?
▪ Can incorporate normal and stressed conditions
© Kaplan, Inc. 48

350 Fixed Income
Credit Strategies
Value at Risk (VaR) Methods

Monte Carlo analysis generates return distribution through
random simulations from a user-defined model:
▪ Flexibility to incorporate nonnormal distributions
▪ Highly dependent upon the assumptions chosen being sound
(i.e., high model risk)
Drawbacks of VaR as a tail risk measure

▪ VaR does not estimate worst possible losses, only to a
confidence level (e.g., 95% or 99%)
▪ Fails to capture liquidity risks or Δ correlations
© Kaplan, Inc. 49
Credit Strategies
Extensions of Value at Risk (VaR)

Conditional VaR (CVaR) is the average loss beyond a VaR
estimate (i.e., the average loss in the tail of the distribution).
CVaR is also known as expected shortfall.
Incremental VaR (IVaR) measures the change in VaR from

adding or removing a position in a portfolio.
Relative VaR measures the VaR of a portfolio’s returns relative

to a benchmark over a given time period with a specified
probability.
© Kaplan, Inc. 50

Fixed Income 351
Credit Strategies
Credit Default Swap Strategies

Synthetic strategies alter portfolio exposures using a derivative
overlay rather than change underlying assets
▪ Can increase or decrease portfolio exposures
Credit default swaps

▪ OTC credit derivative
▪ Bilateral agreement between two parties
▪ ISDA Master Agreement
▪ Counterparty credit risk
© Kaplan, Inc. 51
Credit Strategies
Credit Default Swaps

◼ Protection buyer pays the fixed coupon in return
for credit insurance (long CDS, short CR)
◼ Protection seller receives the fixed coupon in
return for insuring (short CDS, long CR)
Fixed coupon
Reference Protection Protection

asset buyer seller
Credit event
◼ If CR ↑, CDS buyer wins

◼ If CR ↓, CDS seller wins
© Kaplan, Inc. 52

352 Fixed Income
Credit Strategies
Example: Credit Default Swaps

A manager is bullish on Issuer X and bearish on Issuer Y.
Describe the CDS strategies required to create these

exposures.
▪ Strategy for X:
▪ Strategy for Y:
© Kaplan, Inc. 53
Credit Strategies
Solution: Credit Default Swaps

Describe the CDS strategies required to create these
exposures.
Strategy for X:
▪ Sell a CDS on Issuer X; win if spread narrows
Strategy for Y:
▪ Buy a CDS on Issuer Y; win if spread widens
© Kaplan, Inc. 54

Fixed Income 353
Credit Strategies
CDS Spread vs. Fixed Coupon

CDS spread is the fair premium paid by the protection buyer to
seller for the credit protection
Fixed coupon is paid periodically by the protection buyer to

protection seller; payment is standardized to 1% for IG and 5%
for HY
Up-front payment
▪ If fair CDS spread > fixed coupon, protection buyer makes an
up-front payment to seller at initiation
▪ If fair CDS spread < fixed coupon, seller pays buyer
© Kaplan, Inc. 55
Credit Strategies
CDS Spread vs. Fixed Coupon

Scenario Up-Front Premium
CDS spread = None

fixed coupon
CDS spread > (CDS spread – fixed coupon) × *ESDCDS

fixed coupon (paid to the protection seller, CDS price below par)
CDS spread < (fixed coupon – CDS spread) × *ESDCDS

fixed coupon (paid to the protection buyer, CDS price above par)
CDS price ≈ 1 + [(fixed coupon – CDS spread) × ESDCDS]
© Kaplan, Inc. *ESDCDS – effective spread duration of the CDS 56

354 Fixed Income
Credit Strategies
Example: CDS Price and Price Changes

A manager purchases protection on a high-yield reference
obligation using a 5-year CDS contract with a CDS spread of
5.5% and an effective spread duration of 4.5.
1. Calculate the up-front premium and the price of the CDS.

2. Calculate the mark-to-market gain or loss to the protection
buyer if the CDS spread immediately falls to 5.4%.
© Kaplan, Inc. 57
Credit Strategies
Solution: CDS Price and Price Changes

Up-front premium
▪ As the reference obligation is HY the coupon is 5%
= (CDS spread – fixed coupon) × EffSpreadDurCDS
= (0.055 – 0.05) × 4.5
= 0.0225 or 2.25%
▪ As the CDS spread > fixed coupon, up-front premium is

paid by the protection buyer to the protection seller
© Kaplan, Inc. 58

Fixed Income 355
Credit Strategies

CDS price
= 1 + [(fixed coupon – CDS spread) × EffSpreadDur]
= 1 + [(0.05 – 0.055) × 4.5]
= 0.9775 or 97.75%
Quick approach to calculate the CDS price

▪ As the CDS spread > fixed coupon, we know CDS will
trade at a discount
▪ 100 – up-front premium (i.e., 100 – 2.25) = 97.75
© Kaplan, Inc. 59
Credit Strategies

2. Calculate the mark-to-market gain or loss to the protection
buyer if the CDS spread immediately falls to 5.4%.
CDS MtM gain or loss
▪ Manager has purchased CDS protection at a fixed spread
of 5.5%
▪ CDS spread falls to 5.4%; this means she is now paying too
much and will suffer a MtM loss
▪ Price impact = –ΔCDS spread × EffSpreadDur
= –(0.054 – 0.055) × 4.5 = 0.45% MtM loss
(Remember: the CDS buyer wins if spreads ↑, seller wins if spreads ↓)

© Kaplan, Inc. 60

356 Fixed Income
Credit Strategies
CDS Long-Short Strategy

CDS long position
▪ Buy CDS protection on issuers where credit spreads are
expected to widen
CDS short position

▪ Sell CDS protection on issuers where credit spreads are
expected to narrow
CDS long-short strategy

▪ Both strategies simultaneously on different issuers
© Kaplan, Inc. 61
Credit Strategies
Example: CDS Long-Short Strategy

A manager wishes to increase exposure to XYZ Corp and
decrease exposure to ABC Corp in their credit portfolio.
Tenor CDS Spread ESD*
ABC Corp 5 yrs 220 bps 4.59
XYZ Corp 5 yrs 240 bps 4.62
1. Describe the appropriate long-short CDS trades.

2. Calculate the manager’s return if ABC spreads widen by 15
bps and XYZ spreads narrow by 20 bps, based on $15
million notional contracts.
© Kaplan, Inc. 62
*ESD – effective spread duration of the CDS

Fixed Income 357
Credit Strategies
Solution: CDS Long-Short Strategy

Long-short strategy
▪ Reduce ABC exposure: buy CDS protection and profit if
spreads widen
▪ Increase XYZ exposure: sell CDS protection and profit if
spreads narrow
Profit if ABC Δspread +15 bps, XYZ –20 bps

▪ Profit = notional principal × ΔCDS spread × ESD
▪ ABC profit = $15 million × 0.0015 × 4.59 = $103,275
▪ XYZ profit = $15 million × 0.002 × 4.62 = $138,600
▪ Total profit = $103,275 + $138,600 = $241,875
© Kaplan, Inc. 63
Credit Strategies
CDS Curve Trades

Static credit spread curve strategies
A manager who believes the credit spread curve will remain
unchanged will:
▪ Lower the average credit rating of their portfolio
▪ Increase the spread duration by buying and holding
longer-dated bonds
Dynamic credit spread curve strategies

▪ Example: expect upward-sloping CDS curve to flatten
▪ Buy ST CDS protection: win if spreads increase
▪ Sell LT CDS protection: win if spreads narrow
© Kaplan, Inc. 64

358 Fixed Income
Credit Strategies
Example: Static Curve

A manager expects a static credit curve over the next 12 months
and plans to increase spread duration.
Reference Tenor CDS Spread EffSpreadDur

HY Index 5 yrs 450 bp 4.8
HY Index 10 yrs 550 bp 8.9
The manager takes the appropriate position in $50 million

notional of the 10-yr CDS. Assume annual coupon payments
and a 9-yr effective spread duration of 8.1.
© Kaplan, Inc. 65
Credit Strategies
Example: Static Curve

1. State whether the manager should buy or sell protection in
the 10-year CDS.
2. Calculate the total coupon income and rolldown return from

the position in the 10-year CDS.
© Kaplan, Inc. 66

Fixed Income 359
Credit Strategies
Solution: Static Curve

Static curve: increase spread duration
▪ Sell 10-yr CDS protection; assuming a static curve, in 1 yr,
the 9-yr CDS spread will be lower
Total coupon income

▪ High-yield coupon will be 5% (IG is 1%)
▪ Coupon income = 0.05 × $50 million = $2.5 million
Rolldown return
▪ Interpolate to find 9-yr CDS price using the 5 yr and 10 yr
© Kaplan, Inc. 67
Credit Strategies

Interpolate to find 9-yr CDS spread
9 = 5w + (1 – w) 10
9 = 5w + 10 – 10w
1 = 5w w5-yr = 0.2, w10-yr = 0.8
CDS9-yr spread = 0.2(450 bps) + 0.8(550 bps) = 530 bps
Calculate the 10-yr and 9-yr CDS prices

CDSprice = 1 + [(fixed coupon – CDS spread) × ESD]
CDS10-yr price = 1 + [(0.05 – 0.055) × 8.9] = $0.9555
CDS9-yr price = 1 + [(0.05 – 0.053) × 8.1] = $0.9757
© Kaplan, Inc. 68

360 Fixed Income
Credit Strategies

Capital appreciation
▪ Manager has sold CDS protection, so wins if spreads narrow
(like buying a bond, taking risk)
▪ Rolling down the static curve to a 9-yr CDS, the spread is
530 bps (10-yr, 550 bps)
▪ Profit from price appreciation:
= ($0.9757 – $0.9555) × $50 million = $1,010,000
Total return = coupon + price appreciation

= $2,500,000 + $1,010,000 = $3,510,000
© Kaplan, Inc. 69
Credit Strategies
Dynamic Credit Spread Curve Strategies

Economic recovery
▪ HY spreads narrow more than IG spreads
▪ Cash: buy HY bonds, sell IG bonds
▪ CDS: sell HY protection, buy IG protection
Economic recovery
▪ HY credit curve steepens
▪ Cash: buy short-term HY bonds, sell LT HY
▪ CDS: sell CDS short-term HY, buy CDS long-term HY
© Kaplan, Inc. 70

Fixed Income 361
Credit Strategies
Dynamic Credit Spread Curve Strategies

Economic slowdown
▪ HY spreads widen more than IG spreads
▪ Cash: buy IG bonds, sell HY bonds
▪ CDS: sell IG protection, buy HY protection
Economic slowdown
▪ HY credit curve flattens/inverts
▪ Cash: sell short-term HY, buy long-term HY
▪ CDS: buy CDS short-term HY, sell CDS long-term HY
© Kaplan, Inc. 71
Credit Strategies
Example: Dynamic Curve Cash Strategy

Rating OAS Expected Loss EffSpreadDur
A 1.30% 0.09% 6.00
BBB 1.72% 0.39% 6.60
BB 2.60% 0.79% 5.90
A manager’s benchmark is equally weighted across the three

zero-coupon bonds. The manager is expecting an economic
slowdown, causing divergence in the changes of HY spreads
relative to IG spreads over the next 12 mths. The manager
intends to take a 100% long position, and a 100% short position.
© Kaplan, Inc. 72

362 Fixed Income
Credit Strategies

1. Describe the trades the manager should make to profit from
the credit spread curve view.
2. Calculate the excess spread of the portfolio and the

benchmark under an economic slowdown where both OAS
and expected loss increase by 40% for IG and 80% for
HY bonds.
© Kaplan, Inc. 73
Credit Strategies
Solution: Dynamic Curve Cash Strategy

1. Describe the trades the manager should make to profit from
the credit spread curve view.
Economic slowdown
▪ HY spreads will likely widen more than IG spreads
▪ Manager should sell HY bonds, buy IG bonds
▪ 100% long the A rated bond, 100% short BB rated
© Kaplan, Inc. 74

Fixed Income 363
Credit Strategies

2. Excess spread, EL increase 40% IG, 80% HY
Excess spread
ES = spread – (EffSpreadDur × Δspread) – (PD – LGD)
ESA = 0.013 – [6 × (0.4 × 0.013)] – (0.0009 × 1.4)

= –1.946%
ESBBB = 0.0172 – [6.6 × (0.4 x 0.0172)] – (0.0039 × 1.4)
= –3.367%
ESBB = 0.026 – [5.9 × (0.8 × 0.026)] – (0.0079 × 1.8)
= –11.094%
© Kaplan, Inc. 75
Credit Strategies

2. Excess spread, EL increase 40% IG, 80% HY
Excess spread: equally weighted benchmark
ES = (–1.946% – 3.367% – 11.094%) / 3 = –5.47%
Excess spread: active long-short portfolio

▪ Long A rated = –1.946%
▪ Short BB rated = +11.094%
▪ Total excess spread = + 9.15%
This example assumes an active manager is able to source and borrow

the BB rated bond to sell at no cost.
© Kaplan, Inc. 76

364 Fixed Income
Credit Strategies
Global Credit Strategies

Global considerations
▪ Emerging markets are often heavily reliant upon a dominant
industry or commodity, making diversification more difficult.
▪ Developed markets have significant sector differences; for
example, the U.S. has a larger mortgage- and asset-backed
security sector than other markets.
▪ There are differences in accounting standards impacting
liquidity, profitability, and solvency ratios.
▪ There are differences in the magnitude and timing of the credit
cycle across countries.
© Kaplan, Inc. 77
Credit Strategies
Global Credit Analysis

Willingness and ability to pay
▪ Assessment of the ability of the government to meet their
sovereign debt payments
Institutional considerations
▪ Enforcement of property rights, contract law, geopolitical risks,
and political stability of the country
Economic profile
▪ Tax revenues from economic activity, debt levels, annual
deficit to GDP impacting ability to pay
Exchange rate regime
▪ Fixed regime limits monetary policy flexibility
© Kaplan, Inc. 78

Fixed Income 365
Credit Strategies
Global Credit Analysis Ratios

Measures comparing sovereign creditworthiness are usually
expressed as a percentage of GDP
Fiscal stability
▪ Budget deficit to GDP
Financial leverage
▪ External debt to GDP
Liquidity
▪ Currency reserves to GDP 79
© Kaplan, Inc.
Credit Strategies
Structured Instruments
A wide range of instruments exist, which allow taking
exposure to very specific credit risks
◼ MBS and ABS, tailored to specific market sectors
(e.g., real estate, consumer debt)

◼ Level of risk may be tailored by tranche
(e.g., first tranche at AAA to last tranche at below IG)

◼ Collateralized debt and collateralized loan obligations
(CDO and CLO) package corporate credit and loan risk

by tranches and may offer leveraged exposure
opportunities
© Kaplan, Inc. 80

366 Fixed Income
Credit Strategies
Fixed-Income Analytics
Fixed income analytical tools
▪ Inputs include portfolio position data, relevant market data
(e.g., prices, yields, exchange rates, volatilities)
▪ User-defined parameters comprise models for term structure,
risk (e.g., VaR), scenario analysis, and ESG ratings (also the
time horizon and overall fund objective)
▪ Outputs include a summary of portfolio positions and risk
exposures vs. the benchmark index; risk and scenario
analysis, trading, and cash management
© Kaplan, Inc. 81

Equity

368 Equity
Equity
Overview of Equity Portfolio Management
Overview of Equity Portfolio

Management
Capital Appreciation
◼ Main driver of long-term equity returns
◼ Results from investing in companies experiencing growth
in cash flows, revenues, and/or earnings
◼ Equity returns have been higher than bonds and bills.
◼ Equities outperform (underperform) other major asset
classes during periods of strong (weak) economic growth.
© Kaplan, Inc. 2

Equity 369

Management
Dividend Income
◼ When companies generate excess cash flows, they can
distribute them in the form of dividends.
◼ Well-established companies often pay dividends.
◼ Recent annual dividend yields have been 1–3%.
◼ Dividend yields are more stable than equity returns.
© Kaplan, Inc. 3

Management
Diversification Benefits
◼ Equities offer diversification benefits given less than

perfect correlation with other asset classes.
◼ However, risk reduction is not constant:
◼ During a financial crisis, correlations tend to increase.
◼ Asset class standard deviations could also increase.
© Kaplan, Inc. 4

370 Equity

Management
Potential Inflation Hedge
◼ A company that charges customers more when input costs

increase (due to inflation) can provide an inflation hedge.
◼ Commodity-producing companies (e.g., oil producer) may
also benefit directly from commodity price increases.
◼ In general, studies show a positive correlation between
equity real returns and inflation, but this relationship varies
over time and by country.
© Kaplan, Inc. 5

Management
Client Investment Considerations

◼ Clients with a high risk tolerance may prefer growth
companies, while clients with a low risk tolerance may
prefer well-established companies that pay dividends.
◼ Portfolio managers can address client constraints, such as
ESG considerations, using:
◼ Negative or positive screening
◼ Thematic investing
◼ Impact investing
© Kaplan, Inc. 6

Equity 371

Management
Equity Segmentation: Size and Style
◼ Size: categorized by large-cap, mid-cap, or small-cap

◼ Style: categorized by growth, value, or blend
◼ Investment style can be determined by analyzing company
metrics:
◼ P/E ratios, P/B ratios, dividend yield, and earnings
and/or book value growth
© Kaplan, Inc. 7

Management
Equity Investment Style Box
© Kaplan, Inc. 8

372 Equity

Management
Size and Style Advantages

◼ Better address client considerations in terms of risk/return
◼ Potential for greater diversification benefits by investing
across different sectors or industries
◼ Ability to construct relevant benchmarks based on
size/style category
◼ Ability to analyze how characteristics change over time
© Kaplan, Inc. 9

Management
Equity Segmentation: Geography

◼ Segments international markets by stage of
macroeconomic development, such as:
◼ Developed markets (e.g., U.S., U.K., Germany)
◼ Emerging markets (e.g., China, Russia, Brazil)
◼ Frontier markets (e.g., Iceland, Estonia, Jordan)
◼ Advantage is that investors with significant domestic
market exposure can better understand how to diversify
across international markets
© Kaplan, Inc. 10

Equity 373

Management
Equity Segmentation: Economic Activity

◼ Groups companies into sectors or industries using either:
◼ Market-oriented approach: segments companies by
markets served, how products are used by consumers,
and how cash flows are generated
◼ Production-oriented approach: segments companies
by products manufactured and inputs required during
the production process
© Kaplan, Inc. 11

Management
Equity Segmentation: Economic Activity (cont.)

◼ Primary structures for segmenting companies by economic
activity are: GICS, ICB, TRBC, and RGS.
◼ Each structure starts with a broad sector/industry
classification and then divides by sub-sector/sub-industry.
◼ Advantage is that managers can analyze, compare, and
construct benchmarks based on specific sectors/industries
◼ Diversification benefits are also enhanced when investments
span different sectors/industries.
© Kaplan, Inc. 12

374 Equity

Management
Equity Indices and Benchmarks
◼ Equity market indices and benchmarks can combine

size/style and geographic segmentation
◼ e.g., MSCI Europe Large Cap Value Index
◼ Economic activity can also subdivide equity indices by
sector or industry
◼ e.g., MSCI World Energy Index
© Kaplan, Inc. 13

Management
Equity Portfolio Income: Dividends
◼ Dividend income is typically the largest source of equity

portfolio income.
◼ When dividends are received, they may be subject to
income and/or withholding tax.
◼ Some companies pay an optional stock dividend.
◼ Investors choose between cash or new shares
© Kaplan, Inc. 14

Equity 375

Management
Equity Portfolio Income: Securities Lending
◼ Securities lending is often part of a short sale, which is

the sale of a security that is not owned.
◼ Lender is typically paid a small fee (0.2–0.5% annually)
and may receive collateral or cash (can also earn a return)
◼ In the future, the lender receives the loaned security back.
© Kaplan, Inc. 15

Management
Equity Portfolio Income: Additional Strategies
◼ Writing (i.e., selling) options to earn option premiums

◼ e.g., covered call or cash-covered put strategy
◼ Dividend capture where an investor:
◼ buys a stock right before its ex-dividend date;
◼ holds that stock through the ex-dividend date; and
◼ then sells the stock.
© Kaplan, Inc. 16

376 Equity

Management
Equity Portfolio Costs: Management Fees
◼ Management fees (i.e., ad-valorem fees) compensate the

manager and pay research and analysis, computer
hardware and software, compliance, and processing
trades.
◼ Typically based on % of assets under management
◼ These fees are usually higher for actively managed
portfolios due to higher levels of analysis and turnover.
© Kaplan, Inc. 17

Management
Equity Portfolio Costs: Performance Fees
◼ Some managers earn performance fees (i.e., incentive

fees) when the portfolio outperforms a return objective.
◼ Performance fees may be in the range of 10–20% based
on any capital appreciation above threshold return.
◼ To protect investor from paying for performance twice,
there may be a high-water mark.
© Kaplan, Inc. 18

Equity 377

Management
Equity Portfolio Costs: Additional Fees and Costs
◼ Administration fees are associated with corporate

activities (e.g., voting on issues).
◼ Some firms charge separate marketing/distribution fees.
◼ Trading costs (i.e., transaction costs) are associated with
buying/selling securities.
◼ Investment strategy costs are related to the chosen
strategy (e.g., active funds have higher fees).
© Kaplan, Inc. 19

Management
Shareholder Engagement
◼ Investors and managers can interact with companies in

ways that favorably impacts stock price.
◼ Also benefits the company with improved corporate
governance
◼ Engagement includes participating in calls with the
company and/or voting on corporate issues at general
meetings.
© Kaplan, Inc. 20

378 Equity

Management
Shareholder Engagement (continued)
◼ Active managers focus on improving company

performance; passive managers focus on minimizing costs.
◼ Successful engagement also benefits “free riders.”
◼ Engagement can address ESG issues.
◼ Other stakeholders such as employees, customers,
creditors, regulators, and governments are also impacted
by shareholder engagement outcomes.
© Kaplan, Inc. 21

Management
Activist Investing
◼ Takes shareholder engagement further.

◼ Activists may:
◼ Propose shareholder resolutions and launch media
campaigns to influence the vote
◼ Seek representation on board of directors
◼ Launch proxy fights to achieve their goals
© Kaplan, Inc. 22

Equity 379

Management
Passive/Active Management
◼ Passive investors seek to follow an equity market index or

benchmark.
◼ Active managers seek to outperform the benchmark and
add value.
◼ Some managers may invest along the passive-active
spectrum (e.g., closely track an index with limited
deviations to add value).
© Kaplan, Inc. 23

Management
Active Management Rationales
◼ Confidence the manager has expert knowledge and skill to

add value
◼ Client preferences: manager may not be able to attract
enough funds to cover active investing costs
◼ Mandates from clients (e.g., ESG considerations) may
require more active approach (i.e., screening techniques)
© Kaplan, Inc. 24

380 Equity

Management
Active Management Risks
◼ Reputation risk results from violations to rules,

regulations, client agreements, or moral principles.
◼ Key person risk results from individuals who are essential
to the success of the fund leaving the investment firm.
◼ Higher portfolio turnover can lead to higher tax burdens.
© Kaplan, Inc. 25

Equity 381
Equity
Passive Equity Investing
Choosing a Benchmark: Key Considerations

◼ Rules-based
◼ Consistent, objective, and predictable rules
◼ Transparent
◼ Public, clearly stated, and understandable to investors
◼ Investable
◼ Investors can replicate return and risk performance
© Kaplan, Inc. 2

382 Equity
Choosing a Benchmark: Market Exposure

◼ Market segment
◼ Broad vs. focused, domestic vs. international, developed, emerging,
or frontier
◼ Capitalization
◼ Large-cap, mid-cap, and small-cap
◼ Growth vs. value and other risk factors
© Kaplan, Inc. 3
Portfolio Risk Factor Exposure

◼ Expected sensitivity of portfolio returns to various risk
factors, including:
◼ Market risk (beta), firm size, style (e.g., growth vs. value) and prior
returns (momentum)
◼ Other factors to consider:

◼ Liquidity, volatility, and firm “quality”
© Kaplan, Inc. 4

Equity 383
Choosing a Benchmark: Weighting Method (1)

◼ Market-cap weighting
◼ CAPM “market” portfolio
◼ Reflects strategy’s investment capacity
◼ Typically free-float weighting
◼ Price weighting
◼ Higher-priced stocks are more heavily weighted
◼ Not a common investment strategy
© Kaplan, Inc. 5
Choosing a Benchmark: Weighting Method (2)

◼ Equal weighting
◼ Reduces concentration risk, slow to change sector exposures
◼ More volatile than market-cap weighting
◼ Small-cap, low liquidity stocks are overweighted
◼ Fundamental weighting
◼ Weight portfolio by their proportions of the total index value of a
fundamental factor (e.g., sales, income, dividends)
© Kaplan, Inc. 6

384 Equity
Choosing a Benchmark: Stock Concentration

◼ “Effective number of stocks”
◼ Interpreted as the number of stocks in an equally weighted portfolio
that mimics the index’s concentration
◼ Concentration can be captured by the Herfindahl-Hirschman index
(HHI)
◼ Effective number of stocks = reciprocal of HHI
◼ HHI = sum of squared weights of the individual stocks in portfolio
© Kaplan, Inc. 7
Stock Concentration Example

◼ 500-stock index with an HHI of 0.01
◼ Effective number of shares = (1 / 0.01) = 100
◼ This 500-stock index has the concentration risk of an
equally weighted 100-stock portfolio
© Kaplan, Inc. 8

Equity 385
Choosing a Benchmark: Ongoing Adjustments

◼ Rebalancing
◼ Updating constituent stock weights to reflect changes in market cap
◼ Reconstitution
◼ Removing and replacing constituent stocks that no longer fit the
index market exposure
◼ Example: Small-cap stock becomes mid-cap
◼ Both create turnover and increase trading costs

© Kaplan, Inc. 9
Reconstitution: Ongoing Adjustments

◼ Two practices used to reduce trading costs associated with
the mitigation between indexes on reconstitution dates:
◼ Buffering: Establishing a threshold level (buffer zone) for the
change in a stock’s capitalization rank that must be met before
moving it from one index to another on a reconstitution date
◼ Packeting: Move half of the portfolio position into the new index on
the reconstitution date, and move the remainder of the position at
the next reconstitution date
© Kaplan, Inc. 10

386 Equity
Factor-Based vs. Market-Cap Weighted Index

◼ CAPM is a single-factor model where risk is measured by
beta (market risk). Multifactor models consider multiple risk
factors.
◼ Returns and risk of individual securities are the result of
their exposure to these factors.
◼ Indexes with high exposure to a specific risk factor can be
created to augment or replace a market-cap weighted index.
© Kaplan, Inc. 11
Factor-Based vs. Market-Cap Weighted Index

◼ Factor-weighted portfolios have the same exposures as an
index to a set of risk factors
◼ Typically structured as ETFs
◼ Higher fees and trading commissions than passive
cap-weighted investing
© Kaplan, Inc. 12

Equity 387
Equity Risk Factors: Fama and French

◼ Market risk (beta)
◼ Firm size
◼ Book-to-market
◼ Operating profitability
◼ Investment intensity (growth rate of assets)
© Kaplan, Inc. 13
Returns-Oriented Indexes
◼ Momentum-based: Overweight stocks that have
outperformed an index
◼ Dividend yield: Overweight stocks with high dividends
◼ Fundamental-weighted: Base index strategy on company
fundamentals such as dividends, sales, and income
© Kaplan, Inc. 14

388 Equity
Passive Factor-Based Strategies

◼ Return-oriented: Yield, momentum, fundamentally weighted
◼ Risk-oriented: Volatility weighting, MV investing
◼ Diversification-oriented: Equally weighted portfolios and
maximum diversification strategies
© Kaplan, Inc. 15
Approaches to Passive Equity Investing:

Pooled Investments
◼ Open-end mutual funds
◼ Low cost and convenient fund structure
◼ Exchange-traded funds (ETFs)

◼ Investors can sell shares rather than redeeming them
◼ Intraday trading
◼ Higher transaction costs and lower liquidity in some markets
© Kaplan, Inc. 16

Equity 389

Derivatives-Based Approaches
◼ Completion overlay
◼ Move the portfolio back to the index risk exposure if it deviates in
the short term
◼ Rebalancing overlay
◼ Match the reconstitution of the index as stocks are added and
dropped
◼ Currency overlay
◼ Hedge FX exposure
© Kaplan, Inc. 17

Derivatives-Based Approaches
◼ Advantages of derivatives-based approaches:
◼ Low-cost and efficient way of adjusting risk exposures
◼ Liquid derivatives markets
◼ Disadvantages of derivatives-based approaches:

◼ Finite expirations require positions to be rolled over
◼ Position limits
◼ OTC derivatives for specialty portfolio needs involve counterparty risk
◼ Basis risk can increase tracking error
© Kaplan, Inc. 18

390 Equity

Separately Managed Equity Index
◼ Portfolio that holds all constituent stocks in an index or
representative sample
◼ Requires:
◼ Regularly updated data on the index
◼ Sophisticated trading and accounting systems
◼ Well-established broker relationships to facilitate trading
◼ Strong compliance systems
© Kaplan, Inc. 19
Portfolio Construction Methods: Full Replication

◼ Hold all constituent stocks in correct weights; regularly
reconstitute and rebalance
◼ Advantage: Closely matches the index risk/return profile
◼ Disadvantages:
◼ Not all stocks are available, or the asset size mandate makes this
expensive
◼ Tracking error increases as less liquid stocks are added
© Kaplan, Inc. 20

Equity 391
Portfolio Construction Methods:

Stratified Sampling
◼ Hold a subset of constituent stocks, so the sample
replicates the index risk/return profile
◼ Strata are formed across multiple dimensions: industry,
style, country; more strata means less tracking error
◼ Advantages over full replication: lower transaction costs,
less tracking error
© Kaplan, Inc. 21
Portfolio Construction Methods: Optimization

◼ Create portfolios that maximize or minimize some condition
subject to constraints
◼ Example: Minimize tracking error subject to 100 or fewer stocks with
market caps greater than $1 billion
◼ Advantage: Low tracking error

◼ Disadvantage: Based on historical market data, which
changes over time, requiring rebalancing
© Kaplan, Inc. 22

392 Equity
Portfolio Construction Methods:

Blended Approach
◼ For large indexes with a wide range of large-to-small and
liquid-to-illiquid constituent stocks
◼ Full replication for large and liquid stocks
◼ Stratified sampling or optimization for smaller, thinly
traded stocks
© Kaplan, Inc. 23
Tracking Error
◼ TE equals standard deviation of the differences between
portfolio excess returns and index returns
◼ Causes include:
◼ Management fees
◼ Commissions
◼ Sampling (vs. full replication)
◼ Intraday trading (index returns are based on closing prices)
◼ Cash drag (cash does not earn a return, but is held due to
redemptions, dividends, and sale proceeds)
© Kaplan, Inc. 24

Equity 393
Controlling Tracking Error

◼ Tradeoff between higher trading costs from full replication
and increased TE that comes from sampling
◼ Invest cash balances in index futures
© Kaplan, Inc. 25
Return and Risk Sources in Passively Managed

Equity Portfolios
◼ Use attribution analysis to identify sources of tracking error
◼ Securities lending enables passive investors to earn a
return and offset costs by lending shares to short investors
◼ Proxy voting is required by fiduciary duty, but costly; many
passive managers use proxy-voting services
© Kaplan, Inc. 26

394 Equity
Equity
Active Equity Investing: Strategies
Fundamental Approach for Active Management
◼ Subjective; relies on analyst discretion and judgment

◼ Use research, skill, and experience to estimate intrinsic
value of securities.
◼ Research uses financial statements, insights into business
models, management team, and industry positioning.
© Kaplan, Inc. 2

Equity 395
Fundamental Manager Portfolios
◼ Larger positions in fewer holdings

◼ Higher manager conviction ideas receive higher weight
◼ Risk if misestimated intrinsic value or market fails to
recognize mispricing
◼ Manager continuously monitors stock positions and
rebalances at any time
© Kaplan, Inc. 3
Quantitative Approach for Active Management
◼ Objective; relies on models to select investments

◼ Expertise required for large amounts of data
◼ Use historical data to identify relationships between equity
returns and variables (i.e., factors) with predictive power
◼ Factor examples: P/E ratio, market cap, debt-to-equity
ratio, price momentum
© Kaplan, Inc. 4

396 Equity
Quantitative Manager Portfolios
◼ Spread factor bets across smaller positions in larger

number of holdings
◼ Portfolio optimizer sets weights
◼ Risk if factors do not perform as predicted
◼ Automatically rebalances according to strategy rules
© Kaplan, Inc. 5
Bottom-up Strategies
◼ Bottom-up strategies select best individual investments

◼ Quantitative bottom-up managers look for persistent
quantifiable relationships between company information
(e.g., P/E ratio) and expected return.
◼ Fundamental bottom-up managers incorporate quantifiable
and qualitative characteristics into analysis.
© Kaplan, Inc. 6

Equity 397
Bottom-up Strategies: Value-based Approaches
◼ Value-based approaches identify securities trading below

estimated intrinsic value.
◼ Substyles include:
◼ Relative value, contrarian investing, high-quality value,
income investing, deep-value investing, restructuring
and distressed debt investing, and special situations.
© Kaplan, Inc. 7
Bottom-up Strategies: Growth-based Approaches
◼ Growth-based approaches identify companies with

revenues, earnings, and/or cash flows that are expected to
grow faster than their industry or the overall market.
◼ Managers may focus on:
◼ Consistent long-term growth
◼ Short-term earnings momentum
◼ Growth at a reasonable price (GARP)
© Kaplan, Inc. 8

398 Equity
Top-down Strategies
◼ Top-down strategies select best markets or sectors

◼ Fundamental and quantitative managers may focus on:
◼ Overall macroeconomic environment
◼ Broad market variables
© Kaplan, Inc. 9
Top-down Strategies (continued)
◼ Managers can use ETFs and derivatives to overweight

best markets and underweight worst markets according to:
◼ Country/geography
◼ Industry/sector
◼ Volatility
◼ Thematic investment strategies
© Kaplan, Inc. 10

Equity 399
Factor-Based Strategies
◼ A factor is a variable or characteristic with which asset
returns are correlated
◼ e.g., size (SMB) and value (HML) factors introduced by
Fama and French
◼ “Rewarded” factors have positive association with long-term
positive risk premiums
◼ Managers must avoid factors that don’t offer persistent return
© Kaplan, Inc. 11
Identifying Factor Performance

Hedged portfolio approach:
◼ Rank investable stock universe by factor
◼ Divide stock universe into quantiles
◼ Construct long/short portfolio by going long best quantile
and short worst quartile
◼ Hedged portfolio returns are tracked over time and
represent factor performance
© Kaplan, Inc. 12

400 Equity
Equity Style Factors
◼ Size: long small cap stocks; short large cap stocks

◼ Value: long cheap stocks; short expensive stocks
◼ Price momentum: long recent outperformers; short recent
underperformers
© Kaplan, Inc. 13
Equity Style Factors (continued)

◼ Growth: long stocks with high historical or expected
growth rates; short stocks with opposite prospects
◼ Quality: long stocks with high quality earnings; short
stocks with low quality earnings
◼ Unstructured data: uses big data, which includes both
conventional market data and new forms of alternative
unstructured data (e.g., satellite images, textural data,
credit card data, or social media comments)
© Kaplan, Inc. 14

Equity 401
Factor Timing
◼ Subcategory of factor investing is equity style rotation

◼ Different factors work at different times
◼ Could investigate market conditions that lead to factor
outperformance
◼ Regress factor performance against a variable
suspected to be key driver of factor performance
© Kaplan, Inc. 15
Activist Strategies
◼ Activists specialize in taking stakes in companies and

pushing for change to enhance value.
◼ Changes could be strategic, operational, or financial,
potentially involve asset sales, management changes, or
pushing for dividend increases or share buybacks.
◼ Changes could be non-financial (e.g., ESG issues).
© Kaplan, Inc. 16

402 Equity
Activist Investing Process

◼ Screen and analyze opportunities
◼ Buy initial stake in target company
◼ Submit public proposal for company changes
◼ If no agreement, threaten proxy contest
◼ If no agreement, launch proxy contest
◼ Continue to negotiate with management
© Kaplan, Inc. 17
Activist Tactics
◼ Seek board representation
◼ Communicate with management; launch proxy contests
◼ Propose changes at general meetings
◼ Propose financial restructurings (e.g., share buybacks)
◼ Reduce extravagant management compensation
◼ Launch legal proceedings for breach of duties
◼ Launch media campaigns against existing management
◼ Break up large inefficient conglomerates
© Kaplan, Inc. 18

Equity 403
Management Defenses Against Activists
◼ Use multi-class share structures

◼ Grant multiple votes to founders
◼ “Poison pill” clauses
◼ Dilute activist stake
◼ Staggered board provisions
◼ Board members cannot be replaced simultaneously
© Kaplan, Inc. 19
Statistical Arbitrage Strategies
◼ Makes extensive use of technical stock price and volume

data to exploit pricing inefficiencies
◼ Profit from mean reversion in related share prices or by
taking advantage of market microstructure issues
◼ Pairs trading exploits breakdown in stock correlations
◼ Market microstructure-based arbitrage strategies exploit
imbalances in supply and demand
© Kaplan, Inc. 20

404 Equity
Event-Driven Strategies
◼ Exploit market inefficiencies around corporate events

◼ Risk arbitrage is associated with M&A activity
◼ Cash merger: buy shares of target company after deal
has been announced
◼ Share-for-share transaction: short sell shares of
acquirer and buy shares of target company
© Kaplan, Inc. 21
Fundamental Active Investment Process

◼ Define investment universe in accordance with fund mandate
◼ Prescreen universe to obtain a manageable set of securities
◼ Analyze industry, competitive position, and financial reports
◼ Forecast performance (e.g., based on earnings)
◼ Convert forecasts to valuations
◼ Construct portfolio with desired risk profile
◼ Rebalance portfolio with buy and sell disciplines
© Kaplan, Inc. 22

Equity 405
Fundamental Investing Pitfalls
◼ Behavioral biases affect human judgment

◼ e.g., confirmation bias, illusion of control, availability
bias, loss aversion, overconfidence, regret aversion bias
◼ Value trap: stock appears to be attractive because of a
significant price fall, but may still be overvalued
◼ Growth trap: stock has above average future growth
already priced into valuation
© Kaplan, Inc. 23
Quantitative Active Investment Strategy Process
◼ Define market opportunity (investment thesis)

◼ Acquire and process data (e.g., company fundamentals)
◼ Backtest strategy (apply to historical data)
◼ Evaluate strategy (out-of-sample testing)
◼ Construct portfolio (apply risk models and trading costs)
© Kaplan, Inc. 24

406 Equity
Quantitative Investing Pitfalls

◼ Survivorship bias: backtests may overlook failed companies
◼ Look-ahead bias: use previous trading signals for times when
information is not available
◼ Data-mining/overfitting: excessive search analysis of past data
to find data that shows strategy is working
◼ Constraints on turnover
◼ Lack of availability of stock to borrow for short selling
◼ Transaction costs impact backtesting results
© Kaplan, Inc. 25
Equity Investment Style Classification
◼ Segment stock universe (e.g., size and style)

◼ Groups contain stocks that have high correlations
◼ Correlation between groups should be lower indicating
distinct styles
◼ Useful for classifying portfolio style and benchmarking
managers
© Kaplan, Inc. 26

Equity 407
Holdings-based Style Analysis
◼ Aggregates attributes of each stock in a portfolio to

conclude overall style
◼ For example, Morningstar Fund Style Box
◼ In a style box, size and style are split into groups:
◼ Large-cap, mid-cap, or small-cap
◼ Value, blend/core, or growth
© Kaplan, Inc. 27
Holdings-based Style Analysis (continued)

◼ Advantages:
◼ Generally more accurate given actual holdings
◼ Assesses individual holding style contributions
◼ Disadvantages:
◼ Requires availability of all portfolio attributes
◼ Limited derivatives data
◼ Style definitions may differ for similar portfolios
© Kaplan, Inc. 28

408 Equity
Returns-based Style Analysis
◼ Identifies portfolio style through regression of the returns

against a set of passive style indices
◼ For example, conduct a regression of returns against
passive small-cap and large-cap indices as follows:
◼ RP = a + b1SCG + b2LCG + b3SCV + b4LCV + ε
© Kaplan, Inc. 29
Returns-based Style Analysis (continued)
◼ Advantages:
◼ Does not require information on holdings
◼ Can be easily applied
◼ Disadvantage:
◼ Constraints on outputs limit detection of extreme styles
© Kaplan, Inc. 30

Equity 409
Equity
Active Equity Investing: Portfolio Construction
Active Equity Investing: Portfolio

Construction
Sources of Active Returns
◼ Long-term exposures to “rewarded factors”

◼ e.g., market risk (beta), size, value, momentum, etc.
◼ Exposure to mispriced securities, sectors, and rewarded
risks that generate alpha (i.e., related to skill)
◼ Idiosyncratic risk that generate returns related to luck
© Kaplan, Inc. 2

410 Equity

Construction
Portfolio Construction Process
◼ Three main building blocks of portfolio construction:

◼ Overweight/underweight rewarded factors
◼ Alpha skills (identifying mispricings)
◼ Position sizing (affects all sources of active risk)
◼ Building blocks are integrated with breadth of expertise
© Kaplan, Inc. 3

Construction
Breadth of Expertise
◼ Manager with broader expertise is more likely to generate
consistent, active returns
◼ Fundamental law of active management:
E(R
= A) IC BR R A TC
◼ Direct link between breadth and expected outperformance
◼ i.e., higher breadth should lead to higher active return
© Kaplan, Inc. 4

Equity 411

Construction
Portfolio Construction Approaches
◼ Most investment approaches can be classified as either:

◼ Systematic or discretionary
◼ Rules driven versus opinion driven
◼ Bottom-up or top-down
◼ stock-specific versus macroeconomic information
© Kaplan, Inc. 5

Construction
The Implementation Process
◼ Portfolio construction is objective function subject to

constraints
◼ Objectives and constraints can be absolute (e.g., max
Sharpe ratio subject to max volatility) or relative (e.g.,
max information ratio subject to max tracking error)
◼ Constraints may also focus on minimizing risk, maximizing
exposures to rewarded factors, or heuristic approaches.
© Kaplan, Inc. 6

412 Equity

Construction
Active Share
◼ Degree to which number and sizing of positions in a
portfolio differs from the benchmark
1 n
Active
= Share 
2 i =1
w p,i − w b,i
◼ Active share ranges from 0 and 1

◼ e.g., 0.5 means 50% of portfolio is invested in
benchmark and 50% is not
© Kaplan, Inc. 7

Construction
Active Risk (Tracking Error)
◼ Standard deviation of active returns, where active returns

are portfolio returns minus benchmark returns
◼ Realized active risk depends on historical returns
◼ Predicted active risk requires forward-looking estimates
of correlations and variances
◼ Active risk has two sources: active factor exposure and
idiosyncratic risk from concentrated positions
© Kaplan, Inc. 8

Equity 413

Construction
Portfolio Management Approaches
◼ Pure Indexing: zero active share; zero active risk

◼ Factor Neutral: low active share; low active risk
◼ Factor Diversified: high active share; low active risk
◼ Concentrated Factor Bets: high active share; high active risk
◼ Concentrated Stock Picker: highest active share; highest
active risk
© Kaplan, Inc. 9

Construction
Effective Risk Management Process
◼ Determine which type of risk measure is appropriate given

fund mandate (i.e., absolute or relative)
◼ Understand how strategy elements contribute to risk
◼ Determine appropriate risk budget
◼ Allocate risk among individual positions/factors
© Kaplan, Inc. 10

414 Equity

Construction
Absolute Risk: Contribution from Assets
◼ Absolute risk focuses on size and composition of absolute

portfolio variance (without reference to benchmark)
◼ Contribution of asset i to portfolio variance (CVi) is:
n
=CVi =
w w Cov
j=1
i j i, j w i Covi,p
◼ Portfolio variance = sum of each asset’s contribution
© Kaplan, Inc. 11

Construction
Absolute Risk: Contribution from Factors

◼ Portfolio variance can also be separated into variance
attributed to factor exposures and unexplained variance
◼ Contribution of factor i to portfolio variance (CVi) is:
n
CVi =  i jCovi, j = i Covi,p
j=1
◼ Unexplained variance = total portfolio variance – variance

explained by factors
© Kaplan, Inc. 12

Equity 415

Construction
Relative Risk: Contribution from Assets

◼ Relative (active) risk is appropriate when manager is
concerned with performance relative to market index
◼ Contribution of asset i to portfolio active variance (CAVi) is:
CAV
= i (w p,i − w b,i ) RCovi,p
◼ Assets contribute more if (1) higher active weight and (2)

active returns are related to overall portfolio active returns
© Kaplan, Inc. 13

Construction
Appropriate Risk Level Considerations
◼ Implementation constraints: Constraints on short positions,

leverage, and liquidity problems increase costs as active
risk increases.
◼ Limited diversification: Portfolios with higher risk/return
targets eventually lose ability to diversify efficiently.
◼ Leverage: Too much leverage will increase volatility and
eventually reduce expected compounded return.
© Kaplan, Inc. 14

416 Equity

Construction
Heuristic Risk Constraints
◼ Based on experience or general ideas of good practice

rather than empirical evidence
◼ Examples include:
◼ Limits on exposure to positions, sectors, or regions
◼ Limits on leverage, or measures designed to control the
degree of illiquidity and turnover in the portfolio
© Kaplan, Inc. 15

Construction
Formal Risk Constraints
◼ Statistical in nature; requires forecasting of return

distributions, which introduces estimation error
◼ Examples include limits on volatility, active risk, skewness,
drawdowns, and VaR-based measures, including:
◼ Conditional VaR (CVaR)
◼ Incremental VaR (IVaR)
◼ Marginal VaR (MVaR)
© Kaplan, Inc. 16

Equity 417

Construction
Additional Risk Constraints
◼ Leverage magnifies negative impact of incorrect risk

estimations
◼ Unexpected increases in volatility
◼ Risk measures used depend on management style
◼ Portfolios with fewer positions have higher estimation
errors due the specific risk of concentrated positions
© Kaplan, Inc. 17

Construction
Market Impact Costs
◼ Implicit cost related to price movement from trade

execution
◼ Buying (selling) securities may force security prices up
(down), which reduces alpha
◼ Estimating market impact cost of a single execution is
often measured as slippage cost
© Kaplan, Inc. 18

418 Equity

Construction
Factors Affecting Market Impact Costs
◼ Lower trading volume for small caps can be a liquidity

barrier with higher assets under management
◼ Higher portfolio turnover and shorter investment
horizons generally lead to higher market impact costs
◼ Managers whose trades send signals to the market will
likely have higher market impact costs
© Kaplan, Inc. 19

Construction
A Well-Constructed Portfolio
◼ Clear investment philosophy

◼ Consistent investment process
◼ Risk and structural characteristics as promised to investors
◼ Achieve desired risk exposures in most efficient manner
◼ Reasonably low operating costs given the strategy
© Kaplan, Inc. 20

Equity 419

Construction
Efficient Portfolios
◼ Portfolios that achieve desired risk exposures with fewer

positions likely focus more on risk management.
◼ Given similar risk factor exposures, the portfolio with the
lower absolute volatility and lower active risk is preferred.
◼ Given similar risks, costs, and manager skills, the portfolio
with the highest active share is preferred.
© Kaplan, Inc. 21

Construction
Long-Only vs. Long/Short Investing

◼ Choosing between long-only or long/short is influenced by:
◼ Long-term risk premiums (long/short returns can be negative)
◼ Capacity and scalability (short selling requires borrowing)
◼ Limited legal liability (higher risk for long/short)
◼ Regulation (some countries ban short selling)
◼ Transactional complexity (higher for long/short)
◼ Costs (higher for long/short)
◼ Personal ideology (some investors object to short selling)
© Kaplan, Inc. 22

420 Equity

Construction
Long Extension Approach
◼ Long/short strategy constrained to a net exposure of 100%

◼ e.g., long position of 130% and short position of 30%
◼ Preferred by investors who want 100% net exposure, but
also want manager to engage in some short selling
© Kaplan, Inc. 23

Construction
Market-Neutral Approach
◼ Remove market exposure with long and short exposures

◼ With target beta of zero, these funds should have lower
volatility than long-only strategies and low correlation with
other strategies
◼ Market-neutral portfolios can use pairs trading
◼ i.e., securities of similar companies are bought/sold to
exploit perceived mispricings
© Kaplan, Inc. 24

Equity 421

Construction
Long/Short Benefits
◼ Greater ability to express negative ideas than long-only

◼ Ability to use leverage generated by short positions to
apply to high-conviction long ideas
◼ Ability to remove market risk and enhance diversification
◼ Greater ability to control exposure to risk factors
© Kaplan, Inc. 25

Construction
Long/Short Drawbacks
◼ With a short position, losses are potentially unlimited

◼ Cost of borrowing securities can become expensive
◼ Short position losses will increase collateral demands from
stock lenders
◼ Manager may be vulnerable to a short squeeze
© Kaplan, Inc. 26

Alternative Investments

424 Alternative Investments
Hedge Fund Strategies
Overview of Hedge Fund Strategies

◼ Hedge funds are subgroup of alternative investments
◼ Key features include:
◼ Fewer regulatory and legal constraints
◼ Use of short selling and derivatives
◼ Access to a broader investment base
◼ Ability to have aggressive investment exposures
◼ Use of significant leverage, but are subject to liquidity constraints
◼ Often lack of transparency with high costs
© Kaplan, Inc. 2

Alternative Investments 425
Overview of Hedge Fund Strategies

◼ Six broad categories of hedge fund strategies:
1. Equity related: Long/short equity, dedicated short bias, equity
market neutral
2. Event driven: Merger arbitrage and distressed securities
3. Relative value: Fixed income arbitrage and convertible bond
arbitrage
4. Opportunistic: Global macro and managed futures
5. Specialist: Volatility strategies and reinsurance strategies
6. Multi-manager: Multi-strategy funds and funds-of-funds
© Kaplan, Inc. 3
Equity-Related Hedge Fund Strategies

◼ Equity-related hedge fund strategies focus primarily on
stock markets
◼ Main risk profiles involve equity-oriented risk
◼ Three subcategories discussed in this module:
1. Long/short equity
2. Dedicated short bias
3. Equity market neutral
© Kaplan, Inc. 4

1. Long/Short Equity
◼ Characteristics
◼ Long/short (L/S) equity hedge fund strategies invest in long (short)
equity positions the manager thinks will rise (fall) in value.
◼ Combined L/S positions have a beta (market exposure) equal to the
sum of the positive and negative betas.
◼ Managers are not looking to eliminate market exposures. Instead,
they typically keep 40%–60% net long exposure.
◼ Returns are similar to long-only funds, but with only half the
standard deviation.
© Kaplan, Inc. 5
1. Long/Short Equity
◼ Implementation
◼ Typically take a sector-specific focus, investing in equities in
industries familiar to the manager. May also invest in index funds.
◼ Funds that are largely market neutral need to use leverage to
generate meaningful returns.
◼ Role in the portfolio
◼ Generate alpha from long and short exposures to single stocks, but
benefit from an overall long exposure.
◼ Investors need to consider high fees relative to long-only.
© Kaplan, Inc. 6

2. Dedicated Short Selling and Short-Biased

◼ Characteristics
◼ Goal: Produce a negative correlation with conventional securities
◼ Return: Generally lower compared to other hedge fund strategies
◼ Risk: Higher with higher volatility given higher beta than L/S equity
◼ Implementation
◼ Borrow and short a security; profit by repurchasing at a lower price
◼ Managers use a bottom-up approach to identify unprofitable
businesses, bad management, high debt, and dubious accounting
© Kaplan, Inc. 7
2. Dedicated Short Selling and Short-Biased

◼ Implementation (continued)
◼ Dedicated short seller establishes 60%–120% pure short position
but may use cash to offset exposure
◼ Short-biased managers establish net short positions of 30%–60%
◼ Both strategies use little leverage
◼ Role in portfolio
◼ Main goal: Generate uncorrelated returns with conventional assets
◼ However, historical evidence is predictable low returns
© Kaplan, Inc. 8

3. Equity Market Neutral

◼ Characteristics
◼ Goal: Generate alpha from mispricings but zero exposure to the
market
◼ Return is generally modest given zero beta exposure
◼ Implementation
◼ Take long positions in temporarily undervalued equities and short
positions in overvalued equities; often uses leverage
◼ Discretionary managers can rely on intuition; quantitative
managers typically follow set rules
© Kaplan, Inc. 9

◼ Produce alpha without taking market beta risk
◼ Especially beneficial in volatile and poorly performing markets
◼ Lower volatility than beta-only strategies
© Kaplan, Inc. 10


◼ Subtypes
1. Pairs trading: Invests in two related but relatively mispriced
securities; one is overvalued and one is undervalued. May
represent different classes of shares, or a firm and its holding
parent.
2. Stub trading: Take long and short positions in a subsidiary and its
parent company. Positions correspond to percentage owned in a
subsidiary.
3. Multi-class trading: Take long and short positions in mispriced
classes of shares (e.g., nonvoting and voting) of the same firm.
© Kaplan, Inc. 11
◼ Strategies that profit from predicting the outcome of corporate
events (e.g., bankruptcies, mergers, restructurings,
acquisitions)
◼ Can invest in equitiesEvent-Driven
or relatedStrategies
derivatives
◼ But subject to event risk (outcome differs from expectations)
◼ Two subcategories discussed here:
1. Merger arbitrage
2. Distressed securities
© Kaplan, Inc. 12

1. Merger Arbitrage
◼ Characteristics
◼ Earn a return from the uncertainty due to time between
announcement and completion of an acquisition
◼ Similar to writing insurance on an acquisition
◼ A hedge fund that anticipates a successful merger can lose up to
40% in a failed merger (the price of the target will fall, and the price
of the acquirer will rise)
◼ Therefore, there is significant left-tail risk
© Kaplan, Inc. 13
1. Merger Arbitrage
◼ Implementation
◼ The typical expectation is a successful merger—buy the stock of the
target company and short the stock of the acquiring company
◼ If the expectation is a failed merger (regulatory hurdles), reverse the
above
◼ May use 300%–500% leverage to generate strong returns
◼ High Sharpe ratios given relatively steady returns, but large left-tail
risk
© Kaplan, Inc. 14

2. Distressed Securities
◼ Characteristics
◼ Invests in securities of firms that are in financial distress (in or near
bankruptcy, given high leverage, high debt, competitive pressures).
◼ Securities often trade at depressed prices, especially given that
many institutional investors can’t hold non-investment-grade assets.
◼ Firms can reorganize or liquidate. Under liquidation, investors are
often paid back sequentially depending on seniority.
◼ This strategy produces high returns but with high volatility.
◼ Lockup periods can be long, given extended time to exit.
© Kaplan, Inc. 15
2. Distressed Securities
◼ Implementation
◼ Managers can make passive investments, or acquire a majority in a
class of security to have creditor control during bankruptcy
◼ Skills-based strategy—requires knowledge of legal aspects
◼ Generally long positions with low use of leverage
◼ Typically high illiquidity with high return potential, although subject
to market unpredictability
© Kaplan, Inc. 16

Relative Value Hedge Fund Strategies

◼ Implementation
◼ Look to exploit valuation differences between securities
◼ Most often uses hybrid convertible debt or fixed income
◼ Return: from premiums for differences in liquidity, credit
quality, volatility
◼ Two subcategories discussed here:
1. Fixed-income arbitrage
2. Convertible bond arbitrage
© Kaplan, Inc. 17
1. Fixed-Income Arbitrage
◼ Characteristics
◼ Earn return from temporary mispricing of fixed-income instruments
(long overvalued, short undervalued)
◼ Can include debt, bank loans, corporate bonds, or sovereign bonds
◼ Overall low expected return, so significant use of leverage to
magnify returns
◼ Can be 400% up to 1,500%!
◼ Could be less liquid due to complex niche products
© Kaplan, Inc. 18

◼ Implementation
◼ Yield curve trades: Long and short investments in fixed-income
instruments that profit from anticipated yield curve changes
◼ Yield curve can be flattening or steepening
◼ If trading in different firms: Liquidity, credit, and interest rate risks
◼ If trading in the same firm: Mainly interest rate risk present
◼ Carry trades: Short a low-yielding and long a high-yielding security
◼ Return: From yield differential and from price changes
© Kaplan, Inc. 19
◼ Return: From spread narrowing, plus a return from positive carry
◼ But spread between the two instruments can unexpectedly widen
◼ Leverage could lead to volatility (e.g., Asian Financial Crisis of
1997)
© Kaplan, Inc. 20

2. Convertible Bond Arbitrage

◼ Characteristics
◼ Convertible bonds: Coupon-paying bonds with call option on stock
◼ Profit from buying implied volatility of undervalued convertible
bonds
◼ Typically tries to hedge the delta and gamma risks
◼ But subject to liquidity issues:
1. Needs liquidity for borrowing and short selling the underlying equity
2. Could be less liquid because of complexity of the security and sizes
issued can be small
© Kaplan, Inc. 21
2. Convertible Bond Arbitrage

