2022 Level III Fact Sheet

Key Facts & Formulas for the CFA®

Behavioral Finance ExamInvestor behavior and markets
Behavioral bias categories Momentum or trending effects
▪ Herding behavior
Cognitive ▪ Availability bias: more recent events easily recalled and given
Conservatism bias: Maintain prior views by inadequately relatively high weight (recency effect)
incorporating new information. ▪ Hindsight bias → regret → trend-chasing effect
Confirmation bias: Look for and notice what confirms beliefs. ▪ Bubbles: Overconfidence bias (illusion of knowledge and self-
Representativeness bias: Classify new information based on past attribution)
experiences. Crashes: Disposition effect in the context of loss aversion bias.
Illusion of control bias: False belief that we can influence or control Value stocks outperform growth stocks in the long run.
outcomes.
Hindsight bias: See past events as having been predictable. Capital Market Expectations
Anchoring & adjustment bias: Incorrect use of psychological
heuristics. Capital Market Expectations, Part 1 : Framework and
Mental accounting bias: Treat one sum of money (or source of Macro Considerations
return) as different from another.
Framing bias: Answer question differently based on how it is asked. Application of Growth Analysis to Capital Market Expectations
Availability bias: Heuristic approach influenced by how easily Aggregate value of equity: Vte= GDPt x Stk x PEt where Sk = E/GDP
outcome comes to mind. In the long run, total value of equity depends on the growth rate of
Emotional GDP.
Loss-aversion: Prefer avoiding losses overachieving gains. Approaches to Economic Forecasting
Overconfidence: Unwarranted faith in one's abilities. Econometric models – Output variable is predicted based on input
Self-control: Fail to act in pursuit of long-term goals. variables.
Endowment: People value assets more when they hold rights to it. ▪ Structural models specify functional relationships among
Regret aversion: Avoid pain of regret associated with bad decisions. variables based on economic theory.
Status quo: Do nothing rather than make a change. ▪ Reduced-form models are more compact versions of the
underlying structural models.
Moderate biases versus adapt portfolio to biases Econometric indicators – Economic statistics published by official
Type of behavioral biases the client exhibits agencies and/or private organizations. Types include lagging,
▪ emotional → adapt to biases coincident, and leading indicators. Multiple individual indicators
▪ cognitive → try to moderate biases combined ⟶ diffusion index.
BB&K (Bailard, Biehl, and Kieser) model: Checklist approach - subjective involves putting together
information that the analyst consider relevant.
Adviser
Personality Methodology Effects of Monetary and Fiscal Policy on Business Cycles
Investor type relationship
axis axis Aspects of fiscal policy can counteract cyclical fluctuations in the
notes
economy
Reluctant to take Monetary policy is used as a mechanism for intervention in the
Adventurer Confident Impetuous
advice business cycle
May be willing to ▪ Maintain price stability and/or growth consistent with potential.
Celebrity Anxious Impetuous
take advice ▪ Suffers from "Long and variable lags."
Will listen to ▪ Ability to fine-tune the economy is limited.
Individualist Confident Careful
advice The Taylor rule is a useful tool for assessing a central bank's stance
Guardian Anxious Careful May seek advice and for predicting how it will evolve
Straight arrow Mid-point Mid-point Rational i∗ = rneutral + πe + 0.5(Ŷe − Y
̂trend ) + 0.5(πe − πtarget )
Behavioral investor types
Fiscal Policy
Risk Biases Loose Tight
Investor type Active/Passive
tolerance (primarily) Loose High Real Rates + Low Real Rates +
Passive High Expected High Expected
Passive Low Emotional
preserver Inflation = High Inflation = Mid
Friendly Low- Monetary Nominal Rates Nominal Rates
Passive Cognitive
follower moderate Policy Tight High Real Rates + Low Real Rates +
Independent Moderate- Low Expected Low Expected
Active Cognitive
individualist high Inflation = Mid Inflation = Low
Active Nominal Rates Nominal Rates
Active High Emotional
accumulator Macroeconomic, Interest Rate, and Exchange Rate Linkages
Impact of behavioral factors on portfolio construction Between Economies
▪ Status quo bias → Maintaining default portfolio allocation. Macroeconomic Linkages
▪ Regret aversion and framing biases →Naïve diversification or Macroeconomic linkages between countries are expressed through
1/n strategy. their respective current and capital accounts.
▪ Overconfidence, naïve extrapolation of past returns, status-quo, Four primary mechanisms to keep current and capital accounts in
framing, loyalty biases → Investing in the familiar. balance:
▪ Regret aversion, overconfidence, and disposition effect (loss ▪ Changes in income (GDP)
aversion) biases →Excessive trading. ▪ Interest rates and asset prices
▪ Availability, illusion of control, endowment, familiarity, and ▪ Relative prices
status quo biases→ Home bias, investing in one's home country. ▪ Exchange rates

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In the short run, interest rates, exchange rates, and financial asset Liquidity premium: Real estate trades infrequently and is costly to
prices must adjust to keep the capital account in balance with the transact.
more slowly evolving current account.
Interest Rate/Exchange Rate Linkages Forecasting exchange rates
▪ Interest rates and currency exchange rates are linked Goods and services, trade, and the current account
Two countries will share a default-free yield curve if (and only if) Trade in goods and services can influence the exchange rate in 3
there is perfect capital mobility, and the exchange rate is credibly ways: 1) directly through trade flows, 2) through quasi-arbitrage of
fixed forever. prices, and 3) through competitiveness and sustainability of the
If there is lack of credibly fixed exchange rates, yield curves will not current account.
have perfect correlation. Capital flows
The link between interest rates and exchange rates is based on ▪ Capital seeks the highest risk-adjusted expected return.
expectations with floating exchange rates. ▪ Exchange rate will be driven to the point where the expected
▪ Interest rates should be higher in a currency that is expected to percentage change equals the "excess" risk-adjusted expected
depreciate. return on the domestic portfolio over the foreign portfolio.
▪ Interest rates should be lower in a currency that is expected to ▪ E(%ΔSd/f) = (rd – rf) + (Termd – Termf) + (Creditd – Creditf) +
appreciate. (Equityd – Equityf) + (Liquidd – Liquidf)
▪ Three phases in response to relative movements in investment
Capital Market Expectations - Part 2: Forecasting Asset Class opportunities.
Returns
Portfolio balance, portfolio composition, and sustainability
Forecasting Equity Returns
▪ Each country/currency has a unique portfolio of assets that
Historical statistics approach
makes up part of the global "market portfolio."
▪ Equity returns are extremely volatile
▪ Exchange rates provide an across-the-board mechanism for
▪ Fluctuations in P/E and E/GDP
adjusting the relative sizes of these portfolios to match
▪ Forecasts are not reliable
investors' desire to hold them.
▪ In the long run, the relative size of each currency portfolio
DCF approach
D depends mainly on relative trend growth rates and current
▪ Gordon growth model: r = 1 + g account balances.
P
▪ Grinold-Kroner model: ▪ Exchange rates adjust in response to changes in relative sizes
D and compositions of the aggregate portfolios denominated in
E(R 𝑒 ) ≈ + (%∆E − %∆S) + %∆P/E
P each currency.
Risk premium approaches
The Singer-Terhaar model combines two underlying CAPM models Forecasting Volatility: VCV Matrices from Multi-Factor Models
The first assumes complete global integration of markets and asset ▪ To forecast variance-covariance (VCV) matrix linear factor
classes. models are used ⟶impose structure on the VCV matrix - can
The second assumes complete segmentation of markets and asset handle very large numbers of asset classes; covariances are fully
classes. determined by exposures to a small number of common factors;
RPi = φRPiG + (1 - φ)RPiS each variance includes an asset-specific component.
RPGM ▪ Return on asset i with K common factors: 𝑟𝑖 = 𝛼𝑖 +
RPiG = ρi,GM σi ∑𝐾
𝑘=1 𝛽𝑖𝑘 𝐹𝑘 + 𝜀𝑖
σGM
RP𝑖𝑆 ▪ Variance of asset i: 𝜎𝑖2 = ∑𝐾 𝐾
𝑚=1 ∑𝑛=1 𝛽𝑖𝑚 𝛽𝑖𝑛 𝜌𝑚𝑛 + 𝜈𝑖
2
S
RPi = σi ▪ Covariance between the ith and jth assets: 𝜎𝑖𝑗 =
σi
∑𝐾 𝐾
𝑚=1 ∑𝑛=1 𝛽𝑖𝑚 𝛽𝑗𝑛 𝜌𝑚𝑛
▪ Imposing structure with a factor model ⟶ VCV matrix simpler
Forecasting Real Estate Returns
• N assets have [N(N – 1)/2] distinct covariance elements in
Historical real estate returns
the VCV matrix.
▪ Real estate valuation relies heavily on appraisals rather than
• Factor model: estimates [N × K] factor sensitivities plus [K(K
transactions.
+ 1)/2] elements of the factor VCV matrix, Ω.
▪ Historical return data is subject to smoothing
▪ Volatility and correlations are understated Time-Varying Volatility: ARCH Models
▪ Real estate cycles ▪ Financial asset returns tend to exhibit volatility clustering -
▪ Real estate is subject to boom–bust cycles that both drive and ARCH models help address time-varying volatilities.
are driven by the business cycle ▪ One of the simplest and most used ARCH models represents
Capitalization rates today's variance as a linear combination of yesterday's variance
Cap rate = net operating income in the current period divided by and a new "shock" to volatility.
the property value ▪ 𝜎𝑡2 = 𝛾 + 𝛼𝜎𝑡−1
2
+ 𝛽𝜂𝑡2 = 𝛾 + (𝛼 + 𝛽)𝜎𝑡−1
2
+ 𝛽(𝜂𝑡2 − 𝜎𝑡−12
)
▪ Standard valuation metric for commercial real estate
E(Rre) = Cap rate + NOI growth rate – %ΔCap rate Asset Allocation and Related Decisions in Portfolio
Cap rates are higher for riskier property types, lower-quality Management (1)
properties, and less attractive locations
Overview of Asset Allocation
Risk premium perspective on real estate expected return A common governance structure in an institutional investor
Term premium: As a very long-lived asset with relatively stable context will have three levels
cash flows, income-producing real estate has a high duration. 1) governing investment committee 2) investment staff and 3)
Credit premium: A fixed-term lease is like a corporate bond issued third-party resources
by the leaseholder (tenant) and secured by the property.
Equity premium: Owners bear the risk of property value An economic balance sheet includes:
fluctuations and risks associated with rent growth, lease renewal, ▪ Conventional (financial) assets and liabilities
and vacancies. ▪ Extended portfolio assets and liabilities

