CFA PM, AA, Econ, FI, Trading, Perf Eval

Portfolio Management
Individuals
Return Objectives:
!. Cover annual inflation-adjusted living expenses (always), sometimes “in excess of
pension & other retirement income”
#. Provide for mortgage payments for a home (sometimes)
$. Potentially, if concerned about inflation, realize a return high enough to maintain the real
value of their asset base
%. Desire to make inflation-adjusted gifts/bequests (secondary)
&. Potentially supporting charitable endeavors (secondary)
Return Requirement:
!. Adjust living expenses for inflation (depending on how far retirement is, typically one year),
plus any mortgages or other ongoing annual expenses,

#. Calculate asset base (usually exclude residential property), less any immediate withdrawals
like paying off mortgage (note tax or pre-tax), plus any current year immediate inflows
(salary, trust distributions, inheritance)
!. Usually salary cancels out living expenses but not always.
$. Calculate required terminal value of asset base (IF ANY). Can skip this step and the next if
no required TV. If receiving any lump sum payment at this time, deduct that amount from
the TV needed.
%. Use calculator: PV = negative asset base, N = years till retirement, FV = positive terminal
value, PMT = negative if contributing to account, positive if deducting from account, CPT
rate.
&. Now we have the real req return. Add inflation adjustment to get nominal return req.
*** Always ADD INFLATION adjustment to required return if the goal includes the phrase
“maintain purchasing power”!!!! ***
** Real after-tax return = [pre-tax return * (1-tax)] - inflation rate **
** Pre-tax return = (real after-tax return + inflation rate)/(1-tax) **
A couple of examples:
2009: “… a tax rate of 20% [applies] to the … withdrawals from the investment account.”
Here, only the withdrawals are taxable; the inflation component will remain in the account,
untaxed. Increase the return for taxes, then add inflation.
2013:“The tax rate on ordinary income and all investment returns is 30%.”
Here, all returns, whether for living expenses or for inflation, are taxable.  Add inflation, then
increase the sum for taxes. This is probably the default. Inflation component is taxed.
Risk (Ability):
Increases ability:
– Long time horizon (have time to recover from any unanticipated adverse financial events/
recover from market volatility),
– Young (have more human capital, or can seek employment if necessary),
– Will receive trust payout in the future, will inherit large sum of money, have stable income,
substantial asset base relative to spending needs, own a home with no debt (home could be
sold/refinanced if cash is needed),
– if he makes a substantial gift to charity every year (—> if necessary can stop, reducing
expenses)
Decreases ability:
 – Moderate/small asset base relative to required CFs (liquidity needs) from the portfolio,
– Little/no post-retirement employment income (no human capital during retirement) = heavy
reliance on portfolio withdrawals = limits portfolioʼs tolerance for losses
– If almost retiring and no further funds added to investable assets (due to income =
expense), has a small or no pension relative to living expenses (the couple must depend
primarily on their investment portfolio) = heavy reliance on portfolio withdrawals = limits
portfolioʼs tolerance for losses
– Has a high level of spending relative to investable assets (less able to tolerate vol and
negative ST returns)
– Retire too soon (within x years) —> would not have enough time to recover from
investment losses before retirement.
Risk (Willingness): Look at psychological profiles in the question
Increases willingness:
– Owns businesses, plans to retire relatively early, confident that equities will deliver positive
returns.
Decreases willingness:
– Desire for preservation of the real value of their portfolio, preference to avoid losses due
to past experience, conservative nature of current investments, inherited their wealth
(passive source)
Time Horizon (all possible, usually multi-stage):
!. Now till children education (or some other event)
#. Children education (or some other event) till retirement
$. Retirement till death
Taxes: [refer to bottom of this section]. Generally just mention stuff like low cost basis (high
cap gains).
Liquidity:
– If client isnʼt retiring soon, the only liquidity needs are mortgages or any explicitly stated
goals (e.g. cash reserves)
– If client is retiring soon, liquidity needs include e.g.: significant annual distributions to
support living expenses, cash reserves
– After listing the needs, say “they expect no other significant inflows or outflows”
Legal:
Unique:
– Unique circumstances that acts to constrain portfolio choices. E.g. “sheʼs making a large
direct equity investment in RE (sports facility) thatʼs outside the portfolio. Even though this
holding will be maintained separately from the advisor-managed portfolio, the advisor
should consider this outside investment when developing AA of the investment portfolio”.
Misc. Tips:
– PV of future employment income = implied assets. This drops to zero upon retirement and
remain at zero
– PV of retirement expenses = implied liabilities. This peaks at the beginning of retirement,
and declines with life expectancy.
– Advantages of establishing a trust:
– Privacy —> can transfer assets to wife/children without potential publicity with
probate process
– Protection of assets within trust from outside claims (e.g. creditors) against you or
wife/children now and in the future
– Avoids disputes within the family (among wife and children)
– Responsible stewardship of assets while children are minors and afterwards if they
arenʼt able to manage asset themselves
– Earnings risk: decreased if thereʼs a longer-term or guaranteed employment contract.
Increased if employment contract is backed by corporate ownership (subjecting me to
credit risk of owners)
 – Financial mkt risk in retirement: Decrease if: increased savings rate —> larger asset base;
rely on investment portfolio instead of annuity (which means no exposure to the credit risk
of issuer of annuity). Increase if: rely on investment portfolio instead of annuity —> funding
for living expenses now subject to mkt fluctuations.
– This guyʼs current human capital most closely resembles A-rated corporate amortizing
ABS because:
– His HC is bond-like (not equity-like) due to fixed payments provided in his contract.
– His contract = 10yrs, so that eliminates T-bills (ST). His contract is subject to
creditworthiness of employer (so similar to corporate not govt credit risk)
– His HC will gradually deplete as he works to retirement, similar to the principal of corp
ABS securities (unlike gov bonds)
Gift and Estate Taxes:
You're comparing two scenarios. Whether you should gift now, or transfer on death.
Start with the base, which doesn't change: [1+re(1-tie)]^n (1-Te)
Let's say you're the guy that's gonna die. You're the Estate (E in all the formulas). You have to
pay tax on your estate once you die, that's (1-Te). Before you die, your investment gain money
for N number of years, that's 1+re. However, you have to pay taxes on that, so you multiply by 1-
tie (your investment tax, and your investment return.) This does not change with all the formula's
because 1) you're gonna die, and 2) your investment are going to make money, and 3) you pay
taxes.
Top part, this is, say your daughter.
If you gift her the investment, she will also have investment return and investment tax. So....
[1+rg(1-tig)]^N (1-Tg) That's her gift, if she pays the taxes (1-Tg).
Now this is where things get tricky. What if you hate the government and taxes, and want to
minimize the taxes to them, not necessarily prioritizing your daughter?
So now, your goal is to minimize the tax impact OVERALL, regardless. So then you pay the taxes
on BEHALF of your daughter, to limit the amount the government gets.
This means that you minimize (decrease) the taxes by Tg*Te because when you pay the gift
tax you decrease your estate as well
[1+rg(1-tig)]^N (1-Tg+TgTe) = What your daughters return is minus her investment tax PLUS
what you pay in taxes for the gift TgTe.
Divided by, well, your guaranteed formula we talked about in the above. You will pay taxes on
YOUR return, you will pay investment tax return, and finally you will pay ESTATE tax.
Tax advantages to making current gift vs. transferring wealth via bequest upon death
– Sonʼs income tax rate lower than dadʼs, and since pre-tax returns assumed same, the future
after-tax value of any gifted amount will > the amount had it stayed in dadʼs estate.
– If gift tax paid from dadʼs estate, the size of his taxable estate is reduced. Since sonʼs
estate is not taxed, this lowers the ultimate estate tax that will be paid (from the tax credit
of lower estate value)
Taxable vs Tax-Exempt Accounts: if 1. Substantial losses occurred in both accounts, and 2. If
I had a larger portion of my assets be held in taxable account,
– After-tax return: would be greater, as I couldʼve used the substantial losses to offset other
income or realized gains
– Investment risk: would be smaller, as taxable accounts effectively shares investment risk
b/t the investor and the gov. Smoothing effect of taxes reduces overall volatility of returns
stream.
Tax Liability and Tax Loss Harvesting (2017AM Q4):
Cap gains tax = 20%. I have a realized cap gain of 50,000 in my taxable account. Stock Y has an
unrealized loss of 45,000 and a cost basis of 220,000. Two alternate plans:
Plan A: Sell stock Y in Year 1 to realize the loss and replace it with stock z (which has same E(R)
as Y) In Year 2, sell stock Z at an expected mkt value of 250,000
Plan B: Hold stock Y until Year 2 and sell it at an expected mkt value of 250,000
Total 2yr tax liability for Plan A:
 ● Year 1: Realized gains = 50,000, realized losses = 45,000, so net gain = 5,000. Cap gains
tax = 0.20*5,000 = 1,000
● Year 2: Current mkt value = 250,000, cost basis = 220,000 - 45,000 = 175,000, so net gain
= 75,000. Cap gains tax = 0.2*75,000 = 15,000
● Total = 1,000 + 15,000 = 16,000
Total 2yr tax liability for Plan B:
● Year 1: Realized gains = 50,000. So cap gains tax = 0.2*50,000 = 10,000
● Year 2: Current mkt value = 250,000, cost basis = 250,000 - cost basis of 220,000 =
30,000. Cap gains tax = 0.2*30,000 = 6,000
● Total = 10,000 + 6,000 = 16,000
Plan A could increase my expected after tax account value att end of Year 2 because an
advantage of tax loss harvesting is pushing a portion of the tax liability into subsequent years,
even though the 2yr tax liability doesnʼt change. Recognizing an already incurred loss for tax
purposes saves taxes in the current year thus increasing amount of net-of-tax money available
for investment. Assuming on average positive port returns, this larger investment will lead to
a greater future wealth accumulation.
Tax Methods: Credit, Exemption, Deduction:
● Credit: Resident Country provides tax credit for taxes paid in Source Country: TCM =
Max(TRC, TSC)
● Exemption: RC exempts foreign SC income from tax, TEM = TSC
● Deduction: RC allows deduction for taxes paid in SC, TDM = TRC + TSC - TRC*TSC
Community Property Regimes and Forced Heirship:
Under community property regimes, each spouse gets 1/2 of what is earned during the marriage
if the other person dies (i.e. before marriage you have $6, and during the marriage you get it up
to $16. Under community property regimes rules, you get [16-6]*0.5 or $5). Under forced
heirship, you get a portion of whatever is stated of the total estate (i.e. If the total estate is $16,
and you get 1/3 of assets under forced heirship, you get $5.33) So between a community
property regime and forced heirship, you get the greater of the two which is $5.33
Human Capital/Financial Capital vs. Insurance:
– Purpose of life insurance is to replace FC that wouldʼve been accumulated from savings
through HC, but isnʼt, due to premature death. Life insurance protects HC; higher PV means
you want higher insurance.
– Also, all else constant, financial wealth is a substitute for life insurance. The higher the FC,
the lower the demand for insurance.
– If you have less risky employment (e.g. used to have start-up now is a stable biz), you have
a lower discount rate and should be applied to expected future earnings —> higher PV of
earnings —> increases HC —> increases insurance needed.
– Higher salary —> higher PV of earnings —> increases HC —> increases insurance
– Higher discount rate (e.g. lots of risky assets like concentrated in your company, or if your
earnings are highly correlated with the market) —> PV of earnings lower —> decreases HC
—> decreases insurance needed.
Estates and Insurance Benefits:
– The death benefit proceeds could be used to pay estate taxes. Having the insurance policy
proceeds addresses potential lack of liquidity concerns (to pay estate taxes upon death)
– The payment of insurance premiums would serve to reduce the value of the estate —> lower
future estate taxes, especially since death benefits are tax exempt.
To lower cost of hedging of a concentrated position only using puts, you can:
– Use puts with lower strike price. Cheaper, but provides less downside protection than a
higher strike price.
– Combine buying put with sale of a put with lower strike price (and same maturity).
Cheaper, but would lose downside protection if stock price moves below the strike price of
short put
– Use knock-out put option. Cheaper because option expires before its stated expiry if stock
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price increases to a certain level (which means you lose downside protection).
When you use a zero-cost/cashless collar,
– The put exercise <= current stock price
– The call exercise > current stock price
– And their premiums (prices) should be equal
Net Wealth = Total assets - Total liabilities
– Use cash value of life insurance, NOT the death benefit
– Include human capital in assets, and lifetime consumption in liabilities
– Personal assets are consumed, whereas investment assets are held for the potential to
increase in value and fund future consumption. Some assets, such as real estate, can be
described as “mixed assets” because they can act as both personal assets (shelter) and
investment assets (to help fund retirement).
– Financial capital includes the tangible & intangible assets (outside of human capital) owned
by an individual or household. FC includes the vested portion but not the unvested portion
of an employer pension plan (unvested = HC).
Risk Management for Individuals, Techniques:
Risk High Frequency Low Frequency
High Severity Avoidance Transfer
Low Severity Reduction Retention
“Retain” low low risks, “avoid” high high risks. “Transfer risk using insurance” for low frequency
but high severity risks like earthquakes
Annuities:
● Variable joint life annuity. Variable annuities suitable for average risk tolerance and the
ability to adjust their spending in retirement—enabling them to select a variable annuity
for which payment is linked to a risky portfolio of assets. The joint life feature will provide
payments until both of them are no longer living.
● Fixed joint life annuity. A fixed annuity would lock them into a constant income stream that
is guaranteed not to change.
● Variable life annuity with period certain. The life annuity with period certain feature provides
payment for the life of the annuitant and is guaranteed for a min # of years. If Bradley
purchased a variable life annuity with period certain policy with a 10-year guarantee and he
died after 6 years, Reagan would receive payments for only 4 more years as the beneficiary.
If Bradley died after the guaranteed minimum, say at 12 years, Reagan would not receive
any more payments.

