Question 5 B CFA 2011 morning (3 reasons that all sound the same)

I have run into these type of questions more than once, and was wondering if anyone else is having issues with this type of thing…

So they ask three reasons based on Finnegan’s circumstances why ALM is more appropriate than AO… i struggled and could really only come up with the fact that she has that mortgage due …

They say

  • Mortgage payment is crucial because missing it could result in loss of home
  • Mortgage payments are interest sensitive so assets should be as well to hedge this risk
  • ALM is better for loss averse investors with below avg risk tolerance (can someone show me where this is explicitly stated?)

Now to me, statement one and two are pretty much the same damn thing, they both relate to ALM being necessary due to the fact that she has a liability in the form of a mortgage, therefore the portfolio should take that into account. I have seen problems like this all over the curriculum that basically stretch one point into six different ones, how are we suppose to answer this? I mean shit, by this logic I could say:

  • There is a liability due so the portfolio should be managed in this context to meet the liability
  • The liability is interest rate sensitive so assets should be
  • The liability results in ongoing negative cashflow so liquidity should be ample to account for this
  • The assets maturity should be around the liability maturity
  • The PV of assets should equal PV liabilities
  • The Durations should be equal

Yes, i know I am being vague and repeating, but it seems they are too, this kind of stuff really aggravates me.

Oh and also, on the next part (#5 C)

“Finnegan is young and has a large amount of human capital relative to financial capital” seems like an odd reason to decrease the investment amount in equities… I am not quite sure I get it?

Obviously the correlation between human/financial capital needs to be minimized and/or negative, that much I got, but the first part is just confusing to me.

in answer to your question Mark

What types of investors gravitate to an ALM approach? In general, the ALM approach tends to be favored when:

  • the investor has below-average risk tolerance;
  • the penalties for not meeting the liabilities or quasi-liabilities are very high;
  • the market value of liabilities or quasi-liabilities are interest rate sensitive;
  • risk taken in the investment portfolio limits the investor’s ability to profitably take risk in other activities;
  • legal and regulatory requirements and incentives favor holding fixed-income securities; and
  • tax incentives favor holding fixed-income securities.

Pg 230 Bk 3

Yes, stuff like this is annoying, but remember CFAI states that these are guideline answers are often more detailed than would be required for full credit on an examination. Guideline answers may also include an alternative approach(s) that received full credit.

So, your answers could potential receive full credit.

Also, in regard to the three bullet guideline answer “ALM is better for loss averse investors with below-avg risk tolerance” this is because ALM approach results in portfolios with higher allocations to fixed-income which is a typical allocation for investors with below-average risk tolerance.

If I remember the question correctly, Finnegan states that once she gets a new job, she expects it to be highly correlated with equities. So, since she is young, the size and correlation of her human capital is equity-like therefore it needs to be reduced.

I guess they are literally looking for cut and paste replies out of the book. Good thing this test emphasizes logic and practical application rather than rote memorization…

oh wait.

My point is that I don’t see two reasons, I see one reason… the human and financial capital should not be correlated therefore she should put more of her portfolio in bonds since her human capital is equity like.

I don’t understand what being young and having large human capital relative to financial has to do with it. Typically saying someone is young is an argument for more equity, not less (with exceptions, obviously, such as in this case where she has equity like human capital) .

In nutshell the two reasons CFAI gives are

  1. High correlation

  2. Being young

1 is acceptable, But 2 is not clearly. Then then they have only one reason!

In nutshell the two reasons CFAI gives are

  1. High correlation

  2. Being young

1 is acceptable, But 2 is not clearly. Then then they have only one reason!

The question ask at the moment, so being job lost may be another reason (whether it is HC related is arguable)