CFA® Level III

Formula Sheet – 2023 Syllabus

ECONOMICS DERIVATIVES
ECONOMICS Component Compensation for DERIVATIVES
CAPITAL MARKET EXPECTATIONS: One-period default OPTION STRATEGIES
CAPITAL MARKET
FRAMEWORK ANDEXPECTATIONS:
MACRO Interest rate risk OPTION STRATEGIES
risk-free rate
FRAMEWORK AND MACRO CONSIDERATIONS
CONSIDERATIONS Put-Call Parity
+ Term premium Duration risk 𝑋𝑋
𝑆𝑆' + 𝑝𝑝' = 𝑐𝑐' +
A Decomposition of GDP Analysis to CME (1 + 𝑟𝑟).
- One commonly used framework decomposes a + Credit premium Credit/Default risk
country’s aggregate trend growth rate into two Synthetic Positions
+ Liquidity premium Illiquidity Forward
parts: labor inputs and labor productivity.
𝑋𝑋
- The components of the labor input are: 𝑐𝑐' − 𝑝𝑝' = 𝑆𝑆' −
DCF Approach to Equity Returns (1 + 𝑟𝑟).
o Growth in potential labor force size.
Gordon Growth Model Call
o Growth in actual labor force participation. 𝑋𝑋
𝐷𝐷&
- The components of labor productivity are: 𝐸𝐸(𝑟𝑟% ) = + 𝑔𝑔 𝑐𝑐' = 𝑆𝑆' − + 𝑝𝑝'
𝑃𝑃' (1 + 𝑟𝑟).
o Growth from increasing capital inputs. Grinold-Kroner Model Put
o Growth in total factor productivity (TFP). 𝐷𝐷& 𝑋𝑋
𝐸𝐸(𝑟𝑟% ) ≈ − % 𝛥𝛥𝛥𝛥 + %𝛥𝛥𝛥𝛥𝛥𝛥 + %𝛥𝛥𝛥𝛥 𝑝𝑝' = − 𝑆𝑆' + 𝑐𝑐'
𝑃𝑃' (1 + 𝑟𝑟).
Anchoring Asset Returns to Trend Growth where where
The trend GDP growth rate is linked to equity - %𝛥𝛥𝛥𝛥: nominal rate of earnings growth - 𝑆𝑆' : time-0 stock price
prices, as captured by the following formula: - %𝛥𝛥𝛥𝛥𝛥𝛥: change in the P/E ratio - 𝑝𝑝' : time-0 put price
𝑉𝑉 = 𝐺𝐺𝐺𝐺𝐺𝐺 × 𝑆𝑆 × 𝑃𝑃𝑃𝑃 - % 𝛥𝛥𝛥𝛥: change in the number of - 𝑐𝑐' : time-0 call price
where /
shares outstanding - : strike price 𝑋𝑋, discounted at risk-free rate
- V: aggregate value of equity (&2+)!

- GDP: level of nominal GDP 𝑟𝑟 for a period of 𝑇𝑇 years

The Singer-Terhaar Model
- S: share of earnings relative to
- The model estimates risk premiums for assets
the overall economy Useful Greeks
(or asset classes) based on their degree of Delta
- PE: market price-to-earnings ratio
integration with the global market portfolio. 𝐶𝐶ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣 𝑜𝑜𝑜𝑜 𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜
∆≈
- Risk premium assuming full integration: 𝐶𝐶ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣 𝑜𝑜𝑜𝑜 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢
Monetary Policy
𝑅𝑅𝑃𝑃( = 𝜌𝜌(,* 𝜎𝜎( × 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝑆𝑆ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 Gamma
Taylor Rule 𝐶𝐶ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣 𝑜𝑜𝑜𝑜 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑
- Risk premium assuming complete segmentation:
To determine where the policy rate should be set, 𝛤𝛤 ≈
𝑅𝑅𝑃𝑃( = 𝜎𝜎( × 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝑆𝑆ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝐶𝐶ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣 𝑜𝑜𝑜𝑜 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢
central banks can use the Taylor rule:
- The Singer-Terhaar asset risk premium Vega
𝑖𝑖 ∗ = 𝑅𝑅" + 𝐼𝐼# + .0.52𝐺𝐺𝐺𝐺𝑃𝑃# − 𝐺𝐺𝐺𝐺𝑃𝑃$ 4 + 0.52𝐼𝐼# − 𝐼𝐼$ 45
is simply the weighted average of the 𝐶𝐶ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣 𝑜𝑜𝑜𝑜 𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜
where 𝑣𝑣 ≈
fully-integrated and completely segmented 𝐶𝐶ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣 𝑜𝑜𝑜𝑜 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣
- 𝑖𝑖 ∗ : optimal nominal policy rate
Theta (Θ)
- 𝑅𝑅" : neutral real policy rate risk premiums.
Indicator of an option price’s sensitivity to the
- 𝐺𝐺𝐺𝐺𝑃𝑃# : expected GDP growth rate passage of time (usually negative).
