CFA Level III Notes

Mark E. Oblad
For June 2010 Test

Reading 1: Code of Ethics and Standards of Professional Conduct

Standards of Practice Handbook

CFA Institute Professional Conduct Program:

• 2 basic principles: 1. fair process; 2. confidentiality
• Board of Governors  Professional Conduct Program  Disciplinary Review Committee: responsible for
enforcement of code and standards
• CFA Institute Designated Officer, Professional Conduct Staff: conduct inquiries:
o 1. self-disclosures, 2. written complaints, 3. media, 4. exam proctors
o 1. interview subject, 2. interview complainant, 3. collect docs
o No disciplinary sanction; cautionary letters; continue proceedings
o Designated Officer proposes discipline; if rejected then panel of CFA Institute members

Code and Standards:

• encourages firms to also adopt

Code of Ethics
I. Act with integrity, competence, diligence, respect, and in an ethical manner with the public, clients,
prospective clients, employers, employees, colleagues in the investment profession, and other participants in
the global capital markets.
II. Place integrity of the investment profession and the interests of clients above their own personal interests.
III. Use reasonable care and exercise independent professional judgment when conducting investment analysis,
making investment recommendations, taking investment actions, and engaging in other professional activities.
IV. Practice and encourage others to practice in a professional and ethical manner that will reflect credit on
themselves and the profession.
V. Promote the integrity of, and uphold the rules governing, capital markets.
VI. Maintain and improve their professional competence and strive to maintain and improve the competence of
other investment professionals.

Standards of Prof’l Conduct (7 items)

I. Professionalism
a. Knowledge of Law
b. Independence and Objectivity
c. Misrepresentation
d. Misconduct
II. Integrity of Capital Markets
a. Material Nonpublic info
b. Market Manipulation
III. Duties to Clients
a. Loyalty, Prudence, and Care
b. Fair Dealing
c. Suitability
d. Performance Presentation
e. Preservation of Confidentiality
IV. Duties to Employers
a. Loyalty
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 b. Additional Comp Arrangements
c. Responsibilities of Supervisors
V. Investment Analysis, Recommendations, and Actions
a. Diligence and Reasonable Basis
b. Comm’n w/ Clients and Prospective Clients
c. Record Retention
VI. Conflicts of Interest
a. Disclosure of Conflicts
b. Priority of Transactions
c. Referral Fees
VII. Responsibilities as a CFA Institute Member or CFA Candidate
a. Conduct as Members and Candidates in the CFA Program
b. Reference to CFA Institute, the CFA Designation, and the CFA Program
Reading 6: Asset Manager Code of Professional Conduct:

Intended to be adopted at firm level

General Principals of Conduct:

1. Act in a prof’l and ethical manner at all times
2. Act for benefit of clients
3. Act w/ independence and objectivity
4. Act w/ skill, competence, and diligence
5. Communicate w/ clients in a timely and accurate manner
6. Uphold rules governing capital markets

Asset Manager Code of Professional Conduct (6 parts):

A. Loyalty to Clients
1. Place client interests before their own
2. Preserve confidentiality of info communicated by clients w/I the scope of the Manager-client
relationship
3. Refuse to participate in any business relationship or accept any gift that could reasonably be
expected to affect their independence, objectivity, or loyalty to clients
B. Investment Process and Actions
1. Use reasonable care and prudent judgment when managing client assets
2. Not engage in practices designed to distort prices or artificially inflate trading volume w/ the
intent to mislead market participants
3. Deal fairly and objectively w/ all clients when providing investment info, making investment
recommendations, or taking investment action
4. Have a reasonable and adequate basis for investment decisions
5. When managing a portfolio or pooled fund according to a specific mandate, strategy, or style:
a) Only take investment actions that are consistent w/ the stated objectives and constraints
of that portfolio or fund
b) Provide adequate disclosures and info so investors can consider whether any proposed
changes in the investment style or strategy meet their investment needs
6. When managing separate accounts and before providing investment advice or taking
investment action on behalf of client:
a) Evaluate and understand the client’s investment objectives, tolerance for risk, time
horizon, liquidity needs, any other unique circumstances (including tax considerations,
legal or regulatory constraints, etc.), and any other relevant info that would affect
investment policy.
b) Determine that an investment is suitable to a client’s financial situation
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C. Trading
1. Not act, or cause others to act, on material nonpublic info that could affect the value of a
publicly traded investment
2. Give priority to investments made on behalf of the client over those that benefit their own
interests
3. Use commissions generated from client trades only to pay for investment-related products or
services that directly assist the Manager in its investment decision-making process and not in
the management of the firm
4. Maximize client portfolio value by seeking best execution for all client transactions
5. Establish policies to ensure fair and equitable trade allocation among client accounts
D. Compliance and Support
1. Develop and maintain policies and procedures to ensure that their activities comply w/ the
provisions of this Code and all applicable legal and regulatory requirements
2. Appoint a compliance officer responsible for administering the policies and procedures and
for investigating complaints regarding the conduct of the Manager or its personnel
3. Ensure portfolio info provided to clients by the Manager is accurate and complete and
arrange for independent third-party confirmation or review of such info
4. Maintain records for an appropriate period of time in an easily accessible format
5. Employ qualified staff and sufficient human and technological resources to thoroughly
investigate, analyze, implement, and monitor investment decisions and actions
6. Establish a business-continuity plan to address disaster recovery or periodic disruptions of the
financial market
7. (record retention recommendation is 6 yrs (as opposed to 7 for individuals))
E. Performance and Valuation
1. Present performance info that is fair, accurate, relevant, timely, and complete. Managers
must not misrepresent the performance of individual portfolios or of their firm
2. Use fair market prices to value client holdings and apply, in good faith, methods to determine
the fair value of any securities for which no readily available, independent, third-party market
quotation is available
F. Disclosures
1. Communicate w/ clients on an ongoing and timely basis
2. Ensure that disclosures are truthful, accurate, complete, and understandable and are presented
in a format that communicates the info effectively
3. Include any material facts when making disclosures or providing info to clients regarding
themselves, their personnel, investments, or the investment process
4. Disclose the following:
a) Conflicts of interest generated by any relationships w/ brokers or other entities, other
client accounts, fee structures, or other matters
b) Regulatory or disciplinary action taken against the Manager or its personnel related to
professional conduct
c) The investment process, including info regarding lockup periods, strategies, risk factors,
and use of derivatives and leverage.
d) Management fees and other investment costs charged to investors, including what costs
are included in the fees and the methodologies for determining fees and costs.
e) The amount of any soft or bundled commissions, the goods and/or services received in
return, and how those goods and/or services benefit the client
f) The performance of clients’ investments on a regular and timely basis
g) Valuation methods used to make investment decisions and value client holdings
h) Shareholder voting policies
i) Trade allocation policies
j) Results of the review or audit of the fund or account
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 k) Significant personnel or organizational changes that have occurred at the Manager

Reading 7: Heuristic-Driven Bias: The First Theme:

I. Heuristic-Driven Bias: 4 elements

a. People develop general principles as they find things out for themselves
b. They rely on heuristics, rules of thumb, to draw inferences from the info at their disposal
c. People are susceptible to particular errors b/c the heuristics they use are imperfect
d. People actually commit errors in particular situations

• Availability Heuristic: back-of-the envelope calculation based on readily available info

• Representativeness: to view something as a stereo type and make predictions therefrom
i. Regression to the mean – counter to representativeness;
ii. Gambler’s Fallacy – to predict the outcome of an independently probable event as a
dependently probable event to fit the aggregate probability distribution;  the law of large
numbers does not apply to a small sample.
• Overconfidence: setting too narrow of confidence bands; get surprised frequently
• Anchoring-and-Adjustment: to be influenced by and toward the past observation or a number you’re
working from
i. Underreact: when you don’t know how to incorporate the new information, you stay with your
past belief
• Aversion to Ambiguity: fear of the unknown; proclivity to choose 100% probably $1k over 50%
probably $2k and 50% probably $0.

Such heuristics influence: analysts’ earnings forecasts, investors’ evaluation of mutual fund performance, corporate
takeover decisions and the type of portfolios selected by both individual and institutional investors.

Other heuristics: excessive optimism, illusion of validity, hindsight bias, illusion of control and self-attribution error.

Reading 8: Frame Dependence: the Second Theme

Frame: form used to describe a decision problem; traditionally (incorrectly) assumed to be transparent

Frame dependence: equivalent frames may be opaque causing people to feel differently when faced with different but
equivalent frames; “the way people behave depends on the way that their decision problems are framed.”
• cognitive: the way people organize info
• the way people feel as they register the info
i. “house money” effect: more likely to take a gamble if you feel like you just got ahead.

Loss aversion: loss has about 2.5x the impact of a gain of the same magnitude [on emotions]
• “get-evenitis”
• Concurrent decisions: if lose in first game, may behave differently in second game for chance to get
even.
• Mental accounts: failure to see two decision problems together as a concurrent package.
• Hedonic editing: people prefer some frames to others; to choose frames that obscure losses
i. Prefer “transfer your assets” to “close account at a loss”
ii. People are not uniform in their tolerance for risk; some appear to tolerate risk more readily
when they face the prospect of a loss than when they do not
iii. People do not net two gains: they savor them separately (added attraction to gambling)

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 iv. People are incapable of netting out moderately sized losses of similar magnitudes (shy away
from gambling)

Prospect theory

Emotional frames:
• self-control: controlling emotions; people put rules in place to guard against temptation: “don’t dip into
capital” and view dividends not as capital.
• regret minimization: emotion experienced for not having made the right decision; pain of loss and
feeling responsible for loss; may cause people to prefer dividends to finance consumption rather than
capital b/c of the regret from the (frame) of the missed capital appreciation
• money illusion: people think of money in nominal values (and disregard discounting for inflation)

Reading 9: Inefficient Markets: The Third Theme

De Bondt-Thaler winner-loser effect: investors who rely on representativeness heuristic become overly pessimistic
about past losers and overly optimistic about past winners causing price inefficiency

Conservativism due to anchoring-and-adjustment: results in positive earnings surprises to be followed by positive

surprises and vice versa (post-earnings-announcement drift).

Frame dependence: loss aversion causes investors to shy away from stock resulting in relatively high returns (mental
accounting).

Myopic loss aversion: too short of evaluation horizons resulting in individual investors’ historical reluctance to hold
stocks.

House-Money Effect: results in more risk taking after runups and vice versa.

Overconfidence: 1. Investors take bad bets b/c they fail to realize that they are at an informational disadvantage; 2.
investors trade more frequently than is prudent

Reading 10: Portfolios, Pyramids, Emotions, and Biases

Fear induces an investor to focus on events that are especially unfavorable; hope induces to focus on events that are
favorable.

Specific goals: aspire to purchase home, fund college, comfortable retirement

Fear transforms into regret.

Layered pyramid: bottom: securities to provide security (money market; CDs); securities for specific goals (bonds);
top are securities for appreciation (stock, real estate).
• layers can be thought of as mental accounts
• priorities are the mental account associated w/ bottom layer

Use mean-variance to determine portfolio; provide investor w/ probability of achieving at least aspiration level, by
which the investor will evaluate in terms of fear, hope and aspiration.

Security design: layers can explain design of securities: guaranteed principal w/ possibility of upside.
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Portfolio selection: 1. investors excessively optimistic about their portfolio while not about the market; 2.
overconfident: surprised by price changes; 3. price forecasts anchored by past performance; 4. underestimate beta.
• also investors discount diversification
• reject positive tradeoff b/w risk and return

Optimism:
• inadequate insurance coverage
• younger people systematically think less likely to experience bad outcomes and more likely to
experience good outcomes
• failure to diversify
• excessive risk taking

Overconfidence:
• too much trading: investors who are high in desire for control and suffer from illusion of control are
prone to trade frequently.
• believe can pick winners
• internet stocks and day trading: single young men trade more and in riskier companies, resulting in
men earning 1.4% risk adjusted less return by one study and single men 2.3% less.
• Failure to diversify: even when assets other than stocks included
i. Naïve diversification: 1/n rule: divide 401k contribution equally among options in plan.
ii. Home bias: bias toward U.S. stocks (aversion toward ambiguity: fear)

Reading 11: Investment Decision Making in Defined Contribution Pension Plans

Bounded Rationality: limits on intelligence and time

Bounded self-control: fail to do the apparent right thing
Bounded self-interest;

“myopic loss aversion”: seeking to avoid short-term losses, despite the long time horizon usually involved in planning
for retirement

Failure to diversify:
• “1/n diversification heuristic”: split contributions equally amongst the n funds on offer, w/ little regard
to underlying asset composition of the funds.
i. “endorsement effect”: the entire selection of assets is seen as implicit guidance from employer
as to appropriate asset allocation strategy
• “too much choice”: negative relationship b/w # of funds on offer and employee participation
• Too much own-company stock; don’t realize it is riskier; preference to “invest in the familiar”/”home
country bias”; also “endorsement effect”

Employer may paternalistically design plan to maximize chance that most appropriate options are taken: opt-out
rather than opt-in; default contribution rates; default fund options and range and nature of fund choice on offer; nature
of info and advice

UK: DB plans: group personal pension (GPP) and stakeholder plans; DC plans: occupational money purchase (OMP)
• more common that there is “too little choice”
• no “own-company stock” problem

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Reading 12: Global Equity Strategy: the Folly of Forecasting: Ignore All Economists, Strategists, and Analysts

“Those who have knowledge don’t predict. Those who predict don’t have knowledge.”

Economists seem to lag reality; inflation forecasts appear to be largely a function of past inflation rates: adaptive
expectations.

Overconfidence as Driver of Poor Forecasting:

• overconfident: surprised more often that they expect to be; “not well calibrated”
• experts more overconfident than lay people
i. illusion of knowledge: we think we know more than everyone else
ii. illusion of control
• explained as: ignorance: not knowing that overconfidence exists; arrogance: ego defense mechanism
• Those who are amongst the worst performers actually are the most overconfident
• “the skills needed to produce correct responses are virtually identical to those needed to evaluate the
accuracy of one’s responses.”
• “top-down” approach: people start w/ a preconceived belief about their skills or abilities and use those
beliefs to estimate how well they will do at a specific task
• Ego Defense Mechanism:
i. “expertise thus may not translate into predictive accuracy but it does translate into the ability to
generate explanations for predictions that experts themselves find so compelling that the result
is massive overconfidence.”
ii. Conservatism bias: tendency to hang on to views too long and only slowly adjust; failure to
slash probability after the outcome is known.
iii. 5 common strategies/defenses:
• “if only” defense: create a counterfactual; if certain event had occurred, or if original
advice or analysis had been followed
• “ceteris paribus” defense: although advice or analysis was correct, something else
occurred that blew off course
• “I was almost right” defense: event almost happened
• “it just hasn’t happened yet” defense: although the predicted outcome has not yet
occurred, it will eventually come to pass
• “single prediction” defense: analysis is valid, but the act of forecasting was flawed:
“everyone knows (or should know) that forecasting is pointless”
iv. Anchoring: tendency to grab onto the irrelevant when faced w/ uncertainty
• “little wonder that investors cling to forecasts, despite their uselessness.”

Reading 13: Alpha Hunters and Beta Grazers

Acute inefficiencies: discernible opportunities that can be exploited by accessible arbitrages; surrounding
uncertainties can be hedged or minimized; resolution occurs quickly.

Chronic inefficiencies: tend to be less discernible, more ambiguous, more resistant to rapid resolution from available
market forces, and generally longer tem in nature (arise from structural and behavioral sources: trading frictions,
organizational barriers, imbalances in capital flows, valuation ambiguities, lack of catalysts for resolution, convoy or
herding behavior, artificial peer comparisons, rebalancing inconsistencies, compulsive confirmation seeking, filtering
of conflicting data, misreading of market signals, inertia, formulaic action plans, and overly rigid “policy portfolios”)

Behavioral factors: convoy behavior, Bayesian rigidity, price-target revisionism, ebullience cycle
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 • convoy behavior: herding behavior of institutional funds;
i. "Compounding consensus": tendency to seek the opinions of other "experts" who can confirm
one's own views
• Bayesian Rigidity: to relentlessly try to retain old views in the face of new information
• Price-Target Revisionism: price movements in predicted direction tend to be taken as confirmation of
wisdom, and the target is extended; to avoid: have plan to reduce positions as the original target is
approached
• Ebullience Cycle: during up markets, investors inclined to hold on firmly to winning positions (shining
examples of brilliance); in down: "unopened envelope" syndrome and propensity for inaction in the
face of losing positions

Portfolio rebalancing behavior of holders, rebalancers, valuators and shifters

• holders: tend to leave envelopes unopened and positions unchanged in down markets
• rebalancers: investors who formulaically rebalance to policy portfolio allocation, usually institutions
• valuators: take positions based on whether market is cheap or rich and expect reversal; also momentum
• shifters: making fundamental moves from one strategic stance to another (usually individuals), after
event like loss of job

Market impact:
• holders out of game
• rebalancers have smoothing effect
• valuators: those who are contrarians and "reversionists" will act as moderators; momentum investors will have
exacerbating effect
• shifters: exacerbate market movements

Beta investors: buy indexes; alpha investor: chip away at chronic inefficiencies and behavioral biases

Reading 14: Managing Individual Investor Portfolios

Investor Characteristics:
• Situational Profiling:
o Source of Wealth: self-made investors have greater familiarity w/ risk taking, but high sense of control
o Measure of Wealth: subjective nature of financial well-being; one portfolio may seem large to one and
small to another, affecting risk attitudes
o Stage of Life:
 Foundation: establishing base on which to create wealth: skill, establish business, education
 Accumulation: earnings accelerate
 Maintenance phase: maintaining desired lifestyle and financial security (usually retired); risk
tolerance decreases
 Distribution phase: transfer wealth
• Psychological Profiling: aka personality typing; bridges differences b/w traditional finance (economic analysis
of objective financial circumstances) and behavioral finance
o Traditional finance: investors assumed to 1. exhibit risk aversion, 2. hold rational expectations
(coherent, accurate and unbiased forecasters, reflecting all relevant info and learn from past mistakes)
and 3. practice asset integration
o Behavioral Finance: investors 1. exhibit loss aversion; 2. hold biased expectations; 3. practice asset
segregation

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  loss aversion: prospect theory: investors place different weights on gains and losses; prefer an
uncertain loss to a certain loss, but prefer certain gain to uncertain gain
 biased expectations: cognitive errors and misplaced confidence in ability to assess future
 asset segregation: evaluate investment choices individually rather than in the aggregate
 resulting in the following assumptions for portfolio construction:
• asset pricing reflects both economic considerations, such as production costs and prices
of substitutes, and subjective individual considerations, such as tastes and fears
• portfolios are constructed as “pyramids” of assets, layer by layer, in which each layer
reflects certain goals and constraints
 Personality Typing: 1. ad hoc review by investment advisor based on interviews and past
investment activity; 2. client questionnaires
• Cautious Investors: strong need for financial security; demand low-volatility
investments w/ little potential for loss of principal; overanalyze; easily persuaded but
often do not seek professional advice
• Methodical Investors: relies on hard facts; undertake research; conservative; not
emotionally attached to investments
• Spontaneous Investors: constantly readjusting; not experts; doubt all advice;
overmanage;
• Individualist Investors: confident; work hard at info sources and reconcile
Decisions based primarily on Decisions based primarily on feeling
thinking
More risk averse Methodical Cautious
Less risk averse Individualist Spontaneous

Investment Policy Statement:

• return objectives: determined in connection w/ risk tolerance; return requirement vs. return desire;
o “total return” approach: seeks to identify a portfolio return that will meet investor’s objectives w/o
exceeding the portfolio’s risk tolerance or violating its investment constraints
o consider: inflation, taxes
• risk objectives: ability and willingness;
o ability: financial goals relative to resources and time frame; critical goals have low margin of error and
reduce ability to have volatility
o willingness
• Constraints:
o Liquidity: anticipated and unanticipated demands for cash distributions; liquidity affected by
transaction costs and price volatility; general liquidity requirements: ongoing expenses, emergency
reserves, negative liquidity events; should identify illiquid holdings;
o Time Horizon: 15-20 yrs is long; 3 to 15 is intermediate; single vs. multistage; stage of life;
o Taxes: types: income taxes, gains taxes, wealth transfer tax, property tax; tax deferral; tax avoidance;
tax reduction; wealth transfer taxes: transfer at death, early transfers
 Capital gains tax = Price appreciation x CG tax rate x Turnover rate
o Legal and regulatory environment: personal trusts: revocable and irrevocable; Family foundation;
jurisdiction: where taxed
o Unique circumstances: social and special purpose investing; assets legally restricted from sale, directed
brokerage arrangements, and privacy concerns; assets held outside investment portfolio
Investment policy statement outline:
I. Background
II. Return Objectives
III. Risk Tolerance
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 a. Ability
b. Willingness
IV. Constraints
a. Liquidity
b. Time Horizon
c. Taxes
d. Legal and Regulatory Environment
e. Unique Circumstances

Asset Allocation:
• Selecting asset allocation:
o 1. determine asset allocations that meet investor’s return requirements
o 2. Eliminate asset allocations that fail to meet quantitative risk objectives or other inconsistent w/ risk
tolerance
o 3. Eliminate asset allocations that fail constraints
o 4. Evaluate expected risk-adjusted performance and diversification attributes that remain; select most
rewarding
• Monte Carlo Simulation in Personal Retirement: provides a probability of meeting objectives estimate to
assess risk
o advantages:
 more accurately portrays risk-return tradeoff than deterministic approach
 gives info on possible tradeoff b/w short-term risk and risk of not meeting long-term goal
 can model portfolio changes from tax effects
 well suited to model stochastic process and resulting alternative outcomes
o disadvantages
 relies on historical data
 must evaluate performance of specific investments, not just asset classes, and adjust for fees
 must account for tax consequences

Reading 15: Taxes and Private Wealth Management in a Global Context:

Global tax structures:

• taxes on income: progressive or flat
• wealth-based taxes (property and on wealth transfers)
• consumption taxes (sales taxes; value added taxes)

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Classification of Income Tax Regimes
Regime 1 – Common 2 – Heavy 3 – Heavy Capital 4 – Heavy Interest 5 – Light Capital 6 – Flat and Light 7 – Flat and Heavy
Progressive Dividend Tax Gain Tax Tax Gain Tax
Ordinary Tax Progressive Progressive Progressive Progressive Progressive Flat Flat
Rate Structure
Interest Income Some interest taxed Some interest taxed Some interest taxed Taxed at ordinary Taxed at ordinary Some interest taxed Some interest taxed
at favorable rates or at favorable rates or at favorable rates or rates rates at favorable rates or at favorable rates or
exempt exempt exempt exempt exempt
Dividends Some dividends Taxed at ordinary Some dividends Some dividends Taxed at ordinary Some dividends Taxed at ordinary
taxed at favorable rates taxed at favorable taxed at favorable rates taxed at favorable rates
rates or exempt rates or exempt rates or exempt rates or exempt
Capital Gains Some capital gains Some capital gains Taxed at ordinary Some capital gains Some capital gains Some capital gains Taxed at ordinary
taxed favorably or taxed favorably or rates taxed favorably or taxed favorably or taxed favorably or rates
exempt exempt exempt exempt exempt
Example Austria, Brazil, Argentina, Colombia Canada, Denmark, Australia, Belgium, Kazakhstan, Ukraine
Countries China, Czech Indonesia, Israel, Germany, India, Kenya, Russia, Saudi
Republic, Finland, Venezuela Luxembourg, Mexico, New Arabia (Zakat)
France, Greece, Pakistan Zealand, Norway,
HK, Hungary, Spain, Switzerland,
Ireland, Italy, Taiwan, Turkey
Japan, Latvia,
Malaysia,
Netherlands,
Nigeria,
Philippines, Poland,
Portugal,
Singapore, South
Africa, Sweden,
Thailand, UK, US,
Vietnam

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Future value interest factor (if taxed annually): FVIFi = [1 + r(1 – ti)]n

Tax drag may exceed the tax rate: compounds over time. Tax drag increases as the investment return increases.

For deferred taxation: FVIFcg = (1+r)n – [(1+r)n – 1]tcg = (1+r)n(1-tcg) + tcg

If cost basis differs: FVIFcgb = (1+r)n(1-tcg) + tcg – (1 – B)tcg = (1+r)n(1 – tcg) + tcgB; B is the percentage basis to market
value

Annual wealth-based taxes: FVIFw = [(1+r)(1 – tw)]n

Annual return after realized taxes: r* = r(1 – piti – pdtd – pcgtcg); the p’s are the percentages of return and don’t need to
add to 1 b/c unrealized capital gains are not included in the equation; does not capture tax effects of deferred CGs.

Effective CGs tax rate: T* = tcg(1 – pi – pd – pcg)/ (1 – piti – pdtd – pcgtcg)

Future after-tax accumulation for each unit of currency in a taxable portfolio: FVIFtaxable = (1 + r*)n(1 – T*) + T* - (1 –
B) tcg

Accrual equivalent return: the IRR of the after-tax return: starting amount (1 + RAE)n = after-tax return
Accrual equivalent tax rate: the hypothetical tax rate that produces an after-tax return equivalent to the accrual
equivalent return: r(1 – TAE) = RAE

Future after-tax accumulation of a contribution to a tax-deferred account (like IRA): FVIFTDA = (1 + r)n(1 – Tn)
Future accumulation of a tax-exempt account (like Roth IRA): FVIFTaxEx = (1 + r)n

Risk: if investment returns taxed annual at ti, then return is reduced to σ(1 – ti)

Value created by using investment techniques that effectively manage tax liabilities: tax alpha
• asset location
o if strategy causes allocation of heavily taxed asset held in pension fund etc. to be too high, an offsetting
short position in heavily taxed asset outside the pension fund can offset the excessive exposure
• Trading behavior: optimally locating assets in TDAs and taxable accounts cannot overcome negative impact
of poor investment strategy that either produces negative pretax alpha or is highly tax inefficient
• Tax loss harvesting: realizing loss to offset gain or income, thereby reducing current year’s tax obligation;
recognizing an already incurred loss for tax purposes increases amount of net-of-tax money available for
investment
o highest-in, first-out (HIFO) tax lot accounting: sell highest cost basis first
• Holding Period Management: discourage short-term trading; gross up available long-term gain if held by
short-term tax rate to determine if short-term trade will yield greater; defer transaction just long enough for
long-term capital gains
• After-Tax Mean-Variance Optimization: pretax efficient frontiers may not be reasonable proxies for after-tax
efficient frontiers; also substitute after-tax standard deviations of returns for pretax standard deviations in the
optimization algorithm

Reading 16: Estate Planning in a Global Context

Trust: vehicle through which an individual (settlor) entrusts certain assets to a trustee who manages the assets; many
civil countries do not recognize foreign trusts

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Civil law:
• forced heirship rules:
o children have right to fixed share of parent’s estate (may exist regardless of estangement or
nonmarital)
 maybe move assets to offshore trust to avoid
 maybe gift or donate assets during lifetime; some jurisdictions have “clawback” provisions for
lifetime gifts
o spouses have guaranteed inheritance rights
 community property regimes: each spouse has automatically passing, indivisible 1/2 interest in
income earned during marriage (gifts and inheritances received b/f and after marriage are
separate property) (other half through will or intestate)
 separate property regimes: each spouse is able to own and control property as individual and to
dispose, subject to spouses other rights

Net worth tax / Net wealth tax: on assets’ entire capital base
• lifetime gratuitous transfers (inter vivos transfers): lifetime gifts; gift tax may apply depending on residency or
domicile of donor, residency or domicile of recipient, tax status of recipient, type of asset and location of asset
• Testamentary gratuitous transfers: transfers upon death; taxation depending on residency or domicile of donor,
residency or domicile of recipient, type of asset and location of asset
• taxes may apply to transferor or the recipient; may be flat or progressive; usually after deduction for statutory
allowance; may depend on relationship of transferor or recipient (spouses often tax exempt)

Core Capital: amount of capital required to fund spending to maintain given lifestyle, fund goals and provide adequate
reserves for unexpected commitments
• survival probability: multiply future cash flow needs by probability that such cash flow will be needed
o joint probability if married couple: p(survival) = p(H survives) + p(W survives) – p(H survives) x p(W
survives)
N p ( Survival ) × Spending
o PV(Spending need) = ∑
j j

j =1 (1 + r ) j

o estimated that two people can maintain same living standard for 1.6 times the cost of one
o discount such probable cash flow needs
 using the expected return of pension fund assets to discount liabilities they are intended to fund
systematically under-prices those liabilities
 Monte Carlo simulation w/ expected returns and volatility
o safety reserve: for capital market volatility and uncertain future family commitments; suggested 2 yrs
of spending
• Monte Carlo simulation: determine core capital that sustains spending at least, say, 95% of the simulated trials
o Ruin probability: probability of depleting one’s financial assets b/f death)
o volatility reduces future accumulations: RG ≅ r − 1 σ ; geometric mean approximately equals
2
arithmetic mean minus half the volatility; also b/c withdrawals after down volatility reduce capital base

Excess Capital: anything over core capital

• may gift during lifetime:
o certain gifts may be tax-free: allows for gifts to grow to benefit of donee: relative after-tax value of
tax-free gift made during one’s lifetime compared to bequest transferred as part of taxable estate is:

RVTaxFreeGift =
FVGift
=
[1 + r (1 − t ) ]
g ig
n

FVBequest [1 + re (1 − tie ) ] n (1 − Te )
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 o taxable gifts:

RVTaxableGift =
FVGift
=
[1 + r (1 − t ) ] (1 − T )
g ig
n
g
 , if paid by recipient; efficient if gift tax is
FVBequest [1 + re (1 − tie ) ] (1 − Te )
n

lower than estate tax;

 same if progressive tax rate (small gifts over time are efficient);
 but U.S. and other jurisdictions may required cumulative lifetime gift and estate tax
computation
 generation skipping: transfer high-returning assets; relative value is 1/(1-T1), where T1 is tax
rate of capital transferred from first to second generation; consider specific generation skipping
transfer tax
o location of gift tax liability:
 could result in taxation of donor and donee in case of cross-border gift
FVGift [1 + r (1 − t ) ] (1 − T
g ig
n
g + Tg Te )
 if paid by donor: RVTaxableGift = = ; (benefit from
FVBequest [1 + re (1 − tie ) ] n (1 − Te )
reduction of size of taxable estate)
o spousal exemptions: note that there are two, and good to use to transfer to someone else than to living
spouse.
o Valuation discounts: tax levied on fmv, which requires valuation; lack of liquidity; lack of control; use
family limited partnerships
o Deemed dispositions: gains may be taxed at death; may benefit from avoiding by gifting
o Charitable Gratuitous Transfers: 1. usually not subject to gift transfer tax; 2. may be exempt from
paying tax on investment returns

RVCharitableGift =
FVCharitableGift
=
(1 + r )
g
n
+ Toi [1 + re (1 − tie ) ] (1 − Te )
n


FVBequest [1 + re (1 − tie ) ] n (1 − Te )
Estate Planning Tools:
• Trusts: relationship in which trustee holds and manages assets for benefit of beneficiaries; avoid probate
o revocable trust: settlor is responsible for tax payments and reporting; assets reachable by creditors
o irrevocable trust: trustee responsible for tax payments and reporting; greater protection against
creditors
o fixed vs. discretionary trusts
o control
o asset protection (from creditors, from beneficiaries); use to avoid forced heirship rules
o tax reduction: may be progressive schedule and move assets into lower bracket; time discretionary
distributions; create trust in low tax jurisdiction
 however, income of trust may be taxable to settlor
• Foundations: legal entity set up for particular purpose;
o can survive settlor
o allow for settlor’s wishes to be carried out
o control, avoidance of probate, asset protection, and tax minimization
• Life Insurance: death benefit proceeds paid to life insurance beneficiaries are tax exempt in may jurisdictions
o premiums also not in estate and not considered gift
o may have cash value building tax deferred
o avoids probate
o proceeds used to pay inheritance tax
o avoid forced heirship rules

