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348 Cards in this Set
- Front
- Back
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Equity Monetization |
Remove all upside and downside risk from a portfolio, and then borrow against the portfolio. |
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Systematic Risk
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Cannot be diversified away
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Company Specific Risk
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Non-systematic risk of a single company
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Property Specific Risk |
Non-systematic risk of a single property |
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Rule-based margin lending systems |
Rigidly define percentage of investment that can be borrowed |
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Risk-based margin lending system |
Allowed borrowing depends on relative risk and hedges |
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Asset Location |
Type of account in which asset is located Determines tax treatment of asset |
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What is an estate tax freeze? |
Method of transferring a closely held family business to the younger generation. Younger generation absorbs both appreciation and tax liability. |
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What kind of stock should be given in an estate tax freeze? |
Non-voting stock |
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Zero-Cost Collar |
Long put (at or out of the money) and Short call (with same premium as the put) |
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Risk-Reversal or Collar |
Buy a put and Sell a call |
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Short position in a risk-reversal |
Buy a call and Sell a put |
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Bounded Rationality |
Individuals act as rationally as possible, but are constrained by lack of knowledge and cognitive ability |
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Satisfice |
Making reasonable but not necessarily optimal decisions |
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The Price is Right |
Asset prices reflect and instantly adjust to all available information |
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No Free Lunch |
No manager should be able to consistently generate positive alpha |
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Behavioral Portfolio Theory |
Investors structure their portfolios in layers according to their goals |
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Adaptive Markets Hypothesis |
Apply heuristics until they no longer work, and then change them. Must adapt to survive. |
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Framing |
The way income is framed affects whether it is saved or consumed |
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Self-control bias |
Favor current consumption rather than saving income for future goals |
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Belief perseverance |
Stems from individuals' attempts to avoid cognitive dissonance |
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Conservatism bias |
Emphasizing information used in original forecast over new data Involves cognitive cost |
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Cognitive cost |
Effort to analyze new data |
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Confirmation bias |
Seeking data to support beliefs. Discounting contradictory facts. |
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Representativeness bias |
Classifying new information based on past experiences with classifications |
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Examples of representativeness bias |
Base rate neglect Sample size neglect |
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Base rate neglect |
too little weight on the base rate (probability of A given B) |
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Sample size neglect |
Inferring too much from a small sample of new information |
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Control bias |
Individuals feel they have more control over outcomes than they actually do |
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Hindsight bias |
Perceiving actual outcomes as normal and expected |
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Anchoring and adjustment |
Fixating on a target number once an investor has it in mind |
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Mental accounting bias |
Each goal and corresponding wealth is considered separately |
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Availability bias |
Future probabilities are impacted by memorable past events |
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Loss-aversion bias |
placing more value on a loss than on a gain of the same magnitude |
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House money effect |
Less risk aversion when investing profits vs original assets |
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Overconfidence bias |
Illusion of having superior information or ability to interpret |
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Prediction overconfidence |
Leads to setting confidence intervals too narrow |
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Self-enhancing bias |
Individuals take all the credit for their success |
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Self-protecting bias |
Individuals place blame for failure on someone or something else |
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Self-control bias |
Sub-optimal savings due to focus on short-term over long-term goals |
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Status quo bias |
Individual's tendency to stay in their current investments |
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Endowment bias |
Valuing an asset already held higher than if it were not already held |
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Goals-based investing |
Building a portfolio in layers, pyramiding up from base goals |
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Standard of living risk |
If high, investor will be more risk-averse in order to avoid changes in their standard of living |
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Naive diversification |
1/n allocation |
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Disposition effect |
Sell winners, hold losers |
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Home bias |
Placing a high proportion of assets in the investor's own country |
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Gambler's fallacy |