Endowments/Foundations
Return Objective: Maintain the real value of the portfolio and grow the portfolio in order to
provide on-going support = x% of the university budget.
– Does NOT change if no more annual contributions from sponsor, as the Foundation still
needs to preserve the real value of its portfolio and meet its spending requirement.
Return Requirement (%) = (1+spending rule)(1+COLLEGEʼs or foundationʼs overhead
inflation)(1+management expense) - 1
– Preferable to have return requirement < return expectation, as expected portfolio surplus
can then be used as cushion to maintain purchasing power if investment perf deteriorates in
the short term.
– If return req exactly = total return expectation, this will most likely impair portfolioʼs ability
to maintain purchasing power due to mkt volatility.
Risk (Ability):
– If endowment only contributes a low % (e.g. 5%) in the collegeʼs operating budget, a drop in
endowment value should have only minor impact on collegeʼs ability to carry out
operations, thus endowment is able to pursue investments with greater risk.
– Past performance - if the compounded growth rate is low, ability to take risk is lower.
 – Perpetual time horizon —> allows it opportunities to make up for losses sustained by
portfolio or shortfalls any given year, endure/recover from mkt vol —> ability to take risk is
higher.
– If the Board is confident it can raise funds thru donor contrib if necessary, higher potential
asset base, higher ability to absorb losses, higher risk tolerance
– If recent investment returns has been above the return obj, providing a cushion for lower
future returns —> higher risk tolerance
– Goal vs. Liability; e.g. while youth centers depend on Foundationʼs distributions for their
funding, this is not a defined liability of the Foundation, simply a goal. Their tax-exempt
status, while also a goal, is not a binding requirement. Thus, higher ability to take risk.
Risk (Willingness):
– Foundationʼs board wants to seek additional return to maintain real purchasing power of
portfolio —> higher willingness to take risk
– Foundationʼs board seeks to increase the size of the endowment in real terms
– Look at Foundationʼs current AA, see if itʼs entirely invested in bonds (which means lower
willingness)
Risk (if expected inflation increases):
– May cause endowment to demand a higher real return on investments to compensate for a
perceived increase in risk, leads to increase in expected LT real returns. As expected real
returns increase, with nominal spending rule held constant, risk tolerance of endowment
increases.
– May cause endowment to use inflation hedges or to hold more liquid assets in the
portfolio to meet expected increased spending needs. This reduction in risk exposure may
be considered a reduction in risk tolerance.
Time Horizon: Usually single stage, perpetual to support collegeʼs budget in perpetuity.
Taxes: Usually not taxed
Liquidity ($): Usually cite the spending rule (liquidity need is x% of the previous fiscal year end
mkt value, or x+y% including the investment management expense), **IGNORE INFLATION.
Then multiply the % with endowment value since you want dollar $ terms.** then less
contributions from sponsor/outside.
Legal
Unique
Spending rule:
– Adopting rolling 3yr avg spending rule: dampens volatility of the amount available to
spend each year, allows portfolio to accept more volatility —> ability to take risk increases
—> higher LT returns. Places equal weight on mkt values 3yrs ago as it does on recent mkt
values. A single extraordinary return 3yrs ago could still result in a large change in spending
in current year.
– However, if portfolio value is decreasing, and the Foundation adopted this rolling 3yr
avg rule, the Foundationʼs total target spending for the coming year will be higher
because higher portfolio values in the earlier years increase the average > lower recent
portfolio value.
– Geometric spending rule: spending based on geometrically declining average of trailing
endowment values —> greater emphasis on recent market values and less on past values.
Tips:
– Diff in expertise or resources may constrain the types of investments the foundation should
consider. Low-cost, easy to monitor, passive investment strategies are often the best
approach to implementing SAA for smaller portfolios for foundations. For smaller portfolios,
be wary of lock-up provisions in HFs and single-name concentrations in PEs.
– If the policy for determining annual min spending req to retain tax-exempt status is
changed from 5% of bgn-of-yr asset value to 5% of avg-monthly asset value in that
same year, the Foundationʼs cash reserve would be higher. The distribution amount is
unknown at the start of the year, so potential for unanticipated cash needs increases.
Some More Risk Tolerance examples:
– Revising the portfolioʼs AA to decrease its risk reduces the expected return on the asset
portfolio, and the endowment will be less likely to maintain its real value over the long-
term
– Adopting a 3yr rolling avg spending rule spreads/smooths the impact of a particular year,
which reduces volatility of the endowmentʼs funding of College operating expenses, which
increases risk tolerance.
– Lower relative commitment to collegeʼs operating budget means less likely to face
spending obligation short-fall, which suggests higher risk tolerance
– If endowment is committed to covering collegeʼs operating deficit, but only up to its
spending rule, then if the operating deficit ($) < spending rule ($), endowment will spend
less, which means it can accumulate real value, more risk tolerance
– If a collegeʼs operating expense are expected to grow at a slower rate, means less likely to
face a spending obligation short-fall in the future, higher risk tolerance
– Increased donations, college requires fewer liquid assets, relies less on portfolio returns
to satisfy spending needs, risk tolerance higher.
– If investment manager is evaluated with a longer-term metric, less short-term perf pressure,
able to tolerate greater ST vol
– If college receives gov funding rather than private funding, itʼs more stable/reliable external
funding source, higher risk tolerance
Foundation Types:
– Operating: uses resources to conduct research or provide a direct service (e.g. operate a
museum). Decision-making authority is an independent board of directors. Must use at
least 85% of interest and dividend income for active conduct of the institutionʼs own
programs.
– Community: publicly supported org that makes grants for social, educational, charitable, or
religious purposes and is a type of *public charity*. Decision-making authority is a board
of directors, and thereʼs no spending req.
– Independent: (aka private) foundation is a grant-making org established to aid social,
educational, charitable, or religious activities. Decision-making authority lies with the
donor, members of the donorʼs family, or independent trustees. At least 5% of the
12mo avg asset value constitutes an annual spending req. Generally do not engage in
fundraising campaigns, and may not receive any new contrib from the donor nor
receive any public support. “Independent who donʼt need no man”
Foundation Misc.:
– Foundation has no obligation to balance the needs of current and future beneficiaries
– Foundation has high risk tolerance for risk with its long time horizon and ability to replenish
itself thru donations (specific to this example), so ignore the fact that the foundationʼs
portfolio distributions funds a majority (75%) of the collegeʼs admin budget. It doesnʼt
change the risk tolerance of the foundation because itʼs being replenished by donations.

Pensions
Return Objective: to invest so as to minimize the probability that the market value of plan assets
will fall below x% of PBO.
Return Requirement (%): PBO discount rate + excess return target (if any) = total return
objective
Tricky: If retirees receive inflation-adjusted pension payments, expected future liabilities
already incorporate inflation, so the return requirement = discount rate applied to determine
PV of liabilities.
If a Plan is exactly fully funded, and the planʼs assets earn a return = discount rate of
PV(liabilities), then plan assets should be exactly sufficient to pay for the liabilities as they come
due.
Risk:
 – Sponsor financial condition: debt/asset ratio, operating margins. High sponsor profitability
—> increases risk tolerance because strong sponsor has higher ability to fund potential
shortfalls
– Plan funding status: funding level, sponsor contributions. High pension surplus —>
increases risk tolerance because plan can experience some level of negative returns w/o
jeopardizing coverage of plan liabilities
– Plan provisions: early retirement options or lump sum payments (increases PV of benefit
payments, decreases liability durations, less risk tolerance),
– Participant characteristics: older avg age or higher proportion of retired lives = shorter
duration for liabilities = less risk tolerance. Growing ratio of inactive to active
participants —> decreases risk tolerance because shorter duration of liabilities = less
time to recover from/make up for funding shortfalls
– Pension closed to new participants —> decreases risk tolerance because a closed plan
wonʼt be adding younger participants. A plan with increasing average age —> shorter
duration liabilities —> higher liquidity req and shortened time horizon (no longer new
entrants whose effect wouldʼve been to extend the time horizon of the benefit further into
the future).
– No inflation indexing —> increases risk tolerance because in an inflationary environment, a
plan thatʼs not indexed would most likely grow its nominal asset base faster than its pension
liability as payments to current retirees will not increase. Lower liabilities
– If a companyʼs operating earnings are positively correlated with pension asset returns,
low/negative asset returns could occur when the firm is least capable of making
contributions —> decreases risk tolerance
Liquidity ($): Liquidity requirement = Net cash inflow or outflow = payments to beneficiaries -
contributions received from sponsor
From the sponsorʼs perspective, inflation risk is less in the retired-lives pool since payments
to retirees are fixed in nominal terms (no inflation adj). Active-lives pool have more inflation risk
because they accrue pension benefits based on salary increases (which incl inflation as a
component)
Liabilities in active-lives pool have longer average duration than retired-lives pool, reflecting
the time remaining before active employees retire.
ALM perspective: pension investments should be managed relative to pension liabilities and not
to external BMs. ALM goal: limit vol of shortfall, so large equity holdings will increase the vol of
shortfall since changes in equity values will not correlate closely to changes in PBO value. A
downward move in stock would worsen the shortfall.
ALM Advantages: reduces risk by explicitly considering liability exposures of the pension plan,
Asset-only approach can result in inefficient investment policies that may expose the plan to
excessive/unrewarded risk relative to liabilities, ALM typically results in an optimal port with a
higher bond allocation.
If a pension plan is just only fully funded, with 70% equity, 30% bonds, and using AO approach,
the AA may lead to funding shortfall because:
!. The realized returns on the port may not equal expected return. Realized return can be
volatile, and the Plan could experience shortfall b/t assets and PV(liabilities) if realized
returns < expected return
#. The company is partially funding debt-like liabilities with equities. While equites may have
higher potential return, they exhibit higher mkt risk
Tips:
– Smaller asset/liability risk mismatch —> lower shortfall risk.
– Given both pension plans match duration of assets to liabilities, the firm with highest
allocation to FI rather than equities (higher vol) would have smallest asset/liability risk
mismatch
– Lower surplus as % of plan asset —> higher shortfall risk
– If a pension were to change from AO to liability-relative, the key aspect is to have the
 –
investment product have a high correlation with the pension liabilities (given that other
products have similar returns and risks) —> which implies lower shortfall risk.
Rebalancing Pensions:
– Active members will see future wage growth. Since inflation component of wage growth is
highly correlated with returns on real rate bonds, hold them.
– Future real wage growth is best mimicked by equities
– Frozen plan means no new benefits or obligations are accrued, so no new wage increase is
gonna happen. No need for equity.
– If a plan is new with no inactive members —> minimal accrued benefits. Reduces need for
nominal bonds. If plan is in surplus as well (and company is profitable + growing), buy
more equities to better mimic future real wage growth.
Asset Class weightings and Pension characteristics:
!. Equities: correlated with future real wage growth, as productivity growth is correlated with
stock mkt returns
#. Nominal bonds: for active accrued benefits (who wonʼt have inflation adjustments)
$. Real-rate bonds: (i.e. bonds with yields that reflect risk premium and inflation) should be
matched with liabilities subject to inflation (e.g. inflation indexed payments for current
retirees, deferred benefits, and future wage inflation).
A primary characteristic of low-risk investment in AO vs. Liability-Relative Approaches would be:
!. AO approach: low correlation with Plan assets. Focus is on creating efficient frontier
ports, therefore, low-risk investments are those that have low corr with plan assests
#. Liability-relative approach: high positive correlation with plan liabilities. The
investment portʼs assets should mimic the liabilities in mkt-related exposures and expected
cash flows, which should minimize shortfall risk.
DC plan advantages compared to DB (employer):
!. Company doesnʼt have the responsibility to set objectives and constraints (plan participants
do)
#. Company does not bear risk of investment results; employees and beneficiaries do
$. Companyʼs future pension obligations are more stable and predictable
%. Company doesnʼt have to recognize any addtʼl pension liabilities on its balance sheet
DC plan advantages compared to DB (employee):
!. Employee able to choose own risk & return objective consistent with his own situation/
goals/risk tolerance
#. Plan is more portable (to other companies)
$. Employees are immediately vested (usually)
%. No early termination risk (of being terminated by plan sponsor)
&. Employees can personally rebalance and reallocate investments
z. Reduces employee exposure to Companyʼs financial condition
{. Account balances legally belong to Employee.
A DB planʼs liquidity requirement in 2 years:
– Increase in proportion of active lives: the net cash outflow (benefit payments - pension
contrib) is the pensionʼs liquidity req. Distributions remain unchanged while pension contrib
increases from the higher proportion of active lives, so net cash outflow decreases and
liquidity req decreases.
– Abolishing lump-sum distributions: lowers liquidity req in 2 yrs, as large withdrawals
related to exercise of this provision is no longer possible.

Insurance Companies:
If int rates are expected to increase, and duration of assets < duration of liabilities, then:
– Surplus increases as interest rates increases, and asset value declines less compared to
liability value decline
– Reinvestment risk decreases, because all else equal, rising int rates means higher
reinvestment rates, so income from investment portfolio can be reinvested at higher rates
 –

than currently available

– Expected surrender rate increases, as contracts not yet past surrender date offer inferior
E(R) vs. that of competing investments with higher int rates. Annuity owners are expected
to surrender their current contracts to reinvest in competing investments offering
higher yields.
Surrender Cost Index vs. Net Payment Cost Index (perspective of insured civilians):
!. Calculate FV of Premiums [usually mode BEG] received at the BGN of the year
#. Calculate FV of Dividends [usually mode END] paid at the END of the year
$. FV(Spent or Premiums paid) - FV(Dividends received) = FV(net payment)
%. Only if Surrender Cost: FV(net payment) - projected Cash value = FV(Surrender cost)
&. Calculate PMT of FV(net payment) or FV(surrender cost) while using PV=0 [usually mode
BEG], then /$1,000 to get the index number
And then to solidify: The "surrender cost” is lower than the "net payment", because only when
you have even less than the net payments will you surrender. For Net payment youʼre assumed to
be dead, so you canʼt receive the projected cash value.
A life insurance policy's Surrender Cost Index is always less than its Net Payment Cost
Index. This is because Surrender Cost the same as the Net Payment Cost Index except you
subtract the projected cash value of the policy from the future value of the premiums paid when
calculating the interest-adjusted annual cost.