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 o asset protection: premiums not available to creditors
o can combine w/ discretionary trust
• Companies and CFCs:
o defer taxes; and set up in no-tax jurisdiction
o however, tax rules may quash w/ deemed distributions

Cross-Border Estate Planning:

• Hague Convention of the Conflict of Laws Relating to the Form of Testamentary Dispositions: will valid if
consistent w/ internal law associated w/:
o place will made
o nationality, domicile, or habitual residence of testator
o location of immovable assets covered under will
o certain exceptions, though, maybe requiring two wills
o required recognition of written trusts if:
 assets constitute separate fund and are not part of trustee’s own estate
 title to trust assets stands in name of trustee or name of another on behalf of trustee
 trustee has power and duty to manage, employ or dispose of assets in accordance w/ trust and
special legal duties
• Tax system:
o taxation of income: source jurisdiction / territorial tax system vs. residence jurisdiction; (U.S. is
worldwide!)
o taxation of wealth and wealth transfers: may be source or residence based
o exit taxation: deemed disposition on unrecognized gains; taxation on income during “shadow period”
• Double Taxation:
o residence-residence conflict: two counties both claim residence
o source-source conflict: two claim source (say based on location of assets and management of assets)
o residence-source conflict: most common and most difficult to avoid;
 source country commonly viewed to have primary jurisdiction; residence country typically
expected to provide relief
 Foreign tax credit provisions:
• credit method: reduces tax liability for foreign taxes paid: TCreditMethod = Max[TResidence,
TSource]
• Exemption Method: no domestic tax on foreign-source income: TExemptionMethod = TSource
o usually the few territorial-based systems adopt
• Deduction Method: partial concession: TDeductionMethod = TResidence + TSource(1-TResidence) =
TResidence + TSource – TResidenceTSource
o Double Taxation Treaties:
 OECD model treaty sanctions the exemption and credit method to resolve residence-source
conflicts
• interest and dividends: source taxation by withholding by source country; rates
encouraged to be limited to 15% and 10% respectively.
• capital gains are taxed in residence country, except on immovable property
• also resolves residence-residence conflicts based on following ordered list: 1.
permanent home; 2. center of vital interests; 3. habitual dwelling; 4. citizenship
• (don’t typically resolve source-source conflicts)
o Transparency and Offshore Banking:
 consider tax avoidance vs. tax evasion

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  banking secrecy: benefits are security, privacy, intra-family dynamics and politics, and efficient
for clients residing abroad
 tax evasion strategies predicated on bank secrecy and being exposed by increasing info
exchange b/w tax authorities
• Qualified Intermediaries: banks that document info for all customers and provide info
about U.S. customers upon request, w/o requirement to provide info on other non-U.S.
persons beneficially owning U.S. securities

Reading 17: Low-Basis Stock

Usually resulting from:

• being an entrepreneur
• being an executive
• being an investor

Issues:
• Psychological
• risk and return
• taxes

Specific risk / residual risk increases from investor, to executive, to entrepreneur

Equity Holding Lives: 3 stages:

1. entrepreneurial stage: high specific risk: no diversification desired at this stage;
seeking max profit
2. executive stage: after taken business public; relatively concentrated positions w/
some entrepreneurial bent still; greater diversification as one descends the management hierarchy
3. investor stage: multisecurity portfolio (either diversified investor stages or
indexing stage (indexing being more diversified)): no longer have control over underlying fortunes of
company

Reducing exposure:
• outright sale: simplest and most expensive; results in max flexibility; eliminates residual risk; lower
amount of money to reinvest
• exchange funds: pool concentrated positions from multiple individuals
i. public exchange funds: partnership for >= 7 yrs; 20% exposure to other illiquid investments;
portion of pool distributed after 7 yrs
• but, management costs, lack of control and inflexibility
ii. private exchange fund alternative: usually single security; partner w/ another investor who
purchases same stock at current market prices; p’ship then enters into series of partial hedging,
borrowing and reinvesting transactions (avoiding constructive sales);
• increases borrowing ability
• lessens psychological blow
• no need for exposure to illiquid investments
• 7 yrs
• but unclear whether tax sound
• completion portfolios:

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 i. single asset class completion portfolios: make other investments to offset the concentrated
position; may reinvest dividends
• passive structured strategy: reinvest dividends and use all available opportunities to
harvest investable losses experienced by one or several of the stocks in the completion
portfolio.
ii. multi-asset class completion portfolios: reach across asset or sub-asset classes
• requires substantial pool of other assets
• diversification process takes time
• hedging strategies: diversified but to avoid constructive sales; borrows against value of portfolio
(monetization) and reinvests
i. Constructive sale:
• short sale of same or substantially identical proprty
• offsetting notional principal K wrt the same or substantially identical property or
• futures or forward K to deliver same or substantially identical property
ii. Equity collars: pure hedging strategy: buy put and sell call (can cost money, be cashless, or
income-producing).
• suggested that 15% remaining exposure avoids constructive sale
iii. Monetization of position: w/ equity collar, could borrow up to ~90% of put strike price;
however, if more than 50%, must be nonpurpose loan and be intended for investments in
anything other than equities (however, may still increase leverage through margin).
iv. Variable Pre-Paid Forwards: forward sale of contingent number of shares of underlying stock
w/ agreed future delivery date in exchange for cash advance today.
• “properly constructed and documented, does not constitute a constructive sale and not
subject to margin lending restrictions.” (unbalanced collar)
v. debate over whether interest must be capitalized for tax purposes

Reading 18: Goals-Based Investing: Integrating Traditional and Behavioral Finance

Define portfolio efficiency in terms of client goals instead of relying on traditional measures of return and standard
deviation, then create strategies matched to each goal

Investor goals: 1. lifestyle needs, 2. wealth transfers, 3. charitable gifts

Risk Measurement:
• traditionally standard deviation, etc.
i. however, return distributions are non-normal: skewed, excess kurtosis and heteroskedastic
ii. doesn’t describe risk in terms of clear outcomes / the way investors experience risk
• loss aversion: investors are not risk averse, but loss averse
i. risk measures should address : likelihood that loss will occur, severity of loss or both (say
probability of loss and downside deviation)
• risk measures are usually annualized or some short period, failing to convey risk over multiple periods
i. consider troughs occurring at end date

Risk Profiling:
• Decision Framing: slight differences in the way that questions are posed lead to very different answers about
people’s preferences
• Mental Accounting: multiple attitudes about risk; manage risk on goal-by-goal basis; maintaining separate
investment accounts, either mentally or in practice, and making decisions differently depending on the nature of
the account.
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Managing Behavioral Biases:
• loss aversion: develop strategies to manage losses
• mental accounting: develop strategies that can be aligned w/ investors’ separate goals and accounts
• biases should be controlled rather than accommodated
o Overconfidence: overestimate abilities; take risks w/o commensurate returns; overtrade
o Hindsight bias: believe that predicted event when didn’t
o Overreaction: to overinterpret patterns that are coincidental and unlikely to persist
o Belief perseverance: unlikely to change opinions even when new info becomes available
o Regret avoidance: tendency to avoid actions that could create discomfort over prior decisions, even
though those actions may be in the individual’s best interest
 hold losers too long (disposition effect)
o recommendations:
 goals and preferences should be defined as clearly as possible and supported through risk
management, using measures such as probability of breaching goal and potential loss
 progress towards goals should be monitored, w/ performance evaluated in this context
 strategy adjustments should be based on changes in circumstances or goals rather than behavioral
factors

Implementing a Goals-Based Approach:

• goals-based investing: aligning investment strategies w/ goals of individual investor
o match investment strategies to four buckets: liquidity, income, capital preservation and growth
• investing to meet current lifestyle needs:
o measuring risk to current lifestyle goals:
 use efficient frontier but have worst sustainable spending rate as risk axis and expected spending
rate as return axis
 event specific rather than period specific: 1% probability that sustainable spending rate will fall as
far as or below the worst level
o implementing the new measures of reward and risk
o lifestyle protection strategies: investor determines minimum sustainable spending rate based on lifestyle
needs, which is translated to target for potential loss, and portfolios are considered; expected spending rate
can be increased if investor is willing to accept a lower sustainable spending rate in a worst-case scenario
o cash flow matching: state current lifestyle goals more precisely using targets for amount of cash required
in each period; can use laddered bond portfolios to match expenses; high degree of certainty that CF
targets are met
 not appropriate if expense patterns likely to change
 low return
 CFs are predictable but corpus may be volatile
• Investing for a fixed planning horizon: for growth rather than expenses (say retirement, or college enrollment)
o measure reward as expected portfolio value at horizon date
o risk measured depending on psychology of investor
 amt of capital that could be lost
 measure of worst portfolio value at horizon based on confidence interval
 (efficient frontier w/ axes: worst portfolio value and expected portfolio value)
 for fixed horizon strategy, risk free investment would be high-quality zero-coupon bond w/
maturity near horizon date; then balance w/ other investments
• but if horizon likely to change, or is zero-coupon bond sufficient return, or volatility of
corpus ok?

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Reading 19: Lifetime Financial Advice: Human Capital, Asset Allocation, and Insurance

Human Capital: economic PV of investor’s future labor income

• early life stages: financial and investment capital should hedge and diversify human capital
• implications of model:
o younger investors invest more in stocks than older investors
o investors w/ safe labor income invest more in financial portfolio in stocks
o investors w/ labor income that is highly correlated w/ stock markets invest their financial assets in less
risky assets
o ability to adjust labor supply increases as investor’s allocation to stocks
• labor income typically has low correlation w/ stock market
n
E[ ht ]
• HC ( x ) = ∑
t = x +1 (1 + r + v )
t −x

• Human capital as a risk-free asset: invest in stocks and gradually scale back as gets older
• Human capital as a risky asset: 1. if correlated w/ other risky financial assets, buy risk-free asset when young and
gradually move to risky-assets (as risky human capital declines); 2. if not correlated w/ other risky financial
assets, same as case 1.
• Impact of initial financial wealth: greater percentage allocation to risk-free asset (b/c initial wealth reduces
portion of wealth that is safe human capital)
• Correlation b/w wage growth rate and stock returns: make greater allocation to risk-free asset

Implications for Advisors:

1. investors should invest financial assets to diversify and balance human capital
2. young investor w/ safe human capital should invest more financial assets in risky assets than older
3. if human capital correlated to risky assets, reduce allocation to risky assets

Mortality risk:
• asset allocation and life insurance decisions should be made jointly
• life insurance is perfect hedge of human capital in event of death
• optimal amt of insurance depends on: 1. expected value of human capital and 2. risk-return
characteristics of the insurance contract.
• life insurance (θ) optimization: max E[ (1 − D )(1 − q x )U alive ( W x +1 + H x +1 ) + D( q x )U dead ( Wx +1 + θ x ) ]
θ x ,α x
i. q is subjective probability of death
ii. U is utility function
• as correlation b/w shocks to income and risky assets increases, optimal allocation to risky assets
declines and optimal quantity of life insurance declines (implies lower amt of human capital)
• the more financial assets one has, the less optimal quantity life insurance
• less risk tolerance, the more risk-free assets and the more life insurance
• demand for insurance decreases w/ age (primary driver of life insurance is human capital)

Retirement Portfolio and Longevity Risk:

• goals: 1. comfortable life style and 2. bequests
• risks: 1.financial market risk; 2. longevity risk; and 3. risk of not saving enough (including effects of
inflation)
i. financial market risk: portfolio values fluctuate in short run, and may occur early in retirement
• mitigate w/ diversification
ii. longevity risk: outlive assets
• hedge w/ insurance products: lifetime annuities / payout annuities
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 1. fixed: doesn’t account for erosion by inflation; typically can’t trade out of once
purchased
2. or variable: fluctuates w/ performance of funds investor chooses
• main sources of income: social security; DB pension plans; personal savings
iii. risk of spending uncertainty: may not save enough to adequately fund retirement
• behavioral issue
• combination of types of annuitization and systematic withdrawals helps manage financial risks and
income needs
Reading 20: Managing Institutional Investor Portfolios

DC plans may be profit-sharing: based on plan sponsor’s profits

• sponsor directed: sponsor chooses the investments
• participant directed: sponsor provides menu and participants determine
DB plans:
• funded status: fully funded; has pension surplus; underfunded
• ABO: PV of benefits if plan terminated immediately (for accumulated service but not future service
and wage increases)
• PBO: PV of benefits if plan assuming future comp increases (funding status usually determined off of
PBO)
• Total future liability: PV of accumulated and projected future service benefits including projected
future comp increases (most comprehensive but most uncertain; used internally)
• retired lives (retired workers) vs. active lives (active workers)

DB Investment Policy Statement:

• Risk objectives:

Factors Affecting Risk Tolerance and Risk Objectives of DB Plans

Category Variable Explanation
Plan Status Plan funded status (surplus or Higher pension surplus or higher funded status
deficit) implied greater risk tolerance
Sponsor financial status Debt to total assets; Current and Lower debt ratios and higher current and expected
and profitability expected profitability profitability imply greater risk tolerance
Sponsor and pension fund Correlation of sponsor operating The lower the correlation, the greater risk tolerance,
common risk exposures results w/ pension asset returns all else equal
Plan features Provision for early retirement; Such options tend to reduce the duration of plan
Provision for lump-sum liabilities, implying lower risk tolerance, all else
distributions equal
Workforce characteristics Age of workforce; Active lives The younger the workforce and the greater the
relative to retired lives proportion of active lives, the greater the duration of
plan liabilities and the greater the risk tolerance

i. Asset/liability management (ALM): subset of company’s overall risk management practice that
typically focuses on financial risks created by the interaction of assets and liabilities; for given
financial liabilities, asset/liability management involves managing the investment of assets to
control relative asset/liability values.
ii. DB plans may state risk objective relative to level of pension surplus volatility
iii. Shortfall risk: risk (probability) that portfolio value will fall below some minimum acceptable
level over some time horizon
iv. risk objective to: minimize year-to-year volatility of future contribution payments

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 v. risk objective to: minimize probability of making future contributions, if sponsor is currently
not making any contributions b/c plan is overfunded
• Return objectives: broadly: to achieve returns that adequately fund pension liabilities on inflation-
adjusted basis
i. consider: current funded status; contributions in relation to accrual of pension benefits;
ii. return objective may be such to eliminate future pension contributions
iii. return objective may be such to increase pension income in income statement
iv. may have separate return objectives for each of retired lives and active lives
• Liquidity requirement: net cash outflow: benefit payments minus contributions
i. consider percentage of retired lives; corporate contributions in relation to benefit
disbursements; options for early retirement or option to take lump-sum payments
• Time horizon:
i. whether plan is going concern or termination expected
ii. age of workforce and proportion of active lives
iii. may be multistage
• Tax concerns: usually tax exempt (though contributions and termination involve tax planning)
• Legal and regulatory factors:
i. ERISA for corporate and multi-employer plans: standards of care
ii. Taft-Hartley Labor Act for union plans
iii. fiduciary: person standing in special relation of trust and responsibility wrt other parties
• assets to be managed solely in interests of beneficiaries
• Unique circumstances:
i. due diligence wrt alternative investments
ii. prohibitions on investment in certain industries w/ negative ethical or welfare connotations; or
in companies operating in certain countries
Corporate Risk Management and the Investment of DB Pension Assets:
• managing pension investments in relation to operating investments: if business and pension risks are
positively correlated, high degree of operating risk would limit amt of risk that pension could assume
• coordinating pension investments w/ pension liabilities: ALM perspective to match interest-rate
sensitivity of assets and liabilities

DC Plans:
• sponsor directed: IPS is simpler subset of DB plan IPS
• participant-directed:
i. diversification: Section 404(c) of ERISA safe harbor for DC plan sponsors against claims of
insufficient or imprudent investment choice if plan has 1. at least 3 investment choices
diversified versus each other and 2. provision for participant to move freely among options.
ii. Company stock: should be limited to allow for diversification
• plan participants set on risk and return objectives
• IPS becomes overall set of governing principles rather than IPS for a specific plan participant

Hybrid and other plans: combination of DB (benefit guarantees, years of service rewards, ability to link retirement
pay to % of salary) and DC (portability, administrative ease and understandability) plans
• cash balance plans, pension equity plans, target benefit plans and floor plans
• Cash Balance Plan: DB plan w/ benefits displayed in individual recordkeeping accounts; facilitates
portability to a new plan.
i. contribution credit: % of pay based on age
ii. earnings credit: % increase in acct balance typically tied to long-term interest rates
iii. no actual account balance b/c no separate account
iv. some allow for some investment choices
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 • ESOP: DC plans that invest all or a majority of assets in company stock; contributions based on
employee pay; vesting schedules; (not diversified)

Foundations and Endowments:

• Foundation: grant-making institutions funded by gifts and investment assets
i. typically have single donor
ii. have minimum levels of annual spending
iii. typically do not receive new contributions
iv. typically four types: 1. independent, 2. company sponsored, 3. operating and 4. community

Type of Foundations in U.S.

Foundation Description Source of Decision-Making Annual Spending
Type Funds Authority Requirement
Independent Independent grant-making Generally an Donor, members At least 5% of 12-month
foundation organization established to individual, of donor’s family, average asset value, plus
(private or aid social, educational, family, or group or independent expenses associated w/
family) charitable, or religious of individuals trustees generating investment return
activities
Company- A legally independent grant- Endowment Board of trustees, Same as independent
sponsored making org w/ close ties to and/or annual usually controlled foundation
foundation corp providing funds contributions by sponsoring
from a profit- corp’s executives
making corp
Operating Org that uses its resources to Largely the Independent Must use 85% of interest and
foundation conduct research or provide same as board of directors dividend income for active
a direct service (e.g., operate independent conduct of institution’s own
a museum) foundation programs. Some are also
subject to annual spending
requirement equal to 3.33%
of assets.
Community A publicly supported org Multiple Board of directors No spending requirement.
foundation that makes grants for social, donors; the
educational, charitable, or public
religious purposes. A type
of public charity.

• Foundation IPS:
i. risk objectives: desire to keep spending whole in real terms or to grow institutions, but can be
more fluid or creative and aggressive than pensions; still ability and willingness
ii. return objectives: total return; long-term return objective for foundations w/ indefinitely long
horizons: preserve real (inflation-adjusted) value of investment assets while allowing spending
at appropriate (statutory or decided-upon) rate; intergenerational equity/neutrality: equitable
balance b/w interests of current and future beneficiaries of foundation’s support;
• spending (say 5%) times investment management expenses (say 0.3%) times inflation
(say 2%)
iii. liquidity requirements: anticipated (spending rate) or unanticipated needs for cash in excess of
contributions; investment management expenses don’t count toward payout req, though
overhead associated w/ grant making does.
• may use smoothing rule that averages asset values over period of time to dampen
spending rate’s response to asset value fluctuations
• IRS allowes certain carry-forwards and carry-backs w/i limits
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 • cash reserve to allow for end-of year rush spending in case of large asset growth
iv. Time horizon: usually into perpetuity, but sometimes intended to be “spent down”
v. Tax concerns:
• avoid UBTI, including debt-financed portion of income from debt-financed real estate
• private foundations must estimate and pay quarterly in advance 2% tax on net
investment income: dividends, interest and cap gains less foundation’s expenses related
directly to production of such income; reduced to 1% if charitable distributions for year
>= 5% and avg of previous 5 yrs’ payouts plus 1% of net investment income.
vi. Legal and regulatory factors:
• IRC Section 4944: graduated excise taxes if jeopardize carrying out of tax-exempt
purposes
• Uniform Management of Institutional Funds Act (UMIFA): primary state legislation
governing any entity organized and operated exclusively for educational, religious, or
charitable purposes.
vii. Unique circumstances:
• restrictions on diversification (may avoid w/ swaps)
• Endowments: long-term funds generally owned by operating non-profit institutions involved in
charitable activities
i. not subject to legally required spending level
ii. may be supplemented w/ quasi-endowments: funds functioning as endowment (FFE) w/ no
spending restrictions
iii. usually several funds, each w/ specific indenture detailing conditions and intended uses of gifts,
but may be unrestricted
iv. UMIFA both income and cap gains (realized and unrealized) included in determining total
return, freeing from strictures of yield as spending limit
v. frequently use trailing market value in calculating spending, to create stability; possible rules:
• simple spending rule: Spendingt = Spending rate x Ending market valuet-1
• Rolling three-year avg spending rule: Spendingt = Spending rate x (1/3) [Ending market
valuet-1 + Ending market valuet-2 + Ending market valuet-3]
• Geometric smoothing: Spendingt = Smoothing rate x [Spending ratet-1 x (1 + Inflationt-
1)] + (1 – Smoothing rate) x (Spending rate x Beginning market valuet-1); smoothing rate
usually 60 to 80%
vi. Endowment IPS:
• Risk objectives: consider in conjunction w/ spending policy and long-term objective
1. w/o smoothing rule, may have less tolerance for volatility
2. consider endowment’s role in operating budget and ability to adapt to drops in
spending
i. correlation w/ donor base may limit ability to take risk b/c cannot rely on
donors in down markets
3. consider recent returns in relation to smoothing rule (high recent returns
indicates greater risk tolerance)
4. may have short-term performance time horizons limited risk tolerance
• Return objectives: have high return objectives: significant, stable and sustainable flow
of income to operations
1. should maintain long-term purchasing power after inflation
2. consider high inflation for U.S. higher ed (HEPI averages 1% more than CPI or
GDP deflator)
3. low-volatility, low-return portfolio increases risk of endowment failing
objectives

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 4. returns must exceed spending rate, expected inflation rate and cost of generating
investment returns
5. use Monte Carlo simulation to set (may be higher than point above)
• Liquidity requirements: perpetual and measured spending limit need for liquidity
1. need cash for capital commitments and for rebalancing
2. maybe major capital projects
3. generally suited for illiquid investments
• Time Horizon: extremely long
1. planned decapitalizations (large projects) may make for multistage horizons
• Tax concerns: exempt from taxation
1. avoid UBTI
2. dividend withholding tax from non-U.S. securities
• Legal and regulatory factors:
1. UMIFA:
i. allows for delegation of investment responsibility to external advisors
and managers and setting comp for such
ii. board must “exercise ordinary business care and prudence”
iii. spending gain as well as income ok
iv. if fall below historical book, then spend only income
2. 501(c)(3): ensure that no part of net earnings inure or accrue to benefit of any
private individual
i. excise taxes for individuals receiving “excess benefit transactions” (too
high comp)
• Unique circumstances:
1. variance in size: variety of expertise and resources
2. diligence of alternative investments: active management
3. whether investments limited to Qualified Purchasers (>$25M) can be considered
4. ethical investment policies:
i. voting shareholder proxies on issues of social or political significance
ii. exclusions for companies: child labor, gambling, tobacco, firearms,
violations of human rights

Insurance: 1. life; 2. health; 3. property and liability

• life insurance cos:
i. risk objectives: to fund future policyholder benefits and claims;
• looked upon as quasi-trust fund—so conservative fiduciary principles;
• sensitive to change of principal loss or interruption of income;
• must maintain asset valuation reserve based on NAIC quality tests; GAAP-required
market valuations increase balance sheet volatility;
• also fund interest-rate-sensitive liabilities: annuities and deposit-type contracts
• Valuation concerns: a/l duration mismatches create risk of capital adequacy problems
during periods of changing interest rates: limits risk tolerance
• Reinvestment risk: ability to invest maturing assets at rates sufficient to cover the
guarantee rate of annuity contracts on which no interest is paid until maturity
• Credit risk: risk objectives may relate to losses caused by credit risk
• Cash flow volatility: low tolerance for loss of income or delays in collecting and
reinvesting cash flow from investments
• competition has motivated greater risk tolerance
ii. Return objectives:

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 • policyholder reserve (BS liability of estimated pmts to policyholders) rates set by
actuaries; to obtain a net interest spread to increase surplus policyholder reserves
• total return is difficult as only asset side of BS would reflect resulting volatility
• competitive pressures to offer competitive crediting rates
• Segmentation: sub-portfolio return objectives;
• need to grow surplus to support expanding business volume
iii. Liquidity requirements:
• disintermediation: withdrawing or borrowing against cash value; or surrendering policy
for cash value; has resulted in actuaries reducing duration estimates and portfolio
managers to reduce duration of portfolio
• Asset marketability risk: liquidity needs limit ability to invest in private placement
bonds, commercial mortgage loans, equity real estate and venture capital; also liquidity
requirements for forward commitments to purchase private placement bonds or
mortgages
• derivatives and lines of credit have decreased liquidity requirements
iv. Time horizon: traditionally the classic long-term investor, but segmentation creates unique time
horizons; ALM has tended to shorten time horizon
v. Tax concerns: subject to income, capital gains, etc.; focus on after-tax returns; only corporate
share of income (not policyholder share) is taxable
• could be tax law changes regarding deferral from inside buildup of cash values
vi. Legal and regulatory factors: heavily regulated by states—permitted lines of business, product
and policy forms, authorized investments; industry accounting rules and financial statement
forms
• Eligible investments: asset classes and quality standards; interest coverage ratios or
minimum credit ratings; max allocation to common stocks (~20% in U.S.)
• Prudent Investor Rule: replaced laundry lists of approved investments
• Valuation methods: uniform valuation methods established and administered by NAIC
vii. Unique circumstances: say company’s size and surplus position
• non-life insurance cos: (including health, property, liability, marine, surety and worker’s comp):
differences from life:
• shorter durations; longer claim processing and payments periods
• some liabilities exposed to inflation risk (but not interest rate risk directly)
• liabilities are relatively uncertain in value and timing; greater operating volatility
ii. underwriting (profitability) cycle: 3 to 5 yrs; resulting from adverse claims experience or
periods of extremely competitive pricing (often coincide w/ business cycle and require
liquidation of investments)
iii. models attempt to account for: 1. underwriting cycle; 2. liability durations by product line; 3.
any unique cash outflow characteristics
• non-life insurance co IPS:
i. Risk objectives: quasi-fiduciary role; risk of catastrophic events; current cost or replacement
cost coverage: inflation risk;
• Cash flow characteristics: can be erratic; low tolerance for loss of principal or
diminishing investment income; (no regulatory required asset-valuation reserve); ratio
of casualty insurance co’s premiums to total surplus: generally 2-to-1 or 3-to-1
• Common stock holdings to surplus ratio: often self-imposed limits on common stock
holdings
ii. Return objectives:
• Competitive policy pricing: lead to high return objectives; insurance cos may lower
premiums as a result of past high returns

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 • Profitability: investment income and portfolio return are primary profitability
determinants; influenced by underwriting cycle; maximize return on capital and surplus
to extent that prudent ALM, surplus adequacy considerations and management
preferences allow (rather than policy crediting rate); investment returns expected to
offset underwriting losses
1. profitability measured using “combined ratio”: % of premiums that insurance co
spends on claims and expenses (been over 100%)
• Growth of surplus: allows for expansion of volume of underwriting
• Tax considerations: balance of taxable and tax-exempt bonds; managing and optimizing
operating loss carrybacks and carryforwards
• Total return management: active bond portfolio management strategies have increased
as a result of accounting rules requiring capital gains and losses to flow through income
statement
iii. Liquidity requirements: typically maintains portfolio of short-term securities and maintains
balanced or laddered maturity schedule
• uncertainty of cash flow
• variable tax position results in liquidity requirements to alter amount of tax-exempt
holdings
• interest rate conditions
iv. Time horizon:
• casualty liabilities typically shorter duration than that of life insurance
• underwriting cycles
• yield curve for tax-exempts is steeper, so move out on yield curve for yield
1. may be willing to sacrifice A/L matches to degree
• historically long-term for common stock, but recently more turnover in common stock
b/c realized gains and losses flow through income statement
v. Tax concerns:
• current tax provisions require series of calculations to determine net tax levied on tax-
exempt bond income; hence careful mix of tax-exempt and taxable securities
• uncertainty of further tax code modification
vi. Legal and regulatory factors:
• less regulated than life insurance;
• classes of eligible assets and quality standards
• otherwise remainder can be invested in broad array of assets (though some states have
additional reqs on max asset class holdings)
• not required to maintain asset valuation reserve
• new U.S. risk-based capital regulations: min amt of capital that must hold as function of
size and degree of asset risk, credit risk, underwriting risk, and off-balance sheet risk
vii. Determination of portfolio policies:
• limited risk tolerance is dominant
• capital appreciation to build surplus base and support additional investment in business
• underwriting experience
• current tax policy

Banks:
• liabilities chiefly of time and demand deposits, but also include purchased funds and sometimes publicly
traded debt
• assets are loan and securities portfolios; (also trading accounts, bank premises and fixed assets, and other real
estate owned)
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 • net interest margin: net interest income divided by avg earning assets
• interest spread: avg yield on earning assets minus avg % cost of interest-bearing liabilities
• leverage-adjusted duration gap: DA – kDL where DA is duration of assets, DL is duration of liabilities and k =
market value of liabilities over market value of assets; positive interest rate shock: market value of net worth
will decrease for bank w/ positive gap; unaffected w/ zero gap, and increase w/ negative gap.
• position and aggregate Value at Risk (VAR): minimum value of losses expected over specified time at give
probability
• credit measures: internally developed and other like CreditMetrics:
• overall portfolio objectives:
o manage overall interest rate risk of balance sheet
o manage liquidity
o produce income
o manage credit risk
• pledging requirement: pledge gov’t securities against uninsured portion of deposits (in U.S.)
• Bank IPS:
o risk objectives: ALM considerations focusing on funding liabilities; below-average risk tolerance
o return objectives: earn a positive spread over cost of funds
o liquidity requirements: net outflow of deposits; demand for loans; management and regulatory concern
o time horizon: overall short maturity for liabilities than for portfolio; generally 3 to 7 yrs (intermediate)
o Tax concerns: securities portfolios are fully taxable; no longer tax exemptions for municipal securities
etc.; securities gains and losses affect net operating income: leads to managing earnings
o Legal and regulatory factors: reg restrictions on holding common shares and below-investment-grade
risk fixed-income securities
 hold short-term gov’t securities: legal reserve and pledging reqs
 risk-based capital regs
• Basel II: minimum 8% capital requirement for assets weighted 0%, 20%, 50%, 100%
and 150%
o Unique circumstances: no common unique circumstances

other institutional investors: mutual funds; closed-end funds; unit trust; ETFs; commodity pools; hedge funds;
nonfinancial corporations (major investors in money markets)

Reading 21: Linking Pension Liabilities to Assets

Selecting portfolios from asset-only perspective implicitly assumes that liabilities have no market risk
• pension liabilities: PV of deferred wages; focus on volatility of estimated benefit pmts and how they change
over time
Bt
o VL = ∑
t (1 + rt )
t

 discount rate must reflect market-related exposures of benefit pmts: say real if inflation, then
rate should have real-rate bond component
o benefit volatility results from: volatility of wages, inflation, many non-market-related factors; growth
attributable to future service costs, new entrants and other non-market related factors
o Market related exposures:
 inactive participants: fixed unless indexed for inflation
• mimic w/ bond; exposure to term structure
• mimic w/ real rate bonds if inflation indexed

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  active participants: benefits attributable to past service and wages (accrued benefits) and
attributable to future service and wages (future benefit)
• accrued benefits: fixed unless inflation indexed
• future benefits: risk is capital market driven for funded liabilities; if plan is frozen, then
zero future benefit
o future wages: estimated future wage increases/benefits: future wage liability;
both real wage growth and wage inflation
 future wage inflation: long-term relationship b/w general inflation and
wage inflation; exposed only until retirement, after which fixed
• so combination of real rate bonds and nominal bonds
 future real wage growth: economic growth through labor’s share of
productivity increases; evidence of stability of share of labor in national
income, so linked to productivity increases; fixed at retirement, though
• so combination of equities and nominal bonds
 future services rendered: uncertain
 future participants: rarely funded; (zero if closed to new entrants)

Market Related Exposures and Liability Mimicking Assets

Portion of the Investment Benchmark Market Related Exposures Liability Mimicking Assets
Inactive Term structure Nominal bonds
Active-accrued Term structure Nominal bonds
Active-future wage Inflation Real rate bonds
Growth Equities
term structure Nominal bonds

o Non-Market Related Exposures: Liability Noise:

 plan demographic experience different from actuary’s model given certain underlying
probabilities
 model uncertainty: uncertain probabilities
 inactive participants: mortality experience differing from model: difficult to hedge; also
uncertainty of age of retirement
 active participants: mortality assumption; withdrawal, disability, retirement