Wrongly predicting reversion to the mean |
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Social proof bias |
Following the beliefs of a group |
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Momentum effect |
Return pattern caused by investors following the herd |
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Value vs. growth stocks |
Value tends to outperform growth and the market in general |
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IPS Objectives and constraints for individuals |
Risk Return Time Horizon Taxes Liquidity Legal/Regulatory Unique Circumstances |
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Risk tolerance |
Generally the lesser of willingness and ability |
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Return Objective |
Minimum required return to meet client's objectives |
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Constraints |
Time Horizon Taxes Liquidity Legal and Regulatory Unique Circumstances |
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As investment horizon increases, what happens to tax drag? |
Increases |
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As investment return increases, what happens to tax drag? |
Increases |
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Probability of joint survival |
prob(husband survives) + prob(wife survives) - prob(husband survives)*prob(wife survives) |
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Relief from double taxation: Credit Method |
Individual receives a domestic tax credit equal to taxes paid to the source country |
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Relief from double taxation: Exemption Method |
Income generated in a source country is totally exempt from domestic taxation |
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Relief from double taxation: Deduction Method |
Taxes paid to foreign source country are deducted from domestic taxable income |
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Three techniques used to handle a concentrated position |
Sell the asset Borrow against the asset Hedge against the asset |
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Four ways to hedge an asset value |
Short sale against the box Equity forward sale contract Forward conversion with options Total return equity swap |
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Modified Hedging methods Minimizes downside risk while retaining upside potential |
Protective puts Prepaid variable forwards |
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Prepaid variable forwards |
Dealer pays the owner now Owner delivers shares on a future date If price decreases, owner delivers all shares If price increases, owner retains some shares |
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Tax Optimization Strategies |
Combining tax planning with investment strategy Cross Hedge Exchange funds |
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Completeness portfolio |
Structures the other portfolio assets for greatest diversification benefit to complement the concentrated position |
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When to use a cross hedge |
If a direct hedge will cause the underlying gain to be taxed
If the necessary derivatives do not exist |
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Exchange Funds |
Multiple investors contribute their investments into a newly formed exchange fund. Each now owns a pro rata share of the new diversified fund, deferring taxes until the shares of the fund are sold. |
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Managing a private business position: Strategic buyers |
Take a buy and hold position |
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Managing a private business position: Financial Buyers |
Restructure the business Add Value Sell |
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Managing a private business position: Recapitalization |
Retain some equity capital Sell a majority of shares back to the company |
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Strategies in managing a single investment in real estate |
Mortgage financing Donor advised fund Sale Leaseback |
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Effect of high accumulated financial wealth on demand for life insurance |
Decreases |
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Effect of high volatility of human capital on demand for life insurance |
Decreases |
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Effect of high risk aversion on demand for life insurance |
Increases |
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Effect of high probability of death on demand for life insurance |
Increases |
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Effect of high bequest desire on demand for life insurance |
Increases |
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Statistical tools for economic forecasting
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Multiple linear regression |
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ICAPM |
Just like CAPM but for international market |
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What does Singer & Terhaar analysis describe |
Equity risk premium of a partially integrated market |
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The Taylor Rule |
Target Interest rate = Neutral interest rate + 0.5*(expected GDP - trend GDP) + 0.5*(expected inflation - target inflation) |
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Cobb Douglas Production Function |
Y = A * K^alpha * L^beta |
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H Model Valuation |
D x (1 + g) / (r - g) + D x H x (gs - g) / (r - g) D = current dividend g = long-term growth rate gs = short-term growth rate H = half of length of high-growth period |
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10 Year Moving Average P/E Ratio |
Current level of S&P 500 price index / Average of last 10 years earnings (adjusted for inflation) |
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Calculate Tobin's Q |
Market value of debt + equity / Asset replacement cost |
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Interpret Tobin's Q |
If greater than 1, stock should decline If less than 1, stock should increase |
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Interpret Equity Q |
If greater than 1, the stock should decline If less than 1, the stock should increase |
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Utility-adjusted return |
Portfolio's expected return - 0.005*A*variance of portfolio A = investor's risk-aversion score |
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Roy's Safety First Measure |
Expected return - minimum acceptable return / standard deviation of portfolio |