◼ Implementation
◼ Exploits low option volatility relative to stocks
◼ Difficulty is hedging away market, interest rate, and credit risks
◼ If the option is out-of-the-money, the conversion price is well above
the current stock price, and the bond isn’t converted
◼ Leverage (e.g., 3x long bond exposure with 2x short equity exposure)
◼ Performs best during normal market conditions with good liquidity
© Kaplan, Inc. 22

Opportunistic Hedge Fund Strategies

◼ Profit from wide-ranging techniques. Focus isn’t on individual
securities, but top-down on regions, sectors, asset classes.
◼ Risk from macro / global events, including market cycles.
◼ Can use both technical and fundamental analysis.
◼ Managers can use systematic implementation (computer
algorithms and rules) or discretionary process (use instinct).
◼ 2 subcategories discussed here include:
1. Global macro and,
2. Managed futures.
© Kaplan, Inc. 23
1. Global Macro Strategies

Characteristics
◼ Profit from correctly identifying global economic variables like
inflation, exchange rates, yield curves, central bank policies.
◼ Directional: e.g. buy companies that will benefit from rising interest
rates; short companies that will be disadvantaged.
◼ Thematic: e.g. buy companies that will benefit from expected free
trade deals.
◼ Strategy doesn’t do well under low-volatility-mean-reverting markets.
◼ Also, significant risk if global events don’t materialize or risks rise.
© Kaplan, Inc. 24

1. Global Macro Strategies

Implementation
◼ Top-down analysis looking at macro trends; usually discretionary
◼ Manager focus can diverge (technical analysis vs. fundamental
analysis, discretionary vs. systematic implementation)
◼ Can use significant leverage, up to 600%-700% of fund assets
Role in the portfolio
◼ Can have high alpha and strong diversification
◼ Successful manager is contrarian; invests ahead of other managers
◼ Often have right-tail (positive) skew which is beneficial
© Kaplan, Inc. 25
2. Managed Futures
Characteristics
◼ Long/short in derivatives (swaps, forwards, futures, options)
◼ Because investing is via derivatives, usually uses lots of leverage
◼ Extremely liquid, but may be subject to crowding (investors pursue
same trades)
Role in portfolio
◼ Low correlation with traditional assets; improves diversification
◼ Especially useful in times of market stress; often right-tail skew
© Kaplan, Inc. 26

2. Managed Futures
Implementation
◼ Typically systematic approach
◼ Time-series momentum: buy securities with rising price, sell
securities with falling price
◼ Cross-sectional momentum: same, but within an asset class
◼ Wide range of trading strategies based on volatility or momentum
◼ Also uses signals on when to exit trades: price, momentum reversal,
time, trailing stop-loss
© Kaplan, Inc. 27
Specialist Strategies
◼ Uses manager knowledge of market to pursue specialized
investment opportunities
◼ Generate high risk-adjusted returns with low correlations
with traditional assets
◼ 2 subtypes discussed here:
1. Volatility trading
2. Reinsurance/life settlements
© Kaplan, Inc. 28

Characteristics
◼ Goal: purchase underpriced volatility and sell overpriced volatility.
Long position in volatility has positive convexity.
◼ But can also sell volatility to equity investors seeking to buy volatility.
◼ Convexity of volatility derivatives can result in large gains.
◼ But: difficult to benchmark.
◼ Futures and options based on VIX and exchange-traded options are
usually extremely liquid. OTC less liquid.
© Kaplan, Inc. 29
Implementation
◼ Exchange-traded options: straddles, calendar spreads, bull spreads,
bear spreads.
◼ OTC options: can be customized, but counterparty risk.
◼ Futures on VIX index. But VIX is mean-reverting, and other traders
may capture premiums.
◼ Volatility (variance) swaps: forward contracts with a payoff based on
the difference between observed or realized variance.
© Kaplan, Inc. 30

Role in portfolio
◼ Strong diversification because of negative correlation of
market volatility with market returns
© Kaplan, Inc. 31
2. Reinsurance/Life Settlements
Characteristics
◼ Life settlement: insured person sells his/her insurance policy to a
hedge fund which then pays premiums;
◼ Hedge fund benefits: receives death benefits and,
◼ Insured person benefits: receives more than they would from insurer.
◼ Catastrophe risk reinsurance: hedge fund buys earthquake, tornado,
hurricane, flood, etc., insurance from reinsurer. Hedge fund considers
typical and worst-case outcomes.
◼ Typically illiquid.
© Kaplan, Inc. 32

2. Reinsurance/Life Settlements
Implementation
◼ Hedge funds need considerable expertise in life settlement
◼ Hedge fund becomes the beneficiary of insurance contracts
◼ Hedge funds will look for most attractive return:
1. Low purchase price

2. Low premium payments
3. Expectation that insured person will die soon
Role in portfolio
◼ Add alpha while providing diversification (low correlations)
© Kaplan, Inc. 33
Multi-Manager Hedge Fund Strategies

◼ Uses a portfolio of various hedge fund strategies
◼ Periodically adjusts holdings
◼ 2 subcategories discussed here
1. Funds-of-funds (FoFs)
2. Multi-strategy funds
© Kaplan, Inc. 34

1. Fund-of-Funds
Benefits include:
◼ Diversification; manager selection; strategic and style allocation
◼ Due diligence; expertise; access to hard-to-obtain hedge funds
◼ FoFs will provide hedging, leverage, liquidity
Drawbacks include:
◼ Very high fees (multi-layer); no performance fee netting
◼ Lack of transparency; principal–agent issues
© Kaplan, Inc. 35
1. Fund-of-Funds
Characteristics
◼ Typically ‘2 and 20’ structure: 2% management fees + 20%
performance incentive fees

◼ FoF also adds additional management and incentive fees
◼ May have a lock-up period of at least 1 year
◼ Potential netting risk: investors may need to make large incentive

payments even if FoF overall performance is poor
◼ But offers diversification with relatively small capital investment
◼ Offers access to hedge funds otherwise closed for investment
© Kaplan, Inc. 36

1. Fund-of-Funds
Implementation
◼ Implementation involves a series of steps:
◼ Selecting appropriate hedge fund strategies, selecting and
interviewing managers, reviewing financials and audit materials

◼ Requires ongoing monitoring for style drifts and other changes
◼ Manager will adjust weights of hedge fund strategies based on
expectations
Role in portfolio
◼ Offers diversification, lower volatility, less downside risk than
traditional investments
© Kaplan, Inc. 37
2. Multi-Strategy Hedge Funds

Characteristics
◼ Run by one organization, rather than by different hedge fund firms
◼ Goal: steady returns and low volatility
◼ Similar to FoFs, but less diversified operational risks
◼ Advantage is speed and ease of making tactical allocations
◼ Can easily reallocate investments between strategies
◼ More favorable fees than under FoFs because can absorb netting
risk internally
◼ Could have poorer liquidity due to lock-ups and redemption periods
© Kaplan, Inc. 38

2. Multi-Strategy Hedge Funds

Implementation
◼ Managers invest in several varying hedge fund strategies.
◼ Advantage is ability to make tactical reallocations.
◼ Good knowledge of when and how much capital and leverage is
needed. Also good understanding of fund correlations and risks.
◼ Greater leverage than FoFs.
Role in portfolio
◼ Diversification and predictable low-volatility returns, but left-tail risk.
© Kaplan, Inc. 39
Factor Models
◼ A conditional linear factor model is used to quantify the
risk exposures of hedge fund strategies
◼ Called conditional because funds may behave differently
during normal and turbulent market conditions
© Kaplan, Inc. 40

Factor Models
◼ A general conditional factor model can be expressed as:
(Return on HFi)t = αi + βi,1(Factor 1)t + βi,2(Factor 2)t + … +
βi,K(Factor K)t + Dtβi,1(Factor 1)t + Dtβi,2(Factor 2)t +
… + Dtβi,K(Factor K)t + (error)i,t
◼ αi is the intercept for hedge fund i, βs represent factor exposures,
Dt is a variable that is 0 in normal markets and 1 during crises,
Dtβi,K(Factor K)t is an incremental exposure to risk factor K during
financial crisis periods, and (error)i,t is an error term with zero mean
© Kaplan, Inc. 41
Factor Models
◼ Hasanhodzic and Lo use six factors:
1. Equity risk: S&P 500 total return index
2. Interest rate risk: Bloomberg Barclays Corporate AA Intermediate
Bond Index
3. Currency risk: U.S. Dollar Index
4. Commodity risk: Goldman Sachs Commodity Index total return
5. Credit risk: Spread of Moody’s Baa vs. Aaa corporate bond yields
6. Volatility risk (VIX): CBOE Volatility Index (VIX)
© Kaplan, Inc. 42

Factor Models
◼ Stepwise regression avoids highly correlated risk factors and
therefore avoids multicollinearity problems
◼ Stepwise regression uses only four of the previous six factors:
◼ Equity risk, currency risk, credit risk, and volatility risk
◼ Hedge funds have various exposures to different risk factors
© Kaplan, Inc. 43
Portfolio Impact of Hedge Funds

◼ We now look at the effects of reallocating 20% of a traditional
asset portfolio (60% stock/40% bond) to hedge fund strategies
◼ New allocation is 48% stock, 32% bond, and 20% hedge fund
◼ This results in:
◼ Lower total portfolio standard deviation
◼ Higher Sharpe ratio
◼ Higher Sortino ratio
◼ Lower maximum drawdown (in approximately 1/3 of portfolios)
© Kaplan, Inc. 44


◼ Sharpe ratio: uses standard deviation, so both downside and
upside standard deviation impact the Sharpe ratio
◼ Higher Sharpe ratios from: systematic futures hedge funds,
distressed securities,Event-Driven
fixed-income arbitrage, global macro, equity
Strategies
market neutral
◼ Sortino ratio: better reflects hedge fund risk because it only
uses downside deviation
◼ Higher Sortino ratios from: equity market neutral, systematic
futures, L/S equity, event driven
© Kaplan, Inc. 45

◼ Overall, these fund strategies proved most superior:
◼ Systematic futures, equity market neutral, global macro, and
event driven
◼ These fund strategies did not significantly improve risk-adjusted
returns:
◼ Fund-of-funds and multi-strategy funds
© Kaplan, Inc. 46

Risk Metrics
◼ Standard deviation
◼ Overall, these strategies resulted in the lowest risk:
◼ Dedicated short-bias and bear market neutral
◼ These funds also reduced standard deviations:
◼ Systematic futures, FoFs (macro/systematic) and equity market neutral
funds
◼ These strategies did not significantly reduce overall standard
deviation:
◼ Event-driven (distressed securities) and relative value (convertible
arbitrage) (because of long positions and leverage)
© Kaplan, Inc. 47
Risk Metrics
◼ Drawdown
◼ Represents peak-to-trough portfolio decline (expressed as %)
◼ Smaller drawdowns are more optimal
◼ Overall, global macro, systematic futures, merger arbitrage, and equity
market neutral strategies resulted in the smallest maximum drawdown
◼ L/S equity, event driven (distressed securities) and relative value
(convertible arbitrage) did not improve the portfolio’s maximum
drawdown
© Kaplan, Inc. 48

Asset Allocation to Alternative Investments
Asset Allocation to Alternative

Investments
Role of Alternative Investments

◼ Alternative investments include hedge funds, private equity,
private credit, commercial real estate, and real assets
◼ Can improve the portfolio’s risk and returns profile
◼ High return, low risk, high Sharpe ratio
◼ Low return correlations with other assets
© Kaplan, Inc. 2


Investments
Types of Alternative Investments

◼ Hedge funds
◼ Strategies can include long-short hedging, short bias, risk arbitrage,
and various quantitative investment strategies
◼ Low correlation with other assets; may reduce equity beta
◼ Private equity
◼ Can specialize in health care or venture capital investments
◼ Benefit is higher returns, but limited diversification potential
© Kaplan, Inc. 3

Investments

◼ Private credit
◼ Includes both direct lending and distressed debt
◼ Direct lending: mainly on income-producing properties, but illiquidity
relative to public debt
◼ Distressed debt: similar risk-return profile to equities
◼ Commercial real estate
◼ Main benefit is inflation hedge because rental income and property
values increase with inflation
© Kaplan, Inc. 4


Investments

◼ Real assets
◼ Include agricultural commodities, farm land, precious metals,
industrial metals, agricultural land, and oil
◼ Commodities, farm and timberland, and infrastructure provide
inflation protection
◼ However, some infrastructure investments have limited inflation
protection (e.g., due to utility rate regulations)
© Kaplan, Inc. 5

Investments
Alternative Investments and Bonds vs. Equities

◼ Short time horizon
◼ Alternative investments show lower volatility than and low
correlation with equities
◼ However, these statistics are biased by smoothing of returns of
appraised data and sampling bias (survivorship and backfill biases)
◼ True volatility therefore may be higher
◼ Bonds have low correlation and better reduce volatility of an equity
portfolio
© Kaplan, Inc. 6


Investments
Alternative Investments and Bonds vs. Equities

◼ Long time horizon
◼ Main risk is not meeting the minimum required portfolio return
◼ Allocation to bonds may increase the risk of not meeting the return
◼ Alternative investments are better for diversification because of low
return correlation with equities
© Kaplan, Inc. 7

Investments
Investment Opportunity Set

◼ Traditional approach: Classify assets by liquidity and performance
during economic cycles.
◼ Liquidity-based approach: Classify assets based on publicly traded
(e.g., REITs) vs. privately traded (e.g., private equity).
◼ Other: Can also group assets based on performance using different
economic growth and inflation assumptions.
◼ Risk factor based approach: Estimate sensitivities to risk factors
statistically. This is useful because it identifies risks that are common
across asset classes. It may indicate similarities with equities. It allows
the manager to create an integrated risk management framework.
© Kaplan, Inc. 8


Investments

◼ Liquidity-based approach classification
© Kaplan, Inc. 9

Investments

◼ Classification based on inflation
© Kaplan, Inc. 10


Investments
Allocating to Alternative Investments

◼ Important considerations for asset allocation to alternative
investments include risk, return, and correlation
◼ Should also consider liquidity, tax, costs, and fees
◼ Short history of alternative investments makes estimating
returns difficult
◼ Using mean-variance optimization for portfolio allocations is
challenging because returns may not be normally distributed
◼ Illiquidity, optionality, and potential low/negative returns
© Kaplan, Inc. 11

Investments
Investment Vehicles
◼ Limited partnership: appropriate for large investors with
expertise in evaluating managers and strategies
◼ Typical structure (limited partner [LP] provides investment, general
partner [GP] acts as manager)
◼ Fund-of-funds: appropriate for investors who lack expertise
◼ Invest in limited partnerships; may specialize in some strategies
◼ Problem is high fees (fee upon fee)
◼ Separately managed accounts (SMAs): appropriate for
large investors who want favorable investment terms
© Kaplan, Inc. 12


Investments
Investment Vehicles
◼ Fund of one: appropriate for large investors by
establishing a limited partnership with a single client
◼ But a GP prefers LPs who pay the standard fee
◼ Undertakings for collective investment in transferable
securities (UCITS): appropriate for smaller investors
◼ Allows smaller investors to have access to alternative investments
◼ More regulated; therefore, returns may be insufficient
© Kaplan, Inc. 13

Investments
Liquidity Concerns
◼ Hedge funds have liquidity risk because they have lock-up
periods and may only accept new capital or allow redemptions
periodically (e.g., quarterly) or with penalties/notice periods.
◼ Private equity, private credit, real estate, and real asset
sectors have more liquidity risk than hedge funds.
◼ LPs may close investments for new investors.
◼ GPs may call capital periodically.
◼ Redemptions are usually not allowed.
◼ Secondary market for limited partnerships is very limited.
© Kaplan, Inc. 14


Investments
Liquidity Concerns
◼ Let’s illustrate the timeline of cash flows for a $10 million
commitment to a private equity fund:
© Kaplan, Inc. 15

Investments
Liquidity Concerns
◼ In this case the LP committed $10M, but the GP only called
down $9M.
◼ Capital calls can happen any time during the calldown period
(3 years in our example), but there is no fixed schedule.
◼ The GP doesn’t have to call the entire committed amount.
◼ Amounts committed but not called have an opportunity cost.
◼ Long positions are usually more liquid than short positions.
◼ The GP may determine that some illiquid holdings are not subject
to standard redemption terms (side pocket).
© Kaplan, Inc. 16


Investments
Liquidity Concerns
◼ GPs prefer more redemption restrictions to allow the GP to
implement the desired strategy.
◼ GPs may also restrict redemptions during adverse market
conditions to avoid selling at a loss.
◼ Leverage is a very important consideration because creditors
have priority of claims over LPs.
© Kaplan, Inc. 17

Investments
Fees and Expenses

◼ Alternative investments often have significant fees, including a
“2 and 20” fee structure for hedge funds and administrative
expenses.
◼ Investors should be aware that funds with a calldown structure
charge a management fee on the full committed capital!
◼ Investors should be aware of the tax implications of strategies.
◼ These include short-term taxable gain.
◼ Tax-exempt companies need to ensure income is considered
related to the company’s purpose.
© Kaplan, Inc. 18


Investments
Intermediaries or In-House Programs

◼ Investors may use intermediaries like FoFs to implement
alternative investments.
◼ But large investors could develop their own in-house program.
This is optimal if the investor:
◼ needs highly customized solutions;
◼ can generate higher returns/lower costs;
◼ can identify and invest with the best fund managers; and
◼ can perform due diligence on managers.
© Kaplan, Inc. 19

Investments
Suitability of Alternative Investments

◼ Alternative investments are generally suitable for large investors with
expertise and knowledge in selecting investments.
◼ Value is created through returns from active managers.
◼ Therefore, they’re not suitable if the markets are considered price efficient.
◼ They’re generally only suitable for investors with a long (>15 years)
time horizon. If the time horizon is shorter, one must ensure easy
redemption.
◼ Suitability requires investors to have strong governance program.
◼ Investors must be comfortable with lower transparency of alternative
investments in reporting and valuations.
© Kaplan, Inc. 20


Investments
Approaches to Asset Allocation

◼ Statistical tools that help with the decision of which and how
much alternative investments to allocate to portfolios are:
◼ Monte Carlo simulation
◼ Mean-variance optimization
◼ Risk factor based optimization
◼ Data should be tested and adjusted for smoothing of returns
and serial correlation (i.e., need to unsmooth data).
◼ Data should also be tested and adjusted for non-normality of
data, including skewness (fat tails) and excess kurtosis.
© Kaplan, Inc. 21

Investments
Monte Carlo Simulation

◼ Optimizes an asset allocation
◼ Need to:
◼ Choose which risk and return factors to simulate
◼ Define statistical model behavior (mean reversion, fat tails)
◼ Convert risk factors to asset returns
◼ Develop outputs using scenarios (e.g., probability of return
shortfalls)
© Kaplan, Inc. 22


Investments
Mean-Variance Optimization (MVO)

◼ MVO helps allocate alternative investments to traditional
assets
◼ But may result in excessive allocation to alternative assets
◼ May need to constrain allocation to alternative investments in the
optimization model, or limit volatility or downside risk
◼ Investors should treat the model as a guideline rather than a
prescription
© Kaplan, Inc. 23

Investments
Risk Factor-Based Optimization

◼ Similar to MVO, but investors model risk factors and factor
return expectations (not just risk and return characteristics)
◼ Can include constraints as limits on specific risk factor exposures
◼ Need to convert optimized risk exposures to asset allocation
◼ Problem is that risk factor exposures and volatilities may not be
stable over time
© Kaplan, Inc. 24


Investments
Liquidity Planning
◼ Managing liquidity is critical in ensuring a portfolio can meet
capital and cash flow commitments (large opportunity costs!)
◼ Investors can use a simple model to determine how a fund will
call its committed capital:
percentage to be called in period t × (committed capital – capital
previously called)
◼ Can also determine distributions for net asset value (NAV):
percentage to be distributed in period t × [NAV in period t – 1 × (1 +
growth rate)]
© Kaplan, Inc. 25

Investments
Liquidity Planning
◼ Liquidity planning/forecasting is also useful in assessing
target asset allocations.
◼ For example, a $15 billion portfolio needing a 10% allocation
to private equity may achieve this over several years rather
than all at once.
◼ Liquidity forecasting can help with reaching and maintaining
target allocations.
◼ Investors should stress-test liquidity planning models for
unexpected events (e.g., against fund distribution delays).
© Kaplan, Inc. 26


Investments
Monitoring Alternative Investments

◼ Optimal monitoring is against stated goals, not benchmarks.
◼ This is because indexes may be inconsistent with each other.
◼ Ensures investment allocations are consistent with objectives.
◼ Monitoring is especially important for illiquid investments.
◼ Challenges in effective monitoring include reporting time lags
and using IRR and not time-weighted returns.
◼ IRR can be manipulated based on timing of capital calls and
distributions.
© Kaplan, Inc. 27

Investments

◼ Investors may prefer to use multiple on invested capital
(MOIC).
◼ MOIC is calculated by dividing the value of the fund’s underlying
investments (plus distributions) by total invested capital.
© Kaplan, Inc. 28


Investments

◼ Other monitoring includes monitoring:
◼ Key persons
◼ Manager-investor conflicts
◼ Style drift
◼ Fund’s risk management framework
◼ Other investors’ commitment to the fund (including excessive
redemptions)
◼ Increase in new investors that may create excessive capital for the
manager that can only be invested at lower returns
◼ Reliability of auditors, custodians, and third-party service providers
© Kaplan, Inc. 29

Private Wealth
Management,
Institutional Investors

464 Private Wealth Management, Institutional Investors
Private Wealth Management,

Overview of Private Wealth Management
Overview of Private
Wealth Management
Exam Focus
◼ To answer IPS questions successfully, you must do the
following:
1. Be familiar with and understand a large number of potential issues
that may apply in a given situation (these are covered in the
SchweserNotes and CFA readings).
2. Carefully read and understand the facts of the case to determine
which issues are relevant.
© Kaplan, Inc. 2

Private Wealth Management, Institutional Investors 465
Overview of Private
Wealth Management
Exam Focus
3. Recognize that there is a process at work in developing an IPS
and constructing a portfolio for a client.
4. Construct a written answer for the constructed response questions
(practice writing an effective constructed response many
times before the exam).
© Kaplan, Inc. 3
Overview of Private
Wealth Management
Exam Focus
◼ A significant percentage of Level III candidates find this
section frustrating because it does not meet their personal
sense of consistency.
◼ Past answers are quite consistent on the main important
issues, but they also include a range of random unimportant
information, too.
◼ For the exam, you must determine the relevant case facts.
© Kaplan, Inc. 4

Overview of Private
Wealth Management
Investment Objectives: Private Clients

◼ For example, individuals and families
◼ Have a wide range of investment objectives; however, these
objectives may not be precisely defined and can change
◼ Certain investment objectives may be difficult to reconcile,
such as wanting to generate a secure retirement and also
fund charitable projects
© Kaplan, Inc. 5
Overview of Private
Wealth Management
Investment Objectives: Institutions

◼ Are more likely to have clearly defined objectives that are
usually focused on funding liabilities (e.g., defined benefit
pension plans and insurance companies)
◼ The investment objectives of institutional clients also tend
to remain stable over time
© Kaplan, Inc. 6

Overview of Private
Wealth Management
Constraints: Time Horizons

◼ Private clients have shorter time horizons compared to
institutional clients, whose time horizons can be infinite.
◼ The shorter time horizon limits the liquidity and ability to
bear risk (ATBR) of private clients.
◼ A private client may also have different time horizons for
different investment objectives (i.e., mental accounting),
where institutional clients have a single time horizon.
© Kaplan, Inc. 7
Overview of Private
Wealth Management
Constraints: Scale (or Size)

◼ Private client portfolios usually are smaller compared to
those of institutional clients.
◼ Therefore, certain asset classes, such as RE and AI, may
be deemed unsuitable for private client portfolios because
these investments can lead to an overly concentrated
portfolio.
© Kaplan, Inc. 8

Overview of Private
Wealth Management
Constraints: Taxes
◼ Taxes are an important consideration for private clients and
can impact asset allocations and manager selection.
◼ In contrast, some institutional clients, such as endowments
and foundations, may benefit from significant tax
exemptions.
© Kaplan, Inc. 9
Overview of Private
Wealth Management
Other Considerations: Governance Structure

◼ Institutional clients are likely to have a formal investment
governance structure, with a board of directors and an
investment committee that is responsible for the portfolio.
◼ Private clients tend to have less formal investment
governance, often using a private wealth manager to
oversee their account(s).
© Kaplan, Inc. 10

Overview of Private
Wealth Management
Other Considerations: Investment Sophistication

◼ Due to their formal governance structure and greater
access to investment resources, institutional investors tend
to be more sophisticated than private clients.
◼ Private clients are also more likely to display emotional
biases in the their investment decision-making, often
resulting in suboptimal decisions.
© Kaplan, Inc. 11
Overview of Private
Wealth Management
Other Considerations: Regulatory Environment

◼ The regulatory environment for private clients and
institutional investors varies greatly by jurisdiction.
◼ Some countries, like Australia and India, have the same
regulator for these two investor groups, whereas other
countries, like the U.S., employ different regulators for each
investor group.
© Kaplan, Inc. 12

Overview of Private
Wealth Management
Other Considerations: Investor Uniqueness

◼ Due to a private client’s uniqueness and complexity,
individuals with similar investment objectives may choose
very different investment strategies because of their
different concerns and backgrounds.
◼ This is less likely with institutional investors.
© Kaplan, Inc. 13
Overview of Private
Wealth Management
Advising Private Clients: Personal Information

◼ Private wealth managers should gather the following
information:
◼ Family circumstances
◼ Proof of client identification
◼ Retirement plans
◼ Sources of wealth
© Kaplan, Inc. 14

Overview of Private
Wealth Management
Advising Private Clients: Personal Information

◼ Specific return or investment objectives
◼ Risk tolerance
◼ Investment preferences (e.g., liquidity or unique concerns)
© Kaplan, Inc. 15
Overview of Private
Wealth Management
Advising Private Clients: Financial Information

◼ A private client’s assets on a net worth statement include
the following:
◼ Cash and deposit accounts
◼ Brokerage/investment accounts
◼ Retirement accounts (e.g., defined contribution plan account or the
present value of a defined benefit pension)
© Kaplan, Inc. 16

Overview of Private
Wealth Management

◼ Other employee benefits (e.g., stock options)
◼ Stock/ownership of private companies
◼ Life insurance policies with cash value
◼ Real estate and other personal assets (e.g., cars, jewelry)
© Kaplan, Inc. 17
Overview of Private
Wealth Management

◼ A private client’s liabilities on a net worth statement include
the following:
◼ Consumer debt and credit card balances
◼ Mortgage loans
◼ Other types of debt (e.g., car and student loans)
◼ Margin debt in brokerage accounts
© Kaplan, Inc. 18

Overview of Private
Wealth Management
Private Client Sample Net Worth Statement

Assets (in thousands) Liabilities (in thousands)
Cash 500 Credit card debt 175
Brokerage account 1,500 Home mortgage 500
DC plan balance 1,450
Home 750
Other personal property 125 Total liabilities 675
Total assets 4,325 Total net worth 3,650
© Kaplan, Inc. 19
Overview of Private
Wealth Management
Advising Private Clients: Tax Considerations

◼ Some general classifications of taxes are as follows:
◼ Income tax: Taxes paid on any form of income (e.g., wage, rental,
dividend, interest, and capital gains)
◼ Wealth-based taxes: Taxes paid on certain types of assets
(e.g., real estate) and taxes paid on the value of assets transferred
through estates, inheritance, and gifts
◼ Consumption tax: Includes sales tax and value-added tax
© Kaplan, Inc. 20

Overview of Private
Wealth Management

◼ The following strategies can reduce the adverse impact of
taxes:
◼ Tax avoidance: Not to be confused with illegal tax evasion. Private
clients can utilize accounts that are legally exempt from taxes and
capital gains.
◼ Some jurisdictions allow limited gift amounts to be transferred without
incurring wealth-based taxes.
© Kaplan, Inc. 21
Overview of Private
Wealth Management

◼ Tax reduction: The private client can invest in tax-free securities
and/or securities that are more tax efficient.
◼ Tax deferral: The private client can minimize the compounding
effect of taxes on portfolio returns by deferring the recognition of
these taxes into the future (e.g., 403(b) retirement savings
accounts).
© Kaplan, Inc. 22

Overview of Private
Wealth Management
Advising Private Clients:

Other Client Information
◼ Additional information that a private wealth manager will
need for financial planning purposes includes the following:
◼ Wills and trust documents for estate planning
◼ Insurance policies (e.g., life, disability)
◼ Service guidelines regarding the private wealth manager’s ability to
trade (discretionary vs. nondiscretionary accounts)
© Kaplan, Inc. 23
Overview of Private
Wealth Management

Other Client Information
◼ Portfolio reporting requirements
◼ Periodic liquidity requirements
◼ Communications and information to share with other financial
service professionals on behalf of the private client
© Kaplan, Inc. 24

Overview of Private
Wealth Management

Technical and Soft Skills
◼ Private wealth managers need a combination of technical
skills and soft skills to gather and utilize the information
about their clients to formulate an appropriate IPS.
1. Technical skills: These include proficiency in financial planning,
capital markets and asset classes, and portfolio construction and
monitoring.
© Kaplan, Inc. 25
Overview of Private
Wealth Management

Technical and Soft Skills
2. Soft skills: These are essential for the interpersonal aspects of a
client-advisor relationship and include the following:
◼ Communication and language
◼ Social skills
◼ Education skills
◼ Business development and sales skills
© Kaplan, Inc. 26

Overview of Private
Wealth Management
Formulating Client Goals and Risk Tolerance

◼ Private wealth managers help their clients formulate and
prioritize their financial goals.
◼ A private client’s financial goals can be categorized as
follows:
◼ Planned goals
◼ Unplanned goals
© Kaplan, Inc. 27
Overview of Private
Wealth Management
Planned Goals
◼ Goals that can be reasonably estimated within a specified
time horizon
◼ May include:
◼ Retirement goals (e.g., funding a comfortable existence post-
retirement)
◼ Specific purchases (e.g., primary or secondary residence)
◼ Funding the education of dependents
© Kaplan, Inc. 28

Overview of Private
Wealth Management
Planned Goals
◼ Funding significant family events (e.g., weddings)
◼ Charitable giving
◼ Wealth transfer during a private client’s lifetime or at death
© Kaplan, Inc. 29
Overview of Private
Wealth Management
Unplanned Goals
◼ Related to unexpected financial expenditures
◼ More difficult to deal with because of the uncertainty
associated with the amount of expenditure and/or timing
◼ Examples include property repairs and unexpected
medical expenses not covered by health insurance
© Kaplan, Inc. 30

Overview of Private
Wealth Management
Private Wealth Manager’s Role

in Formulating Client Goals
◼ Private wealth managers can assist their clients in
formulating their financial goals in the following ways:
◼ Quantifying goals: A private client may need assistance to
formulate specific and realistic goals when these are difficult to
quantify (e.g., funding a comfortable retirement).
© Kaplan, Inc. 31
Overview of Private
Wealth Management

◼ Prioritizing goals: Often, a private client has conflicting goals that
are difficult to prioritize (e.g., purchasing a vacation property in
retirement vs. providing for the education of their dependents).
◼ A wealth manager can help the client identify the goals that have the
highest priority.
© Kaplan, Inc. 32

Overview of Private
Wealth Management

◼ Changing goals: Private clients may decide to reevaluate their
financial goals after a change in their financial circumstances.
◼ Wealth managers can assist clients in this process and in modifying
their investment strategy.
© Kaplan, Inc. 33
Overview of Private
Wealth Management
Evaluating a Private Client’s Risk Tolerance

◼ A private wealth manager needs to understand a client’s
risk tolerance in order to formulate an appropriate
investment strategy for the client.
© Kaplan, Inc. 34

Overview of Private
Wealth Management

◼ A private client’s risk orientation can be described in
several ways:
◼ Risk tolerance: This reflects both the client’s ability to bear risk
(ATBR) and willingness to bear risk (WTBR).
◼ The opposite of risk tolerance is risk aversion.
© Kaplan, Inc. 35
Overview of Private
Wealth Management

◼ Risk capacity: This addresses a client’s ATBR, based on a client’s
wealth, income, investment horizon, liquidity requirements,
importance of goals, and other relevant considerations.
◼ The higher the risk capacity, the greater the client’s ability to bear risk
and sustain losses without putting their goals in jeopardy.
◼ Risk capacity is a more objective measure compared to risk tolerance,
which can be viewed as more of an attitude toward risk.
© Kaplan, Inc. 36

Overview of Private
Wealth Management

◼ Risk perception: This is a subjective measure of investment risk
(e.g., whether a private client thinks of investment losses in
absolute or percentage terms).
◼ Risk perception varies from one private client to the next.
© Kaplan, Inc. 37
Overview of Private
Wealth Management

◼ For the exam, generally, ATBR is decreased by:
◼ A shorter time horizon
◼ Large critical goals in relation to the size of the portfolio
◼ Goals that are important to the client or those that cannot be
deferred
◼ High liquidity needs
© Kaplan, Inc. 38

Overview of Private
Wealth Management

◼ For the exam, generally, ATBR is decreased by:
◼ Situations where the portfolio is the sole source of support or there
is an inability to incur losses in value
© Kaplan, Inc. 39
Overview of Private
Wealth Management

◼ Private wealth managers can evaluate the risk tolerance of
their clients using a combination of questionnaires and
conversations.
◼ Conversations can yield additional information about a
client’s risk tolerance (e.g., the client’s past investment
successes and failures; risk perceptions; and financial
background and experiences).
© Kaplan, Inc. 40

Overview of Private
Wealth Management

◼ When private clients have multiple financial goals, the
wealth manager should determine the client’s risk
tolerance for each goal.
◼ For example, the client may have a low risk tolerance for
more important goals but higher risk tolerance for lower
priority goals.
© Kaplan, Inc. 41
Overview of Private
Wealth Management
Capital Sufficiency Analysis for Client Goals

◼ Capital sufficiency (capital needs) analysis is used by
private wealth managers to determine the likelihood of their
clients being able to meet their financial objectives.
◼ This analysis can be performed using deterministic
forecasting and Monte Carlo simulation.
© Kaplan, Inc. 42

Overview of Private
Wealth Management
Deterministic Forecasting
◼ A traditional, deterministic, linear return analysis assumes
that a private client’s portfolio will achieve a single
compound annual growth rate across the client’s
investment horizon.
© Kaplan, Inc. 43
Overview of Private
Wealth Management
Deterministic Forecasting: Inputs Needed

◼ A wealth manager needs to establish the following inputs:
◼ Current value of the investment portfolio
◼ Investment horizon
◼ Annual return assumption (this should be based on forward-looking
capital market assumptions rather than the simplistic use of
historical returns)
© Kaplan, Inc. 44

Overview of Private
Wealth Management
Deterministic Forecasting: Inputs Needed

◼ Contributions into the portfolio and cash flows out of the portfolio
over the investment horizon
◼ Impact of taxes, inflation, and investment management fees
◼ Note: While deterministic forecasting is easy to understand

and implement, its main disadvantage is that the use of a
single return assumption is not representative of the actual
market volatility.
© Kaplan, Inc. 45
Overview of Private
Wealth Management

◼ While deterministic forecasting focuses on a single rate of
return, MCS allows input variables to be given a probability
distribution to allow for real-world uncertainty.
◼ If needed, each asset class can be modeled with its own
return and risk assumptions about the assets’ correlation
with the returns of other asset classes.
◼ MCS then generates a large number of independent trials.
© Kaplan, Inc. 46

Overview of Private
Wealth Management

◼ These independent trials are consistent with the assumed
probability distributions, with each trial showing one
potential outcome at the end of the investment horizon.
◼ A wealth manager can then aggregate all the outcomes to
determine the probability that a client will achieve a
financial goal over the investment horizon.
© Kaplan, Inc. 47
Overview of Private
Wealth Management

◼ A key consideration when using MCS is the quality of the
underlying assumptions.
◼ Like any complex model, the output of a MCS will only
be as good as its inputs.
© Kaplan, Inc. 48

Overview of Private
Wealth Management

◼ For the exam:
◼ MCS is also discussed in other readings.
◼ You do not need to know how to actually run MCS, so the questions
are likely to focus on interpreting the results of a simulation.
© Kaplan, Inc. 49
Overview of Private
Wealth Management

◼ Wealth managers tend to use a 75% to 90% probability of
success as a rule of thumb when advising private clients.
◼ If the probability of success is considered too low, a wealth
manager could propose one or more the following courses
of action.
© Kaplan, Inc. 50

Overview of Private
Wealth Management

◼ Increase contributions over the investment horizon.
◼ Reduce the financial goal amount.
◼ Increase the time horizon for the financial goal.
◼ Pursue an investment strategy with higher expected returns while
remaining within the client’s risk tolerance.
© Kaplan, Inc. 51
Overview of Private
Wealth Management
Principles of Retirement Planning

◼ The principles underpinning retirement planning include the
following:
◼ The retirement stage of a private client’s life
◼ The analysis of the client’s financial goals in retirement
◼ Behavioral considerations
© Kaplan, Inc. 52

Overview of Private
Wealth Management
Retirement Stage of Life

◼ Private wealth managers work with their clients to do the
following:
◼ Establish how much they should save toward their financial goals.
◼ Determine when they will be financially able to retire.
◼ Private clients don’t always have a clear idea of their

retirement goals. A wealth manager can help shape
retirement plans for their clients.
© Kaplan, Inc. 53
Overview of Private
Wealth Management
The Financial Stages of Life

◼ Education: The private client gains knowledge and skills
through formal and informal education and develops
human capital rather than saving for retirement.
◼ Early career: The individual enters the workforce, often
starts a family, and assumes other personal
responsibilities.
◼ Saving for retirement often begins at this stage.
© Kaplan, Inc. 54

Overview of Private
Wealth Management

◼ Career development: Job skills can continue to expand and
upward mobility increases. Financial obligations often
increase to fund children’s college education.
◼ Successful individuals generally build financial capital and
retirement savings over time.
◼ Peak accumulation: Financial capital accumulation is

typically greatest in the decade before retirement as human
capital is converted into financial capital.
© Kaplan, Inc. 55
Overview of Private
Wealth Management

◼ Preretirement: Emphasis continues to be on accumulating
financial capital for retirement and reducing liabilities.
◼ Early retirement: Private clients depend on cash flows from
pension income (and sometimes part-time employment)
and their investment portfolio to fund their retirement
lifestyle.
© Kaplan, Inc. 56

Overview of Private
Wealth Management

◼ Late retirement: Expenses on leisure activities generally
decrease, but uninsured health care expenses could
increase, putting more pressure on financial resources.
◼ Determining a rate in which sustainable distributions can be made
from the client’s portfolio for the remainder of the client’s lifetime is a
key challenge.
© Kaplan, Inc. 57
Overview of Private
Wealth Management
Analysis of Retirement Goals

◼ Mortality tables: Shows life expectancy for an individual at
different ages and enables a private wealth manager to
determine the probability that a client is likely to survive to a
given age.
◼ For the exam: No explicit calculations using mortality tables
are required in this reading; however, they are used to
calculate core capital in a later reading.
© Kaplan, Inc. 58

Overview of Private
Wealth Management

◼ Annuities: PV of the client’s retirement spending needs
can be determined by pricing an annuity.
◼ The buyer of an annuity makes an upfront payment in
exchange for receiving a series of payments over time.
◼ An immediate annuity guarantees specified monthly
payments for a predetermined period, with payments
beginning immediately.
© Kaplan, Inc. 59
Overview of Private
Wealth Management

◼ Other types of annuities include the following:
◼ Deferred annuity: monthly payments begin at a specified time in
the future
◼ Life annuity: makes monthly payments for as long as the annuity
holder is alive
© Kaplan, Inc. 60

Overview of Private
Wealth Management

◼ If a private client’s retirement spending needs are expected
to be relatively stable over the client’s life expectancy:
◼ A life annuity can be used to reduce longevity risk and the price of a
life annuity can be used as an estimate of the amount of financial
resources required to fund the client’s retirement goals.
© Kaplan, Inc. 61
Overview of Private
Wealth Management

◼ Monte Carlo simulation: MCS can be used to determine
the probability that a private client’s portfolio will meet the
client’s financial goals in retirement.
◼ MCS can be tailored to the client’s actual portfolio asset allocation
and used to explore different retirement scenarios.
◼ Frequently, a client’s retirement spending needs are

complex.
© Kaplan, Inc. 62

Overview of Private
Wealth Management

◼ MCS output will only be as good as its input assumptions.
◼ MCS can provide the probability of success; it does not
usually consider the amount by which the investment
portfolio falls short of the client’s retirement goals.
◼ This shortfall magnitude is an important consideration for
retirement planning.
© Kaplan, Inc. 63
Overview of Private
Wealth Management
Behavioral Considerations
When Advising Retirees
◼ Private wealth managers need to consider the following
behavioral biases associated with retirees:
◼ Increased loss aversion: Compared to younger investors, retirees
are likely to be more loss-averse, affecting their return assumptions
and AA decisions.
◼ Consumption gaps: Tends to be lower than what economic
studies forecast from loss aversion and uncertainty.
© Kaplan, Inc. 64

Overview of Private
Wealth Management
◼ The annuity puzzle: Life annuities can be used to reduce longevity
risk.
◼ However, individuals tend to avoid buying annuities to meet their
spending needs in retirement.
© Kaplan, Inc. 65
Overview of Private
Wealth Management
◼ Possible explanations for not purchasing annuities include
the following:
1. Clinging to the hope of funding a better retirement lifestyle
2. Desire to keep control of assets
3. High cost of annuities
© Kaplan, Inc. 66

Overview of Private
Wealth Management
◼ Mental accounting and self-control: Retirees prefer to
meet their spending needs from investment income rather
than by liquidating securities.
◼ This preference for investment income over capital appreciation can
be attributed to a lack of self-control regarding spending.
© Kaplan, Inc. 67
Overview of Private
Wealth Management
The Investment Policy Statement (IPS)

◼ The IPS documents a private client’s investment objectives,
risk tolerance, investment time horizon, liquidity
preferences, and any other preferences or constraints.
◼ The private wealth manager uses this information to
construct the client’s investment portfolio given the
prevailing capital market conditions.
© Kaplan, Inc. 68

Overview of Private
Wealth Management
The Investment Policy Statement (IPS)

◼ Client background and investment objectives
◼ Key investment parameters
◼ Portfolio asset allocation
◼ Portfolio management and implementation
◼ Duties and responsibilities of the private wealth manager
© Kaplan, Inc. 69
Overview of Private
Wealth Management
Client Background and Investment Objectives

◼ A private client’s background details are obtained from
personal, financial, and tax information that the wealth
manager has gathered on the client.
◼ The private wealth manager should determine all the
components of a client’s investment portfolio as well as any
other financial assets that the client may be holding outside
from external sources (e.g., defined benefit pension and
additional cash flows).
© Kaplan, Inc. 70

Overview of Private
Wealth Management

◼ Clients may have both planned and unplanned financial
goals and objectives, which may be ongoing or one-off in
nature.
◼ The private wealth manager should work with the client to
quantify investment objectives wherever possible and
reconcile competing objectives should they arise.
© Kaplan, Inc. 71
Overview of Private
Wealth Management

◼ When a client has multiple objectives, the wealth manager
can help the client prioritize these objectives (e.g., primary
and secondary objectives).
◼ A wealth manager can use capital sufficiency (or capital
needs) analysis to determine the likelihood of their clients
being able to meet their financial objectives.
◼ Help clients revise objectives to make them more realistic.
© Kaplan, Inc. 72

Overview of Private
Wealth Management

◼ For the exam:
◼ Past questions have required candidates to specify risk and return
objectives when preparing an IPS.
◼ In this reading, you are required to prepare investment objectives
separately from risk tolerance, which is considered under
investment parameters.
© Kaplan, Inc. 73
Overview of Private
Wealth Management
Key Investment Parameters

◼ Risk tolerance: Considers a client’s ATBR and WTBR
◼ Generally, a client has a low risk tolerance for more important goals
but higher risk tolerance for lower priority goals
© Kaplan, Inc. 74

Overview of Private
Wealth Management

◼ An additional consideration is the proximity of the client’s
goals, with near-term goals associated with lower risk
tolerance compared to longer-term goals.
◼ The process of evaluating a client’s risk tolerance
(i.e., questionnaires and/or conversations) is also covered
in this section.
© Kaplan, Inc. 75
Overview of Private
Wealth Management

◼ Time horizon: Is often described as a range:
◼ Long investment horizon: in excess of 15 years
◼ Short investment horizon: less than 10 years
◼ Clients with multiple objectives can also have a different time
horizon for each objective
© Kaplan, Inc. 76

Overview of Private
Wealth Management

◼ Asset class preferences: This section should list the
acceptable and unacceptable asset classes for the client’s
portfolio, together with the risk-return characteristics of
each asset class.
© Kaplan, Inc. 77
Overview of Private
Wealth Management

◼ Liquidity preferences: Liquidity needs that have not been
specified in the Client Background and Objectives section
should be included here (e.g., the need for a cash reserve).
◼ The private wealth manager should also include liquidity
preferences (e.g., a client’s preference for dividend income may
preclude investment in small-cap, growth stocks).
© Kaplan, Inc. 78

Overview of Private
Wealth Management

◼ Other investment preferences: Some unique preferences
include a concentrated position in a single stock and ethical
investing.
◼ Constraints: These client constraints restrict a private
wealth manager’s choice of investments or strategies for
the client’s portfolio (e.g., a client’s preference for ethical
investing).
© Kaplan, Inc. 79
Overview of Private
Wealth Management

◼ For the exam:
◼ Past questions have required candidates to analyze a private
client’s time horizon, liquidity needs, taxes, legal and regulatory
considerations, and unique preferences as investment constraints.
◼ In this reading, risk tolerance, time horizon, liquidity preferences,
other investment preferences and constraints are analyzed as
investment parameters, while taxes are included as part the client’s
financial background.
© Kaplan, Inc. 80

Overview of Private
Wealth Management

◼ You are provided with all the relevant information for a
client’s investment parameters in the given information.
◼ A typical question may require you to address all the
previously mentioned investment parameters in 10–12
minutes.
◼ You should give brief factual answers for each parameter,
supported by relevant facts from the story.
© Kaplan, Inc. 81
Overview of Private
Wealth Management

◼ If there are no issues to address for a particular parameter,
say so in your answer rather than leaving it blank.
◼ Alternatively, a question may only ask you to address
specific investment parameters and assign more minutes
for each parameter.
◼ In this case, only address what is requested and provide
more detail in your answer.
© Kaplan, Inc. 82

Overview of Private
Wealth Management
Portfolio Asset Allocation (AA)

◼ Strategic asset allocation (SAA): Indicates a long-term
target allocation for each asset class, with the portfolio
being rebalanced periodically to maintain the target
allocation
◼ Tactical asset allocation (TAA): An active management
strategy that normally specifies a range for each asset
class rather than a specific target allocation percentage
© Kaplan, Inc. 83
Overview of Private
Wealth Management
Portfolio Management and Implementation

◼ Discretionary authority: Specifies the ability of the private
wealth manager to take investment actions without first
seeking the client’s approval
◼ Full discretion vs. limited discretionary
◼ A wealth manager providing a nondiscretionary service can

make investment recommendations but is unable to act on
the recommendation without the client’s approval
© Kaplan, Inc. 84

Overview of Private
Wealth Management

◼ Rebalancing
◼ Time-based rebalancing (e.g., quarterly, semiannual, or
annual rebalancing) does not consider deviations between
actual portfolio and target (SAA) percentages.
◼ Threshold-based rebalancing portfolios are rebalanced once
actual asset class weights deviate from target weights by a
prespecified amount.
© Kaplan, Inc. 85
Overview of Private
Wealth Management

◼ Tactical changes: The IPS should clearly state if a private
wealth manager is given discretionary authority to
undertake TAA changes.
◼ The IPS should clearly state the acceptable range of weights
for each asset class as well as the extent to which the
manager is allowed to go beyond the upper or lower bounds
when making TAA.
© Kaplan, Inc. 86

Overview of Private
Wealth Management

◼ Implementation: This section covers information about
acceptable investment vehicles (e.g., the use of in-house
and/or external money managers, ETFs, mutual funds).
◼ The due diligence process for making investment decisions is
also clearly stated.
© Kaplan, Inc. 87
Overview of Private
Wealth Management
Duties and Responsibilities

of the Private Wealth Manager
◼ Formulating and reviewing the IPS, including frequency of
review
◼ Recommending or selecting investment options and
constructing the investment portfolio’s asset allocation
◼ Monitoring and rebalancing the portfolio
◼ Monitoring portfolio implementation costs
© Kaplan, Inc. 88

Overview of Private
Wealth Management
Duties and Responsibilities

of the Private Wealth Manager
◼ Monitoring the third-party service providers
◼ Reporting portfolio performance
◼ Reporting taxes and financial statements
◼ Voting proxies
© Kaplan, Inc. 89
Overview of Private
Wealth Management
IPS Appendix
◼ Modeled portfolio performance: This typically describes
a range of possible portfolio outcomes over different
investment horizons as well as a distribution of returns at
specific percentiles.
◼ Capital market expectations: The covers the expected
return, risk, and correlations of the asset classes that the
private wealth manager can include in a client’s portfolio.
© Kaplan, Inc. 90

Overview of Private
Wealth Management
Evaluate and Recommend Improvements

to an IPS for a Private Client
◼ For the exam:
◼ The nature of constructed response questions gives you some
latitude in developing an acceptable answer. In some cases,
there may be more than one acceptable answer.
◼ You will be graded on whether you answer the questions in a
way that is consistent with what is taught in the curriculum.
© Kaplan, Inc. 91
Overview of Private
Wealth Management
Portfolio Construction
◼ After developing a client’s IPS, a wealth manager
constructs the client’s investment portfolio to implement the
client’s investment strategy:
◼ Traditional approach
◼ Goals-based investing approach
© Kaplan, Inc. 92

Overview of Private
Wealth Management
Traditional Approach to Portfolio Construction

◼ The traditional approach to constructing a private client’s
portfolio views risk in an overall portfolio context and
consists of the following steps:
◼ Identify appropriate asset classes for the client’s portfolio.
◼ Develop capital market expectations (i.e., expected returns,
standard deviations, and correlations of asset classes).
© Kaplan, Inc. 93
Overview of Private
Wealth Management

◼ Determine asset class weights for the portfolio, consistent
with the client’s risk tolerance for the overall portfolio.
◼ Asset investment constraints (e.g., a client’s preference for
ethical investing) that may limit the wealth manager’s choice
of investments.
◼ Implement the portfolio.
© Kaplan, Inc. 94

Overview of Private
Wealth Management

◼ For the exam:
◼ Asset allocation approaches, such as MVO and MCS, are
covered in an earlier reading.
◼ A private wealth manager can use these approaches to
establish an optimal portfolio that maximizes expected return
for a specified level of risk consistent with the client’s risk
tolerance.
© Kaplan, Inc. 95
Overview of Private
Wealth Management

◼ The optimal portfolio may include asset class allocations
that are impractical to implement; the wealth manager may
need to specify asset class constraints in the optimization
process.
◼ The wealth manager may also need to modify the optimal
asset class weights to incorporate client preferences (while
remaining within acceptable risk limits).
© Kaplan, Inc. 96

Overview of Private
Wealth Management

◼ For the exam: Key considerations when implementing the
portfolio include the following:
◼ Use of active or passive management (or a combination) for
each asset class
◼ Degree of focus on specific sectors of each asset class
(e.g., style factors for equity and credit quality for FI)
© Kaplan, Inc. 97
Overview of Private
Wealth Management

◼ For the exam: Key considerations when implementing the
portfolio include the following:
◼ Manager selection
◼ Use of individual securities or pooled investment vehicles
◼ Degree of hedging required (e.g., for currency exposure)
◼ Choosing asset location (e.g., tax advantaged accounts)
© Kaplan, Inc. 98

Overview of Private
Wealth Management
Goals-Based Investing
◼ Essentially, follow the same steps as the traditional
approach to portfolio construction.
◼ The critical difference is that instead of constructing a
single portfolio, the private wealth manager creates
separate portfolios for each of the client’s goals.
© Kaplan, Inc. 99
Overview of Private
Wealth Management
◼ Mean-variance optimization (MVO) can be structured to
maximize expected returns for a given level of risk or to
meet a specified probability of success for each goal
portfolio.
◼ Each goal has a separate portfolio rather than one entire
portfolio for all of the client’s goals.
© Kaplan, Inc. 100

Overview of Private
Wealth Management
◼ With goals-based investing, clients may find it easier to
specify their risk tolerance for each goal rather than the
entire portfolio.
◼ A key disadvantage of this approach is that the client’s
entire portfolio may not be mean-variance efficient.
© Kaplan, Inc. 101
Overview of Private
Wealth Management
Portfolio Reporting and Review, and Evaluating

an Investment Program
◼ Portfolio reporting enables private wealth clients to
understand how their investment portfolio is performing and
whether their financial goals are likely to be achieved.
◼ It provides a basis for a private wealth manager to review a
client’s IPS and investment strategy with the client to
determine if changes are required to achieve the client’s
goals.
© Kaplan, Inc. 102

Overview of Private
Wealth Management
Portfolio Reporting
A portfolio report typically includes the following:

◼ Performance summary for the current period.
◼ Market commentary for the current period to provide
context for the portfolio’s performance.
◼ Portfolio asset allocation at the end of the current period,
including SAA weights or TAA class target ranges.
© Kaplan, Inc. 103
Overview of Private
Wealth Management
Portfolio Reporting
◼ Detailed performance of asset classes and individual

securities.
◼ Benchmark report comparing asset class and overall
portfolio performance to appropriate benchmarks.
◼ Historical performance of client’s investment portfolio since
inception.
© Kaplan, Inc. 104

Overview of Private
Wealth Management
Portfolio Reporting
◼ Transaction details for the current period (e.g.,

contributions, withdrawals, interest, dividends, and capital
appreciation).
◼ Purchase and sale report for the current period.
◼ Impact of currency exposure and exchange-rate
fluctuations.
© Kaplan, Inc. 105
Overview of Private
Wealth Management
Portfolio Reporting
◼ Progress toward meeting goal portfolios when using a

goals-based investing approach.
For the Exam:
◼ Be prepared to identify three or four items from the
preceding list that could be added to a client’s portfolio
to improve the client’s understanding of portfolio
performance.
© Kaplan, Inc. 106

Overview of Private
Wealth Management
Portfolio Reporting
◼ The horizon mismatch between quarterly (or annual)

portfolio reports and the significantly longer investment
horizon of a client can potentially distort a client’s
perception of the portfolio’s long-term effectiveness.
◼ The portfolio reporting and review process enables the
private wealth manager to provide context to investment
performance for the current period and to manage client
expectations.
© Kaplan, Inc. 107
Overview of Private
Wealth Management
Portfolio Review
◼ A portfolio review enables the private wealth manager to

reassess a client’s IPS and investment strategy in light of
recent performance to determine if changes are required.
A portfolio review typically addresses the following
areas:
◼ Appropriateness of client’s existing goals and investment
parameters and if any changes are required.
© Kaplan, Inc. 108

Overview of Private
Wealth Management
Portfolio Review
◼ Rebalancing of portfolio asset allocation to target allocation

or ranges.
◼ Any changes to the wealth manager’s ongoing
management of the portfolio (e.g., degree of discretionary
authority).
© Kaplan, Inc. 109
Overview of Private
Wealth Management
Portfolio Review
◼ Any changes or updates in the wealth manager’s duties

and responsibilities.
◼ Any changes to IPS and portfolio review frequency.
© Kaplan, Inc. 110

Overview of Private
Wealth Management
The Success of the Investment Program
The degree to which a private client’s investment program is

considered a success is measured in terms of three criteria:
◼ Goal achievement
◼ Process consistency
◼ Portfolio performance
© Kaplan, Inc. 111
Overview of Private
Wealth Management
Goal Achievement
◼ An investment portfolio is considered a success if it fulfills a

client’s goals within the specified risk parameter.
◼ Key criteria for success: Is it still likely to meet the client’s
longer-term goals without a significant change in the
original strategy?
◼ The plan is unlikely successful if the client now has to make
significant additional contributions to meet retirement goals.
© Kaplan, Inc. 112

Overview of Private
Wealth Management
Process Consistency
◼ The success of an investment program depends on the

consistency of processes that that manager uses.
The following issues are typically considered in
evaluating process consistency:
◼ Has the wealth manager implemented an investment
strategy that is consistent with the client’s goals and
investment preferences?
© Kaplan, Inc. 113
Overview of Private
Wealth Management
Process Consistency
◼ Is the wealth manager maintaining regular communications

with the client to assess the need for changes to the IPS?
◼ How have recommended third-party investment managers
performed relative to their benchmarks?
◼ What is the impact of recommended fund manager
switches on portfolio performance?
© Kaplan, Inc. 114

Overview of Private
Wealth Management
Process Consistency
◼ How has the use of TAA affected portfolio performance?

