Helpful Notes

CFA Level III
#21

Mneunomic Phrases

1. Seriously did I make adjustments? - Steps in Risk Mgmt

Set Policies and Procedure

Define Risk Tolerance

Identify Risk

Measure Risk

Adjust Risk based upon advantage

2. MULCH - Specify Asset Class

Mutually Exclusive

Uncorrelated

Liquid

Comprehensive in totality

Homogenous

3. FACE - ID (Committee)

Feedback mechanism - prompt and acurate

Agenda - Stick to it

Clear choice after Debate

Encourage Debate

Independent Opinion

Diverse Group

4. SAMURAI

Specificed in advance

Accountable

Measurable

Unambiguous

Reflective of Mgr opinion

Appropriate

Investable

5. Expect Real Models In Every Place Man (Capital Mkt Expectations)

Expect - Expectations are set which include time horizon

Research - The historical Records

Models - are specified as well as method

In - Info is appropriate frequency, used best sources to get it

Every - Environment interpreted and make sure forecasts make sense when put together

Place - Provide finish expectations

Man - Monitor actual and compare to forecast to improve process

6. E-TEA Phone Home (How ERM system is judged)

Effective

Transparent

Efficient

Accountable

7. Emotional - LOSERS

Loss Aversion

Overconfidence

Self Control

Endowment

Regret Aversion

Status Quo

  1. RICH C ognitive belief persistance

Representative

Illusion of control

Conservatism

Hindsight

Confirmation

#22

131. Exotic options are european style

Binary option will pay off fixed amount when they touched immediately and represents highly leveraged position.

132. Call on Price Currency is a Put on base currency. Options are always in reference to base unless otherwise stated.

133. Macro Hedge = Hedge entire portfolio with an index

134. If long in currency A and short in currency B and A&B are highly correlated you will have a natural hedge.

135. 2 Beliefs you must have to choose active:

A. Successful active mgmt is possible

B. You have the skill to select the successful manager

136. Tail Risk = Risk in emerging markets that gov directly intervenes via market intervention or capital controls. Can use nondeliverable forwards to get around this risk which always net in a developed country. So if asked the gain on a nondeliverable forward make sure you convert the gain to the developed currency

137. Excess kurtosis and neg skewness in emerging markets due to contagion, panicked unwiding of carry trade when currency pegs break

138. Certainty overconfidence - belief of success is too high and belief of failure is too low this leads to excessive turnover

Prediction Overconfidence - Set too narrow of a confidence interval or don’t provide a range of outcomes at all which results in a poorly diversified portfolio due to underestimating risks.

139. Myopic Loss Aversion - combines loss aversion, time horizon framing and mental accounting

Occurs due to people evaluating portfolio annually and focusing too heavily on annual gains or losses (framing reference rate as previous years statements to determine gain/loss) which results in focusing on short term and ignoring long term. This causes a higher equity risk premium for the whole market.

140. Consequence of Self Control problems - Insufficient saving, accept too much risk to make up for poor savings, have asset allocation imbalance problems as they focus on income producing securities to provide income to spend more.

#23

141. A con of BB&K is it measures how investors approach life which may be completely different from how they approach investing. Investors will change as they age and may not fit the mold. Biases have both cognitive and emotional aspects. Risk tolerance questionaires usually do not consider behavioral biases and are better suited towards institutional investors who are less likely to be emotional.

142. Technical analysis can provide value by taking advantage of short-term over and underreactions to new data

143. If required return is inconsistent with risk will need to state that you have to counsel investors to either moderate required return (by reducing costs of living, working longer) or by increasing willingness to tolerate risk (if they have the ability)

144. If port has dominant equity portion, does not use options and is long term you can use shortfall risk

145. Make sure when calulating a port after-tax return you consider that muni returns are not taxed

146. 2 Drawbacks of monte-carlo when used by practitioners and 2 improvements

A. Relies on historical data —> Use forecasted data

B. Looks at only asset class returns —>Model specific assets

147. Cap Weight Pro - macro consistent, CAPM consistent, does not require rebalance if div/split, gold standard for indexing (float weighted) Con - Less diversification, possible concentrations that mgr may find unnaceptable, exposed to bubbles

Price Weight Pro - simple and long history. Con - not macro consistent, does not match typical port construction, splits change weights

Equal Weight Pro - small cap bias and more diversification Con - less liquidity, higher turnover, periodic rebalancing required, sell winners buy losers

Fundamental Weight Pro - small cap bias, more representative of economic importance CON - less diversified and reflect creators view of valuation

