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Level III Guidelines Answers 2018
Level III Guidelines Answers 2018
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Question: #1
Topic: Equity
Minutes: 20
Reading References:
#26 − “Introduction to Equity Portfolio Management,” James Clunie, and James Alan Finnegan
#27 − “Passive Equity Investing,” David M. Smith and Kevin Yousif
#28 − “Active Equity Investing: Strategies,” Bing Li, Yin Luo, and Pranay Gupta
#29 − “Active Equity Investing: Portfolio Construction,” Jacques Lussier and Marc Reinganum
LOS:
#26: The candidate should be able to:
a. describe the roles of equities in the overall portfolio;
b. describe how an equity manager’s investment universe can be segmented;
c. describe the types of income and costs associated with owning and managing an equity portfolio and their
potential effects on portfolio performance;
d. describe the potential benefits of shareholder engagement and the role an equity manager might play in
shareholder engagement;
e. describe rationales for equity investment across the passive–active
spectrum.
Question: #1
Topic: Equity
Minutes: 20
The passive investment approach is appropriate for the Fund’s portfolio for the following three reasons:
• The passive approach typically has low turnover and generates lower capital gains relative to active
strategies. Since the Fund is taxed on investment income, the passive approach would likely result in lower
taxes.
• The Fund’s investment committee members believe that equity markets are highly efficient, suggesting that
a manager’s ability to generate alpha may be limited. An efficient market with limited alpha generation
potential supports the use of the passive investment approach.
• The Fund’s investment committee mandates that the portfolio shall have minimum tracking risk. The
passive approach provides low tracking risk relative to an active approach. In particular, indexing has the
goal of minimizing tracking error, subject to realistic portfolio constraints.
The value of the Fund’s equity portfolio is EUR 150 million and is large enough to follow a full replication
approach of the FTSE Eurotop 100 Index. The constituents of this index are the top 100 large capitalization
European equities, which are likely liquid and available for trading. The full replication approach requires owning
each of the securities in the benchmark portfolio. Tracking error is likely to remain low since the number of
constituents in this index is not large.
Stratified sampling is less appropriate since it does not track the index as closely as full replication, which would
result in higher tracking error relative to full replication. The board prefers not to use sophisticated algorithms that
are difficult to understand, making the optimization approach less appropriate.
Bottom-up
Discretionary
i. Active risk
High
High
#14 – Capital Market Expectations by John P. Calverley, Alan M. Meder, CPA, CFA, Brian D.
Singer, CFA, and Renato Staub, PhD
LOS:
#14: The candidate should be able to:
a. discuss the role of, and a framework for, capital market expectations in the portfolio management
process;
b. discuss challenges in developing capital market forecasts;
c. demonstrate the application of formal tools for setting capital market expectations, including
statistical tools, discounted cash flow models, the risk premium approach, and financial equilibrium
models;
d. explain the use of survey and panel methods and judgment in setting capital market expectations;
e. discuss the inventory and business cycles and the effects that consumer and business spending and
monetary and fiscal policy have on the business cycle;
f. discuss the effects that the phases of the business cycle have on short-term/long-term capital
market returns;
g. explain the relationship of inflation to the business cycle and the implications of inflation for cash,
bonds, equity, and real estate returns;
h. demonstrate the use of the Taylor rule to predict central bank behavior;
i. interpret the shape of the yield curve as an economic predictor and discuss the relationship
between the yield curve and fiscal and monetary policy;
j. identify and interpret the components of economic growth trends and demonstrate the application of
economic growth trend analysis to the formulation of capital market expectations;
k. explain how exogenous shocks may affect economic growth trends;
l. identify and interpret macroeconomic, interest rate, and exchange rate linkages between economies;
m. discuss the risks faced by investors in emerging-market securities and the country risk analysis techniques
used to evaluate emerging market economies;
n. compare the major approaches to economic forecasting;
o. demonstrate the use of economic information in forecasting asset class returns;
p. explain how economic and competitive factors can affect investment markets, sectors, and specific
securities;
q. discuss the relative advantages and limitations of the major approaches to forecasting exchange rates;
r. recommend and justify changes in the component weights of a global investment portfolio based on trends and
expected changes in macroeconomic factors.
The risk premium on the Edonia equities is 6.1%, which is calculated in three steps.