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Determine whether an asset should be added based on downside risk |
Add investment if Si > Sp * rho ip Si = Sharpe ratio of proposed investment Sp = Sharpe ratio of portfolio rho ip = correlation of investment with proposed portfolio |
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Return on foreign asset |
(1 + Rfc) * (1 + Rfx) Rfc = return on asset Rfx = return on foreign currency |
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Variance of return on foreign asset |
Var(Rfc) + Var(Rfx) + 2*s(Rfc)*s(Rfx)*corr(Rfc, Rfx) Rfc = return on asset Rfx = return on foreign currency |
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Standard deviation of return on risk-free foreign asset |
s(Rfx)*(1 + Rfc) s(Rfx) = standard deviation of foreign currency Rfc = return on asset |
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Currency management strategies |
Passive hedging Discretionary hedging Active currency management Currency overlay |
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Currency passive hedging |
Eliminates currency risk relative to benchmark |
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Currency discretionary hedging |
Allows manager to deviate modestly from passive hedging The goal is risk-reduction |
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Active currency management |
Allows manager to have greater deviations from passive hedging The goal is adding value |
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Currency overlay
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Outsourcing currency management to another manager |
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Carry trade |
Borrow in a lower interest rate currency Invest in a higher interest rate currency |
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Long Straddle |
If volatility is expected to increase Buy at-the-money call and put |
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Short Straddle |
If volatility is expected to decrease Sell at-the-money call and put |
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Minimum-Variance Hedge Ratio |
Run a regression of past changes in portfolio value to past changes in foreign currency value MVHR is the slope of that regression |
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Dollar duration |
Dollar change in value for 1 basis point change in yield = Effective duration * 0.01 * Value |
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Nominal spread |
Spread between a non-treasury and treasury security of the same maturity |
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Zero-volatility spread |
Spread over the treasury spot rate curve |
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Contingent immunization |
Active management as long as the portfolio's return exceeds a predetermined safety net return Below that, the immunization mode (passive) is triggered |
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Cushion spread |
Difference between return on immunized strategies and safety net return |
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Required terminal value |
A predetermined liability, or the future value of the portfolio compounded at the safety net return |
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Dollar Safety Margin |
Difference between current value of portfolio and value needed to achieve required terminal value based on the immunized rate |
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Types of Immunization strategies |
Multiple liability immunization Cash flow matching Combination matching |
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Multiple liability immunization |
Portfolio duration = duration of liabilities PV of assets = PV of liabilities Range of asset durations > range of liability durations |
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Cash Flow Matching |
Selecting bonds that have cash flows that correspond to those of the liability stream |
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Combination matching |
Creates a duration matched portfolio that is also cash flow matched during the first few years |
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Types of credit risk |
Default risk Credit spread risk Downgrade risk |
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Types of credit derivatives |
Credit options Credit forwards Credit swaps |
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Binary credit options |
Payoff based on a credit event occurring and the underlying asset's price OV = max[(strike - value), 0] |
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Credit spread option |
Payoff based on underlying asset's yield spread |
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Sortino Ratio |
(Return - Minimum Acceptable Return) / Standard Deviation |
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Money Weighted Return |
IRR |
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Steps of an investment policy statement |
Planning Execution Feedback |
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Treynor Measure |
(Return - Risk Free rate) / Beta |
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Synthetically create common stock position |
Buy corresponding futures contract Invest in a T Bill |
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M-Squared Ratio |
Risk free rate + (Sharpe ratio * benchmark standard deviation) |
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High-water mark |
Hedge fund incentive fees are only charged when the fund value reaches a new high Prevents a manager from being paid twice for the same gains |
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Lock-up period |
Period during which hedge fund investors can't withdraw funds |
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Active return |
Portfolio return Less: benchmark return |
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Problem with appraisal data |
Tends to smooth returns Standard deviation appears lower than it actually is |
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Client with actively created wealth |
Entrepreneur Usually has high willingness to take risk Might treat business risk and investment risk differently |
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Client with passively created wealth |
Heir Usually has low willingness to take risk |
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Client's perception of wealth |
If client perceives wealth as large, they are usually willing to accept more risk |
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Stages of life |
Foundation Accumulation Maintenance Distribution |
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Stage of life: Foundation |