- 𝐺𝐺𝐺𝐺𝑃𝑃$ : long-term trend GDP growth rate Forecasting Real Estate Returns
𝑁𝑁𝑁𝑁𝑁𝑁
- 𝐼𝐼# : expected inflation 𝐶𝐶𝐶𝐶𝐶𝐶 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 = Covered Call
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 Covered call = Written call + Long stock
- 𝐼𝐼$ : inflation target 𝐸𝐸(𝑅𝑅+% ) = 𝐶𝐶𝐶𝐶𝐶𝐶 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 + %𝛥𝛥𝛥𝛥𝛥𝛥𝛥𝛥
Macroeconomic Linkages 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣 = 𝑆𝑆. − 𝑀𝑀𝑀𝑀𝑀𝑀[(𝑆𝑆. − 𝑋𝑋), 0]
For finite time periods:
The link between current and capital accounts is 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑎𝑎𝑎𝑎 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 = 𝑆𝑆. − 𝑀𝑀𝑀𝑀𝑀𝑀[(𝑆𝑆. − 𝑋𝑋), 0] + 𝑐𝑐'
𝐸𝐸(𝑅𝑅+% ) = 𝐶𝐶𝐶𝐶𝐶𝐶 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 + %𝛥𝛥𝛥𝛥𝛥𝛥𝛥𝛥 − %𝛥𝛥𝛥𝛥𝛥𝛥𝛥𝛥 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 − 𝑆𝑆'
expressed as follows:
(𝑋𝑋 − 𝑀𝑀) = (𝑆𝑆 − 𝐼𝐼) + (𝑇𝑇 − 𝐺𝐺) Investment objectives:
Estimating Volatility from Smoothed Returns
where - Yield enhancement
𝑅𝑅$ = (1 − 𝜆𝜆)𝑟𝑟$ + 𝜆𝜆𝑅𝑅$,&
- X: exports 1 + 𝜆𝜆 - Reducing a position at a favourable price
- M: imports 𝑉𝑉𝑉𝑉𝑉𝑉(𝑟𝑟) = O P 𝑉𝑉𝑉𝑉𝑉𝑉(𝑅𝑅) > 𝑉𝑉𝑉𝑉𝑉𝑉(𝑅𝑅) - Target price realization
1 − 𝜆𝜆
- S: domestic savings
- I: domestic investment Time-Varying Volatility: ARCH Models Protective Put
𝜎𝜎$- = 𝛾𝛾 + (𝛼𝛼 + 𝛽𝛽)𝜎𝜎$,&
-
+ 𝛽𝛽(𝜂𝜂$- − 𝜎𝜎$,&
- )
Protective Put = Long put + Long stock
- T: taxation
where 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣 = 𝑆𝑆. + 𝑀𝑀𝑀𝑀𝑀𝑀[(𝑋𝑋 − 𝑆𝑆. ), 0]
- G: government spending
- 𝜎𝜎$- : variance of a single asset 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑎𝑎𝑎𝑎 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 = 𝑆𝑆. + 𝑀𝑀𝑀𝑀𝑀𝑀[(𝑋𝑋 − 𝑆𝑆. ), 0] − 𝑆𝑆'
- 𝛾𝛾: a constant − 𝑝𝑝'
CAPITAL
CAPITAL MARKET EXPECTATIONS:
MARKET EXPECTATIONS: - 𝛽𝛽: the effect of a “shock” (𝜂𝜂$- − 𝜎𝜎$,& - ) Investment objectives:
FORECASTING ASSET CLASS RETURNS
FORECASTING ASSET CLASS RETURNS - 𝛼𝛼 + 𝛽𝛽: mean reversion - Protects against losses in the underlying asset
The Building Block Approach to
Fixed-Income Returns
The building block model breaks a bond’s YTM
into the components that compensate investors
for various risks.

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Bull Spreads and Bear Spreads Volatility Conversion Futures Hedge
𝜎𝜎:"";(8 𝜎𝜎*<"$=89 ∆𝑃𝑃
Call Bull Spread Put Bull Spread 𝜎𝜎6(789 = = 𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 = O P × 𝐶𝐶𝐶𝐶
√252 √21 ∆𝐶𝐶𝐶𝐶𝐶𝐶
𝐵𝐵𝐵𝐵𝐵𝐵. − 𝐵𝐵𝐵𝐵𝐵𝐵?