Step 1: Risk premium of Edonia equities under full integration (RPEE, full int)
RPM
RPEE, full int = σ EE ρ EE , M + i = 30% × .50 × .28 = 4.2%
σM
where,
σEE = standard deviation of returns of Edonia equities (given as 30%)
ρEE,M = correlation of Edonia equity returns to GIM portfolio (given as 0.50)
RPM/σM = Sharpe ratio of the GIM portfolio (given as 0.28)
i = illiquidity premium (not required for a developed market)
Step 2: Risk premium of Edonia equities under full segmentation (RPEE, full seg)
RPM
RPEE, full seg = σ EE + i = 30% × .28 = 8.4%
σM
where,
σEE = standard deviation of returns of Edonia equities (given as 30%)
RPM/σM = Sharpe ratio of the GIM portfolio (given as 0.28)
i = illiquidity premium (not required for a developed market)
Lyon also expects the percent change in shares outstanding to increase compared to her previous estimate. Based
on the Grinold-Kroner model, when the percent change in number of shares outstanding increases, the expected
rate of return on equity decreases, and hence the equity risk premium, all else equal.
Both indicators will cause a decrease in the expected return on equity, and hence the equity risk premium.
Factors that are consistent with higher inflation expectations are as follows.
• Consumer Confidence Index: Rising consumer optimism suggests that near-term consumer spending will
increase. Consumer spending represents a sizeable portion of GDP in many developed countries and is an
important business cycle factor. Consumer confidence survey data are watched closely as indicators of
whether consumers are more likely to buy more goods, driving up prices. When consumer confidence is
rising, inflation is more likely to increase.
• Inventory/Sales Ratio: The inventory/sales ratio has been trending down and is expected to continue to
decline. When the inventory/sales ratio declines, the economy is likely to be stronger as businesses try to
rebuild inventory. A strong economy often leads to higher inflation.
• Output gap: The output gap is defined as the difference between actual GDP and potential GDP scaled by
potential GDP. Exhibit 3 shows that output gap has been closing and is expected to become positive as a
proportion of potential GDP, and therefore spare capacity of the economy is forecast to decline. This
implies higher inflationary pressure.
LOS:
#13: The candidate should be able to:
a. contrast a defined-benefit plan to a defined-contribution plan and discuss the advantages and disadvantages
of each from the perspectives of the employee and the employer;
b. discuss investment objectives and constraints for defined-benefit plans;
c. evaluate pension fund risk tolerance when risk is considered from the perspective of the plan surplus, 2)
sponsor financial status and profitability, 3) sponsor and pension fund common risk exposures, 4) plan
features, and 5) workforce characteristics;
d. prepare an investment policy statement for a defined-benefit plan;
e. evaluate the risk management considerations in investing pension plan assets;
f. prepare an investment policy statement for a participant directed defined-contribution plan;
g. discuss hybrid pension plans (e.g., cash balance plans) and employee stock ownership plans;
h. distinguish among various types of foundations, with respect to their description, purpose, and source
of funds;
i. compare the investment objectives and constraints of foundations, endowments, insurance
companies, and banks;
j. discuss the factors that determine investment policy for pension funds, foundation endowments,
life and non-life insurance companies, and banks;
k. prepare an investment policy statement for a foundation, an endowment, an insurance company,
and a bank;
l. contrast investment companies, commodity pools, and hedge funds to other types of institutional
investors;
m. compare the asset/liability management needs of pension funds, foundations, endowments,
insurance companies, and banks;
n. compare the investment objectives and constraints of institutional investors given relevant data, such as
o. descriptions of their financial circumstances and attitudes toward risk.
The maximum spending rate that will allow the Foundation to preserve the portfolio’s real value is calculated using
the following formula.
Rearranging terms to solve for the spending rate and using the expected nominal return for the nominal return level,
we can calculate the maximum feasible spending rate.
• The Foundation is the sole source of funding for the local youth centers and the high
degree of reliance decreases its ability to suffer losses.
• The Foundation is not expected to receive new donations and therefore fully relies on its
investment portfolio returns to cover the operating budget and required spending
distribution.
• The Foundation has a high spending requirement relative to its average return.
i. low ability
to take risk.