Banks:
The bank wants longer duration loans (Assets) and shorter duration deposits (Liabilities) when
rates are falling and shorter duration loans (assets) and longer duration deposits (liabilities)
when rates are rising. The bank manages this through the k variable or the amount of liabilities
(L) it has vs the assets (A) it has in the equation. Section 5.1 pages 519-523.
Risk: below-average risk tolerance, credit risk in bankʼs loan portfolio.
LADG = Leverage-Adjusted Duration Gap = Duration of Assets – Leverage*Duration of
Liabilities, where leverage = k = value of Liabilities/value of Assets
LADG>0, bank net worth would move the opposite way of interest change (int rate decrease,
asset duration > liabilitiesʼ, net assets increase)
LADG<0, bank net worth move same way as interest rate change (int rate decrease, asset
duration < liabilities, net assets decrease)
LADG = 0, net worth immunized.
Return: interest income allocation focuses on positive spread over cost of funds, with the
remaining allocation focusing on higher total return
Liquidity: driven by demand for loans and net outflows of deposits, and regulations
Time horizon: duration spread of assets over liabilities constrains TH for securities portfolio to
an immediate-term
Taxes: pay corp tax
Legal: large % of securities portfolio in gov securities as pledge against reserves. Regulators
restrict allocation to common shares and below IG bonds, risk-based capital requirements

Asset Allocation:
Asset Classes should be:
!. Homogenous - Assets within an AC should have similar attributes and react the same way
to market forces. (Donʼt lump HF, PE, Cmdty, and RE all into one AC)
#. Mutually Exclusive - Overlapping ACs reduce effectiveness of SAA in controlling risk and
developing AC E(R) (Donʼt hold redundant Acs)
$. Diversifying - AC shouldnʼt have high expected correlations with other ACs.
%. ACs as a group should make up a preponderance of world investable wealth (Exhaustive,
need to pretty much cover all imaginable assets)
 &. The AC should have the capacity to absorb a significant fraction of the investorʼs portfolio
w/o seriously affecting the portfolioʼs liquidity
– Low pairwise correlations with other asset classes is not sufficient. An asset class may be
highly correlated with some linear combination of the other ACs even when pairwise
correlations are not high.
– Asset classes should have high within-group correlations but low correlations with other
classes. If liquidity and transaction costs are unfavorable for an investment of a size
meaningful for an investor, an asset class may not be a suitable investment for that investor.
– Asset classes should have a return premium based on an underlying market risk factor
(e.g., beta) and not any underlying skill of the investor. Strategies, on the other hand,
involve combinations of asset classes with the objective of earning a return based on
investment skill.
Basic MVO:
– Input: E(R), stdev, pairwise correlations (covariances)
– Output: Efficient frontier (weights) & optimal AA that maximizeʼs clientʼs utility
– Limitations: AA highly sensitive to small changes in input variables, AA highly
concentrated (only focus on mean & variance of returns), not well-diversified, asset-only,
single-period framework, ignores trading and rebalance costs, doesnʼt address non-normal
or path-dependent returns.
Reverse-Optimization:
– Input: market weights based on global market portfolio that are assumed to be optimal,
covariances,
– Output: implied E(R)
Black-Litterman:
– Input: implied E(R) from reverse-optimization, adjusted for investor views, real world
constraints (e.g. short-selling or minimum weights)
– Output: Efficient frontier & optimal AA
– Advantages:
!. Reverse-engineers the E(R) in a diversified mkt port and combines them with
investorʼs own views on E(R). Better than just using historical mean returns as those
do not reflect either current mkt equilibrium returns or the investorʼs views.
#. BL approach is anchored to a well diversified port, ensures SAA is well diversified
(and less volatile too). Unlike historical mean returns (which often results in highly
concentrated and undiversified ports). Combining the investorʼs own views with
equilibrium returns helps dampen the effect of extreme views that could otherwise
dominate the optimization.
Monte Carlo (To calculate path dependent FV):
Advantages:
!. multi-period framework (able to incorporate the effect of changes to variables over time)
e.g. can demo how various spending policies could affect portfolio value and ability to grow
in real terms. MVO is single period so cannot evaluate likelihood of results.
#. realistic picture of distribution of potential returns or outcomes,
$. can incorporate trading/rebal costs & taxes,
%. can model non-normal distributions (skewness, kurtosis, alt investments, human
capital), serial correlations, evolving AAs,
&. path-dependent decisions & outcomes (e.g. withdrawing from portfolio during bear
market more harmful than during bull market - itʼs the sequence that matters)
To improve the MC simulations even more:
– Incorporate expected capital market assumptions into the simulation, since using only
historical data may not fully reflect the range of possible future investment returns.
Historical data also might contain unlikely outliers
– Model the performance of the portfolioʼs specific assets rather than the performance of its
asset classes. The portʼs perf and risk may differ from AC performance and risk. AC
 –

simulation also might ignore asset-specific issues such as fees and tax efficiencies
Resampling MVO (For AA purposes, results in a more stable EF):
– Combines MVO with Monte Carlo, but all assumptions are still MVO (still doesnʼt
incorporate path dependent decisions, trading/taxes/HC). Typical MVO can be under-
diversified because it relies heavily on the input assumptions. Combining with Monte Carlo
is like running a bunch of MVOs and optimizing/averaging from those resulting EFs.
It allows for the ending asset allocation to be more diversified and is assumed to be more
stable over time compared to plain vanilla MVO asset allocation. However, resampling
method AAs still inherit the estimation errors in the original inputs.
Heuristics:
– The 1/N rule equally weights allocations to assets; 1/N of wealth is allocated to each of N
assets available for investment at each rebalancing date. All assets are treated as
indistinguishable in terms of mean returns, volatility, and correlations.
– The 60/40 stock/bond heuristic allocates 60% of assets to equities, supplying a long-term
growth foundation, and 40% to fixed income, supplying risk reduction benefits. But itʼs not
an OPTIMIZATION model.
– The Norway model passively invests in publicly traded securities subject to ESG (cuz
they oil) concerns. In comparison, the endowment model (Yale Model) asset allocation
emphasizes active management of large allocations to non-traditional investments,
seeking to earn illiquidity premiums.
When ALM approach is better than AO:
– I face a significant penalty for not meeting my liabilities (e.g. if I miss my mortgage
payments I lose my home, and I donʼt want to sell assets to pay the mortgage)
– I have below-avg tolerance while Iʼm unemployed. Loss-averse investors and low risk
tolerance investors are suitable for ALM
– My spending is a fixed amount (e.g. $5mm each year), can be considered a liability, and
policy AA can minimize the uncertainty related to funding this requirement. In AO this
liability is ignored or assumed to be zero.
– My mortgage payments (liabilities) are interest rate sensitive. Holding investment assets
with similar duration and CFs would hedge this risk, so ALM is better than AO.
Tip: I should have lower allocation to equities because: 1. Iʼm young and I have large amount
of human capital relative to financial capital. 2. Correlation b/t my future income (HC) and
equity mkt is very high, so I should balance HC risk through a lower allocation to equities in my
investment port (FC)
*** To reduce a concentrated position ***:
– Short sale against the box: shorting the stock thatʼs held. E.g. 1mm shares of ABC corp,
short (donʼt sell due to tax) 1mm shares. Defers cap gains and is risk-less. Least
expensive strategy to hedge/monetize a concentrated position.
– Prepaid variable forward: prepackages a loan thatʼs paid for by the stock. Receive cash
and can be used for diversification. Downside risk removed as stock will be delivered
(not cash) to repay the loan. Some upside is retained as a smaller # of shares can be
delivered if the stock price increases.
– Forward conversion with options (exchange traded): create a synthetic short forward
position against the underlying (thatʼs held long). E.g. you own ABC corp, then you buy
puts and sell calls at same strike price = $100. This locks in a price of $100. Perfectly
hedged and you can borrow against the value of the stock position (monetization) with a
very high loan-to-value ratio.
– Equity forward sale contract (OTC): private contract for forward sale of an equity
position. E.g. own ABC stock, then agree to sell your shares to a dealer 3yrs from now. In
return, the investor receives the “fwd price” from the dealer 3yrs from now. Allows investor
to sell stock at some future date at a guaranteed price (i.e. fwd price)
– Total return equity swap (OTC): contract for a series of exchanges of the total return of a
specified asset in return for specified fixed or floating payments.
 ● The short sale against the box approach defers capital gains. No sale of stock occurs in
establishing the collar. The short against the box strategy is risk-less, but the collar does
carry risk within the range between the exercise prices of the put and the call. The
dividends will continue to be paid to Richards only in the collar, as he still owns the stock.
The dividends will pass through to the lender of the shares that were borrowed in the short
against the box strategy and thus not available to Richards.
● Although the forward conversion with options avoids counterparty risk (uses exchange-
traded derivatives), the equity forward (OTC) sale and the total return equity swap (OTC)
use a derivatives dealer and thus include counterparty risk.
Concentrated Positions:
There are different types of risk buckets - personal, market and aspirational. Personal and
market risk buckets make up the primary capital, while aspirational includes more risky
assets such as concentrated stock holdings and real estate investments. All concentrated
positions are considered to be in aspirational bucket. Even private business (MTL) is also
considered in aspirational bucket.
Given:
Founded by the Richards family, the company has been run by Edvard Richards for more than 40
years. Richards also owns investment real estate in the form of a warehouse unrelated to MTL,
as well as 70,000 common shares of publicly traded Cintas (CTAS) that he inherited. He wants
these two items to be considered concentrated positions.
Asset Estimated Value ($ Cost Basis ($ thousands)
thousands)
Primary residence (no 2,000 2,000
mortgage)
MTL Corp 11,000 2,000
Common stock (70,000 4,000 1,000
shares CTAS)
Warehouse 3,000 4,300
Municipal bond portfolio 3,000 3,150
Global all-cap equity fund 3,400 1,650
Cash equivalents 300 300
Tax Rates Capital gains tax rate = 20% Income tax rate = 40%
The after-tax primary capital = 8,380 as calculated:
Asset Value Cost ($000s) Gain= Value Tax = Gain × Net Value
($000s) − Cost 0.20 ($000s) after Tax
($000s) ($000s)
Residence 2,000 2,000 0 0 2,000
Muni Bonds 3,000 3,150 (150) −30 3,030
Global 3,400 1,650 1750 350 3,050
Equities
Cash 300 300 0 0 300
Equivalents
Total Net 8,380
Value =
Apparently income tax rate is irrelevant, only care about cap gains…
Other concentrated position tips:
● Staged exit strategy provides for two specific liquidity events: cash up front and a sale or
monetization of the remainder of ownership in the future.
● Given Strategy: A small but rapidly growing publicly traded building materials company is
willing to acquire 100% ownership and pay Richards $7 million in cash up front and
 ●

employee stock options that he can exercise after two years and that expire in five years.
The public company is too small to support publicly traded stock options. Should the public
companyʼs stock rise, Richards can exercise his employee stock options, which will be
taxed as ordinary income. To protect the value of his appreciated stock while participating
in further upside potential, he can purchase long-term protective put options on an industry
exchange-traded fund (ETF) that closely tracks the building materials industry. If the public
companyʼs stock subsequently drops along with the industry, he can sell the puts.
○ Cross-hedging = Buying put options on the ETF is a cross-hedge against the industry
risk faced by the public company
○ Mismatch in character = This difference in tax type; exercise of employee stock
options, which will be taxed as ordinary income, and an eventual profit from a put
option, which will be taxed as a capital gain.

Currency Management:
– In the short run, if the correlation between foreign currency asset returns (RFC) and foreign
currency returns (RFX) is negative, then there may be no need to hedge all foreign
currency exposure because some currency exposure is desirable from a portfolio
diversification perspective. RDC = RFC + RFX, so they may likely cancel out somewhat.
– If you hedge the FX, you will earn the foreign asset return (RFC). If you hedge the foreign
asset return, you will earn the foreign risk-free rate. If you hedge both you earn domestic
risk-free rate.
– Strong (+) correlation b/t RFX and RFC means vol of RDC increases, so hedge ratio > 1
– Strong (-) correlation b/t RFX and RFC means vol of RDC decreases, so hedge ratio < 1
– Regarding the currency overlay program, it will add value to the portfolio only if the
currency alpha has a low correlation with other asset classes in the portfolio (i.e.,
Brazilian equities and corporate bonds).
– For a carry trade, look for lowest volatility in currency pair, and the widest spread in
yields b/t the two countries
– INCREASE in currency values associated with currencies that are 1. Undervalued relative
to fundamentals, 2. Greatest rate of increase in fundamental value, 3. Higher real/nominal
int rates (attracts foreign investors and drives up demand for currency), 4. Lower inflation
relative to other countries, 5. Decreasing risk premiums countries (more developed
country, lower debt load, currency more valuable)
– Factors favoring MORE currency hedging:
!. Significant ST objectives (income/liquidity req)
#. Short time horizon
$. Global fixed income investments are significant
%. Low costs of hedging
&. Markets with high currency or asset vol
z. Lower probability of regret if hedge not profitable
{. High risk aversion
Å. Doubt about value of currency return potential
– Given:
The appropriate risk-neutral strategy is to over-hedge (hedge ratio > 1) AUD and not hedge
CHF. The AUD is selling at a forward premium of 2.27%, which means that the expected roll
yield for a short hedge (remember, hedging means shorting/selling) in AUD is 2.27%.
Furthermore, the AUD is expected to depreciate by 3.28%, which means the short position in
the AUD gains 3.28%. The CHF is at a forward discount of 2.64%, which means that the
expected roll yield for a short hedge of CHF is –2.64%. The CHF is expected to appreciate
1.32%, which means that a short position in CHF would lose 1.32%. Thus, in this instance it
would not be appropriate to hedge the CHF.
Test question example:
– I have an Exposure to 18 million Euros
– So I Buy 6 month forward to Sell Euros sold using the bid of the base currency (euro) at an
all-in forward rate of 1.3935 – 19/10,000 = 1.3916 USD/EUR
– In 3 months sell Spanish stock for 20 million. No longer have exposure to Euro so must
close out Forward; a three-month forward contract would have to be purchased at the offer
of the base currency at an all-in forward rate of 1.4210 – 21/10,000 = 1.4189 USD/EUR.
– Buy a 3 month forward to offset the 3 month Short forward = EUR18 million × (1.4189 –
1.3916) USD/EUR = USD491,400
– Discount 3 month because the contracts donʼt expire for another 3 months and pay the
difference = 491,400/(1 + 0.01266 × 90/360) = USD489,850
** Current Management 2015AMQ9 **:
Given I am a PM for a European tech fund, and my portfolio is valued in USD, and have market
expectations of:
● Expected return (in EUR) of the Portfolio: +13.2%
● Standard deviation (in EUR) of the Portfolio: 15%
● Expected USD/EUR spot rate in one year: 1.2045 (1 EUR = 1.2045 USD)
● Standard deviation of the USD/EUR exchange rate: 5%
● Correlation between the USD/EUR exchange rate and the Portfolio (in EUR): –0.07
And Market quotes of:
USD/EUR spot rate 1.1930

