IPS - Liquidity Constraint question

CFA Level III
#1

Mock 2006 AM - Question 1.C

For liquidity constraint do you normally list out the annual reoccuring expense or just the 1 time purchases like buying a house? I think i’ve seen both and neither is wrong or preferred…

Also how come taxes due aren’t listed in liquidity constraints? I know there is a tax constraint section but you never have to list the amount due, you only have to list the tax rate that applies.

#2

The first type of spending (buying a house, etc) will usually be satisfied from liquidating part of the portfolio. It should be removed from the total wealth computation from the beginning. Some might also arise in later years. That’s what I would call liquidity constraints.

The annual recurring expenses are these that you would need to take into account to compute your return objective. Does it fall under the definition of liquidity constraint then?

There are also annual recurring expenses that are covered by recurring income that is not from the portfolio. They should be netted from the contributions to the portfolio (“non-portfolio income - annual expenses” come as a contribution to the portfolio each year).

These are no real answers to your questions. I am just suggesting points of consideration to answer them. I also fundamentally lack of methodology to address the problems of this chapter. I am looking forward to reading what everyone is saying about that.

#3

Main principle is that all significant cash flow events have to be taken into account within the liquidity req. section :

  • if it’s a one-off payment in the next 12 months, I deduct it from investable assets and mention it as a liquidity requirement

  • if it’s an ongoing need for cash, I mention it in the liquidity requirement and include in the RR calculation

That’s my view though

#4

ok thanks. Let’s keep an eye on this when we do some mocks to confirm.

Cheers

#5

Just to link our discussion to another recent thread which is quite challenging on the same topic:

http://www.analystforum.com/forums/cfa-forums/cfa-level-iii-forum/91349293

#6

I tend to agree with Sunseeker…that’s how I would tackle those two types of liquidity expenses.

#7

I am doing a mock exam right now and for your information they indicate as a tip below the answer “remember to include only spending requirements that must be met by the portfolio.” So for example if you have a significant one-off payment that is covered by a current cash account and therefor needs not be withdrawn from the portfolio, you won’t list it in the liquidity constraints. Or if you have living expenses that are covered by employment income, same

#8

Spending requirement … would that include distribution requirements by law for endowments/foundations? For example if they need to distrbute 5% of assets.

#9

Also just did this example 2009 Morning Exam #1.C

It lists the reoccuring annual expenses not covered by income during retirement…

#10

Regarding liquidity requirements: Are there any time horizon? Let’s say a person wants to refurbish a house in 2 years. Is that a liquidity requirement of too far into the future?

#11

I found a previous post which might answer the question.

“Liquidity & cash reserves are tricky and honestly CFAI isn’t entirely consistent with how they handle what goes in and what goes out but in general, liquidity is a cash outflow < 1-year. After 1-year it generally becomes more of a multi-stage investment horizon. Sometimes a cash-reserve is a long-term liquidity need but generally excluded from the asset base. Sometimes the CFAI text will have you take the PV of the 2 or 3 year liquidity need and invest it into cash like securities, othertimes they just set it aside without discounting it. The context of the question is, obviously, very important.”

#12

Liquidity is current term, not long term issue. If not required something else, upon liquidity constraint, it is considered ongoing year liquidity constraint with noted ongoing net outflows. Regarding cash reserve maintenance, it is rather noted upon liquidity constraint than excluded from asset base in calculating return requirement but it may appear there upon some circumstances which should be noted in a particular case.

#13

I checked once again. Seems both solutions will be pointed, deducting or not deducting cash reserve from an asset base. However, it must be noted under liquidity constraint.