• The long-time horizon of the Foundation, indicated by the Foundation’s stated desire to
operate long into the future, increases the ability to take risk as it gives the Foundation
ample time to recoup short-term investment losses
• While the youth centers depend on the Foundation’s distributions for their funding, this is
not a defined liability of the Foundation; it is simply a goal. Similarly, the tax-exempt
status, while also a goal, is also not a legally defined requirement. Because neither of these
are binding requirements for the Foundation, it has a higher ability to take risk.
A foundation’s cash reserve should include both anticipated and unanticipated needs for cash. The new spending
requirement policy effectively forces the Foundation to increase its cash reserve. With the new policy, monthly
asset values will be used instead of a beginning of year value, so the distribution amount is unknown at the start of
the year. The potential for unanticipated cash needs increases, making higher cash reserves necessary.
Overconfidence bias occurs when people demonstrate unwarranted faith in their own abilities. Richard exhibits this
in two ways:
• Richard’s belief that his outperformance would continue despite not outperforming in the past indicates
overconfidence. This is an example of overconfidence bias that occurs when the probabilities assigned to
outcomes are too high because individuals are too certain of their judgments.
• Richard maintains a poorly diversified portfolio, with 50% of total assets held in 5 companies, versus the
more diversified mutual fund and index funds. When estimating the future value of a stock, investors with
overconfidence bias will incorporate too little variation – using a narrower range of expected payoffs and a
lower standard deviation of returns – than justified based on historical results and fundamental analysis.
Such an investor may underestimate the risks, particularly downside risks, and consequently hold a poorly
diversified portfolio.
i. Sara
sell
ii. Patrick
sell
less than +/− 10% equal to +/− 10% greater than +/− 10%
The decision to moderate or adapt to a client’s behavioral biases depends on two factors: the standard of
living risk / level of wealth (high or low) and the type of bias (emotional or cognitive).
Sara, with a high standard of living risk, is at risk of failing to achieve her goals, so her behaviorally modified
portfolio should be closer to a mean-variance optimized portfolio. In addition, because her bias is cognitive
(representativeness), better information can help to correct it (i.e., moderating the bias is more likely to be
successful). As such, with the appropriate education, Sara should be able to adjust her behavior and tolerate a
portfolio that more closely matches a rational (mean-variance optimized) allocation. This would lead Sara to have a
portfolio with less than a + / − 10% difference in her asset class weights to the rational allocation.
LOS:
#12: The candidate should be able to:
a. discuss the purpose of estate planning and explain the basic concepts of domestic estate planning,
including estates, wills, and probate;
b. explain the two principal forms of wealth transfer taxes and discuss effects of important non-tax issues,
such as legal system, forced heirship, and marital property regime;
c. determine a family’s core capital and excess capital, based on mortality probabilities and Monte Carlo
analysis;
d. evaluate the relative after-tax value of lifetime gifts and testamentary bequests;
e. explain the estate planning benefit of making lifetime gifts when gift taxes are paid by the donor, rather
than the recipient;
f. evaluate the after-tax benefits of basic estate planning strategies, including generation skipping, spousal
exemptions, valuation discounts, and charitable gifts;
g. explain the basic structure of a trust and discuss the differences between revocable and irrevocable
trusts;
h. explain how life insurance can be a tax-efficient means of wealth transfer;
i. discuss the two principal systems (source jurisdiction and residence jurisdiction) for establishing a country’s
tax jurisdiction;
j. discuss the possible income and estate tax consequences of foreign situated assets and foreign-sourced
income;
k. evaluate a client’s tax liability under each of three basic methods (credit, exemption, and deduction) that a
country may use to provide relief from double taxation;
l. discuss how increasing international transparency and information exchange among tax authorities affect
international estate planning.
The Gondos’ total estate is EUR 16 million. Bert is entitled to the greater of:
• One-half of the increase in the value of the total estate during the marriage under community property:
(EUR 16 million – EUR 6 million) x 0.50 = EUR 5 million, or
• One-third of the total estate under forced heirship:
EUR 16 million / 3 = EUR 5.33 million
Therefore, the minimum amount Bert is entitled to, before considering estate taxes, if Emma were to die today, is
the greater of his share under community property and forced heirship, which is EUR 5.33 million.
The Gondos’ three children are collectively entitled to one-third of the total estate under forced heirship. Assuming Emma
were to die today, the estate tax is computed as:
The value of the total estate, on an after-tax basis, is EUR 16,000,000 – EUR 6,200,000 = EUR 9,800,000.