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Investment objectives of asset-only, liability-relative, and ▪ The asset allocations tend to be highly concentrated in a subset
goals-based asset allocation approaches of the available asset classes.
Asset only ▪ Many investors are concerned about more than the mean and
▪ Relation to economic balance sheet: Does not explicitly model variance of returns, the focus of MVO.
liabilities or goals. ▪ Although the asset allocations may appear diversified across
▪ Typical objective: Maximize Sharpe ratio for acceptable level of assets, the sources of risk may not be diversified.
volatility. ▪ Most portfolios exist to pay for a liability or consumption series,
and MVO allocations are not directly connected to what
Liability relative
influences the value of the liability or the consumption series.
▪ Relation to economic balance sheet: Models legal and quasi-
▪ MVO is a single-period framework that does not take account of
liabilities.
trading/rebalancing costs and taxes.
▪ Typical objective: Fund liabilities and invest excess assets for
growth. Some techniques for addressing the limitations of MVO:
Goals based ▪ Reverse optimization.
▪ Relation to economic balance sheet: Models goals. ▪ Reverse optimization tilted toward an investor's views on asset
▪ Typical objective: Achieve goals with specified required returns (Black–Litterman).
probabilities of success. ▪ Constraints on asset class weights to prevent extremely
concentrated portfolios.
Criteria for asset class specification ▪ Resampled efficient frontier.
1. Assets within an asset class should be relatively homogeneous.
2. Asset classes should be mutually exclusive. Liquidity considerations
3. Asset classes should be diversifying. Less liquid asset classes include direct real estate, infrastructure
4. The asset classes as a group should make up a preponderance and private equity; offer illiquidity return premium.
of world investable wealth. Two major problems associated with less liquid asset classes:
5. Asset classes selected for investment should have the capacity ▪ Lack of accurate indexes → challenging to make capital market
to absorb a meaningful proportion of an investor's portfolio. assumptions
▪ Difficult to diversify and no low-cost passive investment
Use of risk factors in asset allocation vehicles.
Examples of how risk factor exposures can be achieved:
▪ Inflation. Going long nominal Treasuries and short inflation- Risk budgeting:
linked bonds isolate the inflation component. ▪ Marginal contribution to total risk (MCTR) = rate at which risk
▪ Real interest rates. Inflation-linked bonds provide a proxy for changes with a small change in the current weights = (Beta of
real interest rates. asset class i with respect to portfolio) x (Portfolio return
▪ Credit spread. Going long, high-quality credit and short volatility)
Treasuries/government bonds isolate credit exposure. ▪ Absolute contribution to total risk (ACTR) = amount asset class
contributes to portfolio return volatility = (Weighti)(MCTRi)
Global market-value weighted portfolio should be the baseline ▪ Asset allocation is optimal from a risk-budgeting perspective
asset allocation. when the ratio of excess return (over the risk-free rate) to MCTR
▪ Represents all investable assets → minimizes diversifiable risk is the same for all assets and matches the Sharpe ratio of the
▪ Investing in the global market portfolio helps mitigate tangency portfolio.
investment biases such as home country bias
Approaches to liability-relative asset allocation
Rebalancing strategies: Two major strategies: calendar Surplus Hedging/return- Integrated asset–
rebalancing and percent-range rebalancing. optimization seeking liability portfolios
▪ Calendar rebalancing rebalances the portfolio to target weights portfolios
periodically. Simplicity Simplicity Increased complexity
▪ Percent-range rebalancing sets a range with thresholds or
Linear Linear or non- Linear or non-linear
trigger points around target weights. It’s a more disciplined
correlation linear correlation correlation
tighter asset mix control than calendar rebalancing.
All levels of Conservative All levels of risk
Strategic Considerations: risk level of risk
▪ Higher transaction costs for an asset class ⟶ wider rebalancing
Any funded Positive funded Any funded ratio
ranges.
ratio ratio for basic
▪ More risk-averse investors will have tighter rebalancing ranges
approach
▪ Less correlated assets ⟶ tighter rebalancing ranges
▪ Beliefs in momentum favor wider rebalancing ranges, whereas Single period Single period Multiple periods
mean reversion encourages tighter ranges
▪ Illiquid investments complicate rebalancing. Heuristics and other approaches to asset allocation
▪ Derivatives create the possibility of synthetic rebalancing. Heuristic Comment Critique
▪ Taxes discourage rebalancing and encourage asymmetric and
wider rebalancing ranges. “120 minus 120 – Age = Lacks nuances of target
your age” Percentage date funds’ glide paths
rule allocated to stocks
Principles of Asset Allocation
60/40 Provides growth Does not consider
Utility adjusted return: U = E(R) − 0.005λ σ2 stock/bond through stocks and investor circumstances
heuristic risk reduction
Criticisms of mean–variance optimization through bonds
▪ The outputs (asset allocations) are highly sensitive to small
changes in the inputs.

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 Endowment Large allocations to Complex and high-cost Strategic asset location: place less tax-efficient assets in tax-exempt
model non-traditional or tax-deferred accounts; place tax-efficient assets (low tax rates
investments driven and/or deferred capital gains) in taxable accounts.
by investment
manager skill Short-term shifts in asset allocation
Risk parity Each asset class Ignores expected Tactical asset allocation (TAA) allows short-term deviations from
should contribute returns; contribution to SAA based on cyclical variations within a secular trend or
equally to total risk risk is highly dependent temporary price dislocations in capital markets.
on the formation of the Discretionary TAA is based on manager skill in predicting short-
investment opportunity term market movements. It considers many data points such as
set valuations, credit spreads, monetary and fiscal policy, GDP growth,
1/N rule Equal weight to all Asset classes treated as economic sentiment indicators, market sentiment indicators, etc.
asset classes indistinguishable in Systematic TAA seeks to exploit asset class level return anomalies
terms of returns, that have been shown to have some predictability and persistence,
volatility, and such as value factor and momentum factor.
correlations

Percent-range rebalancing - Factors affecting the corridor

width of an asset class
Derivatives and Currency Management
Transaction The higher the High transaction costs set a Options Strategies
costs transaction costs, the high hurdle for rebalancing
wider the optimal benefits to overcome.
Covered call
corridor. ▪ short call + stock
Investment objectives
Risk The higher the risk Higher risk tolerance
tolerance tolerance, the wider the means less sensitivity to
▪ Yield enhancement
optimal corridor. divergences from the target ▪ Reducing position at favorable price
allocation. ▪ Target price realization
Correlation The higher the When asset classes move in
with the rest correlation, the wider sync, further divergence Profit and loss at expiration
of the the optimal corridor. from target weights is less Maximum gain = (X – S0) + c0
portfolio likely. Maximum loss = S0 – c0
Volatility of The higher the Containing transaction Breakeven point = S0 – c0
an illiquid volatility, the wider the costs is more important Expiration value = ST – Max[(ST – X), 0]
asset class optimal corridor. than expected utility losses. Profit at expiration = ST – Max[(ST – X), 0] + c0 – S0
Volatility of The higher the Higher volatility makes
the rest of volatility, the narrower large divergences from the Protective put
the portfolio the optimal corridor. strategic asset allocation ▪ stock + long put
more likely. Investment objectives
▪ Loss protection
Asset Allocation with Real-World Constraints ▪ Upside preservation
Constraints in asset allocation
Profit and loss at expiration
Asset size: a portfolio could be:
▪ too large for some asset classes and certain active strategies. Maximum profit = ST – S0 – p0
▪ too small for complex asset classes like hedge funds and private Maximum loss = S0 – X + p0
equity with a minimum investment requirement. Breakeven point = S0 + p0
Expiration value = Max(ST , X)
Time horizon. Two major aspects: Profit at expiration = Max(ST , X) – S0 – p0
▪ Changes in human capital.
▪ Changing character of liabilities. Bull spread
Liquidity constraint has two dimensions: ▪ To benefit from an increase in price of the underlying while
▪ Liquidity characteristics of asset classes. keeping cost low.
▪ Liquidity needs of asset owner. Structure: Buy a call option with low exercise price and sell a call
option with high exercise price.
Regulatory and other external constraints Cost = cL – cH
▪ Allocations to certain asset classes might be constrained by the Maximum profit = XH – XL – cost
regulator. Breakeven price for a call bull spread = XL + cost
▪ Tax incentives. Maximum loss = cost
▪ Need to maintain certain financial ratios.

After-tax portfolio optimization Bear spread

Portfolio optimization should be based on after-tax return and risk ▪ To benefit from a decrease in price of the underlying while
▪ rat = rpt(1 – t) or rat = pdrpt(1 – td) + parpt(1 – tcg) keeping cost low.
▪ σat = σpt(1 – t) Structure: Buy a put option with a high exercise price and sell a put
▪ Correlations are not impacted by taxes. option with a low exercise price.
After-tax volatility < before-tax volatility → larger asset class Cost = pH – pL
movements to materially alter risk profile of taxable portfolio → Maximum profit = XH – XL – cost
wider rebalancing ranges for taxable portfolios relative to tax Breakeven price for a put bear spread = XH – cost
exempt portfolios. Maximum loss = cost

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 Increase Buy puts Buy straddle Buy calls
Straddle
▪ To take advantage of volatility. Swaps, Forwards, and Futures Strategies
Structure: A long straddle is buying a call and buying a put on the
same underlying asset. The exercise price of the call and put should Interest Rate Swaps
be the same. ▪ An interest rate swap is an OTC contract in which two parties
▪ Profitable if there are increased volatility and large price agree to exchange cash flows on specified dates, one based on a
movement of underlying stock. floating interest rate and the other based on a fixed rate (swap
Cost = c0 + p0 rate), determined at swap initiation.
Max profit = unlimited ▪ Interest rate swaps can be used to change a portfolio's modified
Breakeven = X + cost, X – cost (a straddle has two breakeven duration.
• To reduce the modified duration, we can combine the
points)
portfolio with a negative duration swap i.e., a pay-fixed
Max loss = cost
receive-floating swap.
• To increase the modified duration, we can combine the
Collar portfolio with a positive duration swap i.e., a receive-fixed
▪ To limit downside risk at low cost. pay-floating swap
Structure: Long stock + Long put with an exercise price (X1) below
the current stock price + Short call with an exercise price above the The notional amount of the swap NS:
current stock price (X2). MDUR T − MDUR P
Cost = S0 + p0 – c0 NS = ( ) (MVP )
MDUR S
Max profit = X2 – cost
Min profit = X1 – cost Interest Rate Forwards and Futures
▪ An FRA is an OTC derivative instrument used mainly to hedge a
Calendar Spread loan expected to be taken out in the near future or to hedge
▪ To take advantage of time decay. against changes in the level of interest rates in the future.
Structure: Sell an option and buy the same type of option with ▪ An FRA will settle the discounted difference between the
different expiration dates but the same strike price. interest rate agreed on in the contract and the actual rate
Two types of calendar spreads: prevailing at the time of settlement applied on the contract’s
▪ Short calendar spread: selling a longer-dated call, buying a near- notional amount.
term call. Profitable when greater price movements are ▪ Interest rate risk can be hedged using interest rate futures
expected in the near-term relative to price movements expected contracts.
in the future.
▪ Long calendar spread: selling a near-dated call, buying a long- Fixed-Income Futures
dated call. Profitable when investment outlook is flat in the near ▪ Longer-dated compared to interest rate future; a preferred
term, but greater price movements are expected in the future. instrument to hedge bond positions.
Implied Volatility and Volatility Skew ▪ CTD bond is determined by comparing purchase price with
Realized volatility (historical volatility of the underlying asset) = amount received on delivery.
square root of the realized variance of returns Principal invoice amount = (futures settlement
𝑃 −𝑃
Returns = 𝑡 𝑡−1 price/100) x CF x Contract size
𝑃𝑡−1
Implied volatility (expected volatility of the underlying asset) =
The number of bond futures to buy or sell to reach the target basis
calculated from the options' market prices using BSM model.
point value is the basis point value hedge ratio (BPVHR).
252
Annualized volatility = δAnnual(%) = δMonthly(%)√ BPVT − BPVP
21 BPVHR = ( ) × CF
Volatility smile When the implied volatilities priced into both OTM BPVCTD
puts and calls trade at a premium to implied volatilities of ATM 𝐵𝑃𝑉𝑃 = 𝑀𝐷𝑈𝑅𝑃 × 0.01% × 𝑀𝑉𝑃
options, the curve is U-shaped and is called a volatility smile.
To completely hedge a bond portfolio BPVT = 0:
Volatility skew where the implied volatility increases for OTM
−BPVP
puts and decreases for OTM calls as the strike price moves away BPVHR = × CF
from the current price. This shape persists because of less interest BPVCTD
in OTM calls and more demand for OTM puts as portfolio
insurance against a market sell-off. Managing Currency Exposure
Currency Swaps reduce borrowing costs of companies that need
cash in foreign currency.
Choosing options strategies based on direction and volatility of
Cross-currency basis swaps help parties in the swap to hedge
underlying asset
against the risk of exchange rate fluctuations and to achieve better
Outlook on the Trend of
rate outcomes.
Underlying Asset
▪ "Basis" is the difference between interest rates in the cross-
Bearish Trading Bullish
currency basis swap and interest rates used to determine
Range/
forward rates.
Neutral
▪ Currency swaps can use used to earn extra yield
View
Expected
Decrease Write calls Write Write puts Currency Forwards and Futures hedge against undesired moves in
Move in
straddle the exchange rate by buying or selling a specified amount of foreign
Implied
Remain Write calls Calendar Buy calls currency at a defined time in the future and an agreed-on price at
Volatility
Unchanged and spread and contract initiation.
buy puts write puts