Buy Low-strike call Low-strike put 𝑁𝑁# = O P × 𝐶𝐶𝐶𝐶
Other Key Terms: 𝐵𝐵𝐵𝐵𝐵𝐵D.6
- Implied volatility: derived from option where
Sell High-strike call High-strike put
pricing model - 𝐵𝐵𝐵𝐵𝐵𝐵. is targeted basis point value
- Realized volatility: historical observed volatility for the bond portfolio
Expiration Value for Call Bull Spread - 𝐵𝐵𝐵𝐵𝐵𝐵? is the bon portfolio’s current
- Volatility smile: u-shaped volatility curve
= 𝑀𝑀𝑀𝑀𝑀𝑀[(𝑆𝑆. − 𝑋𝑋4 ), 0] − 𝑀𝑀𝑀𝑀𝑀𝑀[(𝑆𝑆. − 𝑋𝑋5 ), 0] basis point value
- Volatility skew: implied volatility increases for
Profit Call Bull Spread
OTM puts but decreases for OTM calls - 𝐵𝐵𝐵𝐵𝐵𝐵D.6 is the basis point value of the CTD bonds
= 𝑀𝑀𝑀𝑀𝑀𝑀[(𝑆𝑆. − 𝑋𝑋4 ), 0] − 𝑀𝑀𝑀𝑀𝑀𝑀[(𝑆𝑆. − 𝑋𝑋5 ), 0]
- Risk-reversal: long call and short put on same in the futures contract
− (𝑐𝑐4 − 𝑐𝑐5 )
where underlying with same time to expiration
- Term structure of volatility: implied volatility 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀. − 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀E 𝑃𝑃
- 𝑆𝑆. : time-T stock price 𝑁𝑁# = O P O P × 𝐶𝐶𝐶𝐶
according to different maturities of option 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀D.6 𝐹𝐹
- 𝑋𝑋4 : lower strike price
- Implied volatility surface: 3D plot of where
- 𝑋𝑋5 : higher strike price - 𝑀𝑀𝑀𝑀𝑀𝑀𝑅𝑅. : portfolio’s targeted modified duration
- 𝑐𝑐4 : call premium with lower strike price days to expiration, option strike prices,
- 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀E : bond portfolio’s current
- 𝑐𝑐5 : call premium with higher strike price and implied volatilities
modified duration
- 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀D.6 : modified duration of the CTD bond
Identifying Appropriate Strategies
Call Bear Spread Put Bear Spread For implied volatility and underlying asset: - P: market value of the bond portfolio
- F: market value of the futures contract as
Buy High-strike call High-strike put product of future contract’s size and the price of
Volatility Bearish Neutral Bullish
the CTD bond per 100 par
Sell Low-strike call Low-strike put
Write Write Write
Decrease
calls straddle puts Equity Forwards and Futures
Expiration Value for Put Bear Spread 𝛽𝛽. − 𝛽𝛽> 𝑆𝑆
= 𝑀𝑀𝑀𝑀𝑀𝑀[(𝑋𝑋5 − 𝑆𝑆. ), 0] − 𝑀𝑀𝑀𝑀𝑀𝑀[(𝑋𝑋4 − 𝑆𝑆. ), 0] Buy puts Buy calls 𝑁𝑁# = l mO P
𝛽𝛽# 𝐹𝐹
Profit Put Bear Spread + Calendar +
Same where
Write spread Write
= 𝑀𝑀𝑀𝑀𝑀𝑀[(𝑋𝑋5 − 𝑆𝑆. ), 0] − 𝑀𝑀𝑀𝑀𝑀𝑀[(𝑋𝑋4 − 𝑆𝑆. ), 0] - 𝛽𝛽. is the target beta
calls puts
−(𝑝𝑝5 − 𝑝𝑝4 ) - 𝛽𝛽> is the equity portfolio’s current beta
where Buy
Increase Buy puts Buy calls - 𝛽𝛽# is the beta of the futures contract
- 𝑆𝑆. : time-T stock price straddle
- 𝑆𝑆 is the value of the equity portfolio
- 𝑋𝑋4 : lower strike price
- 𝐹𝐹 is the value of the futures contract as a
- 𝑋𝑋5 : higher strike price SWAPS, FORWARDS,
SWAPS, FORWARDS,AND
ANDFUTURES product of the contract price and multiplier
- 𝑝𝑝4 : put premium with lower strike price STRATEGIES
FUTURES STRATEGIES
- 𝑝𝑝5 : put premium with higher strike price
Interest Rate Swaps Derivatives on Volatility
Notional value of Swap Variance swaps
Straddle 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑛𝑛𝑛𝑛𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡
𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀. − 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀? 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛 = O P
Straddle = Long call + Long put (same strike) 𝑁𝑁> = O P 𝑀𝑀𝑀𝑀? 2 × 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
Expiration Value for Straddle 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀>
where
= 𝑀𝑀𝑀𝑀𝑀𝑀[(𝑆𝑆. − 𝑋𝑋), 0] + 𝑀𝑀𝑀𝑀𝑀𝑀[(𝑋𝑋 − 𝑆𝑆. ), 0] 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴.