◼ Has the rebalancing process followed IPS guidelines?
◼ What tax-efficient strategies have been employed for the
portfolio?
◼ How has the wealth manager tried to reduce portfolio costs
and expenses?
© Kaplan, Inc. 115
Overview of Private
Wealth Management
Portfolio Performance
◼ Portfolio performance can be measured against an

absolute performance benchmark (e.g., 5% fixed return) or
relative to a passive benchmark (e.g., return on a domestic
stock index).
◼ The impact of investment risk can be evaluated by
comparing the risk-adjusted return (e.g., Sharpe ratio) of
the client’s portfolio and the appropriate benchmark.
© Kaplan, Inc. 116

Overview of Private
Wealth Management
◼ Investment risk can also be evaluated by comparing the

portfolio’s downside risk with the client’s risk tolerance.
◼ Private wealth managers need to recognize that clients prefer
to evaluate portfolio performance against benchmarks they
are familiar with (such as domestic equity indexes) and take
this preference into consideration in the portfolio construction,
reporting, and review process.
© Kaplan, Inc. 117
Overview of Private
Wealth Management
◼ Definition of success. Private wealth managers and their

clients should ideally agree on the measures of success at
the inception of the investment program.
◼ This includes deciding whether to measure portfolio
performance in absolute or relative terms to avoid any
misunderstandings further down the line.
© Kaplan, Inc. 118

Overview of Private
Wealth Management
For the Exam:

◼ Questions are likely to ask you to evaluate a client’s
investment program against the three criteria previously
discussed.
◼ An investment program can be said to be successful only if
it achieves success on all three criteria.
© Kaplan, Inc. 119
Overview of Private
Wealth Management
Ethical and Compliance Considerations, and

Private Client Segments
◼ Private wealth managers need to fulfill many ethical and
compliance requirements when advising their clients and
managing their investment portfolios.
◼ These requirements are briefly discussed in the following
sections.
© Kaplan, Inc. 120

Overview of Private
Wealth Management
Ethical Considerations
◼ A private wealth manager should use the CFA Institute

Code of Ethics and Standards of Professional Conduct as a
basis for managing and resolving ethical issues and
conflicts.
◼ Some of the more relevant ethical considerations include
the following.
© Kaplan, Inc. 121
Overview of Private
Wealth Management
◼ Fiduciary duty and suitability. Assessing the suitability of

potential investments for a private client is an important
component of a wealth manager’s fiduciary duty.
◼ Fiduciary duty and suitability considerations are covered
in the following Standards of Professional Conduct.
© Kaplan, Inc. 122

Overview of Private
Wealth Management
◼ Standard I(B) Independence and Objectivity

◼ Standard III(A) Loyalty, Prudence, and Care
◼ Standard III(C) Suitability
◼ Standard IV(A) Diligence and Reasonable Basis
© Kaplan, Inc. 123
Overview of Private
Wealth Management
◼ Know your customer (KYC). KYC rule requires private

wealth managers to obtain relevant personal and financial
information about their clients for portfolio management
purposes as well as for regulatory compliance.
◼ KYC requirements are covered in Standard III(C)
Suitability.
© Kaplan, Inc. 124

Overview of Private
Wealth Management
◼ Confidentiality. Client confidentiality is a key tenet of a

wealth manager–client relationship and can be a challenge
when a private wealth manager’s clients are known to each
other (i.e., business associates).
◼ Standard III(E) Preservation of Confidentiality deals with
the main considerations in client confidentiality.
© Kaplan, Inc. 125
Overview of Private
Wealth Management
◼ Conflicts of interest. Private wealth managers may face

potential conflicts of interest if their fee- or commission-
based compensation structure influences the provision of
investment advice and recommendations to their clients.
◼ Relevant considerations are covered in Standard I(B)
Independence and Objectivity and Standard VI(A)
Disclosure of Conflicts.
© Kaplan, Inc. 126

Overview of Private
Wealth Management
Compliance Considerations
For the Exam:

◼ Regulatory requirements for private wealth managers vary
by jurisdiction.
◼ Be prepared to state that private wealth managers must
fulfill regulatory requirements as part of their responsibilities
to clients if an exam question asks you to identify
compliance considerations.
© Kaplan, Inc. 127
Overview of Private
Wealth Management
Mass Affluent Segment
◼ The mass affluent segment requires a wide range of wealth

management services, such as portfolio construction, risk
management, and retirement planning.
◼ It is characterized by a larger number of clients per wealth
manager and greater use of technology in delivering
services such as account creation and portfolio reporting.
© Kaplan, Inc. 128

Overview of Private
Wealth Management
Mass Affluent Segment
◼ Due to the larger client-to-wealth-manager ratio, wealth

managers do not tend to tailor their portfolio management
approach for each client.
◼ Compensation for wealth managers in this segment can be
based on commissions from investment transactions for the
client (brokerage model) or fees linked to AUM.
© Kaplan, Inc. 129
Overview of Private
Wealth Management
High-Net-Worth (HNW) Segment
◼ The HNW segment exhibits a smaller number of clients per

wealth manager compared to the mass affluent segment.
◼ Wealth management services provided in this segment are
more likely to concentrate on tailored investment solutions,
tax planning, and estate planning.
◼ The portfolios of HNW clients are more likely to contain AI,
and estate planning is often considered.
© Kaplan, Inc. 130

Overview of Private
Wealth Management
Ultra-High-Net-Worth (UHNW) Segment
◼ This segment is likely to have multigenerational investment

horizons, complex tax and estate planning, and a more
comprehensive range of service requirements.
◼ May include ancillary services (e.g., travel planning) and
advice on luxury investments (e.g., art and automobiles)
◼ The UHNW segment has a relatively low client-to-manager
ratio because of the highly customized services provided.
© Kaplan, Inc. 131
Overview of Private
Wealth Management
Ultra-High Net-Worth (UHNW) Segment
◼ A UHNW wealth manager typically manages the portfolios

of multigenerational family members, requiring
consideration of family governance and inheritance issues.
◼ UHNW clients are more likely to be serviced by a client
relationship team that includes legal, tax, and investment
experts in addition to a relationship manager.
◼ Some UHNW may choose to employ a family office.
© Kaplan, Inc. 132

Overview of Private
Wealth Management
Robo-Advisors
◼ Robo-advisors are automated wealth managed advisors

that assist private clients with their portfolio management
needs.
◼ Robo-advisors gather client information using online
questionnaires and recommend an appropriate asset
allocation for the client’s portfolio using MVO or alternative
techniques.
© Kaplan, Inc. 133
Overview of Private
Wealth Management
Robo-Advisors
◼ The client’s portfolio is constructed using exchange-traded
funds or mutual funds and monitored on an ongoing basis.
◼ Periodic rebalancing and online performance reporting are
also provided to the client.
◼ From the automated client interface, the costs associated
with using robo-advisors are lower than the fees charged
by private wealth managers.
© Kaplan, Inc. 134

Overview of Private
Wealth Management
Robo-Advisors
◼ The scalable technology associated with robo-advisors also
enables their services to be provided to clients with small
portfolios in a cost-effective manner.
◼ Robo-advisors are increasingly being employed by private
clients for more sophisticated purposes.
◼ They can also be used in combination with traditional
private wealth managers to lower fees.
© Kaplan, Inc. 135


Topics in Private Wealth Management
Approaches to Taxation
Here are the main categories of taxes:
◼ Income tax (earnings): paid by individuals,
corporations on wages, rents, interest, and dividends
◼ Capital gains tax (gains): paid on the price
appreciation (i.e., proceeds less cost)
◼ Wealth/property tax (ownership): paid annually on
the value of assets held (e.g., on real estate)
◼ Stamp duties (purchases): real estate, shares
◼ Wealth transfer tax (transfers): estate, gift taxes
© Kaplan, Inc. 2

Interest and Dividends

Interest payments on bonds, debt instruments, and
interest-bearing accounts may vary in tax treatment:
◼ Government bond income may be at a lower rate.
◼ Double taxation may occur if earnings are taxed at
the company level as well as taxing dividends.
◼ Franking credits result in investors only paying the
difference between personal and corporate tax rates.
◼ Qualified dividends relate to shares held for minimum
time periods that qualify for lower taxes.
© Kaplan, Inc. 3
Capital Gains
Capital gains may be realized or unrealized. Gain or
loss equals the selling price less allowable costs.
Calculating the gain
◼ Net sales price less commissions and trading costs
◼ Less the original cost of the asset
◼ Realized losses offset against realized gains
◼ Short-term gains (higher rate), long-term (lower rate)
◼ Step-up in cost basis to fair market value on death
© Kaplan, Inc. 4

Real Estate Taxation

The focus is on real estate as an investment
(not as a principal residence).
Net income is usually taxable
◼ Allowable costs (e.g., interest and repairs)
◼ Depreciation (e.g., straight line or declining
reduces the cost base)
◼ When sold, depreciation may be recaptured if
proceeds of sale exceed the cost base
© Kaplan, Inc. 5
Types of Investment Accounts

Here are three types of investment accounts:
◼ A taxable account (TA) is taxed at the relevant
rates for each type of investment income.
◼ A tax-deferred account (TDA) allows pretax
contributions and tax-free accumulation, but taxes
apply to withdrawals.
◼ A tax-exempt account (TEA) allows for after-tax
contributions and tax-free accumulation with no
taxes on withdrawals.
© Kaplan, Inc. 6

Types of Tax Systems

Here are three types of tax systems:
◼ A tax haven is a jurisdiction with zero or very low tax
rates for residents and foreign investors.
◼ A territorial tax system taxes only income that is
earned locally.
◼ A worldwide tax system will impose taxes on all
sources of income wherever it is earned.
◼ Double taxation treaties may provide credits.
◼ Residence status is often important (not in U.S.).
© Kaplan, Inc. 7
Example: Cross-Border Investing

Cecile is a citizen of the Philippines, and she is considering
investing in property in the United States. Outline the
various implications to Cecile of the various options on
U.S. taxation.
1. Owning property directly as a nonresident
2. Owning property indirectly via a U.S. corporation
3. Owning property indirectly via a non-U.S. corporation
© Kaplan, Inc. 8

Solution: Cross-Border Investing

1. Owning property directly as a nonresident
▪ Withholding taxes may apply to gross, not net,
rental income
▪ U.S. estate tax must be paid upon death
2. Owning property indirectly via a U.S. corporation
▪ Withholding tax may apply to net rental income
▪ Upon death, U.S. shares go directly to Cecile’s
beneficiaries, or if liquidated, any capital gains are
subject to higher corporate than individual taxes
© Kaplan, Inc. 9
Solution: Cross-Border Investing

3. Owning property indirectly via a non-U.S. corporation
▪ Income is generally not subject to U.S. taxation
▪ Upon death, shares go directly to Cecile’s
beneficiaries, not subject to U.S. estate tax
© Kaplan, Inc. 10

Territorial vs. Worldwide Taxation

Home country investment portfolios
▪ Investment portfolios in home country are
subject to taxes in home country
▪ Incorporate capital gains and income tax rates
into allocation decisions
Foreign country investment portfolios
▪ If no tax treaty: withholding taxes on gross income
▪ If tax treaty: may be reduced withholding taxes
© Kaplan, Inc. 11
Territorial vs. Worldwide Taxation

Wealth and estate taxes
▪ Check for estate taxes and what items are
included/excluded that impact investment decisions.
▪ Check for estate tax treaties that may allow for an
estate tax exemption.
▪ Obtaining an exemption may require disclosure of
full net worth to the foreign country tax authorities.
© Kaplan, Inc. 12

Common Reporting Standard (CRS)

Automatic exchange of financial a/c information
▪ To avoid tax leakage from tax evasion, automated
tax information exchange is becoming widespread
▪ CRS was facilitated by the OECD and involves
information exchange between 100+ jurisdictions
▪ Foreign Account Tax Compliance Act (FATDA): a
means for U.S. taxpayers to pay tax on investment
income earned outside the U.S.
▪ FATCA applies to all institutions with U.S. investors
© Kaplan, Inc. 13
Tax Efficiency
A tax-efficient strategy results in higher after-tax
returns compared to pre-tax returns.
Common metrics:
▪ After-tax holding period return
▪ After-tax post-liquidation return
▪ After-tax excess returns
▪ Tax efficiency ratio
© Kaplan, Inc. 14

Example: After-Tax Holding Period Rtn

Assume a portfolio value is $825,000 on April 1, and
$5,000 of interest is received on April 15. The tax
rate on interest income is 25%, and the monthly
pretax overall portfolio return is 1.20%.
Calculate the approximate after-tax portfolio return.
© Kaplan, Inc. 15
Solution: After-Tax Holding Period Rtn

Calculate the approximate after-tax portfolio return.
After-tax return = pretax return – (tax / value0)
= 1.20% – [(0.25 × 5,000) / 825,000 + (5,000 × 0.5*)]
= 1.20% – (1,250 / 827,500)
= 1.20% – 0.151057%
= 1.05%
*Note the interest is received mid-month and so is
adjusted for the days held: (30 –15 / 30) = 0.5
© Kaplan, Inc. 16

Example: After-Tax Post-Liquidation Rtn

A portfolio has embedded unrealized gains equal to
5% of the ending value and pays CGT at 15%.
Pretax After Tax*
Year 1 5.30% 4.80%
Year 2 –3.30% –2.70%
Year 3 6.90% 6.00%
Cumulative 8.85% 8.09%
Annualized 2.87% 2.63%
© Kaplan, Inc. *Distributions and realized capital gains only. Unrealized gains not yet taxed. 17
Example: After-Tax Post-Liquidation Rtn

Calculate the annualized post-liquidation return of
the portfolio over the 3 years.
© Kaplan, Inc. 18

Solution: After-Tax Post-Liquidation Rtn

Portfolio value after 3 yrs
= 1.048 × 0.973 × 1.06% = 1.0809% or 8.09%
Tax liability from unrealized gains on liquidation
= 5% gain × 15% CGT rate = 0.0075
Portfolio value net of tax on unrealized gain
= 1.0809 (1– 0.0075) = 1.07279
Annualized post-liquidation return
= (1.07279)1/3 – 1 = 2.37% (vs. 2.87% gross)
© Kaplan, Inc. 19
After-Tax Excess Returns

After-tax excess return (x’ = R’ – B’)
▪ After-tax portfolio return – after-tax benchmark return
Tax alpha (∝ = x’ – x)
▪ After-tax excess return – pretax excess return
Tax efficiency ratio (TER = R’ / R)

▪ After-tax return / pretax return
© Kaplan, Inc. 20

Tax Location
Taxable accounts
▪ FVAT = (1 + R’)n
Tax-exempt accounts
▪ FVAT = (1 + R)n
Tax-deferred accounts (may allow a tax deduction)

▪ FVAT = (1 + R)n(1 – t)
© Kaplan, Inc. 21
Example: TA vs. TDA vs. TEA

Assume that an investor lives in a country with a flat
35% tax rate on all investment income and returns, and
$100,000 is invested in each of three accounts:
1. A taxable account earning 9% (taxed annually)
2. A tax-deferred account (TDA) earning 9%
3. A tax-exempt account (TEA) earning 9%
Compute the after-tax amounts for each account at the
end of 30 yrs on the assumption of full liquidation.
© Kaplan, Inc. Assume that tax deductions are not permitted with the TDA 22

Solution: TA v TDA v TEA

Taxable account (TA)
FVAT = $100,000 × [1 + 0.09(1 – 0.35)]30 = $550,460
Tax-deferred account (TDA)
FVAT = $100,000 × [(1 + 0.09)30(1 – 0.35)] = $862,399
Tax-exempt account (TEA)
FVAT = $100,000 × [(1 + 0.09)30 = $1,326,768
Note: If a tax deduction is allowed with the TDA, a gross
contribution can be made of $100,000 / (1 – tax) = $153,846 and
the FVAT = $153,846 [(1 + 0.09)30(1 – 0.35)] = $1,326,768
© Kaplan, Inc. 23
Asset Location
Tax-efficient assets: for example, equities in taxable
accounts that allow taxes on gains to be deferred so earning
gross compounded returns until liquidation
Tax-inefficient assets: for example, taxable bonds that pay
interest (which is often subject to higher tax rates) should be
placed in tax-exempt or tax-deferred accounts
Taxable accounts allow losses to be offset against gains and
may allow losses to be carried forward
Passive strategies are more tax efficient, have lower
transaction costs, but may have lower returns
© Kaplan, Inc. 24

Example: Tax Location

Taxable Tax Exempt
Equity 7.5% 10%
Tax-managed equity 9% 10%
Fixed income 3% 6%
Tax-exempt fixed income 4% 4%
(Tax rates: fixed income 50%, equities 25%, managed equities 10%)
Three potential asset location strategies:

▪ Tax indifferent, tax aware, asset location sensitive
Based on the example on page 294 in the CFAI text, Reading 22 25
© Kaplan, Inc.

Tax-indifferent strategy
▪ Allocate 25% of equity and fixed income into taxable
and exempt
Tax-aware strategy
▪ Allocate 25% of each of the four asset classes in
each account taxable and exempt
Asset location–sensitive strategy
▪ 50% tax-managed equity in taxable, 50% fixed
income in exempt
© Kaplan, Inc. 26


Recommend the most tax-efficient allocation. Justify
your choice by calculating the expected returns for
each strategy.
© Kaplan, Inc. 27
Solution: Tax Location

Calculate the expected after-tax returns:
Tax-indifferent strategy
= 0.25(7.5) + 0.25(10) + 0.25(3) + 0.25(6) = 6.63%
Tax-aware strategy
= 0.25(10) + 0.25(9) + 0.25(6) + 0.25(4) = 7.25%
Asset location–sensitive strategy
= 0.5(9) + 0.5(6) = 7.50%
© Kaplan, Inc. 28

Solution: Tax Location

Rule of thumb:
Tax-efficient assets in the taxable account
▪ In this case, managed equities
Tax-inefficient assets in the tax-exempt account
▪ In this case, fixed income
Note: Tax efficiency isn’t the only consideration. The client’s

objectives, time horizon, the need for liquidity, and future
flexibility may also impact allocation decisions.
© Kaplan, Inc. 29
Decumulation Strategies
Flat tax systems
▪ Withdraw from taxable accounts first to preserve
the tax-efficient growth of TDA and TEA accounts.
Progressive tax systems
▪ As marginal tax rates increase with income,
withdraw from a TDA until the lowest tax brackets
have been fully used.
▪ Additional withdrawals then taken from taxable
accounts.
© Kaplan, Inc. 30

Charitable Giving Strategies

Advantages of charitable gifting
▪ In some countries, transfers of assets with
unrealized capital gains to qualifying charities are
exempt for giver (gift taxable, low-basis assets)
▪ Potential tax deduction on the fair market value of
the gifted assets
▪ Gifting from a concentrated holding, lowers risk
▪ Qualifying charities are tax exempt so will not pay
tax on income or gains related to gifted assets
© Kaplan, Inc. 31
Tax Management Strategies

Allocating to minimize taxes
▪ Allocating tax-exempt and deferred accounts
Timing
▪ Holding assets for sufficient time to lower capital
gains tax rates
▪ Retirement may bring lower income, lower taxes
Other strategies
▪ Loss harvesting, deferring income recognition
© Kaplan, Inc. 32

Investment Vehicles
Partnerships pass taxes through to the underlying
partners. The fund operates free of taxation with
distributions typically classed as capital gains.
Mutual funds pass dividend and interest income to
the underlying investors, with tax due in the year it is
received. Treatment of CGT varies with U.K. investors
only liable on disposal, whereas U.S. investors pay a
proportionate share of the fund tax liability on gains
during the year.
© Kaplan, Inc. 33
Potential Capital Gains Tax Exposure

Mutual funds calculate the potential capital gains tax
exposure (PCGE) embedded in the fund.
▪ The PCGE is an estimate of the percentage of a fund’s
assets that represents unrealized gains to measure how
much the fund has appreciated.
▪ PCGE = net gains (losses) / total net assets.
Mutual fund investors receive statements each year detailing
the long- and short-term gains realized during the year.
Investors pay their proportionate share of the tax liability.
© Kaplan, Inc. 34

Investment Vehicles
Exchange-traded funds (ETFs) create opportunities for
reducing or eliminating tax liabilities through the creation
and redemption process.
Separately managed accounts (SMAs) offer the
greatest flexibility for tax management as portfolio
decisions can be tailored to the specific investor.
Losses realized within the SMA can be used to offset
gains on assets held outside the SMA. Losses within
mutual funds cannot be used to offset gains outside
the mutual fund.
© Kaplan, Inc. 35
Example: Tax Lot Accounting

An investor bought 100 shares of stock on three
different dates for $10,000, $12,000, and $15,000.
The investor just sold 100 shares.
1. Contrast the HIFO, FIFO, and LIFO approaches.

2. Assuming future tax rates are expected to be
higher, recommend the preferred approach.
© Kaplan, Inc. 36

Solution: Tax Lot Accounting

Highest-in, first-out (HIFO): sell the highest cost
shares to minimize the current period gain and
current CGT liability
HIFO cost = $15,000
First-in, first-out (FIFO): sell chronologically, and sell

the earliest first and the most recently purchased last
FIFO cost = $10,000
© Kaplan, Inc. 37
Solution: Tax Lot Accounting

Last-in, first-out (LIFO): sell the most recent shares
purchased first and the earliest purchased last
LIFO cost = $15,000
If future tax rates are expected to rise:

Maximize the gain today to pay tax at the current
lower tax rate, to minimize gains paid in the future at
the expected higher rate—recommend FIFO
© Kaplan, Inc. 38

Tax Loss Harvesting

Tax loss harvesting is selling securities that are below acquisition
price to realize a loss that can be used to offset gains:
▪ Harvesting ST losses to avoid ST gains
▪ Tax lot accounting to keep track of cost basis
▪ Wash sale rules disallow a tax loss credit if same security sold is
repurchased within a short time period (30 days in the U.S.)
▪ Selling and holding cash for 31 days (cash drag), or buy an
alternative (e.g., sell Coca-Cola, buy Pepsi)
© Kaplan, Inc. 39
Quantitative Tax Management

Quantitative tax management aims to optimize the
portfolio for tax efficiency while measuring and
incorporating risk constraints:
▪ Aims to minimize tax drag and investment risk
▪ Continuously optimizing loss harvesting strategies
whenever tax opportunities arise
▪ Gain-loss matching algorithms optimize tax
efficiency goals while at the same time minimizing
tracking error to a benchmark
© Kaplan, Inc. 40

Concentrated Positions
Concentrated positions may arise through work,
inheritance, entrepreneurship, or other reasons:
▪ Publicly traded single stock
▪ Privately held business
▪ Real estate investment (not the primary residence)
Risk and tax considerations
(1) Company-specific risk (2) Lack of diversification
(3) Liquidity risk (4) Selling may result in a high tax bill
© Kaplan, Inc. 41
Factors to Consider
Factors impacting concentrated positions
▪ Higher transaction costs and time
▪ Level of concentration
▪ Tax basis and tax rate
▪ Liquidity
▪ Time horizon
▪ Investor restrictions on selling
▪ Emotional attachments
© Kaplan, Inc. 42

Managing Concentrated Positions

Strategies to manage concentrated positions
▪ Sell the entire position, incur the tax liability, and
invest in a diversified manner
▪ Sell the entire position gradually over time
▪ Hedge (with derivatives) and monetize (borrow)
▪ Tax-free exchange funds with investors combining
concentrated positions to create diversification
▪ Tax minimization strategies (e.g. hold asset until
death, allowing a step-up in cost basis)
© Kaplan, Inc. 43
Concentrated Public Equity

Strategies for managing concentrated public equity
▪ Staged diversification strategy over multiple years to
spread out the tax liability
▪ Completion portfolio to structure other portfolio
assets for the greatest diversification benefit
▪ Equity monetization: hedge the risk, then monetize;
zero-cost collar involves buying a put, selling a call
▪ Covered call writing: a form of staged diversification
if the share price appreciates
© Kaplan, Inc. 44

Example: Zero-Cost Collar

An investor owns a large position in a stock currently
trading at $50 per share. The investor is interested
creating a zero-cost collar and compiles the following
option data for the stock:
▪ $48 put, premium of $2.98
▪ $53 call, premium of $2.98
1. Describe the trades to construct the collar.
2. Calculate the maximum profit and loss.
3. Explain if this strategy is a sale for tax purposes.
© Kaplan, Inc. 45
Solution: Zero-Cost Collar

1. Construct the zero-cost collar
▪ Hold the stock at $50
▪ Buy the $48 put, premium of –$2.98
▪ Sell the $53 call, premium of +$2.98
▪ Nets to a zero-cost, and a collar between $48 and $53
2. Maximum profit and loss (stock currently at $50)

▪ Maximum profit is at $53 = +$3 rise in the stock
Maximum loss is at $48 = –$2 fall in the stock
© Kaplan, Inc. 46

Solution: Zero-Cost Collar

3. Is the strategy a sale for tax purposes?
▪ The collar will likely not be viewed as a sale as all
the risk of the position has not been hedged.
▪ The stock is currently trading at $50 and potentially
could fall to $48 before the hedge has any downside
protection.
▪ An effective sale for tax purposes is where all the
risk has been taken away.
© Kaplan, Inc. 47

Example: exchange fund
Consider 10 investors each have a concentrated
position in a different single stock with a low cost
basis. Each investor contributes their holding into a
newly formed exchange fund and owns a pro rata
share of the new fund.
Investor H contributes EUR 5 million to the total fund
value of EUR 100 million. Investor H owns 5% of the
new fund with their original cost basis of EUR 0.5
million and participates in a diversified portfolio.
© Kaplan, Inc. 48


Charitable remainder trust
▪ An individual makes an irrevocable donation of
shares to a charitable remainder trust (CRT)
▪ Receives a tax deduction for the donation
▪ CRT is a tax-exempt entity and could sell the
shares with no tax consequences to diversify
▪ CRT pays out income to the designated
beneficiaries (while living), then the remainder of
capital goes to the designated charity
© Kaplan, Inc. 49
Privately Owned Businesses

Sell the business to a third-party buyer or an insider
(e.g. management), or IPO
Personal line of credit secured by company shares by
borrowing from the company and pledging stock as
collateral (line of credit could be from a third party)
Leveraged recapitalization sells a portion of the
owner’s shares to a private equity firm as part of a
phased exit; taxes are due on the sale
Employee stock ownership plan (ESOP): the owner
sells shares to the ESOP, firm borrows to fund this
© Kaplan, Inc. 50

Real Estate
Property-specific risk is the direct counterpart to
company-specific risk:
▪ Property is a significant portion of investor assets
▪ Unique specific risk factors, generally illiquid
▪ Long time horizons and significant unrealized gains
Mortgage financing raises funds without paying taxes,
losing control or missing future price rises
Donor-advised fund (DAF) gifts the property to a DAF
(a charity of choice) and takes a full tax deduction
© Kaplan, Inc. 51
Gift and Estate Planning

An individual’s estate is everything that is owned by
the individual: financial assets, real estate,
collections, businesses, and intangible assets.
Estate planning is the process of transferring the
estate to others during an individual’s lifetime (a gift)
and at death (a bequest) in a tax-efficient way.
Key objectives:
▪ Meet the donor’s lifestyle goals, keep control over
assets, protect from creditors, privacy, lower taxes
© Kaplan, Inc. 52

Probate
Probate is a legal process that takes place at death:
▪ To determine the validity of a will
▪ To inventory the decedent’s property
▪ To resolve any claims
▪ To distribute property according to the will
Probate is a public, and often long and costly process
If no will (or no valid will)

◼ Decedent dies intestate, and the distribution of assets is
determined by the court (law of the land)

© Kaplan, Inc. 53
Forced Heirship
Forced heirship is a legal requirement that a certain proportion
of assets must pass to family members, such as a spouse and
children, upon death:
▪ Law of the land overrides a will
▪ Restricts passing on wealth to nonfamily members, as
minimum entitlements to family
▪ Found in civil law countries (e.g., Spain, France)
▪ Not in common law countries (e.g., Canada, U.K.)
Asset protection
▪ Trusts may be effective in mitigation planning
© Kaplan, Inc. 54

Example: Forced Heirship

Hope and Larry have been married for 40 yrs. They have two
married children: Emma, age 32, and Toby, age 34. The forced
heirship regime entitles a surviving spouse to 30% of the total
estate, and the children are entitled to split 30% of the total
estate. Larry passes away with a total estate of €1.8 million.
1. Under the forced heirship rules, determine the amount that
Hope would inherit.
2. Determine the amount that each child will inherit.
3. Determine if Larry would be able to leave his sister €800,000.
© Kaplan, Inc. 55
Solution: Forced Heirship

1. Under the forced heirship regime, Hope is entitled to 30% of
the total estate.
= 0.30 × €1.8 million = €540,000
2. Emma and Toby are entitled to share 30% of the total estate.
= (0.30 × €1.8 million) / 2 = €270,000 each
3. Funds available for Larry’s sister:

= €1.8 million – €540,000 – €540,000 = €720,000
© Kaplan, Inc. 56

Tax-Effective Transfer of Assets

Gifts in life
▪ Transfers of assets made during life
▪ Gift taxes may apply to certain types of transfers
Bequests on death
▪ Transfers on death are subject to estate tax
Tax-free allowances
▪ Many countries have tax-free allowances that allow
reduced gift, estate, and inheritance taxes
© Kaplan, Inc. 57

Generation-skipping transfers assets directly to a third
generation (e.g., grandparent to grandchild)
▪ Bypass the parent and avoid double taxation
▪ Limits and restrictions in some jurisdictions (e.g. generation-
skipping tax (GST tax) in excess of lifetime exclusion amount)
Family governance system

◼ Aimed to reduce or eliminate family disputes
◼ Establish philanthropic objectives
◼ Tools include trusts, foundations, and life insurance

© Kaplan, Inc. 58


Business succession involves planning transfer of control
and ownership to the next generation
▪ Is the donor ready to relinquish control?
▪ Does the next generation want to run the business?
▪ Sell business to an external party
Charitable donations
▪ May allow for a tax deduction for the donor
▪ Establish a private foundation to maintain a long-term or
permanent legacy
© Kaplan, Inc. 59
Example: Inheritance Tax (Flat Rate)

Ernestine, a widower, recently died. She was a resident in the
country of Mosario at the time of her death and had a total
estate valued at MOS 5 million. Her children are the
beneficiaries of her estate. Mosario imposes an inheritance tax
on estates worth over MOS 2 million at a flat rate of 25%.
Calculate the inheritance tax to be paid by the children.
© Kaplan, Inc. 60

Solution: Inheritance Tax (Flat Rate)

Calculate the inheritance tax to be paid by the children.
Total estate MOS 5 million

Tax-free allowance MOS 2 million
Taxable estate MOS 3 million
Inheritance tax (25%) = MOS 3 million × 25%

= MOS 750,000
© Kaplan, Inc. 61
Example: Inheritance Tax (Progressive)

Martin, who was single, recently died. He was a resident in the
country of Karene at the time of his death and had a total estate
of KAR 1.8 million. Martin was eligible for KAR 0.4 million of
exemptions.
Taxable estate (KAR) Tax rate

▪ Up to 500,000 5%
▪ 500,001–1,000,000 7%
▪ 1,000,001–1,500,000 12%
▪ 1,500,001–2,000,000 15%
© Kaplan, Inc. 62

Example: Inheritance Tax (Progressive)

Calculate the estate tax payable upon Martin’s death.
© Kaplan, Inc. 63
Solution: Inheritance Tax (Progressive)

Calculate the estate tax payable upon Martin’s death.
Total estate KAR 1.8 million
Exemptions KAR 0.4 million
Taxable estate KAR 1.4 million
500,000 × 0.05 = KAR 25,000

500,001 – 1,000,000 × 0.07 = KAR 35,000
1,000,001 – 1,400,000 × 0.12 = KAR 48,000
Total estate tax = KAR 108,000
© Kaplan, Inc. 64

Charitable Gifts
Charitable gratuitous transfers potentially have three benefits
in tax planning:
▪ The donor usually does not have to pay tax.
▪ The donor receives a tax deduction for the gift, reducing their
current-year tax liability.
▪ The charity is usually tax exempt with tax-free compounding
of returns.
Family establishes its own charitable organization

▪ Tailored philanthropic objectives, tax-free returns
© Kaplan, Inc. 65
Gift or Bequest
Gift in life
▪ Donor makes the gift to the recipient
▪ Either no gift tax, recipient pays, or donor pays*
▪ Recipient owns the asset paying tax on returns
Bequest on death
▪ Donor keeps the asset
▪ Donor pays tax on returns
▪ On death, estate tax is deducted and bequest paid
© Kaplan, Inc. *Donor pays is no longer testable in the 2022 LIII curriculum 66

Relative Value of a Gift or Bequest

Maximize value to the recipient:
▪ Compute the relative value ratio (RV)
RV = FVgift / FVbequest
▪ RV > 1: gift now
▪ RV < 1: bequest at death
Sometimes, a calculation is not required:

▪ Compare the gift tax and estate tax rates
▪ Compare the donor and recipient tax rates
© Kaplan, Inc. 67
Distributing Excess Capital

Comparing a gift now vs. future bequest requires assumptions:
◼ n: time to the bequest
◼ r: pretax return
◼ g: the gift receiver
◼ e: the gift giver
◼ i: investment income
◼ Tg: gift tax rate
◼ Te: estate tax rate on bequest
◼ t: periodic tax rate
© Kaplan, Inc. 68

RV Ratios
A gift subject to no tax (e.g., below the
exclusion amount):
FV at receiver’s rAT
$1 given is $1
received, no Tg
1 + rg (1 − tig )  n
RV =  
n
1 + re (1 − t ie ) (1 − Te )
FV at giver’s rAT
Estate tax reduces the
bequest amount
© Kaplan, Inc. 69
RV Ratios
A gift subject to tax paid by receiver reduces the
value of the gift now:
Same equation, but $1 given is
reduced by Tg
(1 − Tg ) 1 + rg (1 − tig ) n
RV =  
n

1 + re (1 − tie ) (1 − Te )
© Kaplan, Inc. 70

Example: RV of a Gift
Mary Jane is considering making a gift now or a bequest upon
death to her daughter. The jurisdiction requires a gift tax to be
paid by the recipient:
▪ Mary Jane’s life expectancy is 20 years.
▪ The pretax investment return is 8%.
▪ The gift tax rate is 25%.
▪ Estate tax rate is 40%.
▪ Mary Jane’s tax rate is 35%.
▪ Her daughter’s tax rate is 35%.
© Kaplan, Inc. 71
Example: RV of a Gift
1. Calculate the relative value of the gift, assuming the gift is
not subject to gift taxes.
2. Assuming the gift is taxable, justify the optimum approach
with one reason (no calculations required).
3. Calculate the relative value of the gift, assuming the gift
is subject to gift taxes.
© Kaplan, Inc. 72

Solution: RV of a Gift
1. Calculate the relative value of the gift, assuming the gift is
not subject to gift taxes.
1+0.08 1−0.35 20
𝑅𝑅𝑅𝑅 = = 1.67
1+0.08 1−0.35 20 (1−0.40)
Recommendation: Make the gift now

▪ Making the gift now will avoid the 40% estate tax deducted
from a bequest on death
▪ Be aware once the gift is made, can’t take it back
© Kaplan, Inc. 73
2. Assuming the gift is taxable, justify the optimum approach
with one reason (no calculations required).
Two useful comparisons

1. Personal tax rates: both have a 35% tax rate
2. Gift tax v estate tax: 25% v 40%
Recommendation: Make the gift now

▪ Gift now as the gift tax rate < estate tax rate and the personal
rates of tax are the same
© Kaplan, Inc. 74

3. Calculate the relative value of the gift, assuming the gift
is subject to gift taxes.
1−0.25 1+0.08 1−0.35 20

𝑅𝑅𝑅𝑅 = = 1.25
1+0.08 1−0.35 20 (1−0.40)
Recommendation: make the gift now

▪ Making the gift now still results in a higher future value than a
bequest. The gift tax is less than the estate tax, and personal
tax rates are the same.
© Kaplan, Inc. 75
Wealth Across Generations

Trusts are a common estate-planning tool to transfer assets to
trustees on behalf of beneficiaries:
▪ Donor (settlor/grantor) transfers assets to trustees
▪ Donor may also be a trustee, so retains control
▪ Avoids probate; assets often out of the estate
▪ Asset protection from creditors, privacy, maybe lower tax rates
Types of trusts
▪ Inter vivos (in life) vs. testamentary (on death)
▪ Revocable (donor revoke) vs. irrevocable (forever)
▪ Fixed (distributions predetermined) vs. discretionary
© Kaplan, Inc. 76


Foundations are set up to hold assets for a specific purpose
and allow the donor to retain control of the administration and
decision-making:
▪ Charitable foundations (e.g., education, philanthropy)
▪ Private foundation (e.g., a family foundation)
Features
▪ Perpetual vs. predefined time horizon
▪ Minimum annual distributions (5% in U.S.)
▪ Income tax deduction on assets transferred (U.S.)
© Kaplan, Inc. 77

Life insurance provides a sum assured on death to a
beneficiary, and if written in trust, the proceeds will often be
outside the estate to avoid probate and taxes:
▪ Premiums paid are typically not part of estate
▪ Sums assured may be used to pay estate taxes
▪ Faster payment to beneficiaries avoiding probate
Controlled foreign corporation (CFC)

▪ Located outside a taxpayer’s home country
▪ Taxes deferred until earnings are distributed
© Kaplan, Inc. 78

Family Governance
Large, wealthy families may include the main wealth creator(s)
or business founder, children, grandchildren, and wider family
members:
▪ Potential generational conflicts
▪ Sibling rivalries
▪ Emotional challenges
Purpose
▪ To ensure effective wealth generation, transition, and
preservation through time
▪ To avoid a decline in wealth across generations
© Kaplan, Inc. 79
General Principles
Family governance is the process for a family’s collective
communication and decision-making to serve current and future
generations:
▪ Establishing principles for collaboration
▪ Preserving and growing a family’s wealth
▪ Increasing human and financial capital
▪ Governance framework: legal documents, goals
Human, intellectual, and social capital of a family
▪ Knowledge, experience, talents, and unique gifts of family
members; the family’s mission and vision
© Kaplan, Inc. 80

Family Governance Entities

Board of directors: established with mature family
businesses, including experienced outside directors
Family council: selected family members represent
the family in dealing with the board of directors
Family assembly: a forum for all family members to
discuss the direction of the family-owned company
Family office: the investment and administrative
center for the family (i.e., investment management)
Family foundation: a platform for philanthropic goals
© Kaplan, Inc. 81
Family Dynamics
Transition to a new generation either in life or on death, fully
or partially transitioning to retain control
▪ Social proof bias (following others, not the facts)
Sale of the business results in capital gains taxes and

income taxes on the sale
◼ Endowment bias (emotional overestimation of value)
◼ May transfer the business to a trust to remove future
appreciation from the estate as a transfer vehicle

◼ May use a private trust company (PTC)
© Kaplan, Inc. 82

Conflict Resolution
Conflict resolution mechanisms are needed in most legal
relationships associated with shared ownership.
The family constitution

▪ Is a nonbinding document
▪ Has agreed-upon rights and values
▪ Responsibilities of the family members
Trust documentation and shareholder agreements contain

legally binding agreements.
© Kaplan, Inc. 83
Planning for the Unexpected

Divorce laws vary by jurisdiction, providing various rights to
spouses and equivalent less-formal relationships.
▪ In some countries, half of marriages end in divorce.
▪ Matrimonial assets are not necessarily only those earned
during the marriage.
▪ Inherited assets may also be included.
Protection for family businesses
▪ Use of trusts, prenuptial, and postnuptial agreements
▪ Guidance for family members, sensitive issues
© Kaplan, Inc. 84

Planning for the Unexpected

Incapacity
▪ Increasing longevity can result in various disabilities and other
health-related and care issues
▪ What-if? questions and analysis for the family
▪ Capacity to make decisions, give others authority?
▪ A durable power of attorney gives authority to act on behalf
of an individual (financial and medical areas)
▪ Living wills specify types of medical treatment a person
wants in the event of incapacity, respecting a person’s wishes
▪ If no planning: potential disputes, guardian may be appointed
© Kaplan, Inc. 85


Risk Management for Individuals
Human (HC) and Financial Capital (FC)

◼ HC = PV of expected future labor income
◼ FC = all other assets
◼ Social security and other DB retirement benefits are
considered FC
◼ Total wealth (TW) = FC + HC
◼ Net wealth = TW – the individual’s liabilities
© Kaplan, Inc. 2

Human (HC)
◼ HC can only be estimated based on projected:
◼ Earnings and growth in earnings
◼ Probability of life (the probability the earnings will be
realized)
◼ Real and nominal risk-free rates + appropriate risk
premium
◼ Discount higher/lower risk earnings with higher/lower
discount rate
© Kaplan, Inc. 3
Typical Progression
◼ The actual
progression of
HC and FC need
not be smooth
◼ It can be
disrupted by life
events
© Kaplan, Inc. 4

Stages of Life
◼ Education: accumulate skills, little need for saving or risk
management
◼ Early career: may be starting a family and need low-cost life
insurance, earnings and property risk may also require
insurance
◼ Career development: likely beginning to save and
accumulate FC
◼ Peak accumulation: high levels of earnings, substantial rate
of savings and FC accumulation
© Kaplan, Inc. 5
Stages of Life
◼ Preretirement: continued emphasis on FC accumulation,
begin reducing portfolio risk and tax planning for retirement
◼ Early retirement: expenses could increase to take
advantage of more leisure time, portfolio emphasis shifts to
lifetime income, annuities may be appropriate
◼ Late retirement: length of life is unpredictable, health care
expense can be high, and cognitive functions necessary for
decision making can decline
© Kaplan, Inc. 6

Economic (Holistic) Balance Sheet

◼ Expands the traditional balance sheet by including:
◼ Assets, the PV of future labor income (HC), and defined
benefit payouts (FC)
◼ Liabilities, the PV of future expenses, and bequests
◼ Provides a more comprehensive economic view for
planning lifetime consumption and bequests
© Kaplan, Inc. 7
Risk Management: Individuals
Risks
◼ Earnings risk: Loss of income (HC) due to premature job
loss
◼ Disability insurance provides partial income
replacement
◼ Premature death risk: The insured’s HC ceases, life
insurance:
◼ Provides funds to meet needs of the insured’s survivors
◼ Replaces the HC and FC that would have been

accumulated without the premature death of the insured
© Kaplan, Inc. 8

Risks
◼ Longevity risk: Individuals can outlive their accumulated
FC
◼ Estimating adequate FC requires projecting:
◼ Lifespan
◼ Return on portfolio assets
◼ Rate of inflation
◼ Inclusion or exclusion of inflation adjustments in other
income sources
◼ Annuities can provide lifetime income
© Kaplan, Inc. 9
Risks
◼ Property risk: Property (FC) can be damaged or destroyed
◼ Homeowners and automobile insurance compensate
for losses in value of the home and car
◼ Liability risk: Individuals can be held financially
responsible for damages they cause to others (paying
reduces FC)
◼ Liability insurance covers such costs
© Kaplan, Inc. 10

The Role of Insurance Products

◼ Buyers pay for protection to share (diversify) risks to their
wealth
◼ In aggregate, insurance reduces the users’ wealth
◼ Therefore, use insurance when the:
◼ Risk cannot be otherwise avoided or reduced
◼ Financial consequences of retention are unacceptable
© Kaplan, Inc. 11
Life Insurance vs. Annuities

◼ Life insurance: The policyowner makes periodic premium
payments to the insurance company, and the beneficiaries
receive a lump sum payout at death of the insured
individual
◼ Annuity: The policyowner makes a one-time premium
payment to the insurance company, and annuitant receives
periodic payouts
◼ These are the basics; there are multiple possible variations
© Kaplan, Inc. 12

Life Insurance: Types

◼ Temporary (term) insurance: Lasts for a designated time
period
◼ Lowest cost, “pure insurance”
◼ Permanent insurance: Lasts for the lifetime of the insured
◼ Often includes a build up of cash value which can be
accessed by the insured prior to death
◼ Whole life usually has a set periodic premium while
universal life allows adjustments to premium amount
and how it is invested, plus amount of insurance
© Kaplan, Inc. 13
Pricing Life Insurance: The Issues

A TVM problem solved by the insurance company:
◼ Charge the group of insured individuals enough in
premiums to make the promised payouts
◼ When will the death benefits be paid out?
◼ How much will the premiums collected earn before

payouts are made?
◼ What will be the company’s expenses?
◼ What is the profit margin required to cover the risks?

(Not-for-profit companies must also charge a similar
margin to cover risk.)
© Kaplan, Inc. 14

Pricing Life Insurance: The Process

◼ Mortality estimates: Mortality tables provide probability of
death (based on age, sex, and other relevant health and life
style issues) to project when payouts will be made
◼ Net premium: What to charge in premiums based on
projected rate of return on premiums and timing of payouts
◼ Load: Added to net premium to cover company expenses
and profit
◼ Gross premium: The premium paid for the insurance
= Net premium + Load
© Kaplan, Inc. 15
Pricing Life Insurance: Conclusions

Example: Cost (annual premium) for $1 million life insurance
policy will be higher for:
◼ Males
◼ Older individuals
◼ Those with risky habits or bad health
◼ Including other benefits such as accidental death and

dismemberment payouts
◼ A build up of cash value or “dividends” (partial return of
premiums)
© Kaplan, Inc. 16

Pricing Life Insurance: Conclusions

Cost increases as the company assumes more risk
Periodic Premium for Insurance Highest:

Universal
Whole life life with
Lowest: 5-year guaranteed
Annual term with cash value
Annual term with fixed build up
term guaranteed premium
renewal
© Kaplan, Inc. 17
Evaluating the Cost

◼ Comparing “price” versus benefits between policies is
difficult—too many variables
◼ Regulators often require companies to provide
standardized pricing indexes:
◼ Net Payment Cost Index (NPCI) assumes death at the
end of the evaluation period and face value is paid
◼ Net Surrender Cost Index (NSCI) assumes no death and
the policy is cashed at the end of the evaluation period,
terminating insurance coverage
© Kaplan, Inc. 18

Computing the Cost Indexes

For $500,000 of insurance, assume:
20-year horizon 4% discount rate
$9,000 annual premium $2,000 annual dividend
$110,000 terminal cash value
Calculate the FV of premiums (paid beginning of period):
9,000 PMT 4 ip 20 n FV = 278,723
Calculate the FV of dividends (received end of period):
2,000 PMT 4 ip 20 n FV = 59,556
© Kaplan, Inc. 19
Computing the Cost Indexes

FV of Cost:
NPCI: 278,723 – 59,556 = 219,167
NSCI: 278,723 – 59,556 – 110,000 = 109,167
Annualized cost (annuity due, paid at start of period)
NPCI: 219,167 FV 4 ip 20 n PMT = $7,077
per 1,000 of insurance: 7,077/500 = $14.15
NSCI: 109,167 FV 4 ip 20 n PMT = $3,525
per 1,000 of insurance: 3,525/500 = $7.05
© Kaplan, Inc. 20

Annuities
Pay an initial premium, receive payouts in the future:
◼ The payout period can be finite, or for the life of the
annuitant
◼ Life can be joint for the life of two annuitants, or for life
with a specified minimum amount or period certain
(number) of payouts
◼ The payout can be fixed or variable and linked to the
performance of a specified reference asset
◼ The start of payouts can be immediate or deferred
© Kaplan, Inc. 21
Cost of the Annuity

The initial premium paid is the cost
◼ For the same initial premium, all else the same:
◼ A higher periodic payout indicates a lower cost
◼ Premium paid GBP100,000; an annual annuity payout

of 5,000 for life with a minimum of 10 payouts is a
lower cost that a payout of 4,700
◼ A lower periodic payout indicates a higher cost
◼ Premium paid $500,000; an annual annuity payout of

20,000 for the joint life of a couple is a higher cost that
a payout of 21,000 for their joint life
© Kaplan, Inc. 22

Pros and Cons: Fixed vs. Variable

◼ Fixed have a higher initial payout
◼ Variable offer potentially higher total payout over time
◼ Variable payouts are more likely to increase and cover

future inflation costs
◼ Variable are more likely to allow the annuitant to close and
cash out the annuity early (albeit at then fair value and after
surrender fees)
◼ Fixed generally do not allow early close out
© Kaplan, Inc. 23
Pros and Cons: Fixed vs. Variable

◼ Fixed payouts are largely determined by initial interest
rates (i.e., a low payout if purchased when rates are low)
◼ Variable shift more risk to the annuitant, hence the
potentially higher lifetime payout and inflation protection
◼ Fixed are relatively simpler to analyze
◼ Variable offer flexibility, but the complexity carries higher
fees and complicates the assessment of cost versus
benefit
© Kaplan, Inc. 24

Advanced Life Deferred Fixed Annuity

Example: Jane is 60 years old and purchases a $500,000
annuity with $95,000 annual payouts beginning at age 85
◼ The cost is low (annual payout is high) because:
◼ Mortality estimates: A number of annuitants will die

before receiving a payout, and the expected number of
payouts will be low for those that do live past 85
◼ Return expectations: The company can invest the
premium for a longer period until start of payouts
© Kaplan, Inc. 25
Mortality Credits
Sally is statistically identical to Jane and purchases an
identical annuity:
◼ They both pay $500,000 to buy the annuity
◼ Jane dies at 84, collecting no payouts
◼ Sally dies at 105 after collecting 20 payouts
◼ Sally received a mortality credit from Jane
© Kaplan, Inc. 26

How Insurance Works

◼ Mortality credits are a key factor to how insurance works
◼ Risk is shared or pooled
◼ With a large and diversified pool of insured, the company
avoids adverse selection
© Kaplan, Inc. 27
Timing an Annuity Purchase

Example: A 55-year-old investor will purchase a $750,000
fixed annuity and needs payouts starting in 5 years
Alternative A: Purchase now with $80,000 annuity payouts
starting in 5 years
Alternative B: Wait 5 years to purchase when interest
rates are expected to be higher
◼ Same individual and same expected number of payouts
starting at age 60
◼ The higher expected interest rates at
purchase of B is not the full story
© Kaplan, Inc. 28

Factors Affecting the Annual Payout

Higher for Alternative A, buy now:
◼ TVM: The company can invest the premium for 5 years
before starting to payout
◼ Mortality credit: Purchasers who live to collect starting at
age 60 benefit from purchasers who die before age 60
Higher for Alternative B, buy in 5 years:
◼ TVM: The expectation is that interest rates and return on
company assets will be higher
© Kaplan, Inc. 29
Annuity vs. Self-Insure

In aggregate, investors are likely to maximize total wealth by
retaining and investing the premium in their own portfolio
◼ Investors can withdraw from their portfolio:
◼ The annual portfolio return +
◼ A portion of their principal each year
◼ Risk: Some investors will outlive their principal
◼ Self-insurers cannot collect a mortality credit from the
investors who die earlier and did not outlive their assets
© Kaplan, Inc. 30

Choosing: Annuity vs. Self-Insure

Factors favoring the annuity:
▪ The individual’s life expectancy is longer than average
▪ Higher risk aversion/desire for lifetime income
▪ Less desire to leave an estate to others
▪ An absence of other lifetime income streams, such as a
pension
© Kaplan, Inc. 31
Risk Management
Insurance is only one option:
◼ Risk avoidance: If the risk is frequent and financially
severe, avoid it
◼ Swimming with very hungry sharks every day
◼ Risk reduction: If the risk is frequent but not financially
severe, take it less often
◼ Don’t park in the no parking zone every day
© Kaplan, Inc. 32

Risk Management
◼ Risk transfer: If the risk is infrequent and financially
severe, purchase insurance
◼ See the earlier slides on Risk and Stages of Life
◼ Risk retention: If the risk is infrequent and not financially
severe, self-insure
◼ My $49 watch could break or be stolen
© Kaplan, Inc. 33
Optimal Asset Allocation of TW

◼ Higher risk and/or equity like HC
◼ For example, variable income linked to sales or
positively correlated with equity markets
◼ Diversify with FC in bonds
◼ Lower risk and/or fixed income like HC

◼ For example, a tenured professor with steady income
and a retirement pension

◼ Diversify with FC in equity
© Kaplan, Inc. 34

TW Management
◼ Systematic (market) risk can be managed with portfolio
management tools:
◼ Asset allocation to achieve appropriate risk exposures
◼ Idiosyncratic (non-market) risk can also be managed:
◼ Diversify within the portfolio and between HC and FC
◼ Insurance products to transfer risk where appropriate
© Kaplan, Inc. 35
Example
◼ A couple is 3 years from retirement
◼ The wife is the sole income earner
◼ She has a 3-year employment contract at a fixed salary of
100,000 after tax
◼ They are financially secure for retirement starting in 3 years
© Kaplan, Inc. 36

Example
For the husband to maintain his lifestyle until her planned
retirement, he would need to replace 70% of her income.
Calculate the life insurance amount on the wife that is needed
if the discount rate is 10%:
70,000 PMT 3 n 10 ip
PV 191,488 is the amount of insurance needed
For simplicity, the CFA text assumes funds are needed at

start of period, the annuity due function.
© Kaplan, Inc. 37


Portfolio Management for

◼ Like the IPS for individuals, the issue is preparing and
using an appropriate IPS.
◼ Objectives (return and risk) and constraints still apply, but
there are differences in application between individual and
institutional investors.
◼ The key to scoring well on this portion of the exam is to
understand what the various institutions are trying to
achieve (goal) with their investment portfolios and which
risk considerations and constraints apply.
© Kaplan, Inc. 1


Types of institutional investors considered in this reading
include the following:
▪ Defined benefit and defined contribution pension plans
▪ Sovereign wealth funds (SWFs)
▪ University endowments
▪ Private foundations
▪ Insurance companies
▪ Banks
© Kaplan, Inc. 2

Characteristics of Institutional Investors

▪ Scale (size): Institutions tend to be larger than individual
investors, and large institutions may be too large for
investments or managers with low capacity. These large
institutions may choose to directly access investments and
manage them in-house.
▪ Long-term investment horizon: Institutional investors tend
to have longer time horizons than individual investors and
also have relatively low liabilities.
© Kaplan, Inc. 3



▪ Regulatory framework: Institutions are subject to different
legal, regulatory, and tax rules than individual investors.
Since the 2007–2009 global financial crisis, regulators are
attempting to lower leverage, increase centralized clearing,
and improve reporting transparency.
▪ Governance framework: Institutions typically operate under
a formal governance structure, which typically involves a
board of directors and investment committees.
© Kaplan, Inc. 4


▪ Principal-agent issues: Conflict occurs when a principal (i.e.,
owner of asset) appoints an agent to act on their behalf and
the agent’s interests are not aligned with the principal’s
interests.
▪ A typical example of an external principal-agent conflict is
a high management fee paid to a third-party investment
manager regardless of performance.
© Kaplan, Inc. 5


Investment Policy Statement (IPS)

The IPS should include the following:
▪ The institution’s mission and investment objective
(return and risk tolerance)
▪ Discussion of the investment horizon and liabilities
▪ External constraints that affect asset allocation (i.e.,
legal, regulatory, tax, and accounting issues)
© Kaplan, Inc. 6


The IPS should include the following (cont.):
▪ An asset allocation policy (i.e., portfolio weights) with
ranges and asset class benchmarks
▪ A rebalancing policy
▪ Reporting requirements
© Kaplan, Inc. 7



▪ The IPS should be reviewed annually and revisions should
be made when necessary due to material changes in
investor circumstances and/or market environment.
▪ While each institution has unique features, four models
have evolved as different general approaches to asset
allocation.
© Kaplan, Inc. 8

Norway’s Sovereign Wealth Fund (SWF)

▪ Passively managed allocation to public equities and FI
(60/40)
▪ Little or no exposure to alternative assets
▪ Tight tracking error limits
Advantages: Low costs and fees, easy to comprehend
Disadvantages: No opportunity to outperform markets
© Kaplan, Inc. 9


Yale University Endowment

▪ High allocation to alternatives
▪ Significant active management
▪ Externally managed assets
Advantages: Potential for outperformance of the markets
Disadvantages: Difficult for small institutions without expertise
in alternatives, high fees/costs, and may be difficult for large
managers due to capacity issues of external managers
© Kaplan, Inc. 10

Canada Pension Plan

▪ High allocation to alternatives
▪ Significant active management
▪ Internally managed assets
▪ Uses a reference portfolio of passive public assets as
benchmark
Advantages: Potential for outperformance of markets
Disadvantages: Potentially expensive and difficult to maintain
© Kaplan, Inc. 11