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 ▪ To determine the probability of a change in the federal funds
Managing Equity Risk rate, where the current federal funds rate is the midpoint of the
Equity swaps current target range:
▪ An equity swap converts the returns from an equity investment Effective federal funds rate implied by futures contract
into another series of returns. − Current federal funds rate
Federal funds rate assuming a rate hike
▪ Three main types of equity swaps: − Current federal funds rate
• Receive-equity return, pay-fixed.
• Receive-equity return, pay-floating. Currency Management: An Introduction
• Receive-equity return, pay-another equity return.
Return decomposition
▪ The equity leg of the swap can be based on the returns of a Domestic-currency return = RDC = (1+RFC)(1+RFX) – 1
single stock, a portfolio of stocks, or an equity index.
Volatility decomposition
Equity forwards and futures Total risk of the domestic-currency returns:
2 2 2
▪ Equity risk in a portfolio can also be managed using equity 𝜎𝐷𝐶 = 𝜎𝐹𝐶 + 𝜎𝐹𝑋 + 2𝜌𝜎𝐹𝐶 𝜎𝐹𝑋
futures and forwards.
Currency hedging strategies
If the portfolio beta S is different from f the futures contract beta, Passive hedging: To keep the portfolio's currency exposures close,
the number of equity futures contracts to buy or sell (to hedge the if not equal to, those of a benchmark portfolio used to evaluate
portfolio) is: performance, a rules-based approach and removes almost all
βT − βS S discretion from the portfolio manager.
Nf = ( )( ) Discretionary hedging: Measures performance against a "neutral"
βf F
To completely hedge the equity risk, βT = 0, benchmark portfolio. The portfolio manager has some limited
−βS S discretion on how far to allow actual portfolio risk exposures to
Nf = ( ) vary from the neutral position.
βf F
If the portfolio beta S = f the futures contract beta, Active currency management: Portfolio manager can express
−S directional opinions on exchange rates nonetheless kept within
Nf = mandated risk limits.
F
Currency overlay: involves active currency management conducted
Cash Equitization by external, FX-specialized sub-advisors to the portfolio.
▪ Cash equitization is a strategy designed to boost returns by
finding ways to "equitize" unintended cash holdings. Currency trading strategies
Active currency management based on the carry trade: The carry
In this case, βS = 0, the number of futures to be purchased is: trade is a trading strategy of borrowing in low-yield currencies and
βT S investing in high-yield currencies.
Nf = ( )
βf F Buy/invest Sell/borrow
Implementing carry High-yield
Low-yield currency
Volatility Derivatives and Variance Swaps trade currency
▪ VIX option prices are determined from VIX futures. They provide Trading forward Forward discount Forward premium
asymmetrical exposure to potential increases or decreases in rate bias currency currency
anticipated volatility.
Variance swaps allow directional bets on implied versus realized Volatility trading: Trade based on a view about future volatility of
volatility. The payoff for a variance swap at expiration is: exchange rates, not the direction of exchange rates.
Settlement amount = (Variance notional)(Realized variance – Use delta hedging to hedge away the exposure to changes in FX
T
Variance strike) rates.
Vega notional Trader has exposure to other Greeks, the most significant of which
Variance notional (Nvariance ) = is vega (sensitivity of option price to volatility underlying FX rate).
2 × Strike price
Settlement amount T = Nvariance (σ2 − X 2 ) An option strategy that implements a volatility trade is a straddle, a
σ2 − X 2 combination of both an at-the-money (ATM) put and an ATM call.
= Nvega ( ) A similar option structure is a strangle position for which a long
2 × Strike price
position is buying out-of-the-money (OTM) puts and calls with the
same expiry date and the same degree of being out of the money.
Use of Derivatives in Portfolio Management
Use Cases/Applications Derivative Type Strategies to reduce hedging costs and modify a portfolio's
risk profile
1. Inferring expectations for Fed funds futures Forward Over/under- Profit from market view
FOMC moves contracts hedging
2. Inferring expectations for CPI (inflation) Option OTM options Cheaper than ATM
inflation rates swaps contracts Risk reversal Write options to earn premiums
3. Inferring expectations for VIX futures
market volatility Put/call Write options to earn premiums
spreads
▪ Fed funds futures can be used to infer expectations of changes in Seagull spreads Write options to earn premiums
the federal funds rate. Exotic Knock-in/out Reduce upside/downside
Fed funds futures contract price = 100 – Expected FFE rate options features exposure
Digital options Extreme payoff strategies

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Hedging multiple foreign currencies
A cross hedge (proxy hedge) occurs when a position in one asset
(or a derivative based on the asset) is used to hedge the risk
exposures of a different asset.
▪ Hedge ratio = Nominal value of hedging instrument/market
value of hedged asset
▪ Minimum or optimal hedge ratio = Correlation (R DC ; R FX )
S.D. (RDC )
× [ )
] The Macaulay duration statistic divided by
S.D. (RFX
▪ Long position in a risk reversal = Long position in a call option +
Short position in a put option
▪ Short position in a risk reversal = Long position in a put option +
Short position in a call option
▪ Short seagull position = Long protective put + Short deep-OTM
call option + Short deep-OTM put option
▪ Long seagull position = write ATM call + Long deep-OTM call
option + Long deep-OTM put option
Currency management for emerging market currencies
▪ Higher trading costs than the major currencies under "normal"
market conditions.
▪ Increased likelihood of extreme market events and severe
illiquidity under stressed market conditions.
▪ Where capital controls exist, use non-deliverable forwards.
Fixed-Income Portfolio Management (1)
Overview of Fixed-Income Portfolio Management
Fixed-income mandates: liability-based and total return
Liability-based: match or cover expected liability payments with
future projected cash flows.
Immunization: process of structuring and managing a fixed-income
portfolio to minimize the variance in the realized rate of return
over a known time horizon.
▪ Cash flow matching
▪ Duration matching
▪ Derivatives overlay
▪ Contingent immunization
▪ Horizon matching
Total return mandates: track or outperform a benchmark:
➢Pure indexing
▪ Match benchmark return and risk as closely as possible.
▪ Risk factors are matched exactly.
➢Enhanced indexing
▪ Modest outperformance (generally 20 bps to 30 bps) of
benchmark while active risk is kept low (typically around 50 bps
or lower).
▪ Most primary risk factors are closely matched (in particular,
duration).
➢Active management
▪ Higher outperformance (generally around 50 bps or more) of
benchmark and higher active risk levels.
▪ Large risk factor deviations from benchmark (in particular,
duration)
▪ Considerably higher turnover than the underlying benchmark.
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Fixed-income portfolio measures
Macaulay duration is a weighted average of
Macaulay the time to receipt of the bond's promised
duration payments, where the weights are the shares
(MacDur) of the full price that correspond to each of the
bond's promised future payments
Modified one plus the yield per period, which estimates
duration the percentage price change (including
(ModDur) accrued interest) for a bond given a change in
its yield to maturity.
Bond's price sensitivity to a change in a
benchmark yield curve (i.e., using a parallel
Effective shift in the benchmark yield curve (ΔCurve).
duration (EffDur) Effective duration measures the interest rate
risk of a complex bond where future cash
flows are uncertain.
A measure of a bond's sensitivity to a change
in the benchmark yield curve at a specific
Key rate duration
maturity point or segment. Key rate durations
(partial
help identify "shaping risk" for a bond or a
duration)
portfolio—that is, its sensitivity to changes in
the shape of the benchmark yield curve
A measure of interest rate sensitivity that is
determined from market data—that is, run a
Empirical
duration regression of bond price returns on changes
in a benchmark interest rate
A measure of the price change in units of the
Money duration currency in which the bond is denominated.
An estimate of the change in a bond's price
given a 1 bp change in yield to maturity. PVBP
"scales" money duration so that it can be
Price value of a interpreted as money gained or lost for each
basis point basis point change in the reference interest
(PVBP) rate.
A related statistic to PVBP, sometimes called
"basis point value" (or BPV), is the money
duration times 0.0001 (1 bp).
Second-order effect describing a bond's price
behavior for larger yield movements. It
captures the extent to which the yield/price
relationship deviates from a linear
relationship.
If a bond has positive convexity, the bond's
expected return will be higher than the return
Convexity of an identical-duration, lower convexity
bond if interest rates change.
A bond with higher convexity might have a
lower yield to maturity than a similar-
duration bond with less convexity.
Nominal convexity calculations assume that
the cash flows do not change when yields to
maturity change.
A curve convexity statistic that measures the
secondary effect of a change in a benchmark
yield curve. A pricing model is used to
Effective
determine the new prices when the
convexity
benchmark curve is shifted upward (PV+) and
downward (PV−) by the same amount
(ΔCurve), holding other factors constant.
7
Portfolio measures of risk and return Managing the interest rate risk of a single liability
Immunization is achieved if change in cash flow yield on the bond
▪ Modified duration of a bond portfolio AvgModDur = portfolio is equal to the change in the yield to maturity on the zero-
MV
∑Jj=1 ModDurj ( j ) coupon bond being replicated.
MV
▪ Convexity of a bond portfolio AvgConvexity = Key characteristics:
MV ▪ Market value ≥ present value of liability
∑Jj=1 Convexityj ( j ) ▪ Macaulay duration = liability's due date
MV
▪ Effective duration (EffDur) =
(PV− )−(PV+ )
. ▪ Minimize portfolio convexity
2(∆Curve)(PV0 )
(PV− )−(PV+ )
Structural risk: yield curve changes such that immunization is not
▪ Effective convexity (EffCon) = . achieved. This risk can be minimized by minimizing the convexity
(∆Curve)2 (PV0 )
▪ Spread duration: measures the approximate percentage increase statistic.
(decrease) in bond price expected for a 1% decrease (increase)
Managing the Interest Rate Risk of Multiple Liabilities
in credit spread.
Duration matching
▪ Duration times spread (DTS) modification of the spread
▪ Market value of assets ≥ market value of liabilities
duration to incorporate the empirical observation that spread
▪ Match monDoneey duration: asset basis point value = liability
changes across the credit spectrum tend to occur on a
basis point value
proportional percentage basis rather than on absolute basis
▪ Dispersion of cash flow and convexity of assets greater than
point changes.
▪ Portfolio dispersion captures the variance of the times to receipt those of liabilities
of cash flows with respect to the duration. It is used in Derivatives overlay strategy: derivatives such as interest rate
measuring interest rate immunization for liabilities. futures contracts are used to immunize single or multiple liabilities
▪ Convexity is affected by dispersion. Higher cash flow dispersion by maintaining its target duration as the yield curve shifts and
leads to an increase in convexity twists.
Contingent immunization: hedge liabilities and actively manage
surplus.
A model for fixed-income returns Accounting defeasance: Both assets and liabilities can be
E(R) ≈ Yield income + Rolldown return + E(Change in price based removed from the balance sheet.
on investor’s views) - E(Credit losses) + E(Currency gains or Basis point value = Money duration x 1 bp
losses) Money duration = Modified duration x market value
Rolldown return = Modified duration = Macaulay duration / (1 + CFY)
𝐵𝑜𝑛𝑑 𝑝𝑟𝑖𝑐𝑒𝐸𝑛𝑑−𝑜𝑓−ℎ𝑜𝑟𝑖𝑧𝑜𝑛 𝑝𝑒𝑟𝑖𝑜𝑑 − 𝐵𝑜𝑛𝑑 𝑝𝑟𝑖𝑐𝑒 𝑏𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔−𝑜𝑓−ℎ𝑜𝑟𝑖𝑧𝑜𝑛 𝑝𝑒𝑟𝑖𝑜𝑑
Liability portfolio BPV − Asset portfolio BPV
𝐵𝑜𝑛𝑑 𝑝𝑟𝑖𝑐𝑒 𝑏𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔−𝑜𝑓−ℎ𝑜𝑟𝑖𝑧𝑜𝑛 𝑝𝑒𝑟𝑖𝑜𝑑 Nf =
Futures BPV
Futures contracts can be used
Rolling yield = Coupon income + Rolldown return ▪ Over-hedge if yields are expected to decline.
▪ Under-hedge if yields are expected to increase.
E(ΔPrice based on investor's views of yields and yield volatility) =
(–ModDur × ∆Yield) + [½ × Convexity × (∆Yield)2] LDI – An Example of a Defined Benefit Pension Plan
For an ongoing independent institution that preserves its current
E(ΔPrice based on investor’s views of yield spreads) = (−ModDur × pension plan PBO is the appropriate measure for pension plan
∆Spread) + [½ × Convexity × (∆Spread)2] liabilities.
𝑚×𝐺×𝑊0×(1+𝑤)𝑇 1 1
Leveraged portfolio return rp PBO (per employee) = (1+𝑟)𝑇
×[ − ]
𝑟 𝑟×(1+𝑟)𝑍
where:
rp = Portfolio return/Portfolio equity or
𝑉 (𝑟 −𝑟 )
PBO = Projected benefit obligation
rp = 𝑟𝐼 + 𝐵 𝐼 𝐵 m = multiplier
𝑉𝐸
where: G = years worked
VE = value of the portfolio's equity W0 = current wage
VB = borrowed funds w = annual wage growth rate = constant fraction x r
rB = borrowing rate (cost of borrowing) T = remaining work life/ pre-retirement life in years
rI = return on the invested funds (investment returns) Z = post-retirement lifetime in years
rp = return on the levered portfolio r = yield on high-quality corporate bonds
Plan PBO = PBO per employee x no. of employees covered
(𝑃𝑉− )−(𝑃𝑉+ )
Repurchase Agreement Effective duration for liabilities (or assets) =
2×∆𝐶𝑢𝑟𝑣𝑒×(𝑃𝑉0 )
Dollar interest = Principal x repo rate x (terms of repo in days/360)
PBO BPV = Plan PBO x effective duration x 0.0001

Liability-Driven and Index-Based Strategies Laddered bond portfolios

Liability-driven investing ▪ Laddered portfolios offer diversification over the yield curve.
▪ Balance between reinvestment and price risk.
Liability Amount of Timing of Example ▪ Attractive in stable, upward sloping yield curve environment.
type cash outlay cash outlay ▪ Offer liquidity even if underlying bonds are not liquid.
I Known Known Traditional fixed ▪ High convexity.
income bonds Macaulay Duration2+ Macaulay duration+Dispersion
Convexity = (1+cash flow yield)2
II Known Uncertain Callable and
putable bonds ▪ Laddered portfolios can be created using fixed maturity
corporate bond ETFs.
III Uncertain Known Floating rate notes
▪ Decision to build a laddered portfolio should be evaluated
IV Uncertain Uncertain Defined benefit
against buying shares in a fixed-income mutual fund.
plan obligations