Long time horizon allows more risk-taking Most clients won't have enough wealth to take risks |
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Stage of life: Accumulation |
Time of life with highest savings
Higher ability to take risks |
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Stage of life: Maintenance |
Retirement Declining ability to take risks |
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Stage of life: Distribution |
Assets exceed need of individual Can be distributed through gifts or will |
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Traditional finance assumes investors display three characteristics |
1. Risk aversion 2. Rational expectations 3. Asset integration |
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Asset integration |
Investor considers the correlation of a potential investment with current portfolio |
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Behavioral finance assumes investors display three characteristics |
1. Loss Aversion 2. Biased expectations 3. Asset segregation |
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Rebalancing Strategies |
Buy and hold Constant mix Constant proportion portfolio insurance |
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Buy and Hold |
Once the initial investment is made, no rebalancing is done i.e. If equities increase in value, the weight of equities increases |
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Constant mix |
Rebalancing assets to target weights Can be done periodically or when weights move |
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Constant Proportion Portfolio Insurance |
Weight of equities in portfolio depends on "cushion" between portfolio value and floor value Equity weight = M*(portfolio value - floor value) M = multiplier Value of M is greater than 1, and is determined based on client's risk profile |
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Alpha |
Also called Jensen's Alpha Ex Post Alpha Excess returns over what is necessary to compensate for systematic risk |
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True active return |
Manager's total return less: Manager's normal portfolio return |
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Misfit active return |
Manager's normal portfolio return less: Investor's benchmark return |
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Total active risk given true and misfit active risk |
Square root of ( true active risk squared plus: misfit active risk squared ) |
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True information ratio |
True active return / true active risk |
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Methods of calculating implicit cost of trades |
VWAP (volume-weighted average price) Implementation shortfall |
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VWAP |
Volume-Weighted Average Price Weighted average of execution prices during a day Weight is proportion of day's trading volume |
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Disadvantages of VWAP |
Not useful if a trader is a significant part of trading volume Can be gamed by an unethical trader Does not consider missed trades |
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Types of order-driven markets |
Electonic crossing networks Auction markets Automated auctions |
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Electronic crossing network |
Orders are matched at fixed points in time during the day Average of bid and ask quotes No price discovery |
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Disadvantages of electronic crossing network |
A trade may not be filled or may be only partially filled if there is insufficient trading activity Prices do not adjust to supply and demand conditions Price discovery |
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Auction market |
Traders put forth their orders to compete against others for execution |
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Automated auctions |
Markets trade throughout the day, based on a set of rules Electronic Price Discovery |
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Price discovery |
Transaction prices are publicly reported |
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Liquidity-at-any-cost trading |
Trading large blocks of shares Must be ready to pay high price in either market impact, commissions, or both |
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Costs-are-not-important trading |
Trader believes exchange markets will operate fairly and efficiently, and provide best execution price |
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Need-trustworthy-agent trading |
Large trade in thinly traded security Trader cedes control to broker, and is often unaware of details until after the order has been executed |
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Advertise-to-draw-liquidity trading |
Trade is publicized in advance to draw counterparties e.g. IPO |
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Low-cost-whatever-the-liquidity trading |
Trader places limit order outside of current bid-ask quotes |
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Advantages of liquidity-at-any-cost trading |
Quick Certain execution |
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Disadvantages of liquidity-at-any-cost trading |
High costs Leakage of information |
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Advantages of costs-are-not-important trading |
Quick Certain execution at market price |
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Disadvantages of costs-are-not-important trading |
Loss of control of trade costs |
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Advantages of need-trustworthy-agent trading |
Market-determined price |
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Disadvantages of need-trustworthy-agent trading |
Higher commission Potential leakage of trade intention |
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Advantages of advertise-to-draw-liquidity trading |
Market-determined price |
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Disadvantages of advertise-to-draw-liquidity trading |
Higher administration costs and possible front running |
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Advantages of Low-cost-whatever-the-liquidity trading |
Low trading costs |
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Disadvantages of Low-cost-whatever-the-liquidity trading |
Uncertain timing of trade and possibly trading into weakness |
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Implementation Shortfall: Decision Price |
Market Price of the security when the order is initiated |