Liability Driven
▪ Focus is on maximizing expected surplus (A – L) return and
managing surplus volatility
Advantages: Explicitly recognizes liabilities as part of
investment process
Disadvantages: Certain risks of liabilities (i.e., longevity) are
difficult to hedge
© Kaplan, Inc. 12

IPSs of Different Institutional Investor Types

The general outline for each type of institution will be:
▪ The main features/mission of the institution
▪ The stakeholders (i.e., parties impacted by the
success/failure of the institution)
© Kaplan, Inc. 13


IPSs of Different Institutional Investor Types

The general outline for each type of institution will be (cont.):
▪ The key elements of the IPS, usually in the following
order:
- Liabilities and investment horizon
- Liquidity needs
- External constraints
- Investment objectives
- Asset allocation
© Kaplan, Inc. 14

Pension Funds
▪ Pension funds are designed to save and invest in order to
provide income for plan beneficiaries upon retirement.
▪ There are two major types of pension plans:
▪ Defined benefit (DB)
▪ Defined contribution (DC)
▪ Over recent decades, there has been a move from DB to
DC plans driven by the plan sponsor’s preference for lower
risk and the fact DC plans are portable by employees.
© Kaplan, Inc. 15


DB vs. DC
Feature Defined Benefit (DB) Defined Contribution (DC)
Benefit payments Contractually defined (usually Depends on the
dependent on final salary) performance of investments
Creates a measurable liability Once promised contributions

for the plan sponsor have been met, there is no
liability for the plan sponsor
Contributions Primarily by employer Primarily by employee

(employee may contribute (employer may contribute
also) also)
© Kaplan, Inc. 16

DB vs. DC
Investment decision- Pension fund (sponsor Sponsor provides suite of
making and investment staff) available investment funds
Employee decides level of

investment and asset
allocation
Investment risk Faced by sponsor Faced by beneficiary
© Kaplan, Inc. 17


DB vs. DC
Mortality/longevity risk Pooled at the fund Employee faces the
level—beneficiaries who longevity risk of outliving
live longer than their own savings
expected are funded by
those who die earlier
than expected
Risk of general
increases in life
expectancy faced by
sponsor
© Kaplan, Inc. 18

Hybrid Plans
◼ Exhibit features of both DB and DC plans
◼ For example, a cash balance plan involves a sponsor
defining contributions to assets, which are then pooled;
the sponsor faces some of the investment risk, as per a
DB plan.
© Kaplan, Inc. 19


DB Plans
▪ Stakeholders:
▪ Plan sponsors (employers) must make contributions to
plan assets. Poor investment performance will result in
sponsors having to make extra contributions to an
unfunded plan (i.e., assets are lower than liabilities).
▪ Plan beneficiaries (employees and retirees) face the
ultimate risk that an employer defaults on contributions
and plan assets.
© Kaplan, Inc. 20

DB Plans
▪ Stakeholders (cont.):
▪ Investment staff, the investment committee, and/or the
board are directly impacted by the success or failure of
the plan.
▪ Governments are stakeholders as they provide tax
incentives for employees to save for retirement, and
taxpayers will ultimately have to face the costs of
providing welfare for those who failed to adequately
save for retirement.
© Kaplan, Inc. 21


DB Plans
▪ Stakeholders (cont.):
▪ Shareholders in the corporate employer are
stakeholders since an underfunded plan will cause a
balance sheet liability and lower income for the
company.
▪ It will also lead to higher financial risk, which is likely
to increase share price volatility.
© Kaplan, Inc. 22

DB: Liabilities & Investment Horizon

▪ Liabilities of a DB pension plan are the PV of the future
benefits promised to plan participants.
▪ Employees usually only qualify to receive these benefits
after meeting certain requirements (vesting)—typically a
required minimum number of years of service.
© Kaplan, Inc. 23


DB: Liabilities & Investment Horizon

▪ The funded status of the plan can be measured using the
funded ratio or vested benefit index:
funded ratio = (fair value of plan assets) / (PV of DB obligations)
© Kaplan, Inc. 24

DB: Pension Plan Liability Factors

▪ Service/tenure (years worked): Increases liability, and
benefits are usually linked directly to years of service by the
employee
▪ Salary: Increases liability, benefits are usually linked to the
final salary
▪ Longevity: Increases liability, and plan participants are paid
benefits for every year they live in retirement; if they live
longer in retirement, they will receive more years of
benefits
© Kaplan, Inc. 25



▪ Employee turnover: Lowers liability, and higher employee
turnover means fewer employees are likely to work the
number of years of service required for vesting of benefits
▪ Additional/matching contributions: Increases liability,
usually increases the benefits promised to employees
© Kaplan, Inc. 26


▪ Expected investment return: Potentially lowers liability, and
in some cases, an increase in expected returns increases
the discount rate used for liabilities, lowering liabilities
▪ Discount rate: Lowers liability, and a higher discount rate
will give a lower PV of benefits, hence a lower liability
© Kaplan, Inc. 27


DB: Pension Plan—Plan Beneficiaries

▪ Active lives are those still employed and earning benefits.
▪ Retired lives are those receiving benefits.
▪ The higher the proportion of retired lives in the plan, the

shorter the investment horizon of the plan, which lowers the
ability to bear risk (ATBR) for the DB plan.
▪ Plans that are frozen (i.e., closed to new participants) will
also have shorter investment horizons.
© Kaplan, Inc. 28

DB: Pension Plan—Risk Considerations

▪ Plan funded status: Higher funded status potentially
increases ATBR since plan can absorb short-term losses
▪ Sponsor financial strength: Lower debt ratios and higher
profitability of sponsor increase ATBR; sponsor can make
additional contributions in the event of plan asset losses
▪ Size of plan: Smaller plans (relative to the size of the
sponsor) increase ATBR; plan can absorb increased
volatility
© Kaplan, Inc. 29


DB: Pension Plan—Risk Considerations

▪ Common risk exposures: Lower correlation of sponsor
operating results and the returns of pension assets
increase ATBR; sponsor can likely increase contributions
during declines of plan assets
▪ Provisions for early retirement/lump-sum distributions:
Decrease sponsor’s ATBR because lower time horizon
▪ Workforce characteristics: Younger workforce and higher
proportions of active lives increase ATBR because longer
time horizon to recover from losses
© Kaplan, Inc. 30

DB: Pension Plan—Increase ATBR

Two factors that increase the plan’s ATBR:
▪ The plan has zero retired lives; thus, it has a long time
horizon to recover from short-term underperformance.
▪ The plan does not offer early retirement or lump-sum
distribution options to plan participants; it increases the
time horizon and has more predictable liabilities for plan
sponsors.
© Kaplan, Inc. 31


DB: Pension Plan—Decrease ATBR

Two factors that decrease the plan’s ATBR:
▪ The firm has higher debt levels than the industry average,
lowering the ability of the sponsor to increase contributions
to make up for plan asset declines.
▪ The plan is underfunded (liabilities exceed assets).
© Kaplan, Inc. 32

DB: Pension Plan—Liquidity Needs

DB plans must have enough liquidity to pay their pension
benefits as they come due.
Liquidity needs are generally higher when:

▪ The proportion of retired lives is higher, since retired lives
are receiving benefits
▪ The workforce of the employer is older because the time
horizon for the plan is shorter
© Kaplan, Inc. 33


DB: Pension Plan—Liquidity Needs

Liquidity needs are generally higher when (cont.):
▪ The plan has higher funded status, likely leading to lower
sponsor contributions and more benefit payments
▪ The plan participants have the ability to switch or withdraw
from the plan, which triggers payments to participants
▪ Plan with lower liquidity needs can generally invest

larger amounts in more risky asset classes
© Kaplan, Inc. 34

DB: Pension Plan—External Constraints

▪ Regulations vary by country; however, there are similar
themes in global regulation.
▪ Many regulators now require extensive reporting on fees
and costs incurred by plans both internally and externally.
▪ Personal liability for pension trustees has been increased
to ensure they act in the best interests of plan beneficiaries.
▪ Tax rules vary by country but are often treated favorably by
governments.
© Kaplan, Inc. 35


DB: Pension Plan—External Constraints

▪ Accounting rules, again, differ by country.
▪ U.S. DB plans must follow GAAP:
▪ Funded status must be shown on the balance sheet.
▪ Public pension plans must follow GASB rules, which
require plan assets to be reported at market value and
liabilities to be reported using a blended approach.
▪ The focus of the exam is on PM, not forensic
regulations, taxes, and accounting.
© Kaplan, Inc. 36

DB: Pension Plan—Investment Objectives

▪ The primary objective is to achieve a target return over a
specified long-term time horizon, while assuming a level of
risk that is consistent with funding contractual liabilities.
▪ A secondary objective could be to minimize, in PV terms,
the cash contributions the sponsor will be required to
provide.
© Kaplan, Inc. 37


DC Plans
Stakeholders:
▪ Plan sponsors (employers), while not facing the
investment risk or longevity risk of the assets, still
contribute to the plan, oversee the investment of the
plan assets, and offer suitable investment options.
▪ Plan beneficiaries (employees and retirees) face
investment risk of contributions and investment returns
not meeting retirement needs and longevity risk.
© Kaplan, Inc. 38

DC Plans
Stakeholders (cont.):
▪ The board must communicate with participants to keep
them informed and may have to select default
investment options when participants are disengaged.
▪ Governments are stakeholders as they provide tax
incentives for employees to save for retirement.
Taxpayers will ultimately have to pay for the costs of
providing for the welfare of those who failed to
adequately save for retirement.
© Kaplan, Inc. 39


DC: Liabilities & Investment Horizon

▪ Liabilities of a DC pension plan are the required
contributions to plan assets; unlike a DB plan, there is no
liability associated with future benefits.
▪ Individuals in DC plans have an investment horizon linked
to their age—older plan participants will have a shorter time
horizon.
▪ Many DC plans offer a default life-cycle option (target date
option).
© Kaplan, Inc. 40

DC: Liquidity Needs

The primary drivers of liquidity needs include:
▪ The age of the workforce
▪ The ability of participants to switch or withdraw from the
plan
© Kaplan, Inc. 41


DC: External Constraints

▪ Regulations vary by country but frequently require plan
sponsors to educate plan participants on saving for
retirement.
▪ From a tax perspective, DC plans (e.g., 401k in the U.S.)
are tax deferred, but withdrawals before 59½ are penalized
with a 10% tax.
© Kaplan, Inc. 42

DC: Investment Objectives

▪ The main objective of DC plans is to prudently grow assets
to meet personal spending needs in retirement.
▪ There is an onus on plan sponsors to provide cost-efficient
default options for disengaged participants.
© Kaplan, Inc. 43


Sovereign Wealth Funds (SWFs)

Investment funds owned by a government, the International
Monetary Fund (IMF) defines 5 broad categories of SWF:
▪ Budget stabilization funds: Set up when a nation’s
revenues are heavily linked to a natural resource/cyclical
industry and used to insulate gov’t budget from volatility
▪ Development funds: Prioritize national socioeconomic
projects (i.e., infrastructure or supporting key industries)
▪ Savings funds: Invest revenues from nonrenewable assets
for the benefit of future generations
© Kaplan, Inc. 44


▪ Reserve funds: Designed to earn returns on excess foreign
reserves held by central banks
▪ Typically, foreign exchange reserves are low-yielding
assets compared to bonds issued by central banks that
make up the liabilities.
▪ Reserve funds aim to reduce this negative cost of carry.
▪ Pension reserve funds: Used to save and invest to meet
future pension liabilities of governments
© Kaplan, Inc. 45



Stakeholders:
▪ Current and future citizens benefit from the fund’s
success by receiving payments and/or lower taxes.
▪ Investment offices invest SWF assets either directly in-
house or appoint external managers.
▪ The board has a fiduciary duty to the beneficiaries.
▪ Governments are stakeholders since they must rely on
SWF returns to balance budget deficits.
© Kaplan, Inc. 46

SWFs—Liabilities & Investment Horizon

Liabilities of SWFs are linked to their overall mission and
generally are less well defined than other types of institutions:
▪ Budget stabilization: Uncertain liabilities linked to commodity
prices/cyclical industries; short-term investment horizon
because budget support required on a short-term basis
▪ Development: Liabilities linked to socioeconomic
investments made by the fund; long-term (infrastructure) and
medium-term horizons (medical research)
© Kaplan, Inc. 47



▪ Savings: Liabilities are linked to future generations (long
term)
▪ Reserve: Liabilities are technically the yield promised on
bonds issued by governments/central banks; funds will
target higher returns
▪ Investment horizons are very long; typically no near-
term liabilities
© Kaplan, Inc. 48


▪ Pension reserve:
▪ Liabilities are linked to future pension payments;
therefore, long term
▪ Fund may have an accumulation stage in which
contributions are made and a decumulation phase
where benefits are drawn; time horizon will depend on
when the stages occur
© Kaplan, Inc. 49


SWFs—Liquidity Needs
▪ Budget stabilization funds: These must maintain the highest
liquidity level and invest in assets with low risk of significant
losses in the short term to meet short-term deficits caused
by negative economic or commodity-related events.
▪ Development funds: Since infrastructure and research and
innovation investments are long term, funds needed to
develop such projects generally have low liquidity needs.
© Kaplan, Inc. 50

SWFs—Liquidity Needs
Savings funds: The main objective is to accumulate wealth for
future generations; liquidity needs are lowest.
Reserve funds: Liquidity needs are lower compared to
stabilization funds but higher compared to savings funds.
Normally, liquid fixed-income securities are held in a portfolio.
Pension reserve funds: Liquidity needs vary, being lower
during the accumulation stage and higher during the
decumulation stage.
© Kaplan, Inc. 51


SWFs—External Constraints
▪ SWFs are typically established by laws that give the SWF
its mission and structure.
▪ To avoid political influence, SWF’s demonstrate:
▪ High-quality governance
▪ Independence
▪ Transparency
▪ Accountability
© Kaplan, Inc. 52

SWFs—Santiago Principles
A best-practices framework established by the International
Forum of SWFs (IFSWF) addresses such concerns alongside
other key elements expected of a high-quality SWF, including:
▪ Ethics
▪ Risk management
▪ Regular monitoring for compliance with principles
© Kaplan, Inc. 53


SWFs—Investment Objectives
SWF Type Investment Objectives

Budget Capital preservation, earn returns above inflation
stabilization with a low probability of losses, and should avoid
assets correlated with the source of government
revenues
Development Support a nation’s economic development and
increase long-run economic growth; implicit
objective is to earn a real rate of return greater
than real domestic GDP growth or productivity
© Kaplan, Inc. growth 54

SWFs—Investment Objectives
SWF Type Investment Objectives

Savings Maintain purchasing power of the assets over time
while making ongoing spending on gov’t budgetary
needs
Reserve Earn a rate of return greater than the yield the
government/central bank pays on its issued debt
Pension Earn returns to meet future unfunded pension and
reserve social care payments promised by the government
© Kaplan, Inc. 55


SWFs—Asset Allocations
SWF Type Asset Allocation

Budget stabilization Majority of the fund is fixed income and
funds cash due to the defensive nature of fund
Development funds Driven by the socioeconomic mission of the
fund
Savings funds High allocation to equities and AI (e.g., PE
and real assets)
Typically follow the endowment model

© Kaplan, Inc. 56

SWFs—Asset Allocations
SWF Type Asset Allocation

Reserve funds Allocation similar to savings funds but with
lower allocation to AI due to potentially
higher liquidity needs
Pension reserve funds High allocations to equities and AI due to
the long investment horizon and low
liquidity needs in the accumulation phase
Typically follow the endowment model
© Kaplan, Inc. 57


University Endowments: Main Features/Mission

▪ University endowments are funds set up by gifts and
donations.
▪ These funds are invested to earn returns that provide
ongoing support to the university’s operating budget.
▪ The main objective is to balance the needs of the university
today against its needs in the future (intergenerational
equity).
▪ Harvard University’s endowment is one of the largest with
AUM in excess of $30 billion in 2016. 58
© Kaplan, Inc.

University Endowments: Stakeholders

◼ Current and future students
◼ Alumni who contribute gifts and donations
◼ University employees
◼ Stakeholders often have representation on the
endowment’s board or investment committee
© Kaplan, Inc. 59


University Endowments: Liabilities & Horizon

▪ The need to maintain intergenerational equity and the
unlimited life of the university mean endowments have a
perpetual investment horizon.
▪ The endowment’s liabilities are the future payouts promised
to the university, presented in an official spending policy.
▪ The endowment’s spending policy should ensure
intergenerational equity while smoothing payouts to
insulate the university from market volatility.
© Kaplan, Inc. 60

University Endowments: Spending Policy

▪ The dollar amount of spending each year can be stated as
a weighted average of the previous year’s spending
(adjusted for inflation) and a spending rate (e.g., 4%–6%)
applied to a moving average of assets under management
(AUM):
▪ Spendingt+1 = w × [spendingt × (1 + inflation)] + {(1 – w)
x (spending rate × average AUM)}
w = weight of the previous year’s spending amount
© Kaplan, Inc. 61



Three different types of spending policies result from different
values of w:
▪ Constant growth rule (w = 1): The endowment provides a
fixed (real) annual payout to the university once adjusted
for inflation by the Higher Education Price Index (HEPI).
▪ This method provides more certainty to the university of
payouts that will be received, but the percentage of the
endowment paid out fluctuates with the endowment
value.
© Kaplan, Inc. 62


▪ Constant growth rule (w = 1) (cont.):
▪ This spending rule often contains caps and floors
representing minimum and maximum percentage values
of AUM over one or three years that can be paid out in
any period.
▪ Market value rule (w = 0): Annual payouts are a
prespecified percentage (the spending rate, usually
between 4% and 6%) of the three-to-five-year moving
average of asset values.
© Kaplan, Inc. 63



▪ Hybrid rule (0 < w < 1): Spending is a weighted average of
the previous two rules.
© Kaplan, Inc. 64


Other liability-related factors that need to be considered:
▪ Fundraising from donors
▪ Gifts and donations coming into the endowment mean
the net spending rate is closer to 2%–4% of assets
rather than the 4%–6% spending rate applied.
© Kaplan, Inc. 65



▪ Reliance of the university on the spending from the
endowment
▪ All else equal, if the endowment spending comprises a
larger proportion of the university’s operating budget,
then the risk tolerance of the endowment is lower.
© Kaplan, Inc. 66


▪ Capability of the endowment or university to issue debt
▪ Access to debt markets increases the risk tolerance of
the endowment because the institution can borrow to
meet spending in times of poor investment performance.
© Kaplan, Inc. 67


University Endowments: Liquidity Needs

▪ The endowment’s annual spending net of gifts and
donations is usually very low (around 2%–4% of assets).
▪ Low liquidity needs plus the perpetual time horizon mean
endowments usually have a high risk tolerance and absorb
relatively high volatility in the short term in pursuit of longer-
term returns.
© Kaplan, Inc. 68

University Endowments: External Constraints

From a legal and regulatory perspective, regulation varies by
jurisdiction; however, endowments are typically subject to
laws that require:
▪ Investment on a total return basis and diversification using
modern portfolio theory (MPT)
▪ Investment committees or boards and staff who have a
fiduciary duty of care in overseeing investments
© Kaplan, Inc. 69


University Endowments: Investment Objectives

▪ Preserve the purchasing power of the assets in
perpetuity (i.e., grow in line with inflation) while achieving
returns adequate to maintain the level of spending.
▪ A typical spending rate target is 5% of average assets.
▪ This means the primary investing objective is to generate a
real return (i.e., after inflation using the HEPI) of about 5%
on average over a three-to-five-year period.
© Kaplan, Inc. 70


▪ A reasonable volatility limit is typically 10% to 15%.
▪ There may be a secondary objective of outperforming a
passive benchmark or even a tertiary objective of
outperforming a peer group of similar endowments.
▪ Given endowments need to beat inflation, they tend to have
a significant allocation to real assets with expected returns
that meet or beat inflation.
© Kaplan, Inc. 71



▪ One lesson from the 2007–2009 financial crisis is that the
liquidity risk of endowments’ portfolios should be analyzed
with detailed cash flow modeling.
▪ Some endowments use liquidity risk bands—an upper
bound for the fund’s exposure to illiquid investments,
including the endowment’s uncalled commitments in illiquid
alternative asset funds.
© Kaplan, Inc. 72

University Endowments: Asset Allocation

▪ Most large U.S. university endowments follow the
endowment model, which involves a majority (>50%)
allocation to AIs, an allocation that has increased over the
past two decades.
▪ Smaller U.S. university endowments tend to allocate less to
AIs and more to domestic equities and FI, with some
evidence of home bias causing U.S. equities to be
overweighted.
© Kaplan, Inc. 73


Private Foundations: Main Features/Mission

▪ Foundations are nonprofit institutions set up to make grants
to support specified charitable causes.
▪ The focus of this reading is on private foundations set up
by individual donors and their families (e.g., Bill & Melinda
Gates Foundation).
© Kaplan, Inc. 74


Foundations can be:
▪ Community foundations set up by and for the good of the
local community
▪ Operating foundations set up to fund a specific not-for-profit
business
▪ Corporate foundations set up from the profits of an existing
company
© Kaplan, Inc. 75



The main objective of a private foundation is to typically:
▪ Maintain purchasing power in perpetuity
▪ Earn returns sufficient to support the grant-making activities
of the foundation
© Kaplan, Inc. 76

Private Foundations: Stakeholders

▪ They may include the founding family, donors to the
foundation, recipients of grants from the foundation, and
the wider community that that foundation’s activities may
benefit.
▪ Intergenerational tensions may exist like those of an
endowment where the needs of current recipients and
future recipients of spending from the foundation need to
be balanced.
© Kaplan, Inc. 77


Private Foundations: Stakeholders

▪ The government could also be considered a stakeholder
due to the favorable tax treatment of foundations.
▪ Mission-related investing (impact investing) is a technique
increasingly adopted by foundations whereby investments
are made into projects that promote the foundation’s
mission.
◼ Impact investing may be challenging to maintain a
sufficient return on assets to meet the foundation’s
objectives.
© Kaplan, Inc. 78

Private Foundations: Liabilities & Horizon

▪ Foundations typically have a perpetual investment horizon.
▪ There is a trend toward limited-life foundations that are
mandated to spend down assets within a limited time
frame of the founder’s death, which shortens the
investment time horizon.
© Kaplan, Inc. 79


Private Foundations: Liabilities & Horizon

▪ U.S. foundations are legally required to spend 5% of assets
plus investment expenses.
▪ Unlike universities, which have other sources of revenue
outside the spending of their endowment, foundations are
relied upon almost exclusively to meet budgets.
▪ This, along with the higher liquidity requirements of
foundations, means they have a lower risk tolerance than
university endowments.
© Kaplan, Inc. 80

Private Foundations: Liquidity Needs

▪ Foundations should maintain sufficient liquidity to meet
near-term spending, capital calls from private limited
partnership fund investments, and any margin calls on
derivatives employed by the investment portfolio.
© Kaplan, Inc. 81


Private Foundations: External Constraints

▪ From a legal and regulatory perspective, foundations are
subject to similar laws, such as UPMIFA in the U.S. and the
Trustee Act in the U.K.
▪ Regulations demand investment on a total return basis,
diversification, and a duty of care from the board and
investment staff.
© Kaplan, Inc. 82

Private Foundations: Investment Objectives

▪ The investment objective is to generate a real return over
CPI of the spending rate (minimum 5%) plus investment
expenses.
▪ Have expected annual volatility in a reasonable range
(approximately 10%–15%) over a three-to-five-year period.
▪ There may be a secondary objective of outperforming a
policy benchmark based on a tracking error budget.
© Kaplan, Inc. 83


Private Foundations: Asset Allocation

▪ Foundations have a lower ATBR than university
endowments due to higher liquidity requirements and the
heavy reliance on the foundation’s spending.
▪ However, the overall risk tolerance remains high, with a
long-term objective of beating inflation.
▪ Larger U.S. foundations give asset allocations of about 50%
to alternative investments.
▪ Smaller foundations favor domestic stocks and fixed
income. 84
© Kaplan, Inc.

Banks and Insurers

◼ These are different from other institutions in that they are
financial intermediaries that are run for profit.
◼ Note: For the exam, we are advising these institutions
on their investment portfolios, not on their core
business of being a bank or an insurance company.
© Kaplan, Inc. 85


Banks: Main Features/Mission

◼ Banks take in deposits from savers (liabilities) and make
loans (assets) to borrowers.
◼ Other functions carried out by banks include:
◼ Safeguarding assets
◼ Executing transactions in securities and derivatives
◼ Advising and investing in securities
© Kaplan, Inc. 86

Banks: Stakeholders
◼ Most major large international banks are publicly listed,
making shareholders a key external stakeholder with an
interest in maximization of profits.
◼ Customers of banks (i.e., depositors and borrowers) are
also key external stakeholders.
◼ Depositors expect the bank to protect their assets.
◼ Retail borrowers rely on the bank to finance homes.
◼ Commercial borrowers need funding for operations.
© Kaplan, Inc. 87


Banks: Stakeholders
Other external stakeholders include:
◼ Creditors, credit rating agencies, regulators, and
communities where the bank operates
Internal stakeholders include:
◼ The bank’s employees, managers, and directors
© Kaplan, Inc. 88

Banks: Liabilities and Time Horizon

◼ Deposits constitute the majority of the bank’s liabilities.
◼ Demand deposits: Can be withdrawn without notice and
are deemed short term in duration
◼ Time/term deposits: Require advance notice before
withdrawal
◼ Other liabilities include short-term wholesale funding from
other financial institutions, long-term debt, trading/securities
payables, and repo finance payables.
© Kaplan, Inc. 89


Banks: Liabilities and Time Horizon

◼ The majority of assets of a bank consist of longer-term
illiquid mortgages and commercial loans.
◼ Investment horizon for a bank portfolio is influenced by the
difference between the long-term illiquid assets and the
short-term liquid liabilities of the bank.
◼ Although banks are perpetual in nature, their portfolios tend
to be very short term to manage the volatility of shareholder
capital on a medium- to short-term basis.
© Kaplan, Inc. 90

Banks: Liquidity Needs

◼ With deposits as short-duration liabilities and the potential
need to raise liquidity in adverse market conditions, liquidity
management is a key factor for banks.
◼ Since the financial crisis of 2007–2009, regulations have
been focused on requiring banks to have sufficiently liquid
assets to cover near-term expected cash outflows (liquidity
coverage ratios, or LCRs) & adequate levels of capital from
stable sources (net stable funding ratios, or NSFRs).
© Kaplan, Inc. 91



◼ Increased regulation has led to:
◼ Investment portfolios that are more liquid
◼ Relying less on the wholesale interbank funding markets
◼ Banks lending to commercial markets still tend to use
wholesale funding markets more than banks lending to
retail markets.
© Kaplan, Inc. 92


◼ Retail banks use higher level of retail deposits in their
funding
◼ Associated with lower costs and tend to be more stable
than wholesale funds
◼ Give retail banks a better liquidity position than
commercial banks
© Kaplan, Inc. 93


Banks: External Constraints

◼ From a legal and regulatory perspective, the risks that a
systematic bank failure pose to critical economic functions
such as payment processing and extension of credit are
severe.
◼ Regulators are intensely focused on capital adequacy,
liquidity, and leverage levels of banks.
© Kaplan, Inc. 94


◼ The main goal of regulators is to make sure banks have
adequate capitalization to absorb losses rather than the
losses having to be faced by customers, creditors, or
taxpayers.
◼ This can be achieved through diversification, asset quality–
based reserves, and diverse stable sources of funding.
◼ Regulators require banks to maintain LCRs and
NSFRs.
© Kaplan, Inc. 95



◼ Economies of scale and the benefits of diversification
encourage banks to increase their size.
◼ The largest banks are regarded by regulators as
systemically important financial institutions (SIFIs).
© Kaplan, Inc. 96


Since the global financial crisis, regulations for SIFIs have done
the following:
◼ Increased capital required to absorb losses on assets
◼ Placed limits on the amount of dividends and share buybacks
◼ Restricted the ability of subordinated debtholders and
preferred shareholders to exert claims in bankruptcy
◼ Restricted the use of derivatives, proprietary trading, and the
use of off-balance sheet liabilities and guarantees
© Kaplan, Inc. 97



From an accountancy perspective, 3 different accounting
systems apply to financial institutions:
1. Standard financial reporting (GAAP or IFRS) is used to
communicate results.
2. Statutory accounting used by regulators is comprised of a
series of adjustments to make the accounts more
conservative (e.g., removing intangible assets from the
BS, accelerating certain expenses and costs, and
recognition of reserves against unexpected large losses).
© Kaplan, Inc. 98


3. True economic accounting uses market value for all
assets and liabilities.
◼ This is likely to give the most volatile measure of
income.
◼ Banks are fully taxable entities; they must consider the
after-tax returns of their investment programs.
© Kaplan, Inc. 99


Banks: Investment Objectives

◼ The primary objective of a bank’s investment portfolio is to
manage liquidity and reduce risk mismatches between the
bank’s noninvestment assets and liabilities.
◼ Establish an asset and liabilities management committee
(ALMCo) to oversee investment activities.
◼ The ALMCo sets the IPS, monitors performance, and
sets risk limits regarding market, credit, liquidity, and
solvency risks.
© Kaplan, Inc. 100

Insurers: Main Features/Mission

Issuers can be divided into two broad categories:
▪ Life insurers: Write insurance relating to whole life or term
insurance with fixed payments, variable life insurance,
annuity products, health insurance, and universal life
▪ Property and casualty (P&C) insurers: Write insurance
relating to commercial property and liability, home
ownership, marine insurance, surety, and legal liabilities
© Kaplan, Inc. 101


Insurers: Stakeholders
Publicly listed companies’ key external stakeholders:
◼ Shareholders who require long-term maximization of the
value of their capital while simultaneously honoring
obligations to policyholders
Mutual companies’ key external stakeholders:
◼ Owned by policyholders, either retaining profits as surplus
against potential losses or distributing profits through
dividends or premium reductions
© Kaplan, Inc. 102

Insurers: Stakeholders
◼ Other external stakeholders include derivative
counterparties, creditors, regulators, and rating agencies.
◼ Internal stakeholders include:
◼ An insurer’s employees
◼ Management
◼ Board of directors
© Kaplan, Inc. 103


Insurers: Liabilities and Time Horizon

◼ Insurance companies manage their investments with a
focus on asset and liability management.
◼ The nature of the liabilities is critical to the investment
horizon of the investment portfolio.
© Kaplan, Inc. 104


◼ Life insurers generally face a long duration liability stream
through their contract payouts, but this can vary by product
line.
◼ Life insurance firms have historically set investment
horizons of 20–40 years.
© Kaplan, Inc. 105



◼ P&C insurers generally face a liability stream with a shorter
duration and higher uncertainty.
◼ Claims are related to unlikely, unpredictable events with
high payouts (e.g., natural disasters).
◼ While the institution has a perpetual time horizon, the
nature and timing of policy claims will strongly affect the
time horizon of investments held.
© Kaplan, Inc. 106


◼ A key consideration for both life and P&C insurers is the
frequently occurring underwriting cycle, which causes
fluctuations in profitability.
◼ These fluctuations are driven by changes in the level of
competition at different points of the insurance business
cycle.
© Kaplan, Inc. 107


Insurers: Liquidity Needs

▪ An insurer needs to manage both of these:
▪ Internal liquidity (cash from operations and investing
activities)
▪ External liquidity (ability to borrow in debt markets)
© Kaplan, Inc. 108


◼ P&C insurers face significant cash flow uncertainty due to
the nature of their liabilities.
◼ Their portfolios require ample liquidity of high
proportions of cash or cash equivalents and short-term
fixed-income securities.
© Kaplan, Inc. 109



Insurers divide general account investments into two major
components:
▪ Reserve portfolio: Regulators require the account to be
capable of meeting policy liabilities (managed
conservatively)
▪ Surplus portfolio: Used to generate higher returns, often
by assuming liquidity risk and allocations to alternative
investments
© Kaplan, Inc. 110

Insurers: External Constraints

◼ From a legal and regulatory perspective, like banks,
insurers carry out crucial financial intermediary roles and
can be large enough to be classified as SIFIs.
◼ Similar to banks, regulators aim to ensure that insurers
have sufficient capital to absorb losses in the business and
losses from investments.
◼ Insurers typically are fully taxable entities and must run
investment programs considering after-tax returns.
© Kaplan, Inc. 111


Insurers: Investment Objectives

◼ Similar to banks, the primary objective of an insurer’s
investment portfolio is to manage liquidity and reduce risk
mismatches between the institution’s assets and liabilities.
◼ The investment oversight function of an insurer is typically
carried out by a board committee that is responsible for all
investment policies and procedures and reports to
regulators and external stakeholders.
© Kaplan, Inc. 112

Banks & Insurers

Balance sheet management and investment considerations:
◼ For both banks and insurance companies, the primary
objective of the company is to maximize the market value
of the institution’s equity capital.
◼ Have a high level of assurance that the claims of
depositors, creditors, and policyholders can be met.
© Kaplan, Inc. 113


Banks & Insurers

◼ An expression that captures how changes in the market value of
assets, liabilities, and leverage levels affect the change in the
market value of equity is:
%∆E = %∆A(M) – %∆L(M – 1)
where:
%∆E = percentage change in the value of equity
%∆A = percentage change in the value of assets
%∆L = percentage change in the value of liabilities
M = leverage multiplier, A / E
© Kaplan, Inc. 114

Banks & Insurers: Modified Duration of Equity

DE = DA(M) – DL(M – 1)(∆i / ∆y)
where:
DE = modified duration of the institution’s equity capital
DA = modified duration of the institution’s assets
DL = modified duration of the institution’s liabilities
(∆i / ∆y) = estimated change in yield of liabilities, i, relative to
a unit change in yield of assets, y
© Kaplan, Inc. 115


Banks & Insurers: Considering Volatility

σ2E = M2σ2A + (M – 1)2σ2L – 2(M)(M – 1)σAσLρAL
where:
σE = standard deviation of percentage change in market value of equity
σA = standard deviation of percentage change in the value of assets
σL = standard deviation of percentage change in the value of liabilities
ρAL = correlation of percentage value changes in A & L
© Kaplan, Inc. 116

Strategies for Changing Volatility

Impact on Impact on
Strategy Comments
Factor σE
Hold diversified Diversified FI has a
Lowers σA Falls
FI lower σ
Hold high-quality Lower chance of
Lowers σA Falls
FI significant loss
Maintain similar
Increases ρAL Falls Regulatory concerns
A & L durations
Hold common Increases σA Reserves of 100%
Rises
stock Lowers ρAL required
© Kaplan, Inc. 117



Strategy Impact on Factor Impact on σE Comments
Derivatives Lowers σA and σL Less chance of
Falls
transparency Increases ρAL unexpected loss
Hold more liquid

Lowers σA Falls
investments
Surrender Lowers σL Penalty cushions

Falls
penalties losses
Prepayment Prepayments occur

Increases ρAL Falls
penalties on debt in low interest rates
© Kaplan, Inc. 118


Strategy Impact on Factor Impact on σE Comments
Catastrophic Losses are large and
Increases σL Rises
insurance risk unpredictable
Predictability
Total insurance L are
of underwriting Decreases σL Falls
less uncertain
losses
Diversifying
Decreases σL Total insurance L are
insurance Falls
less uncertain
business
Variable Active gains & losses
Increases ρAL Falls
annuities passed through
© Kaplan, Inc. 119


Asset Allocation for Banks & Insurers

◼ Optimal investment management simultaneously focuses
on the investment portfolio and the liabilities of a business,
all within the context of external economic conditions and
regulatory reserve requirements.
◼ The portfolio manager needs to be conscious of the factors
that affect the volatility of shareholders’ equity and optimal
levels of leverage.
© Kaplan, Inc. 120

Trading, Performance
Evaluation, and
Manager Selection;
and Case Studies

656 Trading, Performance Evaluation, and Manager Selection; and Case Studies
Trading, Performance Evaluation,

and Manager Selection; and
Case Studies
Trade Strategy and Execution
Exam Focus
◼ This topic review evaluates the trade component of the
portfolio management process.
◼ Understanding trade motivations, trade characteristics, and
capital market expectations will help you determine the most
appropriate trading strategy.
© Kaplan, Inc. 2

Trading, Performance Evaluation, and Manager Selection; and Case Studies 657
Exam Focus
◼ Key factors that determine the optimal trading approach
include both explicit and implicit costs.
◼ It is vital that you can calculate the total costs of trading
using the implementation shortfall (IS) metric and
decompose trading costs into component parts, including
delay, trading, opportunity, and fixed fees.
© Kaplan, Inc. 3
Trade Motivations
The four categories of trade motivation are as follows:
1. Profit seeking
2. Risk management and hedging needs
3. Cash flow needs
4. Corporate actions, margin calls, and index reconstitution
© Kaplan, Inc. 4

Trade Motivations
1. Profit seeking: Active portfolio managers (PMs) seek to
outperform their respective benchmark (BM)—i.e.,
generate alpha—trading securities they believe to be
mispriced.
◼ PMs frequently need to act on their insight before the rest of
the market; hence, a key consideration is alpha decay.
◼ Alpha decay is a deterioration of alpha once an investment
decision has been made by the PM.
© Kaplan, Inc. 5
Trade Motivations
◼ Alpha decay:
◼ Higher trade urgency—PMs with higher rates of alpha decay
(e.g., PMs trading on daily news flow) have a need to trade in
shorter time frames.
◼ Lower trade urgency—PMs valuing firms on long-term
company fundamentals will have lower rates of alpha decay
and will trade in longer time frames.
© Kaplan, Inc. 6

Trade Motivations
◼ Information leakage:
◼ Occurs when trading activities alert the market to the security
mispricing that was found by the PM
◼ To minimize information leakage, PMs may execute trades in
multiple venues and at multiple times
◼ May include trading in less transparent venues, dark pools,
which are trading systems with low pretrade transparency
© Kaplan, Inc. 7
Trade Motivations
◼ Dark pools:
◼ Advantage: Orders entered can’t be seen by other market
participants before the trade occurs; there is no risk of
information leakage.
◼ An execution venue with high pretrade transparency is called a
lit venue (e.g., national stock exchanges).
◼ Disadvantage: Traders can’t see orders on the other side of
the trade, so they do not know the pretrade likelihood of
execution.
© Kaplan, Inc. 8

Trade Motivations
2. Risk management and hedging needs: Portfolios need
to maintain targeted risk exposures
◼ Could involve rebalancing the portfolio after a change in
market conditions or hedging to remove a risk factor from a
portfolio
◼ Derivative trades may be used to facilitate risk management;
funds that use leverage need to monitor risk levels closely,
because leverage magnifies risk
© Kaplan, Inc. 9
Trade Motivations
3. Cash flow needs: Primarily caused by investor
subscriptions (inflows) and redemptions (outflows)
◼ Trade urgency depends on the nature of the cash flows; a
hedge fund may require a month or more notice for
redemptions from clients
◼ Funds with less liquid holdings may find it difficult to invest
new client funds quickly, causing cash drag, where low
returns from cash can cause the fund to underperform the
benchmark
© Kaplan, Inc. 10

Trade Motivations
◼ To limit cash drag, the PM may use equitization strategies,
using liquid securities (e.g., ETFs or derivatives) to gain
market exposure while the investment in underlying
securities occurs over time.
◼ Client redemptions, frequently based on the fund’s net asset
value (NAV), use the closing prices of securities.
◼ Liquidating securities at closing prices will eliminate the risk
of selling at prices different than those needed to meet
redemptions (the PM should consider liquidity and taxes to
meet redemption requests).
© Kaplan, Inc. 11
Trade Motivations
4. Corporate actions, margin calls, and index
reconstitution:
◼ Corporate actions on portfolio holdings such as mergers,
acquisitions, or spinoffs may require trading.
◼ Dividends or coupons may need reinvesting.
◼ Funds making regular distributions may have to sell securities to
raise cash.
◼ Margin calls may require urgent sales of portfolio holdings.
© Kaplan, Inc. 12

Trade Motivations
◼ Benchmark (BM) index reconstitution:
◼ The PM may need to execute trades to reflect changes; this
is critical for index-tracking funds.
◼ The value of the index BM usually is based on closing prices.
◼ Therefore, trading at closing prices will minimize the fund’s
tracking error in relation to BM.
© Kaplan, Inc. 13
Trading Strategy Inputs

◼ Once the PM makes the decision to invest, the executing
trader and PM work together to create optimal trading
strategy.
◼ Key factors dictating the optimal trading strategy are as
follows:
1. Order characteristics
2. Security characteristics
3. Market conditions
4. Individual risk aversion
© Kaplan, Inc. 14


1. Order characteristics:
◼ Side: Direction of the order—buy, sell, short buyback (cover),
or short sell
◼ A list of only buy orders or only sell orders will have greater
market risk exposure versus a list of buys and sells with
offsetting market risk exposures
◼ Absolute size: Number of securities being traded
◼ Larger orders will have a higher market impact cost than smaller
orders and are often traded with less urgency
© Kaplan, Inc. 15

◼ With relative size, the PM often considers order size as the
percentage of average daily volume (ADV)
◼ Orders that constitute a higher percentage of ADV are expected
to have higher market impact costs
2. Security characteristics: Include security type, short-
term alpha, price volatility, and security liquidity
© Kaplan, Inc. 16


◼ Security type: Different security types (e.g., underlying
securities, ETFs, ADRs, GDRs, derivatives, and FX
contracts) trade in different markets, with different costs,
regulations, and liquidity.
◼ Short-term alpha: Active managers with a high rate of
alpha decay require more urgent trade strategies.
◼ The PM will also have higher urgency in adverse market
conditions (i.e., buying into a rising market or selling into a
falling market).
© Kaplan, Inc. 17

◼ Price volatility: High price volatility implies high execution
risk—the risk that adverse price movements will occur over
the trading horizon.
◼ Security liquidity: Greater liquidity decreases execution
risk and market impact costs.
◼ Narrow bid-ask spreads, with large volumes for trading (i.e.,
market depth), are two key indicators of high liquidity.
© Kaplan, Inc. 18


3. Market conditions: Key market conditions affecting
trading costs include volatility and liquidity levels.
◼ Both can change adversely (increased volatility and lower
liquidity) in times of market crisis.
◼ Even in normal market times, volatility and liquidity can
dynamically change; traders need to reflect this in their
expectations.
◼ Lower liquidity suggests longer trading horizons.
© Kaplan, Inc. 19

4. Individual risk aversion: A PM/trader with higher risk
aversion is typically more concerned with the market risk
of adverse movements in security prices than market
impact costs.
◼ They will trade with more urgency.
◼ These trade strategy inputs are key factors driving the two
major costs of trading: market impact and execution risk.
© Kaplan, Inc. 20

Trader’s Dilemma
◼ Market impact: Comes from trading too quickly, causing
adverse price movements and information leakage as the
market notices liquidity imbalance
◼ Execution risk: Risk of adverse price movements over the
trading horizon, caused by trading too slowly
◼ Trader’s dilemma: Alleviating market impact causes
execution risk, and vice versa
© Kaplan, Inc. 21
Example: Trading Costs

A PM is discussing a list of buy and sell orders with the firm’s
head trader. The trader is specifically interested in how order
size, security liquidity, and rate of alpha decay affect market
impact risk and execution risk.
1. For each of the factors listed (order size, security liquidity,
and rate of alpha decay), briefly describe how the factor
affects the market impact cost of the trade. (Note:
Consider each factor in isolation.)
© Kaplan, Inc. 22


Answer to question 1:
▪ A larger order size will most likely lead to a higher market impact
cost; the trader will have to trade at more adverse prices to
execute a larger transaction.
▪ Higher liquidity results in narrower bid-ask spreads and higher
market depth, both contributing to lower market impact costs; the
trader will likely be able to execute the trade close to current
market prices.
▪ Higher alpha decay prompts traders to trade quickly, leading to a
higher market impact cost.
© Kaplan, Inc. 23

2. The PM makes the following two statements:
Statement 1: High market impact costs could be mitigated by
executing the order over a longer trading horizon.
Statement 2: If done correctly, this will not lead to an increase
in any other types of trading cost.
Discuss whether the two statements are true or false.
Briefly justify your response.
© Kaplan, Inc. 24


Answer to question 2:
◼ Statement 1 is true. Executing the order over a longer trading
horizon will mean the manager can break the order up into
smaller parts and therefore lower the market impact cost of the
trade.
◼ Statement 2 is false. Executing a trade over a longer time
horizon will lead to higher execution risk; the risk of an adverse
price movement increases with the trading horizon.
© Kaplan, Inc. 25
Reference Price Benchmarks for Trade Execution

◼ Reference prices: Used to determine expected trading
costs; enable PMs and traders to choose the optimal
strategy
◼ Key input in the calculation of the actual cost of trading for
posttrade evaluation
◼ Categorized as pretrade, intraday, posttrade, or price target
© Kaplan, Inc. 26


◼ Pretrade benchmarks: Known before start of trading and
include the following:
◼ Decision price: Price at the time the PM made the investment
decision
◼ Previous close: Closing price on the previous day
◼ Opening price: Opening price on the day
◼ Arrival price: Price of the security when the order is sent to
market for execution
© Kaplan, Inc. 27

◼ Intraday benchmarks: Based on prices during the trading
period; used by PMs who trade passively over a day or
funds that my be rebalancing or minimizing risk
◼ Include the following:
◼ Volume-weighted average price (VWAP): Average price of
all trades, weighted by volume, over trading horizon
◼ PMs specify VWAP to achieve the objective of using cash
received from sell orders to fund buy orders during
rebalancing
© Kaplan, Inc. 28


◼ Time-weighted average price (TWAP): Equally-weighted
average price of all trades executed over the trading
horizon (i.e., TWAP ignores volume)
◼ TWAP may be appropriate for PMs who want to remove the
impact of outliers because they believe they are less able to
participate in these extreme trades
◼ TWAP also is appropriate in market conditions with highly
fluctuating volume throughout the day
© Kaplan, Inc. 29

◼ Posttrade benchmarks: Determined after trading has
been completed
◼ The most frequently used posttrade BM is the closing price,
which is often used by PMs who want to execute at the
closing price to lower the tracking error of the fund
◼ A drawback of this BM is that the closing price is not known in
advance
◼ Therefore, the PM can’t assess trading performance during the
trading horizon
© Kaplan, Inc. 30


◼ Price target benchmarks: Prices used by profit-seeking
PMs aiming to earn short-term alpha, related to the PM’s
view of the intrinsic value of security
◼ For example, the PM may think a security that is currently
priced at $10 has an intrinsic value of $10.50
◼ The PM could use a price target BM of $10.50 in a strategy
that purchases as many shares as possible below this level
© Kaplan, Inc. 31
Trading Strategy Selection

◼ The trading strategy selected by the PM and trader should
reflect all costs and risks discussed in the previous section
and be consistent with the PM’s objectives.
◼ Examples of common trade types and most appropriate
trading strategies include the following.
© Kaplan, Inc. 32


◼ Short-term alpha
◼ Objective: Trade short-term mispricing in a liquid equity
market (e.g., overreaction to news flow)
◼ Urgency: High
◼ Reference prices: Price target BM linked to the PM’s estimate
of fair value combined with an arrival price BM for orders
when placed
◼ Execution method: Computer algorithm
© Kaplan, Inc. 33

◼ Long-term alpha
◼ Objective: Trade over long term due to changes in
fundamental conditions
◼ Urgency: Low
◼ Reference prices: Difficult to use in practice
◼ Execution method: Sell securities gradually over a few weeks
in small parts to avoid information leakage and pressure on
dealer’s prices
© Kaplan, Inc. 34


◼ Risk rebalance
◼ Objective: Rebalance or hedge risk exposure
◼ Urgency: Low, because the trader is both buying and selling,
which lowers execution risk
◼ Reference prices: TWAP
◼ Execution method: Algorithmically target TWAP over the next
couple of days
© Kaplan, Inc. 35

◼ Cash flow driven (client redemption)
◼ Objective: Liquidate holdings to meet client redemptions
◼ Urgency: Trade needs to be completed by the end of the
trading day
◼ Reference prices: Closing price
◼ Execution method: Execute a reasonable amount of liquidity
in the closing auction; execute the remainder before the close
of trading (e.g., at VWAP)
© Kaplan, Inc. 36


◼ Cash flow driven (new trade mandate)
◼ Objective: Invest new client funds (e.g., invest a large amount
with a mandate to track a small-cap index with a 3% tracking
error); performance measurement will begin at the current
day’s closing price
◼ Urgency: Liquidity is too low to execute in underlying
securities by the end of the day, but immediate exposure is
required by the client; liquid index futures contracts exist
© Kaplan, Inc. 37

◼ Cash flow driven (new trade mandate) (continued)
◼ Reference prices: Closing price
◼ Execution method: Obtain immediate exposure to the index
through a long position in index futures to eliminate cash drag
◼ Build underlying stock positions over time to reduce market
impact, while simultaneously unwinding the futures position
© Kaplan, Inc. 38


◼ Cash flow driven (new trade mandate) (continued)
◼ There are two issues with this method:
◼ There may not be a closing auction for the futures
contract, in which case the futures trade would need to be
done as close to the market close as possible
◼ The mandate must allow for derivative positions
© Kaplan, Inc. 39
Trade Execution and Strategy Implementation

◼ Once an appropriate trading strategy has been identified,
the trade must be implemented.
◼ Trade implementation choices are as follows:
◼ High-touch approaches: High levels of human involvement;
usually required for large trades (known as block trades) or in
less liquid markets
◼ Finding the other side to larger trades is more difficult
© Kaplan, Inc. 40


◼ High-touch approaches include the following:
1. Principal trades (broker risk trades), where dealers or
market makers assume all or some of the risk relating to
executing the order (priced into their spread)
◼ Quote-driven, over-the-counter (OTC), or off-exchange
markets are primarily principal trade markets
◼ Principal trades also include request-for-quote (RFQ) markets,
where market makers don’t provide continuous quotes (will only
do so on request)
© Kaplan, Inc. 41

2. Agency trades, where the broker finds the other side of
the trade; the risk for order execution remains with the PM
or trader
◼ Electronic trading: trading via computer, used in more liquid
markets
◼ Trading is typically order driven—electronic systems allow
buyers and sellers to advertise their limit orders through a central
limit order book
◼ A limit order is an order to trade at a certain (limit) price or better
© Kaplan, Inc. 42


◼ Electronic trading generally involves direct market access
(DMA) and/or algorithmic trading
◼ DMA: Allows buy-side PMs/traders to access the exchange’s
order book directly through a broker’s technology
infrastructure
◼ Algorithmic trading: Use of programmed rules to
electronically trade orders; primarily used for two purposes:
◼ Profit seeking and trade execution
© Kaplan, Inc. 43

◼ Profit-seeking algorithms use real-time market data to
determine which securities to buy and sell; they’re
employed by electronic market makers, quantitative funds,
and high-frequency traders.
◼ Execution algorithms trade according to the rules specified
by the manager to meet their objectives.
◼ Types of execution algorithms include the following.
© Kaplan, Inc. 44


1. Scheduled algorithms—percent of volume (POV), VWAP,
and TWAP algorithms: Execute trades using rules driven
by historical volumes or specified time periods
◼ POV algorithms (a.k.a. participation algorithms) send orders
according to a volume participation schedule
(e.g., “participate as 5% of traded volume”)
© Kaplan, Inc. 45

◼ POV algorithms
◼ Advantage: Automatically exploit increased liquidity,
when available
◼ Disadvantage: Continue to trade at any (potentially
adverse) price; may not fill order(s) in a specified time
with low liquidity
© Kaplan, Inc. 46


◼ VWAP and TWAP algorithms are time-slicing algorithms.
◼ VWAP algorithms try to match VWAP price for the period by
carving up the trade and sending orders based on historical
intraday volumes.
◼ The usual intraday volume trades more at open and close, and
less in the middle of the day when volume is low.
◼ TWAP algorithms perform a similar task; however, they
ensure an equal number of shares are traded in each time
period (e.g., each hour).
© Kaplan, Inc. 47

◼ VWAP
◼ Advantage: Ensures that a specified number of shares are
executed in a specified time period
◼ Disadvantage: May force trades in times of low liquidity or
trade too little in times of high liquidity
© Kaplan, Inc. 48


2. Liquidity-seeking algorithms (a.k.a. opportunistic
algorithms) aim to take advantage of favorable liquidity
conditions, when offered by the market.
◼ For example, for a buyer, this algorithm would wait until
a large seller appeared, then enter a market order.