1-year USD/EUR forward rate (bid–offer) 1.2065 – 1.2090

Whatʼs the expected USD return? RFX = 1.2045/1.1930 - 1 = 0.96%. Since EUR return (RFC) =
13.2%, RDC unhedged = (1+0.96%)(1+13.2%) - 1 = 14.29%
If I decide to hedge by selling EUR forward, the return on USD/EUR will be 1.2065/1.1930 - 1
= 1.13% (using bid as I am selling I get less USD). The RDC (hedged) = (1+1.13%)(1+13.2%) - 1 =
14.48%
If I donʼt hedge, the expected variance of RDC = variance RFC + variance RFX +
2sd(RFC)sd(RFX)corr(RFC, RFX) = 0.15^2 + 0.05^2 + 2(0.15)(0.05)(-0.07) = 0.2395, so sqrt of
that = 15.48%
If I decide to hedge by selling EUR forward, the expected USD port stdev = stdev of the EUR
portfolio = 15%
If I forecast that the GBP will appreciate by 5% against the USD over the next 6 months,
and current rate is 1.60, I have 3 options:
I want to increase GBP exposure in line with my forecast and also if possible minimize my initial
cash outlay.
Trade 1: Buy 1.68 call, sell 1.72 call. Ineffective, does not provide upside exposure b/t current
spot 1.60 and current spot+5% = 1.68 on expiration date
Trade 2: Buy 1.60 call, sell 1.68 call
Trade 3: Buy 1.60 call, sell 1.72 call. Ineffective because premium income from selling call
with 1.72 less than call with 1.68 strike.
Choose Trade 2.
Buying call struck at current spot rate of 1.60, I will benefit if GBP appreciates per my outlook.
Selling the higher strike out of money call at 1.68 (=5% appreciation) would provide some
premium income to reduce the cost of the trade, while not reducing his potential appreciation
below 5%

Carry Trade: borrow in low int rate (or fwd premium) currencies and invest in high int rate
(or fwd discount) currencies, assuming UCIRP doesnʼt hold
Misc.
– Short fwd premium (- roll yield, so short it), long fwd discount (+ roll yield, so long it)
– Royʼs Safety First Criterion: The higher the ratio, the lower the probability of falling below
the minimum threshold.
Non-Deliverable Forwards (NDFs)
– The credit risk does not relate to the central bank of the developing country but, rather, the
counterparty risk faced in the contract. The credit risk underlying an NDF is lower than an
outright forward contract since the notional size of the contract is not exchanged at
settlement, but only the non-controlled currency amount by which the notional size of the
controlled currency has changed over the life of the contract—that is, the change in the
controlled currency times the notional size converted to the non-controlled currency at the
spot rate on the settlement date.
– When capital controls exist, the free cross-border flow of capital that ensures the
arbitrage condition underlying covered interest rate parity does not function
consistently, and so the pricing of NDFs may differ from what is expected under arbitrage
conditions.
– NDFs exist in situations involving capital controls on one of the currencies. The controlled
currency cannot be physically settled (i.e., not delivered or received), but instead it is
cash settled in the non-controlled currency.
Direct Hedge vs. Cross-Hedge vs. Min Variance Hedge
– If I have taken large positions in both NZ and AU firms, and the two positions are roughly
equal in size in terms of USD, and correlation b/t USD/AUD and USD/NZD = 0.85,
– A direct hedge on each currency is the most appropriate strategy for the long positions in
the Australian and New Zealand dollar. The high correlation between the currencies does
not help here because the investor will be using forward contracts to sell both of these
currencies. The high correlation between the currencies could have been exploited
with a cross-hedge or a minimum-variance hedge if one of the foreign assets was held
long and the other short. HELD OPPOSITE then x-hedge works.
– Although a minimum hedge portfolio can be constructed without simultaneous long and
short positions, the greatest risk reduction (which Testa desires) would arise if that were to
occur.
– Mean-Variance Hedge is a Cross Hedge aimed at minimizing volatility in returns. All
MVHs are Cross Hedges but not all Cross Hedges are MVHs.
Direct Hedging
● Long exposure to a currency is hedged by selling it forward (eg. Exporter receiving
payment) 
 ● Short exposure to a currency is hedged by buying it forward (eg. Importer making payment) 
● The hedged item (the currency) and the hedging vehicle (the forward contract) are
perfectly correlated IF: 
● Size of contract = Size of payment 
● Contract expiration date = Payment date 
Cross hedge (Proxy hedge)
● A perfect hedge may be unavailable or expensive 
● In a cross hedge, the hedged item and hedging vehicle are highly, but not perfectly,
correlated 
● Example: Hedging the Swedish Krona for a Norwegian investment 
● NOTE: Cross hedges are risky because the correlation between the item and hedge vehicle
may change 
Macro hedge
● Designed to hedge portfolio-wide risk as opposed to a single currency risk 
● The correlation will not be perfect, so this is technically a cross hedge 
● Example: Hedging with a fixed basket of currencies similar to those in the portfolio 
● No perfect, but cheaper than perfectly hedging each individual currency 
Minimum Variance Hedge Ratio
● Combination of a cross hedge and macro hedge, designed to minimize the volatility of the
investor's currency 
● Regression-based approach to determining the hedge ratio that will minimize risk 
● A high R² indicates that the hedge should work well, but it's based on historical data and
could change 
● Multiply the amount you want to hedge by the slope coefficient 
● If R
FC is positively correlated with the exchange rate , MVHR > 1 
● If R  is negatively correlated with the exchange rate , MVHR < 1
FC
*** Goals-based asset allocation (want to calc PV, given N, FV, PMT=0, and I/Y) ***
A married couple recently retired with total assets of USD 10mm. They have two goals they wish
to achieve during retirement:
Goal 1: Have 85% chance of transferring USD 7.5mm to their children in 10 years
Goal 2: Have 75% chance of being able to donate USD 15mm to charity in 25 years.
Fucktard, CFA recommends implementing a goals-based approach to construct a portfolio. He
develops a set of sub-port modules. He suggests investing any excess capital in Module A.
Construct the overall goals-based AA for the couple given their 2 goals:
Goal 1 has TH = 10yrs and a required prob of success of 85%, so choose Module B (highest min
expected return of 5.0% given 85% and 10yrs).
The PV of Goal 1, discounted using the 5.0% expected return is, N=10, FV=-7.5mm, I/Y=5; CPT
PV = 4,604,349
So 4.6mm/10mm = 46% of the total assets should be allocated to Module B
Goal 2 has TH = 25yrs and a required prob of success of 75%, so choose Module C.
The PV of Goal 2, discounted using the 6.9% expected return is, N=25, FV=-15mm, I/Y=6.9; CPT
PV = 2,829,102
So 2.83mm/10mm = 28.3% of the total assets should be allocated to Module C
A surplus of 2.57mm/10mm = 25.7% should be invested in Module A as per Fucktardʼs
suggestion.

Economics
Indicators
 leading: coinciding: lagging:
- average weekly - employees on non-farm - average duration of
manufacturing hours payrolls unemployment
- average weekly claims for - personal income less - inventory/sales
unemployment transfer payments - labor cost per unit of output
- new manufacturer orders - industrial production for manufacturing
- vendor performance as per - manufacturing and trade - average prime rate
diffusion index sales - commercial and industrial
- building permits loans
- stock prices - consumer installment credit
- money supply to personal income ratio
- interest rate spread - consumer price index for
- index of consumer services
expectations
YC indicators:
– Flattening YC means weakening economy
– Steepened YC means strengthening economy as longer maturityʼs yield increase, believe
rates will be higher in the future.
Indicator Limitations:
– False signals: occurs when a series thatʼs moving in 1 direction suddenly reverses and
nullifies a prior signal, or hesitates
– Currency of data and revisions: some data are reported with a lag, and revisions can
change magnitude of signal or even change direction
– Economic sectors not reported: e.g. service sector, import-exports, and international
series
– Changes in relationships among economic variables: unstable relationships might invalidate
assumptions about effects of changes in a variable
Approaches to Econ Forecasting:
– Econometric modeling: the relationships between variables are likely to change. In
practice, model-based forecasts rarely forecast recessions well, although they have a
better record of anticipating upturns.
– Economic Indicators: composite of leading economic indicators is based on an analysis of
its forecasting usefulness in past cycles. The indicators are intuitive, simple to construct,
require only a limited number of variables, and third-party versions are also available.
– Checklist approach: highly subjective and time-consuming.
Biz Cycle and Equity Returns:
● The most favorable phases when considering equity returns are initial recovery and early
upswing; the late upswing, slowdown, and recession phases carry the greater risk for
equities. Hungary has the combination of factors consistent with the initial recovery/early
upswing phases of the business cycle—increasing production, low inflation, improving
confidence, stimulatory fiscal/monetary policies, and abundant capacity. These
indicators —> strongly rising stock prices and therefore most attractive for equity returns.
● Spain appears to be in late upswing with high production, exuberant confidence and rising
inflation, and restrictive fiscal/monetary policies. Stocks would be topping out and often
volatile.
● Ireland is likely at risk of entering a recession with production, utilization and inflation each
above long-term averages while confidence is weakening. Fiscal/monetary policies are on
a cautionary note. Stocks would be in bottoming/starting to rise stage.
Inflation Forecasts:
– Consumer confidence index: rising consumer optimism —> near-term consumer spending
increase. Consumers more likely to buy more goods, drives up prices (inflation increases).
– Inventory/Sales ratio: when the ratio declines, the economy is likely to be stronger as biz
try to rebuild inventory when consumers buy them (sales increase). Strong economy leads
 –