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 Fixed-Income Portfolio Management (2)
Yield Curve Strategies
Key yield curve and fixed-income concept for active managers
Factors affecting an investor’s expected fixed-income portfolio
returns:
E(R) ≈ Coupon income
+/− Rolldown return
+/− E (Δ Price due to investor’s view of benchmark yields)
+/− E (Δ Price due to investor’s view of yield spreads)
+/− E (Δ Price due to investor’s view of currency value changes)
Yield curve dynamics
Primary yield curve risk factors are of three types:
1. A change in level (a parallel “shift” in the yield curve) - a first-
order duration statistic used to measure the portfolio value
impact. Larger yield curve changes require second-order
effects.
2. A change in slope (a flattening or steepening “twist” of the
yield curve) - the difference in basis points between the yield-
to-maturity on a long-maturity bond and the yield-to-maturity
on a shorter-maturity bond.
3. A change in shape or curvature (a “butterfly” movement) -
Butterfly spread = -(Short-term yield)+(2xMedium-term
yield) - Long-term yield.
A positive butterfly spread is a “humped” or concave shape to
the midpoint of the curve, while a “saucer” or convex shape
indicates the spread is negative.
Duration and Convexity
E (Δ Price due to investor’s view of benchmark yield) for a single
bond:
%∆PVFull ≈ −(ModDur × ΔYield) + [½ × Convexity × (ΔYield)2]
▪ Duration is a first-order effect that accounts for changes in yield
curve level.
▪ Convexity is a second-order effect that accounts for yield curve
slope and shape changes.
▪ All else equal, the expected price change of a bond with positive
convexity for a given rate decrease will be higher than the price
change of an identical-duration, lower-convexity bond.
Yield curve strategies
Static yield curve
Strategies for a static yield curve:
▪ Cash-based strategies
➢ Buy-and-hold – Constant without active trading
o Income: Coupon income
➢ Rolling down the yield curve - Constant, with Δ Price as
maturity shortens
o Income: Coupon income +/− Rolldown return
➢ Repo carry trade - Finance bond purchase in repo market
o Income: (Coupon income +/− Rolldown return) -
Financing cost
▪ Derivatives-based strategies
➢ Long futures – Purchase contract for future bond delivery
o Targeted return: (Δ Price / Δ Bond yield) − Margin cost
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➢ Receive-fixed swap - Fixed-rate receiver on an interest rate
swap
o Targeted return: (Swap rate − MRR) + (Δ Swap mark-to-
market / Δ Swap yield)
Two ways to achieve excess return given a static yield curve:
▪ Add leverage
▪ Add duration
Dynamic yield curve
Divergent rate level view
Strategies to increase duration
▪ Cash bond purchase (“bullet”) – Extend duration with longer-
dated bonds → Price appreciation as YTM declines
▪ Receive-fixed swap - Fixed-rate receiver on an interest rate
swap → Swap MTM gain plus “carry” (fixed - floating rate)
▪ Long futures position – Purchase contract for forward bond
delivery → Futures MTM gain − Margin cost
Strategies to reduce duration
▪ Cash bond sale (“bullet”) - Reduce duration with short
sale/switch to shorter-dated bonds → Smaller price decline as
YTM increases
▪ Pay-fixed (interest rate swap) - Fixed-rate payer on an interest
rate swap → Swap MTM gain + “swap carry” (MRR − Fixed swap
rate)
▪ Short futures position - Sell contract for forward bond delivery
→ Futures MTM gain − Margin cost
Divergent yield curve slope view
Yield curve steepener strategies
▪ Duration neutral - Net zero duration → Portfolio gain from yield
curve slope increase
▪ Bear steepener - Net negative (“short”) duration → Portfolio
gain from slope increase and/or rising yields
▪ Bull steepener - Net positive (“long”) duration → Portfolio gain
from slope increase and/or lower yields
Yield curve flattener strategies
▪ Duration neutral - Net zero duration position → Portfolio gain
from yield curve slope decrease
▪ Bear flattener - Net negative duration position → Portfolio gain
from slope decrease and/or rising yields
▪ Bull flattener - Net positive duration position → Portfolio gain
from slope decrease and/or lower yields
Divergent yield curve shape view
Yield curve volatility strategies
▪ Bond call option
▪ Bond put option
▪ Callable bond
▪ Putable bond
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Key rate duration for a portfolio Fixed-Income Active Management: Credit Strategies
Key rate duration measures portfolio sensitivity over a set of
maturities along the yield curve. Key credit and spread concepts for active management

Portfolio duration = sum of key rate durations
Key rate durations help:
▪ Quantify exposures along the curve
▪ Identify a bond portfolio’s sensitivity to changes in the shape of
the benchmark yield curve
▪ Identify “shaping risk” – i.e., a bond’s sensitivity to changes in
the shape of the benchmark yield curve
Yield spreads compensate investors for assuming credit risk and
liquidity risk.
▪ Credit risk for a borrower depends on the likelihood of default
and the loss severity.
▪ Credit risk for a specific bond issuance also depends on the
payment period, the debt seniority, and the repayment sources.
Liquidity risk: investor’s ability to easily buy or sell a specific
security.

Active fixed-income management across currencies Default probabilities and recovery rates
Credit valuation adjustment (CVA) framework
The term structure of interest rates and exchange rates vary across
countries.
Yield curve strategies do not have to be limited to a single yield
curve.

Strategies to benefit from interest rate and exchange rate

differentials include:

▪ Invest in foreign bonds

➢ Single asset: RDC = (1 + RFC) (1 + RFX) – 1
➢ Portfolio: RDC = ∑𝑛𝑖=1 ωi (1 + RFC, i) (1 + RFX, i) – 1
o Covered interest rate parity: the return on hedged foreign
currency exposure will be the same as on a domestic
currency investment.
o Uncovered interest rate parity: over time, the return on
unhedged foreign currency exposure will be the same as POD ≈ Spread / LGD
on a domestic currency investment.
Credit spread curves - are based on the difference between yields
o Forward rate bias: observed divergence from interest rate
to maturity for bonds within a particular category and a
parity conditions under which active investors seek to
government benchmark bond or swap yield curve.
benefit by borrowing in a lower-yield currency and
investing in a higher-yield currency. Credit spread curves are usually categorized by rating, issuer type,
▪ Carry trade across currencies - an extension of the single and/or corporate sector.
currency repo carry trade whereby an investor borrows short- Empirical duration is a measure of interest rate sensitivity
term in one currency and invests in another higher-yielding
determined from market data. Empirical duration is used for
currency.
distress bonds and low rated-bonds because market prices of
Cross-currency basis swap - The “basis” or spread in the cross-
lower-rated bonds can differ from predicted values of analytical
currency basis swap is the difference between the USD interest rate
models.
and the synthetic USD interest rate. A positive (negative) currency
basis means that the direct USD interest rate is higher (lower) than ▪ Distress bond price approaches the estimated recovery rate.
the synthetic USD interest rate. ▪ Stress period → “flight to quality” → Prices of high-risk debt fall,
and low-risk government debt rise.

Credit Spread Measures

Spread Description

Yield spread Difference between bond YTM and

government benchmark of similar tenor

G-spread Spread over interpolated government bond

(Government
spread)

I-spread Yield spread over swap rate of same tenor

(Interpolated
spread)

A framework for evaluating yield curve strategies ASW (Asset Spread over MRR of fixed bond coupon
swap)
E(R) ≈ Coupon income +/− Rolldown return +/− E (Δ Price due to
benchmark yields) +/− E (Δ Price due to yield spreads) +/− E (Δ
Price due to currency value changes)