148. Classical immunization causes price and reinvestment risk to offset

Port YTM = Immunization Target return if yield curve is flat

Port YTM > Immunization Target Return if yield curve is upward slowing

Port YTM < Immunization Target return if yield curve is downward sloping

149. 3 Options that the SHORT in an interest rate futures contract possesses

A. Quality Option - can choose which bond to deliver

B. Timing Option - Can determine when in month to deliver

C. Wild Card Option - Can give notice of intent to deliver up to 8pm night before

150. Interest rate options are more liquid, more cost effective, and easier to short vs. cash market

#24

151. Max Drawdown = LARGEST (High point - subsequent low)

152. Act of God/terrorism/input errors = Operational Risk

Use wrong model / model not predictive = model risk

153. Any OTC vehicle has largest potential credit risk in the middle with the exception of Currency Swaps, Forwards or zero coupon bonds which have largest potential credit risk between middle and end

At beginning credit risk analysis has been done which mutes potential credit risk

At end most payments have been made reducing potential credit risk

154. Factor Push - Worst possible combo of variables

Worst-Case Scenario - Worst possible combo analyst thinks is likely

Max Loss Opt - Variable that produces max loss

155. Stressing models (above) can highlight weaknesses in risk mgmt process and are useful in addition to VAR

1 56. caps and floors are OTC and pay 1 month in arrears just like Libor Calls/Puts on interest rates

157. Delta hedging - port return will equal rf if done perfectly (rare as delta changes with passage of time and change in underlying)

158. If Volatility is expected to increase use options instead of forwards/futures as vega (volatility) is the only unobservable input in calculating option price and as volatility increases options become more valuable. Cannot separate vega from gamma/delta

159. Theta = time decay , gamma measures delta sensitivity and is greatest near expiry and when option ATM. Delta moves away from 0 as option becomes more in the money. This is why a put option has a greater change in value when the underlying decreases and a call has a greater change in value when the underlying increases because the option is becoming more in the money and the delta is moving away from 0 and thus becoming more sensitive to changes in the underlying

160. Costs for Swaps/Forwards/Zero cost Collar

Opportunity costs and administrative costs

#25

161. Generally the first period of a loan is unhedged as the rate is known at initiation however the first period could be hedged if the hedge were made in anticipation of a future loan.

162. Generally futures are on the price return not the total return

163. Managed Futures (A subset of maco hedge funds) have positive skew as they earn alpha due to behavioral underreaction to new info. They also have lower transaction costs. They EXCLUSIVELY trade in derivative markets which is what distinguishes them. The GP who runs the fund is called a commodity pool operator. Categorized by style (Trend / Contrarian), market (financial/currency), or Strategy (rules based, discretionary). Cannot have a passive approach as derivatives are zero sum in nature. More regulated than hedge funds. Less STDDEV than stocks but more STDDEV than bonds. Better Sharpe than equity worse sharpe than bonds.

164. Bad Economy = More opportunities for distressed debt. But a recession will also cause distressed debt to take a beating as credit spreads widen.

165. Prepackaged banktruptcy = PE Firm (Vulture Investor) acquires debt of failing company in banktruptcy, gets representation on board, makes concessions to stay in business and keep most valuable assets. Receives equity in new company in return and becomes majority shareholder of new company. Previous shareholders lose everything this is an active approach.

166. True rf asset has known return and std dev of 0 which a TBill doesn’t have over multiple periods as rf changes over time. Should treat rf as any other risky asset unless told otherwise. All ports will be on the efficient frontier use corner ports.

167. Historical volatility of hedge funds persists but not historical returns

168. Commodities do well in crises and exhibit positive event risk

169. Annual Sharpe / (SQRT(12)) = monthly sharpe

170. Survivorship most relevant for hedge funds and not relevant for fund of funds.

#26

Wow…not studying till friday…just gonna binge on this thanks

#27

171. Hedge fund Risk Adj Return Metrics (have to use because sharpe is useless if nonnormal returns)

Calmar Ratio = Port Return / (Max Drawdown)

Sterling Ratio = Port Return / (Avg Annual Monthly Drawdown - 10%)

Gain Loss Ratio = (# Up months / # Down months) * (Avg Up Return / Avg Down Return)

172. Ways sharpe can be gamed

Compound returns on top and have std. dev be noncompound

Lengthening Sharpe measurement period

Smoothing returns by buying illiquid assets or by using special total return swaps to smooth volatility (receiving negative skew in return for less STDDEV)

173. Using options to hedge against an increase in interest rates before taking out a loan you will want to use a call option so you gain if rates rise to offset the loss you will experience due to paying higher interest rates