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Implementation Shortfall: Execution price |
Price at which the order is executed |
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Implementation Shortfall: Revised benchmark price |
Market price of the security after a reasonable amount of time (a day) has passed, if the order has not been completed. |
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Implementation Shortfall: Cancellation Price |
Market Price of the security if the order is not fully executed and the remaining portion of the order is cancelled. |
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Implementation Shortfall: Missed trade cost Opportunity cost Unrealized profit/loss |
abs(Cancellation price - Decision price) x number of shares cancelled |
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Implementation Shortfall: Delay costs slippage |
abs(Revised benchmark - Decision price) x Number of shares later executed |
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Implementation Shortfall: Market Impact Price Impact Realized profit/loss |
abs(execution price - revised benchmark) x number of shares executed at execution price If there is no delay use decision price instead of revised benchmark |
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Implementation Shortfall: Total |
Opportunity cost + Delay costs + Price Impact + Explicit costs |
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Implementation Shortfall: Market-adjusted |
Total implementation shortfall less: CAPM Expected return from security |
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VWAP |
Implicit costs are calculated based on price paid vs volume-weighted average price of trades for that security |
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Pure Sector Allocation from one sector |
(portfolio sector weight - benchmark sector weight) * (benchmark sector return - benchmark total return) |
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Within Sector Allocation Return |
Benchmark Sector Weight * (Portfolio sector return - benchmark sector return) |
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Allocation/Selection Interaction Return |
(Portfolio sector weight - Benchmark sector weight) * (Portfolio sector return - benchmark sector return) |
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Calculate VaR Analytical Method |
Given X% probability Total size * (1+expected return) * standard deviation * z-score z-score for one-tailed 100-X% |
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95% of the normal curve is below what Z-score? |
1.65 |
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99% of the normal curve is below what Z-score? |
2.33 |
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VaR for period shorter than 1 year |
Use expected return and standard deviation for the period. If the period is one day, ignore expected return. |
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Calculate VaR Historical Method |
Accumulate list of daily returns Find lowest 5% The highest return among the lowest 5% is the 1-day 5% VaR |
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Advantage of stress testing over VaR |
Accounts for more extreme outlier events |
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Liability Noise |
Non-market exposures of a pension plan |
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Relative allocations of asset-only approach, asset-liability management, and Liability-mimicking portfolio |
Asset-only approach involves highest allocation to equity and lowest allocation to bonds Liability-mimicking portfolio involves lowest allocation to equity and highest allocation to bonds |
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Inactive Pension Participants |
No longer accruing benefits
Either retirees collecting benefits, or former employees who are not yet collecting benefits |
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Active Pension Participants |
Current employees who are accruing benefits |
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Asset that tracks the liability of inactive pension participants |
If benefits are fixed: Nominal Bonds If benefits are indexed to inflation: Real Return Bonds |
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Asset that tracks the liability of active pension participants |
Bonds for past service Equity for future service |
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Number of futures contracts to adjust portfolio beta |
(Bt - Bp)/Bf x Vp / (Pf x Multiplier) Bt = target beta Bp = portfolio beta Bf = futures contract beta Vp = portfolio value Pf = futures price |
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Number of futures contracts to synthetically create common stock position or cash |
Potfolio Value / Futures price x Multiplier |
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Relative duration of fixed-rate instruments |
Higher than floating rate Lower than coupon free |
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Relative duration of floating-rate instruments |
Close to zero |
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Duration of swap |
Difference between durations of two sides Positive for receive fixed Negative for receive floating |
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Duration of zero-coupon bond |
Time to maturity |
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Box spread |
Combine bull spread and bear spread Constant payoff rate Either equal to risk-free rate, or arbitrage opportunity |
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Best rebalancing strategy in a trending market |
CPPI |
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Worst rebalancing strategy in a trending market |
Constant mix |
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Best rebalancing strategy in a mean-reverting market |
Constant Mix |
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Worst rebalancing strategy in a mean-reverting market |
CPPI |
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Shape of portfolio returns in buy-and-hold strategy |
linear |
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Shape of portfolio returns in constant mix strategy |
Concave (down) |
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Shape of portfolio returns in CPPI strategy |
Convex (down) |
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Information Ratio |
Active Return / Active Risk |
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Active Return |
Average Account return less: Average benchmark return |
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Active Risk |
Standard deviation of excess returns measured at difference between portfolio and benchmark returns |