Linking assets and liabilities via fundamental factors: combination of nominal bonds, real rate bonds and equities
• accrued benefit: discount rate market-related exposure -->term structure-->real rate, inflation and nominal
bond premium
• future wage liability-->change in wage level-->economic growth and inflation

B
accrued liabilities (w/ inflation indexation): VL − AB = ∑
t (1 + rt ) t
• future wage liability: V L − FW =
B
•
( s
)(
(1 + g ) − 1 (1 + r ) − 1d −s
)
; s yrs to retirement
r−g (1 + r ) d
• resulting sensitivity exposures sets asset allocation and is liability mimicking portfolio; is also appropriate
investment benchmark; this low risk portfolio is the baseline: often greater allocation to equities while
minimizing amt of unrewarded risk taken versus liability
o hedge the liability w/ derivatives
o use remaining capital on efficient return generation (asset-only)

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Reading 22: Allocating Shareholder Capital to Pension Plans

Marked-to-market funding status is picture of current status and doesn’t reveal risk of status change: asset/liability
mismatch is great concern;
• equity portion of pension portfolios often even larger than entire market cap of company
• mismatch doesn’t show up in accounting statements
• equivalent to fixed-interest for equity swap
• pension assets are encumbered by a lien against by the pensioners, while gains and losses flow to shareholders
• PBGC bears losses from default
• study result: companies w/ larger fraction of equity in pension portfolio tended to have larger beta

By failing to take account of pension assets and liabilities when estimate WACC, companies probably distorting
operating risk: 1. leaving out pension risk from total risk; 2. understates leverage ratio
• result is larger WACCs: too high of hurdle rates
• by lowering risk in pension plan, risk is freed up to be spent in core operations
o risk budget:
 determine unleveraged/asset beta by adding pension assets to total assets and pension liabilities
to total liabilities; the beta of the assets will be the beta of the stocks in portfolio times % of
portfolio plus the beta of bonds (0). Then calculate asset beta.
Reading 23: Capital Market Expectations

Frameworks for Developing Capital Market Expectations:

1. Specify the final set of expectations that are needed, including time horizon to
which they apply
2. Research historical record
i. collect macroeconomic and market info on 1. geographic area; or 2.
broad asset class
3. Specify the method(s) and/or model(s) that will be used and their information
4. Determine the best sources for information needs
5. Interpret the current investment environment using the selected data and
methods, applying experience and judgment
6. Provide the set of expectations that are needed, documenting conclusions
7. Monitor actual outcomes and compare them to expectations, providing feedback
to improve the expectations-setting process

Beta research: related to systematic risk and returns to systematic risk; development of capital market expectations
Alpha research: related to capturing excess risk-adjusted returns by a particular strategy

Good forecasts are:

• unbiased, objective and well researched
• efficient (reducing magnitude of forecast errors to a minimum)
• internally consistent

Challenges in Forecasting:
• Limitations of economic data
o time lag of collection, processing and dissemination
o changes in definitions and calculation methods (say CPI-U)
 re-basing indices
• Data measurement errors and biases
o Transcription errors: errors in gathering and recording
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 o Survivorship bias: data series reflect only survivors
o Appraisal (smoothed) data (say real estate or alternative investments): results in 1. calculated
correlations w/ other assets tend to be smaller in absolute value than true correlations; 2. true standard
deviation of asset is biased downward
• Limitations of historical estimates: analysis should include discussion of what may be different from past
o changes in technological, political, legal, and regulatory environments; disruptions such as wars
o change of regime: change of governing set of relationships creates nonstationarity (different parts of
data series reflect different underlying statistical properties)
o long data series:
 risk that data cover multiple regimes
 time series of required length may not be available
 in order to get data series of required length, temptation is to use high-frequency data (weekly
or daily): more sensitive to asynchronism (discrepancy in dating of observations that occurs b/c
stale (out-of-date) data may be used in absence of current date) across variables, producing
lower correlation estimates
• Ex Post Risk Can be a Biased Measure of Ex Ante Risk
o ex post returns may reflect that didn’t materialize resulting in overstated estimates of ex ante returns
• Biases in Analysts’ Methods:
o Data-mining bias: repeatedly “drilling” or searching dataset to find statistically significant pattern
o Time-period bias: research findings that are sensitive to selection of starting and/or ending dates, may
bias out-of-time period analysis
• Failure to account for conditioning info: analyst should condition forecasts on the state of economy to
formulate most accurate expectations (say different betas in expansion economies and recession economies)
• Misinterpretation of correlations:
o distinguish b/w exogenous and endogenous variables;
o correlation may be spurious w/ no predictive relationship
 test w/ multiple regression variable significance
 test using time series analysis w/ independent variables including lagged value of dependent
variable, lagged value of tested variable and lagged value of control variables
• Psychological traps:
o anchoring trap: tendency to give disproportionate weight to first info received on topic
o status quo trap: tendency to perpetuate recent forecasts—to predict no change
o confirming evidence trap: bias that leads individuals to give greater weight to info that supports
existing or preferred point of view
 examine all evidence w/ rigor
 enlist an independent-minded person to argue against
 be honest about motives
o overconfidence trap: tendency to overestimate accuracy of forecasts
o prudence trap: tendency to temper forecasts so that they don’t appear extreme; to be overly cautious in
forecasting
o recallability trap: tendency of forecasts to be overly influenced by events that have left strong
impression on person’s memory
o model uncertainty: uncertainty whether selected model is correct
 input uncertainty: uncertainty whether inputs are correct

Tools for Formulating Capital Market Expectations:

• Formal tools: established research methods amenable to precise definition and independent replication of
results
o Statistical methods: descriptive statistics; inferential statistics
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 historical statistical approach: sample estimators (assuming stationarity)
• sample arithmetic mean total return or sample geometric mean total return as estimate
of expected return
• sample variance as estimate of variance
• sample correlations as estimate of correlations
 Shrinkage estimation: taking weighted average of historical estimate of parameter and some
other parameter estimate based on analyst’s belief of weights
• target covariance matrix: selecting an alternative estimator of covariance matrix
 Time-Series Estimators: forecasting a variable based on lagged variables
• good for short-term forecasts
• volatility clustering: tendency for large (small) swings in prices to be followed by large
(small) swings of random direction
o σ t2 = β σt2−1 + (1 − β )ε t2 ; beta is the rate of decay of the influence of the value of
volatility in one period on future volatility; epsilon is random noise
 Multifactor Models:
• useful for estimating covariances:
o estimates of covariances b/w asset returns can be derived using assets’ factor
sensitivities
o may filter out noise
o make it relatively easy to verify consistency of covariance matrix
• factor covariance matrix: cross tabulations showing covariances / variances of factors
o Discounted Cash Flow Models:
 equity markets:
• Gordon (constant) growth model
D
o E ( Re ) = 1 + g
P0
 estimate g by nominal GDP
 could also use: Earnings growth rate = GDP growth rate + Excess
corporate growth (for the index companies)
D
• Grinold-Kroner model: E ( Re ) ≈ − ∆S + i + g + ∆PE ; ΔS is expected % change in
P
number of shares outstanding; i is expected inflation; g is expected real total earnings
growth; ΔPE is per period % change in P/E multiple; if share repurchases, then ΔS is
negative and represents repurchase yield
o expected income return: D/P – ΔS
o expected nominal earnings growth return: i + g
o expected repricing return: ΔPE
o S&P 500 achieved 10.7% compound return from 1926-2001: 4.4% from
income; 4.8% from nominal earnings growth; 1.5% from repricing
• Fed model: stock market overvalued if market’s current earnings yield is less than 10-yr
Treasury bond yield
 fixed-income markets:
• YTM approach: use single discount rate
o Risk Premium Approach (build-up approach): risk-free rate plus one or more risk premiums that
compensate investors for risky asset’s exposure to sources of priced risk
 generally: E(Ri) = RF + (Risk premium)1 + (Risk premium)2 + ... + (Risk premium)K
 fixed-income premiums: E(Rb) = Real risk-free interest rate + inflation premium + default risk
premium + illiquidity premium + maturity premium + tax premium
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 • real risk-free rate: single-period interest rate for completely risk-free w/ no inflation;
reflects time preference
• inflation premium: expected inflation: avg inflation rate expected over maturity plus
premium (or discount) for probability attached to higher inflation than expected (or
greater disinflation)
• default risk premium: sum of expected default loss plus nondiversifiable risk of default
• illiquidity premium: risk of loss to fair value if to convert to cash quickly
• maturity premium: increased sensitivity to change in market interest rates
• tax premium
 equity risk premium: E(Re) = YTM on a long-term gov’t bond + equity risk premium
o Financial Market Equilibrium Models:
 Black-Litterman: reverse-engineers the expected returns implicit in a diversified market
portfolio, combing them w/ investor’s own views in systematic way that take account of
confidence
 Singer-Terhaar approach: International CAPM: (assumes zero risk premium on currency):
domestic risk-free rate plus risk premium based on asset’s sensitivity to world market portfolio
and expected return on world market portfolio in excess of risk-free rate
• E ( Ri ) = R F + β i [ E ( RM ) − R F ]
o β = asset’s sensitivity to returns on world market portfolio: Cov(Ri, RM)/Var(RM)
o world market risk premium: RPM = [ E ( RM ) − RF ]
σi  RP 
o RPi = ρ i , M ( RPM ) = σ i ρ i , M  M  ; estimated at 0.3 or 0.28
σM  σM 
 RPM/σM is the Sharpe ratio;
 an asset class’s risk premium is therefore the expected excess return
accruing to the asset class given its global systematic risk
o illiquidity: ICAPM assumes perfect markets
 illiquidity premium should be related to length of any period of lock-up
 multi-period Sharpe ratio (MPSR): based on investment’s multiperiod
wealth in excess of wealth generated by risk-free investment (i.e.,
compounded return over compounded cash return).
o market segmentation: (market integration: no impediments or barriers to capital
mobility across markets);
 use weighted average of risk premiums for completely integrated and
completely segmented markets based on degree of segmentation
• developed markets estimated to have 80% integration weighting
• risk premium for fully integrated market will be beta times the
world market risk premium (or the correlation times the country
market standard deviation times the world market Sharpe ratio):
 ERPM 
ERPi = ρi ,M σ i  
 σM 
• risk premium for fully segmented market will not include the
correlation, so is country market standard deviation times the
 ERPM 
world market Sharpe ratio: ERPi = σ i  
σ
 M 
• then weight the two and add to the risk-free rate.

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 •covariance of two markets given betas to world markets:
ρ σ ρ j ,M σ j 2
cov i , j = βi β jσ M2 = i , M i σ M = ρi , M σ i ρ j , M σ j
σM σM
• global investable market (GIM): practical proxy for world market portfolio consisting
of traditional and alternative asset classes w/ sufficient capacity to absorb meaningful
investment
o Survey and Panel Methods:
 survey method: of expectations setting involves asking group of experts for expectations
• 2002 survey: 2 to 2.5% equity risk premium; other 3.9%
 panel method: if survey involves a stable expert group queried
• Livingston Survey: covers U.S. GDP growth, CPI and PPI inflation, unemployment
rate, and 3-month T-bill and 10yr T-bond yields
o Judgment: economic and psychological insight to improve forecasts
 checklists

Economic Analysis:
• Business cycle analysis: short-term inventory cycle (2-4 yrs); longer-term business cycle (9-11 years)
o chief measurements of economic activity:
 GDP: consumption, investment, change in inventories, gov’t spending and exports less imports
 output gap: difference b/w GDP trend (potential GDP) and actual; affects inflation
 recession: two successive quarterly GDP declines
o inventory cycle: caused by companies trying to keep inventories at desired levels as expected level of
sales changes
 up phase: businesses confident and increase production
 down phase: business cuts back production to reduce inventories
 inventory / sales ratio: when moved down, economy likely to be strong in next few quarters, as
businesses try to rebuild; when ratio moved sharply up, period of economic weakness can be
expected
• however, downward trend from improved technology (“just in time” inventory
management); but more visibility so sharper changes
o business cycle: 1. initial recovery; 2. early upswing; 3. late upswing; 4. slowdown; 5. recession
 1. initial recovery: short phase (few months) when economy picks up from slowdown; business
confidence rising, though consumer confidence still low from unemployment; stimulatory
economic policies; usually upswing in inventory cycle; inflation still falling and output gap still
large
• gov’t bond yields may still be falling (matching declining inflation) or bottoming;
• stock market may rise sharply, w/ demand for cyclical and riskier assets
 2. Early upswing (1 yr to several years): confidence up and momentum in economic activity,
w/o overheating or sharply higher inflation; consumers prepared to borrow and spend;
businesses build inventories and investment, w/ higher sales and increased capacity use; profits
rise from lower unit costs;
• short rates starting to rise as stimulus withdrawn;
• longer bond yields stable or rising
• stocks still trending up
 3. Late upswing: output gap has closed and danger of overheating; high confidence and low
unemployment; high growth; inflation starts to pick up w/ accelerating wages
• interest rates rising from tighter monetary policy; pressure on credit markets from heavy
borrowing; central banks aiming for soft landing
• bond yields rising
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 • stock markets rising still but nervously; volatile
 4. Slowdown (few months to 1 year): economy slowing from rising interest rates; vulnerable to
shock; business confidence wavers; inflation still rising; businesses reduce inventories
(inventory correction);
• short-term interest rates are high and rising to peak
• bonds top out at first sign of slowing economy, then rally sharply (yields fall)
• yield curve inverts
• stock market falls, w/ utilities and financial services performing best
 5. Recession (6 mos to yr): large inventory pullback and sometimes large decline in business
investment; consumers reduce big-ticket expenses; upon recession confirmation, monetary
policy cautiously eased; consumer and business confidence decline; profits drop sharply;
financial system may be stressed by bad debts, so cautious lending; major bankruptcies and
uncovered fraud; maybe financial crisis; maybe quickly risking unemployment
• short-term interest rates and bond yields drop;
• stock market begins to rise at later stages (b/f recovery)
 trends affecting business cycle:
• growing China
• aging populations
• deregulation
• oil crises
• financial crises

Five Phases of Business Cycle

Phase Economy Fiscal & Confidence Capital Markets
Monetary Policy
1. Initial Inflation still Stimulatory fiscal Confidence Short rates low or declining; bond yields
recovery declining policies starts to bottoming; stock prices strongly rising
rebound
2. Early Healthy economic Increasing Short rates moving up; bond yields stable
upswing growth; inflation confidence to up slightly; stock prices trending
remains low upward
3. Late Inflation gradually Policy becomes Boom Short rates rising; bond yields rising;
upswing picks up restrictive mentality stocks topping out, often volatile
4. Slowdown Inflation continues Confidence Short-term interest rates peaking; bond
to accelerate; drops yields topping out and starting to decline;
inventory stocks declining
correction begins
5. Recession Production Confidence Short rates declining; bond yields
declines; inflation weak dropping; stocks bottoming and then
peaks starting to rise

o Inflation and deflation in the business cycle:

 central bank orthodoxy:
• central bank policymaking must be independent so monetary policy not too loose
• central bank should have inflation target for discipline and to set expectations
• central banks should use monetary policy to prevent overheating or recession
 deflation: 1. undermines debt-financed investments (resulting in panicked asset sales); 2. limits
ability of central bank to conduct monetary policy (liquidity trap)

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 inflation should result in higher profits and higher stock prices, but too high results in efforts to
cool down the economy, resulting in lower stock prices
o Market Expectations and the Business Cycle:
 “growth recession”: slowdown in growth, but not recession; more likely if:
• upswing was relatively short or mild
• no bubble or severe overheating in stock or property markets
• inflation relatively low, so central bank willing to cut interest rates quickly
• world economic and political environments are positive

Inflation/Deflation Effects on Asset Classes

Cash Bonds Equity Real Estate/ Other Real
Assets
Inflation at Short-term Yield levels maintained; Bullish while market in Cash flow steady to rising
or below yields steady market in equilibrium. equilibrium state. slightly. Returns equate to
expectations or declining. [Neutral] [Positive] long-term average. Market
[Neutral] in general equilibrium.
[Neutral]
Inflation Bias toward Bias toward higher yields High inflation a negative Asset values increasing;
above rising rates. due to a higher inflation for financial assets. Less increased cash flows and
expectations [Positive] premium. [Negative] negative for higher expected returns.
companies/industries [Positive]
able to pass on inflated
costs. [Negative]
Deflation Bias toward Purchasing power increasing. Negative wealth effect Cash flows steady to
0% short- Bias toward steady to lower slows demand. falling. Asset prices
term rates. rates (may be offset by Especially affects asset- downward pressure.
[Negative] increased risk of potential intensive, commodity- [Negative]
defaults due to falling asset producing (as opposed to
prices). [Positive] commodity-using), and
highly levered
companies. [Negative]

• Evaluating Factors that Affect the Business Cycle: consumers; business; foreign trade; gov’t activity:
monetary and fiscal policy
o consumer spending: 60 – 70% of GDP
 retail sales; store sales data; consumer consumption data
• can be erratic; affected by weather and holidays
 after-tax income: wages, inflation, tax changes, employment growth
• non-farm payrolls
• weekly new unemployment claims
• savings rate
o business spending: business investment and spending on inventories
 volatile: say decrease by 10-20% for recession and increase by same during upswing
 inventories: rising may mean businesses are confident (early stages of inventory upswing), but
rise may be involuntary from lower sales (late stages of inventory cycle)
 purchasing managers index (PMI); ISM survey of non-manufacturing companies
o foreign trade: 30-50% of GDP in smaller economies; 10-15% in larger
o gov’t policy: 1. try to control business cycle; 2. try to moderate inflation; 3. incumbents try to affect
policy during elections
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  monetary policy: monetary authorities watch: 1. pace of economic growth; 2. amt of excess
capacity still available; 3. level of unemployment; 4. rate of inflation
• relative interest rates matter: in relation to neutral interest rates (4% argued in U.S.)
• Taylor Rule: target short-term interest rate based on rate of growth of economy and
inflation:
o say:
[ ]
Roptimal = Rneutral + 0.5 × ( GDPg forecast − GDPg trend ) + 0.5 × ( I forecast − I t arg et )
• money supply trends: long run stable relationship b/w growth of money supply and
nominal GDP
• if interest rates at zero, can then 1. push cash (bank “reserves”) directly into banking
system; 2. devalue currency; 3. promise to hold short-term rates low for extended
period; 4. bank to buy assets directly from private sector.
 fiscal policy: change spending; cut or raise taxes;
• changes, not levels, are important; and deliberate changes (rather than changing levels
resulting from fluctuating tax revenues based on economy)

Policy Mix and the Yield Curve

Fiscal Policy
Loose Tight
Monetary Policy Loose Yield curve steep Yield curve moderately steep
Tight Yield curve flat Yield curve inverted

Economic Growth Trends:

• consumer impacts: consumption and demand
o permanent income hypothesis: consumers’ spending behavior is largely determined by their long-run
income expectations
o consumer trends usually stable or even countercyclical over business cycle (may reduce savings if
temporary CF reductions to maintain long-term spending patterns): spending rises less than income
rises and falls less than income falls
• Decomposition of GDP Growth and Its Use in Forecasting:
o growth from changes in employment (growth from labor inputs)
 growth in size of potential labor force
 growth in labor force participation rate
o growth from changes in labor productivity
 growth from capital inputs
 growth in total factor productivity (TGP growth): technical progress
• Gov’t Structural Policies: gov’t policies that affect limits of economic growth and incentives w/i private
sector; pro-growth policies:
o 1. Fiscal policy is sound
 large budget deficit leads to current account deficit (“twin deficits” problem), leads to
borrowing abroad; when foreign debt too high, usually requiring devaluing currency
 high inflation if deficit is financed by printing
 crowds out private sector
o 2. Public sector intrudes minimally on the private sector:
 allow marketplace to provide the right incentives to individuals
 labor market rules raise structural level of unemployment
o 3. Competition w/i the private sector is encouraged: causes efficiency and productivity growth;
reduction of trade tariffs and barriers; advances in networking technology; openness to foreign
investment; (but competition may reduce stock market valuations from lower profits)
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 o 4. Infrastructure and human capital development are supported: health and education infrastructure
o 5. Tax policies are sound: simple, transparent, and rarely altered tax rates; low marginal tax rates; very
broad tax base

Exogenous Shocks:
• from changes in gov’t policy
• unexpected breakup of OPEC
• “peace dividend” from fall of Berlin Wall
• new products, markets and technologies
• Oil shocks: sudden rises affects consumers’ income and reduces spending; inflation rises, maybe offset by
contractionary effect of higher oil prices restricting employment and opening up output gap
• Financial Crises: bank lending and investor confidence

International Interactions:
• Macroeconomic linkages: foreign demand for exports; cross-border direct business investment; but not
perfectly integrated
• Interest Rate / Exchange Rate Linkages: formal or informal exchange rate links; unilateral pegs;
• Emerging Markets:
o Essential Differences b/w Emerging and Major Economies:
 need higher rates of investment than developed countries in physical capital and infrastructure
and in human capital
 periodic crises from managing foreign debt required for investment
 volatile political and social environment
 often relatively small and concentrated in areas such as commodities or narrow range of
manufactured goods; may rely heavily on oil imports
o Country Risk Analysis Techniques:
 emerging bonds: risk of country being unable to service debt
 stock: growth prospects and vulnerability to surprises
 Checklist:
• 1. How sound is fiscal and monetary policy? ratio of fiscal deficit to GDP: persistently
above 4% is concern; ratio of debt to GDP: 70-80% extremely vulnerable
• 2. What are the economic growth prospects for the economy? if slow growth w/
population growth, likely political stress from falling per capital income
o Economic Freedom Index
• 3. Is the currency competitive, and are the external accounts under control?
o current account deficit
• 4. Is external debt under control? if reluctance to lend new money, may be exodus of
capital; ratio of foreign debt to GDP: 50% is dangerous; debt to current account
receipts: 200% in danger zone
• 5. Is liquidity plentiful? foreign exchange reserves in relation to trade flows and short-
term debt; ratio of reserves to short-term debt (maturing w/i 12 mos): under 100% is
risky
• 6. Is the political situation supportive of required policies? whether gov’t will
implement necessary adjustment policies: cutting budget deficit, privatization, ending
monopolies

Economic Forecasting:
• econometric models:
o limitations:
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  finding adequate measures for real-world activities and relationships to be modeled
 measurement error
 relationships may change over time from changes of structure of economy
o constrains the forecaster to a certain degree of consistency and also challenges the modeler to reassess
prior views based on what the model concludes
o forecasts upturns much better than recessions
• leading indicators: lagging, coincident and leading
o diffusion index: how many indicators pointing up and how many down
o world:
 OECD Composite Leading Indicators
o Europe:
 Eurozone Harmonized Index of Consumer Prices
 German Industrial Production
 German IFO Business Survey
 French Monthly Business Survey
o Asia Pacific:
 Tankan Survey
 China Industrial Production
o South America:
 Brazil Industrial Production
o North America:
 Conference Board’s Index of Leading Economic Indicators:
• 1. Avg weekly hrs, manufacturing
• 2. avg weekly initial claims for unemployment insurance
• 3. manufacturers’ new orders, consumer goods and materials
• 4. vendor performance, slower deliveries diffusion index
• 5. manufacturers’ new orders, non-defense capital goods
• 6. building permits, new private housing units
• 7. stock price, 500 common stocks
• 8. money supply, M2
• 9. interest rate spread, 10-yr Treasury bonds less federal funds
• 10. index of consumer expectations
• three consecutive mos of increases, or 3 consecutive mos of decreases, signaled upturn
or downturn in economy w/i 3 to 6 mos
• checklists:
o subjective
o ex:
1. Where in the cycle is the economy now? Aggregate
activity
review previous data on GDP growth and its components (consumer spending, business investment,
inventories, net exports, and gov’t spending)
how high is unemployment relative to estimates of “full employment”?
has unemployment been falling?
How large is the output gap?
What is the inventory position?
Where is inflation relative to target, and is it threatening to rise? inflation
2. How strong will consumer spending be? Consumer
Review wage/income patterns. Consumer
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How fast will employment grow? Consumer
How confident are consumers? Consumer confidence indices. Consumer
3. How strong will business spending be? Business
Review survey data (e.g., purchasing managers indices.) Business
Review recent capital goods orders. Business
Assess balance sheet health of companies. Business
Assess cash flow and earnings growth trends. Business
Has the stock market been rising? Business
What is the inventory position? Low inventory/sales ratio implies GDP strength. Business
4. How strong will import growth be? Government
Exchange rate competitiveness and recent movements. Government
Strength of economic growth elsewhere. Government
5. What is the government’s fiscal stance? Government
6. What is the monetary stance? Central bank
Review recent changes in interest rates. Central bank
What do real interest rates tell us? Central bank
What does the Taylor rule tell us? Central bank
Monetary conditions indices (i.e., trends in asset prices and exchange rate). Central bank
Money supply indicators. Central bank
7. Inflation Inflation
How fast is inflation rising, or are prices falling? Inflation

Advantages and Disadvantages of 3 Approaches to Economic Forecasting

Advantages
Econometric Models Approach
Models can be quite robust with many factors used that
can approximate reality.
Once models are built, new data may be collected and
consistently used w/i models to quickly generate output.
Provides quantitative estimates of the effects on the
economy of changes in exogenous variables.
Leading Indicator-Based Approach
Usually intuitive and simple in construction.
May be available from third parties.
May be tailored for individual needs.
A literature exists on the effective use of various third-
party indicators.
Checklist Approach
Limited complexity.
Flexible: allows structural changes to be easily
incorporated
Disadvantages
Most complex and time-consuming to formulate.
Data inputs and relationships not easy to forecast and not
static.
Requires careful analysis of output.
Rarely forecasts recessions well.
Historically, has not consistently worked, as relationships
between inputs are not static.
Can provide false signals.
Subjective.
Time-consuming.
Complexity has to be limited due to the manual nature of
the process.

Using Economic Info in Forecasting Asset Class Returns:

• Cash and Equivalents: reflects markets expectations of rates over maturity period—forecast economy and the
central bank’s reaction to the economy
• Nominal Default-Free Bonds: components of yield are (i) growth rate of GDP and supply and demand for
capital and (ii) forecast inflation over period.
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 o watch business cycle and short-term interest rates
 news of stronger economic growth usually makes bond yields rise (prices fall) b/c implied
greater demand for capital and possibly higher inflation
 rise in short term rates often leads to rise in longer-term bond yields; but may also be expected
to slow economy and bond yields could fall
 if bond markets expect central banks will achieve inflation targets, bond yields should not
change on inflation expectations but could fluctuate w/ short rates
 assess future effects of inflation
• Defaultable Debt: spread over Treasuries in part represents market’s perception of default risk
o spreads tend to rise during recession b/c companies under stress from weak business conditions and
usually higher interest rates
o during strong economic growth, spreads narrow as fears of default decline
• Emerging Market Bonds: sovereign debt of nondeveloped countries;
o country risk: economic and political factors, including whether has power to follow necessary policies
to stabilize economy; compared to spreads over domestic Treasuries of similarly rated domestic
corporate debt
• Inflation-Indexed Bonds: fixed coupon plus adjustment equal to change in consumer prices

Macroeconomy and Real Yields

Economic Observation Effect on Real Bond Yields
Economic growth rising (falling) Rise (fall)
Inflation expectations rising (falling) Fall (rise)
Investor demand rising (falling) Fall (rise)

• Common Shares: consider (i) company earnings and (ii) interest rates, bond yields and liquidity
o price of oil; demand for airline travel
o Economic factors affecting earnings: long term: aggregate company earnings mainly determined by
trend rate of growth of economy
 labor force growth; level of investment; rate of labor productivity growth
• overinvestment; gov’t overregulation; political instability; bursting of asset bubble
 share of profits in GDP varies w/ business cycle and influenced by: final sales, wages, capacity
utilization, interest rates
• recession: reduced sales w/ burden of fixed costs; some companies (food companies)
may not change in earnings in recession, so may go up
• early stages of economic upswing: earnings recover strongly: capacity utilization and
increasing employment; wages modest; efficiency gains from recession;
• later upswing: wage growth; profits contract
o cyclical stocks: sensitive to business cycle from large fixed costs and
pronounced sales cycle (car manufacturers and chemical producers)
o P/E Ratio and the Business Cycle:
 high and rises when earnings expected to rise
 low and falling if earnings falling
 but may anticipate future earnings recovery (Molodovsky effect)
 high inflation tends to depress (past P/Es must be compared after controlling for inflation)
o Emerging Market Equities: ex post risk premiums in U.S. dollar terms positively correlated w/
expansion phases in G-7 economies (industrial production): trade, finance, direct sectoral linkages
 country analysis
 sector-specific research
• Real Estate: growth in consumption, real interest rates, term structure and unexpected inflation
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 • Currencies:
o current account balance: import more --> currency depreciates
o strong domestic growth and opening of new industries: rise in fdi --> currency appreciates
o volatility from inflows and outflows for stocks, bonds and short-term instruments
o high interest rates: usually high inflows --> currency appreciates
o low interest rates ... currency usually depreciates
o however: high interests may be result of slowing economy --> currency depreciates
o approaches to forecasting:
 PPP: exchange rate should offset any difference in inflation rates (useful for long run: say 5
yrs)
 Relative Economic Strength: investment flows: strong economic growth creates attractive
investment opportunities (say high short-term deposit rate) --> currency appreciates
• if particularly high interest rates, speculators less likely to short currency b/c likely to
strengthen from higher rates
• converse: Japan’s carry trade as a result of low interest rates
 Capital Flows: focuses on expected capital flows, particularly long-term such as equity
investment and fdi; inflows --> currency appreciates
• long-term capital flows may reverse usual relationship b/w short rates and currency:
central bank may want to raise interest rates to respond to weak currency that is
threatening to stimulate economy too much and boost inflation, effect may actually be
to push currency lower; reduced effectiveness of monetary policy.
 Savings-Investment Imbalances: (may explain long-term equilibrium departures):
• if private sector or gov’t currency-related trends change (re current accounts), current
account position must change too and the exchange rate moves to help achieve that.
• currency needs to stay reasonably strong as long as domestic investment exceeds
savings; if economy becomes weak enough at this point and domestic investments no
longer exceed domestic savings, then currency will also weaken
o Gov’t intervention: difficulty in attempts to control b/c 1. total value of foreign exchange trading, in
excess of US$1 trillion daily, is large relative to total foreign exchange reserves of major central banks
combined; 2. gov’ts just another player in the market; 3. experience is not encouraging in the absence
of capital controls (unless willing to move interest rates and other policies).