- 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀? : portfolio’s modified duration
Profit of Straddle = (𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛)(𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣
- 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀> : modified duration of the swap − 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠)
= 𝑀𝑀𝑀𝑀𝑀𝑀[(𝑆𝑆. − 𝑋𝑋), 0] + 𝑀𝑀𝑀𝑀𝑀𝑀[(𝑋𝑋 − 𝑆𝑆. ), 0] − 𝑐𝑐' − 𝑝𝑝'
- 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀. : portfolio’s targeted modified duration
Collar (on Existing Holding) - 𝑀𝑀𝑀𝑀? : portfolio’s market value 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉$ = 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛 × 𝑃𝑃𝑃𝑃$ (𝑇𝑇)
𝑡𝑡
Collar = Long put + Short call + Underlying asset × O × [𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑉𝑉𝑉𝑉𝑉𝑉(0, 𝑡𝑡)]-
Fixed-Income Futures 𝑇𝑇
Expiration Value for Collar (𝑋𝑋& > 𝑋𝑋- ) 𝑇𝑇 − 𝑡𝑡
Principal Invoice Amount for CTD Bond +
= 𝑆𝑆. + 𝑀𝑀𝑀𝑀𝑀𝑀[(𝑋𝑋& − 𝑆𝑆. ), 0] − 𝑀𝑀𝑀𝑀𝑀𝑀[(𝑆𝑆. − 𝑋𝑋-), 0] @;$;+%A >%$$8%B%"$ ?+7C% 𝑇𝑇
=f g × 𝐶𝐶𝐶𝐶 × 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
Profit of Collar (𝑋𝑋& > 𝑋𝑋-) &'' × [𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝑉𝑉𝑉𝑉𝑉𝑉(𝑡𝑡, 𝑇𝑇)]-
= 𝑆𝑆. + 𝑀𝑀𝑀𝑀𝑀𝑀[(𝑋𝑋& − 𝑆𝑆. ), 0] − 𝑀𝑀𝑀𝑀𝑀𝑀[(𝑆𝑆. − 𝑋𝑋- ), 0] − 𝑆𝑆' where
- CF: Conversion factor of CTD bond − 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 - P
− 𝑝𝑝' + 𝑐𝑐'

Calendar Spread where

Combination of options with same strike prices but - 𝑃𝑃𝑃𝑃$ (T) is the value of $1 at time 𝑡𝑡 which will
different expiration times. mature at time 𝑇𝑇
Long calendar spread: - 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑉𝑉𝑉𝑉𝑉𝑉(0, 𝑡𝑡) is the realized volatility from
- Buy longer-term call, sell shorter-term call time 0 to time 𝑡𝑡
- Buy longer-term put, sell shorter-term put - 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝑑𝑑 𝑉𝑉𝑉𝑉𝑉𝑉(𝑡𝑡, 𝑇𝑇) is the implied volatility
remaining in the period (𝑇𝑇 − 𝑡𝑡)

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CURRENCY MANAGEMENT: Decomposition of Expected Returns # Futures Contracts (for Immunization)
CURRENCY MANAGEMENT:
AN INTRODUCTION 𝐸𝐸[𝑅𝑅] 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝐵𝐵𝐵𝐵𝐵𝐵
AN INTRODUCTION ≈ 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 ± 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 = 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝐵𝐵𝐵𝐵𝐵𝐵
Domestic Currency Return ± 𝐸𝐸[𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 ∆ 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏ℎ𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚 𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦 ] + 2𝑁𝑁# × 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝐵𝐵𝐵𝐵𝐵𝐵4
𝑅𝑅6D = (1 + 𝑅𝑅@D )(1 + 𝑅𝑅@/ ) − 1 ± 𝐸𝐸[𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 ∆ 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 ] where:
where ± 𝐸𝐸[𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 ∆ 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣 𝑐𝑐ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎] - 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝐵𝐵𝐵𝐵𝐵𝐵 ≈
E?L"!#
- 𝑅𝑅6D is the domestic-currency return (in percent) D@"!#

- 𝑅𝑅@D is the foreign-currency return (in percent) 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 - 𝐶𝐶𝐶𝐶D.6 : conversion factor for the CTD security
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑒𝑒 = - A positive 𝑁𝑁# implies buying futures contracts
- 𝑅𝑅@/ is the percentage change in the foreign 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝
𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 - A negative 𝑁𝑁# implies selling futures contracts
currency against the domestic currency
𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝H"I − 𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝E%J7""7"J
= Accumulated & Projected Benefit Obligation
𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝E%J7""7"J
Approximations: 𝑚𝑚 × 𝐺𝐺 × 𝑊𝑊' 1 1
𝐴𝐴𝐴𝐴𝐴𝐴 = ×} − ~
𝑅𝑅6D ≈ 𝑅𝑅@D + 𝑅𝑅@/ (1 + 𝑟𝑟). 𝑟𝑟 𝑟𝑟 × (1 + 𝑟𝑟)M
𝐸𝐸[𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 ∆ 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏ℎ𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚 𝑦𝑦𝑖𝑖𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 ]
- - - = −𝑀𝑀𝑀𝑀(∆𝑌𝑌𝑌𝑌𝑌𝑌𝑌𝑌𝑌𝑌) 𝑚𝑚 × 𝐺𝐺 × 𝑊𝑊' × (1 + 𝑤𝑤).