◼ These orders use both lit and dark venues.
© Kaplan, Inc. 49

3. Arrival-price algorithms try to trade close to the market
prices prevailing at the time the order is entered.
Algorithms will trade more aggressively (i.e., faster) than
other algorithms to trade more shares at close to the
arrival price.
4. Dark strategies/liquidity aggregators execute trades in
dark pools; aggregator algorithms attempt to optimize
trading across multiple dark venues.
© Kaplan, Inc. 50


5. Smart order routers (SORs) are algorithms that determine
the best destination (either lit or dark) to route an
electronic order to get the best result.
◼ SORs focus on getting the best price for market orders,
or the highest probability of execution for limit orders.
© Kaplan, Inc. 51
Which Algorithm?
◼ Scheduled algorithms are appropriate for relatively small
orders in liquid markets for managers with less urgency
and/or who are concerned with minimizing the market
impact.
◼ Liquidity-seeking algorithms are appropriate for larger
orders in less liquid markets with higher urgency, while
trying to mitigate the market impact.
© Kaplan, Inc. 52

Which Algorithm?
◼ Liquidity-seeking algorithms are appropriate when the PM
is concerned that displaying limit orders may lead to
information leakage, or when liquidity is typically thin and
has sporadic episodes of high liquidity.
◼ Arrival price algorithms are appropriate for relatively small
orders in liquid markets; they’re used by PMs who believe
prices are likely to move against them during the trade
horizon, and therefore wish to trade more aggressively
(e.g., a profit-seeing manager).
© Kaplan, Inc. 53
Which Algorithm?
◼ Arrival price algorithms can also be appropriate for more
risk‐averse managers who want to minimize execution risk.
◼ Dark strategies/liquidity aggregators are appropriate for
large orders in illiquid markets and arrival price or
scheduled algorithms, which would likely lead to high
market impact.
© Kaplan, Inc. 54

Which Algorithm?
◼ Note: A lower chance of execution exists in dark pools; these
strategies are for managers that do not need to execute the
full order immediately.
◼ SORs are appropriate for small market orders with low
market impact, where the market can move quickly, or for
small limit orders with low information leakage, where
multiple potential execution venues exist.
© Kaplan, Inc. 55
Example: Selection of Appropriate Algorithm

A PM wishes to execute three trades as follows:
Order Size Average Daily
Stock Side Share Price Urgency
(Shares) Volume
SFDL Buy $8.50 10,000 20,000 High
TWEL Buy $32.31 5,000 100,000 Low
UDSL Sell $2.05 1,000,000 1,000,000 Low
© Kaplan, Inc. 56


The manager considers executing the orders using the
following strategies:
◼ Scheduled algorithm
◼ High-touch principal approach
◼ Liquidity-seeking algorithm
Recommend the most appropriate implementation strategy

for each order. (Note: Each strategy should only be used
once.)
© Kaplan, Inc. 57

Answer:
◼ SFDL should be purchased using a liquidity-seeking
algorithm.
◼ Low liquidity in the market and the high order size make
minimization of market impact a key consideration, which a
liquidity-seeking algorithm will achieve because it only trades
when liquidity is offered by the other side.
◼ The high urgency of the trade also makes a liquidity-seeking
algorithm appropriate, because execution should occur
relatively quickly.
© Kaplan, Inc. 58


◼ TWEL should be purchased using a scheduled algorithm.
◼ The low urgency of the trade suggests that concerns about
longer trading horizons and adverse price movements are
low.
◼ With low order size and relatively high liquidity, a scheduled
algorithm such as POV, VWAP, or TWAP is most
appropriate.
◼ These strategies trade passively throughout the day, which
minimizes market impact costs.
© Kaplan, Inc. 59

◼ UDSL should be sold using a high-touch principal
approach.
◼ The order represents 100% of the ADV; hence, using an
algorithm is not appropriate due to the high possibility of
information leakage and high market impact cost.
◼ Discretion is required to find the other side of the trade;
hence, a human intermediary is required, making the
high‐touch principal approach the best choice.
© Kaplan, Inc. 60

Which Algorithm?
◼ Recent developments in algorithmic trading include
clustering and high-frequency market forecasting.
◼ Clustering: Machine learning technique where the
computer learns to identify which algorithm is optimal
for different types of trades, based on the key features
of the trade
◼ The term clustering refers to the technique of grouping
trades together with similar attributes (e.g., order size as a
function of the ADV)
© Kaplan, Inc. 61
Which Algorithm?
◼ Clustering is similar to the approach used in the previous
example to select optimal order; however, the difference is
that clustering will quantitatively test factors for their impact
on the performance of different algorithms.
◼ The machine learning nature of the process means
clustering attempts to identify features of trades that
determine the optimal algorithm type that a human
manager had not previously considered important.
© Kaplan, Inc. 62

Which Algorithm?
◼ High-frequency market forecasting tries modeling
short‐term market direction; however, there are large
numbers of variables that could potentially explain market
movements.
◼ Least absolute shrinkage and selection operator (LASSO)
is a machine learning technique that helps reduce the
number of explanatory variables to a manageable number
of significant variables.
© Kaplan, Inc. 63
Characteristics of Key Markets

◼ Stocks are usually traded on stock exchanges (lit markets)
and dark pools.
◼ Equity markets are the most technologically advanced, with
most of the trading executed electronically; the use of
algorithms is common.
◼ Fixed-income (FI) markets tend to trade a large number of
heterogeneous securities; many issuers have multiple
securities outstanding.
© Kaplan, Inc. 64


◼ While FI markets tend to have low liquidity, the typical
order size is large.
◼ Due to these characteristics, trading in FI is mostly
conducted through dealer-based, quote-driven markets.
◼ Electronic RFQ systems are becoming more common;
however, algorithmic trading is largely limited to only the
most liquid on-the-run (most recently issued) U.S. Treasuries
and futures contracts.
© Kaplan, Inc. 65

◼ Electronic trading, while growing for corporate bonds,
remains relevant for only a small fraction of the
universe.
◼ Other FI securities markets generally use high-touch
execution methods; urgent trades require a principal broker
risk trade, while less urgent trades use a broker-agent
approach.
◼ Electronic trading is common for exchange-traded
derivatives.
© Kaplan, Inc. 66


◼ Algorithmic trading is not as common as for equities
markets, and is used more for futures than for options.
◼ Buy-side traders generally use DMA.
◼ OTC derivatives trading takes place in dealer quote-driven
markets, and is usually implemented through high-touch
approaches.
◼ Since the credit crisis of 2008, regulators have attempted to
increase transparency and central clearing of basic OTC
derivatives (e.g., interest rate swaps).
© Kaplan, Inc. 67

◼ Spot foreign exchange trading takes place in OTC markets
that use both electronic trading and high-touch broker
approaches.
◼ For urgent trades, RFQs are used with brokers.
◼ For large non-urgent trades, schedule algorithms or
high‐touch agency approaches are used.
◼ Small trades are usually implemented using DMA.
© Kaplan, Inc. 68

Example: Trade Approach by Market

The trading desk of a large multiasset buy-side firm has
received the following three orders:
Market Size Urgency
Futures Small High
Agency MBS Medium Low
Equity Large Low
© Kaplan, Inc. 69

The trading desk is considering executing the trades using
DMA, scheduled algorithms, or high-touch broker risk
approaches.
Recommend the most appropriate strategy for each order.
(Note: Each approach should only be used once.)
© Kaplan, Inc. 70


Answer:
◼ The most appropriate approach for the futures trade is
DMA. Futures markets have well evolved electronic
trading, and it is likely that an urgent small trade in futures
can be executed most effectively through accessing
exchange systems directly.
◼ There is no need to employ the high-touch approach of a
broker because the order size is small and can be easily
executed on the exchange.
© Kaplan, Inc. 71

◼ Note: Algorithmic trading is not well developed in derivatives
markets, so scheduled algorithms would likely take too long
to execute a high-urgency trade.
◼ The most appropriate approach for the agency MBS trade
is a high-touch brokered approach. FI markets outside of
Treasuries and corporate bonds typically use high-touch
brokered execution methods.
◼ There is unlikely to be algorithmic or DMA available for
agency MBS.
© Kaplan, Inc. 72


◼ The most appropriate approach for the equity trade is a
scheduled algorithm.
◼ It is likely that the trade, being large, would have too much
market impact if executed through DMA.
◼ It is also unlikely that a high-touch broker trade would be
appropriate, because the trade is not urgent and most
trading in equity markets is conducted electronically.
© Kaplan, Inc. 73
Trade Cost Measurement

◼ Trading costs are either explicit (e.g., commissions and
fees) or implicit—that is, embedded in the transaction
(e.g., market impact/execution risk).
◼ The total costs of trading can be measured using
implementation shortfall (IS).
◼ For the exam, you have to master IS (no excuses)!
© Kaplan, Inc. 74

IS Total Costs of Trading

IS = paper (hypothetical) return – actual return
◼ Paper return is the return a hypothetical portfolio would
have had if the trade were executed at the original decision
price with zero cost.
◼ Actual portfolio return of the portfolio is the net of all costs.
◼ The difference between these two amounts is the total cost
of executing the trade.
© Kaplan, Inc. 75
Example: IS
◼ A PM decides to buy 50,000 shares of stock SJB at
9:00 am when the stock price is $20.00 (DP) and submits
instructions to the firm’s trader.
◼ The trader uses a limit price of $20.50 and in total manages
to purchase 40,000 shares at an average price of $20.34.
◼ The fund is charged a commission of $0.02 per share and
there are no other fees.
◼ At the end of the day, SJB closes at $20.55.
© Kaplan, Inc. 76

Example: IS
Calculate (in basis points) the total IS for this trade.
Answer:
◼ The paper portfolio is hypothetically assumed to fill the full
order at the original decision price (DP) of $20.00.

◼ Hypothetical paper return = 50,000 × ($20.55 – $20.00)
= $27,500
© Kaplan, Inc. 77
Example: IS
◼ The actual return of the portfolio reflects that the trader
purchased 40,000 shares at $20.34, and paid:
40,000 × $0.02 = $800 for the execution
◼ The actual return = 40,000 × ($20.55 – $20.34) – $800
= $7,600
◼ In absolute value terms, IS = $27,500 – $7,600 = $19,900
© Kaplan, Inc. 78

Example: IS
◼ The initial cost of the paper portfolio is 50,000 × $20
= $1,000,000
◼ IS in basis points (bps) is calculated as
$19,900 / $1,000,000 = 0.0199, or 199 basis points (bps)
◼ Note: A basis point is 1/100th of 1%. A decimal number is
multiplied by 10,000 to convert it to basis points.
© Kaplan, Inc. 79
IS Component Costs: Decomposition

◼ Based on a hypothetical analysis requiring assumptions
(e.g., reference prices)
◼ Usually, IS is expressed as basis points of the total cost of
the paper portfolio, but check the question specifics
◼ Initial benchmark or decision price (DP) is the market
price when the trade decision is made (previous trading
close if the market is closed)
© Kaplan, Inc. 80


▪ Execution cost occurs when executed shares trade at a
less favorable price than the original decision price (DP).
▪ Execution cost can be further broken down into delay cost
and trading cost.
1. Delay cost comes from adverse price movements and
occurs between the time the PM submits the order to
the trader and the time the trader places the trade.
© Kaplan, Inc. 81

2. Trading cost is due to the market impact of executing
the trade.
◼ Opportunity cost is the cost of not trading any unfilled part
of the order.
© Kaplan, Inc. 82


◼ Note: A paper portfolio assumes all shares are executed
immediately at the original decision price; the actual trade
may have only filled part of the order, and the lost profit on
the unfilled portion is the opportunity cost.
▪ Fixed fees are any explicit commission or fees incurred in
executing the trade.
© Kaplan, Inc. 83
IS Example
◼ To demonstrate IS decomposition, recall, in our previous
example, we had a total IS of $19,900 and the trader
received the order at 9:00 am, when the stock price was
$20.00.
▪ Assume the trader placed the order at 9:30 am and the
stock’s market price had moved to $20.10 ($20.10 is
referred to as the arrival price (AP) of the order).
▪ The decomposition of IS in dollar terms is as follows.
© Kaplan, Inc. 84

IS Example
▪ Delay cost: Adverse movement from $20.00 to $20.10 for
the 40,000 shares that were executed during the day:
Delay cost = 40,000 × ($20.10 – $20.00) = $4,000
▪ Trading cost: Difference between the execution price (EP),
$20.34, and the arrival price (AP), $20.10, for 40,000
shares traded during the day:
Trading cost = 40,000 × ($20.34 – $20.10) = $9,600
© Kaplan, Inc. 85
IS Example
▪ Opportunity cost: Paper profit on 10,000 shares not
purchased, which relates to a paper profit from buying
these shares at $20.00 and the stock closing at $20.55:
10,000 × ($20.55 – $20.00) = $5,500
▪ Fixed fees: Explicit commission paid on the execution of
40,000 shares:
40,000 × $0.02 = $800
◼ Total IS = $4,000 + $9,600 + $5,500 + $800 = $19,900
© Kaplan, Inc. 86

Improving Execution Performance

▪ Delay costs arise due to adverse price movements
between the trader receiving the PM’s order and executing
the trade or passing it on to a broker.
▪ Delay costs can be minimized with efficient trading
practices that give traders the pretrade and posttrade
analysis needed to make swift decisions to design
optimal trading strategies.
© Kaplan, Inc. 87
Improving Execution Performance

▪ Analyzing opportunity costs can help a PM to deploy
unused cash through the next-most attractive investment.
▪ For example, a PM who thinks only 80% of their order is likely
to be filled can invest the remaining 20% of the order into the
next-most attractive trade, avoiding cash drag on uninvested
funds.
▪ Analysis of trading (market impact) costs can help traders
establish proper price benchmarks and appropriate urgency
of trade.
© Kaplan, Inc. 88

Example: IS Detailed Analysis

▪ A PM decides to sell 100,000 shares of Future Recreation
(FTRB) at 1:05 pm when the share price is £2.56.
▪ The trading desk receives the order and conducts a review
of the trade details to determine the optimal trade strategy.
▪ Due to the low market volume, it is decided that a high-
touch agency broker approach is optimal with a limit price
of £2.50.
© Kaplan, Inc. 89

▪ The trader submits the order to a broker at 1:13 pm, when
the share price is £2.59.
▪ By the end of the day, the broker has executed 70,000
shares at an average price of £2.60, and the commission
for the trade is £400.
▪ At the end of the day, the stock closes at a price of £2.54.
© Kaplan, Inc. 90


1. Calculate the total IS for the trade in basis points.
2. Decompose IS into delay, trading, opportunity, and
fixed‐fee costs.
Answers:
1. Note that because this is a sell order, positive returns are
earned when the actual trading price rises above the
decision price.
© Kaplan, Inc. 91

▪ Return of paper portfolio = 100,000 × (£2.56 – £2.54)
= £2,000
▪ Return of actual portfolio =
70,000 × (£2.60 – £2.54) – £400 = £3,800
◼ IS = paper return – actual return
= £ 2,000 – £3,800 = –£1,800
© Kaplan, Inc. 92


◼ Origin cost of paper portfolio = 100,000 × £2.56 = £256,000
◼ IS (in bps) = –£1,800 / £256,000 = –0.00703, or –70.3 bps
◼ Note: A negative cost is a benefit; it means that the trader’s
actions added value relative to the paper portfolio.
© Kaplan, Inc. 93

▪ If the trader had immediately executed the sell order (with
no costs), the portfolio would be worse off than the actual
portfolio (because prices subsequently rose, and the
executions were made at higher prices).
▪ Negative IS indicates that the trader’s actions benefited
the portfolio.
© Kaplan, Inc. 94


2. Delay cost = 70,000 × (£2.56 – £2.59) = –£2,100
Delay cost (bps) = –£2,100 / £256,000 = –82 bps
◼ Note: Negative delay cost represents value added, because
the price movement during the time the trading desk received
the order and submitted it to the market worked in favor of the
seller.
© Kaplan, Inc. 95

◼ Trading cost = 70,000 × (£2.59 – £2.60= –£700
◼ Trading cost (bps) = –£700 / £256,000 = –27.3 bps
◼ Note: Negative trading cost indicates that the execution price
improved on the arrival price of the order.
© Kaplan, Inc. 96


◼ Opportunity cost = 30,000 × (£2.56 – £2.54 = £600
◼ Opportunity cost (bps) = £600 / £256,000 = 23.4 bps
◼ Fixed fees = £400 (given)
◼ Fixed fees (bps) = £400 / £256,000 = 15.6 bps
◼ Total IS = –82.0 – 27.3 + 23.4 + 15.6 = –70.3 bps
© Kaplan, Inc. 97
Evaluating Trade Execution

◼ Trade cost analysis: Vital for portfolio managers to be
able to assess the effectiveness of brokers, algorithms, and
other strategies
◼ Costs evaluated versus specified price benchmarks, which
vary depending upon the objectives of the manager/nature of
the order
© Kaplan, Inc. 98


◼ Benchmark price could be an arrival price, VWAP, TWAP,
or the closing market price
◼ There can even be more than one relevant benchmark if the
strategy has several objectives
◼ In general, buyers incur costs if they execute trades above
relevant BM prices, while sellers incur costs if they execute
trades below relevant BM prices
© Kaplan, Inc. 99

◼ Trade costs are calculated such that a positive value
represents underperformance against the BM
◼ Can generally be formulated as follows:
absolute cost ($) = side × (EP − BM price) × shares executed
where:
side = +1 for a buy order, –1 for a sell order
EP = execution price
BM = benchmark price
© Kaplan, Inc. 100


◼ These costs are often expressed in basis points of the
original benchmark price, using the following expression:
trade cost (bps) = side × [(EP – BM price) / BM price] × 10,000
where:
EP = execution price
BM = benchmark price
© Kaplan, Inc. 101
Example: Trade Cost

◼ A PM is executing a buy order using a market on close
(MOC) benchmark.
◼ The PM purchases at $25.50, and the closing price of the
stock is $25.60.
◼ Calculate the cost (in basis points) based on the closing
price benchmark.
© Kaplan, Inc. 102

Example: Trade Cost

Answer:
◼ Because this is a buy order, side = +1.
absolute cost per share = +1 × ($25.50 − $25.60) = –$0.10

◼ In basis points, this cost is –$0.10 / $25.60 = –39.1 bps
◼ Negative sign indicates that the trader’s actions added value
(a negative cost is a benefit)
◼ Note: The buy trade was executed below the benchmark
price, and buying low is adding value from a trading
perspective.
© Kaplan, Inc. 103

◼ Regardless of the skill of the trader, buying orders in a
rising market and selling orders in a falling market will incur
positive trading costs due to adverse price movements.
◼ To remove the impact of market movements on trade cost,
traders can use market-adjusted cost.
© Kaplan, Inc. 104


◼ Market-adjusted costs ensure the trader is not penalized
or rewarded for general market movements over the trade
horizon.
◼ This subtracts index cost, adjusted for the security’s beta.
◼ The index cost is a representation of the costs due to general
market index movements, and is calculated as follows.
© Kaplan, Inc. 105
index cost (bps) =
(index VWAP – index arrival price)

side × ———————————————— × 10,000
index arrival price
© Kaplan, Inc. 106

market-adjusted cost (bps) =

arrival cost (bps) − β × index cost (bps)
where:
◼ arrival cost = the arrival cost of the trade based on an arrival
price benchmark
◼ β = beta of the security versus the index used to calculate
index cost
© Kaplan, Inc. 107
Example: Market-Adjusted Cost

◼ A trader submits a buy order to a market when the security
price is €10.00 and a relevant index price is 3,500.
◼ The order is executed over the next hour at an average
price of €10.15.
◼ VWAP for the index over this period is 3,507, and the beta
of the security is 1.5.
◼ Calculate the market-adjusted cost of this trade in bps.
© Kaplan, Inc. 108


Answer:
◼ Because the order is a buy, side = +1.
◼ The index cost in basis points is given by:
index cost (bps) = +1 × [(3,507 – 3,500) / 3,500] × 10,000

= 20 bps
© Kaplan, Inc. 109

◼ The arrival cost of the trade is given by:
arrival cost (bps) = +1 × [(10.15 – 10.00) / 10.00] × 10,000
= 150 bps
◼ The market-adjusted cost is given by:
market-adjusted cost (bps) = 150 − (1.5 × 20) = 120 bps
© Kaplan, Inc. 110

Added Value
◼ A different method of trade cost analysis is comparing the
arrival cost to the estimated pretrade cost.
◼ The estimated pretrade cost is calculated using a model
that incorporates key trade cost variables such as order
size and liquidity of the market.
◼ If a fund executes at less than the pretrade cost estimate,
then the trader has added value.
© Kaplan, Inc. 111
Added Value
◼ More formally:
added value (bps) = arrival cost (bps) − estimated pretrade
cost (bps)
◼ In the previous example, the arrival cost of the trade was
150 bps
◼ If the pretrade cost estimate was 160 bps, then the added
value for the trade is 150 bps − 160 bps = –10 bps
◼ Remember: A negative cost is a benefit.
© Kaplan, Inc. 112

Trade Governance
◼ It is both a good practice and usually required by regulation
that the asset manager has a formal written trade policy
that clearly spells out all trade procedures.
◼ Trade policy has four key areas:
1. Meaning of best execution
2. Factors that determine the optimal trading approach
3. Listing of approved brokers and execution venues
4. Details of the monitoring processes used by the PM
© Kaplan, Inc. 113
Trade Governance
1. Meaning of best execution
◼ Best execution: general term used by regulators to describe
the duty of asset managers to seek the best possible result
for clients when trading their assets
◼ The trade policy should define best execution within the
applicable regulatory framework
© Kaplan, Inc. 114

Trade Governance
◼ Generally, the factors that determine best execution
include:
◼ Execution price
◼ Trading costs
◼ Speed and likelihood of execution and settlement
◼ Order size and liquidity
◼ Nature of the trade (e.g., urgency of the trade)
© Kaplan, Inc. 115
Trade Governance
◼ Note: Best execution does not simply mean seeking the
best price or trading at the lowest cost .
◼ For example, a PM who holds many shares in a firm and is
confident the firm is going to file for bankruptcy would likely
achieve better results for clients if . . .
© Kaplan, Inc. 116

Trade Governance
◼ . . . they sell a block with a trusted dealer at a significantly
discounted price, even if there were higher bids for small
quantities at other lit execution venues.
◼ Note: This could be justified as best execution because of the
execution risk of adverse market movements and the risk of
information leakage if the PM began hitting the bids at the
execution venues.
© Kaplan, Inc. 117
Trade Governance
2. Factors that determine the optimal execution approach
◼ The trade policy needs to communicate these criteria:
◼ Urgency and size of the order
◼ Liquidity of security (ADV) and the nature of security
(e.g., standardized vs. customized)
◼ Characteristics of available execution venues
© Kaplan, Inc. 118

Trade Governance
◼ Investment strategy objectives (e.g., long term vs. short term
in nature)
◼ Reason for the trade
◼ Note: Factors need to reflect both relevant regulations and
market trading conventions for different asset classes used
by the portfolio manager.
© Kaplan, Inc. 119
Trade Governance
◼ Soft-dollar arrangements: Arrangements where an asset
manager can pay for goods or services using rebates from
client commissions, offered in return for executing a high
amount of volume with the broker
◼ May jeopardize best execution if the manager uses the
client’s soft dollars for the manager’s own benefit
© Kaplan, Inc. 120

Trade Governance
3. List of eligible brokers and execution venues
◼ The trade policy should include a list of approved brokers,
with a description of the process used to create it
◼ Best practice is to establish a best execution monitoring
committee (BEMC)
◼ Consists of portfolio execution, compliance, and risk personnel
responsible for maintaining, updating, and distributing the list to
parties involved in trade execution
© Kaplan, Inc. 121
Trade Governance
◼ General principles for approval to the list include:
◼ High quality of service in terms of competitive execution price
or speed of service/trade size capacity
◼ Financial stability to mitigate counterparty risk
◼ Good reputation for ethical behavioral
◼ Adequate settlement facilities
◼ Competitive explicit costs (e.g., commissions)
◼ Willingness to commit capital to principal trades when
required for less liquid securities
© Kaplan, Inc. 122

Trade Governance
4. Process for monitoring execution arrangements
◼ The approved broker list should be constantly monitored for
reputational issues, trading error frequency, criminal actions,
and financial stability.
◼ Any brokers who fail to meet the required standard should be
removed promptly.
© Kaplan, Inc. 123
Trade Governance
◼ Execution quality should also be monitored on an ongoing
basis.
◼ Trading records should be kept in order to facilitate this
analysis and to address any client or regulator concerns

regarding the executions or trade allocations made by
an asset manager to her clients.
© Kaplan, Inc. 124


Case Studies
Portfolio Performance Evaluation
Performance Evaluation
◼ Performance evaluation of a portfolio is important to
managers, sponsors, and clients who need to quantify
performance and understand key drivers of both risk and
return.
◼ Some of the calculations in the reading, if done in full, can
be extremely tedious and are best left to spreadsheets and
software programs.
© Kaplan, Inc. 2

For the exam:
◼ Expect the calculations to be reasonable. Also expect a fair
balance of testing on both the calculations and the
qualitative concepts.
◼ There is a sizable amount of material in the reading that
overlaps with previous readings as well as the subsequent
reading on investment manager selection.
© Kaplan, Inc. 3
◼ In a large institutional portfolio, it is common to have
multiple investment managers where decisions are made
by both the fund sponsor as well as by individual managers
within the fund that affect portfolio performance.
◼ Performance evaluation can deconstruct returns to quantify
which decisions added or subtracted value for the fund.
© Kaplan, Inc. 4

◼ The fund sponsor’s perspective will capture all value added
or lost, while the manager’s perspective will focus only on
what a manager did to add or lose value for the fund.
◼ The objective of the reading is to provide the tools
necessary to evaluate active investment decisions
made by plan sponsors and portfolio managers.
© Kaplan, Inc. 5
Components of Performance Evaluation

1. Performance measurement
◼ Compute the return.
2. Performance attribution
◼ Determine the source of the return.
3. Performance appraisal
◼ Assess whether the return is due to skill.
© Kaplan, Inc. 6

Components of Performance Evaluation

In summary, performance evaluation answers three questions
regarding a portfolio’s performance:
1. What performance did the fund achieve during the period
(performance measurement)?
2. How did the fund manager achieve their performance
(performance attribution)?
3. Did the fund manager achieve their performance via skill
or luck (performance appraisal)?
© Kaplan, Inc. 7
Performance Attribution
◼ It is crucial to analyze the results of performance attribution
as part of the portfolio evaluation process.
◼ For performance attribution to be a useful tool, it is
imperative that the attribution process account for all
aspects of the fund’s risk and return.
◼ An attribution that does not account for the total risk and
return of the fund is misleading and cannot be relied upon
for any meaningful analysis.
© Kaplan, Inc. 8

An effective performance attribution process includes:
◼ A reflection of 100% of the portfolio’s return or risk
exposure.
◼ The portfolio manager’s current decision-making process.
◼ The active investment decisions taken by the portfolio
manager.
◼ A full explanation of the portfolio’s excess return and risk.
© Kaplan, Inc. 9
Return Attribution and Risk Attribution

◼ Return attribution evaluates the impact of the active
portfolio management decisions on the fund’s investment
returns.
◼ Risk attribution is the parallel of return attribution but
analyzes the impact of the portfolio manager’s active
investment decisions on portfolio risk.
© Kaplan, Inc. 10

Return Attribution and Risk Attribution

◼ Risk is generally compared to the portfolio’s appropriate
benchmark, but it can also be calculated in absolute terms,
independent of a benchmark.
◼ For example, a relative-based risk attribution analysis
would not be appropriate for a portfolio manager who
has predetermined an absolute target return investment
goal.
© Kaplan, Inc. 11
Micro Attribution vs. Macro Attribution

◼ Micro attribution analyzes the portfolio at the portfolio
manager’s level.
◼ It seeks to verify that the portfolio manager did what they
said they would and to understand the drivers of the
portfolio’s return.
© Kaplan, Inc. 12

Micro Attribution vs. Macro Attribution

◼ Macro attribution analyzes investment decisions at the
fund sponsor’s level; it’s commonly used with institutional
investing.
◼ Macro attribution quantifies the fund sponsor’s decisions
to deviate from their strategic asset allocation and the
timing when they made those decisions.
© Kaplan, Inc. 13
◼ There are multiple methods used in performance
attribution, including returns-based, holdings-based, and
transactions-based attribution.
◼ The primary drivers that determine which method to
select for performance attribution depend upon the
availability of the portfolio data and the investment
process that is being measured.
© Kaplan, Inc. 14

Returns-Based Attribution
◼ Returns-based attribution uses regressions to analyze the
portfolio returns over some period, and it isolates the asset
class components through indexes that would have
generated these returns.
◼ There is no attempt to determine the actual holdings
of the portfolio. Instead, regressions of broad market
indexes are run against the portfolio returns to
decompose investment performance.
© Kaplan, Inc. 15
Holdings-Based Attribution
◼ Holdings-based attribution uses beginning-of-period
portfolio assets; the accuracy of analysis improves as the
time interval for the analysis becomes smaller (e.g., annual
to monthly to weekly).
◼ Since holdings-based attribution does not adjust for any
portfolio changes that are made after the initial period,
this analysis frequently does not match the actual
portfolio returns.
© Kaplan, Inc. 16

Holdings-Based Attribution
◼ The mismatch could be called a timing or trading effect.
◼ It is recommended that holdings-based analysis be used
for passive funds (e.g., index funds) and other strategies
that have very little turnover (e.g., buy and hold).
◼ Holdings-based attribution frequently offers a higher level
of quality of attribution analysis than returns-based
attribution and can detect style drift much faster.
© Kaplan, Inc. 17
Transactions-Based Attribution
◼ It improves upon the holdings-based attribution by updating
the attribution of the portfolio’s beginning-of-period holdings
with any subsequent trades.
◼ Both the weights and the returns of the portfolio will reflect
the actual transactions, including any transaction costs.
◼ Transactions-based attribution is the most reliable of the
measures; it is also frequently the most complicated, time-
consuming, and complex method to implement.
© Kaplan, Inc. 18

Approaches to Return Attribution

Arithmetic Attribution vs. Geometric Attribution
For a periodic portfolio return R, and benchmark return B
◼ Arithmetic (additive) active return = R – B
◼ Geometric (multiplicative) active return = (1 + R) / (1 + B) − 1
◼ Key Point: Geometric active returns compound over time to
give accurate multi-period active returns
◼ However, all the models that follow are arithmetic in nature
© Kaplan, Inc.
The Brinson Model

The Brinson Model comprises two methods:
1. Brinson-Hood-Beebower (BHB) method
2. Brinson-Fachler (BF) method
Both methods break active return (R – B) into:
1. Allocation Effect: overweight/underweight sectors or styles
2. Selection Effect: stock picking
3. Interaction Effect: the interaction of the above two terms
© Kaplan, Inc.

Equity Return Attribution—

the Brinson-Hood-Beebower (BHB) Method
◼ The following equations illustrate the computations and a
simple calculation using the BHB method:
© Kaplan, Inc.
Equity Return Attribution—the BHB Method

where:
wi = portfolio weight of the ith sector/style
Ri = portfolio return in the ith sector/style
Wi = benchmark weight of the ith sector/style
Bi = benchmark return in the ith sector/style
n = number of sectors/styles
© Kaplan, Inc.

BHB Method Example
Style Weight in Return in Weight in Return in

Portfolio Portfolio Benchmark Benchmark
Growth 75% 13% 60% 10%
Value 25% 19% 40% 20%
Total 100% 100%
© Kaplan, Inc.
BHB Method Example

Growth 75% 13% 60% 10%
Value 25% 19% 40% 20%
Total 100% 14.5% 100%
Portfolio return (R) = (0.75 × 13%) + (0.25 × 19%)
© Kaplan, Inc.

BHB Method Example

Growth 75% 13% 60% 10%
Value 25% 19% 40% 20%
Total 100% 14.5% 100% 14%

Benchmark return (B) = (0.60 × 10%) + (0.40 × 20%)
© Kaplan, Inc.
BHB Method Example

Growth 75% 13% 60% 10%
Value 25% 19% 40% 20%
Total 100% 14.5% 100% 14%

Benchmark return (B) = (0.60 × 10%) + (0.40 × 20%)
Active Return = R – B = 14.5% – 14% = 0.50%
© Kaplan, Inc.


◼ The allocation effect for segment i (Ai) is calculated as the
difference between the portfolio and benchmark weights,
multiplied by the sector return in the benchmark.
Ai = (wi – Wi)Bi
© Kaplan, Inc.

◼ Using the previous data, style allocation effects are:
◼ Growth: (0.75 – 0.60) × 10% = 1.5%
◼ Value: (0.25 – 0.40) × 20% = -3.0%
◼ The total portfolio allocation effect is simply calculated by
adding up all of the individual allocation effects.
© Kaplan, Inc.


Total allocation effect = 1.5% – 3.0% = –1.5%
◼ PM overweighted growth style compared to the BM (0.75
versus 0.60)
◼ Decision to overweight growth increased the overall
return, resulting in a growth allocation effect of 1.5%
© Kaplan, Inc.

◼ PM underweighted value style compared to the BM (0.25
versus 0.40)
◼ Decision to underweight value decreased the overall
return, resulting in a value allocation effect of –3.0%
◼ Aggregate allocation effect negatively contributed to the
value add of the portfolio—aggregate allocation effect
was –1.5%
© Kaplan, Inc.


◼ The selection effect for segment i (Si) is calculated as the
benchmark weight multiplied by the difference between the
portfolio and the benchmark style returns.
Si = Wi (Ri – Bi)
© Kaplan, Inc.

◼ Using the previous data, individual style selection effects
are calculated as follows:
◼ Growth: 0.60 × (13% – 10%) = 1.8%
◼ Value: 0.40 × (19% – 20%) = –0.4%
◼ The total portfolio selection effect is simply calculated by
adding up all of the individual selection effects.
© Kaplan, Inc.


Total selection effect = 1.8% – 0.4% = 1.4%
◼ Portfolio’s growth style outperformed the BM’s growth style
by 3% (13% − 10%);
3% × 0.60 BM weight = 1.8% selection effect
◼ Portfolio’s value style underperformed the BM’s value style
by –1% (19% − 20%);
–1% × 0.40 BM weight = –0.4% selection effect
© Kaplan, Inc.

◼ The third component in the BHB model is the interaction
effect, which measures the impact of the previous two
effects acting together simultaneously.
◼ For example, a manager who overweights styles where
there is good stock picking ability will have positive
interaction effect.
© Kaplan, Inc.


◼ For a given style, the interaction effect (Ii) is calculated as
the difference between the portfolio and benchmark
weights multiplied by the difference between the portfolio
and style returns.
Ii = (wi – Wi)(Ri – Bi)
Using the previous data, individual sector allocation effects:
Growth: (0.75 – 0.60) × (13% – 10%) = 0.45%
Value: (0.25 – 0.40) × (19% – 20%) = 0.15%
© Kaplan, Inc.

◼ The total portfolio interaction effect is simply calculated by
summing the individual interaction effects.
◼ Total interaction effect = 0.45% + 0.15% = 0.60%
© Kaplan, Inc.


Analyzing the aggregate results:
◼ Allocation effect: –1.50%
◼ Selection effect: 1.40%
◼ Interaction effect: 0.60%
Total active return of portfolio: 0.50%
© Kaplan, Inc.

the Brinson-Fachler (BF) Method
◼ Issue with the BHB model:
◼ Allocation decision to overweight growth was wrong, yet
the allocation effect for growth was positive…
◼ This minor drawback of the BHB model is fixed by the
BF model…
© Kaplan, Inc.


the Brinson-Fachler (BF) Method
◼ The allocation effect for style i (Ai) is calculated as the
difference between the portfolio and benchmark weights,
multiplied by the difference between the sector return in the
benchmark and the overall return for the benchmark (note
the subtle difference from the BHB method in red below).
Ai = (wi – Wi) × (Bi – B)
© Kaplan, Inc.
Equity Return Attribution—the BF Method

◼ Using the previous data, style allocation effects are:
◼ Growth: (0.75 – 0.60) × (10% – 14%) = –0.60%
◼ Value: (0.25 – 0.40) × (20% – 14%) = –0.90%
◼ Total allocation effect = –0.6% – 0.9% = –1.5%
◼ Key Point: Under the BF method it is explicitly obvious that
the decision to overweight growth had a negative impact on
active returns (this was not the case under BHB)
© Kaplan, Inc.

Equity Return Attribution—BHB vs. BF Methods

◼ Total allocation effect is the same under BHB and BF
◼ Only the individual allocation effects for segments of the
portfolio differ
◼ Selection and interaction effects are computed in exactly
the same way under both the BHB and BF methods
◼ Both methods have the same overall goal of breaking
active return into allocation, selection, and interaction
effects
© Kaplan, Inc.
Return Attribution—Macro vs. Micro
Macro Attribution
Applies to the decisions of the sponsor (e.g., a university
endowment)
◼ Allocation effect: relates to tactical allocation decisions
to overweight/underweight asset classes and/or styles
◼ Selection effect: relates to external manager selection
© Kaplan, Inc.

Return Attribution—Macro vs. Micro
Micro Attribution
Applies to the decisions of the individual portfolio managers
(e.g., an external manager allocated to by the sponsor)
◼ Allocation effect: relates to allocation decisions to
overweight/underweight sectors/styles within portfolio
◼ Selection effect: relates to stock-picking ability
© Kaplan, Inc.
Micro Attribution Using BF Method
© Kaplan, Inc.

Micro Attribution—Analysis of Growth PM

Allocation effect = (0.50 − 0.30) × [8% – 14%] = –1.20%
◼ Growth manager allocated poorly by overweighting large-cap
growth stocks in a period where large cap growth
underperformed
© Kaplan, Inc.

growth stocks in a period where sector underperformed
Selection effect = 0.30 × (15% – 8%) = 2.10%
◼ Manager was a good stock picker in large-cap growth sector
© Kaplan, Inc.


growth stocks in a period where sector underperformed
Selection effect = 0.30 × (15% – 8%) = 2.10%
◼ Manager was a good stock picker in large-cap growth sector
Interaction effect = (0.50 – 0.30) × (15% – 8%) = 1.40%
◼ Manager overweighted sector in which they are good stock picker
© Kaplan, Inc.
Equity Return Attribution—Factor-Based Return

◼ Fundamental factor model allows a portfolio’s sensitivity
to additional factors (outside of allocation/selection) to be
analyzed
◼ Carhart model calculates the excess return from active
portfolio management by determining the impact on the
portfolio of the following factors:
(1) market index excess return (RMRF), (2) market
capitalization (SMB), (3) book value to price (HML), and
(4) momentum (WML)
© Kaplan, Inc.

Carhart Model
Rp − Rf = ap + bp1RMRF + bp2SMB + bp3HML + bp4WML + Ep

Where:
Rp = portfolio return
Rf = risk-free rate
ap = alpha or return above the expected return for the
portfolio’s level of systematic risk
bp = portfolio factor sensitivities
Ep = portfolio return not explained by model
© Kaplan, Inc.
Sample Carhart Factor Model Attribution
© Kaplan, Inc.


◼ Looking at the BM (column 2), the sensitivity to RMRF of 1
indicates that the BM is a diversified index of average
systematic risk.
◼ The negative coefficient of the BM’s sensitivity to SMB
indicates the BM has a large-cap focus tilt.
◼ We can summarize the BM as large-cap blend (no tilt
toward growth or value) that does not use momentum.
© Kaplan, Inc.

◼ To analyze the active investment decisions by the PM,
review column 3 (difference between portfolio and BM).
◼ The portfolio exhibits a value tilt but closely
resembles the BM on the other factors.
© Kaplan, Inc.


◼ Next, determine if the value tilt taken by the PM added
value to the portfolio.
◼ From the factor sensitivities table, the value tilt
contributed 1.29%, or over 78%, of the total realized
active return for the portfolio.
◼ Other effects were minor compared to the value tilt taken
by the PM.
◼ The PM’s effectiveness at stock picking (security selection)
detracted slightly (–0.10%) from the portfolio’s returns.
© Kaplan, Inc.
Fixed-Income Return Attribution

Three common methods of fixed-income attribution include:
1. Exposure decomposition—duration based.
2. Yield curve decomposition—duration based.
3. Yield curve decomposition—full-repricing based.
For the exam: Candidates are not responsible for FI
attribution calculations, only interpreting the output.
© Kaplan, Inc.

1. Exposure Decomposition—Duration
◼ Top-down method that utilizes duration to quantify impact
of active PM decisions regarding:
◼ Interest rates (duration and curve effect)
◼ Sector selection (e.g., government vs. corporate)
◼ Individual bond selection
◼ Uses duration-segmented portfolios (based on market
value weights) and attributes active returns to the above
effects for each duration “bucket”
© Kaplan, Inc.
2. Yield Curve Decomposition—Duration

◼ Attributes active return of manager to differences in:
◼ Coupon income
◼ Rolldown return
◼ Impact of parallel shift in benchmark rates and spreads
◼ Impact of change in shape of the yield curve
◼ Unexplained movements
◼ Requires more data and is more complex than exposure

decomposition
© Kaplan, Inc.

3. Yield Curve Decomposition—Full Repricing

◼ Securities can be repriced from zero-coupon curves or spot rates
◼ Using spot rates is called full-repricing method and is the
most accurate measure of price changes in securities
◼ Active return can be attributed to cash flows at each individual
maturity in the portfolio and benchmark
◼ The full-repricing method is most complex and expensive
fixed-income attribution method to use
◼ See SchweserNotes and CFAI for FI Exposure Decomposition
Analysis examples; focus on interpreting results.
© Kaplan, Inc.
Risk Attribution
◼ Choosing appropriate risk metrics for attribution analysis
requires an in-depth understanding of the process by PMs.
◼ They must identify a top-down or bottom-up process and
define the portfolio’s appropriate BM.
◼ Only looking at returns is insufficient to evaluate the
process; risk taken by the PM needs to be analyzed.
◼ Risk attribution identifies the sources of risk taken by the
PM that resulted in the fund’s returns.
© Kaplan, Inc.

Risk Attribution
© Kaplan, Inc.
Risk Attribution
◼ Tracking risk (or tracking error) is the relevant risk measure
for relative attribution analysis.
◼ General objective: Determine the returns generated
from active management and compare them to the
amount of tracking risk assumed.
◼ Absolute attribution analysis quantifies general risk arising
from market, size, and style exposures and specific risk
arising from stock picking. A common risk measure to use
is standard deviation.
© Kaplan, Inc.

Risk Attribution
◼ Bottom-up approach: Each security in the portfolio has a
marginal contribution to tracking risk, and that amount is
multiplied by its active weight to determine the contribution
to tracking risk.
◼ Top-down approach: This takes a more macro approach
and attributes active return to allocation; then it attributes
tracking error to allocation and selection.
© Kaplan, Inc.
Benchmarking Investments and Managers

Liability-Based Benchmarks
◼ A more frequent BM in institutional investing is the
liability-based BM, which is likely to be used by fund
sponsors and PMs when a firm has a specific liability to
pay in the future.
◼ A liability-based BM focuses on the cash flows
necessary to satisfy the liability and frequently limits the
investment choices available to the PM.
© Kaplan, Inc. 62


◼ Frequently used assets within a liability-based benchmark
include:
◼ Nominal bonds.
◼ Inflation-adjusted bonds.
◼ High-quality stocks.
© Kaplan, Inc. 63

Some of the plan features will likely impact the structure of the
liability and therefore impact which assets the PM should
select to meet those cash flows, including:
◼ How many years until the average number of workers will
retire in the plan.
◼ How many workers have already retired and are drawing
cash from the plan.
◼ The impact of inflation on the liabilities.
© Kaplan, Inc. 64


◼ The correlation between the company’s operating profit
(EBIT) and the plan assets.
◼ If the plan is frozen or has a terminal life.
◼ Any actuarial assumptions, including life expectancy and
required discount rate for the plan.
© Kaplan, Inc. 65
Benchmark Types
Asset-Based Benchmarks
The seven primary types of benchmarks are as follows:
1. Absolute return—earn a fixed return (or more).
2. Manager universes—earn the median manager’s return.
3. Broad market indexes—earn a broad market BM’s
return.
4. Style indexes—earn a style index’s return.
© Kaplan, Inc. 66

Benchmark Types
5. Factor-model-based—earn the return that would have
been received from a set of risk factor exposures (e.g.,
CAPM).
6. Returns-based—earn the return that would have been
received from a set (weightings) of style indexes.
7. Custom security-based—earn the return from some
prespecified combination of the above.
© Kaplan, Inc. 67
Summary
Advantages Disadvantages
Absolute Simple Not investable
Manager Subject to
Measurable
universes “survivor bias”
Widely available,
Broad Manager’s style
unambiguous, investable,
market may differ from the
measurable, specified in
indexes index style
advance
© Kaplan, Inc. 68

Summary
Differing definitions,
Style
Widely available weightings may be
indexes
inappropriate
Helps better Not always intuitive, easy to
Factor-
understand a obtain, specified in advance,
model-
manager’s or investable
based
investment style
© Kaplan, Inc. 69
Summary
Returns- Easy to use, A sufficient number of
based intuitive, meets monthly returns would be
most of the needed; the style indexes
benchmark criteria may be unacceptable
Custom Meets all Expensive to construct and

security- benchmark criteria maintain; lack of
based transparency
© Kaplan, Inc. 70

Custom Security-Based Benchmarks

◼ Identify the manager’s investment process, asset selection
(including cash), and weighting.
◼ Regression of past returns is often used.
◼ Use the same assets and weighting for the benchmark.
◼ Assess and rebalance the benchmark on a predetermined
schedule.
© Kaplan, Inc. 71
Properties of a Valid Benchmark

▪ Specified in advance
▪ Appropriate
▪ Measurable
▪ Unambiguous
▪ Reflective of (the manager’s) investment opinions/style
▪ Accountable (owned)
▪ Investable
© Kaplan, Inc. 72

Benchmark Quality Evaluation

◼ A portfolio return can be broken up into three components:
market, style, and active management.
P=M+S+A S=B–M A=P–B
P = manager’s portfolio return
M = market return
S = incremental return due to manager investment style
B = the return of the manager’s style benchmark
A = incremental return (alpha), manager value added 73
© Kaplan, Inc.
Components of Portfolio Return

Passive investing in the market portfolio earns M*.
P=M S and A = 0*
Passive investing in the style benchmark earns B*.
P=B S=B–M A = 0*
An active manager seeks to earn +A.
P=M+S+A
* Ignoring transaction and management expenses

© Kaplan, Inc. 74

Benchmarking Alternative Investments

Hedge Funds
Three general types of benchmarks could be considered for
hedge funds:
1. Broad market indexes.
2. Risk-free rate.
3. Hedge fund peer universes.
But they present some problems:
© Kaplan, Inc. 75

Broad market indexes are not appropriate as a BM:
◼ Hedge funds cover a wide range of investment strategies.
◼ Hedge funds differ significantly from each other and can have
wide asset allocation fluctuations in the long term.

◼ They can use leverage, short positions, and derivatives.
◼ There is an overall lack of liquidity, transparency, and ability to
monitor.
◼ There is low or no correlation of returns with the broad market
index. 76
© Kaplan, Inc.

Arbitrage strategies that use the risk-free rate with an added

spread:
◼ The majority of hedge funds carry some systematic risk;
the use of leverage exacerbates the risk, resulting in the
spread needing to be increased accordingly.
◼ The lack of correlation of hedge fund returns and the risk-
free rate makes the risk-free rate an unsuitable benchmark.
© Kaplan, Inc. 77

Hedge fund peer universes:
◼ Not suitable because a specific peer group’s risk and return
objectives not likely to match those of a specific hedge fund
◼ Subject to backfill and survivorship bias
◼ Due to the frequent illiquidity of underlying assets, current

pricing may be based on appraisal or prior period price
◼ May be a smoothing effect, reducing reported standard
deviation and increasing the Sharpe ratio and the

allocation to hedge funds
© Kaplan, Inc. 78


Real Estate
◼ BMs are derived from a sample of the RE universe, so they
are not completely representative of the RE asset class.
◼ Performance of the index probably bears a very high
correlation to the largest investments.
◼ BM returns are self-reported and are value-based, so they
could be biased toward the most expensive properties or
geographical areas.
© Kaplan, Inc. 79

◼ Use of appraisal data (e.g., infrequent pricing) leads to
smoothing effect and understated volatility or risk
◼ Lack of comparability with BM returns given that some BM
use leverage while others do not
◼ Indexes assume no transaction costs, full transparency,
and normal liquidity—not normally the case
© Kaplan, Inc. 80


Private Equity
◼ Benchmarks exist to allow for performance comparisons for
specific PE funds and that of a relevant peer group.
◼ A common metric used is usually IRR.
© Kaplan, Inc. 81

◼ Key problems with such PE benchmarks include:
◼ Managers using different methods of valuation, which
makes comparison more difficult.
◼ The IRR may be biased by losses or gains occurring
near the beginning of an investment.
© Kaplan, Inc. 82


Commodities
◼ BMs for commodity investments are usually based on
futures as opposed to actual assets.
◼ Similar to other alternative investments, the different
amounts of leverage employed by portfolios versus BMs
and the different weightings of exposures between
portfolios and BMs make the benchmarking process
problematic for commodities.
© Kaplan, Inc. 83

Managed Derivatives
◼ Managed derivatives use specific BMs because of the lack
of market indexes.
◼ BMs may be too specific or not specific enough for a given
investment strategy and, therefore, are not suitable.
◼ Peer group–based BMs exist that are subject to problems
such as stale pricing and survivorship and backfill bias.
© Kaplan, Inc. 84


Distressed Securities
◼ Given the illiquidity and severe lack of marketability of
distressed securities, it is almost impossible to determine
an appropriate BM.
◼ Should the financial state of a distressed company become
better, it may become more liquid. However, it is likely to
require a significant amount of time to occur and that
creates valuation problems (e.g., stale pricing).
© Kaplan, Inc. 85
Appropriate Choice of Benchmark

◼ Garbage in, garbage out is appropriate to use regarding the
impact of BM misspecification on attribution and appraisal
analysis.
◼ Useful performance evaluation (and any of its three
components) requires an appropriate fund BM.
© Kaplan, Inc. 86

Appropriate Choice of Benchmark

◼ When an incorrect BM is used in the performance
evaluation process, then performance measurement,
attribution, and appraisal analysis will not be useful or
provide valid information on understanding the investment
process.
◼ Misspecified BMs will result in misfit active return.
© Kaplan, Inc. 87
Performance Appraisal
◼ The final stage of the performance evaluation process is
performance appraisal.
◼ Performance appraisal is designed to assess whether
the investment results are more likely due to skill or
luck.
◼ Should we hire or fire the manager?
◼ Can the fund manager outperform their appropriate
benchmark on a risk-adjusted basis consistently?
© Kaplan, Inc. 88

Risk-Adjusted Performance
The following seven appraisal measures will be discussed
(the first five are risk-adjusted measures):
1. Sharpe ratio.
2. Treynor ratio.
3. Information ratio.
4. Appraisal ratio.
© Kaplan, Inc. 89
Risk-Adjusted Performance
5. Sortino ratio.
6. Capture ratios (upside and downside).
7. Drawdown (maximum drawdown, drawdown duration).
© Kaplan, Inc. 90

1. Sharpe Ratio
▪ The portfolio’s excess return, relative to the portfolio’s total

risk
▪ Assumes returns are normally distributed
▪ Denominator does not differentiate between volatility that is
upside versus downside
© Kaplan, Inc. 91
2. Treynor Ratio
▪ The portfolio’s excess return relative to the portfolio’s

systematic risk
▪ Most appropriate for well-diversified portfolios
© Kaplan, Inc. 92

3. Information Ratio
◼ Sharpe is excess return to total risk (standard deviation)

◼ IR is value added to standard deviation of value added
◼ Denominator is known as tracking risk
© Kaplan, Inc. 93
4. Appraisal Ratio
▪ Calculated as alpha divided by standard deviation of the

residual / unsystematic risk (e.g., the standard error of the
regression)
▪ AR is the ratio of returns from active management over risk
of active management
© Kaplan, Inc. 94

5. Sortino Ratio
▪ Sortino ratio only considers the standard deviation of the

downside risk compared to MAR (instead of RF rate)
▪ Positive volatility with the upside can be considered good
volatility
▪ Provides a more meaningful view of risk-adjusted
performance
© Kaplan, Inc. 95
6. Capture Ratios
◼ Capture ratios determine the manager’s relative
performance when markets are up or down.
◼ Consider an up market where the index or benchmark
return is positive. The question is whether the manager’s
portfolio return is also positive and if it is above or below
the benchmark return.
◼ They are usually calculated as upside capture divided by
downside capture.
© Kaplan, Inc. 96

7. Drawdown
◼ Drawdown duration is the total time required to fully recover
a drawdown; it is from when the drawdown commences up
to when the cumulative drawdown is zero.
◼ Drawdown duration can be subdivided into a drawdown
phase and a recovery phase.
◼ Maximum drawdown occurs at the very end of the
drawdown phase and at the very start of the recovery
phase; it is the point at which the cumulative drawdown is
at its highest (in absolute terms). 97
© Kaplan, Inc.
7. Drawdown
© Kaplan, Inc. 98

7. Drawdown
▪ Maximum drawdown is –15.56% and the drawdown
duration is approximately 10 months (from beginning of
drawdown in 02/2018 to full recovery of drawdown in
12/2018)
© Kaplan, Inc. 99
Manager Skill Evaluation

◼ The skill of an investment manager can be evaluated
through attribution analysis.
◼ An example of each type of analysis is provided next.
© Kaplan, Inc. 100

Example of Attribution Analysis

◼ Manager X has a benchmark of the Euronext 100. The
following summary information states that Manager X
underperformed the benchmark by 67 bps.
◼ The question is whether the underperformance is due to
lack of skill or bad luck.
© Kaplan, Inc. 101
© Kaplan, Inc. 102


◼ PM underperformed the benchmark by 12 bps due to
country weighting decisions
◼ Although PM made a good decision in underweighting the
Netherlands by 4% because it underperformed the total
benchmark by 2.34%, PM made bad decisions in all of the
other countries
◼ Overall, PM was not successful with country weighting
decisions
© Kaplan, Inc. 103

◼ PM underperformed the benchmark by 56 bps due to stock
picking decisions
◼ Although PM selected outperforming stocks in the
Netherlands and Belgium that earned a total of 32 bps,
there was significant underperformance in France that lost
81 bps
◼ Overall, PM was not successful with picking stocks
© Kaplan, Inc. 104

Example of Appraisal Analysis
© Kaplan, Inc. 105

◼ Manager X’s volatility of returns (as measured by standard
deviation) is only slightly below that of the BM.
◼ Manager X’s volatility of returns is between that of Manager
Z (Z is lower by about 1.5%) and Manager Y (Y is higher by
about 2.1%).
◼ Those observations are confirmed by the Sharpe ratios for
all three managers and the BM (using an assumed risk-free
rate of 2%).
© Kaplan, Inc. 106


◼ Conclusions based on the Sharpe ratio are consistent with
those for the Treynor ratio and IR; the latter two focus on
systematic risk.
◼ Given that both Manager X and Manager Z
underperformed the BM, it makes sense that their IRs are
negative.
◼ Therefore, on the basis of systematic risk only, Manager
X did not perform as well as Manager Y or the BM.
© Kaplan, Inc. 107

◼ Manager X’s Sortino ratio of 0.75 is higher than its Sharpe
ratio of 0.63.
◼ Manager X should be able to earn greater returns in
relation to the 4% threshold for measuring downside
risk.
© Kaplan, Inc. 108


Conclusion
◼ Overall, Manager X was not able to demonstrate sufficient
skill in investing as demonstrated by losses incurred due to
poor country allocation and poor stock selection decisions,
relative to the BM.
◼ Additionally, on a risk-adjusted basis, Manager X did
outperform Manager Z but fell short when compared to
Manager Y and the BM.
© Kaplan, Inc. 109

◼ Consideration may need to be given to replacing Manager
X.
◼ Look for a suitable manager who is able to outperform
the BM in terms of country allocation and stock selection
as well as outperform its peers on a risk-adjusted basis.
© Kaplan, Inc. 110


Case Studies
Investment Manager Selection
Exam Focus
◼ The investment manager selection process involves
quantitative and qualitative considerations. The focus of
this reading is primarily qualitative.
◼ Some topics in the reading (e.g., returns-based and
holdings-based style analysis and pooled investment
vehicles) are covered in other areas of the curriculum or
were covered in previous levels.
© Kaplan, Inc. 2

Exam Focus
◼ Critical topics for the exam from this reading include:
◼ Type I and II errors
◼ Capture ratios and drawdowns
◼ Computing performance-based fees
© Kaplan, Inc. 3
Manager Selection Process

Due diligence:
◼ Analysis and investigation that supports an investment
decision, action, or recommendation taken by investment
team
◼ Must emphasize the sources and reasons behind the
actual returns generated in the past—“look beyond the
numbers”
© Kaplan, Inc. 4


Due diligence:
◼ Critical assessment and judgement are needed to assess
the likelihood that the investment manager can repeatedly
earn sufficient or better returns in the future using the
same investment process. (Is the manager consistent?)
◼ Overall, due diligence must consider manager universe,
quantitative analysis, and qualitative analysis.
© Kaplan, Inc. 5

Manager universe:
◼ Should consider only those managers who meet the
client’s objectives and constraints that are stated in the IPS
(suitability)
◼ Invest in the relevant style (e.g., large-cap, growth,
blend) desired by the client
◼ Manage the portfolio with the appropriate balance
between active versus passive approaches
© Kaplan, Inc. 6


◼ A process of elimination is recommended that balances
having too many or too few managers in the candidate
pool from which to make a selection.
◼ Defining the purpose for the manager search is critical
(e.g., desire for a specific new strategy, risk exposure, or to
diversify a portfolio).
◼ Benchmark can be determined using one or more of these:
third-party categorization, returns-based style analysis,
holdings-based style analysis, and manager experience.
© Kaplan, Inc. 7

◼ At the manager universe stage, there should not be any
performance assessment; that will occur later during
quantitative analysis.
◼ Instead, there should be an emphasis on the manager’s
risk profile and fit with the client’s objectives and
constraints.
© Kaplan, Inc. 8

Quantitative Analysis
◼ Manager’s performance should be evaluated objectively in
terms of the distribution of past returns.
◼ Through performance attribution and appraisal, one can
distinguish between managerial skills and luck.
◼ Use capture ratio to review performance in both good and
weak market conditions.
◼ Check for any significant drawdowns.
© Kaplan, Inc. 9
Qualitative Analysis
Two important issues:
1. What is the likelihood that the same level of returns will
continue in the future?
2. Does the manager’s investment process account for all
the relevant risks?
© Kaplan, Inc. 10

Qualitative Analysis
◼ Continuity of returns can be assessed by looking at the
four Ps—philosophy, process, people, and portfolio.
◼ Process/people and risk assessment will determine if
the strategy is feasible and if it is possible to execute
the strategy with the employees’ knowledge and skills
◼ Continual monitoring of the PM is needed to ensure
suitability.
© Kaplan, Inc. 11
Type I and II Errors

◼ In making decisions on whether to hire a new manager or
to keep or fire an existing manager, hypothesis testing can
be used.
◼ Null hypothesis (H0) is when there is no value added by
the PM.
◼ Calculated test statistic needs to be large enough to
reject the null hypothesis and show PM adds value.
© Kaplan, Inc. 12

◼ Type I error: Null hypothesis is rejected, when in fact there

was no value added by the PM.
◼ Type II error: Null hypothesis is not rejected, when in fact the
PM added value.
◼ PM who was not hired, or who was fired, did demonstrate
sufficient skill.
© Kaplan, Inc. 13
Realization
Below expectations At or above expectations

(no skill) (skill)
Decision Hire/retrain Type I Correct
Not hire/fire Correct Type II
© Kaplan, Inc. 14


◼ Type I errors receive more attention than Type II
errors.
◼ One reason may relate to the notion of regret aversion
by the decision maker, which is linked to an error of
commission (a Type I error).
◼ Type I errors are easier to determine than Type II
errors. For example, a manager’s relative performance
can be measured against a benchmark.
© Kaplan, Inc. 15
Preventing Type II Errors

◼ An excessive number of Type II errors would be indicative
of a problem with the hiring and firing of managers.
◼ To minimize Type II errors, track subsequent
performance of managers who were not hired as well as
those who were fired.
◼ It is important not to hire or fire managers because of
short-term performance or because of behavioral biases.
© Kaplan, Inc. 16

Costs of Type I and II Errors

◼ Type I errors result in costs associated with retaining
managers who are weak, while Type II errors result in
costs associated with not retaining managers who are
strong.
◼ In an efficient market, the dispersion of return distributions
between the two groups is probably smaller due to greater
difficulty in achieving alpha through active management,
which would lessen the costs of hiring or retaining weak
managers (Type I error).
© Kaplan, Inc. 17
Costs of Type I and II Errors

◼ In mean-reverting markets, Type I errors may occur when
firing a poor performer only to have performance improve
subsequently or when hiring a strong performer only to
have performance deteriorate subsequently.
◼ Type II errors also occur in mean-reverting markets when
strong managers are retained for too long.
© Kaplan, Inc. 18

Approaches to Manager Analysis

Style analysis:
◼ Style analysis examines PM’s risk exposures (e.g., industry,
concentration, capitalization) in relation to an appropriate
benchmark and changes in those exposures over time.
◼ Risk exposures allow for the classification of PMs by style
(e.g., value, growth) for selection purposes and to perform
returns-based style analysis (RBSA) and holdings-based
style analysis (HBSA).
© Kaplan, Inc. 19

◼ Once RBSA and HBSA have been performed, congruence
between the output and the investment process is crucial
to ensure the process can be replicated consistently in the
future.
◼ Monitoring the RBSA and HBSA output over time can
help to detect style drift, whereby the manager’s actions
are deviating from the manager’s stated style.
© Kaplan, Inc. 20


◼ Style analysis works best for publicly traded investments
with frequent pricing data.
◼ For less liquid investments, style analysis can still be
used to generate questions in the due diligence
process.
◼ Style analysis must be meaningful, accurate, consistent,
and timely.
© Kaplan, Inc. 21
Returns-Based Style Analysis (RBSA)

◼ RBSA is a top-down process that estimates the portfolio’s
sensitivities to security market indexes for a set of key risk
factors.
◼ RBSA can also determine the key risk factors and return
drivers for both basic and complex strategies and can be
performed on a timely basis.
© Kaplan, Inc. 22

Returns-Based Style Analysis (RBSA)

◼ If portfolio contains illiquid securities, stale or appraisal-
based prices could understate risk exposure and short-
term volatility (e.g., venture capital and PE).
◼ A manager’s true return standard deviation is best gauged
over a longer time period.
◼ Reporting timeliness will decline with illiquid or
nontraded securities, due to the longer time required for
pricing.
© Kaplan, Inc. 23
Holdings-Based Style Analysis (HBSA)

◼ HBSA looks at the actual securities included in the portfolio
at one time (bottom-up approach)
◼ Most appropriate for equity-based strategies
◼ Can detect style drift faster than RBSA
◼ Key drawback is increased computational requirement as
complexity increases and transparency decreases
◼ Similar to RBSA, illiquid and nontraded securities can result
in stale pricing, understating risk and decreasing timeliness
© Kaplan, Inc. 24

Capture Ratios
◼ Can be used to determine manager suitability for client
◼ Upside capture ratio (UC) looks at capture when the
benchmark has a positive return. Based on the benchmark
return, UC that is higher (lower) than 100% indicates
outperformance (underperformance).
◼ Downside capture ratio (DC) looks at capture when the
benchmark has a negative return. Based on the
benchmark return, DC that is lower (higher) than 100%
indicates outperformance (underperformance).
© Kaplan, Inc. 25
Capture Ratios
capture ratio (CR) = UC ratio / DC ratio
◼ The CR is a measure of return asymmetry:
◼ > 1 = positive asymmetry (convex shape)
◼ < 1 = negative asymmetry (concave shape)
© Kaplan, Inc. 26

Capture Ratios
◼ When betas are increasing (decreasing), momentum-
driven strategies should have higher (lower) UC than
value-driven strategies.
◼ A low-beta (high-beta) strategy will have lower (higher) UC
and DC.
◼ CRs can be used to confirm the investment strategy.
© Kaplan, Inc. 27
Drawdown Ratios
◼ Drawdown is the total peak-to-trough loss for a specified
time period; maximum drawdown is the largest peak-to-
trough loss during that time period.
◼ Large drawdowns are not appropriate for investors
approaching the end of their investment horizon.
◼ Drawdown duration is the total time from when the
drawdown begins to when the total drawdown recovers to
zero.
© Kaplan, Inc. 28

Drawdown Ratios
◼ Drawdowns are useful for identifying poor or poorly
executed investment strategies, weak internal controls,
and operational problems.
◼ Investors with shorter time horizons and lower risk
tolerance with less time to recover from losses should
invest with managers with smaller and less extended
drawdowns.
© Kaplan, Inc. 29
Evaluating Managers
Investment philosophy:
A client’s investment philosophy should drive the investment
process (e.g., markets are efficient or not).
◼ Efficient markets: Active management will underperform
after considering all related costs; execute passive
strategies and earn a risk premium instead.
◼ Inefficient markets: Active strategies can exploit
inefficiencies when market prices of securities deviate from
their intrinsic values. 30
© Kaplan, Inc.