Info Sources for Economic Data and Forecasts:

Selection of Data Sources for Researching U.S. Markets
Categories of Factor Measures Data Data Data Source
Economic Interest Use: Use:
LT ST
Economic Measures of economic output/growth (e.g + www.bea.gov
fundamentals GDP, industrial production) Bloomberg
General Price level stability +
Consumers Employment/unemployment + Bloomberg
Measures of consumption/income + www.bea.gov
Measures of savings, investment, and leverage +
Measures of sentiment + U. of Michigan Survey
Business Measures of profitability + www.bea.gov
Measures of productivity + Federal Reserve Bank
Industry price level stability + + Internal or third-party
Capacity utilization rates + research; Trade pub.
Central bank Measures of monetary policy + + www.stls.frb.org
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 General price level stability (inflation) + + Bloomberg
Assessment of central bank independence + Internal analysis
Government Fiscal policy + + Congressional Budget
Assessment of exchange rate stability/trends + + Office; Bloomberg; Internal;
www.wto.org
Measures of political stability + Internal analysis
Assessment of legal system’s ability to protect + Internal analysis
assets (including intangible assets) and ability
to settle disputes (due process)
Economic technical Capital flows + Internal / third-party
factors Sector/industry supply and demand + research; Trade publications
Market fundamentals Rates of return + + Relative (industry) internal
Valuation trends (e.g., equity P/E multiples) + + research; Third-party
Asset class price volatility: research; Trade publications
Large-cap equities +
Corporate bonds vs. overall market + +
Short sovereign debt +
Exchange rate movements +
Market technical Ratio of advances/declines in equity market + Reuters; Internal research
factors Corporate bond issuance (market yield) + Internal research
Other: unique; social; Demographic influences + + Third-party; Trade pub.
political Seasonal patterns of consumption + +
Current account trends; net exports versus + + Bloomberg
imports
also:
www.imf.org
www.worldbank.org
www.oecd.org
www.federalreserve.gov
www.ecb.int
www.bankofengland.co.uk
www.boj.or.jb/en
www.bis.org
www.nber.org

Reading 24: Macroanalysis and Microvaluation of the Stock Market

Economic series and the economy: NBER has classified numerous economic series as: leading, coincident or lagging:
• leading: peaks and troughs occur before aggregate economic activity
o stock market is a good leading indicator of the economy: expectations of CFs; response to other
leading indicators
o cyclical indicator approach: expansion and contraction can be identified by movements reflected in
specific economic series
• coincident: peaks and troughs coincide
• lagging: peaks and troughs lag
• selected series: influence economy but don’t neatly fit into three above: U.S. balance of payments; federal
surplus/deficit
• composite series: combination of series
• ratio series: coincident over lagging sometimes leads leading or otherwise diverges
• analytical measures:
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 o diffusion index: say % of reporting units in a series indicate a given result
 trend of diffusion index always reaches peak or trough prior to index
o rates of change: (momentum)
o comparison w/ previous cycles: slower or faster
• Limitations:
o false signals: sudden reverses
o currency of data and revisions (esp if revisions are other direction)
o not all economic sectors represented (e.g., service, import-exports, int’l)

• Conference Board’s Index of Leading Economic Indicators:

o 1. Avg weekly hrs, manufacturing
o 2. avg weekly initial claims for unemployment insurance
o 3. manufacturers’ new orders, consumer goods and materials
o 4. vendor performance, slower deliveries diffusion index
o 5. manufacturers’ new orders, non-defense capital goods
o 6. building permits, new private housing units
o 7. stock price, 500 common stocks
o 8. money supply, M2
o 9. interest rate spread, 10-yr Treasury bonds less federal funds
o 10. index of consumer expectations
• coincident:
o 1. number of employees on nonagricultural payrolls
o 2. personal income less transfer payments, expressed in 1992 dollars
o 3. Index of industrial production
o 4. Manufacturing and trade sales, expressed in 1992 dollars
• lagging:
o 1. average duration of unemployment
o 2. ratio of manufacturing and trade inventories to sales
o 3. percentage change in labor cost per unit of output in manufacturing
o 4. average prime rate charged by banks
o 5. commercial and industrial loans outstanding
o 6. ratio of consumer installment credit outstanding to personal income
o 7. change in consumer price index (inflation rate) for services

Center for International Business Conditions Research (CIBCR) (at Columbia):

• Long-Leading Index
• Leading Employment Index
• Leading Inflation Index
• International Leading Indicator Series

Surveys of Sentiment and Expectations: University of Michigan Consumer Sentiment Index; Conference Board
Consumer Confidence Index

Goldman Sachs Financial Conditions Index: increase in index indicates tightening / rising interest rates

Relationship b/w money supply and stock prices: necessary to forecast unanticipated changes in money supply growth

Inflation and interest rates: strong relation; (spread changes over time)

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Inflation, Interest Rates, and Stock Prices:
• 1. positive scenario: negative effect of interest rate increase (required rate of return) partially or wholly offset
by increase in growth of earnings and dividends (inflation pass through)
• 2. mild negative scenario: higher costs and not able to pass through, so higher k and flat g
• 3. very negative scenario: k increases; g declines

Microvaluation: 1. DDM; 2. FCFE; 3. earnings multiplier technique; 4. other relative valuation ratios
• DDM: discount the dividends:
o k: nominal risk-free rate: 10-yr Treasury note; 30-yr Treasury bond;
o k: equity risk premium: geometric for long-term: say 6.5% from Ibbotson Associates; other b/w 2%
and 6%
o g: current and expected changes in growth;
 b x ROE
• ROE: NI/Equity = NI/Sales x Sales / Total assets x Total assets / equity
o so w/ dividend estimate and k and g, can them estimate market value; further can estimate implied
spread from current market prices
o can obtain implied k: k = D/p + g
• FCFE: = NI + Depr – capex – change in working capital – principal debt repayments + new debt issues
o single stage; two-stage
o estimate g from historical (say same in DDM)
o estimate k same as DDM
• Earnings multipliers:
o estimate of spread:
 P = D1 / (k-g)
 P/D1 = 1 /(k-g)
 D1/P = k-g
o 1. estimate future EPS for stock series; 2. estimate earnings multiplier based on k-g spread

Expected EPS:
• 1. estimate sales per share based on GDP: single variable regression
• 2. estimate operating profit margin: profit / sales; (say EBITDA for operating profit)
o can estimate net profit margin, or
o can estimate net before tax profit margin and then estimate taxes, or
o estimate EBITDA profit margin
o affected by: 1. capacity utilization rate; 2. unit labor cost; 3. rate of inflation; 4. foreign competition
• 3. estimate depreciation per share for next year: estimate PPE and then use historical depr rate
• 4. estimate interest expense for next year: estimate 1. amt of total assets for firm based on expected total asset
turnover and 2. expected capital structure based on avg total debt to total assets
• 5. estimate corporate tax rate for next year: evaluate current tax rate and recent legislation

Estimating the Stock Market Earnings Multiplier:

P D E
• determinants: use long-term estimates of k and g: = 1 1
E k −g
o use long-term estimate of D/E: use time-series analysis then relate to earnings estimate
• can estimate direction of change from current, or
• specific value from specific estimates of D/E, k and g.

Other Relative Valuation Ratios: P/BV; P/CF; P/S.

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Microvaluation of World Markets:
• 1. basic valuation model and concepts apply globally
• 2. input values can vary dramatically
• 3. valuation of nondomestic markets be more onerous: say forecasting exchange rates for hedging

Sources of economic info:

• www.morganstanley.com
• www.globalinsight.com
• www.yardeni.com
• www.whitehouse.gov/fsbr/esbr.html
• www.federalreserve.gov
• www.worldbank.org
• www.bankamerica.com
• www.spglobal.com
• www.bis.org/cbanks.htm
• www.nabe.com
• www.conference-board.org
• www.federalreserve/gov/pubs/bulletin
• www.bea.doc.gov/bea/pubs.htm
• www.stats.bls.gov
• www.cbo.gov
• www.whitehouse.gov/cea
• www.gpoaccess.gov/indicators/browse.html
• www.census.gov/csd/qfr
• www.access.gpo.gov/eop
• www.census.gov/statab/www/
• www.federalreservebanks.org
• www.stlouisfed.org
• research.stlouisfed.org/fred2/
• www.phil.frb.org/econ/
• www.eiu.com
• www.oecd.org
• www.economist.com
• un.org/depts/unsd/sd_economic.htm
• www.un.org
• www.imf.org

Reading 25: Dreaming with BRICs: the Path to 2050

BRICs have larger US$GDP than G6 in less than 40 yrs; currently only 15%

Have less capital, so higher returns on capital, resulting in higher growth of capital stock
Technological catch up.

Countries grow richer on back of appreciating currencies; convergence to PPP.

GDP Growth: growth in employment; growth in capital stock; technical progress/TFP.

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 • Maybe lower convergence in India and Brazil than Russia and China b/c lower education levels and poorer
infrastructure
• Maybe 1/3 of increase in US$GDP of BRICs from rising currencies and 2/3s from faster growth

Conditions for growth:

• Robert Barro:
o Higher schooling
o Higher life expectancy
o Lower fertility
o Lower gov’t consumption
o Better maintenance of rule of law
o Lower inflation
o Improvements in terms of trade
• Macro stability: price stability (fiscal deficit reduction, tighter monetary policy, exchange-rate realignment)
• Institutions: efficient legal system, functioning markets, health and education systems, financial institutions
and gov’t bureaucracy
• Openness: trade and fdi
• Education: skilled workers

Reading 26: Asset Allocation

Strategic Asset Allocation: establish exposures to IPS-permissible asset classes by integrating investor’s return
objectives, risk tolerance, and investment constraints w/ long-run capital market expectations.
• result is the Policy Portfolio
• In long run, diversified portfolio’s mean returns are reliably related to systematic risk exposures.
• Strategic asset allocation specifies investor’s desired exposures to systematic risk.
• b/c investors in aggregate are the market and costs do not net out across investors, return on avg actively
managed dollar should be less than return on avg passively managed dollar after costs

Tactical asset allocation (TAA): short-term adjustments to asset-class weights based on short-term expected relative
performance among asset classes.
• creates active risk

Asset-Only (AO) vs. Asset/Liability Management (ALM):

• ALM: explicitly modeling liabilities (and quasi-liabilities) and adopting optimal asset allocation in
relationship to funding liabilities; concern for net returns and risk
o Cash flow matching: exact matching: use bonds to match liabilities and quasi-liabilities
o Immunization: structures investments in bonds to match (offset) weighted-avg duration of liabilities
 riskier than cash flow matching as duration is first-order approximation of interest rate risk
o favored by:
 investor w/ below-avg risk tolerance
 if have high penalties for not meeting liabilities
 if market value of liabilities interest rate sensitive
 if risk taken in investment portfolio limits investor’s ability to profitably take risk in other
activities
 if legal and regulatory reqs and incentives favor holding fixed-income securities
 if tax incentives favor holding fixed-income securities
• AO: no explicit liability modeling; concern for absolute return and risk

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 o Black-Litterman model: take global market-value-weighted asset allocation (Market equilibrium
portfolio) as default and then incorporate deviate from weights reflecting views on asset classes’
expected returns and strength of views

Dynamic vs. Static approach:

• dynamic: link optimal investment decisions to all future time periods
• static: do not consider links b/w optimal decisions at different time periods

Characteristic Liability Concerns of Various Investors

Type of Investor Type of Liability (Quasi-Liability) Penalty for Not Asset Allocation
Meeting Approach in
Practice
Individual Taxes, mortgage pmts (living expense, Varies AO most common;
wealth accumulating targets) ALM
Pension plans (defined Pension benefits High, legal and ALM AO
benefit) regulatory
Pension plans (defined (Retirement needs) Varies Integrated w/
contribution) individual’s asset
allocation approach
Foundations and Spending commitments, capital project High AO ALM
endowments commitments
Life insurance Death proceeds, annuity payments, return Very high, legal and ALM
companies guarantees on investment products regulatory
Non-life insurance Property and liability claims Very high, legal and ALM
companies regulatory
Banks Deposits Very high, legal and ALM
regulatory

Risk objectives:
• Investor’s expected utility for asset mix: U m = E ( Rm ) − 0.005 R Aσ m ; E is expected return for mix; R is
2

investor’s risk aversion (1 to 10?); σ2 is variance of return for mix

• shortfall risk: risk that fall below minimum during time
• downside risk: risk relating to losses or worse than expected outcomes only (also semivariance and target
semivariance)
• Roy’s safety-first criterion: optimal portfolio minimizes probability over stated time horizon that portfolio
E ( RP ) − RL
return will fall below some threshold level: SFRatio =
σP
• could specify maximum probability of not meeting a return threshold

Behavioral Influences on Asset Allocation:

• loss aversion: worry about avoiding losses more than gains; risk-seekers when faced w/ losses (could use
shortfall risk criterion or ALM)
• Mental accounting: associate different level of risk tolerance depending on mental account
• regret avoidance: may promote diversification; may limit divergence from peers’ avg asset allocation

Selection of Asset Classes:

• Criteria for specifying asset classes:
o 1. assets w/i asset class should be relatively homogenous
o 2. asset class should be mutually exclusive
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 o 3. asset classes should be diversifying
o 4. asset classes as group should make up preponderance of world investable wealth
o 5. asset class should have capacity to absorb significant fraction of investor’s portfolio w/o seriously
affecting portfolio’s liquidity
• Traditional asset classes:
o domestic common equity
o domestic fixed income
o non-domestic (international) common equity (maybe developed-emerging distinction)
o non-domestic fixed income (maybe developed-emerging distinction)
o real estate (maybe including other alternative investments)
o cash and cash equivalents
o (consider also tax concerns)
E ( Rnew ) − RF  E ( R p ) − RF 
o test for adding asset class: > Corr ( Rnew , R p )
σ new  σp 
 
o also consider following for whether to add international assets:
 currency risk
 increased correlations in times of stress
 emerging market concerns
o alternative assets: heterogeneous; high diligence costs

Steps in Asset Allocation:

• asset allocation review:
o (AO is special case where liabilities equal 0)

Capital Market Conditions Investor’s Assets, Liabilities, Net Worth, and Risk Attitudes
| |
Prediction procedure Investor’s Risk Tolerance Function
| |
Expected Returns, Risk, and Correlations Investor’s Risk Tolerance
| |
Optimizer
|
Investor’s Asset Mix
|
Returns
|
(back to top)

Optimization:
• mean-variance approach
o identify efficient frontier (part of minimum variance frontier bordered on the bottom by global
minimum variance portfolio)
o mean-variance optimization (MVO):
 unconstrained MVF: asset-class weights sum to 1. (allows for short positions)
 sign-constrained MVF: no short-positions and sum to 1.
• corner portfolios: 1. portfolios hold identical assets and 2. rate of change of asset
weights in moving from one portfolio to another is constant.
o corner portfolio theorem: In a sign-constrained optimization, the asset weights
of any minimum-variance portfolio are positive linear combination of
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 corresponding weights in two adjacent corner portfolios that bracket it in terms
of expected return (or standard deviation of return)
o find adjacent portfolios for desired return and then weight such two portfolios to
obtain return; then weight underlying assets by such weights
 most important inputs in mean-variance optimization are expected returns: highly sensitive to
small changes in inputs
 for cash equivalents: risk-free rate suggests single-period perspective; reported positive
standard deviation suggest multiperiod perspective
 capital allocation line is the line from the risk-free rate and tangent to efficient frontier
• may not be able to use tangency portfolio if have restraint on borrowing

Selected Extensions to Mean-Variance Approach

Concern Adaptation Source
A. Downside risk 1. Mean-semivariance Markowitz(1959)
2. MVO w/ shortfall constraint Leibowitz and Henriksson (1989)
3. MV surplus optimization Leibowitz and Henriksson (1988)
B. Tracking risk relative 5. MVO w/ constraints on asset weights relative to Ad hoc practice
to benchmark benchmarks
6. Mean-tracking error (MTE) optimization Roll (1992)
7. Mean-variance-tracking error (MVTE) Chow (1995)
optimization
C. Changing correlations 9. MVO w/ adjusted correlation matrix Chow et al. (1999)
in times of stress

• Resampled Efficient Frontier: set of resampled efficient portfolios

o resampled efficient portfolio: for given return rank, portfolio defined by avg weights on each asset
class for simulated efficient portfolios w/ return rank (after rerunning optimization many times using
range of inputs around point estimates)
o (if asset class shows up at all in any run, will show up on resampled efficient frontier, however small)
o (lacks theoretical underpinning)
• Black-Litterman Approach:
o unconstrained Black-Litterman (UBL) model: taking weights of asset classes in global benchmark as
neutral starting point, and adjust to reflect views according to Bayesian procedure (allowed to sell
short)
o Black-Litterman (BL) model: combines reverse optimization w/ investor’s views on expected returns
systematically w/ confidence of views (no short sales)
 reverse optimization: reverse engineers expected returns implicit in diversified market portfolio

Steps in BL Model
Step
1. Define equilibrium market weights and
covariance matrix for all asset classes
2. Back-solve equilibrium expected returns
3. Express views and confidence
4. Calculate the view-adjusted market
equilibrium returns
5. Run mean-variance optimization
Purpose
Inputs for calculating equilibrium expected returns
Form neutral starting point for formulating expected returns
Reflect investor’s expectations for various asset classes; the confidence
level assigned to each view determines the weight placed on it
Form the expected return that reflects both market equilibrium and
views
Obtain efficient frontier and portfolios

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 • Monte Carlo Simulation: simulation that imitates an asset allocation’s real-world operation in an investments
laboratory
• ALM: focuses on surplus efficient frontier
o surplus efficient frontier is bordered on bottom by minimum surplus variance (MSV) at which point
strategy might be cash flow matching or immunization
o surplus beta decision: increment of risk accepted above the MSV portfolio
o ALM w/ simulation:
 1. determine surplus efficient frontier and set of efficient portfolios among range
 2. conduct Monte Carlo simulation for each proposed asset allocation and evaluate
 3. choose most appropriate.
o Surplus objective function’s expected value for particular asset mix for specified risk aversion:
U mALM = E ( SR m ) − 0.005 R Aσ 2 ( SR m )
• Experience-Based Approaches:
o 1. 60/40 stock/bond asset allocation is appropriate or at least a starting point for an average investor’s
asset allocation
o 2. Allocation to bonds should increase w/ increasing risk aversion
o 3. Investors w/ longer time horizons should increase their allocation to stocks
o 4. A rule of thumb for % allocation to equities is 100 minus age of investor

Implementing the Strategic Asset Allocation:

• approaches:
o passive investing
o active investing
o semi-active investing or enhanced indexing
o some other combination
• instruments:
o tracking portfolio of cash market securities
o derivatives: swap
o derivatives: index futures
o cash market securities w/ no tracking attempt
o commodity-like derivatives plus market-neutral long-short
o tracking portfolio w/ over- or under-weighting
o derivatives plus cash positions
• currency risk management: active or passive hedging; can be joint decision w/ asset allocation, or after-the-
fact
• Rebalancing: set thresholds for triggering rebalancing: say percentage-of-portfolio approach

Strategic Asset Allocation for Individual Investors:

• consider: taxes; labor income; correlation of financial asset returns and future labor income; outliving
resources
T Ij
• Human capital: HumanCapit al (t ) = ∑
j =t ( 1 + r )
( j =t )

• Asset Allocation and Human Capital:

 investors w/ safe labor income will invest more in equities
 investors w/ labor income highly positively correlated s/ stock markets should have less
exposure to stocks
 ability to adjust labor supply tends to increase investor’s optimal allocation to equities
o establish risk and return characteristics of individual’s human capital
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 • Mortality risk: life insurance and maybe liquidity reserve
• Longevity risk: should be directly related to asset allocation; consider allocating for higher long-term returns
o life annuity (fixed or variable; equity-indexed annuity)

Strategic Asset Allocation for Institutional Investors:

• Defined-Benefit Plans: strong focus on ALM
o 1. regulatory constraints: min, max and “basket clause” (say limit on alternative asset holdings)
o 2. liquidity constraints
o consider acceptable levels of: risk of funding shortfalls; anticipated volatility of surplus; anticipated
volatility of contributions
o consider whether liabilities nominally fixed (inflation)
• Foundations and Endowments: need high long-term rate
o low-cost-, easy-to-monitor, passive investment strategies
o may have limited resources to fund costs and complexities of due diligence
• Insurance Companies: mix of assets to 1. counterbalance risks inherent in mix of insurance products; 2.
achieve stated return objectives
o taxable
o contractual liabilities to insureds
o usually ALM including yield, duration, convexity, key rate sensitivity, value at risk and effects of asset
risk on capital reqs
o Portfolio Segmentation: subportfolios for product lines
o credit quality regulatory reqs
o casualty insurers tend to have higher liquidity reqs
• Banks: taxable w/ short- and intermediate-term liabilities
o ALM approach
 loan portfolio not liquid, so securities portfolio offsets
 regulatory reqs on holdings

Tactical Asset Allocation: deliberately underweighting or overweighting asset classes relative to target weights
• can use derivative securities over asset classes: overlay strategy
• based on principles:
o 1. market prices tell explicitly what returns are available
o 2. Relative expected returns reflect relative risk perceptions
o 3. Markets are rational and mean reverting
• but consider:
o changes in assets’ underlying risk attributes
o changes in central bank policy
o changes in expected inflation
o position in business cycle

Reading 27: The Case for International Diversification

Traditional case: risk reduction (from low correlation) and superior expected returns
• Portfolio variance of return: σp2 = w12 σ12 + w22 σ22 + 2w1w2ρ1,2σ1σ2; Portfolio standard deviation of return: σp =
w12 σ12 + w22 σ22 + 2w1w2ρ1,2σ1σ2
• currency: return in $: r$ = r + s + (r x s); r is return in local currency and s is exchange rate movement; cross
product usually ignored

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 • var(r$) = var(r+s) = var(r) + var(s) + 2cov(r,s) = σf2 = σ2 + σs2 + 2ρσσs; (ignoring cross product); σf2 is the
variance of foreign asset in $; σ2 is variance in local currency; σs2 is variance of exchange rate; and ρ is
correlation of local currency asset return and exchange rate movement
o contribution of currency risk is the difference between the combined standard deviation and the local
currency equity return standard deviation.
• historical correlation experience:
o equity: generally low correlations across equity markets with or without currency hedging
o bonds: low correlations when unhedged; regional blocs exist; hedged different b/c existence of
“leaning against the wind” policies of raising interest rates to defend currencies
• leads and lags: some lagged correlation but can be explained by differences in time zones and not by some
international market inefficiency that is exploitable, and drastically reduced correlations for longer periods
• Returns: int’l investing increases Sharpe ratios (both numerator and denominator effects)
o consider active vs. passive; costs and benefits of both
• Optimization must be based on forward-looking / expected returns: real growth; economic flexibility;
o forecasts may already be reflected in asset prices
• Currency risk: less than local equity risk but more than local bond risk
o market and currency risks are not additive
o currency risk can be hedged
o should be measured for whole portfolio rather than individual markets; offsets
o contribution of currency risk decreases as time period increases (PPP and mean reversion)

Low correlations: factors causing equity market correlations across countries to be relatively low are independence of
different nations’ economies and gov’t policies, technological specialization, independent fiscal and monetary
policies, and cultural and sociological differences
• for bonds: differences in national monetary and budgetary policies

Case against int’l diversification:

• increase in correlations: correlations have trended upward
o capital market deregulation leads to more integration
o capital mobility has increased
o free trade opening has created more economic synchronization
o global corporations
• Correlation increases when markets are volatile: deviations from normality:
o fat tails (leptokurtic)
o market volatility varies over time, but is contagious
o correlation across markets increases dramatically during periods of high volatility (“correlation
breakdown”)
• positive surprises create returns and can’t always be surprised; one country doesn’t always outperform
• Barriers to int’l investments:
o familiarity w/ foreign markets: prefer to invest in local corps w/ int’l exposure
o political risk: unstable and crises (which, in the face of, may have driven past high returns)
o market efficiency:
 liquidity: thin volume; capital controls;
 lack of timely and reliable info
 price manipulation and insider trading
o Regulations: on max amts of investment;
o Transaction costs: brokerage commission; stamp tax; custody costs; money-manager management fees
higher for int’l investments; market impact of large purchases in the ADR market
o Taxes: withholding;
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 o Currency risk: (can be hedged)

Correlation during volatile periods:

• may estimate correlation in periods of high volatility of returns: “conditioning correlation on high volatility”
(but is biased sampling)
• conclusion that correlation increases in periods of crisis seems to be simply a statistical bias due to faulty
econometrics
• still some evidence of increased correlation in volatile periods

Global rather than int’l investing:

• global industry factors: increasing importance of industry factors;
• regional and country factors
• country factors still significant

Case for Emerging Markets:

• large returns over long run
• positive but moderate correlation w/ developed markets
• volatility: much larger; higher probability of shocks; lack of infrastructure; corruption
• correlation: int’l corr tends to increase in periods of crisis; crises may spread depending on whether factors
creating the boom or crisis are primarily local or global
• currency risk: in crisis both stocks and currencies drop (compared to common situation of negatively
correlated stocks and currencies)
• investability:
o max foreign ownership reqs
o small free float
o constrained repatriation of income and capital
o discriminatory taxes
o foreign currency restrictions
o may be limited to authorized investors
o market price impact

Reading 28: Fixed-Income Portfolio Management—Part 1

See chart p. 7 in book 4.

Fixed-Income investment management process:

1. setting investment objectives (and constraints)
2. developing and implementing portfolio strategy
3. monitoring portfolio
4. adjusting portfolio

Classification strategies:
1. Pure bond indexing (or fully replication approach): perfectly match benchmark (costly to implement)
2. Enhanced indexing by matching primary risk factors:
a. primary matched factors: say level of interest rates, yield curve twists, changes in spreads over
treasuries
b. by not fully replicating, reduces costs
c. can try to enhance return
3. Enhanced Indexing by small risk factor mismatches: increase return by tilting toward sector, quality, term
structure, etc.; intended to enhance return only slightly to cover admin
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 4. Active management by larger risk factor mismatches: active management; deliberately larger mismatches
5. Full-blown active management: aggressive mismatches on duration, sector weights and other

Indexing:
• benchmark: generally:
o market risk: have comparable market risk (maturity and duration)
o income risk: comparable assured income streams
o credit risk: comparable, diversified and satisfying IPS
o liability framework risk: some relation to duration of liabilities if play a role
o risk profiles: yield curve changes (shift (90%), twist, other)
 matching techniques:
• cell matching (or stratified sampling): divide benchmark into representative cells and
then match
• multifactor model: use set of factors that drive bond returns:
o effective duration; convexity adjustment;
o key rate duration and PV distribution of CFs:
 key rate duration
 divide into nonoverlapping periods and match PVs
o Sector and quality percent
o sector duration contribution:
o quality spread duration contribution
o sector/coupon/maturity cell weights
o issuer exposure (event risk)
• Tracking risk: variability w/ which portfolio’s return tracks benchmark index return:
standard deviation of active return; active return = portfolio’s return – benchmark
index’s return.
o tracking risk results from mismatches from: 1. portfolio duration, 2. key rate
duration and PV distribution of CFs; 3. sector and quality percent; 4. sector
duration contribution; 5. quality spread duration contribution; (and other factors
listed under multifactor model technique)
• Enhanced Indexing Strategies:
o lower cost enhancements: control costs (say competitive bidding)
o issue selection enhancements: conduct own credit analysis
o yield curve positioning: overweighting undervalued areas of curve and
underweighting overvalued areas
o Sector and quality positioning:
 say tilt toward short-duration corporates
 periodic over- or underweighting of sectors
o Call exposure positioning: determine probability of call around crossover point

Active Strategies: accept large tracking risk:

• process:
o 1. Identify which index mismatches are to be exploited
o 2. Extrapolate market’s expectations (or inputs) from market data
o 3. Independently forecast necessary inputs and compare w/ market’s expectations
o 4. Estimate relative values of securities in order to identify areas of under- or overvaluation
• Total Return Analysis and Scenario Analysis:
o total return analysis: assessing expected effect of trade on portfolio’s total return given interest rate
forecast
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 1
TotalFutur eDollars n
 Semiannual total return = 
 Full Pr iceofBond 
 −1
 
o scenario analysis: conduct analysis on varied assumptions

Monitor/Adjust Portfolio and Performance

Managing Funds Against Liabilities:

• Dedication Strategies:
o Immunization: portfolio over specified horizon that will earn predetermined return regardless of
interest rate changes
o Cash Flow Matching: provides future funding of liability stream from coupon and matured principal
payments of portfolio
• Immunization: rate changes offset by effect of reinvestment
o Classical Single-Period Immunization: assured return (insulation from effects of interest rate changes)
for specific time horizon;
 set portfolio’s duration to duration of specified time horizon
 set initial PV equal to PV of future liability
 Rebalancing an Immunized Portfolio: as interest rates actually change, must rebalance;
frequency based on cost/benefit
 Determining Target Return: total return as opposed to yield to maturity; alternative would be
zero-coupon bond w/ same duration and quality as portfolio
 Time Horizon: immunized time horizon equal to portfolio duration
 Dollar Duration: dollar duration = duration x portfolio value x 0.01; rebalancing for dollar
duration:
• 1. move forward in time w/ shift in yield curve; calculate new dollar duration
• 2. calculate rebalancing ratio: original dollar duration / new dollar duration – 1; result is
% each position needs to change to be rebalanced
• 3. multiply new market value by %: amt of cash needed for rebalancing
 Spread Duration: measure of how market value of bond portfolio changes when parallel 100
bps change in spread over benchmark
• nominal spread: spread of bond over yield of certain Treasury
• static spread (or zero-volatility spread): constant spread over Treasury spot curve that
equates calculated security price to market price
• option-adjusted spread (OAS): current spread over benchmark yield minus spread from
embedded option
o extensions of classical immunization:
 multiple liability immunization: strategy that guarantees meeting specified schedule of future
liabilities regardless of type of interest rate shift
 contingent immunization: degree of active strategy will ensuring certain minimum return in
case of parallel rate shift; immunization serves as fall-back strategy if actively managed
portfolio does not grow at certain rate
• cushion spread: difference b/w minimum acceptable return and higher possible
immunized rate
 Duration and convexity of assets and liabilities: if liabilities and assets are duration matched but
not convexity matched, economic surplus will be exposed to variation in value from interest
rate changes reflecting convexity mismatch
 Types of Risk:
• interest rate risk
• contingent claims risk: (say prepayment risk)
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 • cap risk: say caps on floating rates
 Risk Minimization for Immunized Portfolios: barbell portfolio is high risk while bullet
portfolio is low risk
• portfolio w/ least reinvestment risk has least immunization risk
• if manager can construct portfolio that replicates pure discount instrument that matures
at investment horizon: immunization risk will be zero
• maturity variance: how much given immunized portfolio differs from ideal immunized
portfolio consisting of single pure discount instrument w/ maturity equal to time horizon
• use linear programming
• confidence intervals
o Multiple Liability Immunization:
 for parallel rate shift, conditions: 1. duration of portfolio equals duration of liabilities; 2.
distribution of durations of individual portfolio assets must have wider range than distribution
of liabilities; 3. PV of assets must equal PV of liabilities
o Immunization for General Cash Flows: model cash contributions as part of the portfolio along w/ their
durations
o Return Maximization for Immunized Portfolios: the greater the cushion spread, the more scope the
manager has for active management policy

Cash Flow Matching: select securities to match timing and amount of liabilities
• compared to immunization:
o no reinvestment risk
o cash flow matching requires conservative rates of return
o cash flow matching requires cash to be on or before liability date
o generally inferior to immunization
• extensions of basic CF matching:
o symmetric cash flow matching: short-term borrowing funds to satisfy liability prior to liability due date
(and matched CF maturity)
o combination matching (or horizon matching): creates portfolio that is duration-matched w/ added
constraint that it be cash-flow matched in first few years
• Application considerations:
o universe considerations: quality and characteristics of securities allowed to use
o optimization
o monitoring: periodic performance measurement
o transaction costs

Reading 29: Relative-Value Methodologies for Global Credit Bond Portfolio Management