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 Z-spread (Zero Yield spread over a government (or swap)
volatility spot curve
spread)
CDS Basis Yield spread versus CDS spread of same
tenor
OAS Yield spread using Z-spread including bond
option volatility
Z-spread represents a constant spread over a government (or
interest rate swap) spot curve.
Floating-rate note credit spread measures
FRNs pay a periodic interest coupon equal to a variable MRR plus a
(usually) constant yield spread.
QM (quoted margin): the yield spread over the MRR established
upon issuance to compensate investors for assuming the credit risk
of the issuer and fixed until bond maturity,
DM (discount margin): the discount (or required) margin is the
yield spread versus the MRR such that the FRN is priced at par on a
rate reset date. This changes if the issuer’s credit risk changes.
Z-DM: Yield spread over MRR curve
▪ Z-DM will change based on changes in the MRR forward curve.
▪ In an upward-sloping yield curve, the Z-DM will be below the
DM.
▪ The Z-DM assumes an unchanged QM and that the FRN will
remain outstanding until maturity.
Portfolio Return Impact of Yield Spreads
Change in Price Given Yield Spread Changes
%∆𝐏𝐕𝐒𝐩𝐫𝐞𝐚𝐝≈
−(𝐄𝐟𝐟𝐒𝐩𝐫𝐞𝐚𝐝𝐃𝐮𝐫×∆𝐒𝐩𝐫𝐞𝐚𝐝)+(𝟏/𝟐×𝐄𝐟𝐟𝐒𝐩𝐫𝐞𝐚𝐝𝐂𝐨𝐧×(∆𝐒𝐩𝐫𝐞𝐚𝐝)𝟐)
▪ For a bond portfolio, use market value-weighted averages for
the duration and convexity measures.
▪ For lower-rated bonds, use the Duration Times Spread (DTS)
measure
▪ DTS ≈ (EffSpreadDur × Spread)
▪ A portfolio’s DTS is the market value-weighted average of DTS of
its individual bonds
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▪ Spread changes of a portfolio are measured on a percentage
(ΔSpread/Spread) basis
Excess spread
▪ Spread duration-based measures are used to estimate the first-
order impact of spread movements.
▪ Excess spread is the annualized excess spread return assuming
no defaults for a spread-based bond.
ExcessSpread ≈ Spread0 − (EffSpreadDur × ΔSpread)
Spread0 = initial yield spread
For holding periods of less than a year: Spread0 / (Periods Per
Year)
E [ExcessSpread] ≈ Spread0 − (EffSpreadDur × ΔSpread) − (POD ×
LGD)
Interest Rate Sensitivity Measures for FRNs
Because of the periodic reset of MRRs in both the FRN numerator
and denominator, the rate duration is close to zero for floaters
trading at par on a reset date (prior to MRR reset).
EffRateDurFRN = (𝑃𝑉)_−(𝑃𝑉)+/(2×(∆ 𝑀𝑅𝑅)(𝑃𝑉0)
Changes in spread (DM or Z-DM) are the key driver of price change
EffSpreadDurFRN = (𝑃𝑉)_−(𝑃𝑉)+/(2×(∆ 𝐷𝑀)(𝑃𝑉0)
Bottom-Up credit analysis
Bottom-up credit analysis involves an issuer-specific assessment
and identifying suitable securities.
▪ For unsecured corporate bonds, factors like profitability and
leverage are used to analyze an issuer.
▪ For a sovereign borrower, the relevant metric is the economic
activity and the government’s ability and willingness to levy
taxes and generate sufficient revenue for its obligations.
▪ For a special purpose entity issuer with mortgage-backed bonds
or other securitized cash flows, factors considered are a credit
measure of both the residential borrowers and underlying
collateral value and internal credit enhancements.
Key Financial Ratios for Bottom-Up Credit Analysis
Reduced form models solve for default intensity or the POD over a
specific time.
Z-Score Model = 1.2 × A + 1.4 × B + 3.3 × C + 0.6 × D + 0.999 × E
A = Working Capital/Total Assets, B = Retained Earnings/Total
Assets, C = EBIT/Total Assets, D = Market Value of Equity/Total
Liabilities, E = Sales/Total Assets
Structural credit models use market-based variables to estimate
the market value of an issuer’s assets and the volatility of asset
value. The likelihood of default is defined as the probability of the
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asset value falling below that of liabilities. Two types of structural
credit models are used:
▪ Moody’s analytics expected default frequency (EDF) model
provides daily POD estimates for a broad range of issuers over a
selected period.
▪ Bloomberg’s default risk (DRSK) model provides daily estimates
of POD for different issuers.
Assessing credit quality in a top-down approach
Credit managers frequently use public ratings to categorize and
rank the credit quality of bonds within a portfolio.
Weighted factors are based on the likelihood of credit loss over a
specific period.
Suppose a manager is assessing credit quality for a portfolio. The
portfolio consists of 50% A1/A+ rated bonds and 50% Ba3/BB-
rated.
Using an ordinal scale: average portfolio credit quality score
= 9 (= 50% × 5 + 50% × 13), which corresponds to an average
rating of Baa2/BBB.
Using the weighted scale: portfolio average credit quality score
= 918 (= 50% × 70 + 50% × 1,766), nearer to Ba1/BB+.
Credit spread measures in top-down analysis: Credit spread
measures such as OAS are preferred to measure average portfolio
credit quality. Spread-based rather than rating-based measures can
help determine portfolio value changes due to spread changes.
To calculate a portfolio’s average OAS, each bond’s individual OAS
is weighted by its market value.
Liquidity Risk
Effective spread = Trade size × {Trade price – ((Bid + Ask))/
2 for buy order} and
Trade size × {( Bid + Ask)/2 − Trade price for sell orders}
Tail Risk
Methods to Assess Portfolio Tail Risk
▪ VaR measures the minimum portfolio loss expected to occur at a
specific confidence level over a given time.
▪ Conditional value at risk (CVaR) or expected loss measures the
average loss over a specific time conditional on that loss
exceeding the VaR threshold
▪ Incremental VaR (or partial VaR) can be used to measure the
impact of adding or removing a bond in a portfolio.
▪ Relative VaR is used to measure the expected tracking error
versus a benchmark portfolio by calculating VaR (or CVaR)
based on a portfolio containing active positions minus the
benchmark holdings under a market stress scenario.
Three models are used:
▪ Parametric method
▪ Historical simulation
▪ Monte Carlo analysis
Synthetic credit strategies
Contract references a specific issuer (or issuers) and credit event
terms that, when triggered, lead to a settlement payment equal to
the LGD multiplied by the contract notional amount from the seller
to the buyer.
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CDS pricing
Upfront fee = present value CDS spread – present value of fixed
coupon rate on the notional amount over the contract life.
Fixed coupon rate is 1% for investment-grade issuers and 5% for
high-yield issuers.
Description Upfront Premium
CDS Spread = None
Fixed Coupon
CDS Spread < Protection buyer receives: ((Fixed Coupon -
Fixed Coupon CDS Spread) × EffSpreadDurCDS)
CDS Spread > Protection buyer pays: ((CDS Spread - Fixed
Fixed Coupon Coupon) × EffSpreadDurCDS)
CDS price as a percentage of notional amount ≈ 1 + ((Fixed Coupon
− CDS Spread) × EffSpreadDurCDS)
CDS price change for a given CDS spread change ≈ − (∆(CDS
Spread) × EffSpreadDurCDS)
Change in CDS contract value ≈ − (∆(CDS Spread) ×
EffSpreadDurCDS) x CDS notional amount
Credit spread curve strategies
Static Credit Spread Curve Strategies
If credit curves are expected to remain stable or unchanged over an
investment horizon with low credit defaults and annual loss rates,
an active manager could use the following strategies:
▪ Lower portfolio’s average credit rating
▪ Add credit spread duration with similar rated longer-term
bonds
➢ Buy and hold
➢ Rolling down
▪ Derivative-based credit strategies can add credit spread
duration or increase credit exposure.
➢ Sell CDS single-name or index protection
➢ Use a long-short strategy
Dynamic Credit Spread Curve Strategies
▪ Active strategies to capitalize on divergent market views given
anticipated credit curve changes across maturities and ratings.
▪ Active strategies can be cash-based or derivatives-based.
Global Credit Strategies
Fixed Income Markets in Developed Countries:
▪ Broad range of private and public debt issuers
▪ Bonds denominated in a freely floating domestic or other major
currency
▪ Well-established and liquid derivatives
Fixed Income Markets in Emerging or Frontier Countries:
▪ Sovereign issuers, state-owned or controlled enterprises, banks,
producers operating in a dominant domestic industry
▪ Bonds are denominated in a restricted domestic currency with
varying liquidity
▪ Sovereign government and domestic issuers often issue global
bonds in US dollars or euros
▪ Little to no diversification
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 Equity Portfolio Management (1) for the differences. The sources of return include: company-
specific, sector, country, currency etc.
Overview of Equity Portfolio Management
Equity Investment Universe Equity Portfolio Management (2)
▪ Segmentation by Size and Style
Active Equity Investing: Strategies
▪ Segmentation by Geography
▪ Segmentation by Economic Activity
Fundamental Quantitative
▪ Segmentation of Equity Indexes and Benchmarks
Style Subjective Objective
Decision- Discretionary Systematic,
Income and Costs in an Equity Portfolio
making non-
▪ Dividend Income process discretionary
▪ Securities Lending Income
Primary Human skill, experience, Expertise in
▪ Ancillary Investment Strategies – additional income through
resources judgment statistical
dividend recapture, selling options
modeling
▪ Management Fees (ad valorem fees) – percentage of funds under
Information Research Data and
management – fees include: direct costs of research/investment
used (company/industry/economy) statistics
analysts/portfolio managers, direct costs of portfolio
Analysis Conviction (high depth) in A selection of
management
focus stock-, sector-, or region- variables,
▪ Performance fees (incentive fees) features may include:
based selection subsequently
upwards only, high-water mark, threshold
applied
▪ Administration fees – fees include: processing of corporate
broadly over a
actions, performance and risk measurement, voting at company
large number
meetings, third party services fees
of securities
▪ Marketing and Distribution costs
Orientation Forecast future corporate Attempt to
▪ Trading Costs include explicit costs, implicit costs, total trading
to data parameters and establish draw
costs not generally revealed to investor
views on companies conclusions
▪ Investment Approaches and Effects on Costs – portfolio costs
from a variety
depend upon approach used
of historical
data
Equity Investment Across the Passive-Active Spectrum
Portfolio Use judgment and conviction Use optimizers
The decision of where to position a portfolio on a passive-active
construction within permissible risk
spectrum depends on: parameters
▪ Confidence to outperform
▪ Client preference A factor-based strategy involves identifying favorable factors and
▪ Suitable benchmark tilting the portfolio towards these factors. The commonly used
▪ Client- specific mandates factors are: size, value, growth, quality, and price momentum.
▪ Risks/costs of active management
▪ Taxes Statistical arbitrage strategies use statistical and technical
analysis to exploit pricing anomalies. A popular example of a stat
Passive Equity Investing arb strategy is 'Pairs trading'.

▪ Herfindahl–Hirschman Index (HHI) - a valid measure of stock-
concentration risk in a portfolio = ∑𝑛𝑖=1 𝑤𝑖 2
where wi = weight of stock i in the portfolio, n = no. of securities
HHI of 1/n ⟶an equally weighted portfolio, HHI of 1.0 ⟶
portfolio concentration in a single security
▪ Effective no. of stocks = 1/HHI
In factor-based strategies we try to replicate the performance of a
benchmark by creating a portfolio that has the same exposure to
risk-factors as the benchmark. Some risk factors include: growth,
value, size, yield, momentum, quality, volatility etc.
In market-capitalization-weighted indexing, we create
portfolios with the same weights of constituent securities as the
benchmark index.
In the full replication approach, all securities represented by the
index are purchased.
In the stratified sampling approach, we split the population into
strata (or sub-groups) and then sample from each strata.
In the optimization approach, we try to maximize desirable
characteristics or minimize undesirable characteristics subject to
one or more constraints.
Attribution analysis refers to the analysis of sources of return of
the portfolio and the underlying index and identifying the reasons
Two main approaches to style classification are:
▪ Holdings-based approaches: aggregate the style scores of
individual holdings
▪ Returns-based approaches: Compare the strategy’s returns to
those of style indexes.
Active Equity Investing: Portfolio Construction
The four major building blocks used in portfolio construction
are:
▪ Factor weighting: This involves overweighting, underweighting
or neutralizing rewarded factors.
▪ Alpha skills: This involves using expertise, experience and
superior analysis to identify assets that are
overpriced/underpriced. It also involves timing exposures to
factors, securities and markets.
▪ Position sizing: This refers to the choice between large positions
in a few stocks versus small position in many stocks.
▪ Breadth of expertise: It involves integrating the three building
blocks mentioned above. The breadth of expertise is high when
the number of independent decisions are high.
Active share measures the extent to which the number and sizing
of positions in benchmark differ from the portfolio. It is not
impacted by the correlation between securities, hence a portfolio
manager has complete control on this measure.
It is calculated as:

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 n
1 Fixed-Income Arbitrage
Active Share = ∑|Weight portfolio,i − Weight benchmark,i | Convertible Bond Arbitrage
2
i=1 ▪ Convertible bond = straight bond + equity call option.
Active risk is a more complicated measure. Active risk is affected ▪ Conversion ratio = number of shares to exchange bond.
by the degree of cross correlation. A portfolio manager does not ▪ Stock’s conversion price = bond price / conversion ratio
have complete control on this measure, because it is impacted by ▪ Bond’s current conversion price = current stock price x
the correlation & variances of securities. conversion ratio

Measure of Absolute Risk 4. Opportunistic Strategies seek to profit from investment

Total portfolio variance (Vp) = ∑𝑛𝑖=1 ∑𝑛𝑗=1 𝑥𝑖𝑥𝑗𝐶𝑖𝑗 where: opportunities across a range of markets and securities
xj = asset’s weight in the portfolio using a variety of techniques.
Cij = the covariance of returns between asset i and asset j Global Macro Strategies
Managed Futures Strategies
Contribution of each asset to portfolio variance (CVi) =
∑𝑛𝑗=1 𝑥𝑖𝑥𝑗𝐶𝑖𝑗 = 𝑥𝑖𝐶𝑖𝑝 where:
5. Specialist Strategies require highly specialized skill sets, focus
Cip = the covariance of returns between asset i and the portfolio
on niche markets, and the objective is to generate uncorrelated and
Measure of Relative/Active Risk attractive risk-adjusted returns.
Variance of portfolio's active return (AVp) = Volatility Trading
∑𝑛𝑖=1 ∑𝑛𝑗=1(𝑥𝑖 − 𝑏𝑖)(𝑥𝑗 − 𝑏𝑗)𝑅𝐶𝑖𝑗 where: Reinsurance/Life Settlements

xi = asset's weight in the portfolio 6. Multi-Manager Strategies Most investors invest in a range of
bi = benchmark weight in asset i hedge fund strategies
RCij = covariance of relative returns between asset i and asset j Three main approaches
▪ Creating one's mix of managers
Contribution of each asset to the portfolio active variance (CAVi): ▪ Fund-of-funds
CAVi = (𝑥𝑖 − 𝑏𝑖)𝑅𝐶𝑖𝑝 where: ▪ Multi-strategy funds
RCip = covariance of relative returns between asset i and the
portfolio Conditional Factor Risk Model applied to a hedge fund strategy's
returns is:
Long-only approaches rely on long positions only and no short (𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐻𝐹𝑖)𝑡 = 𝛼𝑖 + 𝛽𝑖,1 (𝐹𝑎𝑐𝑡𝑜𝑟 1)𝑡 + 𝛽𝑖,2 (𝐹𝑎𝑐𝑡𝑜𝑟2)𝑡 + ⋯
positions are taken.
+ 𝛽𝑖,𝐾 (𝐹𝑎𝑐𝑡𝑜𝑟 𝐾)𝑡 + 𝐷𝑡 𝛽𝑖,1 (𝐹𝑎𝑐𝑡𝑜𝑟1)𝑡
Long/short positions have both long and short positions. The + 𝐷𝑡 𝛽𝑖,2 (𝐹𝑎𝑐𝑡𝑜𝑟 2)𝑡 + ⋯ + 𝐷𝑡 𝛽𝑖,𝐾 (𝐹𝑎𝑐𝑡𝑜𝑟 𝐾)𝑡
positions can be negative and are not constrained to sum 1. + (𝑒𝑟𝑟𝑜𝑟)𝑖,𝑡

A long extension portfolio can be considered as a hybrid of long- Performance Contribution to a 60/40 Portfolio - Adding a 20%
only and long/short strategies. It is also called 'enhanced active allocation of a hedge fund strategy group to a traditional 60%/40%
equity' strategy. A popular example is the 130/30 strategy. portfolio typically results in:
▪ Lower total portfolio standard deviation
A market-neutral portfolio is another specialized form of
▪ Higher Sharpe and Sortino ratios
long/short portfolio construction. In dollar-neutral portfolios, ▪ Lower maximum drawdown.
the dollars invested in long positions are equal to the dollars
invested in short positions. In true market-neutral portfolio, the Asset Allocation to Alternative Investments
exposure to the market is cancelled out.
The Role of Alternative Investments in a Multi-Asset Portfolio
Alternative Investments Portfolio Management ▪ Higher risk-adjusted returns
▪ Achieve: capital growth, income generation, risk diversification,
Hedge Fund Strategies and/or safety
▪ Private equity
1. Equity Strategies: Invest in equity and equity-related ▪ Return enhancer
instruments. ▪ Illiquidity risk
Equity L/S Strategies Hedge funds
Dedicated Short Selling and Short Biased ▪ Spectrum: risk reducers to return enhancers.
Equity Market Neutral Long/short equity strategies provide equity-like returns but with
lower exposure to equity premium.
2. Event-Driven Strategies take positions in corporate securities Short-biased equity strategies try to generate alpha by going
and derivatives to profit from events such as mergers and short on overvalued securities.
acquisitions, bankruptcies, share issuances, buybacks, capital Arbitrage and event-driven strategies deliver equity-like returns
restructuring, reorganization, etc. with little to no correlation with traditional asset classes.
Merger Arbitrage Real assets
Distressed Securities ▪ Generally perceived to provide a hedge against inflation.
▪ Timber investments provide both growth and inflation-hedging
3. Relative Value Strategies earn good returns (credit, liquidity, properties.
or volatility premiums) during normal conditions. In a financial ▪ Commodities serve as a hedge against inflation and provide a
crisis, these strategies can result in losses. Equity market-neutral differentiated source of alpha.
investing is a relative value strategy.