to higher inflation
– Output gap: Diff b/t actual GDP and potential GDP scaled by potential GDP. If gap has been
closing and expected to become positive as a proportion of potential GDP (actual GDP now
> potential GDP), spare capacity of economy is forecast to decline —> implies higher
inflationary pressure.
– A decline in inflation is typically associated with an output gap.
Bonds outperform equity when:
!. GDP forecast suggests slowing economic growth
#. Inflation forecasted to be lower
Permanent Income Hypothesis: consumerʼs spending behavior is largely determined by their
LR income expectations. Consequently, short-term economic fluctuations are less likely to affect
consumer spending (although likely to affect consumer savings). E.g. the case provides negative
real GDP growth yet consumer spending growth is positive.
Risk Premium Approach:
Compare market yield on the callable bond with the required yield determined by sum of
applicable risk premiums.
Required yield = Real Rf + inflation premium + default risk premium + maturity premium +
call risk premium + illiquidity premium + tax premium
Case specific example:
– Default risk premium = 5yr BBB rated credit risk spread over 5yr Treasuries
– Maturity premium = spread of 5yr treasury over 1yr treasury
Labor-Based Method (wtf?):
The simplest way to analyze an economyʼs aggregate trend growth is to split it into:
● growth from changes in employment (growth from labor inputs), and
● growth from changes in labor productivity.
For longer-term analysis, growth from changes in employment is broken down further into
growth in the size of the potential labor force and growth in the actual labor force participation
rate.
Growth from Changes in Percent
Employment Growth in potential labor +1.9
force
Growth in labor force -0.3
participation
+ Labor productivity Growth in labor productivity +1.4
= Estimate of GDP growth 3.0
rate
● DO NOT ADD total factor productivity, because TFP is a sub-component of total labor
productivity
Grinold-Kroner Model:
GK DIGS PE: dividend yield + LT inflation + LT corporate real earnings growth rate - shares
outstanding + expansion rate (compound annual growth rate) for PE ratio
E(R) = (D/P - ΔS) + (i + g) + ΔP/E
E(R) = income return + nominal earnings growth + repricing return = “equity compounded annual
growth rate” = expected rate of return on equity
If youʼre given two P/Eʼs numbers (Current P/E and expected P/E 10yrs hence), you compute the
compound annual growth rate of the P/E: (expected PE/current PE)¹/¹⁰ − 1
Fed Model:
In equilibrium, yield on LT gov bonds = fwd earnings yield on broad mkt index. If equity fwd
earnings yield < 10yr gov bond yield, stock market is overvalued as even 10yr bond has higher
yield than equity, so equity SUCKS. NOT justified fwd, just fwd.
Yardeni Model:
Uses yield on risky debt (incorporating risk premium, but not exactly equity risk premium) and a
projected LT earnings growth rate to calculate a justified fwd earnings yield.
Justified = [10yr A-rated corp bond yield] - d*(projected LTEG). If given fwd earnings yield >
Yardeni justified fwd earnings yield, then itʼs undervalued (good investment, higher earnings
yield)
2 Factors not included in Fed but is in Yardeni:
– Equity Risk Premium: Yardeni attempts to address this by incl yield on risky debt (credit
spread on A-rated corp bonds), however itʼs credit risk premium, not exactly ERP.
– Earnings growth: Yardeni include a LT earnings growth forecast –d*(LTEG), which accurately
addresses earnings growth
Fed uses “Forward Earnings Yield (E1/P0)” and compares to LT govt yield. NOT justified.
Yardeni approx. ”Justified Earnings Yield” through the equation (Yb-d(LTEG)) and
compares it to the actual “Forward Earnings Yield (E1/P0)” to see if the current valuation is
justified.
CAPE:
10yr moving average CAPE ratio controls for biz cycle effects and is mean reverting. Compare
the calculated ratio to the LT avg CAPE (100 years), if higher, then overvalued.
CAPE = current level of real S&P500 price index / moving avg of previous 10yrs reported S&P
real earnings (adjusted for inflation)
CAPE controls for biz cycle effects on earnings
Taylor Rule:
R optimal = R neutral + 0.5(GDP forecast - GDP trend) + 0.5(Inflation forecast - inflation target),
then compare R optimal to the current “Fed/Bank of England short-term interest rate”
Cobb Douglas Long term growth trend of economy (GDP):
– Incentives encouraging companies to increase use of tech —> increases TFP growth —>
increases LT GDP
– Increase in mandatory retirement age from 65 to 70 —> increases both potential labor force
size and/or actual labor force participation rate —> increases LT GDP
– A broad increase in taxes to fund low-income family support —> taxes distort economic
activity by reducing equilibrium quantities of goods/services —> results in deadweight loss
—> less capital investment activity, disincentives to indivs and biz —> reduces LT GDP
– A one-time tax rebate to stimulate consumer spending —> short term/temporary influence
on biz cycle, but doesnʼt have impact on LT GDP.
– One-child policy —> limit population growth —> reduce growth rate of labor input in LR —>
decreases LT GDP
– Increase max contrib to tax-free retirement accounts —> 1. Increase savings rate &
investment —> increase capital stock growth rate —> increase LT GDP. Or 2. Increase
TFP growth due to reduction of taxes —> increase LT GDP.
– Issuing new regulations (to reduce pollution) decreases GDP growth trend because total
fixed costs increase as a result of new regs, which lead to lower levels of production and
lower growth rates of GDP in short to medium term
– Decreasing min retirement age by 3yrs for all workers decrease GDP growth as itʼll initially
decrease labor participation and therefore growth in labor input.
Singer-Terhaar
Risk premium = Stdev * correlation * GIM Sharpe + illiquidity premium
Add the liquidity premium in both the fully segmented and the fully integrated.
– Market Integration: No barriers to intʼl capital flows b/t a mkt and the Global Investable Mkt
(GIM), correlation is given (with GIM), lower ERP
– Market Segregation: Capital mkts are dominated by domestic investors (home bias),
correlation = 1 (correlate with itself as itʼs a loner), higher ERP
– A marketʼs ERP is based on its stdev and integration and correlation with the GIM
– Developed mkts are 85% integrated with GIM, developing = 65%
– When a market is segmented, an illiquidity premium is added to ERP
– (RPm / stdevm) = GIMʼs Sharpe Ratio
Example:
Market Indicators
Standard Deviation (σà) 20%
Correlation with GIM (ρà,M) 0.80
Risk-free rate 5.0%
Integration with GIM 65%
Illiquidity Premium 0.6%
GIM Sharpe ratio 0.50
Step 1a: Calculate ERP assuming that the market is fully integrated (use correlation with GIM)
with GIM.
● (20% x 0.80 x 0.50) + 0.6 = 8.6%
Step 1b: Calculate ERP assuming that the market is fully segmented (use correlation = 1) from
GIM.
● (20% x 0.50) + 0.6 = 10.6%
Step 2: Weight fully integrated and fully segmented ERPs based on actual level of integration.
● (8.6% x 0.65) + (10.6% x 0.35) = 9.3%
Step 3: Calculate market's expected return.
● 9.3% + 5.0% = 14.3%
Note: βi = Cov (Ri,RM)/Var(RM)

Domestic Currency Returns:

Variance(RDC) = Variance(RFC) + Variance(RFX) + 2*stdev(RFC)*stdev(RFX)*Corr(RFC,RFX)
Appraisal data – by using interpolated data points to calculate bond prices where none were
available, youʼre creating a smoother (appraised) price series than would actually exist, which
would likely underestimate bond mkt vol, and likely overestimated risk-adjusted return
PPP – Emergistan has higher inflation rate than US, and this diff is forecast to grow. PPP asserts
that movements in an exchange rate should offset any diff in the inflation rates b/t 2 countries
Capital flows – measured by foreign direct investment.
Tobinʼs q = (mkt value of equity + mkt value of debt) / replacement cost of assets. Tobin has
replacement ASSet on her bottom.
Equity q = (mkt value of equity) / (replacement cost of assets – mkt value of debt). Equity on
top, replacement on bottom.
Theory: if Tobinʼs q = 2, it should be lower in the LR. It means the mkt is valued higher than the
replacement cost of assets. Either security prices will fall or companies will continue to invest in
new assets until the ratio reverts to an equilibrium value of 1. It is mean reverting.
Criticisms: difficult to obtain accurate figures for asset replacement costs; itʼs also common for
high/low ratios to persist over extended periods (which makes these measures less useful in the
short term)
Debt service ability for a Country:
– Decreased dependence on a commodity (e.g. iron ore): since the economy heavily
depends on production of a single commodity, itʼs vulnerable to adverse demand shocks.
Less dependence means lower/reduced impact of an economic shock —> improved ability
to service debt.
– Higher external debt/GDP ratio: weakened ability to service debt (external debt burden
increased)
 – NOTE: FX reserves/ST debt ratio measures the availability of liquidity.
All the Parities:
– Uncovered interest rate parity (rarely holds) is a theory that predicts that high interest
rate currencies should weaken such that investors get the same returns regardless of the
currency their deposits are held in. If this theory held, then the carry trade, which involves
depositing in high-interest-rate currencies and borrowing in low-interest-rate currencies,
would never work since interest rate differentials would be offset by foreign exchange rate
movements.
– Covered interest rate parity (always holds) is a no-arbitrage law for pricing futures
contracts and hence is not used to predict where exchange rates will move to. The
expected depreciation of a currency would be the difference of the risk-free rates b/t the
two countries divided by 2. (The currency with the higher interest rate will depreciate to
equilibrium). ** misc. add-on, if the economist forecasts that a currency will depreciate by
1%, but IRP says 1.25%, then you should not use a forward hedge to lock in a currency loss
of 1.25% since if you leave it unhedged youʼd have lower loss of 1%.
– Purchasing power parity predicts that exchange rates are driven by inflation differentials.
(Higher inflation countryʼs currency will fall to offset).
Covariance between Markets:
Factor Covariance Matrix:
Global Equity Global Bonds
Global Equity 0.0225 0.0022
Global Bonds 0.0022 0.0025
Market Factor Sensitivities and Residual Risk:
Global Equity Global Bonds Residual Risk
Market 1 1.2 0 12%
Market 2 0.9 0 7%
Whatʼs the Covariance b/t Market 1 and Market 2?
M1,2 =(1.20×0.90×0.0225)+(0×0×0.0025)+[(1.20×0)+(0×0.90)] × 0.0022 = 0.0243
= (mkt 1 sensitivity to equity * mkt 2 sensitivity to equity * equity variance)
+ (mkt 1 sensitivity to bonds * mkt 2 sensitivity to bonds * bond variance)
+ covariance of equity and bonds * [(mkt 1 sensitivity to equity * mkt 2 sensitivity to bond)
+ (mkt 1 sensitivity to bond * mkt 2 sensitivity to equity)]

Fixed Income
Types of Spreads:
– G-spread: Bondʼs YTM - interpolated yield of correct maturity benchmark (G for GOV)
bond
– I-spread: uses swap rates rather than gov bond yields
– Z-spread: spread added to each YC point such that PV of bondʼs CF = price
– OAS: for bonds with embedded option; spread added to forward rates such that value =
price
Expected Return =
● Yield Income (annual coupon payment/current bond price=B0). DO NOT USE PAR
AMOUNT.
● + Roll down return (B1 - B0 / B0, assuming an unchanged YC over horizon, results from
bond rolling down YC as time to maturity decreases. As time passes, bondʼs price typically
moves closer to par)
● + E(Δprice due to yield change and spread change) (-MD*ΔY + 0.5*C*ΔY^2)
● - E(Credit loss) (default rate * loss severity)
● + E(currency gains/loss)
Excess return = s*t - (Δs * SD) - (t*p*L)
– s = spread at the beginning of the holding period
– t = holding period in fractions of years
– Δs = change in credit spread during the period
– SD = spread duration of the bond
– p = annualized probability of default
– L = the expected loss severity
Convexity:
– Buy convexity if: expect rates to be volatile. Buy call/put options.
– Sell convexity if: expect rates to be stable. Sell call/put options. Buy MBS. Buy callable
bonds.
– In general convexity is good because if yields go up, bond price goes down, but bonds with
more convexity will decrease by a smaller amount than bonds with less convexity.
– If yields go down, bonds with more convexity goes more up.
When credit spreads widen: BUY higher quality corporate bonds because their spreads widen
less than lower quality ones compared to unchanging Rf due to lower default risk
When interest rates decline: DO NOT BUY callable bonds as their negative convexity limits the
price appreciation relative to non-callable bonds. DO NOT BUY higher coupon MBS, as there
will be higher level of prepayments and will have to be reinvested into lower interests when
interests decline.
Sector rotation trading strategies do not perform well in corporate bond market (compared to
equity) because bond market less liquidity & high trading costs compared to equity mkt.
For a single liability, you want the minimum convexity bond because that convexity will still
be greater than the convexity on the zero you would use if using government bonds (which is
preferable). A couple other things to think about with a single liability:
• higher convexity => lower yield
• convexity protects against structural risk - the risk of twists and shifts in the yield curve.
Single liabilities arenʼt as exposed to structural risk as multiple liabilities are, as theyʼre
only going to be at one point on the YC.
Types of Liabilities
!. Type I: amount and timing of CFs known. Allows manager to consider immunization
strategies using yield duration stats such as Macaulay, modified, and money duration
#. Type II: e.g. callable bond. Knows amount but not timing (bond can be repurchased at
preset call prices) on call dates, or if not called, redeemed at par value at maturity.
$. Type III: e.g. floating-rate note. Knows int payment dates but NOT amounts (linked to future
rates). Macaulay, modified duration do not apply
%. Type IV: defined benefit pension plan obligations: both amounts and dates are uncertain.
Immunization Summary:
● An immunization strategy aims to lock in the cash flow yield on the portfolio, which is the
IRR on the cash flows. It is NOT the weighted avg of the YTMs on the bonds that
constitute the portfolio
● Structural risk to immunization arises from non-parallel shifts & twists to the YC. This
risk is reduced by minimizing the dispersion of CFs in the portfolios (by minimizing the
convexity). Concentrating the CFs around the horizon date makes the immunizing portfolio
closely track the 0-coupon bond that provides for perfect immunization.
● There is often a large duration gap between asset and liability BPVs for pension funds
because they hold sizeable asset positions in equities that have low or zero effective
durations and their liability durations are high.
○ Thus often require pay-float, receive fixed int rate swaps (that increase duration).
○ Since receive-fixed swaps gain value as current swap mkt rates fall, the fund manager
could choose to raise the hedging ratio when lower rates are anticipated.
○ If rates are expected to go up, manager could reduce the hedging ratio.
● An alternative is buying a receiver swaption. Confers the buyer the right to enter the swap
 ●
as the fixed-rate receiver. Due to negative duration gap (asset BPV<liability BPV), the
typical pension plan suffers when int rates fall and could become underfunded. The gain on
the receiver swaption as rates decline offsets the losses on the balance sheet.
● Another alternative is swaption collar, the combo of buying the receiver swaption and
writing a payer swaption. The premium received on the payer swaption thatʼs written offsets
the premium needed to buy the receiver swaption.
● To choose: if rates are expected to be low, receive-fixed swap is typically the preferred. If
rates expected to go up, the swaption collar can become attractive. And if rates are
projected to go up and reach a certain threshold that depends on the option costs and the
strike rates, the purchased receiver swaption can become the favored choice.
● Model risks arise in LDI strategies, since liability BPV for DB pension plan depends on
choice of measure (ABO or PBO), and the assumptions that go into the model regarding
future events (e.g. wage levels, time of retirement, time of death, etc.)
● Spread risk in LDI strategies arises because itʼs common to assume equal changes in asset,
liability, and hedging instrument yields when calculating the # of future contracts, or the
notional principal on an int rate swap to attain a particular hedging ratio. The assets and
liabilities are often on corporate securities, however, and their spreads to benchmark yields
can vary over time.
● Total return swap advantages over direct investment in a bond mutual fund or ETF: as a
derivative, it requires less initial cash outlay for similar performance. TRS does carry
counterparty credit risk though. TRS can offer exposure to assets that are difficult to
access directly like some HY and commercial loan investments
● Decision of selecting a bond index: 1. Given that bonds have finite maturities, the duration
of the index drifts down over time. 2. Composite of the index changes over time with the biz
cycle and maturity preferences of issuers, 3. Value-weighted index assign larger shares to
borrowers having more debt, leading to “bums problem”, and thus bond index investors
can become overly exposed to leveraged firms.
● A laddered portfolio offers more diversification than either bullet or barbell. Offers an
increase in convexity because CFs have greater dispersion than a bullet. Provides liquidity
in that it always contains a soon-to-mature bond that could provide high-quality low
duration collateral on a repo contract if needed.