The three children are collectively entitled to one-third of the EUR 9.8 million which equals EUR 3,266,667
(EUR 9,800,000/3). Each child would receive EUR 1,088,889 (EUR 3,266,667)/3.
Tax considerations favor the Gordon making annual gifts for the following reasons:
• By making annual gifts of EUR 30,000 over the next five years, the Gondos and Erica can avoid paying gift
taxes.
• Since Erica’s income tax rate is lower than that of the Gondos and her pre-tax investment returns are
assumed to be the same as that of the Gondos, the future after-tax value of any gifted amount will be greater
than if this amount stayed in the Gondos’ estate.
• The value of the Gondos’ taxable estate is lowered as a result of the annual gifts. Since it is assumed that
Erica’s estate will not be subject to estate tax, the gifts further reduce any future estate taxes for the Gondos.
Life insurance can be used as a planning tool in which the policy holder transfers assets (via premiums) to an
insurer. The insurer has a contractual obligation to pay death benefit proceeds to the beneficiaries named in the
policy.
The purchase of a life insurance policy on himself would provide Bert and his family with the following two
benefits:
• Upon Bert’s death, the death benefit proceeds could be used to pay estate taxes. Having the insurance policy
proceeds addresses Bert’s concerns about a potential lack of liquidity to pay estate taxes upon his death, and
for possibly having to sell shares of the family-owned business.
• The payment of insurance premiums would serve to reduce the value of the estate, which would result in
lower future estate taxes, particularly since death benefit proceeds paid to life insurance beneficiaries are tax
exempt.
A trust is an arrangement created by a settlor or grantor, in this case, the Gondos, who transfers assets to a trustee.
The trustee holds and manages the assets for the benefit of the beneficiaries (Emma and the three children). In a
revocable trust arrangement, the settlor retains the right to rescind the trust relationship and regain title to the trust
assets. Under these circumstances, the settlor’s revocation power makes the trust assets vulnerable to the reach of
creditors having claims against the settlor. An irrevocable trust structure generally provides greater asset protection
from claims coming from outside of the family against a settlor than a revocable trust.
The establishment of an irrevocable trust would provide the Gondos with the following three benefits:
• Protection of the assets within the trust from claims outside the family, such as potential creditors. Bert
wants to secure a financial future for Emma and their three children and worries about claims coming from
outside of the family.
• Avoids disputes within the family (among his wife and three children).
• Transfer of assets to his wife and children without the potential publicity associated with probate. Bert
prefers to keep family’s financial affairs private.
LOS:
#8: The candidate should be able to:
a. discuss how source of wealth, measure of wealth, and stage of life affect an individual investors’ risk
tolerance;
b. explain the role of situational and psychological profiling in understanding an individual investor’s attitude
toward risk;
c. explain the influence of investor psychology on risk tolerance and investment choices;
d. explain potential benefits, for both clients and investment advisers, of having a formal investment policy
statement;
e. explain the process involved in creating an investment policy statement;
f. distinguish between required return and desired return and explain how these affect the individual
investor’s investment policy;
g. explain how to set risk and return objectives for individual investor portfolios;
h. discuss the effects that ability and willingness to take risk have on risk tolerance;
i. discuss the major constraint categories included in an individual investor’s investment policy statement;
j. prepare and justify an investment policy statement for an individual investor;
k. determine the strategic asset allocation that is most appropriate for an individual investor’s
specific investment objectives and constraints;
l. compare Monte Carlo and traditional deterministic approaches to retirement planning and
explain the advantages of a Monte Carlo approach.
The Hidalgos’ funding goal for next year is to both meet next year’s net cash needs and maintain the after-tax, real
size of their post-donation portfolio. The maximum donation they can make today that will satisfy this funding goal
is ORP 535,455.
Inflow:
Ordinary income × (1 + inflation rate) × (1 – tax rate) =
250,000 × (1 + 3.0%) × (1 – 25%) = 193,125
Outflow:
Living expenses × (1 + inflation rate) =
280,000 × (1 + 3.0%) = 288,400
Next year’s net cash needs:
Outflow – Inflow: 288,400 – 193,125 = 95,275
• Calculate the minimum size of the portfolio (min Portfolio) that can meet next year’s net cash needs using the
expected real after-tax return (2.75%):
min Portfolio × net expected return = next year’s net cash needs
min Portfolio × 0.0275 = 95,275
min Portfolio = 3,464,545 = 95,275 / 0.0275
• Calculate the maximum donation (max Donation) that can be made today based on the difference between the
existing portfolio size and the minimum portfolio size that can meet next year’s net cash needs:
• The Hidalgos have a concentrated equity position. This is likely to make their portfolio
more volatile, thus would reduce their ability to take risk in the remaining portfolio.