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 ▪ Farmland investing can have a commodity-like profile or a Some funds report IRR, which is sensitive to timing of cash flows.
commercial real estate-like profile. Pricing issues can distort reported risk and return measures.
▪ Energy investments → the investor owns the mineral rights to
the commodities which are correlated with inflation. Monitoring the Firm and the Investment Process Some areas to
▪ Infrastructure investments usually generate stable/modestly monitor: Key person risk, alignment of interests, style drift, risk
growing income and also tend to have a high correlation with management, client/asset turnover, client profile, and service
overall inflation. providers.
Commercial real estate
▪ Commercial real estate provides protection against Private Wealth Management (1)
unanticipated inflation.
Strategies range from core to opportunistic. Overview of Private Wealth Management
▪ Core strategies focus on income generation.
▪ Opportunistic strategies focus on capital appreciation. Private Clients versus Institutional Clients
Private credit Investment Objectives
Private credit includes direct lending and distressed investments. Private Clients Institutional Clients
▪ Direct lending assets are income-producing; asset owner Investment objectives Relatively well defined
assumes default and recovery risks. are diverse Typically related to a
▪ Distressed investments have an equity-like profile. Idiosyncratic May not be clearly specific liability stream
risk dominates all other risks. defined or quantified Not likely to change
Might compete with materially over time
Traditional Approaches to Asset Classification each other
Two approaches to classify assets: Likely to change over
▪ A liquidity-based approach to defining the opportunity set. time
▪ An approach based on expected performance under distinct
macroeconomic regimes. Constraints

Risk-Based Approaches to Asset Classification Private Clients Institutional

Under risk-based approaches, the typical risk factors applied to Clients
alternative investments include equity, size, value, liquidity, Time Relatively short → more Relatively long
duration, inflation, credit spread, and currency. horizon constrained with respect to Generally a
risk-taking and liquidity single time
Different time horizons for horizon and a
Asset Allocation Approaches
different objectives single
After making the initial asset allocation decision using only the
investment
broad, liquid asset classes, a second iteration of the asset allocation objective
exercise is incorporating alternative assets. Three approaches: Scale Relatively small → asset Relatively
1. Monte Carlo simulation class limitations large
2. Portfolio optimization Taxes Taxable private clients will Tax-exempt
Mean-variance optimization without and with constraints favor tax-efficient institutions
Mean-CVaR Optimization can improve the asset allocation decision. investments will favor
3. Risk factor-based optimization investments
with high
Liquidity Planning taxable income
Three primary considerations associated with private investment
liquidity planning: Information Needed in Advising Private Clients includes
1. How to achieve and maintain the desired allocation. personal information, financial information, and tax considerations.
To determine the annual commitments for reaching and
maintaining the long-term target asset allocation - cash flow, and Private Client Tax Considerations
commitment pacing models are used. ▪ Basic tax strategies that can help reduce the tax outflow of
Capital Contribution = Rate of Contribution × (Capital Commitment individuals - tax avoidance, tax reduction, and tax deferral.
– Paid-in-Capital)
Distributions = Rate of Distribution at time t × [NAV × (1 + Growth Client Goals Two types - planned goals and unplanned goals.
Rate)] Planned Goals: can be estimated or quantified within an expected
NAV at time 1 = prior NAV × (1 + Growth Rate) + Capital time horizon.
Contribution – Distributions Unplanned Goals: related to unforeseen financial needs.
Cash flow and commitment-pacing models enable investors to Wealth Manager's Role: relevant considerations that help clients in
▪ Manage portfolio liquidity their goal creation are goal quantification, goal prioritization, and
▪ Set realistic annual commitment targets to reach desired asset goal changes due to circumstances.
allocation.
2. How to handle capital calls. Technical and Soft Skills for Wealth Managers
3. How to plan for the unexpected. Technical skills - capital markets proficiency, portfolio construction
ability, financial planning knowledge, quantitative skills,
Monitoring the Investment Program technology skills, and language fluency.
Performance Evaluation Two common benchmarking approaches: Soft skills - communication skills, social skills, education/coaching
▪ Custom index proxies skills, and business development and sales skills.
▪ Peer group comparisons

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Investment Planning The value of the taxable account compounds using the after-tax
Capital sufficiency analysis, retirement planning, and the client's returns, R′.
investment policy statement.
Capital sufficiency (needs) analysis: process to determine whether FV = (1 + R′)n
a client has, or is likely to accumulate, sufficient financial resources
The value of a tax-deferred account compounds using the pre-tax
to meet his or her objectives.
returns and is taxed only when assets are withdrawn from the
▪ Two methods:
account.
1. Deterministic forecasting
2. Monte Carlo simulation FV = (1 + R)n(1 − t)

Retirement planning Basic portfolio tax management strategies

▪ Analyzing Retirement Goals – Three commonly used tools for
retirement planning are: Two types of basic portfolio tax management strategies:
▪ Mortality tables
▪ Tax avoidance strategies that avoid or minimize taxation. For
▪ Annuities
example:
• Immediate annuity
➢ Holding assets in a tax-exempt account versus a taxable
• Deferred annuity
account
▪ Monte Carlo simulations
▪ Behavioral Considerations in Retirement Planning ➢ Investing in tax-exempt bonds instead of taxable bonds
▪ Heightened loss aversion ➢ Holding assets long enough to qualify for long-term capital
▪ Consumption gaps gains treatment
▪ The "annuity puzzle." ➢ Holding dividend-paying stocks long enough to pay the
▪ Preference for investment income over capital appreciation. more favorable tax rate

Portfolio Construction and Monitoring

Portfolio Allocation and Investments for Private Wealth Clients: ▪ Tax-deferral strategies that defer the recognition of taxable
Two primary approaches to constructing a client portfolio: a income until some future date. For example:
➢ Limiting portfolio turnover and the consequent realization
traditional approach and a goals-based investing approach.
of capital gains
➢ Tax-loss harvesting - selling securities at a loss to offset a
Topics in Private Wealth Management
realized capital gain
Calculating After-Tax Returns
Investment Vehicles
After-Tax Holding Period Returns
Potential Capital Gain Exposure (PCGE) helps investors determine
(value − value0 ) + income − tax tax whether a significant tax liability is embedded in a
R′ = =R−
value0 value0
mutual fund.
R′G = [(1 + R′1 )(1 + R′2 ) … (1 + R′n )]1/n −1
PCGE = net gains (losses) / total net assets.
After-Tax Post-Liquidation Returns
Tax Loss Harvesting
1/n
liquidation tax ▪ Tax lot accounting – keeping track of how much you paid for an
R PL = [(1 + R′1 )(1 + R′2 ) … (1 + R′n ) − ] −1
final value investment and when you bought it
▪ FIFO = typically the lowest tax basis shares are sold first—often
liquidation tax = (final value − tax basis) * capital gains tax rate making it the least tax-efficient option
Pre-Tax Excess Return ▪ LIFO - last in, first out
▪ HIFO - highest in, first out
x=R–B ▪ Specified-lot method – the portfolio manager identifies
specifically which tax lot is to be traded; provides the most
After-Tax Excess Return flexibility for ensuring trade is tax-efficient.

x′ = R′ − B′ Managing Concentrated Portfolios

Concentrated positions fall into three categories:
αtax = tax alpha = x′ - x
1. publicly traded stocks
Tax-Efficiency Ratio 2. a privately-owned business
3. commercial or investment real estate
R′
TER = Risk and Tax Considerations in Managing Concentrated Single-
R
Asset Positions
Capital Accumulation in Taxable, Tax-Deferred, and Tax-
Exempt Accounts The risks in concentrated single asset positions are:

The value of the tax-exempt account compounds using the pre-tax ▪ The inherent company-specific risk
returns, R. ▪ The decrease in portfolio efficiency caused by a lack of
diversification
FV = (1 + R)n ▪ The liquidity risk inherent in privately-held security or a
publicly-traded security

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▪ The risk of incurring a hefty tax bill that reduces return if a An inheritance tax is paid by each individual beneficiary. Most
portion of the concentrated position is sold jurisdictions only have one of these types of taxes.

Approaches to mitigate the risks of a concentrated position: Introduction to Estate Planning: Wills, Probate, and Legal
Systems
▪ Sell and diversify
▪ Staged diversification ▪ Will: Legal document containing an individual’s instructions for
▪ Hedging and monetization strategies distributing his property after death.
▪ Tax-free exchanges ▪ Testator: The person transferring assets through a will is the
▪ Charitable giving strategies testator.
▪ Tax-avoidance and tax-deferral strategies ▪ Intestate: If an individual dies without leaving a valid will – a
common occurrence - she is declared to have died intestate, and
Tax-Optimized Equity Strategies – Equity Monetization, Collars the distribution of her assets is determined by court.
and Call Writing ▪ Probate: The legal process to confirm the validity of a will.

Equity monetization steps: Efficiency of Lifetime Gifts versus Testamentary Bequests

▪ Enter into a hedging transaction that removes the risk
associated with holding a concentrated position
▪ Borrow against this hedged (and riskless) position and invest
the proceeds in a diversified portfolio

A position can be hedged in several ways:

▪ Selling the security short
▪ Selling a forward/futures contract on the stock
▪ Entering into a total return equity swap

Other strategies: Objectives of gift and estate planning

▪ Zero cost collar
▪ Covered call writing ▪ Maintaining sufficient income and liquidity (Income)
▪ Achieving the clients’ goals with respect to control over the
Strategies for Managing Concentrated Positions in Privately assets (Control)
Owned Businesses and Real Estate ▪ Protection of the assets (Protect)
▪ Minimization of tax liability (Tax)
Strategies for business owners to generate full or partial liquidity:
▪ Preservation of family wealth (Preserve)
▪ Initial public offering (IPO) ▪ Business succession (Succession)
▪ Sale to a third-party investor
▪ Achieving charitable goals (Charity)
▪ Sale to an insider
▪ Divestiture of non-core assets
General principles of family governance
Some important aspects of effective family governance are:
Strategies that do not involve the outright sale of a privately owned
▪ Focusing on the family’s human, intellectual, and social capital.
business:
➢ Human capital – the unique gifts and experiences of
▪ Personal line of credit secured by company shares
individual family members.
▪ Leveraged recapitalization
▪ Employee stock ownership plan ➢ Intellectual capital – the knowledge of family members
outside of the family business.
Strategies for managing concentrated positions in privately ➢ Social capital – the role of family members as
owned businesses and real estate philanthropists and leaders in their local communities.
▪ Mortgage financing ▪ Recognizing the importance of each family member's individual
➢ Loan against value of real estate holding goals.
▪ Improving communication within the family.
➢ Cash flow neutral LTV ratio
▪ Defining a family’s mission and vision.
➢ Non-recourse mortgage
▪ Educating future generations on the skills and responsibilities
▪ Charitable trust or donor-advised fund that come with financial wealth.
Directing and transferring wealth and objectives of gift and
estate planning Private Wealth Management (2)
Objectives:
Risk Management for Individuals
▪ Maintaining sufficient income and liquidity
▪ Achieving the clients’ goals with respect to control over the There is an inverse relationship between financial capital and
assets human capital. At a young age, human capital is high while financial
▪ Protection of the assets capital low. At retirement, human capital is low and financial
▪ Minimization of tax liability capital is high.
▪ Preservation of family wealth The economic (holistic) balance sheet includes:
▪ Business succession ▪ Traditional assets.
▪ Achieving charitable goals ▪ Traditional liabilities.
▪ Present value of all available marketable and non-marketable
An estate tax is levied on the total value of a deceased person’s assets (e.g. human capital and pensions).
assets and paid out of the estate before any distributions to ▪ All liabilities (e.g. consumption needs and bequests) besides
beneficiaries. traditional assets and liabilities.