Immunization Approaches:
Dollar duration:
1.       Dollar duration of Assets = dollar duration of liabilities
2.       PV(Assets) = PV(Liabilities)
– Dollar duration of liability = PV * maturity in yrs * 0.01, OR
– Dollar duration of liability = mkt value * modified duration * 0.01
– Compare the calculated value with dollar duration of current assets in portfolio (should be
given). The dollar duration of the most suitable bond must be the closest to the difference
b/t the two.
– Get the diff b/t PV(Assets) and PV(Liabilities), which means the most suitable bond must
have PV = the difference
– Calculate dollar durations of potential bonds = Modified Duration * PV(Diff) * 0.01. The
oneʼs that closest to the dollar duration diff is the bond to choose.
Modified duration:
1.       Mod duration of Assets = mod duration of liabilities
2.       PV(Assets) = PV(Liabilities)
– Since the single-payment liability has a maturity of 4yrs, its Modified duration = 4.0.
– Modified duration of bond = dollar duration / market value / 0.01 = dollar duration / PV / 0.01
PVBP = mkt value * modified duration / 10000. It scales money duration so that it can be
interpreted as money gained or lost for each bp change in the int rate.
** Dollar duration uses 0.01 while PVBP uses 0.0001 when you calculate mkt value *
modified duration. **
Immunizing single liability:
Most important thing is that the MV is >= the PV of the liability. The 2nd most important is to
pick a *Macaulay* duration that matches the liability's due date. The 3rd most important
thing is to minimize the portfolio convexity relative to its liabilities [convexity of assets
should match or modestly exceed that of the liabilities; so minimize the difference in convexity
between assets and liabilities]...also, you can still immunize a portfolio if liabilities are greater
than assets IF the expected return of assets is greater than the discount rate used to determine
liabilities.
● Minimizing the portfolio convexity (i.e., the dispersion of cash flows around the Macaulay
duration) makes the portfolio closer to the zero-coupon bond that would provide perfect
immunization.
● Want lower average coupon and lower spread duration.
○ Lower coupon = smaller CFs requiring reinvestment = less reinvestment risk = more
similar to 0-coupon bond.
○ Lower spread duration of the portfolio = less exposure to corp bonds (less exposure to
credit risk, less default risk) = more similar to 0-coupon bond.
Immunizing multiple liabilities:
Similar to immunization for single liability, you want to make sure your MV >= than the PV of the
liability. The 2nd thing you look at is the **BPV (instead of duration) and you want your BPV
of the assets = BPV of the liabilities**. The 3rd thing is convexity; but instead of trying to
minimize convexity like in single liabilities, you want your convexity of the assets > convexity
of the liabilities
** The distributions of the durations of individual portfolio assets must have a **wider
range** than the distributions of the liabilities to cover them **
**BPV = Basis Point Value = money (dollar) duration * 1bp = modified duration * market
value * 0.0001**
Methods of Managing Liabilities:
!. Cash Flow matching: build a portfolio of 0-coupon or fixed-income bonds to ensure there
are sufficient cash inflows to pay the scheduled cash outflows. Potentially large cash
holdings —> CF reinvestment risks
#. Duration matching: match asset duration to liability duration.
$. Derivatives overlay: use futures contracts on gov bonds in immunization
%. Contingent immunization: allows for active bond port management until a minimum
threshold is reached
Cash Flow Matching (from textbook, never tested but might be):
Given a schedule of payments due on the debt as of June 2017 that the company plans to
defease using securities with a constraint of minimum denomination of 10,000:
June 2018 3,710,000
June 2019 6,620,000
June 2020 4,410,000
June 2021 5,250,000
The following gov bonds are available. Interest on the bonds is paid annually in May of each year.
Coupon Rate Maturity Date
2.75% May 2018
3.50% May 2019
4.75% May 2020
5.50% May 2021
● Start with the last liability (June 2021 5,250,000). That liability could be funded with the
5.50% bonds due May 2021 having a par value of 5,250,000/1.0550 = 4,976,303. With the
constraint he has to buy 4,980,000 in par value instead. That bond pays 4,980,000*1.0550
 ●

= 5,253,900 at maturity, and also pays 4,980,000*0.550 = 273,900 in coupon interest in

May 2018, 2019, and 2020.
● Then, move to June 2020 obligation, which is now 4,410,000 - 273,900 coupon interest
from 5.50% bond = 4,136,100. Match that with a 4,136,100/1.0475 = 3,948,544 par value
but buy 3,950,000 instead, which pays 3,950,000*1.0475 = 4,137,625 at maturity, and
187,625 in interest in May 2018 and 2019.
● The net obligation in June 2019 is thus 6,620,000 - 273,900 - 187,625 = 6,158,475, etc, etc.
Cash flow matching is *not suitable for pension plans*; participants are entitled to receive a
monthly benefit. Cash flow matching entails building a dedicated portfolio of zero-coupon or
fixed-income bonds to ensure there are sufficient cash inflows to pay the scheduled cash
outflows (Type I liabilities). However, such a strategy is impractical for pension liabilities and can
lead to large cash flow holdings between payment dates, resulting in reinvestment risk and
forgone returns on cash holdings.

Duration Matching (Overhedge and Underhedge for ALM):

** Nf = (Liability BPV - Asset BPV) / Futures BPV **
** Futures BPV = BPV of Cheapest to Deliver / Conversion factor **
If a portfolioʼs Liabilities has BPV of 59,598 and Assets has BPV of 91,632, and the manager
uses futures contracts to reduce the duration gap b/t A and L, and he uses a contingent
immunization strategy, and he is currently short 254 contracts with a BPV of 97.40 per
contract, he most likely believes interest rates will FALL, because:
– The number of futures contracts needed to fully remove the duration gap between the asset
and liability portfolios is given by Nf = (BPVL – BPVA)/BPVf = (59,598 – 91,632)/97.4 = –
328.891, where the minus sign indicates a short position or selling of 329 futures contracts
(328,891/1,000). He has under-hedged, leaving a net position that will benefit from a
reduction in interest rates (A duration>L duration), just as the unhedged position would
benefit from a reduction in interest rates. Thus, he must believe interest rates will fall.
– If he believed rates would rise, he would over-hedge (so that duration A < L, so A will
decrease less in value than L), leaving a net position that would benefit from rising rates.
– If he believed rates wouldnʼt change, he would hedge fully, in case rates moved in an
unexpected way.

Rebalancing Ratio = desired dollar duration / portfolio dollar duration. Take the ratio - 1 and
* market value of positions to get the $ cash required to rebalance.

Most appropriate AA for pension fund:

If the pension fund currently has a surplus of USD 2bn (10bn assets - 8bn PV liabilities), to
adopt a hedging/return-seeking portfolio, you should first hedge the liabilities by allocating an
amount = PV of liabilities, USD 8bn, to a hedging portfolio (using index-linked gov bonds, as itʼs
the factor driving the returns of liabilities). So board should allocate 80% (USD 8bn/10bn) of the
fundʼs assets to index-linked gov bonds.
The residual 2bn would then be invested into return-seeking port (perhaps corp bonds and
equities).

Liabilities for DB Pension (from textbook, never tested but might be):
● Timeline: Start work till Date 0 (now) = G years
● Date 0 (now) till Retirement = T years
● Retirement till death = Z years
● ABO vs PBO
○ If itʼs going to be closed, bought or convert DB to DC, use ABO (legal liability thus
far)
○ If corporation is going to be ongoing and preserve the plans, use PBO
○ ABO is the legal liability of the plan sponsor, so itʼs the PV of the annuity, discounted
 ○
at an annual rate r on high quality corporate bonds. The liability is calculated based on
G years worked and the current annual wage (W0), even though the annuity paid in
retirement is based on WT and G+T years.
○ PBO uses projected wage for year T instead of the current wage
○ PBO always >> ABO by the factor of (1+w)^T, which is the annual wage growth
rate^time till retirement
● In practice, partial hedges are common rather than attempt to reduce the duration gap to
zero
● When manager anticipates lower mkt rates and gains on receive-fixed interest swaps (pay
lesser float), manager prefers to be at top of allowable range of hedge ratio.
● If mkt (swap) rates are expected to go up, manager could reduce hedging ratio (use less
pay float receive fixed swaps)
● Also, instead of entering a 30yr, receive-fixed int rate swap against 3mo LIBOR, the pension
fund could purchase an option to enter a similar receive-fixed swap (swaption).
● Or use a swaption collar. Buys the same receiver swaption, but instead of paying premium
in cash, the plan writes a payer swaption.
● Advantage of buying receiver swaption is that like an insurance contract, its cost is a
known amount paid upfront. Vs. receive-fixed swap and swaption collar where the potential
losses are time-deferred and rate-contingent, and therefore uncertain.
● Drawback of derivatives overlay strategies for LDI for DB. Hedging with futures means daily
oversight of the positions, since they are marked to market and settled at end of day into
margin account. Realized losses is offset by ** unrealized reduction in the PV of liabilities
**, which leads to significant daily cash inflows and outflows. Thatʼs why itʼs better to use
OTC int rate swaps rather than exchange-traded future contracts.
Example 7 (p. 85)
Given:
● Effective duration of liabilities = 9.2, so BPV = 1.215mm
● Effective duration of assets = 25.6, so BPV = 528,384, so the negative money duration gap
is substantial (need to increase asset money duration)
● There are 3 interest rate derivatives available:
!. 30yr 3.80% received-fixed swap referencing 3mo LIBOR. Swap effective duration =
17.51 and BPV = 0.1751 per USD 100 of notional principal
#. Receiver swaption with strike rate = 3.60%. Plan pays premium of 145bps upfront to
buy the right to enter a 30yr swap as the fixed rate receiver. Expiry date = when
pension plan next reports its funding status
$. Swaption collar, combo of buying the 3.60% receiver swaption and writing a 4.25%
payer swaption. Premiums offset so zero-cost collar
● Manager ends up choosing the 3.80% receive-fixed int rate swap and a hedge ratio of 75%.
Why???
Answer:
● First, calculate the NP on the int rate swap to achieve the 75% hedging ratio: Asset BPV +
(NP*Swap BPV/100) = Liability BPV, solve for NP = 392,127,927. A 75% hedging ratio means
0.75*392,127,927 = 294mm
 ● The plan managerʼs likely view is that the 30yr swap rate will < 3.80%. Then the gain on the
swap exceeds that of the purchased receiver swaption having a strike rate of 3.60% as the
chart above
● If the view is that the swap rate > 3.80%, the swaption collar will be preferred.
● The purchased receiver swaption will be preferred only if the swap rate is expected to be >
4.25% (the strike rate on the written payer swaption) to offset premium paid.
● This rate view is also consistent with the concern about lower corporate bond yields and the
relatively high hedging ratio.
Example 8 Defeasing callable Bond = write receiver swaption (p. 89)
Question:
● The corporation currently has enough cash assets to retire the bonds, but it will be
prohibitively expensive. Still want to defease the bonds though.
● The 10yr fixed-rate bonds are callable at par value in three years. This is a one-time call
option (if do not exercise, bonds are then non-callable for remaining time to maturity)
● Corporationʼs CFO anticipates higher benchmark interest rates in the coming years (i.e.
bonds price decreases), so the strategy of investing the available funds for 3yrs and then
calling the debt is not feasible because the embedded call option will be out of the money
when the call date arrives.
● Consultant suggests buying a 10yr non-callable, fixed-rate corp bond and use a swaption
to mimic the characteristics of the embedded call option and the combo can defease
● Should the corporation buy a payer swaption or receiver swaption or write payer swaption or
receiver swaption? The contracts are an option to enter a 7yr int rate swap in 3yrs.
Answer: callable bond = built in receive fixed swaption, so you want to write a receiver swaption
to defease it and get the premium.
!. Should choose to write a receiver swaption. Gives the swaption buyer the right to enter
into a swap to receive fixed and floating, which means for the corporation to receive
floating and pay fixed. When the corporation issued the callable bond, it effectively
bought a call option (giving corp the flexibility to refinance at a lower cost of borrowing if
benchmark rates and/or corpʼs credit spread narrows = receive fixed). Writing the receiver
swaption “sells” that call option and gets the premium, which captures the value of the
 embedded call option.
#. Suppose that mkt rates in 3 years are higher than the strike rate on the swaption and the
yield on the debt security, then both options (the embedded call option as well as the
swaption) expire out of the money. The asset and liability both have 7 yrs until maturity and
are non-callable
$. Suppose that mkt rates in 3 years fall, and bond prices go up. Both options are now in the
money. The corp sells the 7yr bonds (the assets) and uses the proceeds to call the debt
liabilities at par value. The gain on the transaction offsets the loss on closing out the
swaption with the counterparty.
%. Potential risks to using swaptions:
a. Credit risk if swaption not collateralized (buyer of swaptions is exposed to credit risk of
the writer)
b. Collateral exhaustion risk if itʼs collateralized (if the corp exhausts its cash collateral or
mktable securities and cannot maintain the hedge)
c. Spread risk b/t swap fixed rates and the corpʼs cost of funds (value of embedded call
option in 3yrs depends on corpʼs cost of funds at that time, including its credit risk. The
value of the swaption only depends on 7yr swap fixed rates at that time)
Should I buy a payer swaption, write a receiver swaption, or buy enter a pay-fixed swap?
Which one will protect my portfolio against increasing int rates but will not produce large
losses if rates decrease?
Most likely buy a payer swaption. Refer to the graph. Although all three choices would hedge
against rising interest rates, the potential losses on a payer swaption if rates fell would be limited
to the option premium and would not be potentially large with uncertain timing.
The potential loss on writing a receiver swaption if rates fell would be contingent on the
interest rate and would be uncertain until termination of the contract. You donʼt control the
outcome, the buyer of the swaption does.
Pay-fixed swap is incorrect because the amount of the potential loss if interest rates fell is
contingent on the interest rate and would be uncertain until termination of the contract with a
pay fixed swap.

Leveraged Fixed Income portfolios:

Return on total funds invested = [borrowed funds * (return on invested funds – cost of
borrowing) + initial equity * return on invested funds]/ initial equity
Equity duration * equity = Asset duration * asset – Liability duration * liability, where liability =
borrowed funds
The following methods of leverage may be used to increase portfolio returns relative to an
unleveraged portfolio:
(1) futures contracts, (2) swap agreements, (3) structured financial instruments, (4) repo
agreements, and (5) securities lending.

