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Inflation affecting risk objective

I was quite caught off guard by Schweser book 2 Exam 1 morning Q5. We are asked to analyse a foundation, nothing out of the ordinary. Question 5B then askes about how inflation affects the foundation’s risk objective.

Obviously, I sticked with what I have learnt meaning that (while return objective is naturally affected by inflation as it is incorporated in calculating required return) there shall be no impact on the risk objective as the risk objective for a foundation solely from the ability to take risk.

The answer however recognises a need for maintaining intergenerational equality (first time I have ever heard of that aspect and I have read Schweser 3 times + x) and therefore maintaining the real value of the portfolio requires taking additional risk.

Has anybody more insights on this argument? To me this argument still raises only a need for a higher required return rate. If this return rate can be achieved then would depend on the fundation’s ability to take risk. But the ability to take risk would not be changed.

What is the difference between the risk objective and risk tolerance? Is there a difference defined in the CFA curriculum?

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Risk tolerance is the ability to take risk.

Risk objective is one of 7 IPS objectives/constraints.

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Yes, so what do I do to state a risk objective besides analysing the overall risk tolerance?

in this sense, risk objective goes in line with return objective. (more return generally requires more risk). so this is what I think schweser is saying in that regard. since the return objective is going to be higher when inflation goes up, we might have to accept a higher risk exposure.

now, according to curriculum, risk objective IS risk tolerance (which is composed solely of ABILITY and WILLINGNESS to take risk), if our ABILITY and WILLINGNESS to accept risk is low, our risk objective is low. in conclusion, I think schweser needs to clear up the terminologies.

“An individual’s risk objective, or overall risk tolerance, is a function of both ability to take risk and willingness to take risk.”

(Institute 174)

Institute, CFA. 2018 CFA Program Level III Volume 2 Behavioral Finance, Individual Investors, and Institutional Investors. CFA Institute, 07/2017. VitalBook file.

Thanks Edbert! From my review of the Schweser script I would make the following differentiation in considering that for institutional investors ALM for instance might be part of the risk objective and should be stated there but might not be relevant for the risk tolerance itself. I hope I will encounter in the next days an essay question that will make this point clearer for me.

Regarding the inflation I still have no convincing idea on why this should affect risk objective. To me it would be more appropriate to include if the question was about how the actual risk taken might be affected (under the assumption that risk tolerance is not constraint for higher risk)

In a sense, inflation increases the NEED to take risk, in order to maintain the real value. Now, need may be different from ability and willingness to take risk but it still needs to go into the IPS risk objective.

So from that perspective, the risk objective is broader than just risk tolerance. 

The risk objective is measurable.

For example:

  • Ratio of plan assets to plan liabilities ≥ 100% for a DB pension plan
  • Mean return less two standard deviations ≥ −5%
  • Volatility (standard deviation) of returns ≤ 10%
  • And so on

Simplify the complicated side; don't complify the simplicated side.

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