• The donation to the research organization will reduce the size of the investment portfolio.
A smaller portfolio puts more pressure on remaining assets to produce the same cash flow.
• They have a liquidity need from the portfolio because their living expenses exceed their
income.
• Juan’s recent disability would prevent him from working which reduces future human
capital.
i. low ability
to take risk.
• The Hidalgos have ten years remaining before Mariana plans to retire. This is a long-time
horizon, giving the portfolio time to recover from an unexpected drop in value.
• Mariana’s pension will be able to cover at least some of their expenses in retirement. This
reduces the minimum return required from the investment portfolio to support them in
retirement.
• Their income and expenses are expected to remain stable, growing at the expected inflation
rate. This leads to a stable shortfall which will be reevaluated at retirement.
• Even though the Hidalgos’ home is excluded from their investment portfolio, it remains an
asset that could be utilized if necessary, particularly since it is mortgage-free.
i. return objective.
The recommended portfolio meets the return objective.
The recommended portfolio’s real after-tax rate of return of 5.6% is greater than the 4.5% return objective.
Alternative answer:
The recommended portfolio’s pre-tax nominal rate of return of 12.8% is greater than the 11.3% return
objective.
Reading References:
#22 – “Introduction to Fixed-Income Portfolio Management,” Bernd Hanke, PhD, CFA and Brian J. Henderson, PhD, CFA
#23 − “Liability-Driven and Index-Based Strategies,” James F. Adams, PhD, CFA, and Donald J. Smith, PhD, CFA
#24 − “Yield Curve Strategies,” Robert W. Kopprasch, PhD, CFA, and Steven V. Mann, PhD
LOS:
#22: The candidate should be able to:
a. discuss roles of fixed-income securities in portfolios;
b. describe how fixed-income mandates may be classified and compare features of the mandates;
c. describe bond market liquidity, including the differences among market sub-sectors, and discuss the effect of
liquidity on fixed-income portfolio management;
d. describe and interpret a model for fixed-income returns;
e. discuss the use of leverage, alternative methods for leveraging, and risks that leverage creates in fixed-income
portfolios;
f. discuss differences in managing fixed-income portfolios for taxable and tax exempt investors
The characteristics of a bond portfolio structured to immunize a single liability are that it (1) has an initial market
value that equals or exceeds the present value of the liability; (2) has a portfolio Macaulay duration that matches
the liability’s due date; and (3) minimizes the portfolio convexity statistic. Portfolio A is the most appropriate
portfolio to immunize the future liability. Since all three portfolios have approximately equal cash flow yields, we
can use the following three criteria to select the best portfolio for the immunization:
1. Market Value: The immunizing portfolio’s initial market value must equal or exceed the present value of the
liability. Portfolio A’s initial market value of USD 92,339,315 exceeds the outflow’s present value of USD
92,221,521. Portfolio B is not appropriate because its market value of USD 92,101,324 is less than the present
value of the future outflow.
2. Macaulay Duration: The immunizing portfolio’s Macaulay duration must closely match the due date of the
single liability outflow. Portfolio A’s Macaulay duration of 9.998 closely matches the ten-year horizon of the
outflow. Portfolio C is not appropriate because its Macaulay duration of 9.537 is furthest away from the
investment horizon of ten years.
3. Convexity: For given levels of Macaulay duration and cash flow yield, smaller convexity is preferable to
minimize structural risk. Minimizing convexity is the same as minimizing dispersion when considering
portfolios with similar Macaulay durations and cash flow yields. Reducing a portfolio’s dispersion reduces its
structural risk—the risk that yield curve twists and non-parallel shifts create duration gaps between the
immunization portfolio and the liability outflow. Although Portfolio C has the lowest convexity at 108.969, its
Macaulay duration does not closely match the outflow time horizon. Of the remaining two portfolios, Portfolio
A has the lower convexity at 119.079; this lower convexity will minimize structural risk.
Long Short
Calculate the number of futures contracts required to close the duration gap.