174. Look through leverage on hedge funds. If borrow 100 and have 100 in equity monthly return will be (220 - 200) / 200

175. Translation exposure is if you have a foreign subsidiary and you want to hedge balance sheet volatility

176. FS (1, 3) Swaption = 1 year swap option, 2 year underlying swap

177. A total return swap can be used to diversify a concentration but you can have a cash flow risk as well as basis risk if the concentration does way better than the index the total return swap is based on as you will have to pay the net performance between the two in cash which you might not have if you just have one huge concentration

178. CAN ONLY COMPARE VAR IF SAME TIME ELEMENT DO NOT IGNORE TIME ELEMENT

179. % of Port Rebalance = Interval Rebalance = % Range Rebalance

Set same tolerance band for all asset classes ignores differences in liquidity and transaction costs between asset classes

Requires frequent monitoring and rebalances WHOLE PORT if just ONE asset class is out of range

Exercises tighter control

180. If a hedge did not work out perfectly despite following the formula it could be because

Futures contract was mispriced

Beta/Duration was an incorrect estimate

Beta exhibited mean reversion to 1 (can calc effective beta and compare to previous beta to see if this the case)

#28

181. Dynamically hedge - change hedge ratio to over or under hedge to add convexity (Think CPPI)

182. Flat or unknown volume and you want to use a VWAP based? Use TWAP which evenly spaces it out based upon time

183. Roll’s Critique of the CAPM/Treynor/Alpha:

Can have majorly different estimates depending upon what index is used for mkt port

Using indexes overstates the performance of a passive alternative as they don’t consider the transaction costs

CAPM underlying assumptions and single index nature are questionable

Stability of managers beta can change over time and is merely an estimate of historical risk taken.

184. If Quoted Spread > Effective Spread then dealers are providing price improvement otherwise market impact.

185. Opportunistic participation seeks to take advantage of liquidity by providing it to those who needs it. Pegging/discretion not a true participation strategy.

186. One of the ways to assess a persons willingness to take risk is to look at how their portfolio is currently allocated

187. If time horizon is perpetual do not forget to state "Single Stage"

188. Legal Liability (bank, defined benefit, life insurance, casualty) decreases ability to take risk

189. Geometric smoothing rule places greater emphasis on recent market values. A dramatic return 3 years ago can still have a big impact on 3 year avg rule while not so on geometric

190. An increase in interest rate lowers the roll yield. A increase in convenience yield increases the roll yield

#29

191. The credit risk on currency swaps is bilateral. The default risk on an OTC is not isolated between the two parties on the contract because if either party defaults on an obligation to a 3rd party and declares banktruptcy the swap may then go into default

192. Grinold Kroner = (Div Yield + Repurcase Yield) + Inflation + Real Earn Growth + Repricing Return (beneficial change in P/E)

Grinold Kroner = Income Return + Nominal Earnings Growth + Repricing Return

If a company buys back (decreases) shares this is a positive for shareholders (obviously) thus it will add to return

193. Daily/Weekly Data = Short Term forecast Quarterly/Annual Data = Long term forecast

194. If Market A is highly correlated with Market B and Market B is highly correlated with Market C. Market C cannot be negatively correlated with Market A

195. Possible problems with econ data: IMF Reports econ data for emerging countries with huge time lags. Methods and definitions can change and indexes can be rebased.

196. High frequency data (weekly/daily) produce lower correlation estimates

197. Time Series data is useful for short term forecasts and can capture VOLATILITY CLUSTERING which is low volatility followed by low volatilty and high volatility followed by high volatility.

198. Major advantage of multi-factor model is ability to establish consistency efficiently. If first layer is consistent the layers that feed into it will be consistent

199. YTM on a zero coupon bond is a superior estimate of the total returns in fixed income

200. Inflation premium is one of the most volatile elements of interest rates that is based upon EXPECTED FUTURE INFLATION

#30
  1. The Fed Bank prefer some inflation for monetary flexibility during low periods

202. Growth Policies of a good Gov

Sound Fiscal Policy - Long term deficit close to 0

Minimal Private Sector intrusion by gov

Competition is encouraged (Bad for profits, good for GDP) (openness to foreign investment, no tarriffs)

Infrastructure and Human Capital Development Encouraged (Build roads, encourage education)

Tax Policies are Broad based and not redistributive they are simple

203. 8 Emerging Market Warning Signs

Monetary Fiscal Policy - Greater than 4% fiscal deficit to GDP ------Greater than 80% Debt/GDP

Economic & Currency - Lower than 4% GDP Growth ------ Current account financed with Debt

External Debt - Greater than 50% foreign Debt / GDP -------Greater than 200% Debt / Current Acct Receipts