Evaluating Managers
◼ Risk premiums are returns above the risk-free rate
earned by bearing undiversifiable (systematic) risks.
◼ To earn risk premiums, passive strategies target specific
systematic risk factors, including the following:
◼ Equity risk
◼ Credit risk
◼ Liquidity and volatility risk
© Kaplan, Inc. 31
Two Types of Inefficiencies

◼ Behavioral inefficiencies are mispricings caused by other
investors and their behavioral biases (e.g., trend-following,
herding).
◼ Mispricings are frequently short-term in nature and must
be quickly exploited (sometimes within seconds).
◼ Structural inefficiencies occur because of laws and
regulations, which can make them long-term in nature and
likely more repeatable.
© Kaplan, Inc. 32

Capacity
◼ Capacity refers to the amount, repeatability, and
sustainability of the inefficiency.
◼ Inefficiency must provide enough excess returns to
cover transaction costs, fees, taxes, margin, and
any borrowing costs associated with leverage.
◼ Sustainability also depends on market depth and liquidity
and the amount of capital that must be utilized to exploit
the inefficiency.
© Kaplan, Inc. 33
Investment Decision-Making Process

Idea generation:
◼ To effectively exploit inefficiencies, investment strategies
must utilize unique information that can be obtained and
used on a very timely basis. Often, only a short-term
window of opportunity exists to exploit inefficiency.
◼ PM must have superior cognitive or interpretive skills
with regards to utilizing this information.
© Kaplan, Inc. 34


Idea implementation:
◼ Investment idea must be transformed into an investment
position to benefit from the inefficiency.
◼ Two key concerns are the following:
1. Repeatability of the investment strategy
2. Strategy must be suitable with IPS
© Kaplan, Inc. 35

Portfolio construction:
◼ A fundamental question is what kinds of securities will be
used to construct the portfolio.
◼ Portfolio allocations may be done quantitatively and/or
qualitatively and must be suitable with client’s objectives
and constraints.
◼ AUM will likely increase over time, so portfolio will need to
be rebalanced.
© Kaplan, Inc. 36


◼ Stop losses can be used to sell a security once it reaches a
certain price and can be an important risk management tool.
◼ Hard: Sell automatically
◼ Soft: Evaluate when threshold price is reached
◼ Hedges can be used to manage risk.
◼ Liquidity needs of the portfolio must be determined so the
portfolio can react appropriately to changing market
conditions or investor liquidity requirements.
© Kaplan, Inc. 37
Liquidity Recommendations
◼ PM should analyze how much of the portfolio can be
liquidated in five days or less and what percentage of the
portfolio will take more than 10 days to liquidate.
◼ Average daily volume (weighted by portfolio position size)
should also be calculated.
◼ PM should analyze any position that is greater than 5% of
a security’s total market capitalization for potential liquidity
constraints.
© Kaplan, Inc. 38


Portfolio monitoring:
◼ Includes analyzing external factors (e.g., general economy
and financial markets) and capital market expectations
◼ Reviews internal factors such as historical returns, risk
level, and allocations
◼ PM should check for any significant deviations from the
investment process (e.g., style drift)
© Kaplan, Inc. 39

◼ Separately managed accounts (SMAs) and pooled
investment vehicles can be used to execute investment
strategies.
◼ Pooled vehicles bring together the funds from all investors
into one portfolio (e.g., mutual funds, ETFs, hedge funds).
◼ However, there is no customization for any specific
investor.
© Kaplan, Inc. 40


◼ SMAs allow for the tailoring of client-specific objectives and
constraints.
◼ Compared to pooled investments, SMAs have higher
transaction costs but provide control, customization, tax
efficiency, separate reporting, and greater transparency.
◼ The control is in the form of direct and legal ownership
of the underlying securities by the investor.
© Kaplan, Inc. 41
Manager Contracts and Fees

Liquidity:
◼ Closed-end funds and ETFs have the highest liquidity
(traded intra-day), and open-end funds offer almost as
much liquidity (traded based on end-of-day NAV).
◼ Private equity and venture capital funds have the lowest
liquidity because of capital calls. Investors only receive
returns after about five years into the 10-year average life.
PM may extend life of the fund.
© Kaplan, Inc. 42


Limited partnerships:
◼ Advantages: Ability to have a long investment horizon,
earning illiquidity premiums, and not being forced to sell
assets at depressed prices due to redemption requests
◼ Disadvantages: Impaired ability to change portfolio
allocations in response to changes in the market, causing
impaired ability to meet sudden liquidity demands
© Kaplan, Inc. 43

Management fees:
◼ Managers charge fees to cover their fixed and variable
costs as well as to earn a profit.
◼ The average asset-weighted expense ratio paid by mutual
investors has declined substantially over the years as
investors have increasingly allocated to no-load mutual
funds and index funds, which have lower fees.
© Kaplan, Inc. 44


◼ An advantage of investors paying fees based on AUM is
that it rewards clients on the PM’s skill and ability to grow
the asset base. Unfortunately, luck may play a
significant role in the short-term growth of assets.
◼ A disadvantage is that once the assets are attained by the
managers, there is more incentive to retain the assets and
earn the AUM fees (e.g., engage in safe strategies, such
as indexing) rather than take risks for the benefit of the
investor.
© Kaplan, Inc. 45

Basic forms: Performance based fees, form of risk sharing
between PM and investor to align their interests
1. Symmetrical structure with full upside and downside
exposures
fee = base + performance sharing
◼ The greatest alignment between investor and manager
incentives but increased risk to manager due to the full
downside exposure
© Kaplan, Inc. 46


2. Bonus with full upside and limited downside exposures
fee = greater of (1) base, or (2) base + sharing of
positive performance
3. Bonus with limited upside and downside exposures
fee = greater of (1) base, or (2) base + sharing of
positive performance (within limit)
© Kaplan, Inc. 47

◼ Performance-based fee structures transform symmetrical
gross active return distributions into asymmetrical net
active return distributions.
◼ The result is lower relative variance on the upside versus
the downside.
◼ Using a symmetrical risk measure such as standard
deviation could underestimate downside risk.
© Kaplan, Inc. 48


◼ Performance-based fees benefit investors since they will
pay relatively lower fees if active returns are low (rather
than relatively higher standard fixed fees).
◼ Performance-based fees benefit managers, as they may
incentivize them to increase their efforts to benefit the
investor’s portfolio, increasing their own compensation.
◼ For all three structures, base fees are paid even when
the manager underperforms.
© Kaplan, Inc. 49

◼ Some investments have no limits on performance fees, but
performance fees could be tempered by including high-
water or clawback provisions (e.g., hedge funds) that will
offset prior period negative returns from current period
positive returns.
◼ Bonus fee structures are analogous to the PM having a
long position (call option) on the portfolio’s active return
and a theoretically unlimited payout, with the exercise price
as the base fee.
© Kaplan, Inc. 50

Sample Performance-Based Fee Schedule

Standard fee 0.50%
Base fee 0.25%
Sharing on active return, beyond base fee 20%
Breakeven active return 1.50%
Maximum annual fee 0.75%
Active Return
≤ 0.25% 1.50% ≥ 2.75%
Billed fee 0.25% 0.50% 0.75%
Net active return ≤ 0.00% 1.00% ≥ 2.00%
© Kaplan, Inc. 51

◼ Fee schedule is a bonus with limited upside (maximum
billed fee) and downside (minimum billed fee) exposures.
◼ There is symmetry within the active return range of 0.25%
and 2.75%, with a breakeven active return of 1.50%.
◼ Breakeven return calculation:
(1.50% – 0.25%) × 20% = 0.25% performance fee
© Kaplan, Inc. 52


Adding the performance fee to the base fee of 0.25% results
in a total billed fee of 0.50% (same as the standard fee of
0.50%).
◼ An active return of 0.25% or less results in the
performance fee equaling zero, with the billed fee being
the base fee of 0.25%.
◼ An active return of 2.75% or more results in the
performance fee maximized at 0.50%, with the billed fee
being a maximum of 0.75%.
© Kaplan, Inc. 53


Case Studies
Case Study in Portfolio Management:
Institutional

Institutional
Exam Focus
◼ This case study covers the following issues:
◼ Capturing the illiquidity premium
◼ Managing liquidity
◼ Asset allocation
◼ Using derivatives or cash for TAA
◼ Portfolio rebalancing
© Kaplan, Inc. 2


Institutional
Exam Focus
◼ This reading also covers ethical violations that can occur
during manager selection.
◼ Note: Some of the material covered in this reading
assumes prior knowledge of alternative investments (AI)
and other basic portfolio management concepts.
© Kaplan, Inc. 3

Institutional
Managing Liquidity Risk

◼ Liquidity risk—disposing of illiquid securities at a discount
during periods of market turmoil
◼ There are four key methods to manage liquidity risk:
1. Liquidity profiling and time-to-cash tables
2. Rebalancing and commitments
3. Stress testing
4. Derivatives
© Kaplan, Inc. 4


Institutional
Liquidity Profiling and Time-to-Cash Tables

◼ Potential cash inflows and outflows must be estimated.
◼ For example, for a university endowment with sizable
holdings of illiquid assets, the PM must estimate cash
outflows to the university and capital call requests for
certain types of holdings (e.g., hedge funds or PE).
◼ Cash inflows would typically include donations and
investment income earned from the portfolio.
© Kaplan, Inc. 5

Institutional

◼ The next step is to build a time line that involves
constructing a liquidity classification schedule (time-to-
cash table).
◼ There are three distinct components:
1. Amount of time needed to convert assets to cash
2. Liquidity classification level
3. Liquidity budget
© Kaplan, Inc. 6


Institutional
© Kaplan, Inc. 7

Institutional

◼ Liquidity classification—closely linked to the amount of time
it takes to liquidate an investment without having a major
impact on markets
◼ In addition, an investment that takes over one year to
exit would likely be considered illiquid.
◼ The time to cash may include a full range of periods
beyond the four time periods shown in the table to better
match the investor’s cash outflows.
© Kaplan, Inc. 8


Institutional

◼ Liquidity budget—provides minimum or maximum
percentage allocations for each time period
◼ For example, the three more liquid groups state
minimum allocations, while the illiquid group states a
maximum.
◼ Results from stress tests are useful in determining the
requirements for the liquidity budget because the
requirements apply in all market situations.
© Kaplan, Inc. 9

Institutional

◼ Developing a liquidity budget begins by reviewing the liquidity
traits of the investments over a reasonable time period.
◼ Within specific asset classes, various investments could have
very diverse liquidity characteristics (e.g., ETFs may be more
liquid than commingled funds).
◼ Additionally, the same type of investment (e.g., commingled
fund) may offer different levels of liquidity.
© Kaplan, Inc. 10


Institutional
© Kaplan, Inc. 11

Institutional
Rebalancing and Commitments

◼ Rebalancing
◼ Managing liquidity is not enough; it is critical to maintain the
portfolio’s risk profile, within desired (quantitative) ranges.
◼ Over time and during times of market stress, asset values
will change.
◼ Rebalancing costs for illiquid investments tend to be very
high; it is critical to maintain enough liquid assets to execute
necessary rebalancing transactions.
© Kaplan, Inc. 12


Institutional

◼ Systematic rebalancing policies
◼ These are designed to maintain long-term SAA
(e.g., calendar and percent-range rebalancing with
predetermined acceptable ranges for various asset classes).
◼ Narrow ranges incur frequent transaction costs each time the
allocation percentage for a given asset class falls outside of
its (narrow) range; use wider ranges for more volatile assets.
© Kaplan, Inc. 13

Institutional

◼ Automatic adjustment mechanisms
◼ These assist in keeping the PM’s risk profile relatively
constant if there is a change from the target.
◼ For example, assume the portfolio has exposure to market
risk relating to private companies and public companies, and
that we use public companies as a proxy for private firms.
© Kaplan, Inc. 14


Institutional

◼ The PE has a beta of 1 and PE allocation falls by 2% relative
to the target; automatic adjustment increases the public
equity allocation by 2%.
◼ This maintains the level of systematic risk; the level of
unsystematic risk (which we can also think of as illiquidity
risk) has decreased.
© Kaplan, Inc. 15

Institutional

◼ Commitments
◼ PE funds make it more difficult for the portfolio to keep a
stable or specific allocation level in the long term because the
timing and frequency of committed capital drawn and the
return of capital distributions are beyond the control of the
PM.
◼ Investing in multiple funds provides more stability for timing
and frequency distributions.
© Kaplan, Inc. 16


Institutional

◼ A multiyear funding strategy tries to determine the optimal
level of annual commitments from the portfolio by calculating
a long-term exposure to asset classes.
◼ Derived from extensive quantitative analysis: estimate the rate
of committed capital draws, the rate in which distributions are
made, and the rate of change of asset sizes.
◼ Determination of asset class exposure (% of total portfolio) is
needed for several hypothetical commitments.
© Kaplan, Inc. 17

Institutional

◼ Stress testing
◼ Considers changes in portfolio liquidity during periods of
market stress
◼ Conduct analysis to assume “worst case” or very extreme
market conditions and the impact on both assets and
liabilities at the same time
◼ Based on history, statistical models, and scenario analysis
© Kaplan, Inc. 18


Institutional

◼ Derivatives
◼ Requires far less cash than investing in underlying assets—
ideal method for rebalancing
◼ Futures overlay allows for rebalancing of many (but not all)
asset classes without altering any of the asset allocations
determined by the external active managers
© Kaplan, Inc. 19

Institutional

◼ With leverage, a long futures position requires only minimal
cash requirements for margin.
◼ Cash not required for margin can be used to invest in other
assets with differing levels of liquidity, or to meet other liquidity
requirements.
◼ Options can be purchased at premiums that are often only a
fraction of the cost of the underlying asset, or they can be sold
to earn premium income that helps to generate liquidity.
© Kaplan, Inc. 20


Institutional

◼ Illiquid investments (e.g., PE and RE) will earn an
additional return (over the market return) for taking on the
risk of holding up capital for an unknown amount of time,
known as the illiquidity (or liquidity) premium.
◼ Studies have shown that the illiquidity premium increases
with the amount of time (think of an upward-sloping yield
curve, for example).
© Kaplan, Inc. 21

Institutional

◼ An alternative way to model illiquidity premium is to use the
value of a put option, where the strike price is the
marketable price (a theoretically estimated price, as if it
were freely traded) of the illiquid asset when it was
purchased.
◼ This leads to the computation of the price of the illiquid
asset as follows:
illiquid asset price = marketable asset price – put price
© Kaplan, Inc. 22


Institutional

◼ Using the marketable asset and the illiquid prices, expected
returns can be derived for both, and the difference in expected
returns would be the illiquidity premium in percentage terms
as follows:
illiquidity premium (%) = expected return on illiquid asset (%) –
expected return on marketable asset (%)
◼ There are a substantial number of studies to support the
positive correlation between illiquidity and expected returns for
publicly traded stocks.
© Kaplan, Inc. 23

Institutional
Addressing Liquidity Needs

◼ This section describes Quadrivium University’s endowment
(e.g., objectives and constraints).
◼ Refer to the Module Quiz in the SchweserNotes to evaluate
your understanding of the material presented in this
section.
© Kaplan, Inc. 24


Institutional

◼ Quadrivium University (QU) endowment
◼ The endowment was set up many years ago to offer
financial assistance to undergraduate students.
◼ The current value of the endowment is $8 billion, and
about 75% of that amount has unrestricted use.
◼ The other 25% is subject to donor-specified use
restrictions.
© Kaplan, Inc. 25

Institutional

◼ QU’s annual operating budget is $583 million; more than
two-thirds of that amount covers the remuneration of faculty
and administrative staff.
◼ The remainder covers debt payments, maintenance
costs, research, and financial aid.
◼ The endowment makes annual distributions to fund about
60% of QU’s operating budget, and the dollar amounts
have been increasing for each of the past five years.
© Kaplan, Inc. 26


Institutional

◼ Formerly, a simple spending rule existed based on 5% of
the market value of the endowment at the beginning of the
year.
◼ Now, the spending rule incorporates geometric
smoothing and is expressed as follows:
(66% × spending for the previous fiscal year) + 34% ×
(5% × endowment value at the end of the previous fiscal
year)
© Kaplan, Inc. 27

Institutional

◼ To compute QU endowment’s spending for the current
year, the previous year’s spending was $358.1 million and
the endowment’s market value at the end of the previous
fiscal year was $7,002.3 million.
(66% × $358.1 million) + 34% × (5% × $7,002.3 million)
= $355.4 million
© Kaplan, Inc. 28


Institutional

◼ The QU endowment’s investment objective is to earn a
sufficient return over the long term to cover annual
spending and to maintain the real value of the endowment.
◼ At an annual 5% spending rate, 2%–3% annual inflation
applicable to universities, the endowment has an annual
nominal return requirement of 7%–8%.
◼ The risk objective is between 12% and 14% annual
standard deviation of portfolio returns.
© Kaplan, Inc. 29

Institutional
Quadrivium University Investment Co. (QUINCO)

◼ The board of trustees (“the Trustees”) oversees the activities
of QU.
◼ QUINCO is the university investment office and is
responsible for managing the QU endowment.
◼ Aaron Winter is the president of QUINCO; he reports to the
university president and to the QUINCO board of directors
(“the Board”).
◼ The Board deals with approving IPS and QUINCO staff are
charged with the implementation of IPS.
© Kaplan, Inc. 30


Institutional

◼ QUINCO’s 13 investment professionals are officially
employed by QU.
◼ QUINCO’s investment model involves implementation of
investment strategy by external managers instead of
having in-house investment management.
◼ Internal staff deal with asset allocation, risk
management, manager selection, and continuation
decisions regarding the external managers.
© Kaplan, Inc. 31

Institutional

◼ Assets are invested in (1) fixed income, (2) public equity,
(3) private equity, (4) real assets (e.g., private real estate,
natural resources), and (5) diversifying strategies
(e.g., hedge funds).
◼ Each of the five categories is managed by a senior PM and
an analyst. The three other employees are a portfolio
strategist and an analyst, who are responsible for asset
allocation and risk management, and the president, who
serves as the chief investment officer (CIO).
© Kaplan, Inc. 32


Institutional

◼ The portfolio strategist has ongoing duties involving
rebalancing, overlays, and TAA tilts.
◼ Any decisions made by the external investment managers
and TAA deviations require the approval of the internal
investment committee, led by Winter.
◼ The Board must provide final approval for the hiring of any
external managers.
© Kaplan, Inc. 33

Institutional
QUINCO Investment Strategy

◼ QUINCO’s investment strategy is concerned primarily with
the long term and has benefited from the knowledge of the
best-in-class managers, along with alumni support.
◼ Initially, its investment universe was confined to traditional
publicly traded stocks and bonds. With growth of the
endowment, the strategy began to include alternative
investments (e.g., private equity, real estate, commodities,
hedge funds), which may allow for greater diversification
and higher risk-adjusted returns.
© Kaplan, Inc. 34


Institutional

◼ Alternative investments (AI) have helped to boost the
endowment’s returns over the past 20 years.
◼ QU’s allocation to AI is still below average compared to
other comparable endowments.
◼ Over a long time span, the AI portion of the portfolio has
become more established and diversified with respect to
managers and strategies.
© Kaplan, Inc. 35

Institutional

◼ Spanning a period from 1996 to 2017, the QU endowment
asset allocation has changed as follows:
◼ Cash allocation has remained constant at 1%.
◼ Traditional stocks (domestic) and bonds initially accounted for
almost 70% of assets and have been reduced to about 30%.
◼ International equity (developed markets) initially accounted
for almost 25% of assets and has been reduced to 10%.
© Kaplan, Inc. 36


Institutional

◼ Emerging market equity increased from 0% to 10%–15%.
◼ PE initially accounted for less than 5% and has increased to
15%–20%.
◼ Real assets (e.g., real estate, commodities) initially
accounted for less than 5% and have increased to 10%–15%.
◼ Diversifying strategies (e.g., hedge funds) initially accounted
for 0% and have increased to 10%–15%.
© Kaplan, Inc. 37

Institutional

◼ During the most recent strategic asset allocation (SAA) review
by the QUINCO Board two years ago, they resolved to do the
following:
1. Increase the allocation to AI.
2. Decrease the allocation to developed market equities
(domestic and international).
◼ Winter has worked at QUINCO for five years. He became the
president and CIO one year ago and will be performing his
first asset allocation review.
© Kaplan, Inc. 38


Institutional

◼ After consulting with the Board, Winter advises the team to
deal with the following matters pertaining to the review:
1. An optimal liquidity profile and liquidity management plan for
the endowment
2. The SAA in context of the investment outlook—there is an
expectation of lower future returns in most traditional asset
classes
© Kaplan, Inc. 39

Institutional

3. The use of TAA as a complement to SAA to improve risk-
adjusted returns
4. The QU endowment’s underperformance compared to its
peers
© Kaplan, Inc. 40


Institutional
Strategic Asset Allocation (SAA)

◼ The strategy team has finished the work requested and will be
making a presentation to the Board.
◼ As part of their economic analysis, they used unsmoothing
methods for private equity due to the smoother reported returns
resulting from the lack of frequency of pricing data.
◼ The unsmoothing methods resulted in an upward adjustment to
the reported volatility of private equity.
◼ The following figure summarizes the results of the team’s
analysis.
© Kaplan, Inc. 41

Institutional
© Kaplan, Inc. 42


Institutional
© Kaplan, Inc. 43

Institutional

◼ The primary reasons for the QU endowment’s
underperformance relative to its peers were:
1. Lower amount of risk taken
2. Lower allocation to AI
◼ Some metrics suggest increasing the allocation to private

equity and real assets would raise the Sharpe ratio.
© Kaplan, Inc. 44


Institutional

◼ Returns data is on a net-of-fees basis due to higher
investment management and performance fees for PE and
real assets compared to public equity and fixed income.
◼ Monte Carlo simulation brings attention to the potential
erosion in purchasing power.
◼ The Board is willing to accept an annualized standard
deviation of returns between 12% and 14%.
© Kaplan, Inc. 45

Institutional
© Kaplan, Inc. 46


Institutional

◼ Thompson, the team lead, argues that the higher Sharpe
ratio is sufficient reason to amend the SAA. She knows the
standard deviation of returns increases by 0.7% if the
proposed asset allocation is accepted.
◼ Her reasons for taking on more stand-alone risk include the
following:
1. Lower future returns expected for all asset classes will
necessitate taking on more risk to maintain the same level of
returns.
© Kaplan, Inc. 47

Institutional

2. QU’s endowment takes on less risk than its peers.
3. The estimated Sharpe ratio for fixed-income investments
(less risky) means that there should not be as much
allocated to less risky assets.
4. Monte Carlo simulation indicates that in the long term, the
proposed asset allocation has a better chance of earning the
desired real return and preserving purchasing power.
© Kaplan, Inc. 48


Institutional
Liquidity Management
◼ Managing liquidity is paramount for the endowment given
QU’s need for cash flows from the endowment.
◼ Thompson’s team performs cash flow modeling over
several time horizons and under normal and stressed
market conditions. They are worried that liquidity may
deteriorate significantly during stressed market conditions.
© Kaplan, Inc. 49

Institutional
◼ Three reasons why deterioration may occur include the
following:
1. For PE, capital calls are greater than capital distributions,
resulting in a greater concentration of PE (a more illiquid
investment) in the portfolio.
2. Certain investments made by the PM may restrict investors
from withdrawing their funds during stressed market
conditions.
◼ This decreases the portfolio’s overall liquidity.
© Kaplan, Inc. 50


Institutional
3. PE investments are not valued as frequently as public equity.
◼ Lagged valuations result in an increase in percent of PE in

the portfolio and a decrease in liquid assets during stressed
market conditions (liquid assets fall in value “faster”
because they are valued more frequently).
◼ The percentage of assets available for meeting liquidity
needs is reduced when it could be needed most during
periods of market stress.
© Kaplan, Inc. 51

Institutional
Existing Portfolio Liquidity Profile

◼ Normal conditions: highly liquid (19%), liquid (26%),
semi‐liquid (22%), illiquid (33%)
◼ Stress conditions: highly liquid (15%), liquid (26%),
© Kaplan, Inc. 52


Institutional
Proposed Portfolio Liquidity Profile

◼ Normal conditions: highly liquid (14%), liquid (24%),
◼ Stress conditions: highly liquid (11%), liquid (25%),
© Kaplan, Inc. 53

Institutional
Modifying Asset Allocation

◼ Asset manager selection
◼ Several months later, the process of hiring more
external PMs to implement proposed AA changes has

begun.
◼ A request for proposal (RFP) for a private equity
manager was issued, and a response came from Genex
Venture Capital (GVC), with a proposal to invest in its
VC fund, called “GVC Fund II.”
© Kaplan, Inc. 54


Institutional

◼ GVC is owned and operated by Virginia Hall, CFA, who is
on the QU endowment board and has been a long-time and
highly supportive donor to the university.
◼ Both the university treasurer and president are strongly in
support of GVC’s proposal and have indicated so to Winter.
◼ Winter, on the other hand, believes that Hall asked the
two individuals in advance to support her proposal.
© Kaplan, Inc. 55

Institutional

◼ The two finalists selected are GVC and Beacher Venture
Investments (Beacher).
◼ GVC and Beacher must present to QUINCO’s investment
committee.
◼ Jason Allen, a former colleague of Winter, is GVC’s
managing director and gives the GVC presentation.
◼ Winter knows the presentation contains confidential
information, possibly obtained from the university treasurer.
© Kaplan, Inc. 56


Institutional

◼ GVC’s historical returns are presented with amounts
materially greater than reported elsewhere by third parties.
◼ Beacher is seen as the more established choice despite
some problems with the performance of its previous fund.
◼ Some concerns were also raised about GVC’s short
existence to date.
◼ Ultimately, Bud Davis, one of QUINCO’s top PMs in PE, is
asked to make a recommendation.
© Kaplan, Inc. 57

Institutional

◼ Davis states that GVC is finding it difficult to raise the
targeted $300 million for Fund II, since Fund I only raised
$100 million.
◼ Investors are worried about the threefold expansion and
are uncertain if GVC can achieve its goal.
◼ Davis tempers that point with strong positive comments
about GVC’s manager and investment approach, and he
confirms GVC’s investment management fee will be
lowered.
© Kaplan, Inc. 58


Institutional

◼ The investment committee agrees with Davis to select
GVC.
◼ Winter speaks with Allen. During the conversation, Allen
states that Davis’s spouse, Andrea, is Hall’s daughter.
◼ When Winter confronts Davis with that info, Davis says
that it was well known and he assumed that everyone
on the investment committee already knew of the
relationship.
© Kaplan, Inc. 59

Institutional

◼ The Board has approved a much larger active risk budget
for QUINCO’s proposed TAA plan. The annual tracking
error limit was increased from 100 bps to 250 bps in an
attempt to increase portfolio returns.
◼ Winter and his staff are responsible for implementing the
new TAA plan. They have the authority to use 150 bps of
the 250 bps budget.
© Kaplan, Inc. 60


Institutional

◼ Because the use of derivatives in the implementation will
result in increased leverage, the Board approves a
maximum leverage position of 5% of portfolio value.
◼ Winter thinks the TAA plan will allow weighting positions in
acceptable asset classes and allow investing in assets
beyond the policy portfolio BM universe while still being
suitable with the IPS.
© Kaplan, Inc. 61

Institutional

◼ In implementing the plan, Winter starts with fair value and
mean reversion by creating fair value models for the
portfolio assets.
◼ Relevant economic and financial data, known to have
predictive power, are gathered and used to estimate
future risk and return for periods ranging from one to
three years.
© Kaplan, Inc. 62


Institutional

◼ Output from the models (theoretically correct fair value) is
compared to actual prices to assess whether any variances
are significant enough to be exploited after considering
costs.
◼ Backtesting reveals the models work well.
◼ Large-cap U.S. equities were priced far below their fair
value and mean reversion would occur in about a year.
© Kaplan, Inc. 63

Institutional

◼ Thompson uses that information and proposes to
overweight U.S. equities by 1%, using a total return swap,
equity futures, or ETFs.
◼ The objective is to minimize the use of cash and
transaction costs.
◼ Her team comes up with the summary shown in the
following table.
© Kaplan, Inc. 64


Institutional
© Kaplan, Inc. 65

Institutional

◼ Thompson feels that ETFs require too much up-front cash
(100% of the value) and the 50% permitted margin would
provide only limited leverage opportunities ($80 million
investment with $40 million in cash and $40 million
borrowed).
◼ Using futures and total return swaps to obtain
$80 million exposure would require far less cash than
using ETFs.
© Kaplan, Inc. 66


Institutional

◼ ETFs and futures are liquid—they are widely traded and
have low transaction costs.
◼ Both instruments allow for early termination should
market conditions warrant it.
◼ Flexibility is important to Thompson.
◼ Total return swaps are traded over the counter (OTC) with
terms that are negotiated and customized features.
© Kaplan, Inc. 67

Institutional

◼ With futures, Thompson does not like the daily margin
monitoring tasks.
◼ She has concerns over interest rate and counterparty credit risk.
◼ Overlay will be performed using a leverage level of 4, meaning
25% of the investment is provided in cash and 75% is borrowed.
◼ Financing costs are based on a 2% 3-month LIBOR rate for
futures and swaps, with an additional 0.5% financing cost for
ETFs.
© Kaplan, Inc. 68


Institutional

◼ Asset allocation rebalancing
◼ It is now three months after the overweight position in U.S.
equities, and the position has done well.
◼ FI has not performed well due to a large rise in interest rates.
◼ As a result, there has been noticeable drift in the QU
endowment asset allocation.
◼ Rebalancing is performed quarterly for cost control reasons.
◼ Portfolio drift from the SAA is checked on a monthly basis.
© Kaplan, Inc. 69

Institutional

◼ At the end of each quarter, if a relatively liquid asset class
moves outside the rebalancing corridor it is systematically
rebalanced back to either the target allocation or to the
edge of the corridor.
◼ For more illiquid asset classes, high transaction costs
mean that rebalancing is done more implicitly by altering
the commitments and reinvestments when allocations drift
to the either end of the corridor.
© Kaplan, Inc. 70


Institutional
© Kaplan, Inc. 71

Institutional

◼ Based on her analysis of the previous table, Thompson
notices the following:
1. International developed equity, at a current allocation of
11.5%, has exceeded the top end of the corridor (11%)
by 0.5%.
2. FI, at a current allocation of 6.5%, is off significantly
from the target of 9%, but still within the acceptable
range of 6%–12%.
© Kaplan, Inc. 72


Institutional

3. PE, at a current allocation of 19.2%, is near the low end
of the corridor (18%).
4. Real assets, at a current allocation of 13.8%, is near
the low end of the corridor (13%).
◼ As an immediate action, Thompson wishes to reduce the
international developed equity allocation and increase the
FI allocation by 0.5%, taking the former back to the top
edge of its corridor.
© Kaplan, Inc. 73

Institutional

◼ The question is whether to perform the transaction through
1. the cash market, or
2. the derivatives market.
◼ She is aware that implementation will take more time in the
cash market, but it is necessary for larger or more
important adjustments.
© Kaplan, Inc. 74


Institutional

◼ Thompson finds the 0.5% rebalancing transaction over a
three-month investment horizon will incur 30 bps of
transaction costs in the cash market:
◼ Bid/offer spread of 5 bps
◼ Price impact of 5 bps
◼ Cash drag of 20 bps, which includes the impact of timing
delays and disruptions to active manager portfolios
© Kaplan, Inc. 75

Institutional

◼ The same 0.5% rebalancing transaction will incur 24 bps of
transaction costs in the futures market:
◼ Mispricing of 17 bps
© Kaplan, Inc. 76


Institutional

◼ Thompson rebalances international developed equity to the
SAA target allocation of 9%, which involves a 2.5%
decrease to equity and a 2.5% increase to fixed income.
◼ The investment horizon is one year and will incur 60 bps of
transaction costs in the cash market:
◼ Cash drag of 50 bps
© Kaplan, Inc. 77

Institutional

◼ The same trade in the futures market would incur 82 bps of
transaction costs:
◼ Cash drag of 68 bps
◼ Cost of rolling futures contracts of 6 bps
© Kaplan, Inc. 78


Institutional
Quinco Case Highlights

▪ Environmental, Social & Governance Risks
▪ QU University Student Association protesting against
investments made in Portro Inc.
▪ Portro ‘named and shamed’ due to claims of terrible
labor conditions, child labor and health and safety
violations of their suppliers
▪ Reputational risk for QU University
79
© Kaplan, Inc.

Institutional
Quinco Case Highlights

▪ QUINCO ESG Policy Improvements
▪ Hired an experienced ESG analyst
▪ Integrate ESG risk factors into decision making
▪ Enhanced due diligence of external managers: ESG
policies and processes
▪ Responsible ownership: voting, engagement
▪ Monitoring ESG data: ESG scores, benchmarks
▪ Principles for Responsible Investing (PRI)
80
© Kaplan, Inc.


Case Studies
Case Study in Risk Management:
Private Wealth

Private Wealth
Exam Focus
◼ Risk management is a vital piece of putting together a
personal financial plan.
◼ By understanding a client’s full situation and taking a
holistic view of their circumstances, we have the best
opportunity to offer advice tailored to their goals and needs.
◼ For the purposes of this reading, we will focus on the
Learning Outcome Statements (LOS).
© Kaplan, Inc. 2


Private Wealth
Exam Focus
◼ The original reading provides numerous details, including
local regulations, current economic conditions, tax laws,
and so on.
◼ Details provide a more holistic view; however, it is very
likely that the exam will forgo multiple pages of background
information.
◼ Instead, exam question will likely provide a narrower list
of things you need to consider in your answer.
© Kaplan, Inc. 3

Private Wealth
Exam Focus
◼ This reading will focus on identifying a family’s risk
exposures throughout different stages of their lives.
◼ The reading follows the family members through four
stages of their careers: early career, career development,
peak accumulation, and early retirement.
◼ Each stage comes with new variables and new challenges;
we must find ways to help mitigate or remove any risks the
family might face.
© Kaplan, Inc. 4


Private Wealth
Exam Focus
◼ Keep in mind, each stage provides a snapshot in time, with
multiple variables.
◼ Focus on the information that is being presented for that
stage.
◼ Resist the temptation to use external variables (e.g., your
practitioner experience) to justify a risk management
recommendation.
◼ Stick to what you have been taught in the CFAI material.
© Kaplan, Inc. 5

Private Wealth
Early Career Stage

◼ Jessica and Paul Schmitt, both age 28, were recently married.
They are in the early phase of their careers.
◼ Both Jessica and Paul graduated with master’s degrees
three years ago in computer science and mathematics,
respectively.
◼ Paul took a teaching position at a local school upon
graduation. He earns a gross annual salary of €45,600, which
translates to a take-home pay of €33,670, after Social
Security and tax deductions.
© Kaplan, Inc. 6


Private Wealth
Early Career Stage

◼ After graduation, Jessica joined an IT startup. Her gross
annual salary is €24,000, which after taxes and Social
Security contributions becomes €20,490.
◼ Though her current salary is low, she expects to receive a
bonus if the startup becomes successful; this would likely
represent a significant share of her compensation.
◼ She believes the startup will succeed and prefers this
potential upside rather than looking at other higher-paying
positions.
© Kaplan, Inc. 7

Private Wealth
Early Career Stage

◼ The couple have combined savings of €15,000.
◼ Aside from their participation in their government’s pension
plan, the Schmitts have almost no other financial assets.
◼ Their only other asset of note is their car, for which the
Schmitts have automobile insurance, protecting them
from liability for other parties’ repair costs or injury
compensation.
© Kaplan, Inc. 8


Private Wealth
Early Career Stage

◼ The Schmitts are debt-free because their parents covered
their expenses while in college and tuition costs were
relatively low.
◼ The Schmitts’ monthly expenses are €2,900, which
includes rent of €1,000.
◼ The following table is a summary of the Schmitts’ finances.
© Kaplan, Inc. 9

Private Wealth
Early Career Stage
© Kaplan, Inc. 10


Private Wealth
Early Career Stage

◼ The Schmitts have the following objectives: (1) ensure
long-term financial security, (2) ensure a comfortable
retirement, (3) start a family soon, (4) purchase a
condominium.
◼ They toured a €270,000 home in a popular area that has
seen considerable property value appreciation.
◼ A 25-year mortgage would be 3.6% per year, fixed for five
years and floating thereafter.
© Kaplan, Inc. 11

Private Wealth
Early Career Stage

◼ So far, we have identified the Schmitts’ financial objectives
and their financial assets and liabilities.
◼ Because they are early on in their careers, the majority
of their economic balance sheet consists of their human
capital.
© Kaplan, Inc. 12


Private Wealth
Early Career Stage

◼ Notice that Paul and Jessica’s human capital differ in the
following ways:
◼ Paul’s human capital is very bond-like as long as he
continues his career as a teacher.
1. He has high job security, which limits earnings risk.
2. Paul’s job may not be portable to other countries due to
licensing requirements.
3. His income is expected to increase as he gains seniority
and has very limited upside potential.
© Kaplan, Inc. 13

Private Wealth
Early Career Stage

◼ Jessica’s human capital is very equity-like in her current
industry role.
1. There are significant unknowns related to her future
employment cash flows.
2. Unemployment is a much greater worry for Jessica
because, unlike Paul, Jessica’s job does not have
significant job security.
3. Her discretionary bonus payments are uncertain.
4. Jessica’s human capital is portable across countries.
© Kaplan, Inc. 14


Private Wealth
Early Career Stage

◼ As a result, Jessica and Paul’s marriage creates a
diversified mix of human capital.
◼ Next, we must turn to actually identifying and analyzing
the couple’s risk exposures.
◼ Despite being young and in good health, they still face the
following risks.
© Kaplan, Inc. 15

Private Wealth
Early Career Stage

◼ Earnings risk
◼ They face earnings risk from either unemployment or
disability. Both are young and have little in the way of
financial capital; their largest asset on their economic
balance sheet is their human capital.
◼ The two big drivers of earnings risk at this career state
are (1) the risk of unemployment and (2) the risk of a
health event or disability.
© Kaplan, Inc. 16


Private Wealth
Early Career Stage

◼ Unemployment
◼ Jessica, more than Paul, faces a significant risk of
unemployment. The probability of Jessica losing her job
is difficult to estimate, but it is higher than the likelihood
of Paul becoming unemployed.
◼ They have been paying into the Social Security system
for a few years and are entitled to an unemployment
benefit would partially replace each of their salaries.
© Kaplan, Inc. 17

Private Wealth
Early Career Stage

◼ Disability
◼ Despite the fact that Jessica and Paul are young and fit,
the risk of a health event or disability is still present.
◼ Again, the couple would be entitled to disability
payments from the state Social Security system, but
monthly income from that source would likely not be
enough to cover their current salary.
© Kaplan, Inc. 18


Private Wealth
Early Career Stage

◼ Premature death risk
◼ The case suggests the likelihood of a premature death
is low, as both Paul and Jessica are in good health.
◼ If premature death occurs, the surviving spouse, at this
stage of life, would have one-time costs (e.g., funeral
expenses) and would need to establish an emergency
fund and pay all monthly living expenses (rent, utilities,
food, etc.) alone.
© Kaplan, Inc. 19

Private Wealth
Early Career Stage

◼ Car accident and/or repair costs
◼ The Schmitts own an older car. They have an insurance
policy in place that should protect them in case they
need to pay compensation or repair costs to other
motorists.
◼ However, they are not covered for repair or
replacement of their own car.
© Kaplan, Inc. 20


Private Wealth
Early Career Stage

◼ Home purchase
◼ At this stage of their lives, the Schmitts don’t have a lot of
cash flow to support short-term expenditures. However,
most of the couple’s assets are covered by insurance; no
other apparent major liability risks were discussed.
◼ While they could finance a house purchase through a
mortgage, making a substantial down payment would
leave them with little liquid assets to handle emergencies.
© Kaplan, Inc. 21

Private Wealth
Early Career Stage

◼ Managing a family’s risk exposures during the early career
stage
◼ Earnings risk
◼ We previously identified two drivers of earnings risk:
sudden unemployment and a health/disability event.
◼ The methods of mitigating these risks are different.
© Kaplan, Inc. 22


Private Wealth
Early Career Stage

◼ Unemployment
◼ Earnings risk resulting from unemployment can be
problematic to insure against. In some countries,
supplemental income provided by government
assistance is available to aid the unemployed.
◼ One of the best ways to protect against sudden job loss
is to accumulate a savings “buffer” of several months of
normal expenditures; six months is recommended.
© Kaplan, Inc. 23

Private Wealth
Early Career Stage

◼ Disability
◼ Disability insurance can address earnings risk from
serious illness or disability. Because the Schmitts’
salaries are expected to increase, we recommend they
choose a policy that allows them to purchase additional
coverage going forward.
◼ To determine the amount of disability insurance needed,
we calculate the present value (PV) of net earnings that
would need to be replaced—see the following table.
© Kaplan, Inc. 24


Private Wealth
Early Career Stage
© Kaplan, Inc. 25

Private Wealth
Early Career Stage

◼ To protect against premature death risk, both Jessica
and Paul should take on life insurance to support the
other’s loss of future income.
◼ As a reminder, there are two methods for calculating the
amount of coverage necessary:
1. Human life value: estimates the amount of future
earnings that must be replaced
© Kaplan, Inc. 26


Private Wealth
Early Career Stage

2. Needs analysis: estimates the amount needed to
cover living expenses for the surviving spouse
◼ At this stage, we choose to determine the amount of
coverage using the needs analysis method, because there
is uncertainty about the level of future earnings life
insurance would need to replace.
© Kaplan, Inc. 27

Private Wealth
Early Career Stage
© Kaplan, Inc. 28


Private Wealth
Early Career Stage

◼ Car accident and/or repair costs
◼ The Schmitts’ existing car insurance plan covers damages
to other parties in an accident, but it does not cover their
car. Because they rarely use their car, they should self-
insure by means of a sufficient savings buffer.
◼ Liability risk
◼ They have minimal liability risk; there is nothing to
recommend at this stage.
© Kaplan, Inc. 29

Private Wealth
Early Career Stage

◼ House purchase
◼ The couple has little financial capital and should be
advised against purchasing a home at this time to
decrease their risk exposure.
◼ Instead of a home purchase, they should develop a
savings plan and increase their financial assets.
◼ Purchasing a home in the near future would virtually
leave them without any other financial assets.
© Kaplan, Inc. 30


Private Wealth
Early Career Stage

◼ The Schmitts should create a substantial savings buffer of
at least six months’ worth of expenses.
◼ Once the savings buffer is in place, the couple should
draw up an investment plan.
© Kaplan, Inc. 31

Private Wealth
Career Development Stage

◼ We continue the Schmitts’ case 17 years later. They have
experienced career success and remain healthy.
◼ Both of their incomes are greater now, Jessica’s
significantly so.
◼ With their increased incomes, they have repaid the entire
loan from Jessica’s parents and most of their mortgage,
while accumulating a liquidity buffer of just under €80,000.
© Kaplan, Inc. 32


Private Wealth

◼ Based on their understanding of the IT industry, the
Schmitts have assembled a portfolio of shares in 10 local
IT companies.
◼ They now own residential property in the area where
these companies are located and are considering
investing in additional residential property there.
© Kaplan, Inc. 33

Private Wealth

◼ Jessica and her employer each contribute €3,000 annually
to a defined-contribution pension plan.
◼ Paul’s benefits include life insurance coverage equal to
three times his salary and disability benefits that would
equal €2,520 per month.
◼ They have two children: Roxane, age 12, and Peter, age 7.
Peter requires extra support at school to accommodate
mental development issues.
© Kaplan, Inc. 34


Private Wealth

◼ The family’s annual living expenses have increased to
€65,000.
◼ After Roxane was born, the Schmitts increased their life
insurance coverage, but they have not adjusted it since.
◼ The following two tables provide a summary of the
Schmitts’ financial circumstances and annual budget.
© Kaplan, Inc. 35

Private Wealth
© Kaplan, Inc. 36


Private Wealth
© Kaplan, Inc. 37

Private Wealth

◼ Earnings risk
◼ As in the early stage of the couple’s careers, the same two
earnings risks apply:
1. Unemployment: Jessica continues to be at greater risk
of unemployment than Paul.
◼ Because Jessica’s salary is now substantially higher
than it was before, the amount of income at stake is
much greater.
© Kaplan, Inc. 38


Private Wealth

2. Disability: Should Jessica or Paul become disabled, the
rest of the family would suffer from lost earnings and the
nondisabled spouse could be limited in their opportunity
set, impacting income and costs.
◼ Having children increases the adverse financial
consequences for the family. Not only would the cost of
raising the children no longer be met, but the surviving
spouse could also suffer a reduction in income.
© Kaplan, Inc. 39

Private Wealth

◼ Investment portfolio
◼ The couple has built up their main investment vehicle,
but the account is concentrated in a volatile sector, IT.
◼ Because Jessica works in IT, the portfolio’s performance
is likely to be highly correlated with her human capital. If
the IT sector underperforms, their investment portfolio
and Jessica’s career prospects are likely to suffer
simultaneously.
© Kaplan, Inc. 40


Private Wealth

◼ Note: Speculative residential property the Schmitts are
considering is located near Jessica’s office, where many
other IT companies are located, and is comparable to their
existing property.
◼ Retirement goals
◼ The Schmitts’ retirement funds could turn out to be
inadequate for the lifestyle they desire if their contributions to
the retirement plans are inadequate or if the funds do not
perform well.
© Kaplan, Inc. 41

Private Wealth

◼ In addition to their state pension income in retirement,
Jessica is participating in her employer’s defined
contribution company pension, which will help increase the
probability of reaching their retirement goals.
◼ If Paul and Jessica remain employed until their retirement
age of 65, they will have a total gross retirement income of
€76,000 (inclusive of pension and DC pension income),
which is roughly half of their current income.
© Kaplan, Inc. 42


Private Wealth

◼ It is likely the couple’s living expenses will be less than
their current living expenses, but at this point there is a
risk that their retirement income will be insufficient.
◼ Other risks
◼ These could include property risks or other liabilities.
© Kaplan, Inc. 43

Private Wealth

◼ Earnings risk
◼ Disability insurance
◼ Both Paul and Jessica already have disability
insurance policies.
◼ However, the current level of coverage no longer
matches the present value of future earnings, as
demonstrated in the following table.
© Kaplan, Inc. 44


Private Wealth
© Kaplan, Inc. 45

Private Wealth

◼ Over 20 years, assuming an annual benefit adjustment of 2%
and a discount rate of 3%, the PV of Jessica’s required futures
earnings replacement is €519,000. For Paul, it is €297,000.
◼ Jessica’s level of disability coverage is €112,200 and Paul’s is
€686,100.
◼ We should recommend they adjust their level of coverage to
reflect the PV of future earnings replacement. Jessica’s
coverage should be increased to €520,000, and Paul’s should be
reduced to €300,000.
© Kaplan, Inc. 46


Private Wealth

◼ Life insurance
◼ To protect against the risk of Jessica or Paul’s untimely
death, each purchased life insurance at age 28.
◼ However, both of their salaries have increased and they
now have children, so it is likely the amount of coverage
needs to be changed.
◼ To determine the new coverage amount, we can use the
human life value and needs analysis methods.
© Kaplan, Inc. 47

Private Wealth

◼ Human life value
◼ Both Paul and Jessica will require additional life insurance

coverage, although the specific amount will depend on the
calculation method used.
© Kaplan, Inc. 48


Private Wealth

◼ One way to select between the results is to go with the option
that best matches the client’s position.
◼ Another is to treat the different results as a range. In this case,
we recommend increasing Paul and Jessica’s policies to
€900,000 and €1 million, respectively.
◼ The CFAI reading isn’t very clear on how to determine the
amount of coverage. One method is to focus on balancing the
needs of the family against how much the premiums will cost.
© Kaplan, Inc. 49

Private Wealth

◼ Concentrated stock positions
◼ The couple’s investment portfolio should have a low
correlation to their human capital.
◼ We should recommend to diversify the portfolio,
rather than hold concentrated positions in only
10 companies.
© Kaplan, Inc. 50


Private Wealth

◼ In order for the couple to achieve better diversification, we
should recommend that, at a minimum, no new
contributions be made in shares of IT companies.
◼ Contributions should be directed into pooled investment
vehicles—specifically, funds that are well diversified by
region, sector, and security selections.
© Kaplan, Inc. 51

Private Wealth

◼ Real estate
◼ Reasons the couple should avoid investing in speculative RE:
1. The local property’s value is highly correlated to the
strength of the local IT sector, which is highly correlated
to the value of Jessica’s human capital.
2. Funding for the purchase would need to come from their
investment portfolio and a loan because the couple has
limited resources available.
© Kaplan, Inc. 52


Private Wealth

3. If they opt to fund the purchase with their investment
portfolio, they will further decrease their diversification.
4. An investment property would be a large, illiquid, and
concentrated holding.
5. They would incur ongoing costs to own and manage
rental property.
© Kaplan, Inc. 53

Private Wealth

◼ Retirement savings plans
◼ We can identify a substantial shortfall in the Schmitts’
projected income in retirement relative to their
retirement goals.
◼ To mitigate the risk of having inadequate funds to
support their lifestyle in retirement, the Schmitts should
consider dedicating a greater amount to their retirement
needs.
© Kaplan, Inc. 54


Private Wealth

◼ According to their budget, the couple’s after-tax monthly
€8,350 income is greater than their monthly expenditures
by approximately €2,700; even after insurance premium
payments, this should leave the couple with €2,350 per
month (€28,200 per year) to invest.
◼ The Schmitts have built up a substantial liquidity buffer
(€80,000) and should consider redirecting further
contributions toward Jessica’s pension or the investment
portfolio to fund future retirement income.
© Kaplan, Inc. 55

Private Wealth

◼ Outcome
◼ Suppose the Schmitts accept your recommendations.
◼ They set aside the idea of buying a property near the
IT district and they stop adding to their savings buffer,
instead increasing their contributions to the pension
plan from Jessica’s employer.
© Kaplan, Inc. 56


Private Wealth

◼ Furthermore, the Schmitts will continue their contributions
to their investment portfolio but will begin moving away
from investing in individual securities, instead putting funds
into diversified equity funds.
© Kaplan, Inc. 57

Private Wealth
Peak Accumulation Stage

◼ It is 10 years later. Jessica and Paul are in their peak
accumulation phase at age 55.
◼ Over the past decade, they have progressed in their
careers and have seen rising incomes.
◼ Jessica’s employer is making significantly increased
contributions to the firm’s pension plan; Jessica has also
been aggressively contributing to this plan and her new
private pension, partly to benefit from tax breaks.
© Kaplan, Inc. 58


Private Wealth

◼ The segment of the technology sector that Jessica’s
company competes in is facing challenges arising from the
ever-changing market environment.
◼ Paul’s job remains steady and he has consistently
contributed to a private pension plan.
© Kaplan, Inc. 59

Private Wealth

◼ The Schmitts’ investment portfolio has grown substantially
from regular contributions and investment returns. The
portfolio is invested in diversified funds and comprises the
following:
◼ 70% stocks (primarily global equity, plus some
Eurolandian stocks)
◼ 30% fixed income (divided approximately evenly
between domestic government bonds and high-quality
corporate bonds)
© Kaplan, Inc. 60


Private Wealth

◼ The value of their residential home has seen a decline in
real terms due to a general softness in Eurolandia’s real
estate market and the local area losing its previous appeal.
◼ The Schmitts have paid down their mortgage and are still
supporting Roxane, who recently completed her
undergraduate degree and is now pursuing graduate
studies.
© Kaplan, Inc. 61

Private Wealth

◼ The couple continues to provide for the special needs of
Peter, who is now 17.
◼ Peter has made progress but will need assistance for
life, costing €13,000 per year.
◼ The Schmitts plan to retire in 10 years (at age 65) and
maintain a healthy lifestyle. Together, they compile a
summary of their current financial circumstances, shown in
the following table.
© Kaplan, Inc. 62


Private Wealth
© Kaplan, Inc. 63

Private Wealth

◼ Financial objectives
◼ The couple develops the following financial objectives:
1. Maintain financial security over the next decade while
continuing to work full-time
2. Have a comfortable retirement
3. Be able to provide Peter with lifelong support and
assistance
4. Leave a substantial inheritance for Roxane
© Kaplan, Inc. 64


Private Wealth

◼ Earnings risks
◼ Unemployment: Profitability is volatile in Jessica’s
industry. If she loses her job at age 55, it may be hard
for her to find equivalent employment.
◼ Disability: The couple maintains a healthy lifestyle, but
the risk of losing future earnings due to disability
remains. Their current earnings situation should be
examined to identify how much would be covered by
Social Security.
© Kaplan, Inc. 65

Private Wealth
© Kaplan, Inc. 66


Private Wealth

◼ Once again, there is a shortfall between the Schmitts’ net
income and what is covered by the Social Security system.
◼ However, the couple has more than adequate
supplementary insurance coverage to handle this shortfall.
With the adjustments they made to their coverage 10 years
ago, Jessica and Paul have disability coverage of €633,900
and €365,700, respectively.
© Kaplan, Inc. 67