Bullet v Barbell v Laddered:

– Bullet: Concentrates the bonds at a particular point on the yield curve. Lowest convexity,
so better if you expect yields to stay stable. Takes advantage of steepening yield curves (a
widening spread indicates a steepening YC)
– Barbell: Places bonds at the short-term and long-term ends of the curve. Has the highest
convexity, and has the most reinvestment risk, so better if you expect yields to become
more volatile. Takes advantage of a flattening yield curves (a narrowing spread indicates
a flattening yield curve). This is because the price on the longer-term maturities increase
while the price on the shorter-term maturities decrease but at a much smaller amount.
– Under normal market conditions and an upward sloping yield curve, a low volatility
environment dominates the landscape. Donʼt want bonds with convexity in a low
volatility environment. You would not want this feature that comes at a cost of a lower
yield. So a barbell portfolio will underperform under this scenario.
 – I.e. barbell better when more volatile.
– Laddered: Spreads the bonds maturities and par values evenly along the yield curve
– Convexity of barbell > Convexity of laddered > Convexity of bullet, so
– Cash flow reinvestment risk of barbell > ladder > bullet
Carry Trades/YC Strategies Summary:
Assuming normal, upward sloping YC,
● Lend at long end and borrow at short end on the relatively steep curve.
● Lend at short end and borrow at long end on the relatively flat curve.
● Receive fixed/pay floating (increase duration) in the steeper market and pay fixed/
receive floating (reduce duration) in the flatter market
● Take a long position in bond futures in steeper market and a short futures position in
the flatter market
Carry Trades:
Given two upward-sloping yield curves that are both expected to remain stable, an inter-market
carry trade can be constructed to avoid currency risk by simultaneously buying and selling both
currencies. The choice of the trades depends on which yield curve has the steeper slope,
which in this case is the bund yield curve. For swaps, one should pay floating/receive fixed
in the steeper market (bunds) and pay fixed/receive floating in the flatter market
(Treasuries). For futures, one should take a long position in the futures in the steeper market
(bunds) and a short position in the futures in the flatter market (Treasuries).
– The steeper curve has a greater difference between the long rate and the short rate than
the flatter curve does.
– The floating payments will increase faster than on a flatter curve (hope is they donʼt change
at all)
Butterflies:
A Butterfly with long wings and short body has positive convexity (long higher convexity
barbell, short lower convexity bullet). Benefits from flattening of YC. Since convexity is more
valuable in more volatile rate environments, this long wing butterfly also generates a small
additional profit if interests are more volatile than the mkt is currently pricing
A Butterfly short in the wings (short barbell) and long bullet is a trade predicated on a view of
stable interest rates (selling convexity) or on a YC steepening. If the mkt is pricing in an
expectation for vol while the PM believes that rates will be stable, convexity is useless, so sell
convexity and earn higher yield.
MBS and Convexity:
MBS has negative convexity, which means itʼs more sensitive to increase in rates and less
sensitive to decline in rates than Treasuries because, as int rates rise, prepayments of the
underlying mortgages decline, lengthening the duration of the MBS and making it more
sensitive to rising rates. As int rates fall, prepayments of the underlying mortgages rise,
shortening effective duration of MBS and decreasing its sensitivity to declining rates.
Inter-Market Curve Strategies BB4 (p. 175):
My expectations: 1. Yield spreads on Greek bonds relative to other Euro countries to tighten
substantially over next few years. 2. With Euro rates extraordinarily low, a significant portion of
the spread tightening may result from a general rise in the Euro yield curve.
3mo 6mo 2yr 10yr
Greek gov 1.56% 5.21% 5.91%
German gov -0.92% -0.72% -0.66% 0.43%
EUR swap -0.33% -0.25% -0.15% 0.79%
Bonds and fixed side of swaps pay annually, Floating side of swaps pay semi-annually at 6mo
rate. Yields are annual w/ annual compounding
Should I buy Greek 2yr (4.75% coupon, price=99.18) or the Greek 10yr (3% coupon, price =
78.86). Or should I do an asset-swap, in the case of 10yr, pay fixed at 3% timed to match the 3%
annual coupon from the bond and receiving a spread to the 6mo floating rate. The asset swap
can be done at a spread of 220 bps (pay fixed, receive floating of LIBOR+2.2%).
!. Convergence Trade: there are 2 YCs. Greeceʼs outstanding obligations implicitly trade on
the new drachma curve. As long as Greece remains in EU the new drachma is one-to-one
with euro. However, if Greece were to leave EU and pays its debt in new drachma the parity
will be broken. The higher yields being demanded on Greek bonds reflect the marketʼs
assessment that a new drachma would be worth substantially less than one euro
#. Tradeoffs: Greek 2yr bond vs. Greek 10yr bond
a. 2yr appear safer than 10yr, as it provides higher CF (4.75% vs 3% coupons), shorter
duration, and a shorter period exposure to Greeceʼs uncertainties. Also, 2yr offers higher
spread over German bond and the EUR swap compared to Greek 10yr
b. However, the 10yr offers a higher yield and greater opp to benefit from the view that
spreads will tighten. Longer duration = greater potential gains if Greek yields decline, even
if German yields and EUR swap rates rise. Longer maturity also means that the 10yr bond
can capture the currently high Greek yield for 10yrs while 2yr earns the current yield for a
much shorter period.
$. Tradeoffs of doing the Asset swap: allows me to make separate decisions w.r.t. overall
duration and spread duration.
a. Since I expect Euro yield curve to rise, I donʼt want to add overall duration to my
portfolio.
b. But on the other hand I want to reap as much benefit as I can from my view that Greek
spreads will tighten. So I should buy the 10yr Greek bond and pay fixed/receive
floating on the swap to neutralize the overall duration impact (reduce duration)
c. In addition, the asset swap allows the position to profit on both sides of the expected
spread tightening – lower Greek yields and/or higher EUR swap rates.
d. The asset swap though means you have to give up CF since even with a 220 bps spread
to the 6mo rate, the floating payments will initially be well below the 3% coupon on the 10yr
bond: LIBOR + spread = -0.25% + 2.20% = 1.95%
e. The fixed rate swap payments offset the coupons on the bond, so the floating rate
payments (received) are also the net interest flow
Inter-Market Positioning BB5 (p. 179). But I just copied s2000magician on Reddit:
In a nutshell (assuming two normal yield curves, though it can be extrapolated to more):
● On each curve, create a duration-neutral, currency-neutral carry trade
○ Start with a currency-neutral, very long / very short carry trade (say, buy 30-year
bonds, sell 2-year bonds); it won't be duration neutral
○ Add a currency-neutral, mid-long / mid-short inverse carry trade (say, buy 10-year
bonds, sell 20 year bonds), with the negative of duration of the first carry trade
○ Make sure that the profit on the carry trade exceeds the loss on the inverse carry trade
○ Make sure that the maturities you use are the same on both curves
● Now do the inter-market stuff
○ Looking at each of the maturities that you used in the single-market trades, make
equal-maturity inter-market trades
◆ Net positive yield pickup
◆ Currency-neutral
○ Note that these trades are (essentially) duration-neutral because you're trading equal-
maturity bonds
● Calculate your net positive / negative positions in each bond and pull the trigger
IG vs HY:
HY: credit risk (default risk & loss severity), higher liquidity risk, more affected by spread
changes
IG: int rate risk, credit migration risk (risk of downgrade, if so, many institutions will not hold
them anymore), spread risk (spread widening due to macro events like recessions, market value
decreases), more affected by risk-free rate changes
IG: the correlation between credit spreads and the risk-free interest rate is negative.
Spread risk is a function of credit migration. For IG, the risk of credit rating migration (credit
deterioration) is greater than the risk of actual credit loss. Accordingly, credit spread volatility, as
opposed to outright credit default loss, is a more relevant consideration as it relates to IG.
Spread duration measures the credit spread volatility risk in a portfolio of IGs.
CDOs:
– CDOs are securities whose underlying cash flows are the interest and principal of the
underlying debt instruments that are pledged as collateral.
– Whenever the value of a CDO is different from the value of its underlying collateral (in this
example, the CDO value is lower as implied by the BB rating of its underlying debt
instruments), an arbitrage opportunity exists.
– In this example, the trade opportunity is to (1) short (alternatively, purchase credit default
swaps on) the underlying bonds and (2) purchase the undervalued CDO.
– The collateral for a CDO consists of its underlying corporate bonds. Accordingly, there is
no diversification benefit.
– The mezzanine tranche of a CDO increases by more than the senior tranche whenever
correlations increase (since if both are likely to default anyway, you should buy the higher
yielding tranche)
Tips:
– Liquidity influences fixed income pricing, but illiquidity enhances the portfolioʼs YTM
– Conversion factor (for CTD bonds) and yield betas are always in the numerator when
multiplied.
– Or, you divide the future BPV with the conversion factor, and divide again to get Nf
(which = multiplying in the numerator)
– When choosing asset to immunize multiple liabilities under normal expected YC, first
eliminate the portfolios that have less convexity than the liabilities. From the remaining
portfolios, you would choose the one with the lowest convexity (since theyʼll have highest
yield)
– Main advantage of contingent immunization is the flexibility to increase returns using the
surplus portfolio, which if successful, would increase cushion in meeting liability.
– Using corporate bonds will increase cost of immunization, as they have default risk.
Immunization assumes no defaults. Corp bonds also less liquid and subject to credit
spread risk —> increases cost of rebalancing —> increases costs of immunization
– Liabilities should be discounted by the IRR (aka cash flow yield) on the immunized
portfolio.
– Given expectations of strong economy and fewer corp defaults, I should decrease the
average credit quality of my portfolio. Lower quality bonds tend to outperform higher quality
bonds during periods of increased econ activity (higher yield).
– Given expectations of no change in ST int rates and rise of 2% in LT int rates, this would
decrease value of long duration bonds in my port, which decreases my overall port return.
So sell LT bonds, buy ST bonds.
– If a company wants to retire an outstanding bond issue, and it can likely be purchased for a
small premium over market value, there is no reason to engage in a more complicated and
likely more expensive retirement process using a cash flow-matching or duration-matching
strategy.
– Effective duration is used to measure the impact of a parallel change in the yield curve,
not a steepening in the yield curve.
– Determining the timing and location of credit cycle weakening is an important top-down
relative value consideration for global credit portfolio managers. Regional differences
exist in credit cycles, credit quality, sector composition, and market factors.
– Ratings of emerging market debt issuers are typically concentrated in the low-IG/high-HY
range, which reflect the sovereign ratings of the countries in which they are domiciled.
Rating agencies typically apply a “sovereign ceiling” to corporate debt issuers, implying
that any debt issuer is normally rated no higher than the sovereign rating of its domicile.
 – Global differences in regulations and laws, such as bankruptcy laws, are a source of risk for
investors in international bonds. Non-domestic investors of a particular companyʼs bond
issuances face contractual rights that are less certain than those for domestic investors
in the event of debt restructurings.
– In anticipation of upward parallel YC shift, the duration of the fund should be reduced to
lessen the impact of price decline. The higher the coupon rate, the shorter the duration
will be, and the less sensitive the price will be to changes in interest rates.
–

Active vs. Enhanced Indexing vs. Pure Indexing:

When managing taxable FI portfolios,

– You SHOULD NOT minimize cap gains relative to cap losses because cap losses are
generally only used to offset cap gains. Cap gains is always the primary goal.
– You SHOULD WANT to minimize interest income relative to cap gains because cap gains
are typically taxed at a lower effective tax rate.
– You SHOULD WANT to dismiss attractive relative value trades due to tax implications.
Callable Bonds Z spread vs OAS
Z spread includes optionality while OAS takes out (adjusts for) optionality. Callable bondʼs
optionality is BAD for investor (called by company), so investor wants higher spread (z
spread) to compensate.
– So callable bondʼs Z spread > OAS
– Putable bondʼs Z spread < OAS