To determine the number of futures contracts required to close the duration gap, compute the money durations
for the liability and the immunization portfolio:
The basis point values (BPVs) can then be calculated for the liability and the immunization portfolio:
Nf ≈ 44 futures contracts
Since the money duration of the liability is less than that of the immunizing portfolio, Zerbe should short
44 futures contracts to close the duration gap.
The most appropriate portfolio is Portfolio 2. Barbell portfolios—combining securities concentrated in short and
long maturities, as in Portfolio 2—are typically used to take advantage of a flattening yield curve. Zerbe expects
the yield curve to flatten, with the twist pinned at the 10-year yield. That means the 10-year yield will remain
unchanged, while the 2-year and 5-year yields will increase, and the 30-year yield will decrease.
Although all three portfolios have similar modified durations, and therefore approximately the same change in
value for a parallel shift in the yield curve, the impact of Zerbe’s forecasted yield curve flattening will be most
advantageous for the barbell (Portfolio 2) and least advantageous for the bullet (Portfolio 1), with the ladder
(Portfolio 3) in the middle.
The only yield that falls, thereby creating a price increase, is that of the 30-year bond. Portfolio 2 benefits most
from the drop in the 30-year yield, while Portfolio 3 benefits less because of its smaller allocation to the 30-year
bond, and Portfolio 1 doesn’t benefit at all because it doesn’t hold any of the 30-year bond. For Portfolio 2, even
though the 2-year and 30-year yields change by the same absolute magnitude, the price impact on the 30-year bond
will be much larger than on the 2-year because the duration of the 30-year bond is much larger than that of the 2-
year bond.
Since the forecasted twist is pinned at the 10-year yield, the 10-year yield will not change; therefore, there is no
price impact on Portfolio 1 from this forecasted curve twist. Portfolio 3 will underperform Portfolio 2 for this yield
curve flattening, as it holds a smaller position in the 30-year bond, giving it less price increase than Portfolio 2.
Portfolio 3 also holds a larger position in the 5-year bond, which will cause some price decrease with the increase
in the 5-year yield.
The expected return on the fixed-income portion of Oswayo’s portfolio invested in Country X for the next year is
calculated as:
The E(change in price based on investor’s views of yields and yield spreads) term is equal to 0% since Zerbe
expects the yield curve and yield spreads in Country X to be unchanged over the year. Because Zerbe fully
hedges currency risk the expected gains or losses from currency, E(currency gains or losses), is also 0%.
#28 – Risk Management Applications of Forward and Futures Strategies by Don M. Chance, PhD, CFA
#29 – Risk Management Applications of Option Strategies by Don M. Chance, PhD, CFA
LOS:
#28: The candidate should be able to:
a. demonstrate the use of equity futures contracts to achieve a target beta for a stock portfolio and calculate and
interpret the number of futures contracts required;
b. construct a synthetic stock index fund using cash and stock index futures (equitizing cash);
c. explain the use of stock index futures to convert a long stock position into synthetic cash;
d. demonstrate the use of equity and bond futures to adjust the allocation of a portfolio between equity and debt;
e. demonstrate the use of futures to adjust the allocation of a portfolio across equity sectors and to gain exposure
to an asset class in advance of actually committing funds to the asset class;
f. explain exchange rate risk and demonstrate the use of forward contracts to reduce the risk associated with a
future receipt or payment in a foreign currency;
g. explain the limitations to hedging the exchange rate risk of a foreign market portfolio and discuss feasible
strategies for managing such risk.
If Yang hedges the foreign market return and the exchange rate movement, she can expect to earn the domestic
risk-free rate.
The original value of the USD 50,000,000 portfolio expressed in the domestic currency is:
USD 50,000,000 x spot rate (CVA/USD) = USD 50,000,000 x CVA 12.00 = CVA 600,000,000
If the domestic risk-free rate is earned, the value of the portfolio in one year is:
Alternative answer
Because the one-year forward rate is consistent with prevailing risk-free rates, covered interest rate parity holds so
we have:
𝐹𝐹
(1 + 𝑟𝑟𝑑𝑑 ) = � � (1 + 𝑟𝑟𝑓𝑓 )
𝑆𝑆
Where
rd = the domestic (Covina) risk-free rate
rf = the foreign (U.S.) risk-free rate
F = the one-year forward exchange rate quoted as CVA/USD
S = the spot rate quoted as CVA/USD
To completely hedge the US equity portfolio value in CVA, the risk of fluctuations in the value of the US equity
portfolio must be hedged. Yang cannot know the actual US equity return over the next 12 months. Therefore, Yang
would not know at the beginning of the 12 months the number of USD to sell forward. This might lead to either
over-hedging or under-hedging, depending on the change in the USD value of the portfolio.