Private Wealth

◼ One of the couple’s objectives is providing financial
security for the family over the next 10 years, and an
early death could easily derail this objective.
◼ Both Jessica and Paul have life insurance. Consider the
current coverage to see if adjustments need to be made.
© Kaplan, Inc. 68


Private Wealth
◼ Regardless of the method used, it is apparent the couple’s

current life insurance coverage is more than enough to
cover the surviving spouse’s financial needs.
© Kaplan, Inc. 69

Private Wealth

◼ Retirement lifestyle goals
◼ The couple has continued to contribute to the mandatory
government pension.
◼ Upon retirement in 10 years, at age 65, the Schmitts
expect to immediately purchase a fixed annuity (with an
assumed 5.0% annuity yield).
◼ Further assumptions are in the following table.
© Kaplan, Inc. 70


Private Wealth
© Kaplan, Inc. 71

Private Wealth

◼ Excluding the investment portfolio, the couple’s estimated
total pension income will be €111,500 before taxes, or
approximately €84,000 after taxes.
◼ They think they will need approximately €75,000 (in real
terms) to live on in retirement.
◼ Risks to these assumptions include loss of employment,
solvency of the state pension systems, and poor returns in
the DC plans in the years before the couple retires.
© Kaplan, Inc. 72


Private Wealth

◼ The investment portfolio has two objectives:
1. Supporting Peter
2. Leaving an inheritance for Roxane
◼ The couple requires a probability of success for
supporting Peter of 100%, and a required probability of
success for leaving an inheritance to Roxane of 60%.
© Kaplan, Inc. 73

Private Wealth

◼ Goal 1: Support Peter
◼ Peter is expected to survive his parents by 40 years (to
age 90). The couple estimates it costs them €13,000 to
care for Peter each year; this increases to €30,000 per
year if outside help is used.
◼ Assuming the Schmitts assist their son up until retirement,
the PV of these costs equals €500,000.
◼ This amount is less than the current portfolio of
€611,000.
© Kaplan, Inc. 74


Private Wealth

◼ Goal 2: Inheritance for Roxane
◼ The required probability of success is lower than that of
supporting Peter, with a longer time horizon because the
inheritance will be left upon the couple’s death.
◼ When asked about a dollar amount, the couple said they
want to leave “as much as possible.”
© Kaplan, Inc. 75

Private Wealth

◼ Asset allocation (AA)
◼ The portfolio’s AA should first address the objective of
supporting Peter, while leaving the remaining balance
as an inheritance for Roxane. The Schmitts’ multiple
objectives span multiple time periods.
© Kaplan, Inc. 76


Private Wealth

◼ Earnings risk
◼ Unemployment: It is almost impossible to insure against
job loss. The couple has built up savings, effectively self-
insuring against loss of employment.
◼ Disability: The PV of earnings not covered by Social
Security is €452,000 for Jessica and €163,000 for Paul.
The couple has more than sufficient coverage through their
disability insurance (€633,900 and €365,700, respectively).
We should recommend decreasing this coverage.
© Kaplan, Inc. 77

Private Wealth

◼ Premature death
◼ As in the case of disability insurance, the couple has
higher life insurance than what is necessary.
◼ We should recommend decreasing this coverage to
lower the premiums paid.
© Kaplan, Inc. 78


Private Wealth

◼ Retirement savings
◼ The Schmitts are in a position to retire comfortably.
◼ Their current projected income (assuming they continue
to contribute the maximum amount) from their pension
assets in retirement is in excess of their projected
spending needs.
◼ The couple should continue to contribute the legal
maximum to their pension plans.
© Kaplan, Inc. 79

Private Wealth

◼ Investment portfolio asset allocation
◼ Because the couple’s first retirement goal, to live
comfortably, is covered through their retirement plans,
we can focus on the other two objectives:
1. Supporting Peter
2. Leaving an inheritance to Roxane
© Kaplan, Inc. 80


Private Wealth

◼ The current balance of the investment portfolio is €611,000.
◼ The couple has been contributing €33,000 to this portfolio
on an annual basis. We should recommend the Schmitts
continue making these contributions.
◼ The higher the contributions, in addition to capital gains
and dividends, the higher the probability of meeting the
couple’s objectives.
© Kaplan, Inc. 81

Private Wealth

◼ Because the couple has multiple objectives that span
multiple time periods, use a goals-based investing
approach.
◼ Use this approach to create two subportfolios that
correspond to supporting Peter and leaving an inheritance
to Roxane.
© Kaplan, Inc. 82


Private Wealth

◼ Peter’s subportfolio
◼ Assets devoted to the goal of Peter’s care, currently
€500,000 allocated 70% equity and 30% fixed income,
should be reallocated gradually toward an increasing
proportion of inflation-protected government bonds.
◼ This allocation will help ensure the portfolio maintains its
real value over time, because the portfolio will not be
touched for almost 20 years.
© Kaplan, Inc. 83

Private Wealth

◼ Roxane’s subportfolio
◼ Most of the portfolio is allocated to Peter’s long-term
care objectives, leaving only €111,000 in investable
assets available for Roxane’s subportfolio.
◼ This objective has an even longer time horizon (30+
years), so this subportfolio should initially be 100%
allocated to diversified global equity funds to benefit
from the high expected returns from equities.
© Kaplan, Inc. 84


Private Wealth

◼ Bear in mind the importance of reviewing whether the
allocation stays in line with these goals as the Schmitts
continue to save and accumulate assets.
◼ The portfolio allocations should be monitored regularly.
© Kaplan, Inc. 85

Private Wealth
Early Retirement Stage

◼ We close the Schmitts’ case study with the couple about to
turn 65 and retire.
◼ They are generally in excellent health, though they
infrequently make use of the government’s medical
system.
◼ They currently spend less than they did in previous stages
of life, and their investments now amount to approximately
€1.5 million.
© Kaplan, Inc. 86


Private Wealth

◼ There has been a gradual transition from equity funds to
fixed-income funds as they age.
◼ Equities still account for 50% of the total portfolio, as a
result of vigorous returns from this asset class.
◼ The rest is divided evenly between the following:
◼ Inflation-protected government bonds
◼ High-quality corporate bonds
© Kaplan, Inc. 87

Private Wealth

◼ Jessica’s earnings have diminished because she decided
to withdraw from her management role and enter IT
consulting.
◼ The Schmitts’ expenditures have also decreased
because Roxane is now living independently.
◼ In a meeting, the couple describes some of their goals as
they enter this new stage of their career.
© Kaplan, Inc. 88


Private Wealth

1. Retire soon with a comfortable income level for their
lifetimes and avoid a scenario where they outlive their
money.
◼ The Schmitts consider themselves to be in good health,
and they expect to live beyond the typical life
expectancy.
◼ They want to ensure that they preserve the
purchasing power of their income in retirement.
© Kaplan, Inc. 89

Private Wealth

2. Provide financial support for Peter—the Schmitts
estimate that in 10 years, the cost of their son’s care will
be €35,000 per year before inflation.
3. Leave an inheritance to Roxane in a still-undefined
amount.
4. Help Roxane buy her first property by providing her with
up to €150,000.
© Kaplan, Inc. 90


Private Wealth
© Kaplan, Inc. 91

Private Wealth
© Kaplan, Inc. 92


Private Wealth

◼ Before assessing the couple’s risk exposures, we establish
the following:
◼ With the Schmitts’ retirement imminent, there is no
longer a need for disability or life insurance coverage.
◼ The government pension income they will soon begin
receiving is now known with certainty.
© Kaplan, Inc. 93

Private Wealth

◼ A strategy should be established for the pension schemes
the Schmitts have. Their financial advisor explains the
couple’s options are as follows:
1. Create a stream of income for the remainder of their
lives by purchasing annuities.
◼ The current nominal rate is 4.5% after costs
© Kaplan, Inc. 94


Private Wealth

2. Withdraw lump sums. Up to one-third of the employer
pension can be withdrawn, while the private pension offers
more flexibility.
◼ Current law states that 25% of a lump sum distribution is
tax-free.
3. Keep the monies invested in the retirement plans.
© Kaplan, Inc. 95

Private Wealth

◼ The couple’s risks look slightly different than they have in
previous stages.
◼ There is no need to keep their life or disability insurance
because they are no longer employed and earnings risk is
no longer an issue.
◼ Two big risks still exist in this stage.
© Kaplan, Inc. 96


Private Wealth

1. Retirement income risk
◼ One of the risks the Schmitts face is outliving their
assets in retirement.
◼ Because the couple will receive pension income from
the mandatory government pension plan, we know that
part of their retirement income is already covered.
However, both Jessica and Paul have private and
employer pension plans, which do not provide known
income in retirement.
© Kaplan, Inc. 97

Private Wealth

2. Investment portfolio goals
◼ Provide economic support for Peter (this is a top priority)
◼ Give an inheritance to their children, chiefly Roxane
◼ Offer Roxane a deposit on her house purchase
◼ Maintain the ability to draw on their investments to cover
unexpected expenses
© Kaplan, Inc. 98


Private Wealth

◼ Retirement income objectives
◼ The Schmitts’ objective is to make sure their after-tax
retirement income covers their €70,000 of living
expenses.
© Kaplan, Inc. 99

Private Wealth

◼ Their combined government pension plan income will yield
€77,150 before taxes. The couple will have to supplement
the rest of this income with their employer and private
pensions.
◼ Current law says the couple can withdraw up to 25% of
their company pension plans tax-free.
© Kaplan, Inc. 100


Private Wealth

◼ Withdrawing 25% from Jessica’s largest account and
Paul’s only pension account as lump sums leaves the
remaining balance to purchase an inflation-protected
annuity at 4.5% after all fees.
◼ The couple would receive a total of €93,600 in pretax
income, or €72,000 after tax.
◼ This is greater than the €70,000 in annual living
expenses.
© Kaplan, Inc. 101

Private Wealth
© Kaplan, Inc. 102


Private Wealth

◼ The remaining 25% of the two pension plans could be
taken as a tax-free lump sum (creating a total of €121,250).
◼ Jessica’s remaining, untouched, private pension plan would
not be needed as a source of retirement income.
◼ We should suggest withdrawing 25% of that plan as a
tax‐free lump sum of €43,750, leaving the remainder
invested in the plan.
© Kaplan, Inc. 103

Private Wealth

◼ The end result is that the couple’s living expenses are
covered by pension income and inflation-protected
annuities.
◼ The couple is able to withdraw €165,000 tax-free
(€121,250 + €43,750) as lump sums.
© Kaplan, Inc. 104


Private Wealth

◼ Investment portfolio asset allocation
◼ Suppose the Schmitts ask for advice about their
investment portfolio, which currently stands at
€1,511,000.
◼ The couple will additionally receive a pension lump sum
of €165,000 tax-free, which will leave €131,250 in
Jessica’s private pension plan and bring the total value
of resources available to about €1.8 million.
© Kaplan, Inc. 105

Private Wealth

◼ We must address the couple’s top-priority objective of
supporting Peter.
◼ At the moment, the couple is taking care of their son as
part of their current living expenses.
◼ However, they estimate the annual cost of supporting
Peter will be €35,000 in nominal terms in 10 years, at
which point they believe they will no longer be able to
provide for him.
© Kaplan, Inc. 106


Private Wealth

◼ This amount is expected to remain relatively constant in
real terms.
◼ Using some assumptions around life expectancy, we
estimate that the present value of these costs amounts to
€800,000.
◼ Next, we inquire about the couple’s investment
preferences, to which they respond with the following.
© Kaplan, Inc. 107

Private Wealth

◼ The Schmitts do not want to experience more than a 20%
drop in the overall value of their investment portfolio.
◼ They like to feel “in control” and wish to invest in
instruments they can liquidate easily.
◼ Despite Eurolandia’s stability, they worry about inflation.
◼ They do not want to make investments in real estate funds.
© Kaplan, Inc. 108


Private Wealth

◼ The Schmitts’ income needs are being met by their pension
income and annuities. ATBR in their investment accounts
is much higher than that of other couples who may need to
use such accounts to supplement their pension income.
◼ Based on Jessica’s comments about not wanting to see
their portfolio value decrease more than 20% in any year,
their WTBR is lower.
© Kaplan, Inc. 109

Private Wealth

◼ Because the Schmitts have multiple objectives, it is
appropriate to use a goals-based asset allocation
approach.
◼ Using a combination of goals-based investing techniques
and capital market assumptions for major asset classes,
the following proposal is developed.
© Kaplan, Inc. 110


Private Wealth
© Kaplan, Inc. 111

Private Wealth

◼ We recommend the following:
1. To help Roxane with a down payment on the home,
keep the funds received from the pension lump sum in
cash.
2. The PV of Peter’s care is €800,000; allocate this
amount in the investment portfolio to inflation-protected
government bonds to maintain purchasing power.
© Kaplan, Inc. 112


Private Wealth

3. The majority of the remaining balance should be
allocated to global equities; this allows the investment
portfolio to benefit from long-term stock returns.
4. The portfolio is already invested in various asset
classes, so a transition will require the couple to realize
capital taxes.
◼ Recommend these moves be made in a manner that takes
advantage of capital gains tax exemptions, if applicable.
© Kaplan, Inc. 113


Case Studies
Case Study in Risk Management: Institutional

Institutional
Institutional Investors Objectives

Pension funds
▪ Objective: provide retirement income to members
▪ Risk: inability to meet contractual liabilities
Endowments and foundations
▪ Objective: support current and future beneficiaries
▪ Risk: inability to fulfill mission and purpose
© Kaplan, Inc. 2


Institutional

Sovereign wealth funds
▪ Objective: support govt. spending in ST, MT, or LT
▪ Risk: unable to provide support when needed
Banks
▪ Objective: asset liability management
▪ Risk: duration mismatch, interest rate risk, credit risk, and
liquidity risk
© Kaplan, Inc. 3

Institutional

Insurance companies
▪ Objective: asset liability management
▪ Risk: funding contingent liabilities, liquidity risk
© Kaplan, Inc. 4


Institutional
Risk Considerations Illiquid Assets

The endowment model
▪ High allocations to private equity, real estate hedge funds,
natural resources, and infrastructure
▪ Illiquid assets
Liquidity in a crisis
▪ Inflows from donations slow, spending outflows continue
▪ Market liquidity: able to sell at a fair price
▪ Funding liquidity: ability to raise funds
© Kaplan, Inc. 5

Institutional
Illiquid Assets: Smoothed Returns

Return smoothing
▪ Results from a lack of transactions in private markets
▪ Typically in private equity and real estate markets
▪ Appraisals lag true valuations and returns
Impact of smoothing
▪ In a rising market, appraised values and returns are too low
▪ In a falling market, appraised values and returns are too high
▪ Return and correlations volatility falsely appear lower
© Kaplan, Inc. 6


Institutional
Direct Investments in Illiquid Assets

Direct investments in illiquid assets
▪ Direct control over the asset
▪ Increased liquidity and timing over exits
▪ Difficult to diversify across enough projects
▪ Potential for additional liabilities due to direct ownership
▪ Need to attract and retain an in-house investment team
© Kaplan, Inc. 7

Institutional
Indirect Investments in Illiquid Assets

Indirect investments in illiquid assets
▪ Invest via a fund
▪ Diversified
▪ Limited liability
▪ Less control over exits, leading to lower liquidity
▪ Higher fees
© Kaplan, Inc. 8


Institutional
Managing Liquidity Risk

This is a five-step process:
1. Establish liquidity risk policy guidelines.
2. Assess current liquidity.
3. Project future expected cash flows.
4. Stress test future liquidity needs.
5. Set an emergency liquidity contingency plan.
© Kaplan, Inc. 9

Institutional
Enterprise Risk Management

Perspectives of risk management (1)
▪ Top down: set by the board
▪ Bottom up: implemented by the investment team
▪ Portfolio-level view: risk factors, exposures, and correlation

▪ Asset-level view: detailed individual asset information
▪ Returns based: historic returns data

▪ Holdings based: details of a fund’s holdings and exposures
© Kaplan, Inc. 10


Institutional

Perspectives of risk management (2)
▪ Absolute risk: stand-alone measure of risk
▪ Relative risk: compared to a benchmark
▪ Short-term metrics: value at risk, conditional VaR

▪ Long-term metrics: Monte Carlo simulation
▪ Quantitative approaches: stress test critical factors

▪ Qualitative approaches: risk experience and expertise
© Kaplan, Inc.

Institutional

Enterprise risk management (ERM)
▪ ERM is a top-down approach encompassing all risks
faced by an organization.
▪ Risks include credit risk; market risk; operational risk;
liquidity risk; regulatory risk; reputational risk; and
environmental, social, and governance (ESG) risks.
▪ The board of directors defines risk tolerance and return
objectives. ERM includes identifying, measuring, assessing,
mitigating, and measuring and reporting risks.
© Kaplan, Inc. 12


Institutional
Investment Policy Statement

Setting risk tolerances
▪ Volatility
▪ Maximum drawdown
▪ Value at risk and conditional value at risk
▪ Leverage
▪ Derivatives and short positions
▪ Limits on illiquid holdings
▪ Tracking error budgets
© Kaplan, Inc. 13

Institutional
Risk Metrics: Value at Risk

Value at risk (VaR)
▪ Estimate of a low frequency, high impact (unexpected loss)
▪ Assumes a confidence level, distribution, and time period
Example: 1-day 95% VaR is estimated to be $1 million

▪ 5% error is assumed, termed the significance level
▪ VaR does not describe the maximum loss
▪ Conditional VaR is the average loss in the tail (beyond VaR)
© Kaplan, Inc. 14


Institutional
Environmental and Social Risks

Principles for responsible investing
▪ Voluntary framework for investors
▪ Encourages active ownership, engaging with portfolio firms
seeking ESG disclosures
▪ Identify firms that will prosper in the transition to a
zero-carbon economy and those with dependencies
upon fossil fuels
Universal ownership
▪ Large institutional investors will have ESG winners and losers
© Kaplan, Inc.

Institutional
Environmental and Social Risk Factors

Environmental issues
▪ Air and water pollution
▪ Carbon emissions and climate change
▪ Energy efficiency
▪ Water scarcity
▪ Waste management
▪ Deforestation
▪ Biodiversity
© Kaplan, Inc.


Institutional
Environmental and Social Risk Factors

Social issues
▪ Human rights and labor working conditions
▪ Gender and diversity
▪ Occupational health and safety
▪ Customer satisfaction
▪ Product responsibility
▪ Data security and privacy
▪ Community relations and charities
© Kaplan, Inc.

Institutional
Climate Risk
2015 Paris Climate Agreement
▪ Set target to limit global temperature increases to 2 degrees
Celsius above pre-industrial levels (aspirational target +1.5)
▪ Voluntary nationally determined contributions (NDCs)
(i.e., pledges from countries to reduce carbon emissions)
The inevitable policy response (IPR)

▪ Suggests zero-carbon regulation is inevitable
© Kaplan, Inc.


Institutional
Climate Transition Risk

Climate transition risk
▪ Being too slow or unable to transition to a zero-carbon
economy; being left behind with an outdated business model
▪ Resulting in stranded assets (e.g., coal mines)
Drivers of transition risk
▪ Changes in carbon regulation and carbon taxes
▪ Higher input cost of fossil fuels
▪ New clean technology and shifts in consumer preferences
© Kaplan, Inc.

Institutional
Physical Climate Risk

Physical climate risk
▪ Acute physical risks: one-off weather events
(e.g., storms, heatwaves, hurricanes, wildfires)
▪ Chronic physical risks: gradual effects of climate change
(e.g., sea level rise, temperature rise)
▪ Location and temperature are two new climate factors
impacting portfolio managers indicating risks to
coastal regions and local communities
© Kaplan, Inc.


Institutional
Climate Risk Strategies

Mitigation
▪ Reduce the reliance and exposure to fossil fuels and
carbon technology
▪ Reduce vulnerability to changes in carbon policy and shifts
in demand and consumer preferences
Adaption
▪ Align portfolios to sectors and firms that will prosper in the
transition to a zero-carbon economy
▪ New opportunities in clean energy and energy efficiency
© Kaplan, Inc.

Institutional
Social Issues for Institutional Investors

Reputational damage
▪ Being associated with the exploitation of employees via
investments made in international companies
▪ Attracting negative publicity and actions
Examples:
▪ Exploitation of workers, poor working conditions
▪ Health and safety issues
▪ Equality and human rights
▪ Standards within the value chain of suppliers and distributors
© Kaplan, Inc.


Institutional
Sustainable Development
United Nations Sustainable Development Goals (2005)
▪ No poverty, no hunger, health, and well-being
▪ Quality education, clean water, affordable energy
▪ Decent work, reduced inequalities, and peace and justice
for all
“Just transition”
▪ Respecting the rights of those impacted by climate change
policies, especially those in developing countries
▪ Encouraging dialogue with those impacted, providing support
© Kaplan, Inc.

Institutional
Case Study Highlights

Ruritania Sovereign Wealth Fund (R-SWF)
▪ Ruritania discovered valuable rare minerals
▪ $50 billion invested long term for future generations
Considering two direct illiquid investments

▪ Sunnyland Airport infrastructure project
▪ Atusi Beverage Company (ABC) private equity project
▪ Case study has three time periods: today, +3 yrs, +2 yrs
© Kaplan, Inc. 24


Institutional
Sunnyland Airport Project

Due diligence data
▪ Sunnyland is a frontier market island nation
▪ $100m investment in a private-public partnership to build a
new airport terminal and runway within 1km of the sea
▪ Investment represents 0.2% of R-SWF AUM
▪ 25-year expected investment horizon
▪ Build-operate-transfer model; two-year construction plan
▪ Airport Operating Group (AOG) will run the airport
© Kaplan, Inc. 25

Institutional
Atusi Beverage Company (ABC)

Due diligence data
▪ Atusi is a tropical frontier market
▪ ABC is only local beverage manufacturer
▪ Investment opportunity for a 35% stake in ABC for $25m as
a co-owner with the founder
▪ Plan is to modernize the ABC plant, reduce headcount from
500 to 300 to lower costs, and expand product lines
▪ ABC is located near a river with unique biodiversity
▪ Atusi applies 100% tariffs to foreign competition
© Kaplan, Inc. 26


Institutional
Case Study Questions

1. Evaluate the liquidity risk of each investment to R-SWF
2. For each investment, identify and explain one

environmental concern within the due diligence data that you
would recommend investigating further before proceeding.
Q1 and Q2 based on in-text questions in the CFA text for Reading 30 27

© Kaplan, Inc.

Institutional
Solution: Case Study Questions

1. Evaluate the liquidity risk of each investment to R-SWF.
Both investments represent relatively small exposures to

R-SWF. Sunnyland is 0.2% of AUM, and ABC is 0.05% of AUM.
While each individual project is relatively illiquid (Sunnyland has
a 25-year time horizon), being direct investments does provide
direct control over exits, which increases future liquidity.
Overall, the investments have little impact on R-SWF liquidity.
© Kaplan, Inc. 28


Institutional

2. Environmental concerns
Sunnyland: The airport and terminal are being built near the
sea. Sea level rise due to climate change is a risk to investigate
further, especially with a 25-year time horizon.
ABC: The nearby river has unique biodiversity. The impacts of

this on ABC operations should be investigated further as well as
local regulations impacting the business.
© Kaplan, Inc. 29

Institutional
Sunnyland Airport: 3-Year Review

Update on climate risk
▪ Underestimated the impacts of climate change
▪ Sea level rise will impact Sunnyland much faster than
expected during the 25-year investment horizon
▪ Increases in temperature have shortened the tourist season
(May is now too hot for tourists)
Economic recession
▪ Vastly reduced tourist traffic; stress testing was inadequate
▪ Airport operator requesting lower fees
© Kaplan, Inc. 30


Institutional
ABC: 3-Year Review

Modernization and efficiencies
▪ Modernization is complete, but local employment laws require
a 2-year notice period for impacted employees
▪ Recession has hit the region; drinks are a luxury item, so
revenues are down
▪ Need to cut the workforce (costs) by 50% rather than 40%
ABC management practices
▪ Dumping waste in nearby river, cutting employee breaks to
30 minutes, and removing soap from the restrooms
© Kaplan, Inc. 31

Institutional
ABC: 3-Year Review

New government
▪ Recent elections have seen a change of administration.
▪ Import tariffs have been reduced from 100% to 20%.
Environmental complaints
▪ Environmental groups have started complaining about the
dumping of waste in the river. The area is home to rare
wildlife and is known as a local area of natural beauty.
© Kaplan, Inc. 32


Institutional

3. Identify and explain one social risk in each of the Sunnyland
and Atusi investment projects.
4. Identify and explain another risk to R-SWF common to both

investments.
Q3 and Q4 based on in-text questions in the CFA text for Reading 30 33

© Kaplan, Inc.

Institutional

3. Social risks
Sunnyland: The investment is a public-private partnership
involving many stakeholders such as R-SWF, the Sunnyland
government, the airport operator, and the local tourist industry.
Maintaining effective working relationships with all stakeholders
is challenging as evidenced by AOC wanting to renegotiate
fees. If relations were to break down, R-SWF would be left
without an airport operator. The goodwill of the government
is also essential.
© Kaplan, Inc. 34


Institutional

3. Social risks
ABC: The plans to reduce the headcount by 50% will have a
significant impact on the local community. It is essential that
ABC works with the local community to support a just transition.
Secondly, the cost-cutting measures reducing employee breaks
and ending access to soap in restrooms could be viewed as
employee exploitation; this brings reputational risk for R-SWF.
© Kaplan, Inc. 35

Institutional

4. Another common risk—reputational risk
Sunnyland: Any errors or mishandling of stakeholder
relationships will lead to reputational risk. These relationships
may be tested over the 25-year investment horizon when tough
investment decisions will need to be made over necessary
climate change defenses.
ABC: Being associated with the environmental malpractice of
dumping waste in the river is already attracting negative publicity.
The alleged exploitation of employees is another source of
reputational risk for ABC.
© Kaplan, Inc. 36


Institutional
Sunnyland Airport: 5-Year Review

Project update
▪ Airport traffic is down (50% below the base case forecast).
▪ Revenues are significantly down.
▪ Costs are rising (50% higher than the base case forecast,
due to climate adaption programs).
▪ The outlook for the medium to long term is unfavorable.
© Kaplan, Inc. 37

Institutional
ABC: 5-Year Review

Project update
▪ R-SWF sold their 35% stake in ABC to an international
beverage company for $27 million.
▪ R-SWF avoided the potential reputational damage of
associations with ABC over environmental and social issues.
© Kaplan, Inc. 38


Institutional

5. A key risk in the Sunnyland Airport project is key changes to
customer traffic. Explain and describe a form of analysis that
could have been implemented to explore this risk and to
increase confidence before investing.
Q5 based on in-text questions in the CFA text for Reading 30 39

© Kaplan, Inc.

Institutional

Q5. Scenario analysis and stress testing
Scenario analysis and stress testing of the base case
customer traffic assumptions would have improved the
understanding of the possible variations before investing.
Monte Carlo simulation could be used to explore the impacts
on revenues and costs of changing customer traffic as well as
identifying breakeven points. Stress testing the impacts of an
economic downturn should have been explored in advance.
© Kaplan, Inc. 40

Ethical and
Professional Standards

918 Ethical and Professional Standards
Ethical and Professional

Standards
Code of Ethics and Standards of Professional
Conduct
Code and Standards
CFA Institute Professional

Conduct Program
Disciplinary Review Committee of CFA Institute
Board of Governors has responsibility for the
Professional Conduct Program and for enforcement
of the Code and Standards
CFA Institute, through Professional Conduct staff,
conducts inquiries related to professional
conduct
© Kaplan, Inc. 2

Ethical and Professional Standards 919
Code and Standards

Conduct Program
Inquiry can be prompted by:
◼ Self-disclosure by members or candidates
◼ Written complaints about a member or

candidate’s professional conduct
◼ Evidence of misconduct by a member or
candidate
© Kaplan, Inc. 3
Code and Standards

Conduct Program
Inquiry can be prompted by:
◼ Report by a CFA exam proctor
◼ Analysis of exam scores and materials,
monitoring of websites and social media
© Kaplan, Inc. 4

Code and Standards

Conduct Program
CFA Institute Professional Conduct staff may decide:
1. That no disciplinary sanctions are appropriate
2. To issue a cautionary letter
3. To discipline the member or candidate
Sanctions may include condemnation by member’s
peers or suspension of candidate’s participation in
the CFA Program
© Kaplan, Inc. 5
Code and Standards
Code of Ethics
Act with integrity, competence, diligence,
respect, and in an ethical manner—public,
clients, prospects, employers, employees,
colleagues. Act in an ethical manner.
Integrity of investment profession and client
interests above personal interests. Integrity is
paramount and clients always come first.
© Kaplan, Inc. 6

Code and Standards
Code of Ethics
Reasonable care, independent professional
judgment when conducting analysis, making
recommendations, taking investment actions, and
in other professional activities. Use reasonable
care; be independent.
Practice, encourage others…in a professional,
ethical manner…reflect credit on themselves and
profession. Be a credit to the investment
profession.
© Kaplan, Inc. 7
Code and Standards
Code of Ethics
Promote integrity of capital markets for ultimate
benefit of society. Uphold capital market rules
and regulations.
Maintain, improve professional competence,
and strive to do the same for other investment
professionals. Be competent.
© Kaplan, Inc. 8

Code and Standards
Standards of Professional Conduct

I. Professionalism
A. Knowledge of the Law
B. Independence and Objectivity
C. Misrepresentation
D. Misconduct
© Kaplan, Inc. 9
Code and Standards

II. Integrity of Capital Markets
A. Material Nonpublic Information
B. Market Manipulation
© Kaplan, Inc. 10

Code and Standards

III. Duties to Clients
A. Loyalty, Prudence, and Care
B. Fair Dealing
C. Suitability
D. Performance Presentation
E. Preservation of Confidentiality
© Kaplan, Inc. 11
Code and Standards

IV. Duties to Employers
A. Loyalty
B. Additional Compensation Arrangements
C. Responsibilities of Supervisors
© Kaplan, Inc. 12

Code and Standards

V. Investment Analysis,
Recommendations, and Actions
A. Diligence and Reasonable Basis
B. Communication with Clients and
Prospective Clients
C. Record Retention
© Kaplan, Inc. 13
Code and Standards

VI. Conflicts of Interest
A. Disclosure of Conflicts
B. Priority of Transactions
C. Referral Fees
© Kaplan, Inc. 14

Code and Standards

VII. Responsibilities as a CFA Institute
Member or CFA Candidate
A. Conduct as Participants in CFA Institute
Programs
B. Reference to CFA Institute, the CFA
Designation, and the CFA Program
© Kaplan, Inc. 15


Standards
Guidance for Standards I - VII
Ethical and Professional Standards
Standard I:
Professionalism

Standard I: Professionalism
Standard I(A) Knowledge of the Law

Understand and comply with all laws, rules,
and regulations (including Code and Standards)
of any government, regulatory agency, or
association governing professional activities
Comply with more strict law, rule, and regulation
Do not knowingly assist in violation, otherwise
dissociate from activity
© Kaplan, Inc. 3
Standard I(A) - Knowledge of the Law

Guidance
◼ Most strict
◼ First, notify supervisor or compliance
◼ May confront wrongdoer directly
◼ Dissociate if necessary
◼ Inaction may be construed as participation
◼ No requirement to report violations to
governmental authorities, may be appropriate in
certain cases
© Kaplan, Inc. 4


Recommended Procedures
Keep informed, regularly review written
compliance procedures, maintain files
Seek compliance/legal advice as needed
Encourage firms to adopt code of ethics
© Kaplan, Inc. 5

Distribute information internally on applicable
laws and regulations
Have written procedures for reporting
suspected violations
Members strongly encouraged to report
violations by other members
© Kaplan, Inc. 6

Standard I(B) - Independence and Objectivity

Use reasonable care, judgment to achieve and
maintain independence in professional activities
Do not offer, solicit, or accept any compensation
that could compromise independence or
objectivity
© Kaplan, Inc. 7

Guidance
Modest gifts okay
Distinguish between gifts from clients and gifts from
entities trying to influence a member’s behavior
May accept gift from clients—disclose to
employer—get permission if for future performance
© Kaplan, Inc. 8


Guidance
Members responsible for hiring outside managers
should not accept travel, gifts, or entertainment that
could impair their objectivity
Investment banking relationships—do not bow to
pressure to issue favorable research
For issuer-paid research, flat fee structure is
preferred; must disclose
© Kaplan, Inc. 9

Guidance
Members working for credit rating firms should
avoid influence by issuing firms
Users of credit ratings should be aware of this
potential conflict
Best practice is for analysts to pay for their own
commercial travel to firms being analyzed or to
firm events
© Kaplan, Inc. 10


◼ Protect integrity of opinions—reports should
reflect unbiased opinion
◼ Create a restricted list
◼ Restrict special cost arrangements
◼ Limit gifts; clear value limits by firm
◼ Be careful with IPO share allocations
© Kaplan, Inc. 11
Standard I(C) – Misrepresentation

Do not make misrepresentations relating to
investment analysis, recommendations, actions,
or other professional activities
© Kaplan, Inc. 12


Guidance
◼ Standard covers oral, written, and electronic
communications
◼ Do not misrepresent qualifications, services of self
or firm, performance record, or characteristics of
an investment
◼ Do not guarantee a certain return
◼ No plagiarism
© Kaplan, Inc. 13

Firms can assist employees by providing a written list
of the firm’s available services and a description of the
firm’s qualifications
Maintain records of materials used to prepare research
reports, and quote source, except for recognized
financial and statistical reporting services
© Kaplan, Inc. 14


Models and analysis of others at the firm may
be used without attribution
Should encourage firm to establish procedures
for verifying marketing claims of third parties
recommended to clients
© Kaplan, Inc. 15
Standard I(D) – Misconduct

Do not engage in any professional conduct
involving dishonesty, fraud, or deceit or commit
any act that reflects adversely on professional
reputation, integrity, or competence
© Kaplan, Inc. 16


Guidance
This Standard covers conduct that may not be
illegal, but could adversely affect a member’s
ability to perform duties.
© Kaplan, Inc. 17

◼ Adopt a code of ethics to which every
employee must adhere
◼ Disseminate a list of potential violations and
associated disciplinary sanctions
◼ Conduct background checks on potential
employees—look for good character and
eligibility to work in the investment industry
© Kaplan, Inc. 18

Standard II:
Integrity of Capital
Markets
Standard II: Integrity of Capital Markets
Standard II(A) Material Nonpublic Information

Members in possession of nonpublic information
that could affect an investment’s value must not
act or cause someone else to act on the
information.
© Kaplan, Inc. 20


Guidance
“Material”—if disclosure of information would affect a
security’s price or if an investor would want to know
before making an investment decision
If price effect is ambiguous, information may not be
considered material
Extends to info such as upcoming rating change and
influential analysis to be released
© Kaplan, Inc. 21

Guidance
Information is nonpublic until it has been made available
to the marketplace.
Information made available to analysts is considered
nonpublic until it is made available to investors in
general.
Act includes related swaps and options and mutual
funds with the security.
© Kaplan, Inc. 22


Guidance
May use firm-provided information for certain
specified purposes (e.g., due diligence for
transactions with firm)
Mosaic Theory—no violation when an analyst
combines nonmaterial, nonpublic information with
public information to reach conclusion
© Kaplan, Inc. 23

Information barrier or “firewall” is recommended to
control interdepartmental communications
Information barrier includes use of restricted list
Review employee trades
© Kaplan, Inc. 24


Increase review/restrict proprietary trading while
firm is in possession of material nonpublic
information
© Kaplan, Inc. 25
Standard II(B) Market Manipulation

Do not engage in practices that distort prices or
artificially inflate trading volume with intent to
mislead market participants
© Kaplan, Inc. 26

Standard II(B) Market Manipulation

Guidance
Do not engage in transaction-based manipulation:
◼ Giving false impression of activity/price movement
◼ Gaining dominant position in an asset to manipulate
price of the asset or a related derivative
Do not distribute false, misleading information
© Kaplan, Inc. 27
Standard III:
Duties to Clients and
Prospective Clients

Standard III: Duties to Clients and Prospective Clients
Standard III(A) – Loyalty, Prudence and Care

Duty of loyalty to clients—act with reasonable
care and exercise prudent judgment
Act for benefit of clients and place their interests
before employer’s or own interests
Determine and comply with any applicable
fiduciary duty
© Kaplan, Inc. 29

Guidance
Take investment actions in client’s best interests
Exercise prudence, care, skill, and diligence that
a person familiar with such matters would use
© Kaplan, Inc. 30


Guidance
Follow applicable fiduciary duty
“Client” may be investing public
Manage pools of client assets according to
terms of governing documents
© Kaplan, Inc. 31

Guidance
Make investment decisions in context of total portfolio
Vote proxies responsibly and disclose proxy voting
policies to clients
“Soft dollars” must benefit client
© Kaplan, Inc. 32


◼ Follow rules and laws
◼ Establish client investment objectives
◼ Diversify
◼ Deal fairly with clients—investment actions
◼ Disclose all possible conflicts
© Kaplan, Inc. 33

◼ Vote proxies in best interest of clients and
ultimate beneficiaries
◼ Keep client information confidential
◼ Seek best trading execution for clients
◼ Place client interests first
© Kaplan, Inc. 34

Standard III(B) – Fair Dealing

Deal fairly and objectively with all clients when:
◼ Providing investment analysis
◼ Making investment recommendations
◼ Taking investment action
◼ Engaging in other professional activities
© Kaplan, Inc. 35

Guidance
No discrimination against any clients when
disseminating investment recommendations or
taking investment action
Fair does not mean equal
© Kaplan, Inc. 36


Guidance
Different levels of service are okay as long as
disclosed and do not disadvantage any clients
All clients must have fair chance to act on every
investment recommendation
If client is unaware of recommendation change,
advise before accepting trade order
© Kaplan, Inc. 37

Guidance
Treat all clients fairly—consider investment
objectives and circumstances
Disclose written allocation procedures
Do not disadvantage any clients when
distributing “hot” issues
© Kaplan, Inc. 38


Limit number of people aware of upcoming
changes
Shorten time frame—decision to dissemination
Have pre-dissemination guidelines
Simultaneous dissemination
© Kaplan, Inc. 39

Maintain list of clients and their holdings
Disclose trade allocation procedures
Review accounts regularly to ensure fair client
treatment
© Kaplan, Inc. 40


If firm offers different levels of service, disclose
this fact to all clients
Deviations from strict pro rata allocation of IPO
is sometimes okay (e.g., minimum block sizes)
© Kaplan, Inc. 41
Standard III(C) – Suitability

When in advisory relationship with a client:
◼ Make reasonable inquiry as to client’s
investment experience, risk/return
objectives, financial constraints prior to
making any recommendation, or taking
investment action
◼ Update information regularly
© Kaplan, Inc. 42


When in advisory relationship with client:
◼ Ensure investment is suitable to client’s
situation and consistent with written
objectives before recommending an
investment or taking investment action
◼ Look at suitability in a portfolio context
© Kaplan, Inc. 43

When responsible for managing a portfolio to a
specific mandate, strategy, or style, only make
recommendations or take investment actions that
are consistent with the stated objectives and
constraints of the portfolio
© Kaplan, Inc. 44


Guidance
◼ When in advisory relationship, gather client
information at the outset and prepare IPS
◼ Update IPS at least annually
◼ Consider whether leverage (derivatives) is suitable
for client
◼ If managing a fund to an index or other mandate,
invest according to mandate
© Kaplan, Inc. 45

Guidance
If a client requests an unsuitable trade, discuss
suitability with the client before executing
◼ If not material to portfolio, follow firm’s policies for
client approval
◼ If material, discuss whether IPS needs update
◼ If client declines to update IPS, follow firm’s policies
or reconsider advisory relationship
© Kaplan, Inc. 46


When formulating IPS for client, know the client’s:
◼ Return objectives
◼ Risk tolerance
© Kaplan, Inc. 47

Determine the client’s constraints:
◼ Liquidity needs
◼ Expected cash flows, investable funds
◼ Time horizon, tax considerations
◼ Regulatory/legal constraints
◼ Unique circumstances/needs
© Kaplan, Inc. 48

Standard III(D) – Performance Presentation

When communicating investment performance
information, make reasonable efforts to ensure
that it is fair, accurate, and complete
Can make brief presentation, note limited
nature, and make detailed information
available on request
© Kaplan, Inc. 49

Guidance
◼ Do not misstate performance or mislead clients
about investment performance
◼ Do not misrepresent past performance
◼ Provide fair and complete performance
information
◼ Do not state or imply ability to achieve returns
similar to those achieved in the past
© Kaplan, Inc. 50


◼ Consider audience sophistication when
presenting performance
◼ Use performance of the weighted composite
of similar portfolios
◼ Include terminated accounts as part of
historical performance
◼ Make all disclosures and maintain records
© Kaplan, Inc. 51
Standard III(E) – Confidentiality

Keep current and prospective client information
confidential, unless:
◼ Illegal activities are suspected
◼ Disclosure is required by law
◼ Client or prospect allows disclosure of the
information
© Kaplan, Inc. 52


Guidance
In some cases it may be required by law to report
activities to relevant authorities
This Standard extends to former clients
Exception: May provide confidential information to
CFA Institute for an investigation under Professional
Conduct Program
© Kaplan, Inc. 53

Avoid discussing any information received from
a client except to colleagues working on the
same project
Follow firm’s electronic data storage procedures;
recommend adoption of procedures if none exist
© Kaplan, Inc. 54

Standard IV:
Duties to Employers
Standard IV: Duties to Employers
Standard IV(A) – Loyalty

On matters related to employment, act for
benefit of employer and do not deprive
employer of the advantage of skills/abilities,
divulge confidential information, or otherwise
cause harm to employer
© Kaplan, Inc. 56


Guidance
Place client interests first but consider effects
on firm integrity and sustainability
Members encouraged to give employer a copy
of the Code and Standards
No incentive or compensation structure that
encourages unethical behavior
© Kaplan, Inc. 57

Guidance
Independent Practice:
◼ If planning to engage in independent practice,
notify employer of services provided, expected
duration, and compensation
◼ Do not proceed without consent from employer
© Kaplan, Inc. 58


Guidance
Leaving an Employer:
◼ Act in best interest of employer until resignation is effective
◼ Employer records on any medium (e.g., cell phone, PDA,
home computer) are property of the firm
◼ Simple knowledge of names of former clients is okay; but
don’t solicit prior to leaving
◼ No prohibition on use of experience or knowledge gained at
former employer
© Kaplan, Inc. 59

Guidance
Whistleblowing:
◼ Permitted only if it protects client or integrity
of capital markets
◼ Not permitted for personal gain
© Kaplan, Inc. 60


Recommended Practices
Encourage firms to adopt policies regarding:
◼ Outside practice, non-compete agreements
◼ Leaving employer (resignation, termination)
◼ Incident reporting
◼ Employee classification (full-time, part-time,
contractor)
© Kaplan, Inc. 61
Standard IV(B) – Additional Compensation

Do not accept gifts, benefits, compensation, or
consideration that competes with, or creates a
conflict of interest with, employer’s interest
unless written consent is obtained from all
parties involved
© Kaplan, Inc. 62


Guidance
Compensation and benefits covers direct
compensation by the client and other benefits
received from third parties
For written consent from “all parties involved,”
email is acceptable
© Kaplan, Inc. 63

◼ Written report to employer with details of
proposed compensation in addition to normal
compensation and benefits
◼ Details of incentives verified by offering party
◼ Include nature of compensation, amount, and
duration of agreement
© Kaplan, Inc. 64

Standard IV(C) – Responsibilities of

Supervisors
Make reasonable efforts to ensure that anyone
subject to your supervision or authority
complies with applicable laws, rules,
regulations, and Code and Standards
© Kaplan, Inc. 65

Supervisors
Guidance
Supervisors must take steps to prevent
employees from violating laws, rules, regulations,
or the Code and Standards
Supervisors must make reasonable efforts to
detect violations
© Kaplan, Inc. 66


Supervisors
Adequate compliance procedures should:
◼ Be clear and understandable
◼ Designate a compliance officer
◼ Have checks/balances; permitted conduct
◼ Have procedures for reporting violations
© Kaplan, Inc. 67

Supervisors
Supervisor and compliance officer should:
◼ Distribute procedures; update periodically
◼ Continually educate staff
◼ Review employee actions
◼ Promptly initiate procedures once a

violation has occurred
© Kaplan, Inc. 68


Supervisors
Once a violation has occurred, a supervisor should:
◼ Respond promptly
◼ Conduct a thorough investigation
◼ Place appropriate limitations on the wrongdoer
until investigation is complete

© Kaplan, Inc. 69
Standard V:
Investment Analysis,
Recommendations, and
Actions

Code of Ethics
Standard V: Investment Analysis, Recommendations, and Standards
and Actions
of Professional Conduct
Standard V(A) – Diligence and
Reasonable Basis
Exercise diligence, independence, thoroughness in
analyzing investments, making investment
recommendations, and taking investment action
Have a reasonable and adequate basis, supported
by research, for analysis, recommendation, or action
© Kaplan, Inc. 71
Code of Ethics
and Actions
Reasonable Basis
Guidance
Make reasonable efforts to cover all relevant
issues when arriving at an investment
recommendation
Level of diligence will depend on product or
service offered
© Kaplan, Inc. 72

Code of Ethics
and Actions
Reasonable Basis
Guidance
Using secondary or third-party research:
◼ Determine soundness of the research—review
assumptions, rigor, timeliness, and independence
◼ Encourage firm to adopt policy of periodic review of
quality of third-party research: assumptions, timeliness,
rigor, objectivity, and independence
© Kaplan, Inc. 73
Code of Ethics
and Actions
Reasonable Basis
Establish policy that research and recommendations
should have reasonable and adequate basis
Review/approve research reports and
recommendations prior to external circulation
© Kaplan, Inc. 74

Code of Ethics
and Actions
Reasonable Basis
Establish due diligence procedures for judging if
recommendation has met reasonable and adequate
basis criteria
Develop measurable criteria for assessing quality of
research
© Kaplan, Inc. 75
Code of Ethics
and Actions
Reasonable Basis
Consider scenarios outside recent experience to
assess downside risk of quantitative models
Make sure firm has procedures to evaluate external
advisers they use or promote, including how often to
review
© Kaplan, Inc. 76

Code of Ethics
and Actions
Reasonable Basis
◼ Written procedures of acceptable scenario testing,
range of scenarios, cash flow sensitivity to
assumptions and inputs
◼ Procedure for evaluating outside information providers
including how often
◼ No need to dissociate from group research that the
member disagrees with
© Kaplan, Inc. 77
Code of Ethics
and Actions
Standard V(B) – Communication with
Clients and Prospective Clients
Disclose basic format/general principles of
investment processes used to analyze investments,
select securities, and construct portfolios
Promptly disclose any changes that may affect
those processes materially
© Kaplan, Inc. 78

Code of Ethics
and Actions
Disclose risks and limitations (e.g., liquidity, capacity)
associated with investment process
◼ Use reasonable judgment in identifying which
factors are important to investment analyses,
recommendations, or actions
◼ Include those factors in communications with
clients/prospective clients
© Kaplan, Inc. 79
Code of Ethics
and Actions
Distinguish between fact and opinion in
presentation of investment analysis and
investment recommendations
Clearly communicate potential gains and losses
on an investment
© Kaplan, Inc. 80

Code of Ethics
and Actions
Guidance
Include basic characteristics of the security
Inform clients of any change in investment processes
Suitability of investment—portfolio context
All communication covered, not just reports
© Kaplan, Inc. 81
Code of Ethics
and Actions
The inclusion or exclusion of information depends
on a case-by-case review
Maintain records
© Kaplan, Inc. 82

Code of Ethics
and Actions
Standard V(C) – Record Retention
Develop and maintain appropriate records to
support investment analyses, recommendations,
actions, and other investment-related
communications with clients and prospective clients
© Kaplan, Inc. 83
Code of Ethics
and Actions
Guidance
◼ Maintain records to support research, and the
rationale for conclusions and actions
◼ Records are firm’s property and cannot be taken
when member leaves without firm’s consent
◼ If no regulatory requirement or firm policy, CFA
Institute recommends retention period of 7 years
© Kaplan, Inc. 84

Code of Ethics
and Actions
Responsibility to maintain records generally falls
with the firm
However, individuals must retain documents that
support investment-related communications
© Kaplan, Inc. 85
Code of Ethics
and Actions
When member changes firm, must recreate records
from public sources and new firm’s information
(can’t rely on memory or materials from old firm)
© Kaplan, Inc. 86

Standard VI:
Conflicts of Interest
Standard VI: Conflicts of Interest Code of Ethics and Standards

Standard VI(A) – Disclosure of Conflicts
Make full, fair disclosure of all matters that could
reasonably be expected to impair
independence/objectivity, or interfere with duties to
clients, prospects, or employer
Ensure disclosures are prominent, delivered in
plain language
© Kaplan, Inc. 88


Guidance
Disclose to clients:
▪ All matters that could impair objectivity—allow
clients to judge motives, biases
◼ For example, between member or firm and
issuer, investment banking relations,

broker/dealer market-making activities,
significant stock ownership, board service
© Kaplan, Inc. 89

Guidance
Disclose to employers:
◼ Conflicts of interest—ownership of stock
analyzed/recommended, board participation,
financial and other pressures that may influence
decisions
◼ Also covers conflicts that could be damaging to
employer’s business
© Kaplan, Inc. 90


Disclose compensation arrangements with
employer that conflict with clients’ interests
If firm does not permit disclosure, consider
dissociating from the activity
Firms are encouraged to include compensation
information in promotional materials
© Kaplan, Inc. 91

Standard VI(B) – Priority of Transactions
Investment transactions for clients and employers
must have priority over transactions in which a
member or candidate is the beneficial owner
Do not use knowledge of pending trades for
personal gain
© Kaplan, Inc. 92


Guidance
◼ “Beneficial owner”—has direct/indirect personal
interest in the securities
◼ Client, employer transactions take priority over
personal transactions (including beneficial
ownership)
◼ Family member accounts that are client accounts
must be treated as other client accounts
© Kaplan, Inc. 93

Firm’s compliance procedures should:
◼ Limit participation in equity IPOs
◼ Restrict purchase of securities through private
placements
© Kaplan, Inc. 94


Establish blackout/restricted periods
Establish reporting procedures and prior clearance
requirements
Disclose policies on personal investing to clients,
upon request
© Kaplan, Inc. 95

Standard VI(C) – Referral Fees
Disclose to employer, clients, and prospective clients,
as appropriate, any compensation, consideration,
benefit received from, or paid to, others for the
recommendation of products or services
© Kaplan, Inc. 96


Guidance
Disclosure allows clients and employers to evaluate
full cost of service and any potential biases
Disclosure is to be made prior to entering into any
formal agreement for services
Disclose the nature of the consideration
© Kaplan, Inc. 97

Guidance
Encourage firm to have clear policy regarding
referral compensation
Firms that do not prohibit should have clear
approval process
Members should update referral compensation
disclosure to employer at least quarterly
© Kaplan, Inc. 98

Standard VII:
Responsibilities as a
CFA Institute Member
or CFA Candidate
CodeMember
Standard VII: Responsibilities as a CFA Institute of Ethics
orand Standards
Candidate
Standard VII(A) – Conduct as Participants in
CFA Institute Programs
Do not engage in any conduct that compromises
the reputation or integrity of CFA Institute or CFA
designation, or the integrity, validity, or security of
CFA Institute programs
© Kaplan, Inc. 100

CodeMember
orand Standards
Candidate
Guidance
Conduct includes:
◼ Cheating on the exam
◼ Disregarding rules and policies or security

measures related to exam administration
◼ Giving confidential information to candidates
or public
© Kaplan, Inc. 101
CodeMember
orand Standards
Candidate
Guidance
Conduct includes (continued):
◼ Improper use of CFA designation to further
personal and professional objectives

◼ Misrepresenting the CFA Institute Professional
Development Program or the Professional

Conduct Statement
© Kaplan, Inc. 102

CodeMember
orand Standards
Candidate
Guidance
Don’t disclose:
◼ Formulas tested or not tested on exam
◼ Specific question information
◼ Topic emphasis on the exam or topics tested
© Kaplan, Inc. 103
CodeMember
orand Standards
Candidate
Standard VII(B) – Reference to CFA Institute,
the CFA Designation, and the CFA Program
When referring to CFA Institute, membership,

designation, or candidacy, do not misrepresent or
exaggerate the meaning or implications of
membership in CFA Institute, holding the CFA
designation, or candidacy in the CFA program
© Kaplan, Inc. 104

CodeMember
orand Standards
Candidate
Guidance
CFA Institute membership:
◼ Complete PCS annually
◼ Pay membership dues annually
◼ Failure to comply with above results in an

inactive member status
© Kaplan, Inc. 105
CodeMember
orand Standards
Candidate
Guidance
Use the marks “Chartered Financial Analyst” or
“CFA” in a manner that does not misrepresent or
exaggerate the meaning or implications of holding
the CFA designation
© Kaplan, Inc. 106

CodeMember
orand Standards
Candidate
Guidance
Reference to the CFA program:
◼ Candidates may reference participation in CFA
program, but do not imply achievement of any
type of partial designation
◼ Okay to say “passed all levels on first attempt,”
but do not imply superior ability

© Kaplan, Inc. 107
CodeMember
orand Standards
Candidate
Make sure that your employer is aware of the
proper references to the CFA designation and
CFA candidacy
© Kaplan, Inc. 108


Standards
Application of the Code and Standards: Level III
Application of the Code

and Standards: Level III
Ethical Decision Making

◼ Identify the material facts and issues.
◼ To whom are duties owed?
◼ What are the potential or actual conflicts of interest?
◼ What ethical principals apply?
◼ Seek professional guidance as needed.
◼ Are circumstances affecting judgement?
◼ Identify possible actions and review the results.
© Kaplan, Inc. 2


Sovereign Investment Corporation

Case outline (1)
▪ Victoria Adebayo is the chief financial officer of the
Sovereign Investment Corporation (SIC).
▪ The objectives of the SIC are to develop the country’s
economy by financing local projects and attracting international
investors (also to develop the country’s capital markets).
▪ The SIC controls an investment company, National
Investments (NI), which offers domestically listed stock to
international investors in return for overseas finance.
© Kaplan, Inc. 3


Case outline (2)
▪ A regional governor, who is the leader of the main opposition
party, is lobbying for a major investment in a mining project in
a remote area.
▪ The project will bring development benefits to the region and
a positive ROI, but it requires significant capital investment.
▪ The current government’s minister of finance prefers a
smaller urban infrastructure project, which will create
hundreds of new jobs for supporters of the government.
© Kaplan, Inc. 4



Case outline (3)
▪ The minister of finance was involved in the hiring of Adebayo.
▪ Adebayo believes that undertaking both projects
simultaneously would place too great a strain on NI resources.
▪ She decides to invest in the smaller infrastructure project first,
and then invest in the larger mining project.
▪ Adebayo believes this approach would benefit the current
government regime and that the opposition party may have
taken power in time for the deferred mining project.
© Kaplan, Inc. 5

Example: Sovereign Investment Corporation

1. Determine if Adebayo has violated Standard V(A) Diligence
and Reasonable Basis.
2. Determine if Adebayo violated Standard III(C) Suitability.
© Kaplan, Inc. 6


Solution: Sovereign Investment Corporation

Standard V(A) Diligence and Reasonable Basis
▪ Adebayo has violated this standard as she acted quickly
based upon political considerations rather than proper
analysis.
▪ She must remain independent and avoid conflicts of interest.
▪ NI should have developed a strong governance framework
for investment decisions, allowing staff to perform sufficient
due diligence free from bias. Disclosure of conflicts without
due diligence would be insufficient for Standard V(A).
© Kaplan, Inc. 7


Standard III(C) Suitability
▪ Suitability requires members to make investment decisions
that are consistent with a funds mandate.
▪ Adebayo has dual mandate to invest in projects that boost
her country’s economic development while generating ROI.
▪ Adebayo has not breached this standard as both projects
are considered consistent with this mandate.
© Kaplan, Inc. 8



Case outline (4)
▪ Anthony Corrales worked with Adebayo at her previous
employer, a U.K. hedge fund, HFI.
▪ Corrales contacts Adebayo about a potential investment in
NI, requesting information on NI’s financial condition including
both current and future projects.
▪ Adebayo provides him with the standard investor disclosure
package. To convince his partners at HFI to invest, Corrales
invests 25% of his personal portfolio in NI.
© Kaplan, Inc. 9


Case outline (5)
▪ The partners at HFI decide to invest in NI, asking for
assurance that NI maintain its aggressive strategy
targeting high returns.
▪ Adebayo assures HFI that NI is committed to generating a
high ROI for investors.
▪ Once HFI’s investment in NI is publicly announced, the
shares of NI rise on the exchange.
▪ Corrales requests regular updates directly from Adebayo.
© Kaplan, Inc. 10