𝜎𝜎 (𝑅𝑅6D ) ≈ 𝜎𝜎 (𝑅𝑅@D ) + 𝜎𝜎 (𝑅𝑅@/ ) + 2𝜎𝜎(𝑅𝑅@D ) ∙ 𝜎𝜎(𝑅𝑅@/ ) 1 𝑃𝑃𝑃𝑃𝑃𝑃 =
∙ 𝜌𝜌(𝑅𝑅@D , 𝑅𝑅@/ ) + (𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶)(∆𝑌𝑌𝑌𝑌𝑌𝑌𝑌𝑌𝑌𝑌)- (1 + 𝑟𝑟).
2 1 1
where ×} − ~
Uncovered Interest Rate Parity 𝑟𝑟 𝑟𝑟 × (1 + 𝑟𝑟)M
- MD: modified duration
%∆𝑆𝑆5/4 ≈ 𝑖𝑖5 − 𝑖𝑖4
where:
- %∆𝑆𝑆5/4 is percentage change in the 𝑆𝑆5/4 spot - 𝑚𝑚: percentage of final salary
Leveraged Portfolio Return
exchange rate (low-yield currency is base 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝑟𝑟K (𝑉𝑉H + 𝑉𝑉E ) − 𝑟𝑟E 𝑉𝑉E - 𝐺𝐺: number of years worked
currency) 𝑟𝑟? = = - 𝑊𝑊' : current salary
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 𝑉𝑉H
- 𝑖𝑖5 is interest rate on high-yield currency 𝑉𝑉E - 𝑤𝑤: wage growth
= 𝑟𝑟K + (𝑟𝑟K − 𝑟𝑟E ) - 𝑟𝑟: discount rate on high-quality corporate bonds
- 𝑖𝑖4 is the interest rate on low-yield currency 𝑉𝑉H
where - 𝑇𝑇: years until retirement
- 𝑟𝑟K : return on invested funds - 𝑍𝑍: years after retirement
Minimum-Variance Hedge Ratio
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 (𝑦𝑦, 𝑥𝑥) 𝜎𝜎9 - 𝑟𝑟E : borrowing rate
= 𝜌𝜌9,G O P Swap Notional Principal to Close Duration Gap
𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉(𝑥𝑥) 𝜎𝜎G 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝐵𝐵𝐵𝐵𝐵𝐵
Futures Leverage 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 𝐵𝐵𝐵𝐵𝐵𝐵 = 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐵𝐵𝐵𝐵𝐵𝐵 + }𝑁𝑁𝑁𝑁 × ~
100
𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣 − 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀
FIXED INCOME FIXED INCOME 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿@;$;+%A =
𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 Full Interest Rate Hedging
(𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐵𝐵𝐵𝐵𝐵𝐵) × (∆𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦)
OVERVIEW OF FIXED-INCOME
OVERVIEW OF FIXED-INCOMEPORTFOLIO Dollar Interest in Repurchase Agreement + (𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻 𝐵𝐵𝐵𝐵𝐵𝐵)
MANAGEMENT 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 = 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 × (∆𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻 𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑑𝑑𝑑𝑑)
PORTFOLIO MANAGEMENT
× 𝑅𝑅𝑅𝑅𝑝𝑝𝑝𝑝 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 ≈ (𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 𝐵𝐵𝐵𝐵𝐵𝐵)
Roles of Fixed-Income Securities in Portfolios × (𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑜𝑜𝑜𝑜 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝑖𝑖𝑖𝑖 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 × (∆𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦)
- Diversification Benefits /360)
- Benefits of Regular Cash Flows YIELD CURVE
YIELD CURVE STRATEGIES
STRATEGIES
- Inflation Hedging Potential Rebate Rate in Securities Lending
𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 = 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 Butterfly spread = −Short-term yield +2 Medium-
Fixed-Income Mandates − 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 term yield −Long-term yield
Liability-Based Mandates
- Cash flow matching LIABILITY-DRIVEN AND
LIABILITY-DRIVEN & INDEX-BASED Duration Approximation
STRATEGIES
INDEX-BASED STRATEGIES 1
- Duration matching %𝛥𝛥𝑃𝑃𝑃𝑃 @;88 ≈ −𝐷𝐷 × ∆𝑌𝑌 + × 𝐶𝐶 × (∆𝑌𝑌)-
2
- Contingent immunization Convexity Sensitivity of a Bond Futures to Changes in
- Horizon matching 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 Yield
Total Return Mandates (𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝑑𝑑𝑑𝑑𝑑𝑑. )- + 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝑑𝑑𝑑𝑑𝑑𝑑. +𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝐵𝐵𝐵𝐵𝐵𝐵D.6
= 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝐵𝐵𝐵𝐵𝐵𝐵 ≈
- Pure indexing (1 + 𝐶𝐶𝑎𝑎𝑎𝑎ℎ 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦 )- 𝐶𝐶𝐶𝐶D.6
- Enhanced indexing Sensitivity of a Swap to Changes in Yield
Duration 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁