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Fundamental law of active management |
Information ratio = Information coefficient x sqrt(investor breadth) |
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Information coefficient |
Percentage of predictions that are correct |
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The bums problem |
A large bond issue is heavily weighted in an index. A large bond issue may be evidence of high leverage, which indicates high default risk. |
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Dollar duration of a portfolio |
The sum of the dollar durations of the bonds in the portfolio |
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To change portfolio dollar duration while maintaining proportions of bonds |
Buy or sell equal portions of each bond |
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Equity Strategy with the highest information ratio |
Enhanced Indexing |
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Creating an optimal portfolio from corner portfolios |
Start with the two corner portfolios with returns immediately above and below the desired return Solve for the weights of both portfolios that arrives at the desired return Find the weighted average of the standard deviations. It will be a slight overestimate. |
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When to use full replication |
The index has fewer than 1000 stocks Stocks are liquid |
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Returns-based style analysis |
Returns are regressed against returns for various indexes |
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Style fit |
R-squared in returns-based style analysis Percent of returns explained by style |
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Holdings-based style analysis |
Looks at fundamentals of securities |
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Examples of value industries |
Utilities Financial Services |
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Examples of growth industries |
Technology Health Care |
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Type of style analysis that identifies style drift more quickly |
Holdings-based |
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Type of style analysis that is cheaper and faster to execute |
Returns-based |
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Biases of socially responsible portfolios |
Growth stocks Small cap stocks |
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Short extension strategy |
Short position on some percent of portfolio value Long position on over 100% of portfolio value Not market neutral |
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Annual turnover for value managers |
20% - 80% |
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Annual turnover for growth managers |
60% to several hundred percent |
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Core-Satellite approach |
Core of passive and enhanced indexed portfolios Satellites are active managers |
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Completeness Fund |
Combined with active portfolio so that combined portfolios have risk exposure similar to benchmark |
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Misfit active risk and return |
Arise from securities that don't fit manager's normal style Some amount of misfit active risk and return can be okay |
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Tax Drag |
Gain lost to taxes |
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Cautious investors |
Risk-averse Base decisions on feelings |
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Methodical Investors |
Risk-averse Base decisions on thinking |
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Individualistic Investors |
Less Risk-averse Base decisions on thinking |
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Spontaneous investors |
Less risk-averse Base decisions on feelings |
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Types of Financial Risk |
Market Credit Liquidity |
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Spot Return |
Change in spot price of underlying |
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Collateral return |
Risk-free rate |
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Roll Return |
Change in futures price less: Change in spot price Positive in backwardation Negative in contango |
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J-Factor Risk |
Risk caused by courts and judges |
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Decision risk |
Risk of abandoning a strategy at a point of maximum loss |
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Buffering |
A stock is not immediately moved into a different style category when its characteristics have changed slightly Decreases turnover |
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Alpha and Beta separation |
Combine ETF (for beta) with long-short strategy (for alpha). |
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Tracking Risk |
Active Risk Standard deviation of active returns |
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Vulture Funds |
PE Funds that specialize in undervalued distressed securities |
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Orphan Equities Investing |
Purchasing equity in firms emerging from reorganization |
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Effective spread for a buy order |
2 x (execution price - midquote) |
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Effective spread for a sell order |
2 x (midquote - execution price) |
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Absolute Benchmark |
Return Objective |
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Properties of a valid benchmark |
Specified in advance
Appropriate
Measurable Unambiguous
Reflective of manager's current investment opinions
Accountable
Investable |
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Macro performance attribution |
Comparing different managers |
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Matrix Pricing |
Method of calculating price for thinly traded fixed income security Derived from quoted prices on similar securities |
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Commodities that hedge against inflation |
Storable commodities Commodities with performance that is correlated to economic activity |
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Storable Commodities |
Metals Energy |
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Nonstorable commodities |
Agricultural |
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Systematic Futures Trading |
Trades according to a system of rules May be contrarian |