Currency units:
Effective interest is equal to interest on the floating rate loan minus the interest payoff on the caplet.
Effective interest = Loan amount × (Libor on previous reset date + loan spread) × (days in settlement period / 360)
– Notional value of cap × Max (0, Libor on previous reset date – exercise rate) × (days in settlement period / 360)
Effective rate:
Effective rate = [(Loan amount + effective interest paid)] / Loan amount](360/days in settlement period) – 1.0
LOS:
#19: The candidate should be able to:
a. describe and critique the use of mean-variance optimization in asset allocation;
b. recommend and justify an asset allocation using mean-variance optimization;
c. interpret and critique an asset allocation in relation to an investor’s economic balance sheet;
d. discuss asset class liquidity considerations in asset allocation;
e. explain absolute and relative risk budgets and their use in determining and implementing an asset allocation;
f. describe how client needs and preferences regarding investment risks can be incorporated into asset allocation;
g. discuss the use of Monte Carlo simulation and scenario analysis to evaluate the robustness of an asset
allocation;
h. describe the use of investment factors in constructing and analyzing an asset allocation;
i. recommend and justify an asset allocation based on the global market portfolio;
j. describe and evaluate characteristics of liabilities that are relevant to asset allocation;
k. discuss approaches to liability-relative asset allocation;
l. recommend and justify a liability-relative asset allocation;
m. recommend and justify an asset allocation using a goals-based approach;
n. describe and critique heuristic and other approaches to asset allocation;
o. discuss factors affecting rebalancing policy.
Portfolio A Portfolio B
Based solely on expected utility, Sarzi should recommend Portfolio B since it results in higher expected utility.
The expected utility for each portfolio is calculated as follows:
Um = E(Rm) – 0.005λσ2m
The pension fund currently has a surplus of USD 2 billion (USD 10 billion – USD 8 billion) where USD
8 billion is the present value of the fund’s liabilities. To adopt a hedging/return-seeking portfolio approach, the
board would first hedge the liabilities by allocating an amount equal to the present value of the fund’s liabilities,
USD 8 billion, to a hedging portfolio. The hedging portfolio must include assets whose returns are driven by the
same factors that drive the returns of the liabilities, which in this case are the index-linked government bonds. So,
the board should allocate 80% (USD 8 billion / USD 10 billion) of the fund’s assets to index-linked government
bonds. The residual USD 2 billion surplus would then be invested into a return-seeking portfolio. Allocation 2 is
the most appropriate asset allocation for the fund because it allocates 80% of the fund’s assets to index-linked
government bonds, and the remaining 20% of fund assets in a return-seeking portfolio consisting of corporate
bonds and equities.
Goal 1 has a time horizon of 10 years and a required probability of success of 85%. As a result, Module B
should be chosen because its 5.0% expected return is higher than the expected returns of all the other modules.
The present value of Goal 1, discounted using the 5.0% expected return, is calculated as:
N = 10, FV = –USD 7,500,000, I/Y = 5.0%; PV = USD 4,604,349 (or USD 4.60 million)
So, approximately 46.0% of the total assets of USD 10 million (= USD 4.60 million / USD 10.00 million)
should be allocated to Module B.
For Goal 2, which has a time horizon of 25 years and a required probability of success of 75%, Module C should
be chosen because its 6.9% expected return is higher than the expected returns of all the other modules. The
present value of Goal 2, discounted using the 6.9% expected return, is calculated as:
N = 25, FV = –USD 15,000,000, I/Y = 6.9%; PV = USD 2,829,102 (or USD 2.83 million)
So, approximately 28.3% of the total assets of USD 10 million (= USD 2.83 million / USD 10.00 million)
should be allocated to Module C.
Finally, the surplus of USD 2,566,549 (= USD 10,000,000 – USD 4,604,349 – USD 2,829,102), representing
25.7% (= USD 2.57 million / USD 10.00 million), should be invested in Module A following Sarzi’s suggestion.