3. Determine if Adebayo has violated Standard III(C) Suitability,
in the disclosures made to Corrales concerning NI’s investment
mandate.
4. Determine if Adebayo has violated Standard III(C) Suitability,

in sharing NI financial information to Corrales.
5. Determine if Adebayo providing regular updates directly to

Corrales is a violation of Standard III (B) Fair Dealing.
© Kaplan, Inc. 11


▪ 3. Adebayo has violated this standard by not disclosing that NI
has a dual mandate to promote economic development and
positive ROI. Investors must be made aware that investment
returns are not the only factor driving NI’s investment decisions.
▪ 4. Sharing of information is not a violation provided it is not
confidential or material non-public information. Providing
standard investor information is not a violation.
▪ 5. Providing regular updates is also not a violation as long as
Adebayo does not show any favoritism i.e. Fair Dealing.
© Kaplan, Inc. 12



6. Determine if Corrales has committed a violation in
purchasing his stake in NI before his employer.
7. Determine if Corrales investing in the same stock as his

employer is a violation of Standard VI(A) Conflicts of Interest.
© Kaplan, Inc. 13


▪ 6. Corrales has committed a violation in “front running”
(i.e., trading before his employer (or before clients).
▪ This is a violation of Standard VI(B) Priority of Transactions
and also may be illegal in some jurisdictions, resulting in a
violation of Standard I(A) Knowledge of the Law.
▪ Corrales should have waited until after his employer has
traded, before trading for his personal account.
▪ 7. Investing in the same stock as your employer does not
automatically create a conflict of interest.
© Kaplan, Inc. 14



Case outline (6)
▪ Corrales recruits overseas subadvisors to identify
private market investments for HFI to aid with local laws
and regulations.
▪ The subadvisors are paid directly from the fund assets and
have connections with high-ranked local government officials,
but have minimal/no experience as financial advisors.
▪ The advisors make payments to government officials aimed
at gaining government support, reported as operating costs.
© Kaplan, Inc. 15


8. Determine if using subadvisors is a violation of Standard
V(A) Diligence and Reasonable Basis.
9. Determine if reporting the payments to government officials

as operating expenses is a violation of any of the Standards.
© Kaplan, Inc. 16



▪ 8. The use of subadvisors is not a violation under Standard
V(A) Diligence and Reasonable Basis.
▪ 9. Reporting payments to government officials as legitimate
operating costs is a violation of Standard I(C)
Misrepresentation. The true nature of these payments
appears to be bribes which are likely to be illegal also
violating Standard I(A) Knowledge of the Law.
© Kaplan, Inc. 17


Case outline (7)
▪ Ani Mehrotra is hired by Adebayo to promote NI globally to
potential investors.
▪ Adebayo discloses to Mehrotra that she has not paid her CFA
Institute membership dues but continues to use the
designation on her business card.
▪ Adebayo claims the designation is like a degree that cannot
be taken away. At a client meeting attended by both, she
claims that all of NI’s senior staff are CFA charterholders.
© Kaplan, Inc. 18



Case outline (8)
▪ Mehrotra leads an exam prep class for local candidates.
▪ After the exam, his students describe their experience of the
exam including the areas of the syllabus that were not tested.
▪ Mehrotra asks his students for their opinion on the most
difficult exam questions, so he can better prepare future
candidates.
© Kaplan, Inc. 19


10. Determine if Adebayo has committed a violation in her use of
the CFA Designation.
11. Determine if Metrotra has committed a violation in the client

meeting where Adebayo claimed that all NI staff were CFA
charterholders.
12. Determine if Metrotra has committed a violation asking his

students about their exam questions or about the exam difficulty.
© Kaplan, Inc. 20



▪ 10. Adebayo has committed a violation of Standard VII(B)
Reference to CFA Institute, in her reference to the
designation being like a degree. To use the designation
members must pay annual dues and meet the
membership requirements.
▪ 11. Mehrotra also commits a violation by remaining silent in
the client meeting where it was claimed that all senior NI staff
are CFA charterholders. He should discuss this issue with
Adebayo and if she refuses, notify the compliance dept.
© Kaplan, Inc. 21


▪ Q12. Mehrotra has committed a violation soliciting
information on specific questions. This breaches Standard
VII(A) Conduct as Participants in CFA Institute Programs.
▪ If he also informs future candidates of specific questions
tested in the past or areas that were not tested this would
also be a violation
▪ Discussing how candidates perceived the difficulty would not
violate the standard as this is non-specific subjective
information
© Kaplan, Inc. 22

Application of the
Code and Standards
Maria Lopez: Case Facts

◼ Maria Lopez has completed a master’s degree in finance,
recently passed the CFA Level I exam, and also accepted
a position in the wealth management department at a
large financial institution, BankGlobal.
◼ Her supervisor, David Hockett, CFA, is reviewing Lopez’s
business card request, which states “Maria Lopez, CFA
Level I.”
◼ Hockett adds that she should also include the year in
which she expects to earn the CFA charter.
© Kaplan, Inc. 23
Application of the
Code and Standards

◼ Currently, there is a 45-minute delay between the time a
research analyst submits their changes and when these
changes are reflected on BankGlobal’s website and
forwarded on to clients.
◼ As a courtesy, BankGlobal analysts often verbally update
Hockett’s team prior to updating their research in the
system, and Hockett’s team immediately contacts their
discretionary clients with any updates.
© Kaplan, Inc. 24

Application of the
Code and Standards

◼ Lopez is referred new clients, Marty and Mary Kochanski,
by a business banker from BankGlobal and is told the
clients are 61 years old, retired, and have $7.4 million to
invest from the sale of Mary’s business.
◼ The banker instructs Lopez to design a balanced portfolio
for the clients.
◼ Lopez designs the portfolio by averaging selected funds’
five-year annualized returns and excludes terminated
accounts to simplify the analysis.
© Kaplan, Inc. 25
Application of the
: Code and Standards

◼ The Kochanskis invest $7.4 million in a balanced portfolio with
BankGlobal.
◼ In a conversation with the banker, Hockett discusses his
incentive and quarterly bonus program and says that the
majority of his clients have low risk tolerance and tend to favor
long-term investing.
◼ Hockett has found a way to earn excess return by frequently
buying and selling high beta stocks for many of his clients.
◼ Lopez sends a message to her close friends that she has taken
on the Kochanskis as new clients.
© Kaplan, Inc. 26

Application of the
Code and Standards
Maria Lopez: Possible Steps

◼ A CFA candidate may not suggest any partial designation or
any expected date for earning the charter (Std. VII(B):
Reference to CFA Institute, the CFA Designation, and the CFA
Program).
◼ Hockett’s team may not use the timely verbal updates from
BankGlobal’s analysts and provide preferential treatment for
their discretionary clients (Std. III(B): Fair Dealing).
◼ Hockett and Lopez did not conduct significant due diligence
before recommending the balanced portfolio to the Kochanskis
(Std. III(C): Suitability).
© Kaplan, Inc. 27
Application of the
Code and Standards
Maria Lopez: Possible Steps

◼ It is not appropriate for Lopez to calculate performance by
removing terminated accounts (Std. III(D): Performance
Presentation).
◼ It is not appropriate for Hockett to invest his clients’ assets
in investments that don’t suit their goals and objectives
(Std. III(C): Suitability).
◼ Lopez violated the Code and Standards by disclosing her
new clients to her friends (Std. III(E): Preservation of
Confidentiality).
© Kaplan, Inc. 28

Application of the
Code and Standards
Castle Biotech: Case Facts

◼ Castle Biotechnology (Castle) operates a
biopharmaceutical company and controls nine other
biopharmaceutical companies.
◼ Last year, Castle acquired a controlling interest in Global
Capital Management (Global), an investment banking and
asset management firm.
◼ Two of Castle’s subsidiaries, Street Pharmaceuticals
(STRX) and Appaloosa Biotech (APBX), went public and
Castle maintains voting control for each of them.
© Kaplan, Inc. 29
Application of the
Code and Standards

◼ David Plume, PhD, CFA, is a biopharmaceutical analyst
for Global.
◼ Plume previously was a biochemist for Castle for many
years, maintains close relations with Castle executives,
and received preferred stock and common shares of
Castle.
◼ Plume’s salary at Global has an annual bonus of 0.10% of
the gross proceeds raised for each IPO he is involved in.
© Kaplan, Inc. 30

Application of the
Code and Standards

◼ After STRX’s and APBX’s IPOs, Plume issued buy
recommendation research reports on each firm.
◼ Several months after issuing the APBX buy report, Plume
sells short APBX shares and does not disclose that he is a
beneficial owner of the stock.
◼ Plume also fails to disclose Castle’s controlling interest in
Global, STRX, and APBX.
◼ Finally, Plume doesn’t disclose that he owns Class A
preferred shares and options on Castle’s common stock. 31
© Kaplan, Inc.
Application of the
Code and Standards
Castle Biotech: Possible Steps

◼ Plume’s independence and objectivity may have been
impacted by not disclosing in his research report that
Global is controlled by Castle, creating a violation (Std.
VI(A): Disclosure of Conflicts).
◼ Plume violated Std. VI(A): Disclosure of Conflicts by not
disclosing material personal ownership in Castle and that
Global is controlled by Castle.
© Kaplan, Inc. 32

Application of the
Code and Standards

◼ Plume violated Std. VI(A): Disclosure of Conflicts by not
disclosing his material ownership in STRX and APBX in
his buy recommendation research reports and then later
selling short shares of APBX after his buy
recommendation.
◼ Plume failed to disclose his annual bonus in his research
reports, which is a violation (Std. I(B): Independence and
Objectivity).
© Kaplan, Inc. 33
Application of the
Code and Standards

◼ Sandra Benning, CFA, was an investment advisor at
Kodiak Securities (Kodiak) and recently resigned to work
at Global.
◼ Upon resignation, she used social media and personal
email to encourage her clients to move with her to Global.
◼ Benning’s signing bonus is calculated on the percentage
of her clients who transfer with her and also contains an
annual bonus based on client’s IPO participation—neither
is disclosed by Benning to her clients.
© Kaplan, Inc. 34

Application of the
Code and Standards

◼ Benning violated Std. VI(A): Disclosure of Conflicts
twice—by not disclosing her signing bonus was based on
the percentage of her clients that moved with her to Global
and by not disclosing her annual bonus will be based on
her client’s participation in IPOs.
◼ Benning did not violate Std. IV(A): Loyalty because there
was not a noncompete agreement, and her solicitation of
her clients from Kodiak occurred after she resigned.
© Kaplan, Inc. 35
Application of the
Code and Standards

◼ Global is underwriting an IPO for Frontier Therapeutics
(FTSX), one of the subsidiaries controlled by Castle.
◼ Global’s IPO allocation policy is to allocate IPO shares to
institutional clients who agree to purchase more shares on
the first day of trading.
© Kaplan, Inc. 36

Application of the
Code and Standards

◼ A tie-in agreement exists when an underwriter requires
the client to purchase additional shares of the new issues
in the secondary market in exchange for the ability to
purchase IPO shares.
◼ The effect is to manipulate increased demand and
increase share price on the day of the IPO.
◼ This is a direct violation of Std. II(B): Market Manipulation
& Std. III(B): Fair Dealing because Benning is not treating
all institutional clients fairly.
© Kaplan, Inc. 37
Application of the

◼ Benning has a new client, Claris Deacon. Benning modifies the
client agreement regarding Deacon’s suitability. To save the
client another visit, Benning decides to initial the changes to the
agreement for Deacon.
◼ Later, the client has difficulty transferring funds, and Benning
discovers the account was not set up correctly.
◼ Benning receives verbal authorization from the client to sign the
Account Linking form on the client’s behalf.
© Kaplan, Inc. 38

Application of the
Code and Standards

◼ Benning also receives a call from Deacon’s husband, Steve.
◼ Steve advises that his wife is having major medical problems
and requests that Benning sell assets and transfer the proceeds
immediately.
◼ Benning processes numerous redemptions and withdrawals
from Deacon’s account at Steve’s request over the coming
weeks.
© Kaplan, Inc. 39
Application of the
Code and Standards

◼ Benning changing the language in the client agreement
and initialing the form on behalf of the client is a violation
(Std. I(D): Misconduct).
◼ Benning was also in violation of Std. III(A): Loyalty,
Prudence, and Care when she redeemed shares and
processed withdrawals in Deacon’s account without
Deacon’s written consent.
◼ Deacon’s husband was not listed as a joint account holder
and was not given permission to make any transactions.
© Kaplan, Inc. 40

Application of the
Code and Standards
Lionsgate & Bank of Australia: Case Facts

◼ Lionsgate Limited (LL) is a fund manager, and its best
performing fund, the Victory Capital Fund (VCF), is
managed by Tony Hill and his team.
◼ In LL’s marketing materials, statements include VCF being
the best performing Australian equity fund for a 10-year
period, earning returns of 28.7% gross of fees over the
most recent 1-year period and 13.2% annually since
inception.
© Kaplan, Inc. 41
Application of the
Code and Standards

◼ Hill often appears on financial talk shows that offer him
nonmonetary items such as wine, retail gift cards, and
travel discounts. Hill doesn’t disclose these items to LL.
◼ Hill has become less involved with VCF. Over the past
three years, VCF’s performance was solely attributable to
Nicole Martin, CFA, an analyst on Hill’s team.
◼ However, publicly, Martin and Hill maintain that Hill is in-
charge of all investment decisions.
© Kaplan, Inc. 42

Application of the
Code and Standards

◼ During LL’s board meeting, Hill announces his resignation
and informs them he will be starting his own firm.
◼ The board requests that Hill not disclose to anyone for the
next two weeks while they look for a replacement. Hill
agrees.
◼ Immediately after the board meeting, Hill informs his team
of his departure and asks his team to join him.
© Kaplan, Inc. 43
Application of the

◼ Hill advises the analysts that will be moving to the new firm with
him to use their time after work and weekends to work on the
transition.
◼ Hill states that there is no noncompete contract signed with LL,
so they are able to begin soliciting their clients from LL as soon
as the new firm is established.
© Kaplan, Inc. 44

Application of the
Code and Standards
Lionsgate & Bank of Australia: Possible Steps

◼ LL’s performance of VCF are factual statements, so there
is no violation of Std. III(D): Performance Presentation.
◼ Hill’s appearance on talk shows promotes LL and VCF, so
acceptance of nonmonetary items is not a violation of Std.
IV(B) Additional Compensation Arrangements.
◼ Both Martin and Hill violated Std. V(B)1: Communication
with Clients and Prospective Clients.
© Kaplan, Inc. 45
Application of the
Code and Standards

◼ Hill violated Std. IV(A): Loyalty by not honoring his
agreement with the board to maintain a two-week period
of confidentiality.
◼ Hill asking his team to work with him at the new firm is not
a violation (Std. IV(A): Loyalty), as team members are free
to make their own decisions.
© Kaplan, Inc. 46

Application of the
Code and Standards

◼ Performing activities for the transition to the new firm
outside of normal business hours is not a violation of Std.
IV(A) Loyalty or Std. III(A) Loyalty, Prudence, and Care.
◼ In the absence of a noncompete agreement with LL, Hill
does not violate Std. IV(A): Loyalty by asking his team to
solicit former clients with LL after they move to the new
firm.
© Kaplan, Inc. 47
Application of the
Code and Standards

◼ Rob Portman, CFA, works at LL as a salesperson for VCF
and has set up a major event for prospective clients so
that he can meet his annual sales targets.
◼ To clients and prospective clients, Portman emphasizes
Hill’s investment skills and his role as the primary portfolio
manager.
◼ For more detailed client questions regarding investment
management of VCF investments, Portman directs clients
to Martin, who is referred to as Hill’s assistant.
© Kaplan, Inc. 48

Application of the
Code and Standards

◼ Portman reaches out to LL’s chief investment officer (CIO)
to inquire about the rumors regarding Hill and members of
his team leaving LL.
◼ The CIO advises Portman to disregard the rumors.
◼ Through public information, Portman learns that the CIO
and some board members recently sold shares in LL and
VCF.
◼ Portman also decides to sell his shares.
© Kaplan, Inc. 49
Application of the
Code and Standards

◼ Portman violated Std. I(C): Misrepresentation by making
investors think that Hill is in charge of the investment
decisions at VCF.
◼ LL’s CIO and board members used material nonpublic
information in selling their shares and violated Std. II(A)
Material Nonpublic Information.
◼ Portman did not trade using material nonpublic information
in his decision to sell and did not violate Std. II(A): Material
Nonpublic Information since the information was public.
© Kaplan, Inc. 50

Application of the
Code and Standards

◼ LL is partially owned by Bank of Australia (BOA).
◼ Kirk Graeme, CFA, works as a financial advisor for BOA’s
wealth management group and specializes in new issues.
◼ He receives additional compensation for new issue
purchases that are paid by the issuer.
◼ BOA has a capital markets group, and the group is a
member of the syndicate for the new issues purchased by
Graeme.
© Kaplan, Inc. 51
Application of the
Code and Standards

◼ BOA’s policy does not require disclosure of commissions
on new issues since client’s already received such info
found in the prospectuses they received when they
purchased the new issues.
◼ Graeme will disclose his new issue commissions only to
those clients who ask about it.
© Kaplan, Inc. 52

Application of the
Code and Standards

◼ Graeme violated Std. VI(A): Disclosure of Conflicts by only
informing the clients who asked about his commissions on
new issues only.
◼ Graeme must disclose information to all clients about the
commissions on new issues; it does not matter that the
information is already included in the new issue
prospectus.
© Kaplan, Inc. 53
Application of the
Code and Standards

◼ Graeme opened a joint account for Melissa and Rodney
Delaney, which represented most of their investable
assets.
◼ The Delaneys stated they had a long investment horizon
(in excess of 15 years) and a low risk tolerance.
© Kaplan, Inc. 54

Application of the
Code and Standards

◼ Over the next 10 months, Graeme purchased primarily
new issues, and 5 months was the longest holding period
for any new issues in the account.
◼ Jane Balmer, Graeme’s supervisor, met with Graeme to
discuss her concerns over his handling of his accounts
and referred Graeme to BOA’s director of compliance.
◼ Graeme substantially curtailed this activity in his client
accounts after meeting with Balmer.
© Kaplan, Inc. 55
Application of the
Code and Standards

◼ The Delaneys have a low risk tolerance and Graeme is in
violation of Std. III(C)1: Suitability.
◼ Balmer should have opened up a full investigation; merely
referring the situation to the director of compliance was
insufficient in her duties as supervisor.
◼ Balmer violated Std. IV(C): Responsibilities of
Supervisors.
© Kaplan, Inc. 56

Application of the
Code and Standards

◼ Graeme opened an account for David Milgram five years
ago, and the investment policy statement (IPS) has not
been updated since.
◼ Recently, Milgram complained to Balmer about the decline
in his account’s value. Balmer meets with Graeme to
discuss the complaint and nothing is reported to the
director of compliance.
◼ Graeme, Balmer, and Milgram meet to review Milgram’s
account.
© Kaplan, Inc. 57
Application of the
Code and Standards

◼ Graeme has violated Std. III(C)1: Suitability, and the IPS
must be updated at least annually.
◼ Balmer was in compliance with her supervisor duties (Std.
IV(C): Responsibility of Supervisors) by immediately
beginning an investigation of the complaint, as well as
meeting with both Graeme and Milgram.
◼ Balmer does not have to report everything to the director
of compliance, as long as she performed her duties.
© Kaplan, Inc. 58

Application of the
Code and Standards
Gabby Sim: Case Facts

◼ Gabby Sim is now working at Global Harvest Bank (GHB),
a private bank offering a wide variety of services.
◼ Sim first meets with her supervisor, Ahmad Yousoff, who
is the CIO. She next meets with the president, Irene
Wong, and two board members, David Tan and Audrey
Chuong, CFA.
◼ The four of them meet to discuss a memorandum of
understanding (MOU) signed with a new institutional
client, MGM2.
© Kaplan, Inc. 59
Application of the
Code and Standards

◼ MGM2 is owned by the government of Sasparia and is
tasked with promoting Sasparian economic development.
◼ Yousoff and Wong paid Tan and Chuong part of the
advisory fees earned from bringing on MGM2 as a client.
◼ Yousoff did not disclose the fee-sharing agreement to
MGM2.
© Kaplan, Inc. 60

Application of the

◼ Chuong encourages Yousoff to meet Boe Hie, a businessman
in Sasparia who was one of the founders of MGM2.
◼ Chuong did not disclose to Yousoff that Hie has given her son
an executive position at MGM2.
© Kaplan, Inc. 61
Application of the
Code and Standards
Gabby Sim: Possible Steps

◼ The compensation paid to Tan and Chuong is not a
referral fee since they did not refer MGM2 to GHB as a
client, so there is no violation of Std. VI(C): Referral Fees.
◼ There is a potential conflict of interest for Chuong since
Hie hired her son as an executive at MGM2.
◼ The lack of disclosure by Chuong is a violation of Std.
VI(A): Disclosure of Conflicts.
© Kaplan, Inc. 62

Application of the
Code and Standards

◼ Sim has been assigned by Yousoff to open a new account
for Hie in the name of Bad Moon Rising, Ltd. (Bad Moon).
◼ Hie is the sole beneficial owner and authorized signatory.
◼ Sim did not have an opportunity to ask Hie about his
investment experience or his goals and objectives.
© Kaplan, Inc. 63
Application of the
Code and Standards

◼ Hie refuses to answer any questions and wants all notes
of their meeting destroyed and replaced with the following
statement: Self-employed consultant, net-worth of $110
million. Long-term investment consultant with annual
return goals between 5% and 10%.
◼ Hie advises Sim that many large deposits will be going
into his account from MGM2. These funds will need to be
wired to his other accounts across the globe; Sim will earn
a performance bonus for efficiently handling the transfers.
© Kaplan, Inc. 64

Application of the

◼ Sim uses the information provided by Hie to create the
IPS. She later meets with Yousoff to review the meeting
with Hie and makes no mention of the year-end bonus
from Hie.
◼ Sim opens the account.
© Kaplan, Inc. 65
Application of the
Code and Standards

◼ Sim is not maintaining appropriate records by destroying all
meeting notes and has violated Std. V(C): Record Retention.
◼ Although Hie wants all notes to be destroyed, Sim would not
violate Std. III(E): Preservation of Confidentiality or Std. III(A):
Loyalty, Prudence, and Care if she didn’t destroy the notes.
◼ Opening the account for Hie violates Std. III(C): Suitability
because Sim was not provided enough information to develop a
reasonable IPS.
© Kaplan, Inc. 66

Application of the
Code and Standards

◼ The bonus promised by Hie is considered additional
compensation, so Sim violated Std. IV(B): Additional
Compensation.
◼ The existence of the bonus could also impair
independence and objectivity for Sim (Std. I(B):
Independence and Objectivity).
◼ Bonuses from clients are permissible if they are both
disclosed and approved by the employer. Sim did not
disclose the bonus to Yousoff.
© Kaplan, Inc. 67
Application of the
Code and Standards

◼ After the Bad Moon account is opened, a large amount of
money is wired into the account from MGM2.
◼ Sim reaches out to Hie to inform him about the wire and
also to complete the investment agreement between
MGM2 and Bad Moon to support the deposit.
◼ Sim is not comfortable with the large deposit or the lack of
clarity on the account agreement and raises her concern
to Yousoff, her supervisor.
© Kaplan, Inc. 68

Application of the
Code and Standards

◼ Sim explains to Yousoff that she wants to meet with both
Hie and a representative from MGM2 to provide
assurance over the validity of the account.
◼ Yousoff says the copy of the investment agreement is fine
and she should contact Tan and Chuong instead (board
members).
◼ Sim contacts the board members, who confirm the validity
of the account and Hie’s interactions with MGM2.
© Kaplan, Inc. 69
Application of the
Code and Standards

◼ Yousoff has violated Std. IV(C): Responsibilities of
Supervisors by not investigating Sim’s concern further and
advising Sim to contact the board members instead.
◼ A meeting with Hie and a representative from MGM2 was
a reasonable idea proposed by Sim and should have been
arranged.
◼ Sim did not violate Std. III(E): Preservation of
Confidentiality because she was instructed by Yousoff to
contact Tan and Chuong.
© Kaplan, Inc. 70

Application of the
Code and Standards

◼ In the following months, MGM2 wires numerous large
deposits into the Bad Moon account.
◼ Hie provides Sim with documentation in the form of
agreements signed by Yousoff in his role as GHB’s CIO.
◼ Most of the money is transferred to Hie’s various personal
accounts around the world.
◼ Sim suspects money laundering and informs Yousoff, who
tells her to ignore her suspicions.
© Kaplan, Inc. 71
Application of the
Code and Standards

◼ Yousoff has clearly failed in his duty as a supervisor.
◼ Sim must now escalate this matter further and obtain
advice from either legal council and/or compliance
according to Std. I(A): Knowledge of the Law.
© Kaplan, Inc. 72

Application of the
Code and Standards

◼ Hie recommended that Sim meet with his mother-in-law,
Madam Tan Swee Neo.
◼ Sim meets with her and learns that Neo is 70 years old
and made her money through real estate and has since
moved her investable assets into bonds and low risk utility
stocks.
◼ Neo informs Sim that she wants to be more aggressive to
fund her grandchildren’s education by investing in
conservative stocks.
© Kaplan, Inc. 73
Application of the
Code and Standards

◼ Neo discusses an oil structured note that she has heard
about from friends with Sim, but Neo knows nothing about
this type of investment and she can’t read the brochure on
this investment because it is written in English.
◼ Sim verbalizes the summary of the product for Neo in
Chinese but leaves out some of the fine print. Sim does
warn her there is no guarantee of the annual coupon and
there is a penalty for early withdrawal.
◼ Neo invests half of her life savings in the notes.
© Kaplan, Inc. 74

Application of the
Code and Standards

◼ Sim violated Std. III(C): Suitability because the investment
is not suitable for Neo’s investment goals and objectives.
◼ Merely summarizing a brochure written in English (which
Neo can’t read) is not sufficient, even though Sim
explained that the annual coupon was not guaranteed.
© Kaplan, Inc. 75
Application of the
Code and Standards

◼ A year later, Neo doesn’t receive the coupon payment
from her investment and requests for Sim to redeem her
investment immediately and move the funds into a deposit
account.
◼ Sim reminds Neo of the early redemption penalties, but
Neo is not interested in the details and just wants her
money.
◼ The investment has decreased from $50k to $30k, and
Neo has filed a complaint against Sim.
© Kaplan, Inc. 76

Application of the
Code and Standards

◼ Sim could be in violation of Std. III(C): Suitability because
Neo’s immediate request for the early withdrawal indicates
her lack of investment knowledge.
◼ Sim is in violation of Std. III(A): Loyalty, Prudence, and
Care because Sim should have insisted on explaining the
penalties for early redemption.
© Kaplan, Inc. 77


Standards
Asset Manager Code of Professional Conduct
Asset Manager Code of

Professional Conduct
The Code and Standards vs. the Asset Manager

Code (AMC)
The Code and Standards: The AMC:
◼ Applies to individuals ◼ Applies to the firm
◼ Mandatory for covered ◼ Firms are encouraged
persons to adopt the AMC
◼ Partial compliance is ◼ Claims of partial
not acceptable compliance are not
© Kaplan, Inc.
acceptable 2


The AMC
◼ Foster a culture of ethics and professionalism
◼ A template and guide post for clients seeking ethical
managers
◼ Managers can adopt or use the AMC to evaluate their existing
code
◼ A global standard and framework for providing fair and
professional services with full disclosure to clients
◼ Allows flexibility to develop relevant policies by the firm
© Kaplan, Inc. 3

General Principles of Conduct

1. Act ethically and professionally
2. Act in the client’s best interests
3. Act independently and objectively
4. Act with skill, competence, and diligence
5. Communicate accurately with clients
6. Comply with capital market laws and regulations
© Kaplan, Inc. 4


The AMC: Loyalty to Clients

1. Clients come first
2. Maintain client confidentiality
3. Do not compromise independence, objectivity, and loyalty
to clients
© Kaplan, Inc. 5

The AMC: Investment Process and Actions

1. Use reasonable care and judgement
2. Do not manipulate market price and volume
3. Deal fairly with all clients
4. Have a reasonable basis for investment decisions
5. Make decisions consistent with portfolio objectives and
provide adequate disclosure to clients
6. Determine client objectives and constraints and make
suitable decisions based on those
© Kaplan, Inc. 6


The AMC: Trading

1. Do not act on or cause others to act on material non-public
information that could affect the value of public securities
2. Put client trades ahead of the manager’s interests
3. Use client commissions (soft dollars) for the benefit of the
client
4. Seek best execution and maximization of client portfolio
value
5. Establish fair trade allocation policies
© Kaplan, Inc. 7

The AMC: Risk Management, Compliance, and Support

1. Maintain policies and procedures (P&P) to meet the AMC
2. Provide clients with accurate portfolio information that has
been confirmed by independent third party review
3. Maintain appropriate records
4. Maintain a qualified staff
5. Establish a business continuity plan
6. Establish a firm-wide risk management process
© Kaplan, Inc. 8


The AMC: Performance and Valuation

1. Present fair, accurate, relevant, timely, and complete
information with no misrepresentation
2. Use fair market pricing (or fair value when that does not
exist)
© Kaplan, Inc. 9

The AMC: Disclosures

Principals of disclosure:
1. Ongoing and timely communication
2. Truthful, accurate, complete, and understandable
information
3. Include all material facts regarding the firm and its process
© Kaplan, Inc. 10



▪ Conflicts of interest
▪ Regulatory or disciplinary actions against the firm or its
personnel
▪ The investment process and information on lock-ups, risk,
derivatives, and leverage
▪ Soft dollars and bundled commission information
© Kaplan, Inc. 11


▪ Regular and timely communication of performance
information
▪ Valuation methods used in decision making
▪ Shareholder voting and trade allocation processes
▪ Firm review or audit results
▪ Significant changes in personnel or organization
▪ The risk management process
© Kaplan, Inc. 12


The AMC
▪ The SchweserNotes include lists of recommended P&P
designed to prevent violations of the AMC.
▪ They are eclectic in that not all provisions of the AMC
have suggested P&P.
▪ Suggested is not required.
▪ Work the practice questions in the SchweserNotes and
QBank and the CFA end of chapter for this reading.
© Kaplan, Inc. 13


Standards
Overview of the Global Investment
Performance Standards

GIPS Overview
GIPS is part of Ethics, which is 10%–15% of exam
▪ Read the SchweserNotes™ and/or CFA text
▪ Watch these videos
▪ Know the rules, apply them to the case specifics, and reach
expected solution
▪ Work practice questions
▪ For GIPS, work all Schweser practice questions
▪ Also work the CFA end-of-chapter questions
© Kaplan, Inc. 2


The GIPS Myth

▪ The reading will cover everything you can think of
▪ Reality: GIPS is principal based
▪ Firms must determine how it applies to their
specific situations
▪ The CFA Institute has extensive resources to
assist firms
▪ You can pursue the Certificate in Investment
Performance Measurement (CIPM) if interested
© Kaplan, Inc. 3

GIPS Standards
▪ Ethical and Professional Standards for the presentation of
investment performance results
▪ GIPS are a voluntary set of standards
▪ GIPS standards are not all-encompassing; no standards
address every situation
▪ GIPS standards refer to separately managed client
accounts and to pooled fund investors
▪ If a firm claims compliance, all prospective clients and
prospective investors must receive a GIPS report
© Kaplan, Inc. 4


GIPS Standards
▪ 2020 edition of GIPS standards has three sections:
1. Standards for investment management firms
2. Standards for asset owners
3. Standards for verifiers
▪ Asset owners who compete for business:
▪ Use GIPS standards for firms
▪ Asset owners who do not compete for business:
▪ Use GIPS standards for asset owners
© Kaplan, Inc. 5

GIPS Objectives
▪ Objectives of GIPS
▪ Advance interests of investors and increase their
confidence in the investment industry
▪ Provide accurate and comparable data to investors
▪ Create globally accepted standards for the determination
and presentation of investment performance
▪ Facilitate fair global competition of investment managers
▪ Encourage self-regulation in the global investment industry
© Kaplan, Inc. 6


GIPS Scope
▪ Only investment management firms and asset owners who
compete for business may claim compliance to GIPS
standards for firms
▪ GIPS can only be claimed on a firmwide basis
▪ GIPS cannot be claimed only for specific products,
composites, or portfolios
▪ Firms must comply with all GIPS requirements
▪ GIPS recommendations are optional best practices
▪ GIPS standards evolve over time
© Kaplan, Inc. 7

GIPS Scope
▪ GIPS terminology for assets under management
▪ A composite is a collection of portfolios with similar
investment mandates, objectives, or strategies
▪ A segregated account is a portfolio owned by a single
investor, a.k.a. separately managed account (SMA)
▪ A pooled fund is a portfolio owned by multiple investors
▪ Broad distribution pooled funds are available to the
public (e.g., mutual funds); limited distribution pooled
funds are not available to the public (e.g., hedge funds)
© Kaplan, Inc. 8


Claiming GIPS Compliance

▪ Claiming GIPS compliance indicates the following:
▪ A firm’s data inputs, processes, and return
calculations are compliant
▪ All the firm’s fee-paying segregated accounts have
been assigned to at least one composite
▪ All the firm’s limited distribution pooled funds are
included in an appropriate composite
▪ Broad distribution pooled funds are excluded unless
their strategy is also offered in separate accounts
© Kaplan, Inc. 9

Benefits of GIPS
▪ Benefits to prospective clients and investors
▪ Helps investors make sound investment decisions
▪ Standardizes the determination and presentation of
investment results to be more comparable
▪ Manager performance is more reliable if GIPS compliant
▪ Facilitates discussions about past and future
performance and investment strategy
© Kaplan, Inc. 10


Benefits of GIPS
▪ Benefits to investment managers
▪ GIPS increase investor confidence in both the
investment industry and the firm
▪ GIPS compliance helps attract new investors
▪ GIPS helps firms compete internationally as firm
performance is comparable across borders
▪ GIPS helps firms strengthen and maintain controls due
to GIPS recordkeeping and reporting requirements
▪ GIPS technology helps firms manage their operations
© Kaplan, Inc. 11

Definition of the Firm

A firm is defined as:
◼ An investment firm, subsidiary, or division held out to
clients or potential clients as a distinct business entity
A distinct business entity is defined as:
◼ A unit, division, department, or office that is organizationally
or functionally separated from other units and divisions
◼ Retains discretion over the assets and has autonomy over
the investment decision-making process
© Kaplan, Inc. 12


Characteristics of a Distinct Business Entity

Firm is likely to have a distinct:
◼ Legal organization (e.g., a separate subsidiary)
◼ Market
◼ Client base
◼ Investment process
◼ Investment strategy
◼ Physical location
◼ Chain of command
© Kaplan, Inc. 13

Fair Value of Total Firm Assets

Total firm assets includes:
◼ Discretionary and nondiscretionary assets*
◼ Fee-paying and non-fee-paying assets
◼ Actual, not simulated, assets and net of leverage
Total firm assets excludes:
◼ Advisory-only assets
◼ Uncalled committed capital (i.e., pledged but not yet drawn)
*Nondiscretionary assets are not included in composite assets
© Kaplan, Inc. 14


Other Compliance Fundamentals

◼ To initially claim compliance, the firm must attain
compliance for a minimum period of 5 years, or since
inception if less
◼ If GIPS conflict with local laws, the firm must comply with
local laws and disclose the conflict
◼ Firms must establish and update policies and procedures
for meeting GIPS
◼ Firms must provide an annual GIPS-compliant report to
existing clients showing relevant composites
© Kaplan, Inc. 15

Other Compliance Fundamentals

Benchmarks:
◼ Must reflect the corresponding investment strategy
◼ Must be total return benchmarks, not price-only benchmarks
Material errors and data:
◼ The firm must disclose all material errors and disclose
corrected reports to current clients and verifiers
◼ The firm must maintain data needed for GIPS compliance
and a list of composites for the last 5 years
© Kaplan, Inc. 16


Presentation Standards
Return Calculations
▪ GIPS requires monthly return calculations for nonprivate
investment portfolios
▪ Portfolio returns must be on a total return basis using
beginning (BV) and ending fair value (EV)
▪ Interim external cash flows (ECF)
▪ Client withdrawals (outflows), additional funds (inflows)
▪ Large ECFs distort return calculations, so the
investment is valued each time an interim ECF occurs
© Kaplan, Inc. 17

Time-Weighted Rate of Return

Calculate subperiod returns:
▪ To eliminate the potential distortion of external cash flows
▪ To clearly identify the return due to manager performance
▪ Subperiod returns must be geometrically linked to create
a time-weighted rate of return
▪ Rtwrr = (1 + R1) × (1 + R2) × (1 + R3) x … x (1 + Rt)
© Kaplan, Inc. 18


Example: Time-Weighted Rate of Return

The Rooney account was $2,500,000 at the start of the month
and $2,700,000 at the end. During the month, there was a
cash inflow $45,000 on Day 7 and $25,000 on Day 19. The
values of the Rooney account are $2,555,000 and $2,575,000
(inclusive of the cash flows for the day) on Day 7 and Day 19,
respectively.
Calculate the time-weighted rate of return (assuming 30 days
in the month).
© Kaplan, Inc. 19

Solution: Time-Weighted Rate of Return

Calculate the three subperiod returns:
Subperiod 1 (Days 1–7)
R1 = [($2,555,000 – $45,000) / $2,500,000] – 1 = 0.40%
R2 = [($2,575,000 – $25,000) / $2,555,000] – 1= –0.20%
R3 = ($2,700,000 / $2,575,000) – 1 = 4.90%
© Kaplan, Inc. 20


Solution: Time-Weighted Rate of Return

Chain-link the subperiod returns to calculate an overall
time-weighted rate of return for the 30-day period:
TWRR = (1 + 0.004) × (1 – 0.002) × (1 + 0.0049) – 1

= 5.1%
The account was valued each day there was an interim ECF,
so the TWRR was not distorted by the ECFs.
© Kaplan, Inc. 21

Approximate Return Calculations

Approximate returns
▪ Some portfolios are not valued every day
▪ External cash flows may be relatively small
GIPS approximate return calculations
▪ Modified Dietz
▪ Modified internal rate of return (MIRR)*
*Calculating the MIRR requires trial and error and is not a required LOS
© Kaplan, Inc. 22


Modified Dietz Return

The Modified Dietz return method:
Adjusted external cash flow:

▪ The ECF is weighted by the number of days held in the
portfolio during the month (e.g., if a ECF is received on Day
10 in a 30-day month, the adjustment is 30 – 10 / 30 × ECF).
© Kaplan, Inc. 23

Example: Modified Dietz Return

Returning to the previous Rooney Account example:
▪ Day 7 +$45,000 External cash inflow
▪ Day 19 +$25,000 External cash inflow
Adjusted ECF (to days held within the month):

▪ (30 – 7 / 30) × $45,000 = $34,500
▪ (30 – 19 / 30) × $25,000 = $9,167
© Kaplan, Inc. 24


Example: Modified Dietz Return

Returning to the Modified Dietz return formula:
Rooney account:
© Kaplan, Inc. 25

Modified Internal Rate of Return (MIRR)

The MIRR is the IRR that adjusts for the timing of the ECFs:
▪ Can be solved for by trial and error or using a spreadsheet
▪ The MIRR and the Modified Dietz typically provide similar
values as both use the number of days to weight ECFs
▪ MIRR calculation is not required for the exam
GIPS requirements:
▪ GIPS requires both MD and MIRR to create monthly returns
that are geometrically linked to create annual return
© Kaplan, Inc. 26


GIPS Return Requirements

▪ Must calculate monthly returns for nonprivate portfolios
▪ If daily valuations are used, the daily returns must be
geometrically linked to create a “true” monthly TWRR
▪ Small ECFs: approximations to the true TWRR can be used
▪ Large ECFs: the portfolio must be valued and subperiod
returns used and geometrically linked around ECFs
▪ Defining a large ECF? Determined by each firm’s policy
© Kaplan, Inc. 27

GIPS Return Requirements

Private market investment portfolios:
▪ Portfolio values and returns must be calculated quarterly
▪ Includes nonpublicly traded investments (e.g., real estate
and private equity)
Pooled funds:
▪ Pooled funds not in a composite must be valued and
returns calculated at least annually
▪ Also valued at the time of subscriptions and redemptions
© Kaplan, Inc. 28


Other Return Calculation Topics

Money-weighted returns (MWR) can be used:
▪ If the firm has control of the timing of ECFs
▪ If the portfolios are closed end, or fixed life, or fixed
commitment
▪ If the portfolio has a significant amount of illiquid assets
GIPS MWR requirements
▪ Portfolio must be valued at least annually
© Kaplan, Inc. 29

Other Return Calculation Topics

Other return calculation requirements:
▪ Trade date, not settlement date to calculate returns
▪ Partial year returns cannot be annualized
▪ Must use total returns (including income and capital gains)
▪ Accrual accounting used for income-producing assets
▪ Returns must reflect allocations to cash/cash equivalents
▪ Cash equivalents include securities with maturities <1 yr
© Kaplan, Inc. 30


Fees and Transaction Costs

Gross-of-fees returns:
▪ Gross-of-fees returns must have been calculated after the
deduction of transactions costs
▪ Transactions costs reflect the costs of buying and selling
securities (e.g., brokerage commissions, spreads, and fees)
▪ Custody fees should not be included
▪ Bundled or all-in-fees may include trading costs, custody,
and investment management costs
© Kaplan, Inc. 31

Fees and Transaction Costs

▪ When trading fees cannot be separated from bundled
fees, and:
▪ Presenting gross-of-fees: reduce return for entire
bundled fee or portion of bundled fee known to include
the trading fees
▪ Presenting net-of-fees: reduce return for entire
bundled fee or portion of bundled fee known to include
the trading fees and management fees and disclose the
nature of the bundled fee
© Kaplan, Inc. 32


Composite Construction
▪ Composites are groupings of one or more portfolios with
similar investment mandates, objectives, or strategies.
▪ GIPS require composite return calculations to be at least
monthly, except for private market investments (quarterly)
and pooled funds not in a composite (annually).
© Kaplan, Inc. 33

Composite Returns
Composite returns must be calculated in one of three ways:
1. Asset-weighting portfolio returns by
beginning-of-period values
2. Asset-weighting portfolio returns by both
beginning-of-period values and external cash flows (ECFs)
3. The aggregate method
© Kaplan, Inc. 34


Example: Composite Returns

A U.S. manager’s equity portfolio composite contains three
portfolios (A, B, and C). These values for October show the
BVs, ECFs, and EVs in $ millions.
Sep 30 Oct 3 Oct 13 Oct 19 Oct 31
A $110.00 –$10.10 $109.20
B $167.80 –$11.10 $166.90
C $344.20 $22.00 $345.10
Total $622.00 $22.00 –$11.10 –$10.10 $621.20
© Kaplan, Inc. 35

Example: Composite Returns

1. Calculate the Modified Dietz return for each portfolio.
2. Calculate the composite return using the
beginning-of-period portfolio values.
beginning-of-period portfolio values with external cash flows.
4. Calculate the composite return using the aggregate
return method.
© Kaplan, Inc. 36


Solution: Composite Returns

1. Calculate the Modified Dietz return for each portfolio.
First, calculate the adjusted ECFs:

A: (31 – 19) / 31 × –$10.10 = –$3.91
B: (31 – 13) / 31 × –$11.10 = –$6.45
C: (31 – 3) / 31 × +$22.00 = $19.87
© Kaplan, Inc. 37

© Kaplan, Inc. 38



beginning-of-period portfolio values.
First, calculate the portfolio weights:
A: $110.00 / $622.00 = 17.68%
B: $167.80 / $622.00 = 26.98%
C: $344.20 / $622.00 = 55.34%
© Kaplan, Inc. 39


The composite return is the weighted average of the
portfolio returns:
A = 0.1768 × 8.77% = 1.55%
B = 0.2698 × 6.32% = 1.71%
C = 0.5534 × –5.80% = –3.21%
Composite return = 0.05%
© Kaplan, Inc. 40



beginning-of-period values with external cash flows.
Recalculate the weights incorporating ECFs (using Mod Dietz)
A: $110.00 – $3.91 / $631.51 = 16.80%
B: $167.80 – $6.45 / $631.51 = 25.55%
C: $344.20 + $19.87 / $631.51 = 57.65%
Note: $106.09 + $161.35 + $364.07 = $631.51 (the denominators from MD)

© Kaplan, Inc. 41


The composite return is the weighted average of the
portfolio returns:
A = 0.1680 × 8.77% = 1.4734%
B = 0.2555 × 6.32% = 1.6148%
C = 0.5765 × –5.80% = –3.3437%
Composite return = –0.2555%
© Kaplan, Inc. 42



4. Calculate the composite return using the aggregate
return method.
Aggregate all values into the Modified Dietz calculation:
© Kaplan, Inc. 43

Discretion and Composite Construction

A discretionary portfolio provides the manager the ability to
implement the investment strategy:
▪ Nondiscretionary portfolios must not be included in
calculation of composite returns
Portfolios that must be included in at least one composite:
▪ All actual, fee-paying, discretionary segregated accounts
▪ Pooled funds that are also offered as segregated accounts
▪ Disclose non-fee-paying, discretionary segregated portfolios
© Kaplan, Inc. 44


Discretion and a Client’s Risk Preferences

A client’s investment policy statement (IPS) will specify risk
references and constraints:
▪ Risk controls (e.g., limits on leverage, derivatives, credit risk)
▪ Environmental, social, and governance (ESG) preferences
▪ Limits on the sale of low-basis stock to optimize tax planning
▪ Legal restrictions
▪ Restrictions on the sale of company stock
© Kaplan, Inc. 45

Discretion and a Client’s Risk Preferences

Client risk preferences do not automatically make the portfolio
nondiscretionary:
▪ Is the manager’s ability to use professional judgment
materially constrained?
▪ ECFs can indicate that a portfolio is nondiscretionary
(e.g., a client makes significant withdrawals that necessitates
a large cash balance).
▪ Low-basis stock may be considered nondiscretionary if the
manager is unable to reallocate.
© Kaplan, Inc. 46


Model Portfolios
Model portfolios are also known as simulated, hypothetical,
or theoretical portfolios:
▪ Often used to backtest investment strategies
▪ Simulated portfolios cannot be included in a composite
▪ Can be provided in supplemental information
▪ Must be clearly labeled
© Kaplan, Inc. 47

Composites must be the following:
▪ Be determined by investment mandate, objective, or strategy
▪ Contain all portfolios that match the composite definition
▪ Be based upon documented criteria within a firm’s policy
▪ Be representative of the firm’s products and marketing
▪ Enable clients to compare the performance of firms
© Kaplan, Inc. 48


Composite construction may include the following:
▪ Equity style
▪ The benchmark
▪ Equity or bond sector
▪ Risk/return profile using measures such as tracking error
▪ Active, passive, or core plus management approach
▪ Investment strategy such as sector rotation, fundamental, etc.
© Kaplan, Inc. 49

Portfolio Inclusion Into Composites

GIPS requires firms to have policies regarding moving
portfolios between composites to prevent unethical practices:
▪ New portfolios should be included in a composite at
beginning of the next full measurement period (e.g., funds
received July 6 should be included August 1)
▪ Firm has some discretion when investing in illiquid securities
such as emerging markets, and where other securities are
being sold to fund the trade
© Kaplan, Inc. 50


Portfolio Exclusion From Composites

Terminated portfolios:
▪ Terminated portfolios should be included in a composite
through the last full measurement period in which the firm
had discretion.
▪ Clients sometimes direct a firm to stop trading an account or
transfer control to a new manager before the portfolio is fully
liquidated. (For example, on June 4, a client notifies a firm to
stop trading. The portfolio will be included to May 31.)
© Kaplan, Inc. 51

Switching Portfolios Between Composites

Switching may be due to actions by the firm or the client:
▪ A client may change the portfolio’s mandate, objective, or
strategy (e.g., agrees to use of derivatives)
▪ A firm may redefine the composite and the portfolio is no
longer appropriate in the composite (highly unusual)
▪ When a portfolio is switched to a new composite, the
portfolio’s performance must remain in old composite’s
historical performance
© Kaplan, Inc. 52


Significant Cash Flows

Significant cash flows are large enough to impede the firm
from implementing the strategy on a timely basis:
▪ Large client inflows/outflows in illiquid markets may delay
the investment process
▪ Temporarily exclude the portfolio from the composite
▪ Or, create and report on a temporary new account that
contains cash until it can be invested or securities until they
can be divested
© Kaplan, Inc. 53

Minimum Asset Levels

Minimum asset levels are defined by firms to determine the
minimum size of portfolios to be included in composites:
▪ A portfolio may be excluded from a composite if its size is
below firm’s minimum asset level
▪ As portfolios change in size, they must be added or removed
from composites to meet this ongoing requirement
▪ Historical performance must remain for portfolios that are
removed
© Kaplan, Inc. 54


GIPS Presentation and Reporting

Marketing investment strategies:
▪ GIPS requires that firms make every reasonable effort to
provide a GIPS report to prospective clients and limited
distribution pooled fund investors.
Two types of GIPS reports:
▪ GIPS Composite Reports*
▪ GIPS Pooled Fund Reports
*The curriculum focuses on requirements of the Composite Time-Weighted Return Reports
© Kaplan, Inc. 55

Performance History, Returns, and Size

Upon GIPS adoption:
▪ Firms are required to present annual performance history for
at least 5 years (unless the firm is < 5 yrs old)
▪ Extend each year until a 10-year GIPS compliant history
GIPS report must include:
▪ Time-weighted returns for the composite and the benchmark
▪ Amount of firm assets, composite assets, and number of
portfolios in the composite (if there are six or more)
© Kaplan, Inc. 56


Risk Measures
GIPS report must include annual measures of internal
composite dispersion (if minimum six or more portfolios)
▪ Internal dispersion measures variability of portfolio
returns, allowing a client to evaluate return consistency
▪ Acceptable internal dispersion methods include:
▪ Range, high and low returns, equal- or asset-weighted
standard deviation, or other measure chosen by the firm
▪ Annual standard deviations, previous 3 yrs, benchmark also
© Kaplan, Inc. 57

Portability
When one firm acquires or joins with another, the new firm
may link the historical performance of the old firm if:
▪ Substantially all the decision makers are retained
▪ The decision-making process remains substantially intact
and independent within the new firm
▪ The new firm has records that document the previous firm’s
historical performance, and there is no break in performance
▪ If the old firm was GIPS compliant, 1 yr to attain compliance
© Kaplan, Inc. 58


GIPS Valuation Hierarchy

Fair value is amount an asset would be sold in an arm’s-length
transaction between willing and knowledgeable parties:
▪ Quoted price for an identical asset in a liquid market
▪ Quoted price for a similar asset in a liquid market
▪ Quoted price for identical or similar assets in markets that are
not active (e.g., price is days old)
◼ A value based upon market inputs (e.g., applying a P/E ratio)
◼ A subjective value that is unobservable is a last resort; the
proportion of assets valued in this way must be disclosed

© Kaplan, Inc. 59

GIPS Valuation Hierarchy

GIPS recommended valuation hierarchy:
▪ A method lower in the hierarchy is used only when all
higher methods in the hierarchy are unavailable.
▪ Firms must document their valuation process and
methodologies, which should be composite or pooled fund
specific.
▪ Fair value should include income for bonds and other
income-generating assets.
© Kaplan, Inc. 60


Verification
Verification is the process whereby an independent outside
party assesses the firm’s:
▪ Policies and procedures for composite and pooled fund
construction and maintenance
▪ Performance calculation and presentation
▪ Distribution of performance
Verification is recommended, but not required, by the GIPS

and does not assure that all data is accurate.
© Kaplan, Inc. 61

Benefits of Verification to the Firm

Verification provides greater confidence to investors and to
the firm in its claim of GIPS compliance.
Benefits to the firm:

▪ Increased knowledge of performance presentations
▪ Better quality presentations
▪ Better internal processes and procedures
▪ Possible marketing benefits
© Kaplan, Inc. 62


Selecting a GIPS Verifier

A firm should consider its own operations, products, and
needs when selecting a suitable verifier:
▪ A large global firm vs. a small local firm
▪ A tax-exempt investor (e.g., a pension fund) vs. a firm
that focuses on managing portfolio taxes
▪ A quantitative manager using derivatives vs. a direct real
estate investor
© Kaplan, Inc. 63

Selecting a GIPS Verifier

A firm should request the following information from
potential verifiers:
▪ A description of the verifier, including its personnel and
organizational structure
▪ Services offered and previous projects completed
▪ The verifier’s project management, sampling, and testing
procedures
▪ References from previous clients
▪ Fees, proposal, and timeline
© Kaplan, Inc. 64


Scope of GIPS Verification

Verification can only be claimed for the entire firm:
◼ Verification cannot be provided for a single portfolio,
composite, or pooled fund
◼ A firm must meet all GIPS requirements to claim compliance
◼ A firm may have the verifier perform a detailed
performance examination of one or more composites or
pooled funds and state that this has been completed
© Kaplan, Inc. 65

The GIPS Verification Process

The GIPS Standards for Verifiers provides the various
procedures that verifiers must follow:
◼ Gather information about the firm, products, calculation
methodologies, and GIPS policies and procedures
◼ Verifiers use samples (similar to audits)
◼ If the verifier discovers deficiencies, larger samples or
additional verification may be necessary
◼ Perform testing to assess recordkeeping, policies, and
procedures
© Kaplan, Inc. 66


Verification Testing
Verifiers should perform testing to see if the firm satisfies
requirements in the following areas:
◼ Recordkeeping, policies, and procedures
◼ Definition of the firm, definitions of discretionary
◼ Thoroughness of the firm’s list of composites
◼ Input data and calculation of total firm assets
◼ Assignment of portfolios to appropriate composites
◼ Contents of the firm’s GIPS Report and marketing material
© Kaplan, Inc. 67


CFA 2024 Level III Module Videos Workbook Secured

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

CFA 2024 Level III Module Videos Workbook Secured

Uploaded by

Copyright:

Available Formats

Module Videos

00_CFA2024_L3_VideoWB_FM.indd 1 7/25/23 6:54 AM

Published in 2023 by Kaplan, Inc.

00_CFA2024_L3_VideoWB_FM.indd 2 7/25/23 6:54 AM

00_CFA2024_L3_VideoWB_FM.indd 3 7/25/23 6:54 AM

01_CFA2024_L3_VideoWB_R1-2.indd 1 7/25/23 6:54 AM

Fixed Income Investments

Capital Market Expectations

Capital Market Expectations

Formulating Capital Market Expectations

01_CFA2024_L3_VideoWB_R1-2.indd 2 7/25/23 6:54 AM

Capital Market Expectations

Formulating Capital Market Expectations (cont.)

Capital Market Expectations

Capital Market Expectations

01_CFA2024_L3_VideoWB_R1-2.indd 3 7/25/23 6:54 AM

Capital Market Expectations

Capital Market Expectations

Challenges to Forecasting (cont.)

01_CFA2024_L3_VideoWB_R1-2.indd 4 7/25/23 6:54 AM

Capital Market Expectations

Capital Market Expectations

01_CFA2024_L3_VideoWB_R1-2.indd 5 7/25/23 6:54 AM

Capital Market Expectations

Selecting the Time Period

Capital Market Expectations

01_CFA2024_L3_VideoWB_R1-2.indd 6 7/25/23 6:54 AM

Capital Market Expectations

Challenges to Forecasting (cont.)

Capital Market Expectations

Challenges to Forecasting (cont.)

01_CFA2024_L3_VideoWB_R1-2.indd 7 7/25/23 6:54 AM

Capital Market Expectations

Challenges to Forecasting (cont.)

Capital Market Expectations

Setting Capital Market Expectations

01_CFA2024_L3_VideoWB_R1-2.indd 8 7/25/23 6:54 AM

Capital Market Expectations

The Trend Rate of Economic Growth

Capital Market Expectations

The Trend Rate of Economic Growth (cont.)

01_CFA2024_L3_VideoWB_R1-2.indd 9 7/25/23 6:54 AM

Capital Market Expectations

The Trend Rate of Economic Growth (cont.)

Capital Market Expectations

Pro-Growth Governmental Policies

01_CFA2024_L3_VideoWB_R1-2.indd 10 7/25/23 6:54 AM

Capital Market Expectations

Key Factors for Economic Growth Trends

Capital Market Expectations

Forecasting the Economic Growth Rate

01_CFA2024_L3_VideoWB_R1-2.indd 11 7/25/23 6:54 AM

Capital Market Expectations

Economic Forecasting: Econometrics

Capital Market Expectations

Economic Forecasting: Economic Indicators

01_CFA2024_L3_VideoWB_R1-2.indd 12 7/25/23 6:54 AM

Capital Market Expectations

Economic Forecasting: Checklist

Capital Market Expectations

The Business Cycle and Growth

trend rate of growth over

01_CFA2024_L3_VideoWB_R1-2.indd 13 7/25/23 6:54 AM

Capital Market Expectations