- Active management 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 = 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝐵𝐵𝐵𝐵𝐵𝐵 ≈ 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀>N(O ×
10,000
× 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉
Effective Duration and Effective Convexity
𝑃𝑃𝑉𝑉, − 𝑃𝑃𝑉𝑉2 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑
𝐸𝐸𝐸𝐸𝐸𝐸6;+ = 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 =
𝑖𝑖
2 ⋅ 𝛥𝛥𝛥𝛥𝛥𝛥𝛥𝛥𝛥𝛥𝛥𝛥 ⋅ 𝑃𝑃𝑉𝑉' 1+
𝑘𝑘
𝑃𝑃𝑉𝑉, + 𝑃𝑃𝑉𝑉2 − 2 ⋅ 𝑃𝑃𝑉𝑉' where
𝐸𝐸𝐸𝐸𝐸𝐸D<" =
(𝛥𝛥𝛥𝛥𝛥𝛥𝛥𝛥𝛥𝛥𝛥𝛥)- ⋅ 𝑃𝑃𝑉𝑉' - 𝑖𝑖 is the annualized cash flow yield
- 𝑘𝑘 is the compounding periods per year

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FIXED
FIXED INCOME
INCOME ACTIVE
ACTIVE MANAGEMENT:
MANAGEMENT: CREDIT Duration Times Spread (DTS) Tracking Error Management
STRATEGIES 𝐷𝐷𝐷𝐷𝐷𝐷 ≈ 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 × 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 - The excess return is the difference between the
CREDIT STRATEGIES
portfolio returns and the benchmark returns.
Credit Risk Excess Spread Return 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟O = 𝑅𝑅O − 𝑅𝑅U
A borrower's credit risk is determined by default 𝐸𝐸[𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸] ≈ 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑑𝑑' - Tracking error measures how closely the
risk and loss severity. − 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 × 𝛥𝛥𝛥𝛥𝛥𝛥𝛥𝛥𝛥𝛥𝛥𝛥𝛥𝛥
portfolio return matches the benchmark return.
- Default risk: Measured by the probability of − 𝑃𝑃𝑃𝑃𝑃𝑃 × 𝐿𝐿𝐿𝐿𝐿𝐿
default (POD) 𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒O = Ñ𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑒𝑒V$,V%
- Loss severity: Measured by the loss given Credit Default Swap (CDS)
The amount of the upfront payment can be
default (LGD). It can be calculated as LGD = 1 ACTIVE EQUITY INVESTING
approximated as: ACTIVE EQUITY INVESTING
– RR, where RR is the recovery rate 𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈 𝐶𝐶𝐶𝐶𝐶𝐶 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃
Active Return
Over a single period, a bond's credit spread can be ≈ (𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 − 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶) Active return is the sum of the security returns
approximated as 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 ≈ 𝑃𝑃𝑃𝑃𝑃𝑃 × 𝐿𝐿𝐿𝐿𝐿𝐿. × 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝑟𝑟𝐶𝐶𝐶𝐶𝐶𝐶 times the weight differences between the portfolio
The CDS price per unit of par value can be and benchmark:
P
Fixed-Rate Bond Credit Spread Measures calculated as:
- Benchmark spread (yield spread): The difference 𝐶𝐶𝐶𝐶𝐶𝐶 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑅𝑅: = É 𝛥𝛥𝑊𝑊7 𝑅𝑅7 𝛥𝛥𝑊𝑊7 = 𝛥𝛥𝑊𝑊?7 − 𝛥𝛥𝑊𝑊E7
between the yields on a risky bond and an on- ≈ 1 − (𝐶𝐶𝐶𝐶𝐶𝐶 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 − 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶) 7T&
the-run government bond with a similar × 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝑟𝑟D6>
maturity. Expected Active Return
- G-spread (government spread): The difference The change in a CDS' price can be approximated as: The expected active portfolio return can be
between a bond's yield and an interpolated %𝛥𝛥 𝐶𝐶𝐶𝐶𝐶𝐶 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 ≈ −𝛥𝛥𝛥𝛥𝛥𝛥𝛥𝛥 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 determined as follows:
government bond yield. × 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝑟𝑟D6> 𝐸𝐸[𝑅𝑅: ] = 𝐼𝐼𝐼𝐼 × √𝐵𝐵𝐵𝐵 × 𝜎𝜎V& × 𝑇𝑇𝑇𝑇
- I-spread (interpolated spread): The difference where
between a bond's yield and a swap rate, or - IC: Expected information coefficient of the
market reference rate (MRR), rather than the EQUITY INVESTMENTS manager, which is how much the manager’s
EQUITY INVESTMENTS
government yield. This measure relies on a forecasted active returns correspond to the
single point on the curve and it can only be used PASSIVE EQUITY INVESTING
PASSIVE EQUITY INVESTING manager’s realized active returns
for option-free bonds.