Liquidity - Less than 100% Reserves / Short Term Debt

Political - If any of the above warning signs flash red then governments willingness or lack therof to make necessary reforms are what will matter

204. Econometric mode l (Think Top Down Approach) Pro - Challenges prior views, maintains degree of consistency, good at forecasting upswing

Con - Complex, time consuming, relies on personal judgement and historical info that may change, not good at forecasting downswing

205. TIPS - Real Yields rises and falls with real economic growth. If inflation becomes volatile and is expected to increase demand for tips will increase and (due to supply and demand) yields will fall. They are a distinct asset class because they do not have inflation premium volatility which is the largest part of nominal bonds volatility

206. Molodovsky Effect - P/E for cyclical companies low at peak and high at bottom

Low inflation increases P/E because earnings are more real

Slow growth lowers P/E

207. PPP - Long term parity relationship which asserts that changes in inflation will be offset by currency movements. It gains more importance when investors don’t believe a deficit can be financed without printing money.

208. Relative Econ Strength (CARRY TRADE EXPLAIN)

Shorter term relationship

Better Economic growth increases inflation and thus increases rates which causes investors to borrow their currency and buy higher yielding debt causing the currency to increase.

209. Capital Flows (Cut Interest Rates, Boosts Stocks, Boosts Currency) (AKA WHAT HAPPENED IN 2009 with US QE)

Inflow to gain attactive stock returns boosts currency

Shorter term Relationship

210. Savings-Invest Imbalance

Medium Term Relationship that explains longer term divergences with PPP but not easy to use

Economic expansion will need to be financed by money. If investors aren’t saving enough to finance the current expansion they will need foreign dollars which will cause the currency to strengthen. Eventually it will strengthen to a point where the stronger currency impacts their export/import mix and causes the economy to slow which will then decrease the currency as the Demand for investment will be less than domestic saving.

#31

211. Government can only control exchange rates with capital controls or interest rate policy changes

212. Best Expecution

A. Tied to strategy cannot be viewed independent from strategy

B. Must measure after the trade

C. Cannot evaluate just one trade over a short period of time. Must be over a longer period

213. Trading is a process

A Establish policy on best execution evaluation

B Disclose to clients and prospects the policies as well as conflicts of interest

C Maintain proper records

214. Market Adjusted Implementation Shortfall = Implementation Shortfall - (Change in Market * Stock Beta)

215. Delay costs are the largest part of trade costs and are the least visible

216. Bid - Ask, Price impact of large trades, delay/slippage are implicit trading costs

217. Costs of trading correlated to:

A. Stock Liquidity

B. Risk

C. Order Size / Avg. Daily Trade Vol

D. Momentum - (More costly to buy in uptrending mkt)

E. Order Type - (Limit less expensive than mkt)

218. Pretrade analysis is an econometric approach to estimate cost in order to guage right trade size and assess execution quality.

219. Electronic Limited Order =Automated Auction = Electronic Communication Network (ECN)

This is the same as a crossing network but it OPERATES CONTINOUSLY and provides PRICE DISCOVERY wheras a Crossing network does NOT provide price discovery which leads to PARTIAL FILLS

Benefits of both: Low Cost, Good for Illiquid Stocks, Provides anonominty

220. Broker = Agent = Provides secrecy and finds willing parties = best used for large block trades. Can cause info leak.

#32

221. Mid Quote = (Bid + Ask) / 2

Effective Spread = ABSOLUTE VALUE OF ( Execution Price - Mid Quote ) * 2

Weighted effective spread is weighted by shares traded

222. Con of VWAP

A. Not informative if Trade = Large % of Daily Volume

B. Can be gamed by evenly trading throughout the day or delaying trade

223. Natural Liquidity = Extensive pool of knowledgable buyers and sellers

224. Factors that Contribute to Quality market / Liquidity

A. many buyers and sellers who have different opinions

B. Easy and convenient to trade

C. Fair and honest market via effective regulation

D. Low Bid Ask Spread

E. Large Quoted Depth

F. Market Price = Intrinsic Value AKA Market is “Reslient”

225. 3 purposes of a market - Liquidity, Transparency, Assurity of Completion

226. Market Not Held - broker can decide when and at what price

Participate (Do not initiate) - Broker waits until demand initiated from other side

Best Efforts - Floor broker has most discretion

227. Undisclosed Limit Order = Iceberg = hidden reserve —> Hides max quantity of limit order

Mkt Open/Close order’s motivation is that this is when liquidity is typically the highest

Port Trade = Whole port traded at once, low cost because its obviously not an info trade