Trading
Quoted spread = diff b/t bid and ask spread
Midquote = midpoint between bid and ask prices = (bid + ask)/2
Effective spread = 2*(execution price – (bid + ask)/2)
If market is providing price improvement, effective spread < quoted spread
Trading Strategies:
!. Limit order: for value-motivated trades (less urgent & price sensitive), and for passive
traders who are rebalancing to indexes (they are price sensitive)
#. Market order: for info-motivated trades (need exec quickly), for liquid markets (high depth
- can absorb large order without significant price impact)
$. Principal trade order: broker will commit capital to facilitate the trade. Large volume,
prompt execution, minimal market impact, but hefty commissions in form of price
concession and fast execution. Suited for wide spreads and large orders.
%. Crossing network order: for less urgent orders (for matching buyers and sellers at end of
day), shares mostly held by institutions, anonymous (no info leakage), large trades
relative to ADV, large spreads mitigated by using broker or crossing system
Algo Trading Strategies:
!. VWAP: for low-urgency trades, for order sizes that are lower % of ADV (less price impact,
higher chance of success)
#. TWAP: assumes trading volume is constant throughout trading day, so trades executed in
equal proportion over the whole day.
$. Implementation Shortfall: for more urgent trades (higher volumes of the mkt at beginning
of the day; front-loading, aggressive), for order sizes that are smaller relative to ADV (less
price impact). Minimizes market impact costs and missed trade opportunity costs.
%. Opportunistic: passive trading, takes advantage of trading opps when they come up (I.e.
when illiquid security becomes liquid). Use this strategy if order size relatively large vs.
ADV. When urgency is NOT important. Uses broker or crossing system.
Trading Techniques:
– Advertise to draw liquidity: liquidity-enhancing used with IPO, 2ndary offerings, sunshine
trades, which publicly displays trading interest in advance of actual order. If publicity
attracts enough traders taking the opposite side, the trade might execute with little/no
market impact.
– Not for info-motivated traders as they want it executed quickly but this technique
doesnʼt guarantee immediate execution.
– Can bear the risk of others trading in front of the order - info leakage, increasing share
price
Higher Quality Market:
– Bid-ask spread: tighter spreads —> cost of trading small amounts is lower
– Market hours: open 5 days/week > 3 days/week. Greater convenience, more opportunity to
trade, increases liquidity
– Market depth: based on typical quotes given, a larger # of shares at each price level in the
order book —> cost of trading a large amount of shares is lower
– # of member firms: increased market liquidity due to larger # of buyers and sellers. Create
more competition and diversity of opinion
Higher: Corridor/Band Reason:
Correlations Wider ACs more likely to move in
sync, less likely to have
divergence from target AA
Transaction costs Wider Wider for benefits of rebal to
more likely > transaction
 Higher: Corridor/Band Reason:
Correlations Wider ACs more likely to move in
sync, less likely to have
divergence from target AA
Transaction costs Wider Wider for benefits of rebal to
more likely > transaction
costs.
Risk tolerance Wider Prefer to let overweighted AC
ride its momentum more to
profit more
Volatility Narrower Greater chance for AC weight
moving away from target AA,
so narrower width to remain
close to the optimal AA
Tips (ALWAYS USE THE GEOMETRY TO CALCULATE IS COMPONENTS, see BM price lower
or Decision price lower, plan accordingly):
If using %-of-port rebal method, if one AC is outside the tolerance band, all ACs would be
rebalanced to target weights
For Implementation Shortfall: OCD DBD MEDB.
OCD: (missed trade) Opportunity: |Cancellation - Decision| * # shares canceled
DBD: Delay: |Benchmark - Decision| * # shares later executed
MEDB: Market Impact: |Execution - Decision or Benchmark| * shares executed at that EP
I just remember that with OCD I use the unexecuted number of shares and DBD/MEDB I use the
executed number.
OCD? Dude, Big Deal, need MEDical attention Bro
What are the prices that we need to know to calculate implementation shortfall?
● Benchmark price (BP): The price that the manager sees and decides to buy/sell at (assume
that it's the closing price on the first day of a case/question set).
● Decision price (DP): This is the closing price on the day before any part of the order gets
filled, so it will be different for parts of the order that are filled on different days.
Wait, the "benchmark price" is the price that the manager sees and decides to buy/sell at,
but the "decision price" is something else?
● This is probably the most frustrating part of a very frustrating LOS.
● If you trade on Day 1, then DP = BP.
● But, think of DP as resetting every day, because the manager makes the decision to
continue to try and get his order filled.
● In the example that starts on page 24, the actually puts in a new order price, so that's a
pretty clear example of a new decision price being set.
● But the manager may just decide to keep the order open, in which case the decision price
 ●
resets without her putting in a new order price.
Whatever. If they try to pull crap like that on exam day, I'm going to start a riot. Anyway,
what are the other prices that we need to know to calculate implementation shortfall?
● Execution price (EP): The actual transaction price (for the portion of the order that actually
gets filled).
● Cancellation price (CP): The closing price on the day that the order is cancelled and the
remaining portion is unfilled.
● Implementation Shortfall (and especially Market-Adjusted Implementation Shortfall) can be
negative, which means that these costs can actually end up being a net benefit to you.
Implementation Shortfall using Paper Portfolio Method:
!. Calculate return on paper portfolio = (closing price - benchmark price) * all # of shares
ordered
#. Calculate cost of actual portfolio = sum of cost of individual legs (# shares * exec price) +
(# shares actually executed * exec fees)
$. Calculate value of actual portfolio = (# shares actually executed * closing price).
%. Calculate return on actual portfolio = value (step 3) - cost (step 2)
&. Implementation Shortfall ($) = Return on paper port - Return on actual port
z. Value of paper port at initiation = all # of shares ordered * benchmark price
{. Implementation Shortfall (bps) = Step 5/Step 6 = (return on paper - return on actual) /
paper port value at initiation
Implementation Shortfall using Component Method:
Kinloch enters a good-till-cancelled order to buy 30,000 shares of an equity, ticker SJTL, to the
trading desk with a limit of GBP 11.20 (decision price?) and a benchmark price of GBP 11.10.
Transaction costs are GBP 0.02 per share and the trade is executed in the following manner:
● 4 June: 15,000 shares are bought at GBP 11.12; SJTL closes at GBP 11.15.
● 5 June: 10,000 shares are bought at GBP 11.14; SJTL closes at GBP 11.25 and the remainder
of the order is cancelled.
DECISION PRICE RESETS TO PREVIOUS DAY CLOSING PRICE EVERY DAY.
Delay
4th 11.20 - 11.10/11.10 x 15/30 = 0.0045
5th 11.15 - 11.10/11.10 x 10/30 = 0.0015. —> 11.15 (previous dayʼs closing price) became the new
Decision Price.
Commission 
4th 15000x 0.02/30000x11.10 = 0.0009
5th 10000x 0.02/30000 x 11.10 = 0.0006
MTOC
11.25-11.10/11.10 x 5/30 = 0.00225
Realized Gain/loss
4th 11.12-11.20/11.10 x 15/30 = -0.0036
5th 11.14-11.15/11.10 x 10/30 = -0.0003003
I/S = Delay + Commission + MTOC + Realize G/L 
0.0045 + 0.0015 + 0.0009 + 0.0006 + 0.00225 - 0.0036 - 0.0003003

Performance Evaluation
Year Year-end Cash Flow Year-end Value (incl. year-
end CF)
2012 --- 90
2013 5 100
2014 5 110
2015 120 230
2016 –30 250
 2012 --- 90
2013 5 100
2014 5 110
2015 120 230
2016 –30 250
Calculating TWR = geometrically linking returns of 1+(EV - CF - BV)/BV
Calculating MWR; 250 = 90(1+MWR)^4 + 5(1+MWR)^3 + 5(1+MWR)^2 + 120(1+MWR)^1 -
30(1+MWR)^0
TWR vs MWR: There are only two reasons why MWR can be less than TWR:
!. A withdrawal prior to the fund value rising
#. A contribution prior to the fund decreasing in value
$. TWR more appropriate than MWR to evaluate investment perf of PM because he doesnʼt
have control over the timing and size of CFs into and out of the account.
Style Return = Benchmark Return - Market Index Return
– Note if Question says the fund uses a broad equity market index as its benchmark, the style
return = 0. Ignore any reference to risk-free rate!!
Active Return = Portfolio Return - Benchmark Return
Portfolio Return = Market Return + Style Return + Active Return —> P = M + S + A
How to judge if a portfolio is most appropriate for a client:
– If a client wants all his assets invested in a stand-alone energy sector fund, he doesnʼt have
a fully diversified portfolio. So total risk is most relevant, and thus Sharpe Ratio is the best
performance measure to use.
– If a client already holds a well-diversified portfolio, Beta risk is most relevant for a portfolio
in which nonsystematic risk has been diversified away already. So Treynor measure is the
most appropriate performance measure.
How to judge highest quality benchmark for a portfolio:
– Beta of portfolio relative to BM should be close to 1. Minimal systematic biases or risks in
the BM relative to the portfolio.
– Lowest tracking error —> the BM is mostly capturing the portfolioʼs investment style.
NRABIA: In macro attribution, stands for components of return and incrementally what you
receive:
• Net contributions (cash inflows)
• Risk free (lending @ RFR)
• Asset category (taking market risk)
• Benchmark (style/misfit return)
• Investment managers (going active)
• Allocation effect (sponsor-level plug)
Fund Attribution (Incremental Return Contrib):
Given:
Investment Fund Value Incremental Return Incremental Value
Alternative Contribution Contribution
Beginning value 104.56
Net contributions 105.77 0.00% 1.21
Risk-free asset 107.72 1.95
Asset category 115.7 7.98
Benchmarks 116.23 0.53
Investment managers 118.55 2.32
Allocation effects 120.33 1.78
Total fund 120.33 15.77
The incremental return contribution of the total fund is the total fund incremental value
contribution ($120.33 − $104.56 = $15.77 million) minus the net contributions ($1.21 million)
divided by the beginning value of the fund ($104.46 million).
Another Example (2015 AM Q5):
 Decision-Making Fund Value (in USD) Incremental Return Incremental Value
Level (Investment Contribution (%) Contribution/
Alternative) (Withdrawal) (in
USD)

Beginning value 360,000,000 --- ---

Risk-free asset 361,800,000 0.50 1,800,000

Asset category 388,872,000 7.52 27,072,000

Benchmarks 389,376,000 0.14 504,000

Investment managers 389,664,000 0.08 288,000

Allocation effects 389,304,000 –0.10 (360,000)
Total fund 389,304,000 8.14 29,304,000

● Did the fund outperform a pure index strategy? Yes. The fund wouldʼve returned 8.02%
with pure indexing strategy (cumulative return up to Asset Category level = 0.50% Rf
return + 7.52% AC return), which is less than actual return of 8.14%
○ This is because AC investment strategy assumes that the Fundʼs bgn value and
external CFs are invested passively in a combo of the designated AC benchmarks, with
the specific allocation to each benchmark based on the fundʼs sponsorʼs policy
allocations to those ACs, i.e. pure index fund approach.
● Return due to style bias = incremental return from Benchmarks = 0.14%
● Return due to active management = incremental return from Investment Managers =
0.08%
Fundamental Factor Model Micro-attribution:
– “Active impact” = active value contributed by the factor.
– Compare port exposure to normal exposure to see overweight/underweight
– “Value added thru active mgmt.” = Actual port return – normal port return
Macro attribution analysis requires: portfolio returns, valuations, external CFs, and policy
allocations (to determine normal weightings for each AC and individual manager), and
benchmark returns (to adequately evaluate the value added by the managers).
Micro attribution:
!. Pure sector allocation return = (Portfolio weight – Benchmark weight) × (Benchmark return
– Benchmark total return)
#. Within-sector allocation return = Benchmark weight × (Portfolio return – Benchmark
return)
$. The allocation/selection interaction return = (Portfolio weight – Benchmark weight) ×
(Portfolio return – Benchmark return)
Micro attribution (total value-added return):
Sector: Portfolio Benchmark Portfolio Return Benchmark
Weight (%) Portfolio (%) Portfolio Return
Weight (%) (%)
1 20 30 −0.4 −0.7
2 40 30 3.8 4.2
3 10 20 2.4 2.6
4 25 20 5.4 2.92
Cash: 5 0 0.09 0
Note: DF fund manager has trading costs of 27 basis points.
The total value-added return is the weighted average of the managerʼs portfolio return minus
the weighted average of the benchmark return minus the trading costs.
Weighted average of managerʼs portfolio return: (20% × −0.40%) + (40% × 3.80%) + (10% ×
2.40%) + (25% × 5.40%) + (5% × 0.09%) = 3.03%.
Weighted average of benchmark portfolio return: (30% × −0.70%) + (30% × 4.20%) + (20% ×
2.60%) + (20% × 2.92%) = 2.15%.
Total value added return, rv = 3.03% − 2.15% − 0.27% = 0.61%.
Ratios:
M^2 is an extension of the Sharpe ratio which is a method of calculating risk-adjusted returns.
= Rf + SR * mkt stdev, so produces same ranking as Sharpe
Ex-post alpha & Treynor measure produces same ranking. They are based on systematic risk
(Beta)
Ex-post alpha = Actual return - predicted account return (predicted = Rf + Beta*(Market return -
Rf))
Treynor measure = (actual return - Rf) / Beta
Performance Attribution for Fixed Income:
– “Int rate mgmt effects” includes returns due to duration, convexity, and YC shape change
management and prediction and managerʼs value add
– “Other management effects” includes 3 components - sector/quality effects, security
selection, and transaction costs
– “Expected interest rate effects” is the E(R) of port based on the implied forward rates of
Treasury bonds calculated at the beginning of the period
– “Unexpected interest rate effects” is the difference b/t actual realized return of the port and
the expected int rate effects. E.g. a positive one would be unexpected falling yields that
werenʼt predicted by the implied forward rates.
Type I H0RN: Type I error is rejecting null when itʼs correct
– Null = Manager adds no value/underperforms —> fire
– Ha = Manager adds value/outperforms —> hire
– If I change the level of stat significance from 15% to 5%, I reduce the probability of zero-
value-add managers being misclassified as a value-adding manager. I make it harder to
reject the null, therefore risk of committing a Type I error decreases.
– If I allow exceptions to manager guidelines, I increase tolerance for guideline violations —>
increases probability of retaining zero-value-add manager who otherwise wouldʼve been
fired. I made it easier to reject the null, so risk of committing a Type I error increases.
Good Benchmark:
The manager has a good benchmark when the manager can know what the constituents and
weights inside the benchmark are (Specified, Unambiguous), that it reflects their style
(Appropriate), and they can actual invest in the constituents (Reflects managersʼ Options/
expertise). The manager can only Accept accountability/Own it when all of those are true.
FAILING all that, the benchmark itself is only really good if if it is Measurable (which is pretty
much always even if it's an absolute value) and Investable (passively).
Custom security based BM is the best (meets all 7 properties)
– Specified in advance: Benchmark is known to all at start of evaluation period. E.g. so
comparing to average manager in a universe is NOT specified in adv
– Appropriate: The BM should accurately reflect the managerʼs performance style
– Measurable: You must be able to measure the results
– Unambiguous: A good benchmarkʼs components should be known (clearly defined
identities and weights of securities constituting the BM), so multi factor models are NOT
unambiguous.
– Reflective of managerʼs current investment expertise
– Accountable: Manager should agree that the benchmark is an appropriate measure and be
accountable for it
– Investable: You should be able to replicate and invest in a benchmark
Bad Benchmark example: median of a universe of HFs with similar mandates
– Itʼs not specified in advance
– The appropriateness of the benchmark style cannot be verified
– It is MEASURABLE however
– It is ambiguous
– It doesnʼt reflect current investment opinion
– Manager is not accountable; he isnʼt aware and canʼt accept accountability because itʼs not
specified in advanced
– + it is subject to survivorship bias (bonus!)

Misc
Day count & compounding conventions vary among different financial instruments, there are 3
variations in the CFA curriculum:
All LIBOR Based contracts (FRA, SWAP, caps & floors,...) => 360 days per year and simple
interests (i.e. multiply r by 'days/360)
Equity, Bonds, Currencies, stock options =>365 days per year and periodic compound interest
(i.e. raise (1+r) to an exp of 'days/365')
Equity indexes => 365 days per year and continuous compounding (i.e. raise e to an exponent
of 'r x days/365')