- Asset swap spread (ASW): The difference - BR: Breadth, which is the number of
Index Concentration
between a bond's coupon rate and the MRR on a - The Herfindahl-Hirshaman Index (HHI) can be independent decisions made each year
swap of the same maturity. used to measure stock concentration risk in a - TC: Transfer coefficient, which is the ability to
- Z-spread (zero-volatility spread): The constant convert portfolio insights into investment
portfolio. The HHI is the sum of the constituent
spread that is added to each point on the decisions; an unconstrained portfolio has a
government spot curve to force the present weightings squared:
" transfer coefficient of 1
value of a bond's future cash flows to equal its
current market value. This can only be used for 𝐻𝐻𝐻𝐻𝐻𝐻 = É 𝑤𝑤7-
bonds without embedded options. 7T& Active Share and Active Risk
- The effective number of stocks represents - Active share measures how the size
- CDS basis: The difference between a bond's Z-
spread and the spread on credit default swaps the number of stocks required in an positions in a manager’s portfolio differs
(CDS) of the same (or interpolated) maturity for equally-weighted portfolio that would from the benchmark:
"
the issuer have the same HHI: 1
- Option-adjusted spread (OAS): This is very 1 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑆𝑆ℎ𝑎𝑎𝑎𝑎𝑎𝑎 = ÉÖ𝑊𝑊O<+$,7 − 𝑊𝑊U%"C=B(+W,7 Ö
𝐸𝐸𝐸𝐸𝐸𝐸𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛 𝑜𝑜𝑜𝑜 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 = 2
similar to the Z-spread but it also works for 𝐻𝐻𝐻𝐻𝐻𝐻 7T&
bonds with embedded options. This measure is Approaches to Passive Equity Investing - Active risk can be measured using realized
highly dependent on assumptions about interest - Pooled Investments: Mutual funds and historical numbers or using predicted estimates
rate volatility and prepayment speed. exchange-traded funds, are easy to purchase, of correlations and variances:
hold, and sell. "
Floating-Rate Note Credit Spread Measures
- Derivatives-Based Approaches: Options, 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 = Ü𝜎𝜎 - áÉ.𝛽𝛽OW − 𝛽𝛽UW 5𝐹𝐹W à + 𝜎𝜎%-
Floating-rate notes (FRNs) make payments based
on a variable MRR. swaps, and futures contracts can be used WT&
- Coupon rate: Determined by taking the sum of to gain index performance.
the MRR and a quoted margin (QM) - Separately Managed Equity Index-Based Causes and Sources of Absolute Risk
- Discount rate: Determined by taking the sum of Portfolios: An indexed portfolio can be The total portfolio variance (𝑉𝑉O ) and contribution
built by purchasing the constituent securities
the MRR and discount margin (DM) of each asset to portfolio variance (𝐶𝐶𝐶𝐶𝑖𝑖 ) can be
of the index.
calculated with the following formulas:
(𝑀𝑀𝑀𝑀𝑀𝑀 + 𝑄𝑄𝑄𝑄)(𝐹𝐹𝐹𝐹) " "

𝑃𝑃𝑃𝑃 = 𝑚𝑚 Portfolio Construction 𝑉𝑉O = É É 𝑥𝑥7 𝑥𝑥Y 𝐶𝐶7Y

(𝑀𝑀𝑅𝑅𝑅𝑅 + 𝐷𝐷𝐷𝐷) & - Full Replication: Hold all the securities in an 7T& YT&
O1 + P "
𝑚𝑚 index in proportion with the index weightings.
(𝑀𝑀𝑀𝑀𝑀𝑀 + 𝑄𝑄𝑄𝑄)(𝐹𝐹𝐹𝐹) 𝐶𝐶𝐶𝐶7 = É 𝑥𝑥7 𝑥𝑥Y 𝐶𝐶7Y = 𝑥𝑥7 𝐶𝐶7O
- Stratified Sampling: Index constituents are first
+ 𝑚𝑚 +⋯ YT&
divided into strata or subgroups. Securities are
(𝑀𝑀𝑀𝑀𝑀𝑀 + 𝐷𝐷𝐷𝐷) - where
O1 + P chosen for the portfolio so the portfolio weights
𝑚𝑚 - 𝑥𝑥Y : the asset’s weight in the portfolio
(𝑀𝑀𝑀𝑀𝑀𝑀 + 𝑄𝑄𝑄𝑄)(𝐹𝐹𝐹𝐹) by strata will match the index weights by strata.
+ 𝐹𝐹𝐹𝐹 - 𝐶𝐶7Y : the covariance of returns between asset i
+ 𝑚𝑚 - Optimization: Minimize the tracking error
(𝑀𝑀𝑀𝑀𝑀𝑀 + 𝐷𝐷𝐷𝐷) P and asset j
O1 + P subject to specified constraints.
𝑚𝑚 - 𝐶𝐶7O : the covariance of returns between asset i
- Blended Approach: A blend of the three
and the portfolio
approaches can be used to track a
particular index.