Credit Relative-Value Analysis

• Relative value: ranking of fixed-income investments by sectors, structures, issuers, and issues in terms of their
expected performance during some future period of time
• classic analysis: top-down and bottom-up analysis
• Relative-Value Methodologies:
o Total return analysis
o primary market analysis
o liquidity and trading analysis
o secondary trading rationales and constraints analysis
o spread analysis
o structure analysis
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 o credit curve analysis
o credit analysis
o asset allocation / sector analysis
• Total Return Analysis: optimize risk-adjusted total return; analyze detailed dissection of past returns and
project expected returns; uncover patterns (large v. small issue performance variation, seasonality, election-
cycle effects, gov’t benchmark auction effects, etc.)
• Primary Market Analysis: new issue supply & demand; contrary to normal supply-price relationship, relative
credit returns often perform best during periods of heavy supply
o effect of market-structure dynamics: adapt portfolio to long-term structure changes in composition of
global credit asset class due to desire of issuers to minimize funding costs under different yield curve
and yield spread, as well as needs of both active and asset/liability bond managers to satisfy their risk
and return objectives
o Effect of product structure:
 1. dominancy of bullet structures translates into scarcity value for structures w/ embedded call
and put features
 2. bonds w/ maturities beyond 20 yrs are small share of outstanding credit debt
 3. use of credit derivatives has skyrocketed
• Liquidity and Trading Analysis: maybe trade potential liquidity disadvantage for incremental yields
• Secondary Trade Rationales:
o popular reasons for trading:
 1. yield/Spread Pickup Trades: say determine rating differential b/w two issues irrelevant and
pickup yield difference
 2. Credit-Upside Trades: when manager expects upgrade to issuer’s credit quality but not
already reflected in yield spread; popular in crossover sector
 3. Credit-Defense Trades: in defense of geopolitical and economic uncertainties
 4. New Issue Swaps: use swaps to add exposure to a new issuer or a new structure
 5. Sector-Rotation Trades:
 6. Curve-Adjustment Trades: portfolio duration tilt based on projected changes in credit term
structure or credit curve
 7. Structure Trades: swaps into structures expected to have better performance given expected
movements in volatility and shape of yield curve
 8. Cash Flow Reinvestment: take advantage of cash flow reinvestment effect on spreads
o Trading constraints:
 1. Portfolio constraints: say from IPS or regulatory; say can’t own non-investment grade
 2. “Story” Disagreement: action may be limited by uncertainty of one story over another
 3. Buy-and-Hold: as a result of accounting constraints
 4. Seasonality: say when month ends, or at year-end, when reports etc. made

Spread Analysis:
• Alternative Spread Measures:
o OAS has diminished from reduction in structures w/ embedded option
o zero-volatility spread
o swap spreads in Europe
o credit spread using U.S. agency benchmark curve
o credit-default swap spreads
• Closer look at swap spreads: many practitioners envision convergence to single global spread standard derived
from swap spreads
• Spread tools:
o 1. mean-reversion analysis
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 o 2. Quality-Spread Analysis: examine spread differentials b/w low- and high-quality credits
o 3. Percent Yield Spread Analysis: ratio of credit yields to gov’t yields for similar duration securities;
not very predictive

Structural Analysis: bullet, callable, putable, sinking fund

• bullets
o front-end bullets (1 to 5-yr maturities): useful for barbellers; asset swappers may convert short bullets
into floating-rate products
o intermediate credit bullets (5- to 12 yr maturities):
o 30-yr maturity
• Callables
• Sinking Funds: series of partial calls prior to maturity
• Putables:

Credit Curve Analysis:

• almost always positively sloped
• credit barbell strategy: take credit risk in short and intermediate maturities and substitute less-risky gov’t
securities in long-duration portfolio buckets
• default risk increases non-linearly as credit-worthiness declines

Credit Analysis: predict upgrades and downgrades

Asset Allocation/Sector Rotation:

• “macro” among industrials, utilities, financial institutions, sovereigns, and supranationals
• “micro” detailed risk/return breakdown of main credit sub-sectors (banks, brokerage, energy, electrics, media,
railroads, sovereigns, supranationals, technology); exhibit on book 4, p. 85

Reading 30: Fixed-Income Portfolio Management—Part II

Other Fixed-Income Strategies:

• Combination Strategies: active/passive combination; active/immunization combination
• Leverage: 1. the larger the amt of borrowed funds, the greater the variation in potential outcomes; 2. the
greater the variability in annual return on invested funds, the greater the variation in potential outcomes
o portfolio rate of return = R P = rF + ( B E ) × ( rF − k )
D A − DL L
o duration: D E = A
E
o Repurchase Agreements: K involving sale of securities such as Treasury instruments coupled w/ agmt
to repurchase same securities on later date (functions like collateralized loan)
 difference b/w selling price and purchase price referred to as “interest”
 provides low-cost way for managers to borrow funds by providing Treasury securities as
collateral
 enables investors to earn return above risk-free rate on Treasury securities w/o sacrificing
liquidity
 transfer of securities: forms:
• physical delivery (costly)
• transferred simply be credits and debits at clearing agent (still involves fees and
charges)
• deliver securities to custodial account at seller’s bank (reduces costs)
• may not require delivery at all if comfortable
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  Factors affecting repo rate:
• Quality of collateral
• Term of repo
• Delivery requirement: the greater the repo investor control, the lower the rate
• Availability of collateral: the more difficult (in short supply) it is to obtain the securities
the lower the rate
• Prevailing interest rates in economy: if federal funds rate (unsecured overnight loans of
excess reserves) higher, higher rate
• seasonal factors
• Derivatives-Enabled Strategies: means to create, reduce or magnify factor exposures of an investment
o Interest rate risk:
n

 portfolio duration is weighted avg:

∑D
i =1
i ×Vi

Vp
 adjustments to portfolio often such to keep duration same, so often reference to dollar duration:
D ×Vi
Dollar duration = i
100
o Other risk measures:
 Semivariance: measures dispersion of return outcomes below target returns
 Shortfall risk: probability of not achieving some specified return target
 Value at risk (VAR): estimate of loss portfolio manager expects to be exceeded w/ given level
of probability over specified time
o Bond Variance v. Bond Duration: standard deviation difficult to use to measure risk: number of
parameters to estimate increases dramatically w/ number of bonds; variances and covariances change
w/ time
o Interest Rate Futures:
 cheapest-to-deliver; delivery options: quality option; timing option; wild card option
 Strategies w/ Interest Rate Futures: price negatively correlated w/ interest rates: increases
duration/sensitivity to interest rates
• Duration Management: use to match portfolio duration when deviates from target
o portfolio’s target dollar duration = Current portfolio’s dollar duration w/o
futures + dollar duration of futures Ks
o Dollar duration of futures = dollar duration per futures K x number of futures Ks
o Approximate # of Ks =
( DT − DI ) PI ( D − DI ) P DCTD PCTD ( D − DI ) P
= T × = T × ConvFactorForCTDBond
DollarDurPerFuturesK DCTD PCTD DollarDurPerFuturesK DCTD PCTD
• Duration Hedging: futures Ks involves taking futures position that offsets existing
interest rate exposure; if properly constructed as cash and futures prices move together
any loss realized by hedger from one position will be offset by profit in other
o basis risk: risk that basis (difference b/w cash price and futures price) will
change in unpredictable way
o cross hedging: bond to be hedged is not identical to underlying in futures; may
involve substantial basis risk
o price risk: risk that cash market price will move adversely; reason for hedging
o hedge ratio = factor exposure of bond (portfolio) to be hedged / factor exposure
of hedging instrument = (factor exposure of bond to be hedged / factor exposure

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 of CTD bond) x (factor exposure of CTD bond / Factor exposure of futures K) =
DH PH
HedgeRatio = × ConvFactor ForCTDBond
DCTD PCTD
o Yield on bond to be hedged = a + b(Yield on CTD bond) + error term
 b is beta yield
DH PH
o HedgeRatio = × ConvFactor ForCTDBond × YieldBeta
DCTD PCTD
• Interest Rate Swaps:
o Dollar duration of interest rate swap:
 for pay float receive fixed: dollar duration of swap = dollar duration of
fixed-rate bond – dollar duration of floating rate bond
• Interest Rate Options:
o duration for option = delta of option x duration of underlying x (price of
underlying / price of option instrument)
o protective put establishes minimum value for portfolio
o covered call yields best results if prices are essentially going nowhere
o buy calls to protect against decline in reinvestment rates
o also caps, floors and collars
• Credit Risk Instruments:
o credit risk: default risk, credit spread risk, downgrade risk
o credit options: protect against credit risk;
 1. credit options written on underlying asset:
• binary credit options provide payoffs contingent on occurrence of
specified negative credit events
o credit put option pays difference b/w strike price and
market price when event triggered
 2. Credit Spread Options: payoff based on spread over benchmark:
• Payoff = Max [(Spread at option maturity – K) x Notional amt x
risk factor, 0]
o credit forwards:
 for buyer of credit forward: payoff = (Credit spread at forward K
maturity – Ked credit spread) x Notional amt x risk factor
o credit swaps: credit default swaps, asset swaps, total return swaps, credit-linked
notes, synthetic collateralized bond obligations, basket default swaps
 cds: for periodic premiums, agree to deliver physically or cash upon
default event

International Bond Investing:

• Active v. Passive Management; active:
o bond market selection: analyze global economic factors for selecting national markets
o currency selection:
o duration management / yield curve management
o sector selection
o credit analysis of issuers
o investing in markets outside benchmark
• Change in value of foreign bond = - Duration x Change in foreign yield given change in domestic yield x 100
o ∆y foreign = α + β∆y domestic ; beta is country beta

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 • Currency risk: 1. expected effect captured by forward discount/premium; 2. unexpected movement of foreign
currency relative to forward rate
o interest rate parity: forward foreign exchange rate discount/premium over fixed period should equal
risk-free interest rate differential b/w two countries over period: f ≈ id − i f
o hedging currency risk: forward hedging, proxy hedging, cross hedging
 forward hedging: use forward K b/w bond’s currency and home currency
 proxy hedging: use forward K b/w home currency and currency highly correlated w/ bond’s
currency;
 cross hedging: using two non-home currencies to convert to a less-risky exposure to investor
 for hedged position while IRP holds, hedged bond return:
HR ≈ rl + f ≈ rl + ( id − i f ) = id + ( rl − i f ) ; sum of domestic risk-free interest rate plus bond’s
local risk premium
• Breakeven Spread Analysis: determine the size of spread widening that would offset any yield advantage
YieldAdvan tage
o spread widening that would eliminate yield advantage: W = ; use the higher of the
Duration
two countries’ durations
• Emerging Market Debt:
o Growth and Maturity of the Market: after 1980s Mexican crisis, Brady plan allowed emerging country
gov’ts to securitize their date: Brady bonds; has resulted in liquid market for Brady bonds
o Risk and Return Characteristics: potential for consistent attractive rates of return; countries can cut
spending and raise taxes and borrow from IMF and World Bank; have currency reserves; but volatile;
negative skewness; lack transparency: unclear laws and regs; little standardization in covenants and
lacks enforceable seniority structure
o Analysis of Emerging Market Debt: look at:
 fundamentals: source of revenues, fiscal and monetary policies; current debt levels, willingness
of citizens to make sacrifices
 risk of being able to exchange currency
 political risk and currency risk
 changes in liquidity and taxation

Selecting a Fixed-Income Manager:

• Historical Performance as predictor of future performance: not necessarily good approach
• Developing Criteria for Selection:
o 1. Style analysis: helps explain historical performance
o 2. Selection bets: decompose portfolio returns to determine manager’s selection skill
o 3. organization’s investment process: research methods; decision process for changes
o 4. Correlation of alphas: prefer low correlations across managers
• Comparison w/ selection of equity managers:
o 1. both usually involve using consultants
o 2. in both, past performance not reliable guide
o 3. same qualitative factors: philosophy of manager and org, market opportunity, competitive
advantages, delegation of responsibility, experience of prof’ls
o 4. avoid high mgmt fees

Reading 31: Hedging Mortgage Securities to Capture Relative Value

Convexity
• Value of mortgage security = value of Treasury security – value of prepayment option

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 • many investors consider mortgages to be market-directional investments that should be avoided when interest
rates expected to decline

Mortgage Security Risks:

• 1. Spread risk:
o portfolio manager does not seek to hedge spread risk, but increases allocation to mortgage securities
when yield spreads are wide and reduces when narrow
• 2. Interest Rate Risk: corresponds to interest rate risk of comparable Treasury securities; can be hedged
directly by selling Treasury notes or Treasury note futures
o yield curve risk: exposure to nonparallel change in yield curve shape
 rate duration: can provide some measure of exposure
 key rate duration: rate duration for key maturities
• can model steepening
• POs have high positive duration; IOs have high negative duration
• 3. Prepayment Risk:
o w/ prepayment option, duration of mortgage securities extends as rates rise and shortens as rates fall
 the percentage increase in price becomes smaller and smaller as rates decline; percentage
decline in price becomes greater and greater as interest rates rise.
o hedge by hedging dynamically or buying options
• 4. Volatility Risk: option value increases w/ interest rate volatility
o hedge by hedging dynamically (when high volatility expected to normalize) or buying options (when
low volatility and expect to increase)
• 5. Model Risk: current models calibrate to historical experience; consider prepayment innovation
o cannot hedge, but can measure

How Interest Rates Change Over Time:

• statistical technique used to decompose rate movements: principal components analysis
• 95% of historical movements in rate changes explained by 1. overall level of interest rates and 2. twists in
yield curve

Hedging Methodology:
• Interest Rate Sensitivity Measure: Richard and Gord’s Interest Sensitivity (IRS): measures % price change in
response to shift in yield curve
o two bond hedge (say 2-yr and 10-yr Treasuries)
o calculate appropriate two-bond hedge for typical yield curve shifts and twists
o for shift: 1. compute prices for assumed interest rate increases and decreases (say 24.3 basis points as
the typical monthly change in level) for each of (i) the mortgage security (ii) the 2-yr, and (iii) the 10-
yr
o for shift: 2. determine 6 changes (yields) in step 1.
o for shift: 3. calculate averages from increase and decrease (absolute values) for each of 3 in step 2.
o for twist: 4. compute prices for assuming flattening and steepening (say 13.8 basis points as the typical
monthly twist) for each of 3
o for twist: 5. determine 6 changes (yields) in step 4
o for twist: 6. calculate averages from flattening and steepening (absolute values) for each of 3 in step 5
o for shift: 7. compute change in value of 2-bond hedge for level change in yield curve
 H2 x (2-H priceL) + H10 x (10-H priceL)
o for twist: 8. compute change in value of 2-bond hedge for twist
 H2 x (2-H priceT) + H10 x (10-H priceT)

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 o 9. determine system of equations that equates change in value of 2-bond hedge to change in price of
mortgage security
 H2 x (2-H priceL) + H10 x (10-H priceL) = -MBS priceL
 H2 x (2-H priceT) + H10 x (10-H priceT) -MBS priceT
o 10. solve simultaneous equations for H2 and H10
• properly hedged mortgage securities are not “market-directional”
• underlying assumptions of 2-bond hedge: 1. yield curve shifts are reasonable; 2. prepayment model estimates
changing cash flows well; 3. underlying assumptions in Monte Carlo simulation hold; 4. avg price change is
good approximation of price change for small interest rate movements

Hedging Cuspy-Coupon Mortgage Securities: where small changes in interest rates have large effect on prepayments
and thus prices
• so, tangent line at yield is not a good proxy for price/yield changes
• more negative convexity than current coupon mortgages
• hedge by buying interest rate option

Reading 32: Equity Portfolio Management

• Role of the Equity Portfolio
o inflation hedge: if returns are sufficient on average to preserve purchasing power during periods of
inflation
 superior protection for unanticipated inflation than nominal bonds
o long-term portfolio growth

Approaches to Equity Investment:

• passive, active, semiactive:
o Semiactive (aka enhanced indexing and risk-controlled active management): tracking risk watched
o Information ratio = mean active return / tracking risk

Passive Equity Investing:

• Equity Indices:
o Index Weighting Choices:
 Price Weighting: according to absolute share price; performance represented by one share (as
adjusted for splits) of each index component; biased toward highest priced share
 Value weighted (or market-capitalization weighted): weighted according to market cap;
performance represents owning all outstanding shares of index components; biased toward
highest market cap
• float-weighted index: not all, but all of the free float (principal S&P funds are float
weighted)
 Equal weighted: say $1000 in each index component; require periodic rebalancing; small
company bias
o Composition and Characteristics of Major Indices:
 most major are float-weighted
 DJIA is price weighted
• Passive Investment Vehicles:
o Indexed portfolios: 1. conventional index mutual funds; 2. ETFs; 3. separate or pooled accounts
 separate or pooled accounts are extremely low-cost products (may be able to cover costs by
security lending)
 4 differences b/w ETFs and mutual funds:
• 1. shareholder accounting at mutual fund level and expensive; none for ETFs
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 • 2. ETFs pay higher index license fees
• 3. ETFs more tax efficient: in kind redemptions
• 4. ETFs pay transaction costs to trade but better protected w/ liquidity
 full replication: say if fewer than 1000 stocks: costs that cause differences from index:
• cost of managing and administering fund
• transaction costs of adjustments to reflect changes in index composition
• transaction costs of investing and disinvesting cash flows
• drag from cash positions while market is upward trending
 stratified sampling (aka representative sampling): 1. divide index along multiple dimensions
(create multidimensional cells); 2. determine weight of each cell; 3. take random sample from
w/i cells and weight according to cell weight; consider diversification reqs;
 optimization: use multifactor risk model of index and individual securities, and function to
minimize tracking risk; factors may be market cap, beta, industry, macro etc.
• accounts for covariances (stratified sampling does not)
• model risk
• overfitting data
• requires periodic trading
o Equity Index Futures: use stock index futures; delivery involves portfolio trades / program trades /
basket trades
 consider uptick rules
o Equity Total Return Swaps:
 application has been curtailed by U.S. tax law changes (constructive sales?)
 tax-oriented applications focus primarily on differences in tax treatment accorded domestic and
int’l recipients of corporate dividends (withholding taxes)
 may save costs in case of rebalancing portfolio (tactical allocation)

Active Equity Investing:

• Equity Styles:
o value: focus on purchasing at low P/E
 say b/c of mean reversion
 may be cheap for good economic reasons
 low P/E style: usually found in defensive, cyclical and simply out of favor
 contrarian style: look for stocks that have been beset by problems (P/B < 1); in depressed
industries; buy when expected rebound
 high yield style: purchase w/ high and growing dividend yield
o growth: focus on selecting high-earnings-growth cos
 industries include: technology, health care, consumer products
 consistent growth style: long history of unit-sales growth, superior profitability and predictable
earnings
• relative strength indicators: compare stock’s performance during specific period to past
performance or performance of group
 earnings momentum style: bet on continual high earnings growth
o Other active management styles:
 market oriented (aka blend or core): intermediate grouping; buy stocks based on intrinsic value
regardless of whether value or growth; tends to resemble broad-market equity index
• w/ value bias: almost value style
• w/ growth bias: almost growth style

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 •growth-at-a-reasonable price: above avg growth prospects selling at conservative
valuations (not as diversified as straight growth style)
• style rotators: invest in style that will be favored in the near term
• small cap style / micro cap style (underresearched, or better growth prospects)
• mid cap (underresearched but stronger than micro caps)
• large cap: emphasis on superior analysis and insight
o Technique for identifying investment styles:
 returns-based style analysis on portfolio returns (RBSA): regress realized returns on return
series for set of securities indices (set must be mutually exclusive, exhaustive and risk distinct);
betas set to total 1.
• the weights set the “normal portfolio/benchmark”
• 1 minus style fit equals selection
• error term represents selection return
 holdings-based style analysis (aka composition-based style analysis): categorize individual
securities by characteristics and aggregate results; evaluate:
• valuation levels
• forecast EPS growth rate
• earnings variability: (greater would be indicative of value-oriented)
• industry sector weightings: value-oriented would have financing and utilities; growth
have info tech and health care
• Barra fundamental multifactor risk model: commercial holdings-based style analysis
model
• consider category approach (stick security in basket representing one style); quantity
approach: divide security among baskets based on spectrum

2 approaches to style analysis: advantages and disadvantages

Advantages
Returns-based Characterizes entire portfolio
style analysis Facilitates comparisons of portfolios
Aggregates effect of investment process
Different models usually give broadly similar results
and portfolio characterizations
Clear theoretical basis for portfolio categorization
Requires minimal info
Can be executed quickly
Cost effective
Holdings-based Characterizes each position
style analysis Facilitates comparisons of individual positions
In looking at present, may capture changes in style
more quickly than returns-based analysis
Disadvantages
May be ineffective in characterizing current
style
Error in specifying indices in model may
lead to inaccurate conclusions
Does not reflect way many portfolio
managers approach security selection
Requires specification of classification
attributes for style; different specifications
may give different results

o Equity Style Indices:

 buffering: rules for maintaining style assignment of stock consistent w/ previous assignment
when stock has not clearly moved to new style
 style index publishers use growth and value either as categories (no overlap) or as quantities
(w/ overlap)
o Style Box: cross tabs by market cap and style based on holdings-based style analysis; Morningstar’s
style box:
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 Value Core Growth
Large-cap # stocks # stocks # stocks
Mid-cap # stocks # stocks # stocks
Small cap # stocks # stocks # stocks

o Style Drift: inconsistency in style

• Socially Responsible Investing: positive and negative screens by:
o industry classification (avoid tobacco, gaming, alcohol, armaments, etc)
o corporate practices (re: environmental pollution, human rights, labor standards, animal welfare,
integrity in corp governance, etc.)
o may bias the style: say shift toward small-cap shares
• Long-Short Investing:
 common constraint on shorting
 two alphas: from long position and from short position
 market neutral: zero beta, resulting in “portable alpha”
 pairs trades
o Price Inefficiency on Short Side: impediments to short selling; opportunities arising from management
fraud, “window-dressing”, negligence; analysts always make many more buy recommendations;
o Equitizing Market-Neutral Long-Short Portfolio: given equity market systematic exposure; by holding
permanent stock index futures position equal to cash position from shorts
 may be better to short ETFs than to continually roll short futures positions
 market neutral should have no systematic risk, so risk-free rate is benchmark; if equitized, then
equity benchmark
o Long-Only Constraint: underweighting is similar to shorting, but limited on extent of underweighting
(e.g., can’t short); asymmetric
o Short Extension Strategies (aka partial long-short strategies): specifies use of stated level of short
selling; say 130/30
o Sell Disciplines/Trading:
 opportunity cost sell discipline: find stocks w/ higher risk-adjusted expected return and replace
lower
 deteriorating fundamentals sell discipline: sell when fundamentals deteriorating
 rule driven: say P/E reaches historical avg: valuation-level sell discipline; also down-from-cost,
up-from-cost, target price sell disciplines

Semiactive Equity Investing (aka enhanced index or risk-controlled active): perform better than benchmark w/o much
additional risk
• derivatives-based semiactive equity strategies: exposure to equity market w/ derivatives and enhance w/ other
than equity (say equitize cash and enhance by altering duration)
• based on stock selection: generate alpha by selecting stocks
• Grinold and Kahn’s Fundamental Law of Active Management: IR ≈ IC Breadth : info ratio approximately
equal to what you know about given investment (info coefficient) multiplied by square root of investment
discipline’s breadth (number of independent active investment decisions made each year)

Managing a Portfolio of Managers:

• U A = r A − λ Aσ A
2

• portfolio active return = ∑h

i =1
Ai rAi : weighted avg of active return of managers

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 n
• portfolio active risk = ∑h
i =1
2
Ai σ Ai2 : square root of weighted sum of individual manager’s variances; assumes

uncorrelated
• Core-Satellite: to anchor a strategy w/ index or enhanced index and use active managers opportunistically
around anchor to achieve acceptable level of active return while mitigating some active risk associated w/
portfolio consisting entirely of active managers
o core should resemble benchmark
o further breakdown of active return:
 manager’s return – manager’s normal benchmark = manager’s true active return
 manager’s normal benchmark – investor’s benchmark = manager’s misfit active return
o manager’s total active risk = [(Manager’s “true” active risk)2 + (Manager’s “misfit” active risk)2]1/2
o manager’s risk-adjusted performance = IR = (Manager’s “true” active return) / (Manager’s “misfit”
active risk)
• Completeness Fund: when added to active managers’ positions, establishes overall portfolio w/ approximately
same risk exposures as investor’s overall equity benchmark
o can be passive or semiactive
o needs to be re-estimated periodically
o misfit may be optimal while completeness fund tends to eliminate misfit
• Other Approaches: Alpha and Beta Separation
o say index for beta exposure, then hire managers for portable alpha

Identifying, Selecting and Contracting w/ Equity Portfolio Managers:

• Developing a Universe of Suitable Manager Candidates: consultants evaluate managers qualitatively (people
and org structure, investment philosophy, decision-making process, strength of equity research) and
quantitatively (comparisons w/ benchmarks and peers, measures style orientation and valuation
characteristics)
• Predictive Power of Past Performance: good investment record of set of managers over long period following
consistent disciplines, more likely to indicate future satisfactory results than comparable record for manager
w/ turnover and shifts in investment orientation
• Fee Structures:
o ad valorem fees: multiply % by assets managed (management fee or AUM fees)
o performance-based fees: usually base fee plus sharing %;
 may have fee cap
 may have high water mark
 one sided performance fee can be valued as an option
• Equity Manager Questionnaire: 5 areas:
o 1. organization/people
o 2. philosophy/process
o 3. resources
o 4. performance
o 5. fees

Structuring Equity Research and Security Selection:

• Top-Down v. Bottom-Up: most investors use some combination
• Buy-Side v. Sell-Side:
• Industry Classification:
o S&P and MSCI: Global Industry Classification Standards (GICS): divided into:

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 10 sectors (consumer discretionary, consumer staples, energy, financials, health care,
industrials, info tech, materials, telecomm, utilities)
 24 industry groups
 62 industries
 132 sub-industries
o Industry Classification Benchmark
o North American Industry Classification System

Reading 33: Corporate Governance

Separation of Ownership and Control:

• corporate governance: “ways in which suppliers of finance to corps assure themselves of getting return on
investment”
o consider stakeholders
• Moral Hazard:
o insufficient effort: allocation of work time to various tasks
o extravagant investments
o entrenchment strategies: invest in lines of activities that make managers indispensible; manipulate
performance measures; excessive or insufficient risk taking; resist hostile takeovers; lobby for limits
on shareholder control and set up complex cross-holding structures
o self-dealing: perks; pick a friend as successor; select costly supplier based on friendship; finance their
political picks; below-market-price asset sales w/ related party; insider trading
• Dysfunctional corporate governance:
o lack of transparency: levels of comp; stock options; perks;
o comp level: “runaway compensation”
o tenuous link b/w performance and comp: comp stable or increased despite poor performance; see
upside of market rises, but not downside of market falls; “getting out on time”: say selling options
before problems surface; golden parachutes
o accounting manipulations: off-balance-sheet deals; hide poor performance; prevent violation of bank
covenants; continued financing

Managerial Incentives:
• Sophisticated Mix of Incentives: bonuses and stock options; concern about future; threat of being fired;
financial distress; monitoring by large investors (also intrinsic motivation; fairness, horizontal equity, morale,
trust, corp culture, social responsibility and altruism, feelings of self-esteem, interest in job; though
economists concerned about residual incentives to act in firm’s interest over and beyond absence of rewards
and monitoring)
o monetary incentives:
 comp package: salary, bonus and stock-based incentives
 bonuses and shareholdings: substitutes or complements
 comp base
 straight shares or stock options:
 exec comp controversy
o implicit incentives: keep job; avoid proxy fight; avoid bankruptcy or reorg;
o monitoring: by Boards, auditors, large shareholders, large creditors, investment banks, rating agencies
 active monitoring: interfering to increase investors’ claims; exercise of control rights
 speculative monitoring: adjust position in firm: invest further, hold, sell (the analyst)
o product market competition: beneficial effects; may also create gambling behavior

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Board of Directors:
• watchdogs or lapdogs:
o lack of independence: may be hand picked by CEO; may have business relationships; bribes: lucrative
consultancy etc; mutual interdependence of CEOs
o insufficient attention: unprepared and rely on management info
o insufficient incentives: mostly just fees and perks; huge barriers to liability
o avoidance of conflict: ongoing relationship
• Reforming the Board:
o teammates or referees
o knowledge versus independence: those closest to firm have knowledge but susceptible to conflicts of
interest
o Link from performance to board comp:
 Cadbury report calls for: 1. nomination of recognized senior outside member where chairman
of the Board is CEO; 2. procedure for directors to take independent professional advice at
company’s expense; 3. majority of independent directors; 4. comp committee dominated by
nonexecutives directors and audit committee conferred to nonexecutive directors most whom
should be independent; also recommends against performance-based comp

CalPERS criteria % companies in compliance

Has outside chairman 5%
Only one insider on Board 18%
Some form of mandatory retirement for directors 18%
Independent nominating committee 38%
Fewer than 10% of directors over 70 68%
Independent governance committee 68%
No retired CEO on the Board 82%
Independent ethics committee 85%
Independent audit committee 86%
A majority of outside directors on Board 90%
Independent comp committee 91%

Investor Activism:
• Active monitoring requires control:
o formal control: majority of voting shares etc.
o real control: sufficient ownership to build coalition
• proxy fight
• Pattern of ownership:
o pension funds play minor role in France, Germany, Italy and Japan; ownership concentration in such
countries is substantial; also cross-shareholdings
o ownership concentration: high in Italy, France, Germany, Sweden, Europe generally, East Asia
 extremely dispersed in U.S. dispersed in Anglo-Saxon countries
o stability of holdings v. active management: Japan and German stable; Anglo-Saxon reshuffle
frequently
• Limits of Active Monitoring:
o who monitors the monitor: monitors not always acting in interest of their beneficiaries
o congruence w/ other investors:
 undermonitoring: substantial free-riding by small institutional shareholders
 collusion w/ management: quid pro quo
 self-dealing: transactions w/ affiliated firms
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 o Cost of providing proper incentives to monitor: entails liquidity costs to cause long-term holding which
allows for proper monitoring
o Perverse effects on the monitorees: become short-term focused
o Legal, fiscal, and regulatory obstacles: liability for directors; holding restrictions once reach ownership
threshold; diversification rule;

Takeovers and Leveraged Buyouts:

• keep managers on their toes, but may cause myopia
• allow for fresh ideas from new managerial teams
• raider may be value-reducing
• may shatter implicit Ks w/ stakeholders
• Takeover Bids and Defenses:
o usually preceded by toehold
o tender offer
o defenses:
 corporate charter defenses:
• staggered board
• supermajority rule
• fair price clauses
• placing shares in ESOP
• differential voting rights
• dual-class recapitalizations
• move to state w/ tougher antitakeover statutes
 dilution defenses:
• Scorched-earth policies
• litigation
• poison pills
 post-takeover bid defenses:
• white knights
• greenmail
• Leveraged Buyouts:
o buyout partnership arrangement: 1. strong monetary incentives of new managers of that of publicly
traded corp; 2. active monitoring taken seriously; 3. high leverage
o Rise and backlash:
 Hypothesis 1: Decline of corp governance
 Hypothesis 2: Financial innovation: new and superior form of corporate governance
 Hypothesis 3: Break-up of conglomerates
 verdict:
• large gain for target shareholders
• neutral outcome for acquirer
• increase in total value

Debt as a Governance Mechanism:

• as incentive mechanism: forces firm to disgorge cash flow
o managers can’t consume cash
o managers must focus on repaying creditors
o threat of financial distress
o residual claim goes to entrepreneur so right incentives
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 • limits:
o costs of illiquidity; say to fund projects; say in face of uncontrollable adverse shocks
o bankruptcy costs:
 direct costs
 indirect costs: managerial decisions in anticipation
o transaction costs: lots of parties to deal w/
o bargaining inefficiencies:

International Comparisons of the Policy Environment:

• protection of shareholders is strongest in common law countries, weakest in French-style civil law countries
and somewhere in b/w in German- and Scandinavian-style law
• positive covariation b/w shareholder protection and breadth of equity market
• substitute protections:
o mandatory dividends
o more concentrated ownership structures

Shareholder Value or Stakeholder Society?