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Discretionary Futures Trading |
Based on the discretion of the commodities trading adviser Similar to active management |
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Calculate Portfolio active risk |
Square root of the sum of the squared active risks |
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When do growth stocks perform better? |
During a contraction |
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Uptick Rule |
Every short sale transaction must be placed at a higher price than the previous trade. |
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Repo Agreement |
Sell security and agree to buy it back at an agreed-upon date for an agreed-upon price |
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Spread duration |
Measures how much the price of one bond will change relative to another bond if the difference in yield changes. |
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Convexity and concavity are measured against what axes? |
X = Value of stock market Y = Value of assets |
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Breakeven yield change |
Change in price / - Duration Change in price = difference in yield x number of years |
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Equitize |
Hold shares of an equity index to add systematic risk to a market-neutral long-short portfolio |
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Disintermediation risk |
Risk of life insurance policyholders withdrawing funds during times of high interest |
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Evaluation performance of a leveraged hedge fund |
Look through the leverage Treat each asset as if it were fully paid-for. Leverage affects weighting, but not return. |
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Hedged equity strategies |
Take long and short positions on equity Not market neutral May be net long or short |
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When buying/selling futures to adjust the duration of a bond portfolio, what is the multiplier for duration and beta. |
Yield beta*(Desired duration - current duration)/ Futures contract duration |
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How to calculate active risk |
Square root of Sum of(sector portfolio risk - benchmark total risk)^2 x (portfolio sector weight)^2 |
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When buying/selling futures to adjust the beta of an equity portfolio, what is the multiplier for beta? |
(Desired beta - Current beta)/Futures contract beta |
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Standard Deviation of foreign denominated risk-free asset |
Standard deviation of foreign currency*1 + return |
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Cross hedge |
Hedging with an instrument that is not perfectly correlated with the exposure being hedged |
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Macro hedge |
Imperfectly hedges portfolio-wide risk, rather than individual asset. |
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Minimum variance hedge ratio |
Regress returns on underlying against returns on indirect hedge MVHR is the slope of that regression Determines size of investment in hedge Will not perform as well as expected, due to correlations changing over time |
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Direct hedge |
Is perfectly correlated with exposure being hedged |
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Adventurer |
Confident and impetuous |
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Individualist |
Careful and confident |
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Guardian |
Careful and anxious |
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Celebrity |
Impetuous and anxious |
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Straight arrow |
Not too confident, impetuous, careful, or anxious |
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Optimization |
Match risk factor exposures of index Accounts for covariances between risk factors |
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Original Dietz method |
Formula for time weighted rate of return Assumes all cash flows occur in the middle of the period
Permitted until 1-1-2005 |
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Modified Dietz method |
Formula for time weighted rate of return Assumes constant rate of return Weights cash flows based on the day they occur |
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Relative value analysis |
If yield spread is expected to narrow, choose higher yield bond If yield spread is expected to widen, choose lower yield bond |
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Percentage yield spread analysis |
Divide yield on corporate bonds by yield on treasuries with same maturity Compare to historical ratio |
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Fed model |
S&P earnings yield / 10 year treasury yield If low, equities are undervalued |
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Yardeni model |
like dividend discount model for broad equity market |
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Total implementation shortfall |
Gain on Hypothetical ending portfolio value Less: Gain on Actual ending portfolio value |
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GIPS how often should real estate be valued and appraised |
Valued every quarter
Appraised every year Unless client agrees to some longer internal, up to 3 years |
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Tactical asset allocation |
Deviations from strategic asset allocation for short term opportunities |
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Most common rebalancing strategy for strategic asset allocation |
Constant mix |
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Disadvantages of VWAP |
Not informative for trades that dominate trading volume Can be gamed by traders Does not evaluate delayed or unfilled orders Does not account for market movements or trade volume |
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Advantages of implementation shortfall |
Managers can see the cost of implementing their ideas Demonstrates tradeoff between quick execution and market impact Decomposes and identifies costs Can be used as an optimizer to minimize costs and maximize performance Not subject to gaming |
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Disadvantages of implementation shortfall |
May be unfair to traders Requires considerable data and analysis |
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Reinvestment rate risk |
Risk that reinvestment income falls as interest rates fall |
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Classical immunization |