#32 - Monitoring and Rebalancing by Robert D. Arnott, Terence E. Burns, CFA, Lisa Plaxco, CFA, and Philip Moore
LOS:
#31: The candidate should be able to:
a. compare market orders with limit orders, including the price and execution uncertainty of each;
b. calculate and interpret the effective spread of a market order and contrast it to the quoted bid–ask spread as a
measure of trading cost;
c. compare alternative market structures and their relative advantages;
d. explain the criteria of market quality and evaluate the quality of a market when given a description of its
characteristics;
e. explain the components of execution costs, including explicit and implicit costs, and evaluate a trade in terms of
these costs;
f. calculate and discuss implementation shortfall as a measure of transaction costs;
g. contrast volume weighted average price (VWAP) and implementation shortfall as measures of transaction costs;
h. explain the use of econometric methods in pretrade analysis to estimate implicit transaction costs;
i. discuss the major types of traders, based on their motivation to trade, time versus price preferences, and preferred
order types;
j. describe the suitable uses of major trading tactics, evaluate their relative costs, advantages, and weaknesses, and
recommend a trading tactic when given a description of the investor’s motivation to trade, the size of the trade, and
key market characteristics;
k. explain the motivation for algorithmic trading and discuss the basic classes of algorithmic trading strategies;
l. discuss the factors that typically determine the selection of a specific algorithmic trading strategy, including
order size, average daily trading volume, bid–ask spread, and the urgency of the order;
m. explain the meaning and criteria of best execution;
n. evaluate a firm’s investment and trading procedures, including processes, disclosures, and record keeping, with
respect to best execution;
o. discuss the role of ethics in trading.
The report forecasts an increase in correlation between equities and fixed income. In a portfolio that has increased
correlation among asset classes, there is less chance of an asset class diverting from its target weight. As an asset
class increases in value, the other asset class will likely increase in value. Therefore, reduce the chance of
divergence. This supports widening the corridor width.
The report also forecasts that transaction costs for equity executions will decrease. If transaction costs decrease, the
costs of more frequent rebalancing decrease and the performance needed to compensate for the transaction costs is
lower. This supports a narrower corridor width. In addition, the forecasted increase in volatility for commodities
would also support having a narrower corridor width for equities, for similar reasons. All asset classes’ volatilities
would affect the optimal corridor in this multi-asset case.
Forecasts that support opposite actions do not permit a definitive conclusion to be drawn with respect to the equity
corridor width, making Kinloch’s conclusion correct.
ii. commodities.
The analyst report forecasts that volatility for the commodities will increase. In a volatile market, being off target
can lead to greater potential losses as further divergence from the strategic asset allocation becomes more likely.
This supports Kinloch’s conclusion of a narrower corridor width for commodities.
The implementation shortfall is the difference between the return on the paper portfolio and the actual (real)
portfolio return. The return on the paper portfolio assumes that the trade was fully executed at its benchmark price.
The cost of the actual portfolio is the cost of the individual legs plus any execution fees:
(15,000 × 11.12) + (10,000 × 11.14) + (25,000 × 0.02) = GBP 278,700
Therefore, the return on the actual portfolio is the difference between its cost and value:
281,250 − 278,700 = GBP 2,550
This makes the implementation shortfall equal 4,500 – 2,550 = GBP 1,950
The value of the paper portfolio at initiation is 30,000 × 11.10 = GBP 333,000
In relation to the paper portfolio this equates to a shortfall of 1,950/333,000 = 0.00586 = 59 bps
Alternate approach:
Implementation shortfall can also be broken down into commission cost plus three components.
The first component is delay costs or slippage which equals the cost of not trading shares over a day the order is
outstanding. The second component is realized profit and loss for the trades executed. The third component is
missed trade opportunity cost. Adding the commission cost plus all the components equals the implementation
shortfall.
i. HRET. IS
opportunistic
The case states that Kinloch wants to complete the trade before WPGS financial
results come out. This implies a degree of urgency which supports the use of an
implementation shortfall. The implementation shortfall algorithm is a front-
loaded strategy that can be adjusted to aggressively execute an order when the
VWAP order has a high urgency. Either VWAP or opportunistic strategies would be less
appropriate as the longer the trade takes to execute, the greater the chance of
increased opportunity costs.
ii. WPGS. IS
opportunistic