• list of stakeholders:
o duties toward employees
o duties toward communities
o duties toward creditors
o ethical considerations: environment, pay taxes, avoid bribes
• rather than simply make longer-term investments, stakeholder perspective is at extreme of “socially
responsible corporation is one that consciously makes decisions that reduce overall profits.”
• arguments against:
o discourages financing in first place
o inefficiencies in decisionmaking: conflicting objectives resulting in deadlocks
o difficulty in accountability created by such wide array of immeasurable missions
o tax on business whose proceeds escape control by political process
• shareholder value position: freedom of contract:

• stakeholder society: Incentives and Control Issues:

o monetary incentives:
 explicit: bonuses and stock options: measure on aggregate welfare; but recommendation that
stakeholder value would be best promoted by fixed wage
• enlarged fiduciary duty
 implicit: substitute for explicit incentives in environments in which performance cannot be
well-described ex ante, but can be better assessed after the fact due to accrual of new info
• career concerns
• analogy to joint ventures: heterogeneity of interests among partners of joint venture seriously impedes
efficacy: conflicts of interest among partners create mistrust and lead to deadlocks to decision making

Cadbury Report:
• Code of Best Practice:
o 1. Board of Directors
o 2. Non-Executive Directors
o 3. Executive Directors
o 4. Reporting and Controls
o Notes and add’l recommendations
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Reading 34: International Equity Benchmarks:
• Need for Float Adjustment: consider cross-holdings; no int’l equity benchmark uses full cap any more
• Trade-Offs in Constructing Int’l Indexes:
o Breadth v. investability: consider illiquidity of smallest-cap in emerging markets
o Liquidity and crossing opportunities v. index reconstitution effects: most popular and widely used
indexes and benchmarks have greater index level liquidity for investors seeking to buy or sell index
fund position or actively managed position resembling index
 also program/portfolio trades: crossing, but with a broker
 reconstitution effects: upward price pressure on stocks chosen for inclusion in index and vice
versa
o Precise float adjustment v. transaction costs from rebalancing: no longer matter of controversy: all
indexes have some float adjustment
 float bands allow for less transaction costs
o Objectivity and transparency v. judgment:
• Emerging market benchmark: MSCI EMF for emerging markets (similar to MSCI EAFE for developed
markets)
• some transaction costs and reconstitution effects in index changes

Reading 35: Emerging Markets Finance

Market integration and liberalization:

• financial liberalization: allowing inward and outward foreign equity investment
• market prices can change upon announcement of liberalization or as soon as investors anticipate liberalization
may occur in the future
• expected returns should decrease as volatility decreases; but may become more sensitive to world events
(increasing covariance w/ developed markets)
• Barriers to integration:
o legal barriers treating foreign and domestic investors differently
o indirect barriers from differences in available info, accounting standards and investor protection
o emerging market risks: liquidity, political risk, economic policy risk, currency risk

Financial Effects of Market Integration:

• Liberalization and returns:
o dividend yields decline after liberalization but by less than 1% on average
o possibility that pre-liberalization returns already biased from integration
o unconditional correlations and betas increase after liberalization
• liberalization and capital flows:
o net capital flows to emerging markets increase rapidly after liberalization, but level out after 3 yrs
o concern that portfolio flows are not as “sticky” as fdi
• liberalization and political risk:
o some evidence country ratings significantly increase (lower risk) w/ equity market liberalization
• liberalization and diversification benefits: small but significant increase in conditional correlations and
reduced diversification benefits

Real Effects of Financial Market Integration: inflow of foreign investment, boom, currency appreciation

Contagion:
• speculative attacks on the currency?
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 o after gov’ts follow policies inconsistent w/ peg?
o as self-fulfilling: investors just decide to speculate against and cause crisis?
• if self-fulfilling, then channel for contagion
• income effect channel: reduced growth and lower income levels after crisis reduce demand for imports from
other countries
• “wake up call” channel: second country also experienced similar negative macroeconomic conditions or
followed similar inconsistent policies
• other channels: credit crunch; forced-portfolio recomposition or liquidity effect

Other issues:
• Corporate finance: emerging markets as testing ground for legal institutions / agency theories
• Fixed Income: high correlation b/w emerging market debt and equity returns
• Market Microstructure: price discovery; liquidity
• Stock Selection: information asymmetry; returns not explained by traditional asset pricing models
• Privatization: transfer of productive resources from public sector to private sector

Reading 36: Alternative Investments Portfolio Management

Diligence on Alternative Investments:

1. market opportunity
2. investment process
3. organization
4. people
5. terms and structure
6. service providers
7. documents
8. write-up

Also:
• tax issues
• determining suitability
• communication w/ client
• decision risk
• concentrated equity position of client in closely held company

Real Estate:
• types:
o direct: residences, commercial real estate, agricultural land
o indirect:
 homebuilders, real estate operating companies, etc.
 REITs
• Equity REITs own and manger office buildings, apartment buildings, shopping centers,
etc.
• Mortgage REITs invest >75% of assets in mortgages; lend money to builders and make
loan collections
• Hybrid REITs: operate real estate and buy mortgages
 Commingled real estate funds (CREFs )
• Opened ended and closed ended (closed are usually leveraged)
• Private investment vehicles
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  Separately managed accounts
 Infrastructure funds:
• Designs, finances, and builds projects
• Financed by debt and equity
• Leased to public sector to operate; allows public sector to avoid raising debt
• Benchmarks and historical performance:
o Direct real estate: in U.S.: National Council of Real Estate Investment Fiduciaries (NCREIF) Property
Index;
 Value weighted
 Includes subindices for apartments, industrial, office and retail and by geographic region
 Based on property appraisals; underestimate volatility
 Not an investable index
o Indirect real estate investment:
 NAREIT
• Real time market-cap weighted index of all REITs actively traded on NYSE and Amex
• Also monthly equity REIT index
• Also other specialized subindexes
• Note that the underlying REITs often leveraged
• Real Estate: Investment Characteristics and Roles:
o Has intrinsic value
o Substantial income component
o Lack of liquidity
o Large lot sizes
o High transaction costs
o Heterogeneity
o Immobility
o Low info transparency
o Factors: interest rates (real interest rates); term structure of interest rates; change in GDP; growth in
consumption; population growth; unexpected inflation
o Inflation hedge?
o Idiosyncratic variables
o Benefits:
 Deductible mortgage interest
 Permits more financial leverage
 Direct control over property
 Can obtain diversification through different geographic locations
 Low volatility compared to public equities
o Disadvantages:
 Not easy to divide parcels; only large part of portfolio
 High cost of info
 High broker commissions
 Substantial operating and maintenance costs
 Risk of neighborhood deterioration
 Political risk on tax deductions
o Follows economic cycles
o Provides some diversification benefits relative to stock/bond portfolio, but relatively less effective than
hedge funds and commodities
 But unsmoothed NCREIF provided greater diversification benefits
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 o Apartments have highest risk-adjusted returns; office have lowest

Private Equity / Venture Capital:

• Private equity funds: financing private businesses, leveraged buyouts of public companies; distressed debt
investing; public financing of public infrastructure projects
o Buyout funds: mega-cap buy-out funds: take public companies private; middle-market buy-out funds:
purchase private companies whose revenues and profits are too small to access capital from public
equity markets
 Add value by: restructuring operations and improving management
• Opportunistically purchasing at discount
• Gains from adding debt or debt restructuring
 Insert management
 Dividend recapitalization
 Capital commitments come from: public pension funds, corporate DB pension plans,
endowments, foundations, family offices
 Types:

Investment Processes of (Direct) Private Equity Investment and Investment in Publicly

Traded Equities
Private Equity Investments Publicly Traded Securities
Structure and Valuation
Deal structure and price are negotiated b/w the Price is set in context of market. Deal structure
investor and company management is standardized. Variations typically required
approval from securities regulators.
Access to Info for Investment Selection
Investor can request access to all info, Analysts can use only publicly available info to
including internal projections assess investment potential
Post-Investment Activity
Investors typically remain heavily involved in Investors typically do not sit on corporate
the company after the transaction by Boards or make ongoing assessments based on
participating at the Board level and through publicly available info and have limited access
regular contact w/ management to management.

• Venture capital: equity financing of new or growing private companies

o Assist in IPO
o May use PPM
o Demand for VC:
 Formative-stage companies: newly formed to product development stage
 Expansion-stage: expanding sales stage, significant revenues, stage of preparing for IPO
 Financing stages:
• Early-stage financing:
o Seed
o Start-up
o First-stage
• Later-stage financing:
o The Exit:
 Merger
 Acquisition
 IPO
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 o Supply of VC:
 Angel investors
 VC
 Large companies: corporate venturing / strategic partners
o Convertible preferred stock
• PE and VC usually indirect investment vehicles: limited partnerships
o Management fee plus incentive fee (carried interest)
 Carried interest sometimes subject to hurdle rate and subject to claw back
o Funds of funds:
• Benchmarks: annualized IRRs compiled by Cambridge Associates, Thomson Venture Economics, and NVCA.
o Performance of fund based on manager’s appraisals
o Make vintage year comparisons
• PE: Investment Characteristics and Roles:
o Growth
o Investment characteristics:
 Illiquidity
 Long-term commitments required
 Higher risk than seasoned public equity investment
 High expected IRR required
 (for VC) limited info
o Differences b/w PE and VC:
 Buyout funds are usually highly leveraged
 CFs to buyout fund investors come earlier and are often steadier than VC
 Returns to VC fund investors subject to greater error in measurement
o Roles:
 PE has moderately high correlation w/ public equity
 More idiosyncratic risk
 Ability to achieve sufficient diversification (high commitments)
 Liquidity of position
 Provision for capital commitment
 Appropriate diversification strategy
• Other issues:
o Evaluation of prospects for market success
 Markets, competition and sales prospects
 Management experience and capabilities
 Management’s commitment (consider % ownership and comp incentives)
 Cash invested (by management)
 Opinion of customers
 Identity of current investors
o Operational review
 Expert validation of technology
 Employment contracts
 Intellectual property
o Financial/legal review
 Potential for dilution of interest
 Examination of financial statements

Commodity Investments:
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 • Types:
o Direct commodity investment: cash market purchase involving actual possession and storage
o Indirect commodity investment: say as equity in companies specializing in production
• Benchmarks:
o Reuters Jefferies/Commodity Research Bureau (RJ/CRB) Index – uses unequal fixed weights based on
perceived relative importance
o Goldman Sachs Commodity Index (GSCI) – arithmetic averaging of monthly component returns; total
return version and spot version
o Dow Jones-AIG Commodity Index (DJ-AIGCI)
o S&P Commodity Index (S&PCI)
• Historical performance:
o On stand-alone basis, commodities have lower Sharpe ratio than U.S. and world bonds and equities
o Correlations w/ traditional asset classes are close to zero
o Return components: spot return / price return; collateral return; roll return (positive for long in
backwardation market)
• Investment characteristics:
o Understand investment characteristics of commodities on sector- or individual-commodity level
o Special risk characteristics:
 Unusually low correlations w/ equities and bonds
 Price risk in periods of financial and economic distress
 Long-term growth in world demand in limited supply: long-term trend growth
 Generally business cycle sensitive
 Determinants of return:
• 1. business cycle-related supply and demand:
• 2. convenience yield: embedded consumption timing option; inverse relationship b/w
level of inventories and convenience yield
o Samuelson effect: term structure of forward price volatility generally declines w/
time to expiration (mismatched supply and demand at shorter horizons, but
equilibrium in longer horizons)
• 3. Real options under uncertainty:
 Inflation: “natural” sources of return; protection against unexpected inflation
• Positive correlation w/ unexpected inflation
• Roles:
o Potent risk diversifier
o Inflation hedge: classes such as livestock and agriculture exhibit negative correlation w/ unexpected
inflation as measured by monthly changes in inflation rate; storable commodities directly linked to
economic activity exhibit positive correlation w/ changes in inflation and have superior inflation-
hedging properties

Hedge Funds:
• Types:
o Equity market neutral: roughly equal exposure long and short
o Convertible arbitrage:
o Fixed-income arbitrage: mispricing based on term structure of interest rates or credit quality
o Distressed securities:
o Merger arbitrage:
o Hedged equity: not equity market neutral
o Global macro:

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 o Emerging markets:
o Fund of funds
• Groups:
o Relative value
o Event driven
o Equity hedge
o Global asset allocators
o Short selling
• Fees:
o AUM fee and incentive fee
o High-water mark
• Initial Lock-up period: maybe 1 to 3 yrs
• Benchmarks:
o CISDM of the University of Massachusetts
o Credit/Suisse/Tremont
o EACM Advisors
o Hedge Fund Intelligence Ltd.
o HedgeFund.net
o HFR
o MSCI
o Dow Jones Hedge Fund Strategy benchmarks
o HFR hedge fund indices
o MSCI Hedge Invest Index
o Standard & Poor’s Hedge Fund Indices
• Differences in major manager-based hedge fund indices:
o Selection criteria: which hedge funds are included
o Style classification:
o Weighting scheme:
o Rebalancing scheme:
o Investability:
• Absolute return vehicles? Defined as having no benchmark, while estimates of alpha must be made relative to
a benchmark
o Can establish comparable portfolios using 1. single factor or multifactor methodology; 2. optimization
to create tracking portfolios w/ similar risk and return characteristics
• Historical performance:
o HFCI has higher Sharpe ratio than any other reported assets; correlation of 0.59 w/ S&P 500
o b/c equity hedge funds load on similar return factors as S&P 500, offer less diversification than many
relative-value strategies and can be more rightly considered return enhancers
• Interpretation Issues:
o Biases in Index Creation: concern is whether index reflects actual relative sensitivity of hedge funds to
various market conditions, such that each index provides info on true diversification benefits of
underlying hedge fund strategies
o Relevance of Past Data on Performance: best forecast of future returns is one that is consistent w/ prior
volatility and not one that is consistent w/ prior returns
o Survivorship Bias
o Stale price bias: results in lower reported correlations

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 o Backfill bias (inclusion bias): when missing past return date for component of index are filled at
discretion of component when it joins the index—only components w/ good past results will be
motivated to supply them
• Investment Characteristics:
o Common set of return drivers based on trading strategy factors (e.g., option-like payoffs) and location
factors (e.g., payoffs from buy-and-hold policy) help explain returns of each strategy
o Long-biased hedge funds are return enhancers rather than diversifiers
o Hedge funds attempting to be least affected by market direction may be diversifiers
• Role in portfolio:
o Scrutinize managers
o Emphasize style selection
o Often have option characteristics that present challenge when relying on MVO
o Mean-variance improvement
o Lower skewness and higher kurtosis
 Adopt mean-variance, skewness and kurtosis-aware approach to hedge fund selection
 Invest in managed futures: tends to have skewness opposite many hedge funds
• Other issues:
o Young funds outperform old funds on a total-return basis, or at least old funds do not outperform
young ones
o On average, large funds underperform small funds
o FOFs may provide closer approximation to return estimation than indices do
o Performance fees and lock-up periods: some evidence of better performance of funds w/ quarterly
lock-ups over monthly
o FOFs: style drift: may time one market and have become less useful in asset allocation strategies
o FOFs: don’t usually impose lock-up periods
o Fund size: smaller more nimble and higher risk-adjusted returns; larger have more clout
o Age (vintage) effects
• Hedge Fund Due Diligence:
o Structure
o Strategy
o Performance data
o Risk
o Research
o Administration
o Legal
o References
• Performance Evaluation:
o Returns: monthly usually;
 Rate of return = [(Ending value of portfolio) – (Beginning value of portfolio)]/(Beginning value
of portfolio)
 Usually compounding over 12 mos; frequency can materially affect reported performance b/c
entry and exit and drawdowns
 Typically “look through” leverage as if asset were fully paid
 Rolling return: moving average of holding-period returns that matches investor’s time horizon:
RR n ,t = ( Rt + Rt −1 + Rt −2 + ... + Rt −n ) / n ; RR12 ,t = ( Rt + Rt −1 + Rt −2 + ... + Rt −12 ) / 12
o Volatility and Downside Volatility:
 Annualize monthly by multiplying by 12
 Positive excess kurtosis and skewness
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 ∑ [min ( r )]
n
2
t − r * ,0
 Downside deviation = i =1

n −1
 Maximum drawdown: largest difference b/w high-water point and subsequent low
 Length of drawdown period: time from high-water mark until next high-water mark
o Performance Appraisal Measures:
 Sharpe ratio; limitations:
• Time dependent and increases proportionally w/ square root of time
• Doesn’t account for asymmetrical return distribution or negative or positive skewness
• Illiquid holdings bias upward
• Doesn’t account for serial correlation
• Doesn’t account for correlations w/ other investments
• Not very good predictive ability for hedge funds
• Can be gamed: lengthening measurement interval; compounding monthly returns but
calculating standard deviation from not compounded monthly returns
• Writing out of the money puts and calls on a portfolio
• Smoothing of returns w/ derivative structures
• Getting rid of extreme returns w/ total return swaps
 Sortino ratio = (Annualized rate of return – annualized risk-free rate)/Downside deviation
 Gain-to-loss ratio = (Number of months w/ positive returns / Number of months w/ negative
returns) x (Average up-month return/ average down-month return)
 Calmar ratio
 Sterling ratio
o Correlations: assumes normality
o Skewness and Kurtosis: positive skewness is good; high kurtosis means extreme returns
o Consistency:
 Number of positive months
 % positive months
 Avg return in up-months
 Number of negative months
 % negative months
 Avg return in down-months
 Avg monthly return in index up-months
 Avg monthly return in index down-months

Managed Futures: private pooled investment vehicles that can invest in cash, spot, and derivative markets for benefit
of investors and have ability to use leverage; run by general partners known as commodity pool operators (CPOs)
• skill based, absolute-return strategies
• types: private commodity pools; separately managed accounts; publicly traded commodity funds
o investment style: systematic (rule based or trend based) or discretionary (based on trader beliefs or
economic data)
o markets traded: currency, financial, or diversified (financial, currency and commodities)
o trading strategy (e.g., trend following or contrarian)
• Benchmarks:
o Mount Lucas Management Index: based on technical trading rules
o CISDM CTA: based on peer group
• Performance:
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 o standard deviations comparable to U.S. blue-chip stocks;
o Sharpe ratio better than equities but not bonds
o correlations slightly negative w/ equities; 0.42 and 0.46 w/ U.S. and global bonds respectively
• Interpretation:
o survivorship bias
• Investment characteristics: potential for improved risk and return
o derivative markets are zero-sum games: passively managed, unlevered futures position should earn
risk-free return on invested capital less management fees and transaction costs
o momentum strategies and trend following; resulting in positive skewness
o diversification capabilities (to stocks and bonds)
• Roles:
o diversification from stocks, bonds and hedge funds
o improved Sharpe ratios
• other issues:
o performance persistence;
o leveraged

Distressed Securities: securities of companies in financial distress or near bankruptcy or already in Chapter 11:
• many investors cannot hold b/c of IPS; unresearched: exploit the inefficiency
• skill in negotiation or influencing management
• Types:
o hedge fund structure: more liquid
o private equity fund structure: closed end
o types of assets:
 publicly traded debt and equity securities in distressed company
 newly issued equity of co emerging from reorg (orphan equity)
 bank debt and trade claims
 “lender of last resort” notes
 variety of derivative instruments for hedging purposes
• Benchmarks:
o subindexes of major hedge fund indices: EACM, CISDM, HFR; Altman-NYU Salomon Center
Defaulted Public Bond and Bank Loan Index
• Performance:
o non-normal: negative skewness (downside risk); large kurtosis (outlier events)
o high mean returns w/ low standard deviation: high Sharpe ratio
o low correlation w/ world stock and bond investments
• investment characteristics:
o consider IPS restrictions (limits to investment grade; might be required to sell fallen angels)
• Roles:
o Long-Only Value Investing: investing in undervalued distressed securities; if public debt: high-yield
investing; if orphan equities: orphan equities investing
o Distressed Debt Arbitrage: purchasing co’s traded bonds and selling short its equity
o Private Equity: become major creditor to influence
 prepackaged bankruptcy: converting distressed debt to private equity
o Risks:
 event risk
 market liquidity risk
 market risk
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  J factor risk: judge’s track record in adjudicating bankruptcies and restructuring
 not normal
 illiquid
 stale pricing
• other issues:
o Bankruptcy in U.S. v. other countries:
 other countries, bankruptcy usually liquidation; rehabilitation of debtor is distinctive to U.S.
o Absolute Priority Rule: satisfy senior claims first (but new value exception)
o Prepackaged Bankruptcy Filing: debtor agrees in advance w/ creditors on plan of reorg b/f formally
files for Chap 11 protection

Reading 37: Swaps

Commodity swaps: fixed price of swap is weighted average of corresponding forward prices.
n

∑ P( 0, t ) F i 0 ,t i
F= i =1
n

∑ P( 0, t )
i =1
i

∑Q P( 0, t ) Fti i 0 ,t i

With varying quantities: F =

i =1
n

∑Q P( 0, t )
i =1
ti i

For summer and winter varying:

Fs ∑P(0, t )Q
i∈summer
i ti +F w ∑P(0, t )Q
i∈w int er
i ti =
i∈summer
∑P(0, t )Q
i ti F0 ,ti + ∑P( 0, t )Q
i∈w int er
i ti F0 ,ti

Because fixed swap payment equal, while the futures prices vary, the mismatch creates a borrowing/lending
component.

Reading 38: Commodity Forwards and Futures

F0,T = S 0 e ( r −δ )T

Synthetic commodity: long forward plus zero coupon bond w/ face value equal to forward price

Link b/w expected commodity price and forward price: F0,T = E 0 ( S T ) e

( r −α ) T

Nonstorability: Electricity:
• different prices in summer and winter and in night and day

Commodity Lease Rate:

1
• δl = r − ln ( F0,T S )
T
• Cash and carry arbitrage: borrow cash, buy commodity, lend commodity and short forward
• Reverse cash and carry arbitrage: short commodity, lend cash, long forward
• Contango occurs when lease rate is less than risk-free rate;
• Backwardation occurs when lease rate is greater than risk-free rate
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 • Carry: storage
( r +λ )T
• Forward price with storage costs (like negative dividend; applies only when storage occurs): F0,T = S 0 e
( r +λ−c )T
• Forward price factoring in convenience yield: F0,T = S 0 e
o Those who earn convenience yield likely already hold optimal amount of commodity; there may be no
way for you to earn convenience yield when performing cash and carry
o For average investor arbitrageur, price range w/I when no arbitrage is S 0 e ( r +λ−c )T ≤ F0,T ≤ S 0 e ( r +λ )T

Gold Futures:
• Easily storable; often sold certificated; Has lease rate: use lease formula to determine lease rate; synthetic gold
generally preferable way to obtain exposure

Seasonality: Corn Forward Market:

• Harvested in U.S. from Sept to Nov.
• Prices rise at interest rate plus storage costs; falls at harvest
• Occasional storage across harvests

Natural Gas:
• Seasonality and storage costs
• Difficult to transport internationally so, forward curves vary regionally
• Costly to store
• In U.S., demand highest in winter months
• Steady stream of production w/ variable demand (as opposed to corn)

Oil:
• Easy to transport
• Easier to store than gas

Commodity spreads: some commodities are inputs in creation of other commodities

• Crush spread: position in soybeans and opposite position in equivalent quantities of soybean meal and soybean
oil
• Crack spread: oil and distillates: oil => gas & heating oil

Hedging Strategies:
• Basis risk: the price of the commodity underlying the futures contract may move differently than price of
commodity you are hedging
o Say based on differing delivery locations and times
o Say differing grades
• Strip hedge: buy commodity over time for over-time obligation;
• stack hedge: enter futures w/ single maturity w/ number of Ks selected so that changes in PV of future
obligations are offset by changes in value of “stack” of futures Ks.
• Stack and roll: stacking futures Ks in near-term K and rolling over into new near-term K (profitable in
backwardation)
• Weather derivatives: (a cross hedge): contracts that make payments based upon realized characteristics of
weather
o Heating degree-day
o Cooling degree-day

Reading 39: Risk Management:

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Risk Management Process:
• 1. Set Policies & Procedures
• 2. Define Risk Tolerance
• 3. Identify Risks
• 4. Measure Risks
• 5. Adjust Level of Risk
• 6. Execute Risk Management Transactions
• 7. Identify Appropriate Transactions
• 8. Price Transactions
• 9. Execute Transactions

Risk Governance:
• Enterprise risk management (ERM): centralized risk management for overall company at level close to senior
management. Steps:
o 1. Identify each risk factor exposed to
o 2. quantify each exposure’s size in money terms
o 3. map inputs into risk estimation calculation
o 4. identify overall risk exposures as well as contribution from each factor
o 5. set reporting process to senior mgmt: committee
o 6. monitor compliance

Identifying Risks: market risk (interest rate risk, exchange rate risk, equity price risk, commodity price risk); credit
risk; liquidity risk; operational risk; model risk; settlement risk; regulator risk; legal/contract risk; tax risk; accounting
risk; sovereign/political risk
• Market risk: interest rate risk, exchange rate risk, equity price risk, commodity price risk
• Credit risk: counterparty risk
• Liquidity risk: that financial instrument cannot be purchased or sold w/o significant concession in price
o Size of Bid-ask spread: a measure of liquidity risk
o Volume
• Operational Risk: risk from failure in co’s systems and procedures or from external events
• Model Risk:
• Settlement (Herstatt) Risk: paying counterparty while counterparty is declaring bankruptcy
o May net to reduce
• Regulatory Risk: how transactions will be regulated or that regulation will change
• Legal/Contract Risk: say fraud or illegal contract, or otherwise unenforceability of K
• Tax Risk: uncertainty associated w/ tax laws
• Accounting Risk: uncertainty about how transaction should be recorded and potential for accounting rules and
regulations to change
• Sovereign and Political Risks: changing political conditions in countries
o Sovereign risk: where borrower is gov’t
o Political risk: changes in political environment
• Other risks:
o ESG risk: environmental, social and governance
o Performance netting risk: potential for loss resulting from failure of fees based on net performance to
fully cover contractual payout obligations to individual portfolio managers that have positive
performance when other portfolio managers have losses and when there are asymmetric incentive fee
arrangements w/ the portfolio managers

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 o Settlement netting risk: that liquidator of a counterparty in default could challenge netting arrangement
so that profitable transactions are realized for benefit of creditors

Measuring Risk
• Measuring Market risk:
o standard deviation / volatility
o active risk / tracking risk / tracking error volatility
o beta, duration, delta
o convexity, gamma
o vega, theta
• Value at Risk (VAR): probability-based measure of loss potential, expressed as % or units of currency;
“estimate of loss (in money terms) that we expect to be exceeded with a given level of probabiliby over a
specified time period.”
o requires: 1. probability level; 2. time period; 3. model
o analytical or variance-covariance method: infer VAR from standard deviation and normal distribution
 delta-normal method: assume that change in option price is assumed to equal change in
underlying price multiplied by delta (avoids non normality of options)
o Historical Method (historical simulation method): set VAR according to actual historical experience /
historical distribution
 nonparametric
o diversification effect: difference b/w sum of individual VARs (say for different divisions) and total
VAR
o Monte Carlo Simulation Method:
o “Surplus at Risk”: VAR as it applies to pension funds
o backtesting: process of comparing number of violations of VAR thresholds w/ figure implied by user-
selected probability level
• Extensions and Supplements to VAR:
o Incremental VAR (IVAR): measures incremental effect of an asset on VAR
o cash flow at risk (CFAR)
o earnings at risk (EAR)
o tail value at risk (TVAR): VAR plus the expected loss in excess of VAR, when such excess loss occurs
• Stress Testing: identify unusual circumstances that could lead to losses in excess of typical
o Scenario analysis: under different states of the world
 actual extreme events
 hypothetical events
o Stressing Models:
 factor push: push prices and risk factors of underlying model in most disadvantageous way and
work out combined effect
 maximum loss optimization: optimize mathematically the risk variable that will produce the
max loss
 worst-case scenario analysis
• Measuring Credit Risk: likelihood of loss and amount of associated loss
o current credit risk (jump-to-default risk): risk of events happening in immediate future
o credit VAR (default VAR or credit at risk)
o option-pricing theory and credit risk: bond w/ credit risk can be viewed as default-free bond plus
implicit short put option on the assets written by bondholders for stockholders
o credit risk of forward Ks: current credit risk at expiration; otherwise, potential credit risk
o credit risk of swaps: credit risk present at series of points

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  for interest rate and equity swaps: potential credit risk is largest during middle period of swap’s
life
 currency swaps have greatest credit risk b/w midpoint and end of life
o credit risk of options: unilateral credit risk
• Liquidity Risk:
o maybe liquidity-adjust VAR estimates
• Measuring Nonfinancial Risks: maybe more suitable for insurance (maybe extreme value theory)
o operational risk:
o Basel II

Managing Risk:
• key components:
o effective risk governance model, which places overall responsibility at senior mgmt level, allocates
resources effectively and features appropriate separation of tasks b/w revenue generators and those on
control side of business
o appropriate systems and technology to combine info analysis in such way as to provide timely and
accurate risk info to decision makers
o sufficient and suitably trained personnel to evaluate risk info and articulate it to those who need info
for purposes of decision making
• Managing Market Risk:
o Risk Budgeting: might be set in terms of VAR units or on individual transaction size, amount of
working capital needed to support the portfolio or amount of losses acceptable for any given time
period, or IR for portfolio managers, or risk to the surplus. Also:
 performance stopouts
 working capital allocations
 VAR limits
 Scenario Analysis limits
 risk factor limits
 position concentration limits
 leverage limits
 liquidity limits
• Managing Credit Risk: one-sided risk
o Reducing Credit Risk by Limiting Exposure: limit transactions w/ any single counterparty
o Reducing Credit Risk by Marking to Market: OTC derivatives (options not marked to market)
o Reducing Credit Risk with Collateral: usually cash or highly liquid, low-risk securities
o Reducing Credit Risk with Netting: used in two-way contracts (forwards, swaps); also netting among
multiple contracts: closeout netting
 cherry picking: bankrupt company enforcing only profitable contracts (not netting)
o Reducing Credit Risk w/ Minimum Credit Standards and Enhanced Derivative Product Companies:
 Enhanced Derivatives Products Companies (EDPCs): subsidiaries separated from parent’s
debts so as to minimize counterparty risk
o Transferring Credit Risk with Credit Derivatives:
 credit default swaps
 total return swap
 credit spread option
 credit spread forward
• Performance Evaluation:
o Sharpe ratio

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 o Risk-Adjusted Return on Capital (RAROC): divides expected return by a measure of capital at risk
o Return over Maximum Drawdown (RoMAD): average return in given year over maximum difference
b/w high-water mark and subsequent low
o Sortino Ratio: Sortino Ratio = (Mean portfolio return – minimum acceptable return (MAR))/Downside
deviation (below MAR)
• Capital Allocation: measure of capital:
o 1. nominal, notional, or monetary position limits (seldom sufficient risk control)
o 2. VAR-based position limits
o 3. Maximum loss limits
o 4. Internal capital requirements: say using VAR
o 5. Regulatory capital requirements
• Psychological and Behavioral Considerations: risk governance should anticipate points in cycle when
incentives of risk takers diverge from those of capital allocators (say when fall into negative performance)

Reading 40: Currency Risk Management

Hedging w/ Futures or Forward Currency Ks:

• Basic Approach: Hedging Principal:
o unhedged asset return: Vt * − V0* = Vt S t −V0 S 0
o return on hedge: Realized gain = V0 ( − Ft + F0 )
o Profit = Vt S t − V0 S 0 + V0 ( − Ft + F0 )
Vt S t − V0 S 0 ( − Ft + F0 )
o hedged position rate of return: RH = + = R * − RF
V0 S 0 S0
• Minimum-Variance Hedge Ratio: used when foreign currency value of foreign investment reacts
systematically to an exchange rate movement
o RH = R * − h × RF

o optimal hedge ratio (regression hedge ratio): h =

* (
cov R * , RF )
; also can be estimated as R* = a + h*RF
σ F2
+ error term
o Translation risk: from translation of value of asset from foreign currency to domestic currency; hedge
ratio for translation risk is 1
 RH − R = s (1 − h ) : minimizing the first term comes from an h of 1
o Economic Risk: when foreign currency value of foreign investment reacts systematically to an
exchange rate movement (say when country raises interest rates to fight currency depreciation)
cov ( R, s )
 hedge ratio estimated by:
σs
2

o Hedging Total Currency Risk: both translation risk and economic risk
• Influence of the Basis: futures and spot exchange rates differ by a basis
o Basis risk: basis equals interest rate differential
o Implementing hedging strategies:
 1. short-term Ks, rolled over at maturity
 2. Ks w/ matching maturity
 3. long-term Ks w/ maturity extending beyond hedging period
o Hedging Multiple Currencies:
 try to find Ks on other currencies that are closely correlated w/ (nonactively traded) investment
currencies
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  optimization techniques can be used to construct hedge w/ futures Ks in only a few currencies
 practice:
• select independent major currencies w/ futures Ks available
• run multiple regression of domestic currency returns of portfolio on futures returns of
selected currencies
• use regression coefficients as hedge ratios