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Life Insurance Policy: ▪ Savings funds and pension reserve funds hold relatively higher
Permanent: provides lifetime coverage; non-cancelable; fixed allocations of equities and alternatives because of their longer-
premiums term liabilities.
▪ Whole life: fixed, annual premiums and non-cancelable; cash University Endowments
value ▪ Most large endowments follow the endowment investment
▪ Universal life: more flexible than whole life; variable premium model and allocate a significant portion to alternative
payments investments.
Temporary/term: for a certain period of time; non-cancelable; ▪ Larger endowments have a higher allocation to alternatives and
policy specific premium; less costly. a relatively smaller portion to fixed income.
Annuities hedge the risk of living longer than expected and ▪ "Home bias" is more prominent in smaller endowments.
outliving assets. Immediate annuities provide an immediate Foundations
income stream and cost more. Whereas, deferred annuities cost ▪ Investment approach is similar to endowments in spite of
less. Annuities can be either fixed or variable. differences in liability structure.
▪ Larger foundations have higher allocation to alternatives.
Fixed Annuities Variable Annuities ▪ Private foundations have higher allocation to alternatives
Volatility of Constant income Variable income compared to community foundations.
Benefit stream; suitable for stream; suitable for Banks and Insurers
Amount investors with low investors with ▪ Portfolio decisions depend heavily on the underlying liabilities.
risk tolerance relatively high risk ▪ Undertake asset-liability management (ALM) and focus on
tolerance liability-driven investing (LDI).
Flexibility Low; generally High; access to ▪ Proper implementation of the investment policy is difficult –
irrevocable funds but at a cost various factors to consider.
Future Market Bond-like returns Variation in ▪ Key portfolio decisions -at the highest levels of the institution's
Expectations Interest rate risk payments but management.
higher expected
value of payments University Endowments—Liabilities and Investment Horizon
Fees Low High Three types of endowment spending policies:
Inflation Major concern Less of a concern
1. Constant growth rule - a fixed amount annually adjusted for
Concerns
inflation (the growth rate).
2. Market value rule - spending rate is a pre-specified percentage
of the moving average of asset values, typically between 4% -
Portfolio Management for Institutional Investors
6%.
Overview of Investment Policy 3. Hybrid rule - spending is a weighted average of the constant
Common investment approaches used by institutional investors growth and market value rules.
are:
Investment Description All three spending rules: SA = w × [SA × (1 + Inflation Rate)] +
t+1 t
Approach (1 – w) × Spending Rate × Average AUM
Norway Traditional style characterized by 60%/40%
Model equity/fixed-income allocation, few alternatives, Banks and Insurers—Balance Sheet Management and
largely passive investments, tight tracking error Investment Considerations
limits, and benchmark as a starting position. The interest rate sensitivity of shareholder's capital
Endowment Characterized by high alternatives exposure, 𝐴 𝐴 ∆𝑖
𝐷𝐸∗ = ( ) 𝐷𝐴∗ − ( − 1)𝐷𝐿∗ ( )
Model active management and outsourcing. 𝐸 𝐸 ∆𝑦

Canada Characterized by high alternatives exposure, Volatility of Shareholder's Equity

Model active management, and insourcing. 𝐴 𝐴 𝐴 𝐴
2 2 2
Liability Characterized by focus on hedging liabilities and 𝜎∆𝐸 = ( )2 𝜎∆𝐴 + ( − 1)2 𝜎∆𝐿 − 2 ( ) ( − 1) 𝜌𝜎∆𝐴 𝜎∆𝐿
𝐸 𝐸 𝐴 𝐸 𝐿 𝐸 𝐸 𝐴 𝐿
Driven interest rate risk including via duration-matched,
Investing fixed-income exposure. A growth component in
(LDI) Model the return-generating portfolio is also typical Trading, Performance Evaluation, and Manager
(exceptions being bank and insurance company Selection
portfolios).
Trade Strategy and Execution
Evaluating Investment Portfolios
Commonly used benchmarks for trade execution include:
Pension Plans: Usually, similar goals, but asset allocations vary due
▪ Pre-trade benchmarks - decision price, previous close, opening
to differences in: price, arrival price
▪ Legal, regulatory, accounting, and tax constraints, investment ▪ Intraday benchmarks - volume-weighted average price, time-
objectives, risk appetites, and investment views of the weighted average price
stakeholders, liabilities to and demographics of the ultimate Post-trade benchmarks – closing price
beneficiaries, availability of suitable investment opportunities, ▪ Price target benchmarks – fair value
and the expected cost of living in retirement.
Sovereign Wealth Funds Trade Strategies
▪ Budget stabilization funds are generally risk-averse and invest ▪ Short-term alpha trade, long-term alpha trade, risk rebalance
mainly in bonds and cash. trade, client redemption trade, new mandate trade.
▪ Reserve funds invest in equities and alternatives but maintain a
significant allocation of bonds for liquidity.

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Trade Implementation Choices Approaches to Return Attribution
Quote-driven, over-the-counter, off-exchange markets Return attribution: a set of techniques used to identify the sources
▪ Large blocks of securities require a high touch approach of excess return of a portfolio against its benchmark.
▪ Principal trades or broker risk trades Equity Return Attribution – The Brinson Model
▪ Dealer or market maker becomes the counterparty Portfolio return R = ∑𝑖=𝑛 𝑖=𝑛
𝑖=1 𝑤𝑖 𝑅𝑖 Benchmark return B = ∑𝑖=1 𝑊𝑖 𝐵𝑖
▪ Request for quote is a variation of quote-driven markets The Brinson Model: a portfolio's
outperformance/underperformance can be attributed to three
Order-driven markets
sources:
▪ Buyers and sellers display prices and quantities at which they ▪ Allocation effect: The allocation effect refers to the value the
are willing to transact portfolio manager adds (or subtracts) by having portfolio sector
▪ Order matching systems use rules to arrange trades weights that are different from the benchmark sector weights.
▪ Works for liquid, standardized securities
▪ Selection effect: The selection effect refers to the value the
portfolio manager adds by holding individual securities or
Algorithmic Trading instruments within the sector in different-from-benchmark
▪ Computerized execution of investment decisions based on a set weights.
of trading instructions ▪ Interaction effect: The interaction effect is the effect resulting
▪ Slice large orders into smaller pieces to minimize market impact from the interaction of the allocation and selection decisions
▪ Used for trade execution and profit-seeking. combined.
Execution Algorithm Classification ▪ Individual sector allocation effect - ith sector: Ai = (wi – Wi)Bi;
▪ Scheduled (POV, VWAP, TWAP) ▪ Individual sector selection effect - ith sector: Si = Wi(Ri – Bi);
▪ Liquidity seeking ▪ Interaction effect - interaction of the allocation and selection
▪ Arrival price decisions – Ii = (wi – Wi)(Ri – Bi);
▪ Dark strategies/Liquidity aggregators
▪ Smart order routers Equity Return Attribution – Factor-Based Attribution: One of the
factor models used is – Carhart model
Trade Cost Measurement ▪ Rp – Rf = ap + bp1RMRF + bp2SMB + bp3HML + bp4WML + Ep
▪ Implementation shortfall - ex post trade cost measurement IS
= Paper return – Actual return Fixed-income attribution
IS = Execution cost + Opportunity cost + Fees
Exposure Decomposition – Duration Based
IS = ∑ 𝑠𝑗 𝑝𝑗 − ∑ 𝑠𝑗 𝑝𝑑 + (𝑆 − ∑ 𝑠𝑗 )(𝑃𝑛 − 𝑃𝑑 ) + 𝐹𝑒𝑒𝑠 ▪ Top-down attribution approach
▪ Expanded implementation shortfall ▪ Active decisions: duration, yield curve positioning, sectors
IS = Delay cost + Trading cost + Opportunity cost + Fees
where Delay cost + Trading cost = Execution cost. Yield Curve Decomposition – Duration Based
IS =
(∑ 𝑠𝑗 )𝑝0 −(∑ 𝑠𝑗 )𝑝𝑑
+
∑ 𝑠𝑗 𝑝𝑗 −(∑ 𝑠𝑗 )𝑝0
+
(𝑆−∑ 𝑠𝑗 )(𝑃𝑛 −𝑃𝑑 )
+ 𝐹𝑒𝑒𝑠 ▪ Can be executed as a top-down or bottom-up approach
𝐷𝑒𝑙𝑎𝑦 𝑐𝑜𝑠𝑡 𝑇𝑟𝑎𝑑𝑖𝑛𝑔 𝑐𝑜𝑠𝑡 𝑂𝑝𝑝𝑜𝑟𝑡𝑢𝑛𝑖𝑡𝑦 𝑐𝑜𝑠𝑡
▪ % total return = % income return + % price return where price
return = - duration x change in YTM
Evaluating Trade Execution ▪ Compare differences between benchmark's return drivers and
▪ Trade evaluation measures the execution quality of the trade portfolio's return drivers
and the performance of the trader, broker, and/or algorithm. ▪ Quantify the effect of active portfolio management decisions
▪ Various techniques measure trade cost execution using different
benchmarks (pre-trade, intraday, and post-trade). Yield Curve Decomposition – Full Repricing
▪ Provides more precise pricing
▪ Cost($) = Side × (𝑃̅ − 𝑃 ∗ ) × Shares ▪ Allows for broader range of instrument types and yield changes
Cost($/share) = Side × (𝑃̅ − 𝑃 ∗ )
where 𝑃̅ = Average execution price; 𝑃 ∗ = Reference price → Risk Attribution
Arrival price, or VWAP, or TWAP, or MOC; Type of Attribution Analysis
Shares = Shares executed Investment Relative(vs. Absolute
Decision-Making Benchmark)
𝑃̅−𝑃∗ Process
Cost(bps) = Side × × 10,000 bps
𝑃∗
Bottom-up Position's marginal Position's marginal
Side = {+1 Buy order, −1 Sell order}
contribution to contribution to
tracking risk total risk
▪ Market-adjusted cost (bps) = Arrival cost (bps) -  x Index cost Top-down Attribute tracking Factor's marginal
(bps) risk to relative contribution to
• Index cost (bps) = Side x [(Index VWAP – Index arrival allocation and total risk and
price)/Index arrival price] x 10^4 selection decisions specific risk
Factor-based Factor's marginal
▪ Added value (bps) = Arrival cost (bps) – Est. pre-trade cost (bps) contribution to
tracking risk and
Portfolio Performance Evaluation active specific risk
The Components of Performance Evaluation: Performance
Return Attribution Analysis at Multiple Levels
measurement; Performance attribution; Performance appraisal.
▪ Macro attribution: attribution analysis to determine impact of
fund sponsor decisions: allocation, selection.
Performance Attribution - includes return attribution and risk
▪ Micro attribution: attribution of individual portfolio
attribution management decisions.
▪ Return attribution effects using the Brinson–Fachler approach

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 • Allocation = (wi – Wi)(Bi – B) Capture Ratios
• Selection + Interaction = Wi(Ri – Bi) + (wi – Wi)(Ri – Bi) Upside capture ratio (UC) measures capture when the benchmark
return is positive
Benchmarking Investments and Managers Downside capture ratio (DC) measures capture when the
▪ Liability-Based Benchmarks: Used when the assets are required benchmark return is negative
to pay a specific future liability; focus on the cash flows that the Capture ratio (CR) is the upside capture divided by downside
assets are required to generate. capture
▪ Asset-based benchmarks contain a collection of assets to
compare against the portfolio's assets
Investment Decision-Making Process: There are four elements:
signal creation, signal capture, portfolio construction, portfolio
▪ Properties of a Valid Benchmark - unambiguous, investable,
monitoring.
measurable, appropriate, reflective of current investment
opinions, specified in advance, accountable.
Evaluation of Investment's Terms (Management Fees)
Evaluating Benchmark Quality: Analysis Based on a ▪ Assets under management fees and performance fees
Decomposition of Portfolio Holdings and Returns ▪ Performance-based fees can be structured in three ways
1. Fully exposed to upside and downside – symmetric structure
P = M + S + A; where A = P – B and S = B – M, S = style return, M =
⟶ Fee = Base + Sharing of performance.
market index return
2. Not fully exposed to downside but fully exposed to upside –
If benchmark is broad market index, S = 0.
bonus structure⟶ Fee = Higher of either (1) Base or (2) Base
plus sharing of positive performance]
Appraisal Measures
𝑅̅𝐴 − 𝑟̅𝑓 𝑅̅𝐴 − 𝑟̅𝑓 3. Not fully exposed to either the downside or the upside – bonus
▪ The Sharpe Ratio 𝑆𝐴 = ; The Treynor Ratio 𝑇𝐴 = ; structure ⟶ fee = Higher of (1) Base or (2) Base plus sharing of
𝜎
̂𝐴 𝛽𝐴
The Information Ratio IR =
𝐸(𝑟𝑃) – 𝐸(𝑟𝐵)
; performance, to a limit.
𝜎(𝑟𝑃 −𝑟𝐵 )
𝛼 𝐸(𝑟𝑃 )− 𝑟𝑇
▪ Bonus-style fees are like a call option for the manager with base
The Appraisal ratio AR = ; The Sortino Ratio SRD = ; fee ⟶ the strike price.
𝜎𝜀 𝜎𝐷
∑𝑁 𝑚𝑖𝑛(𝑟𝑡 −𝑟𝑇)2 1/2
𝜎𝐷 = [ 𝑡=1 ]
𝑁 Cases in Portfolio Management & Risk Management
▪ Capture ratios: UC(m,B,t) = upside capture for manager m
relative to benchmark B for time t; DC(m,B,t) = downside Case Study in Portfolio Management: Institutional
capture for manager m relative to benchmark B for timet;
CR(mB,t) = UC(m,B,t)/DC(m,B,t) Institutional investors use several tools to manage a portfolio's
▪ Drawdown: cumulative peak-to-trough loss during a continuous liquidity risk, such as:
period ▪ Liquidity profiling and time-to-cash tables
• Drawdown duration is the total time from the start of the ▪ Rebalancing and commitment strategies
drawdown until the cumulative drawdown recovers to zero. ▪ Stress testing analyses
▪ Derivatives
Investment Manager Selection
▪ Liquidity Classification Schedule (Time-to-Cash Table) and
A Framework for Investment Manager Search and Selection - Liquidity Budget - The liquidity classification schedule defines
three broad components: the universe, a quantitative analysis of portfolio categories (or "buckets") based on the estimated time
the manager's performance track record, and qualitative analysis of it would take to convert assets into cash in that particular
the manager's investment process. category. The liquidity budget assigns portfolio weights in the
time-to-cash table and establishes a liquidity benchmark.
Type I and Type II Errors in Manager Selection ▪ Liquidity profiling for a portfolio identifies – asset classes,
allocations as a percent of portfolio, investment vehicles, and
Realization
liquidity classification (highly liquid, liquid, semi-liquid, illiquid)
Null hypothesis: manager is Below At or above
for each asset and investment vehicle.
not skillful expectations expectations
Rebalancing, Commitments
(no skill) (skill)
Rebalancing mechanisms:
Decision Hire/Retain Type I Correct
▪ Systematic rebalancing policies
Not Hire/Fire Correct Type II
• Calendar rebalancing
• Percent-range rebalancing
Type I Errors Type 2 Errors ▪ Automatic adjustment mechanisms
Errors of commission Errors of omission Cash flow and commitment-pacing strategies/models enable
Explicit costs Opportunity costs investors to
Easily measurable Less likely to be measured ▪ Manage portfolio liquidity
▪ Reach desired asset class exposure
More transparent to investors Less transparent to investors
Stress Testing – seek to understand how a portfolio's liquidity
More psychological pain Less psychological pain profile and an institution's liquidity needs may be impacted during
periods of stress.
Style Analysis - Managers can be evaluated using returns-based Derivatives - can be used to manage cash flow needs and change
analysis style analysis (RBSA) and holdings-based style analysis risk exposure, such as:
(HBSA). ▪ futures overlay program can be used to rebalance exposures to
public asset classes and
▪ using leverage to modify the portfolio's liquidity profile.