Principal Trade = Broker transacts with dealer at a discount for an urgent block of stock

228. Purpose of Manager Continuation Policy - Type 1 Error = Keeping bad manager

A. Retain superior, remove inferior

B. Minimize turnover

C. Consistency

D. Ensure Qualitative assesment is given more weight than Quantitative

229. Direct Market Access is for small liquidity motivated trades

330. Benchmark Quality Test

A. Beta relative to bench are similar on average over long period of time (not just at present moment, its ok to deviate short term)

B. High coverage ratio, large % of securities in bench are in portfolio

C. More overweights in ports relative to bench than underweights

D. Low Tracking Error

E. (Style Bench - Broad Bench) is uncorrelated with (Port - Style Bench)

F. (Style Bench - Broad Bench) HIGHLY correlated with (Port - Broad Bench)

#33

331. Info Trader/Mutual Fund ------ Liquidity at any cost -----Broker for large bloc principal Trade ---- Con is huge cost and possible info leak

Illiquid Security Sale ------ Need Agent ----broker trades over time receive details when complete ----con is high commission, motivation revealed, and lose control over trade

IPO/Secondary offering ----- Advertise to Draw Liquidity -----Little market impact get fair price ------con is difficult and costly to administer also possible front running

Passive/Value Traders ---- Low cost whatever liquidity ----- limit order ----- Con is execution uncertainty

332. Fixed Income attribution is expensive and only used by large managers, it can lead to spurious correlations

333. Passive traders use index and trade via limit order/ ECN/Cross network natural counterparty is Value traders who trade based upon research and us limit, ECN, and cross network.

334. Liquidity traders raise cash, its beneficial that their motivation be known, use market order, ECN, and crossing networks because they can tolerate partial fills. Their natural counter party is info traders who are trying to hide their intentions and use market orders, brokers via principal trade and “manual handling” they cannot tolerate partial fills.

335. Business spend is the most volatile part of GDP. Foreign trade is most important for small econ.

336. Only Deliberate Fiscal Policy counts. If lower tax revenue during recession due to unemployment this isn’t a deliberate fiscal boost.

337. Leading indicators Pro - easy and available. Con - Can give false flags, historical relationships can change

338. Assuming recent history will continue = Naive extrapolation = status quo = halo effect

339. Growth Illusion in Emerging Markets

A. Growth already reflected in prices

B. Poor corporate governance squanders shareholder wealth

C. Labor captures the growth benefit via higher wages

D. Growth concentrated in government owned/private corporations

340. Use H-Model for emerging market to avoid compounding forecasting errors due to frequent regime changes and long departures of corporate profits from GDP

#34

341. 10 Year Moving Avg. P/E - Earnings and the Price index are restated using CPI

Pro - Considers full business cycle

Con - backward looking little predictive power, does not consider accounting changes

342. Cobb Douglas = constant returns to scale and TFP is not directly observable in national income

343. Pro of using experience based asset allocation = easy and cheap and consistent with other approaches. Con is it may be too simple for some investors and its possible to produce contradictions

344. Benefits of Segmentation for Insurance ALM

A. Accurate way to estimate product profit

B. Aids in managing interest rate risk

C. Provides focus for meeting return objective

D. Assists regulators and management in determining suitability

Con of too many segments = can create control issues and lead to suboptimal results

345. Covered calls can psychologically prepare investors for disposal. They won’t protect fully against downside but the income can provide some downside buffering

346. Short Sale against the box - Cheapest monetization technique but you don’t get dividends of underlying. Usually can borrow 100% LTV, earn rf rate, and no counterparty risk

347. Equity Forward Cons are must be constantly rolled over, roll yield issues, counterparty risk

348. Total Return Swap - Counterparty Risk, get the dividends, rf rate earned, costlier than short sale, basis/cash flow risk

349. Forward conversion with options = Long Put + Short Call on same underlying at same strike, equivalent to a short forward but without the counterparty risk, earns rf rate, has premiums instead of roll yield

350. Internal inconsistency in the tax codes is the reason monetization tools provide value.

#35

Gotta go for the night I will finish this tommorow. Have about 50 points left. And also have GIPS notes, and Asset Manager Code Notes

Ethics you can’t really take notes on you just have to do every question you can get your hands on until you puke then eat your puke and keep going.

#36

#someonesgonnaoweyouaBJforallthis

#notme

#37

Thanks a ton.

#12 is incorrect though. It should be

FV = [(1+R)(1-T)]^n

#38

^^ its correct… look carefully.

#39

^^ its correct… look carefully.

#40

#12 is correct. T = Tax rate