Insuring and Hedging w/ Options: as insurance or as hedging by accounting for relationship b/w premium and
underlying exchange rate
• Insuring w/ Options:
o Net dollar profit on put = V0 ( K − S t ) −V0 P0 when K>St; = −V0 P0 otherwise.
o Not a good hedge unless variations in spot price swamp the premium
• Dynamic hedging w/ options: match dollar loss (gain) in underlying w/ dollar gain (loss) in option
o Good currency hedge requires holding –V0/δ options; hedge ratio is 1/δ; (delta hedge)
o Hedge ratio fluctuates
o Where direction of currency movement is clearly forecasted, currency futures provider cheaper hedge

Other Methods for Managing Currency Exposure:

• Buying high beta equities
• Increase duration of foreign portfolio to foreign interest rates w/o increasing currency exposure
• w/ options, currency fluctuations affect mostly translation of profit into dollars not the principal (if the
underlying were bought instead)
• see chart on p. 314

Strategic and Tactical Currency Management:

• Strategic Hedge Ratio: see IPS for private investors and benchmark hedge ratio for institutional investors
o Traditional approach: minimize variance: fully hedge currency
o Total Portfolio Risk: depends on proportion of int’l assets; may add some diversification
o Asset Types: different currency sensitivities
o Investment Horizon: longer the horizon, the lower the benchmark hedge ratio
o Prior Beliefs on Currencies: may see weakness in own currency
o Costs: transaction costs, administrative and monitoring; interest rate differential
o Is Regret Proper Measure for Currency Risk? Hedge 50% to minimize regret?
• Currency Overlay: manage currency risks in existing portfolio; not to speculate
o Given parameters on hedge ratios and max level of tracking error relative to benchmark; or set of
acceptable currencies
o Tactical approaches:
 Management of the Currency Risk Profile: active risk management through dynamic hedging
or option-based approaches: protect from downside and allow for upside potential
 Technical Approach: exploit temporary market inefficiencies by identifying predictable price
patterns and volatility
 Fundamental Approach: economic analysis
o Shouldn’t separate asset allocation from currency exposure: currency overlays are suboptimal
• Currencies as an Asset Class:
o Low correlation b/w currencies and equities; also low b/w currencies and bonds
o Absolute return basis: currency for alpha funds

Reading 41: Risk Management Applications of Forward and Futures Strategies

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Strategies and Applications for Managing Equity Market Risk:
cov SI
• Beta: β =
σI
2

o Dollar beta: beta times portfolio value; for futures, beta times futures price
 β − β S  S 
o Number of futures contracts to obtain target beta: N f =  T  
 f 
 β f 
• Creating equity out of cash: long stock = long risk-free bond + long futures
V (1 + r )
T
o Rounded off number of futures contracts to buy: N *f = ; resulting investment is no longer V
qf
N *f qf
but V*: V =
*
; and dividends are treated as reinvested and result in larger number of contracts
(1 + r ) T
than if just received the dividends, the implicit number of contracts starting with (growing to the
N *f q
previous number of contracts by the dividend reinvestment) is ; however transaction does not
(1 + δ ) T
actually capture dividends, just the performance of the index
o Equitizing Cash: do above transaction; maintains liquidity of cash
o Consider the under/over pricing of the futures
• Creating Cash out of Equity: Long stock + short futures = Long risk-free bond
o Effectively convert (V/S)(1+δ)T to cash;
V (1 + r )
T
o N *f = −
qf
− N *f qf
o V = *

(1 + r ) T
Asset Allocation w/ Futures:
• If reducing equity position, use futures to reduce the beta of the dollar amount of such reduction to zero: say
want to turn $10M of equity position to bonds, sell futures such that beta on $10M is zero; then buy bond
futures.
 MDUR T − MDUR B B
o For the bonds: N bf =  
f
 MDUR f  b
• Pre-Investing in an Asset Class: don’t have the cash currently, but will in future; long underlying + loan = long
futures; like a fully leveraged position in the underlying;

Strategies and Applications for Managing Foreign Currency Risk:

• Transaction exposure: risk of exchange rate movement on a somewhat predictable future cash flow in foreign
currency (say a co’s foreign sales)
• Translation exposure: need to consolidate balance sheets of foreign subs
• Economic exposure: say reduced sales when currency appreciates
• Transaction exposure:
o Managing risk of foreign currency receipt: as if long the foreign currency; lock in exchange rate by
selling forward (short)
o Managing risk of foreign currency payment: as if short the foreign currency; lock in exchange rate by
buying forward (long)
o Managing risk of foreign-market asset portfolio: future value of portfolio unknown;

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  If only foreign stock market return hedged, portfolio return is foreign risk-free rate b/f
converting to domestic currency; if both foreign stock market and exchange rate risk are
hedged, return equals domestic risk-free rate

Futures or Forwards?
• Risks that have specific dates: use forwards
• Forward market been around for longer than futures market and is liquid
• Dealers of forwards use futures to quickly hedge their own risk
• Forwards allow to keep private transaction activity

Reading 42: Risk Management Applications of Option Strategies

Risk Management Strategies w/ Options and the Underlying:

• Reduce exposure to underlying by: 1. selling a call; or 2. buying a put.
• Covered call: underlying plus short call.
o Profit: Π = ST − S 0 − max ( 0, ST − X ) + c0
• Protective put: underlying plus long put
o Profit: Π = ST − S 0 + max ( 0, X − ST ) − p0
o Can be viewed as insurance
• Money Spreads:
o (as compared to time spreads: which differ by expiration date)
o Bull spreads: makes money if market rises: long position in call w/ exercise price and short position in
call w/ higher exercise price
 Value at expiration: VT = max ( 0, ST − X 1 ) − max ( 0, S T − X 2 )
 Profit: Π = max( 0, ST − X 1 ) − max( 0, ST − X 2 ) − ( c1 − c2 )
 Maximum profit = X 2 − X 1 − c1 + c2
 Maximum loss = c1 −c 2
 Breakeven price: ST = X 1 + c1 − c2
*

o Bear spreads: makes money if market goes down: sell call w/ exercise price and buy call w/ higher
exercise price; or: buy put w/ exercise price and sell put w/ lower exercise price
 Value at expiration: VT = max( 0, X 2 − ST ) − max( 0, X 1 − ST )
 Profit: Π = max( 0, X 2 − ST ) − max( 0, X 1 − S T ) − p2 + p1
 Maximum profit = X 2 − X 1 − p 2 + p1
 Maximum loss = p 2 − p1
 Breakeven: ST = X 2 − p2 + p1
*

o Butterfly spreads: combines bull and bear spread: buy calls w/ exercise price X1 and X3 and sell two
calls w/ exercise price X2
 Value at expiration: VT = max ( 0, ST − X 1 ) − 2 max ( 0, ST − X 2 ) + max ( 0, ST − X 3 )
 Profit: Π = max ( 0, ST − X 1 ) − 2 max ( 0, ST − X 2 ) + max ( 0, ST − X 3 ) − c1 + 2c2 − c3
 Maximum profit = X 2 − X 1 − c1 + 2c2 − c3
 Maximum loss = c1 − 2c2 + c3
Breakeven: ST = X 1 + c1 − 2c2 + c3 and ST = 2 X 2 − X 1 − c1 + 2c2 − c3
* *

 Strategy based on expectation of low volatility in underlying; profitable if less volatility than
market expects; if expect to be more volatile than market expects, sell the butterfly spread
 Can create w/ puts: buy puts w/ exercise prices X1 and X3 and sell two puts w/ exercise price
X2.
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 • Combinations of Calls and Puts: (aka range forward or risk reversals)
o Collars: underlying plus long put plus short call
 zero-cost collar: premium received for call offsets premium paid for put
 Value at expiration: VT = ST + max( 0, X 1 − ST ) − max ( 0, X 2 − ST )
 Profit: Π = ST + max ( 0, X 1 − ST ) − max ( 0, X 2 − ST ) − S 0 ; (assuming zero-cost collar)
 maximum profit = X2 – S0
 maximum loss = S0 – X1
 breakeven: ST = S 0
*

o Straddle: buy call and put as same price; bet on large volatility
 makes sense only when investor believes market will be more volatile than everyone else
 value at expiration: VT = max ( 0, ST − X ) + max( 0, X − ST )
 profit: Π = max ( 0, ST − X ) + max ( 0, X − ST ) − c0 − p0
 maximum profit = ST – c0 – p0; ∞
 maximum loss = c0 + p0
 breakeven ST*= ST + c0 + p0 or ST – (c0 + p0)
o Strap: add call to straddle
o Strip: add put to straddle
o Strangle: straddle with different exercise prices; similar graph as straddle but w/ flat section in stead of
point on bottom
o Box Spreads: combination bear and bull spread: buy call w/ exercise price X1 and sell call w/ exercise
price X2 and buy put w/ exercise price X2 and sell put w/ exercise price X1.
 value at expiration:
VT = max( 0, ST − X 1 ) − max( 0, ST − X 2 ) + max( 0, X 2 − ST ) − max( 0, X 1 − ST ) ; thus: X2 – X1
 profit: Π = X 2 − X 1 − ( c1 − c2 + p2 − p1 )
 maximum profit = (same as profit)
 maximum loss = (no loss possible, given fair option prices)
 Breakeven: no breakeven; transaction always earns risk-free rate, given fair option prices

Interest Rate Option Strategies:

• calls pay off if option expires w/ underlying interest rate above exercise rate (used by / benefits borrowers);
puts pay off if option expires w/ underlying interest rate below exercise rate (used by / benefits lenders).
• payoff of interest rate call option: (notional principal) max(0,Underlying rate at expiration – Exercise rate)
(Days in underlying rate / 360). say borrow at LIBOR and want cap on interest rate paid
• payoff of interest rate put option: (notional principal) max(0,Exercise rate – Underlying rate at expiration)
(Days in underlying rate / 360). say lend at LIBOR and want floor on interest rate received
• Interest rate cap w/ floating-rate loan: Cap: series of interest rate call options w/ same exercise rate on
individual caplets
o note that first payment is set at start so makes no sense to set cap on such known rate
• Interest rate floor w/ floating-rate loan: floor: series of interest rate put options w/ same exercise rate on
individual floorlets
• Interest rate collar w/ floating-rate loan: long cap plus short floor (to offset some or all of premium).
(usually used by borrowers, but could be reversed for a lender)

Option Portfolio Risk Management Strategies:

• could lay off risk using put-call parity: c = p + S-X/(1+r)T; not commonly employed b/c of availability and
pricing
• could delta hedge:
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 o delta = change in option price / change in underlying price
Nc 1
o =−
NS ∆c ∆S
o but gamma
 gamma = change in delta / change in underlying price
 as expiration approaches, deltas of in-the-money options will move toward 1.0 and deltas of
out-of-the money options will move towards 0.0. So if close to expiration and at-the-money,
can have fast moves to 1.0 or to 0.0
o delta constantly changing (price and time)
 further away the underlying price moves from current price, the worse the delta-based
approximation and effects are asymmetric
• for calls, delta underestimates effects of increases in underlying and overestimates
effects of decreases in underlying
o some error from rounding
o delta is the N(d1) term in Black-Scholes
o use continuously compounded rates
o can delta hedge with a similar option rather than underlying: need delta b/w the options
o any additional funds released from selling underlying or other options are invested in risk-free bonds
• Vega and Volatility Risk: vega = change in option price / change in volatility
o option more sensitive to vega when at-the-money
• bullish equity investors buy calls; bullish bond investors buy puts

Reading 43: Risk Management Applications of Swap Strategies

Using Interest Rates Swaps to Convert a floating-rate loan to a fixed-rate loan (and vice versa)
• (swaps are most common instrument used to manage interest rate risk)
• duration: pay-fixed is similar to long position in floating-rate bond and short position in fixed-rate bond.
• swaps function as hedge from planning and accounting perspective, but tremendously speculative from market
value perspective

Using Swaps to Adjust Duration of Fixed-Income Portfolio:

• pay-fixed: duration of floating-rate bond minus duration of fixed-rate bond: value is negative
 MDUR T − MDUR B 
• NP = B  ; NP is notional principal of swap; B is value of bond portfolio
 MDUR S 
• approximation of duration of swap: 75% of the maturity minus (1 divided by 2 times the frequency of the
floating payments); so for 4 year maturity w/ quarterly floating payments: .75 x 4 – 0.125 = 2.875.

Using Swaps to Create and Manage Risk of Structured Notes:

• Structured Notes: short- or intermediate-term floating-rate securities w/ feature: leverage, or inverse feature,
etc.
• using swaps to create and manage risk of leveraged floating-rate notes (leveraged floating-rate note or
leveraged floater): issue structured note w/ say 1.5 times LIBOR interest payments; invest 1.5 times proceeds
(not clear where extra .5 comes from) in fixed rate bonds; swap the fixed rate payment for LIBOR; swapped
LIBOR payment is on a notional principal 1.5 times structured note so its payments equal the payment on the
structured note.
• using swaps to create and manage risk of inverse floaters: issue structured note, invest proceeds in fixed-rate
note, then swap fixed rate for floating rate to match structured note

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Strategies and Applications for Managing Exchange Rate Risk:
• Converting a loan in one currency into a loan in another currency:
o say issue bond in home country in home currency, swap proceeds for foreign currency and receive
interest payments in home currency (to further pay bond payments in home country) while paying
interest in foreign currency; (may have to come up with additional proceeds to cover the fixed
payments on the home country bond); at end of life, undo notional amounts of swap.
• Converting Foreign Cash Receipts into Domestic Currency: no exchange of notional principals; say pay fixed
amount in foreign currency and receive fixed amount in home currency
• Using Currency Swaps to Create and Manage Risk of Dual-Currency Bond: interest paid in one currency and
principal paid in another: say multinational generates sufficient cash in foreign currency to pay interest but not
enough to pay principal; (equivalent to issuing ordinary bond in one currency and combining w/ currency
swap that has no principal payments)

Strategies and Applications for Managing Equity Market Risk:

• (to continue managing equity market risk after expiration, swap would need to be renewed periodically and
would be subject to new environment)
• Diversifying a Concentrated Portfolio: (say large equity gift that can’t sell)
o pay return on one equity and receive return on another equity; no exchange of principal
o consider problem of negative return: could mean payment of both negative return normally to be
received from other party and payment of positive return normally to be paid.
• Achieving International Diversification: swap such that give up domestic market performance for return on
international market
o also consider possibility of negative cash flow
o consider tracking error if keyed to indexes
• Changing Asset Allocation b/w Stocks and Bonds: swap return on one class for return on another class
o consider tracking error if keyed to indexes
o consider cash flow problems
• Reducing Insider Exposure: same as diversifying concentrated portfolio
o consider issues of insiders selling (b/c not avoided by swap)

Strategies and Applications Using Swaptions:

• options to enter into swaps
• payer swaption: put equivalent on coupon bond; receiver swaption: call equivalent on coupon bond
• Using Interest Rate Swaption in Anticipation of Future Borrowing:
• Using Interest Rate Swaption to Terminate Swap:
• Synthetically Removing (Adding) a Call Feature in Callable (Noncallable) Debt:
o remove call by selling receiver swaption: equivalent to selling call on coupon bond; makes sense if
rates not expected to fall: receive premium and if rates don’t fall swaption not exercised and not
required to pay at the underlying fixed rate.
o add call by buying receiver swaption: equivalent to buying call on coupon bond; makes sense if
interest rates expected to fall; pay premium, and then have ability to receive underlying fixed rate in
case interest rates fall.
o (difference is that synthetically removing (adding) involves lump sum premium whereas with
embedded feature, premium is allocated over time in the coupon payments)
o use payer swaptions if want to synthetically replicate put features on putable bonds. not common.

Reading 44: Execution of Portfolio Decisions

Context of Trading: Market Microstructure:

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• Order Types:
o market order: instruction to execute order promptly in public markets at best price available
 emphasizes immediacy of execution; bears some degree of price uncertainty
o limit order: trade at best price available but only if price is at least as good as specified limit price
 emphasizes price; has execution uncertainty
o market-not-held order: where handled by broker; not-held means not required to trade at specific price
or specific time interval; allows for discretion to not trade based on judgment
o Participate (do not initiate) order: variant of market-not-held: broker stays deliberately low-key and
waits and responds to initiatives of more active traders (to capture better price)
o Best efforts order: even more discretion to broker to judge market conditions
o undisclosed limit order: doesn’t disclose total quantity of order
o Market on open order: to be executed at opening of market
o market on close order: to be executed at market close
o (principal trade: broker buys/sells the position for self)
o (portfolio trade (or program trade or basket trade): specified basket of securities; reduces risk to other
side of asymmetric info)
• Types of Markets: (markets provide liquidity, transparency and assurity of completion)
 market fragmentation: many places to trade
 straight through processing: automatic settlement of trade after execution
 open outcry auction market: old style
o Quote-Driven (Dealer) Market: dealers establish firm prices at which securities can be bought and sold
 (closed-book markets: if limit order book is not visible in real time to public)
 bond markets are overwhelmingly dealer markets (b/c of lack of liquidity)
 effective spread: 2 x deviation of actual execution price from midpoint of market quote at time
order is entered (may result in effective spread lower than quoted spread)
o Order-Driven Markets: transaction prices established by public limit orders
 Electronic Crossing Networks: buy and sell orders are batched (accumulated) and crossed at
specific point in time, usually anonymous fashion (POSIT is an electronic crossing network)
• avoids dealer costs and effects a large order can have on price and information leakage
• volume may be low
• doesn’t provide price discovery (where transactions prices adjust to equilibrate supply
and demand)
 Auction Markets (periodic/batch auction markets or continuous auction markets): orders of
multiple buyers compete for execution (after reopening market for day may be auction market)
 Automated Auction (Electronic Limit-Order Markets): computer-based auctions that operate
continuously w/i day using specified set of rules to execute orders
o Brokered Markets: transactions largely effected through search-brokerage mechanism away from
public markets
 mostly used for block transactions
 also in less liquidity countries
o Hybrid markets: say NYSE: batch market at opening, continuous auction market (intraday trading) and
quote-driven market
• Roles of Brokers and Dealers
o represent the order
o find opposite side of trade
o supplying market information
o providing discretion and secrecy
o providing other supporting investment services
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 o supporting market mechanism
• Evaluating Market Quality:
o liquidity:
 low bid-ask spreads
 market is deep
 market is resilient: only small discrepancies b/w market price and intrinsic value and corrected
quickly
 factors contributing to liquidity:
• many buyers and sellers
• diversity of opinion, info and investment needs
• convenience
• market integrity
o transparency:
 pretrade transparency: quickly, easily and inexpensively obtain accurate info about quotes and
trades
 post-trade transparency: details of completed trades are quickly and accurately reported to
public
o Assurity of the contract

Costs of Trading:
• transaction cost components:
o explicit costs: broker commissions, taxes, stamp duties and exchanges fees
o implicit costs:
 bid-ask spread
 market impact
 missed trade opportunity
 delay costs (b/c of size of order and liquidity of market)
o (measures)
 time-of-trade midqoute
 volume-weighted average price (VWAP): avg price security traded at during day weighted by
trade volume
 implementation shortfall: difference b/w money return on notional or paper portfolio in which
positions are established at prevailing price when decision to be made (decision price) and
actual portfolio return
• explicit costs (commissions, taxes, fees)
• realized profit/loss: price movement from decision price (often using previous day’s
close). though if broken over several days, each day has its own benchmark
• Delay costs (slippage): close-to-close price movement over day order placed when
order is not executed that day and based on amount of order actually subsequently
filled; This is zero for any shares traded same day as decide to trade.
• missed trade opportunity cost (unrealized profit/loss): price difference b/w trade
cancellation price and original benchmark price based on amount of order that was not
filled
 market adjusted implementation shortfall: difference b/w money return on notional or paper
portfolio and actual portfolio return, adjusted using beta to remove effect of return on market
• if 1% market move and beta of 1.0, then subtract 1% from implementation shortfall; the
1% is not counted against you

Comparison of VWAP and Implementation Shortfall

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 VWAP Implementation Shortfall
Advantages - easy to compute - links trading to portfolio manager activity;
- easy to understand can relate cost to value of investment ideas
- can be computed quickly to assist traders during - recognizes tradeoff b/w immediacy and price
execution - allows attribution of costs
- works best for comparing smaller trades in - can be built into portfolio optimizers to reduce
nontrending market turnover and increase realized performance
Disadvantages - does not account for costs of trades delayed or - requires extensive data collection and
cancelled interpretation
- becomes misleading when trade is substantial - imposes unfamiliar evaluation framework on
proportion of trading volume traders
- not sensitive to trade size or market conditions
- can be gamed by delaying trades

• Pretrade analysis: Econometric Models for Costs:

o factors: stock liquidity characteristics; risk; trade size relative to available liquidity; momentum;
trading style

Types of Traders and Their Preferred Order Types:

• Types:
o information-motivated traders: act quickly on info;
 need liquidity and speed of execution over better price
 likely use market orders and rely on market makers
 use less obvious orders and may use dealers
o value-motivated traders: based on slow research
 wait for better price and accumulate over time
 use limit orders
o liquidity-motivated traders: not based on info, but may simply need to release cash
 use market, market-not-held, best efforts, participate, principal trades, portfolio trades and
orders on ECNs and crossing networks
o passive traders: work for index funds etc.
 concerned about cost of trading: exchange lack of urgency for lower-cost execution
 use limit orders, portfolio trades and crossing networks
o day traders: rapidly buy and sell

Trade Execution Decisions and Tactics:

• Decisions Related to Handling Trade:
o small, liquidity-oriented trades can be packaged up and executed via direct market access (DMA;
platforms sponsored by brokers that permit buy-side traders to directly access equities, fixed income,
futures, and foreign exchange markets, clearing via the brokers)
o large, info-laden trades: need skill
• Objectives in Trading and Trading Tactics:
o Liquidity-at-Any-Cost Trading Focus:
 expensive but timely execution
o Costs-Are-Not-Important Trading Focus: market orders
o Need-Trustworthy-Agent Trading Focus: for larger orders
 best efforts, market-not-held or participate
o Advertise-to-Draw-Liquidity Trading Focus: IPOs, secondary offerings, sunshine trades
o Low-Cost-Whatever-the-Liquidity Trading Focus:
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  limit orders

Objectives in Trading
Focus Uses Costs Advantages Weaknesses
Liquidity at any Immediate execution High cost due to Guarantees execution High potential for
cost (I must trade) in institutional block tipping market impact and
size supply/demand info leakage
balance
Need trustworthy Large-scale trades; Higher commission; Hopes to trade time Loses direct control
agent (possible low-level advertising possible leakage of for improvement in of trade
hazardous trading info price
situation)
Costs are not Certainty of Pays the spread; may Competitive, market- Cedes direct control
important execution create impact determined price of trade; may ignore
tactics w/ potential
for lower cost
Advertise to draw Large trades w/ lower High operational and Market-determined More difficult to
liquidity info advantage org costs price for large trades administer; possible
leakage to front-
runners
Low cost whatever Non-info trading; Higher search and Lower commission; Uncertainty of
the liquidity indifferent to timing monitoring costs opportunity to trade trading; may fail to
at favorable price execute and create
need to complete at
later, less desirable
price

• Automated Trading:
o algorithmic trading: automated electronic trading subject to quantitative rules and user-specified
benchmarks and constraints
o smart routing: use algorithms to route orders to most liquid venues
o classifications of algorithmic execution systems:
 Logical Participation Strategies:
• Simple Logical Participation Strategies:
o break up order over time according to prespecified volume profile: a VWAP
strategy
o or time-weighted average price (TWAP) strategy: assumes flat volume and
trades in proportion to time
o or percentage-of-volume strategy
• Implementation Shortfall Strategies: solves for optimal strategy to minimize trading
costs as measured by implementation shortfall
 Opportunistic Participation Strategies: post some orders at beneficial prices, use hidden orders
and take advantage of crossing networks, seize liquidity when arises
 Specialized Strategies:
• passive order strategies: no guarantee of execution
• “hunter” strategies: seek liquidity
• market-on-close algorithms: target closing price
• smart routing

Serving the Client’s Interests:

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 • CFA Institute Trade Management Guidelines:
o best execution: “trading process Firms apply that seeks to maximize the value of a client’s portfolio
within the client’s stated investment objectives and constraints.”
 intrinsically tied to portfolio-decision value and cannot be evaluated independently
 prospective, statistical, and qualitative concept that cannot be known with certainty ex ante
 has aspects that may be measured and analyzed over time on an ex post basis, even though such
measurement on a trade-by-trade basis may not be meaningful in isolation
 interwoven into complicated, repetitive, and continuing practices and relationships
o Trade Management Guidelines:
 1. processes: formal policies and procedures aimed at best execution, and then measure
 2. disclosures: general info on trading techniques and on conflicts of interest
 3. record keeping: showing compliance w/ firm policies and showing necessary disclosures
• Importance of Ethical Focus: any trader who does not adhere to his word quickly finds that no one is willing to
deal with him; loyalty to client

Reading 45: Monitoring and Rebalancing

Monitoring:
• Investor Circumstances and Constraints:
o changes in investor circumstances and wealth
o changing liquidity requirements
o changing time horizons
o tax circumstances
o changes in laws and regulations
o unique circumstances: say emotional ties to holding or SRI (socially responsible investing)
• Market and Economic Changes:
o Changes in asset risk attributes: mean return, volatility, correlations
o market cycles: tactical adjustments
o central bank policy
o yield curve and inflation
• Monitoring the portfolio:
o events and trends affecting prospects of individual holdings and asset classes
o changes in asset values that create unintended divergences from client’s strategic asset allocation

Rebalancing the Portfolio: 1. adjusting portfolio to strategic allocation; 2. changes from changes to investor’s
objectives and constraints or capital market expectations; 3. tactical asset allocation. here, discuss only 1.
• cost/benefit:
o drifts from strategic allocation results in expected utility loss
o level of portfolio risk may drift upward (higher risk returning more and taking greater % of portfolio)
o drift toward holding over priced assets
 rebalancing by selling appreciated assets and buying depreciated assets can be seen as
contrarian
o transaction costs:
 explicit costs
• illiquid assets; but may be able to accomplish some of rebalancing through cash flows
 implicit costs
• bid-ask spread
• market impact
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 o tax costs: incur short- or long-term capital gains; reduces deferral benefit from long-term capital gains
• Rebalancing disciplines:
o Calendar rebalancing: on periodic basis
o Percentage-of-Portfolio Rebalancing:
 ad hoc approaches: say +/- 5% points of target allocation, or +/- 10% of target allocation %:
target +/- (target allocation x P%).
 ad hoc doesn’t account for 1. transaction costs; 2. risk tolerance: tracking risk v. strategic asset
allocation; 3. correlation; 4. volatility; 5. volatilities of other asset classes

Factors Affecting Optimal Corridor Width

Factor Effect on Optimal Width of Corridor (All Intuition
Else Equal)
Factors positively related to optimal corridor width
Transaction costs The higher the transactions costs, the wider High transaction costs set a high hurdle for
the optimal corridor rebalancing benefits to overcome
Risk tolerance The higher the risk tolerance, the wider the Higher risk tolerance means less sensitivity to
optimal corridor divergences from target
Correlation w/ rest The higher the correlation, the wider the When asset classes move in synch, further
of portfolio optimal corridor divergence from targets is less likely
Factors inversely related to optimal corridor width
Asset class The higher the volatility of a given asset A given move away from target is potentially
volatility class, the narrower the optimal corridor more costly for a high-volatility asset class, as a
further divergence becomes more likely
Volatility of rest of The higher this volatility, the narrower the Makes large divergences from strategic asset
portfolio optimal corridor allocation more likely

o Calendar-and-Percentage-of-Portfolio Rebalancing: monitor say quarterly and rebalance only if %

outside corridor
o Equal Probability Rebalancing: corridor for each asset class as a common multiple of standard
deviation of asset class’s return
o Tactical rebalancing: calendar rebalancing but less frequent when markets trending and more frequent
when reversal occurring
• rebalancing to target weights v. to allowed range: latter allows from tactical adjustments; better manage
weights of relatively illiquid assets
• setting optimal thresholds: minimize expected utility losses and transaction costs

Perold-Sharpe Analysis of Rebalancing Strategies:

• Buy-and-Hold Strategies: buy risky asset and risk-free asset and do nothing
o portfolio value = investment in stocks + floor value (e.g., risk free asset value)
o upside is unlimited, but portfolio value can be no lower than allocation to bills
o portfolio value is linear function of value of stocks, and portfolio return is linear function of return on
stocks
o value of stocks reflects cushion (above floor value)
o implication of using this strategy is that investor’s risk tolerance is positively related to wealth and
stock market returns. risk tolerance is zero if value of stocks declines to zero.
• Constant-Mix Strategies: always rebalancing; contrarian and supplies liquidity
o Target investment in stocks = m x portfolio value
o consistent w/ risk tolerance that varies proportionately w/ wealth

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 • Constant-Proportion Strategy: CPPI: dynamic strategy in which target equity allocation is function of value of
portfolio less floor value:
o Target investment in stocks = m x (portfolio value – floor value)
o consistent w/ zero tolerance for risk when cushion is zero
o if m is greater than 1, then: constant-proportion portfolio insurance (CPPI)
 consistent w/ higher tolerance for risk than buy-and-hold strategy
 sell shares as stock value declines and buy shares as stock values rise

Relative Return Performance of Different Strategies in Various Markets

Market Condition Constant Mix Buy and Hold CPPI
Up Underperform Outperform Outperform
Flat (but oscillating) Outperform Neutral Underperform
Down Underperform Outperform Outperform
Investment Implications
Payoff curve Concave Linear Convex
Portfolio insurance Selling insurance None Buying insurance
Multiplier 0<m<1 m=1 m>1

Execution Choices in Rebalancing:

• cash market trades: actually transact in the asset: more costly and slower
• derivative trades: say futures Ks and total return swaps; lower transaction costs; rapid implementation; leaves
active managers’ strategies undisturbed

Reading 46: Evaluating Portfolio Performance

Fund Sponsor’s Perspective: enhances effectiveness of fund’s investment policy by acting as feedback and control
mechanism

Investment Manager’s Perspective: feedback and control loop, helping to monitor proficiency of various aspects of
portfolio construction process

3 components of performance evaluation: 1. account’s performance? (performance measurement) 2. why did account
produce observed performance? (performance attribution) 3. luck or skill? (performance appraisal)

Performance Measurement:
• w/o intraperiod external cash flows
MV1 − MV 0
o rt =
MV 0
MV1 − ( MV0 + CF )
o cash flow at start of period: rt =
MV0 + CF
( MV1 − CF ) − MV0
o cash flow at end of period: rt =
MV0
• Total Rate of Return: measures increase in investor’s wealth due to both investment income and capital gains
• Time-Weighted Rate of Return (TWR): compound rate of growth over stated evaluation period of one unit of
money initially invested in the account; requires account be valued every time external CF occurs
o chain linking: create wealth relative by adding return to 1; multiply all wealth relatives for cumulative
wealth relative; subtract one; or take to time period power to weight by time
o requires valuation on each date of CF
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 • Money-Weighted Rate of Return (MWR): the IRR
o MV 1 = MV 0 (1 + R ) m + CF1 (1 + R ) m−L (1) + ... + CF n (1 + R ) m−L ( n )
• Linked Internal Rate of Return: take MWR of frequent periods and chain-link those
• (account valuations should be reported on trade-date, fully accrued basis: that is stated value of account should
reflect impact of unsettled trades and any income owed by or to the account but not yet paid)