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QUINCO Case: 3. Risk Considerations for Long-Term Investors
This case covers important aspects of institutional portfolio
management, such as:
▪ Capturing illiquidity premium
▪ Liquidity management
▪ Asset allocation
▪ Use of derivatives versus the cash market for tactical asset
allocation and portfolio rebalancing. The case also covers
potential ethical violations in manager selection.
▪ Finally, the case highlights ESG considerations that arise with
investing.

Case Study in Risk Management: Private Wealth

The case is based on the different life stages – from early career
phase to retirement of a married couple, the Schmitts.
In this case study:
▪ We identify and analyze the Schmitts' risk exposures and
observe how the types of risk exposure change across their 4. Risks Associated with Illiquid Asset Classes
different life stages. The analysis is conducted holistically
starting from the economic balance sheet, including human Key risks
capital. ▪ Uncertain cash flow pattern
▪ We recommend and justify methods to manage the Schmitt ▪ Smooth returns
family's risk exposures at different stages of their professional ▪ Rebalancing is costly
life. We use insurance, self-insurance, and adjustments to their
investment portfolio. Cash flow modeling
▪ We recommend and justify modifications to the Schmitts' life
▪ Drawdown structure
and disability insurance at different stages of the income
▪ Commitment strategy and liquidity requirements to meet capital
earners' lives.
calls
▪ Finally, we recommend and justify a plan to manage risk to the
▪ Too much → Severe liquidity risk; Too little → falling short of
Schmitts' retirement lifestyle goals.
return expectations
Human capital ⟶present value (PV) at a wage-risk adjusted
Addressing return smoothing behavior of illiquid asset classes
discount rate of the expected stream of income from employment
𝑝(𝑠𝑡)𝑤𝑡−1(1+𝑔𝑡 ) ▪ Using public market proxies in place of private asset classes.
 𝐻𝐶0 = ∑𝑡=𝑁
𝑡=1 (1+𝑟 +𝑦)𝑡 ▪ Unsmoothing observed returns.
𝑓

Amount of coverage that the life insurance policy should
provide can be calculated using two methods.
▪ the human life value method ⟶ estimates the amount of future
earnings that must be replaced,
▪ the needs analysis method ⟶ estimates the amount needed to
cover a survivor's living expenses.
Integrated Cases in Risk Management: Institutional
Financial risks faced by institutional investors
1. Long-Term Perspective
▪ Pension funds, sovereign wealth funds, endowments, and
foundations take a long-term investment perspective
▪ Ability to invest in illiquid assets
▪ Important to understand the financial risks that arise from
illiquid assets
▪ Important to understand the interaction between liquidity risk
and market risk
▪ These risks can pose ‘an existential threat’ to long-term
institutional investors
Techniques used to unsmooth returns:
▪ Geltner method - removes only the first-order serial correlation
in observed returns.
▪ Okunev and White method - extended the method of Geltner
(1993) to include higher-order serial
▪ correlations.
▪ Getmansky, Lo, and Makarov (GLM) method - assumes that
observed returns for illiquid asset classes and hedge funds
follow a moving-average process.
5. Managing Liquidity Risk
▪ Establish liquidity risk parameters.
▪ Assess the liquidity of current portfolio and monitor the
evolution over time.
▪ Develop a cash flow model and project future cash flows.
▪ Stress test liquidity needs and cash flow projections.
▪ Develop an emergency action plan.
6. Enterprise Risk Management for Institutional Investors

2. Dimensions of Financial Risk Management

▪ Top-down versus bottom-up risk analysis
▪ Portfolio-level versus asset-class-specific risk
▪ Return-based versus holdings-based risk approaches
▪ Absolute versus relative risk
▪ Long-term versus short-term risk metrics
▪ Quantitative versus qualitative risks
▪ Pre- and post-investment risk assessment

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Material Environmental Issues for an Institutional Investor
▪ Physical climate risks – increasing temperatures, frequent
erratic weather, heavy precipitation, droughts, and hurricanes
impact economies and investments.
▪ Impact on real assets – can lead to increased levels of stress on
residential and commercial real estate
▪ and infrastructure, such as roads and railways.
▪ Climate transition risks – According to PRI, markets have
inefficiently priced climate transition risks. A forceful policy
response can leave institutional investors' portfolios exposed to
significant risks that need to be mitigated.
▪ Climate opportunities
o Climate mitigation – companies in business segments of
clean energy, energy efficiency, batteries and storage, smart
grids, materials benefit from efforts to mitigate the long-
term effects of global climate change.
o Climate adaptation – companies in sustainable agriculture,
water help better adjust to actual or expected future change
in climate.
Material Social Issues for an Institutional Investor
▪ Social issues include community relations, occupational health
and safety, privacy and data security, modern slavery and other
human rights violations in the supply chain, inequality
▪ Social issues are difficult to quantify and integrate into financial
models
▪ Managing community relations and the social license to operate
– investments can have positive or negative social impacts. Best
practices include extensive stakeholder consultation meetings to
understand the community’s needs and address their concerns,
providing alternative employment opportunities to affectees,
and ensuring fair land acquisition, rehabilitation, and
resettlement practices.
▪ Labor issues in the supply chain can lead to financial and
reputational risks.
▪ The “just” transition – tries to ensure that there are limited
negative social impacts in our pursuit of positive environmental
impacts via avoiding fossil fuels and implementing sustainable
agriculture and business practices.
Case study
The case covers an SWF of a fictitious country – ‘Republic of
Ruritania’
R-SWF is considering two new investments in alternative
investments:
▪ Direct infrastructure investment in an airport
▪ Direct PE investment in a beverage manufacturer
Issues discussed are:
▪ Direct investments
▪ Infrastructure or real estate near the sea
▪ Adaptation versus mitigation
▪ Factory near the river
▪ Factory in low-income region
▪ Active engagement with portfolio companies
Ethical and Professional Standards (1)
I (A) Knowledge of the law: comply with the strictest law;
disassociate from violations.
I (B) Independence and objectivity: do not offer, solicit, or accept
gifts that might compromise independence and objectivity.
I (C) Misrepresentation: do not guarantee performance; avoid
plagiarism.
I (D) Misconduct: do not behave in a manner that affects your
professional reputation or integrity.
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II (A) Material nonpublic information: do not act or cause others
to act on this information; to act on a mosaic of information is not a
violation.
II (B) Market manipulation: do not manipulate prices/trading
volumes to mislead others; do not spread misleading information.
III (A) Loyalty, prudence, and care: act with reasonable care and
exercise prudent judgment; place client's interest before
employer's or your own interests.
III (B) Fair dealing: treat all clients fairly; disseminate investment
recommendations or take investment action without
discrimination.
III (C) Suitability: in advisory relationships, understand client's
risk profile, develop and update an IPS periodically; in fund/index
management, ensure investments are consistent with stated
mandate.
III (D) Performance presentation: do not misstate performance;
make detailed information available on request.
III (E) Preservation of confidentiality: maintain confidentiality of
clients: unless disclosure is required by law; information concerns
illegal activities; client permits disclosure.
IV (A) Loyalty: do not cause harm to your employer; obtain
written consent before starting an independent practice; do not
take confidential information when leaving.
IV (B) Additional compensation arrangements: do not accept
compensation arrangements that will create a conflict of interest
with your employer; unless written consent is obtained from all
parties involved.
IV (C) Responsibilities of supervisors: prevent employees under
your supervision from violating applicable laws.
V (A) Diligence and reasonable basis: have a reasonable and
adequate basis for any analysis, recommendation, or action.
V (B) Communication with clients and prospective clients:
distinguish between fact and opinion; make appropriate
disclosures.
V (C) Record retention: maintain records to support your
analysis.
VI (A) Disclosure of conflicts: disclose conflict of interest in plain
language.
VI (B) Priority of transactions: client transactions come before
employer transactions that come before personal transactions.
VI (C) Referral fees: disclose referral arrangements to clients and
employers.
VII (A) Conduct as participants in CFA Institute programs: do
not compromise the integrity of the CFA institute; keep exam
information confidential.
VII (B) Reference to CFA Institute, the CFA designation, and the
CFA program: do not state that the holders of CFA charter are
better than others; references to partial designation not allowed.
Ethical and Professional Standards (2)
Overview of the Global Investment Performance
Standards (GIPS)
The GIPS Standards for Firms are divided into eight sections:
1. Fundamentals of Compliance
2. Input Data and Calculation Methodology
3. Composite and Pooled Fund Maintenance
4. Composite Time-Weighted Return Report
5. Composite Money-Weighted Return Report
6. Pooled Fund Time-Weighted Return Report
7. Pooled Fund Money-Weighted Return Report
8. GIPS Advertising Guidelines
Review the study notes for the requirements and
recommendations of the GIPS standards.
22
Important formulas from this section:

Time weighted return: rtwr = (1 + rt,1) × (1 + rt,2) × ... × (1 + rt,n) − 1

Modified Dietz method

𝑉1 − 𝑉0 − 𝐶𝐹
𝑟𝑀𝑜𝑑𝐷𝑖𝑒𝑡𝑧 =
𝑉0 + ∑𝑛𝑖=1(𝐶𝐹𝑖 × 𝑤𝑖 )
𝐶𝐷 − 𝐷𝑖
𝑤𝑖 =
𝐶𝐷
MIRR: Modified IRR = value of r that satisfies the following
equation: EV =
𝑛

∑[𝐶𝐹𝑖 × (1 + 𝑟)𝑤𝑖 ] + 𝐵𝑉0 (1 + r)

𝑖=1

Composite returns
Sum of beginning assets and weighted external cash flows =
𝑛

𝑉𝑝 = 𝑉0 + ∑(𝐶𝐹𝑖 × 𝑤𝑖 )
𝑖=1
Beginning assets weighting method composite return =
𝑉0,𝑝𝑖
𝑟𝐶 = ∑ [𝑟𝑝𝑖 × 𝑛 ]
∑𝑝𝑖=1 𝑉0,𝑝𝑖
Beginning assets plus weighted cash flows method composite
return =
𝑉𝑝𝑖
𝑟𝑐 = ∑ (𝑟𝑝𝑖 × )
∑ 𝑉𝑝𝑖

Dispersion Measure
The standard deviation for a composite in which the constituent
portfolios are equally weighted =

∑𝑛 ̅̅̅̅ 2
𝑖=1(𝑟𝑖−𝑟𝐶 )
SC = √
𝑛

The asset-weighted standard deviation for a composite =

2
SCaw = √∑𝑛𝑖=1 [(𝑟𝑖 − 𝑟̅𝑝𝑟𝑜𝑥𝑦 ) × 𝑤𝑖 ]

𝑉0,
wi = 𝑖
𝑉0, 𝑇𝑜𝑡𝑎𝑙

𝑟̅𝑝𝑟𝑜𝑥𝑦 = ∑(𝑤𝑖 × 𝑟𝑖)

𝑖=1

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