Buy bonds that result in the effects of price risk and reinvestment rate risk exactly offsetting each other |
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Contingent immunization: required terminal value |
Usually given. If not, Future Value of invested amount at minimum acceptable return |
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Contingent immunization: present value of liabilities |
Present value of terminal value discounted at available immunization rate |
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Contingent immunization: surplus |
Present value of assets Less: present value of liabilities |
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How to calculate effective annual rate for a loan with options |
For all intermediate calculations, use simple interest and 360 day year Option premium is paid today. Calculate future value on first day of loan. Option proceeds are received at end of loan. No TVM calculations necessary. When annualizing final rate, raise to the power of 365/D |
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Equilibrium neutral interest rate |
Expected GDP growth plus Targeted inflation rate |
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Foundation vs Pension risk tolerance |
Foundations can have a higher risk tolerance |
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Spending requirement for independent foundation |
5% of assets |
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Spending requirement for company sponsored foundation |
5% of assets |
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Spending requirement for operating foundation |
85% of dividend and interest income Maybe also 3.33% of assets |
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Spending requirement for community foundation |
None |
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Spending requirement for endowment |
None |
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Flat and heavy tax regime: What is treated favorably? |
Interest |
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How is Bayes' theorem used in decision making? |
Updating expectations for new information |
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Strategic asset allocation in changing economy |
Can still perform well Allocation is subject to feedback loop, and can be adjusted. |
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Types of algorithmic execution systems |
Simple logical participation strategies
Implementation shortfall strategies Opportunistic participation strategies Specialized strategies |
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Simple logical participation strategies |
VWAP TWAP Percentage-of-volume |
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percentage of volume strategy |
Trading takes place at a proportion of overall market volume (usually 5-20%) until the order is complete |
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When to use VWAP |
Small relative volume Small spread Low urgency |
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When to use implementation shortfall |
Small relative volume High urgency |
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When to use broker or crossing network |
Large relative volume Large spread |
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Sell disciplines |
Substitution Valuation level Down from cost Up from cost Target price |
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Substitution discipline |
Replace an existing security with another |
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Valuation level sell discipline |
Sell based on P/E ratio or P/B ratio relative to historic mean |
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Down from cost sell discipline |
Sell if price declines a certain amount from purchase price |
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Up from cost sell discipline |
Sell when price has appreciated a certain amount |
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Target price sell discipline |
Determine fundamental value at time of purchase. Sell when stock reaches this value. |
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Parts of trade management guidelines |
Processes Disclosures Record-keeping |
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Equity q |
Market value of equity / (replacement value of assets less market value of liabilities) |
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Implied forward exchange rate from interest rate parity |
Spot rate * 1 + domestic rate / 1 + foreign rate |
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Approximate duration of a floating rate bond |
Half the payment interval (in years) |
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Receiver swaption |
Option to receive fixed |
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Upward sloping term structure |
Each successive futures price is higher Contango |
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What does a downward sloping yield curve say about the economy |
Likely to contract |
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Forward Discount |
(Forward - Spot)/Spot |
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Determining whether to hedge currency risk |
Compare forward premium/discount to expected change in currency |
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Comparing bonds in different countries |
Excess Return Bond return - Risk Free Return |
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Effective beta |
Portfolio return + Futures return / Portfolio return |
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Personal risk bucket |
Lowest risk Protect client from poverty |
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Market risk bucket |
Stocks and bonds earning market return Maintain client's standard of living |
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Aspirational risk bucket |
Highest risk Could substantially improve standard of living |
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Black Litterman Model |
Start with index Adjust weights based on expected returns BL model is constrained against short selling. UBL model is not. |
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Calculate beta with covariance |
Covariance / Market variance |
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Approximate duration of a fixed rate bond |
75% of time to maturity |
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Potential credit risk of FRA |
PV of proceeds of FRA discounted at risk-free rate |
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Implementation shortfall as a percentage |
Divide by beginning value of hypothetical portfolio |