Benchmarks:
• P = M + S + A: portfolio performance is equal to market return plus style return (together the benchmark
return) plus the active management return
• Properties of Value Benchmark:
o unambiguous
o investable
o measurable
o appropriate
o reflective of current investment opinions
o specified in advance
o owned
• Types of Benchmarks:
o absolute: say a return objective; not investable and not really valid benchmark
o manager universes: median manager or fund from broad universe; measurable, but not otherwise valid
benchmark
 critique of median manager benchmark: not investable, is ambiguous, can’t verify
appropriateness, subject to survivor bias
o Broad market indexes: say S&P 500; may not reflect style
o Style Indexes: still may not reflect manager’s style
o Factor-Model-Based:
 market model is one factor (beta)
 normal portfolio: portfolio w/ exposures to sources of systematic risk that are typical for
manager, using manager’s past portfolios as guide
o Returns-Based: constructed using 1. series of manager’s account returns (ideally monthly and back to
beginning) and 2. series of returns on several investment style indexes over same period; allocation
algorithm solves from combination of investment style indexes that most closely tracks account’s
return
o Custom Security-Based: simply manager’s research universe weighted in a particular fashion
 Building custom security-based benchmarks: steps:
• identify prominent aspects of manager’ investment process
• select securities consistent w/ investment process
• devise weighting scheme for benchmark securities, including cash position
• review preliminary benchmark and make modifications
• rebalance benchmark portfolio on predetermined schedule
o Tests of Benchmark Quality:
 minimal systematic biases or risks in benchmark relative to account
 tracking error: should reduce noise in performance evaluation process
 risk characteristics: should systematically differ over time (okay to rotate from greater and
lesser, but shouldn’t stay on one side)
 coverage: should have high overlap of securities
 turnover: of the benchmark: if too high, then not really investable

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  positive active positions: high proportion of positive active positions is good; high proportion
of negative active positions indicates not very good benchmark fit
o Hedge Funds and Hedge Fund Benchmarks: tend to be “absolute return”, have investment strategies
that incorporate high degree of optionality (skewness), but usually have clearly definable investment
universes

Performance Attribution: identifies differential returns

• (on fund sponsor level: macro attribution; on investment manager level: micro attribution)
• Impact equals (active) weight times return
• Macro Attribution: 1. policy allocations; 2. benchmark portfolio returns; and 3. fund returns, valuations, and
external cash flows
o analysis: break return down to 6 levels:
 1. net contributions: net cash inflows/outflows (basically starting point)
 2. risk-free asset: as if all invested in risk-free asset
 3. asset categories: incremental return over risk-free return from policy asset allocation:
rAC = ∑ wi × ( rCi − r f ) ; (if stopped here, would be all-passive approach)
A

i =1

 4. benchmarks: incremental return from weighted average benchmark returns:

∑w × w × ( r − rCi ) ; calculated by multiplying each manager’s policy proportion

A M
rIS = ∑ i ij Bij
i =1 j =1

of the total fund’s beginning value and net external cash inflows by difference b/w the
manager’s benchmark return and the return of the manager’s asset category, and then summing
across all managers; (if stop here, would be passive in the benchmark)

∑ w × w × (r − rBij ) ;
A M

 5. investment managers (value of active management): rIM = ∑ i ij Aij

i =1 j =1

assumes that fund sponsor has invested in each of the managers according to managers’ policy
allocations
 6. allocation effects: incremental contribution from difference b/w fund’s ending value and
value calculated at investment manager level
• Micro attribution: investment results of individual portfolios relative to designated benchmarks
[ ]
o value added: rv = ∑ ( w pi − wBi ) × ( ri − rB ) ; from both differing weights and differing returns from
n

i =1
securities selection: outperform only if both positive or both negative; underperform if one negative
and other positive (e.g., overweighting underperforming securities, or underweighting outperforming
securities)
o factor models (instead of looking at each individual security): market model is just beta.
 sector weighting/stock selection micro attribution:
• return may be weighted sum of sectors: and thus difference to actual return is from
S S

security selection: rv = ∑w pj rpj − ∑wBj rBj

j =1 j =1

• based on buy and hold: so category for trading and other to catch these effects
rv = ∑( w pj − wBj )( rBj − rB ) + ∑( w pj − wBj )( rpj − rBj ) + ∑ wBj ( rpj − rBj )
S S S

• j =1 j =1
    j =1 
PureSector Allocation Allocation / SelectionI nteraction Within −SectorSele ction
o pure sector allocation return: equals difference b/w allocation (weight) of
portfolio to given sector and portfolio’s benchmark weight for that sector, times

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 the difference b/w the sector benchmark’s return and the overall portfolio’s
benchmark return, summed across all sectors
o within-sector selection return: equals difference b/w return on portfolio’s
holdings in given sector and return on corresponding sector benchmark, times
weight of benchmark in that sector, summed across all sectors
o allocation/selection interaction return: joint effect of portfolio managers’ and
security analyst’s decisions to assign weights to both sectors and individual
securities: difference b/w weight of portfolio in given sector and portfolio’s
benchmark of that sector, times difference b/w portfolio’s and benchmark’s
returns in that sector, summed across all sectors
 can also have factor model based on fundamentals: company’s size, industry, growth
characteristics, financial strength, and other factors
o Fixed Income Attribution:
 instead of sectors: gov’t bonds, agency and investment-grade corporate credit bonds, high-yield
bonds, mortgage-backed securities, etc.
 determinants: changes in general level of interest rates; changes in sector, credit quality,
individual security differentials or nominal spreads to yield curve
 yield curve twists, steepening, flattening
 Total portfolio return:
• effect of external interest environment
o return of default-free benchmark assuming no change in forward rates
o return due to change in forward rates
• contribution of management process:
o return from interest rate management: performance from predicting interest rate
changes (also duration, convexity, and yield-curve shape change)
o return from sector/quality management: from selecting right issuing sector and
quality group
o return from selection of specific securities: specific securities w/i sector
o return from trading activity: effect from sales and purchases (residual)

Performance Appraisal: skill?

• (investment skill: ability to outperform appropriate benchmark consistently over time)
• Risk-Adjusted Performance Appraisal Measures:
o ex post alpha (Jensen’s alpha): R At − r ft = α A + β A ( RMt − r ft ) + ε t ; alpha is the measure
RA −r f
o Treynor measure (reward-to-volatility or excess return to nondiversifiable risk): TA = ; bars
β̂ A
indicate average values over time
RA −r f
o Sharpe ratio (reward to variability): S A =
σ̂ A
o M2: mean incremental return over market index of hypothetical portfolio formed by combining account
w/ borrowing or lending at risk-free rate so as to match standard deviation of market index; measures
what account would have returned if it had taken on the same total risk as market index:
 RA −r f 
M A2 = r f +  σˆ M

 σˆ A 
RA − RB
o Information ratio: IR A =
σ̂ A−B
• Quality Control Charts:
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 o cumulative annualized value-added: x-axis is time and y-axis is benchmark return; alpha will be a
jagged line around the benchmark return (set to zero); funnel-shaped confidence interval set around
benchmark return; skill would be expected to exceed the benchmark return and (at least some of the
time) be outside of the confidence funnel.
 if inside the funnel, then can’t reject null hypothesis that manager has no skill.

Practice of Performance Evaluation:

• 6 criteria for manager selection (among finalists):
o 1. physical: organizational structure, size, experience, other resources
o 2. people: investment professionals, compensation
o 3. process: investment philosophy, style, decision making
o 4. procedures; benchmarks, trading, quality control
o 5. performance: results relative to an appropriate benchmark
o 6. price: investment management fees
• manager continuation policies (MCP): policy for deciding whether to replace a manager
o manager monitoring: identify warning signs
o manager review: if manager monitoring identifies item of sufficient concern to trigger review
o MCP as filter: null hypothesis is that managers under evaluation are best zero-value-added managers:
 Type I error: keeping (or hiring) managers w/ zero value-added (rejecting null hypothesis when
it is correct); (course filter creates this error)
 Type II error: firing (or not hiring) managers w/ positive value-added (not rejecting null
hypothesis when it is incorrect); (fine filter creates this error)

Reading 47: Global Performance Evaluation

Performance Attribution in Global Performance Evaluation:

• return in local currency: capital gains in percent plus dividend yield
• return in base currency:
V jt S tj + D tj S tj −V jt −1 S tj−1
o rj0 =
V jt −1 S tj−1
o rj 0 = p j + d j + s j (1 + p j + d j ) ; or r j 0 = p j + d j + c j

• total return is weighted average return of returns of all segments: r = ∑

j
w j p j + ∑w j d j + ∑w j c j
j j

• Performance Attribution:
o rj0 = I j + ( p j − I j ) + d j + c j

o
r= ∑w I j j + ∑w ( p
j j −Ij) + ∑w d j j + ∑w c j j


j

 
j
  

j

 
j
 
Market Re turnCompan ent SecuritySe lectionCon tribution YieldCompo nent CurrencyCo mponent

o Asset allocation:

r= ∑ wI *
j j0 + ∑ (w − w )I + ∑ (w c − w C ) + ∑ w ( p − I ) + ∑ w d
j
*
j j j j
*
j j j j j j j


j
 j  j  j  
j

I n 'ltB e n c h Rm teau r *kn I M a r k ec t aA t li loo n rCi bo un t ti o Cn u r r e nl oc cy aA t li on nt rCi bo u2 t i oSne c u r liet yc St i eo nt rCi bo un t i oY ni e l d C no emn pt o
 here Ij0 is return on market index j, translated into base currency 0: Ij0 = Ij + Cj
o can also attribute based on:
 Market timing
 Industry and Sectors
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  Factors and Styles
 Risk Decomposition
o Measuring active currency exposure relative to benchmark:
 any deviations from benchmark should be thought of as active exposure
 using derivatives:
• linear approximation for forward sale: c j = s j + R j − R0 : exchange rate movement plus
f

interest rate differential

 overall currency component is sum of: 1. currency component of passive benchmark; 2.
currency allocation contribution; 3. return on currency hedges
• Multiperiod Attribution Analysis:
o correct multiperiod attribution is not equal to either simple sum of individual periods or compound
return of individual periods;
o two-period attribute can be decomposed into first-period attribution compounded at second-period
benchmark rate of return plus the second-period attribution compounded at the first-period portfolio
rate of return
o performance evaluation services may use different methods of allocating cross products

Performance Appraisal in Global Performance Evaluation:

• Risk: 1. calculate absolute risk; 2. calculate risk relative to benchmark
• Absolute:

o σ total =
1 T
∑
T −1 t =1
( ) 2
rt − r ; if monthly, annualize by multiplying by 12

• Relative risk: Tracking Error:

o σ er =
1 T
∑
T −1 t =1
( )
ert − er
2

• Risk-Adjusted Performance:
o Sharpe ratio
o Treynor ratio
o Jensen measure
o (consider problems from what constitutes “passive” world market portfolio)
o Information ratio
• Risk Allocation and Budgeting: 1. absolute risk allocation among asset classes; 2. active risk allocation of
managers in each asset class
• Potential Biases in Risk and Return:
o infrequently traded assets
o option-like investment strategies
o survivorship bias: return
o survivorship bias: risk

Implementation of Performance Evaluation:

• benchmarks: consider
o individual country/market weights
o countries, industries, and styles: industry factors have grown in importance
o currency hedging: publicly available market indexes are generally not hedged against currency
movements
Reading 48: Global Investment Performance Standards

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GIPS governance:
• GIPS Executive Committee (formerly Investment Performance Council)
i. Four standing subcommittees:
• GIPS Council: works w/ Country Sponsors in development, promotion and maintenance
of standards
• Interpretations Subcommittee: provides guidelines for new issues
• Practitioners/Verifiers Subcommittee: forum for 3rd-party service providers who apply
and implement GIPS
• Investors/Consultants Subcommittee: forum for end-users of GIPS info

GIPS:
Preface: Background of the GIPS Standards
I. Introduction
a. Preamble: Why Is a Global Standard Needed?
b. Vision Statement
c. Objectives
d. Overview
e. Scope
f. Compliance
g. Implementing a Global Standard
II. Provisions of the Global Investment Performance Standards
0. Fundamentals of Compliance
1. Input Data
2. Calculation Methodology
3. Composite Construction
4. Disclosures
5. Presentation and Reporting
6. Real Estate
7. Private Equity
III. Verification
a. Scope and Purpose of Verification
b. Required Verification Procedures
c. Detailed Examinations of Investment Performance Presentations

Appendix A: Sample GIPS-Compliant Presentations

Appendix B: Sample List and Description of Composites
Appendix C: GIPS Advertising Guidelines
Appendix D: Private Equity Valuation Principles
Appendix E: GIPS Glossary

GIPS:
Preface: Background of the GIPS Standards
IV. Introduction
a. Preamble: Why Is a Global Standard Needed?
b. Vision Statement
c. Objectives
d. Overview
i. Firms required in include “all actual fee-paying, discretionary portfolios in aggregates, known
as composites, defined by strategy or investment objective.
ii. Show history for min of 5 yrs or since inception, and then add on yrs to build 10-yr record
e. Scope
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 f. Compliance
g. Implementing a Global Standard
V. Provisions of the Global Investment Performance Standards
0. Fundamentals of Compliance
i. Must be firm-wide basis; the firm: “an investment firm, subsidiary, or division held out to
clients or potential clients as a distinct business; a distinct business entity is a “unit, division,
department, or office that is organizationally and functionally segregated from other units,
divisions, departments, or offices and retains discretion over the assets it manages and should
have autonomy over the investment decision-making process.
ii. Must document in writing policies and procedures used in establishing and maintaining
compliance w/ GIPS
iii. Compliance statement: “[Name of firm] has prepared and presented this report in compliance
with the Global Investment Performance Standards (GIPS®).”
iv. Must “make every reasonable effort” to provide all prospective clients w/ a compliant
presentation
v. Must provide a list and description of all composites to any prospective client asking, and must
provide upon request compliant presentation for any composite listed. Discontinued must stay
on list for 5 yrs.
vi. Recommends verification (which must be firm-wide). Verification language: “[Name of firm]
has been verified for the periods [dates] by [name of verifier]. A copy of the verification report
is available upon request.”
1. Input Data
i. All data and info necessary … captured and maintained
ii. Portfolio valuations: market rather than cost or book
iii. Trade-date accounting req’d: the “transaction is reflected in the portfolio on the date of the
purchase or sale, and not on the settlement date.”
iv. Accrual accounting req’d for fixed-income securities and other assets that accrue interest
v. Frequency and timing of portfolio valuations: beginning 1/1/10: on the date of all large external
cash flows; and as of the calendar month-end or the last business day of the month
2. Calculation Methodology
i. Time-Weighted Total Return adjusted from cash flows req’d:
MV 1 − MV 0
1. simplest form: rt =
MV 0
2. when external cash flows: “value portfolio whenever an external cash flow occurs,
compute a subperiod return, and geometrically chain-link subperiod returns expressed
in relative form: rtwr = (1 + rt ,1 ) × (1 + rt , 2 ) ×... × (1 + rt , n ) −1 ; rt,1 through rt,n are
subperiods.
3. (used to be able to use from 1/1/05 until 1/1/10 the Original Dietz method reflecting
MV1 − MV 0 − CF
midpoint assumption: rDietz =
MV 0 + ( 0.5 × CF )
4. daily weighted CFs required after 1/1/05 but not after 1/1/10:
MV1 − MV 0 − CF CD − Di
a. Modified Dietz: rModDietz = ; wi = where CD is
MV 0 + ∑ ( CFi × wi ) CD
total calendar days in month and D is the # of days from beginning of month that
CF occurs (so 5 for CF on the 5th).
∑ [CF × (1 + r ) ] + MV (1 + r )
wi
b. Modified or Linked IRR: solve for r: MV1 = i 0

5. returns from cash and cash-equivalents must be included in total return calculations
6. returns must be calculated after deduction of actual—not estimated—trading expenses
(but not custody fees)
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 a. if bundled fees (all-in fees and wrap fees) and not extricable, then deduct entire
fee
7. recommendation: calculate returns net of nonreclaimable withholding taxes on
dividends, interest and capital gains (but accrue reclaimable withholding taxes)
8. Composite return calc standards: “Composite returns must be calculated by asset-
weighting the individual portfolio returns using beginning-of-period values or a method
that reflects both beginning-of-period values and external cash flows.”
a. Denominator of method using beginning-value plus external CFs:
V p = MV 0 + ∑( CF i × wi )
 MV 0, pi 
b. So, composite return using just beginning: rC = ∑ rpi × 
 ∑ 0, pi 
MV
 V pi 
c. composite return using beginning and external CFs: rC = ∑ rpi × 
 ∑ V pi


d. after 1/1/10, composite returns must be calculated monthly using monthly asset-
weighting.
3. Composite Construction: “All actual, fee-paying, discretionary portfolios must be included in at least
one composite. Although non-fee-paying discretionary portfolios may be included in a composite
(with appropriate disclosures), nondiscretionary portfolios are not permitted to be included in a firm’s
composites.”
i. Discretionary: if the manager is able to implement the intended investment strategy.
Restrictions that impede investment process to extent that strategy cannot be implemented as
intended: presumed nondiscretionary.
ii. Defining investment strategies: must be defined according to similar investment objectives
and/or strategies, and the full composite definition as documented in the firm’s policies and
procedures must be made available upon request.
1. suggested hierarchy: Investment Mandate | Asset Classes | Style or Strategy |
Benchmarks | Risk/Return Characteristics
iii. including and excluding portfolios: must include new portfolios on a timely and consistent
basis after the portfolio comes under management unless specifically mandated by the client.
Preferably, beginning of next full performance measurement period. Must include terminated
portfolio in historical record of the appropriate composite up to last full measurement period.
1. cannot be switched from one composite to another unless documented changes in client
guidelines or the redefinition of the composite make it appropriate. Historical record
must remain in composite.
2. recommendation: event of significant external CFs, use temporary new accounts rather
than temporarily removing portfolios from composites. May be compelled to
temporarily remove portfolios from composites when large external CFs occur.
3. if minimum asset level threshold for inclusion, must strictly follow that policy: none
below can be included. May require time threshold so that temporarily devalued
portfolios don’t go in and out of composite. Any changes to minimum threshold:
cannot be applied retroactively. Firm should not market composite to prospective
clients falling below minimum threshold.
iv. Carve-Outs: cannot exclude cash; “When a single asset class is carved out of a multiple asset
class portfolio and the returns are presented as part of a single asset composite, cash must be
allocated to the carve-out returns in a timely and consistent manner.” 2 acceptable cash
allocation methods: “Beginning of period allocation” and “Strategic asset allocation” (for
strategic: the cash amount is the deviation for the target: so 2.5% when target is 37.5% and
actual is 35%.). From 1/1/10, carve-out returns cannot be included in single-asset-class

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 composite returns unless the carve-out is actually managed separately with its own cash
balance.
4. Disclosures
i. Def of “firm”; if re-defined, disclose date and re-def
ii. All significant events that help interpret performance record
iii. Use of subadvisors and periods for which used
iv. Make available complete list (last 5 yrs) and description of all composites
v. Recommended: disclose firms w/I parent company
vi. Recommended: if verified, disclose and periods verified if not all
vii. Currency to express performance; disclose and describe exchange rate inconsistencies among
composites and b/w composite and benchmark
viii. Treatment of withholding tax
ix. Tax basis of benchmark vs. composite (Lux vs. U.S.)
x. Disclose availability of add’l info on calc and reporting returns (e.g., methodology, valuation
sources, treatment of large external CFs)
xi. Recommended: disclose when change of calc methodology or valuation sources has material
impact
xii. Fees: clearly label returns gross of or net of; for gross of, also disclose whether anything other
than direct trading expenses deducted; for net of, also disclose whether anything other than
direct trading expenses and investment management fee deducted; disclose appropriate fee
schedules; if bundled-fee, present % of portfolios for each annual period that are such and
disclose various types of bundled fees.
xiii. Investment objectives, style, and strategy of composite (more than broadly indicative name)
xiv. Composite creation date
xv. Measure of dispersion and which measure
xvi. If minimum asset level for inclusion in composite, disclose minimum and any changes thereto
xvii. Presence, use and extent of leverage or derivatives, if material, including use, frequency and
characteristics of instruments
xviii. Whether conforms to local laws and regs that differ from GIPS, and disclosure of such conflict
5. Presentation and Reporting
i. Show at least 5 yrs and extend thereafter until 10 yrs
ii. Annual returns (calendar yr unless noncalendar fiscal yr); number of portfolios; amount of
assets in composite; % of total firm assets composite represents or total firm assets; measure of
dispersion of individual portfolio returns if >=6 portfolios (high/low, interquartile range,
standard deviation)
iii. Can link to prior-to-1/1/00 non-GIPS-compliant performance if disclosed
iv. Cannot annualize partial-year returns
v. “portability”
1. Prior affiliation performance must be linked if: 1. substantially all the investment
decision-makers are employed by the new firm; 2. staff and decision-making process
remain intact and independent w/ the new firm; and 3. new firm has records that
document and support the reported performance.
2. linking must be disclosed
3. can be linked if: substantially all of the assets from past firm’s composite transfer to the
new firm
4. one yr to comply if GIPS-compliant firm acquires noncompliant firm
vi. single-asset-class carve-outs from multiple-asset-class portfolios: presentation must include %
of composite that is composed of carve-outs from 1/1/06 forward.
vii. Benchmarks: benchmarks reflecting composite’s investment strategy or mandate must be
presented for each annual period; if none shown, must explain why; dates and reasons for

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 changes of benchmarks must be presented; for custom benchmarks, describe benchmark
creation and rebalancing process; once established, rebalancing must be consistently applied
viii. If composite includes any non-fee-paying portfolios, must present % of composite.
ix. Recommended: present composite performance gross of investment management and
administrative fees and before taxes except for nonreclaimable withholding taxes.
x. Recommended: present cumulative composite and benchmark returns
xi. Recommended: present equal-weighted mean and median returns for each composite
xii. Recommended: present composite-level country and sector weightings
xiii. Recommended: present charts and graphs
xiv. Recommended: present risk measures: beta, tracking error, modified duration, information
ratio, Sharpe ratio, Treynor ratio, credit ratings, value at risk and volatility or variability of
composite and benchmark
6. Real Estate
i. Publicly traded real estate securities, securities issued by public companies, CMBSs and private
debt investments (including commercial and residential loans for which the expected return is
solely related to contractual interest rates w/o any participation in the economic performance of
the underlying real estate) are treated under the regular GIPS standards and not the real estate
standards. Portfolio holding both must carve out.
ii. Despite regular GIPS, must be valued quarterly internally or externally, valued every 12
months externally and “Real estate investments must be valued by an external professionally
designated, certified or licensed commercial property valuer/appraiser at least once every 36
months.”
iii. Must present methods, sources, and frequency of valuations; also asset-weighted % of
composite real estate assets valued by an external valuation for each period as well as
frequency w/ which real estate investments are valued by external valuers.
iv. Must describe definition of discretion; generally: if manager has sole or primary responsibility
for major investment decisions.
v. Must present total return w/ income and capital appreciation breakdown; and calculation
methodology (e.g., whether chain-linked time-weighted; or adjusted to make the capital return
and income return equal total return); adjust for time-weighted cash flows
1. capital employed: C E = C 0 + ∑( CFi × wi )
( MV1 − MV0 ) − EC + S
2. capital return: rc = ; where E is capital expenditures and S is
CE
sale proceeds
INC A − E NR − INT D − T
3. income return: rI = ; INC is income accrued, E is
CE
nonrecoverable expenditures, INT is interest on debt and T is property taxes
4. total return: rT = rC + rI
vi. recommended: present capital and income segments of the appropriate real estate benchmark
vii. recommended: annual/annualized since-inception IRR for composite: SI-IRR; should disclose
time period and frequency of cash flows; should use quarterly cash flows at minimum.
viii. Recommended: present time-weighted rate of return and SI-IRR gross and net of fees, and
reflecting ending market value and also reflecting only realized cash flows excluding
unrealized gains.
7. Private Equity
i. Open-end and evergreen funds subject to regular GIPS standards and not PE standards
ii. Private Equity Valuation Principals
1. obligate firms to ensure that valuations are prepared w/ integrity and professionalism by
individuals w/ appropriate experience and ability under direction of senior management
and in accordance w/ documented review procedures
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 2. valuation basis must be divulged
3. clearly disclose methodologies and key assumptions
4. logically cohesive and rigorously applied
5. must recognize events that diminish an asset’s value
6. present on consistent and comparable basis from one period to next; any change in
valuation basis or method must be disclosed
7. valuations at least annually, but quarterly recommended
8. recommended: valuations on fair value basis; hierarchy:
a. market transactions (e.g., most recent arms-length financing)
b. market-based multiples
c. risk-adjusted discounted expected cash flows
iii. must disclose net-of-fees (including net of carried interest, investment management fees and
transaction expenses; net of investment advisors fees … if applicable) and gross-of-fees SI-IRR
of composite for each year; use daily or monthly CFs and end-of-period valuation of
unliquidated holdings remaining in composite; stock distributions valued at time of distribution
iv. all closed-end PE investments to be included in composite defined by strategy and vintage year;
direct investments and investments made through other funds or p’ships must be in separate
composites
v. must disclose:
1. vintage years,
2. composite investment strategy,
3. total committed capital for composite,
4. valuation methodologies and change thereof,
5. if also complies w/ local or regional guidelines,
6. that valuation review procedures are available upon request
7. if fair value not used, why, number of investments not fair valued and their carrying
value in absolute amount and relative to total fund
8. unrealized appreciation or depreciation of composite for most recent period
9. whether using daily or monthly CFs for SI-IRR
10. if benchmarks disclosed, disclose calc methodology for benchmark and cumulative
annualized SI-IRR; if no benchmark disclosed, explain why
11. if not calendar, disclose period-end used
12. for discontinued PE composites: final realization or liquidation date must be stated
13. funding status: cumulative paid-in-capital (including paid-in but not yet invested), total
current invested capital, cumulative distributions paid out to investors in cash or stock,
TVPI, DPI, PIC, RVPI
14. recommended: disclose average holding period of investments over life
VI. Verification: review of performance measurement policies, processes, and procedures by an independent
third-party for purposes of establishing that a firm claiming compliance has adhered to the GIPS standard
a. Scope and Purpose of Verification:
i. Verification can only be as to whole firm; may have a detailed Performance Examination
conducted on a composite thereafter
ii. Minimum verification period is one year
iii. Verification report must confirm that firm has complied w/ all composite construction
requirements of GIPS on firmwide basis and that firm’s processes and procedures are designed
to calculate and present performance results in compliance w/ GIPS
iv. Must have report to claim verification
v. If not fully compliant, verifier must provide report to firm stating why cannot issue verification
report
vi. Minimum knowledge-based qualifications for verifiers
b. Required Verification Procedures
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 i. Learn about firm, firm’s performance-related policies and valuation basis for performance
calculations
ii. Obtain selected samples of investment performance reports and other available info
iii. Determine firm’s assumptions, policies and procedures for establishing and maintaining
compliance including:
1. written def of investment discretion and guidelines therefor
2. list of composite definitions w/ written criterion for including account w/i
3. policy regarding timeframe for including new accounts in and excluding closed
accounts from composite
4. policies re input data: dividend and interest income accruals and market valuations,
portfolio and composite return calculation methodologies including assumptions on
timing of CFs, presentation of composite returns
5. info on use of leverage and derivatives, investments in securities or countries not
included in composite’s benchmark, timing of implied taxes on income and realized cap
gains if firm reports on after-tax basis
6. “any other policies and procedures relevant to performance presentation”
iv. Stuff to gather:
1. sample performance presentations and marketing materials
2. all of firm’s performance-related policies, such as firm’s definition of discretion, the
sources, methods, and review procedures for asset valuations, the time-weighted rate-
of-return calculation methodology, the treatment of external cash flows, the
computation of composite returns, etc.
3. complete list and description of composites
4. composite definitions, including benchmarks and written criteria for including accounts
5. list of all portfolios under management
6. all investment management agreements or contracts, and clients’ investment guidelines
7. list of all portfolios that have been in each composite during the verification period, the
dates they were in the composites, and documentation supporting any changes to the
portfolios in the composites.
8. sample historical portfolio- and composite-level performance data
v. Determinations:
1. determine has been and remains appropriately defined
2. determine defined and maintained composites consistently in compliance
3. determine benchmarks are appropriate
4. determine list of composites is complete
5. determine that all actual discretionary fee-paying portfolios are included in at least one
composite, and that all accounts are included in their respective composites at all times,
and that none belonging is excluded
6. determine def of discretion has been consistently applied
7. determine accounts consistently apply discretionary and non-discretionary
8. obtain complete list of open and closed accounts; select appropriate sample
9. confirm timing of inclusion and shifting of accounts conforms to definition
10. recalculate sample of returns and dispersion measures and determine computations
conform
11. review sample of composite presentations for compliance
vi. must maintain sufficient info to support verification report
vii. firm must provide representation letter to verifiers of major policies and other reps
c. Detailed Examinations of Investment Performance Presentations

Appendix A: Sample GIPS-Compliant Presentations

Appendix B: Sample List and Description of Composites
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Appendix C: GIPS Advertising Guidelines
1. mandatory if claim GIPS compliance
2. any written or electronic materials addressed to more than one prospective or existing client (excludes one-on-
one advertisements!)
3. all advertisements that claim compliance must include description of firm and info about how to obtain list
and description of all firm’s composites or a presentation that complies w/ GIPS
4. “[Name of firm] claims compliance w/ the Global Investment Performance Standards (GIPS®).”
5. if further present performance, must describe strategy of advertised composite, indicate gross or net of fees,
currency. Must present period-to-date composite results. Less than year returns cannot be annualized. Must
present 1, 3, and 5, or just 5 year composite returns, and indicate end-of-period; present compliant benchmark
total return for same periods and described, if none, disclose why; disclose material leverage and derivatives
6. if presenting noncompliant info, must disclose such, reasons and periods of such
7. supplemental info must not be more prominent
Appendix D: Private Equity Valuation Principles
Appendix E: GIPS Glossary

• Other issues:
i. After-Tax Return Calculation Methodology: not required by GIPS
ii. Guidance Statement for Country-Specific Taxation Issues
• Preliquidation return:
1. Consistent use of “anticipated tax rates”
i. Anticipated income tax rate = Federal tax rate + [State tax rate x (1 –
Federal tax rate)] + [Local tax rate x (1 – Federal tax rate)]
ii. if client’s tax rate unknown, then may use maximum federal tax rate for
specific category of investor etc.
2. “realized taxes”: Treal = (G Lreal × TLcgr ) + (G Sreal × TScgr ) + ( INC tA × Tincr )
MV1 − MV 0 − CF − Treal
3. Preliquidation after-tax Modified Dietz: rPLATModDie tz =
MV 0 + ∑ ( CFi × wi )
4. After-tax LIRR: MV1 − Treal = ∑ [CF × (1 + r )
i
wi
] + MV (1 + r )
0

5. Preliquidation after-tax return with daily valuations:

MV ED − MV BD − Treal
rPLATdv = ; can then be chain-linked
MV BD
6. Pre-tax returns for composites that hold tax-exempt securities must not be
grossed up for taxes.
7. Full credit for net realized losses
• mark-to-liquidation return: use liquidation value in both numerator and denominator
1. may provide supplemental info regarding tax effects from nondiscretionary:
adds back
G real + Gunreal
2. gain ratio: GR =
MV 1 + CF NetOut
3. Adjustment factor: F = CF NetOut ×Tcgr ×GR
4. Tcgr = should be weighted average of short-term and long-term cg
5. Modified Dietz aftertax return calculation w/ adjustment factor (removes effect
of nondiscretionary realized taxes):
MV1 − MV 0 − CF − Treal + F
rAdjPLATMod Dietz =
MV 0 + ∑ ( CFi × wi )
6. tax loss harvesting: recommended to disclose % benefit of tax-loss harvesting
for composite if realized losses are greater than realized gains during period
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 i. Benefit of tax loss harvesting: B = Lnet ×Tcgr
B
ii. Percent benefit of tax loss harvesting =
( MV 0 + MV 1 ) 2

• Objectives of GIPS:
i. To obtain worldwide acceptance of a common standard for calculating and presenting
investment performance
ii. To ensure accurate and consistent performance data
iii. To promote fair, global competition for all markets
iv. To foster the notion of industry self-regulation

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