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Causes and Sources of Relative/Active Risk Specialist Strategies PORTFOLIO MANAGEMENT (PART I)
- Volatility Trading: Relative value volatility PORTFOLIO MANAGEMENT (PART I)
The variance of the portfolio’s active return %𝐴𝐴𝐴𝐴𝑝𝑝 &
arbitrageurs can take advantage of differences THE BEHAVIORAL BIASES OF INDIVIDUALS
can be used to measure relative risk. THE BEHAVIORAL BIASES OF INDIVIDUALS
" "
in implied volatility for the same product across
time zones (time-zone arbitrage) or markets
𝐴𝐴𝐴𝐴O = É É(𝑥𝑥7 − 𝑏𝑏7 )2𝑥𝑥Y − 𝑏𝑏Y 4𝑅𝑅𝐶𝐶7Y Cognitive vs. Emotional
(cross-asset volatility trading). - Cognitive errors are statistical,
7T& YT&
where - Reinsurance/Life Settlements: The sale of a life information-processing, or memory errors.
- 𝑥𝑥7 : asset’s weight in the portfolio insurance policy to a party other than its Can be moderated through better
- 𝑏𝑏7 : benchmark weight in asset i originator is called a life settlement. Third-party information and education.
- 𝑅𝑅𝐶𝐶7Y : covariance of relative returns between brokers will then package the individual policies - Emotional biases stem from attitudes or
asset i and asset j that they have acquired into pools to be resold feelings. Must often be adapted to because
to hedge funds. it is very difficult to reduce or eliminate them.

Multi-Manager Strategies
Cognitive Errors
ALTERNATIVE INVESTMENTS
ALTERNATIVE INVESTMENTS - Fund-of-Funds: The FoF manager will make
Belief Perseverance Biases
allocations to a diverse group of funds. - Conservatism Bias: Maintain prior views by
HEDGE
HEDGE FUND STRATEGIES
FUN STRATEGIES - Multi-Strategy Hedge Funds: Multiple inadequately incorporating new information.
teams pursuing distinct strategies within Tend to overweight initial beliefs and
Classification of Hedge Funds and Strategies the same organization.
Hedge Fund Characteristics underreact to new information.
- Legal/ Regulatory Overview - Confirmation Bias: Tend to only notice what
Conditional Factor Risk Model confirms their beliefs.
- Flexible Mandates - A conditional risk-factor model goes a step
- Large Investment Universe - Representativeness Bias: Tend to use past
further to account for the possibility that
- Aggressive Investment Styles classifications for new information, even if it
factor exposures can change under different
- High Leverage does not fit into the category.
market conditions.
- Liquidity Constraints - Illusion of Control Bias: Believe they can control
- Using the example of a managed futures with
- High Fees outcomes that they cannot.
exposure to equity and commodity risks, the
Equity Strategies - Hindsight Bias: Look at past events and think
conditional factor model is: they would have been predictable.
- Long/Short Equity: Buy undervalued stocks and
𝑟𝑟=# = 𝛼𝛼 + 𝛽𝛽H 𝑅𝑅H + 𝛽𝛽D 𝑅𝑅D + 𝐷𝐷𝛽𝛽H 𝑅𝑅H + 𝐷𝐷𝛽𝛽D 𝑅𝑅D Information-Processing Biases
sell overvalued stocks short.
- Dedicated Short-Selling and Short-Biased: Take where - Anchoring and Adjustment Bias: When people
short-only positions in equities but may vary the o 𝐷𝐷: Dummy variable with a value of 0 under estimate an unknown value or probability, they
short positions by holding cash. normal market conditions and 1 during crises often start by adjusting from an “anchor” value.
- Equity Market-Neutral: Use offsetting long o 𝐷𝐷𝛽𝛽H 𝑅𝑅H : Incremental exposure to equity risk - Mental Accounting Bias: Put money in separate
and short positions to establish an overall during periods of market stress mental buckets and treat them differently.
portfolio with near zero net exposure to equity
- Framing Bias: Answer the same question
market risk (beta). ASSET ALLOCATION
ASSET ALLOCATIONTO
TOALTERNATIVE
ALTERNATIVE differently just based on how the question
INVESTMENTS
Event-Driven Strategies INVESTMENTS is framed.
- Merger Arbitrage: Take positions based on Achieving and Maintaining the - Availability Bias: Use heuristics (mental
their expectations about merger activity. Strategic Asset Allocation shortcuts) when making decisions.
- Distressed Securities: Focus on firms that are - In private partnerships, GPs have broad
either already in the bankruptcy process or Emotional Biases
discretion over decisions related to capital
that are currently experiencing financial - Loss-Aversion Bias: Prefer avoiding losses more
distress and are expected to file for bankruptcy calls and distributions.
- The net asset value of a private fund with a than achieving gains.
in the near future.
drawdown structure at time t is: - Overconfidence Bias:
Relative Value Strategies 𝑁𝑁𝑁𝑁𝑉𝑉$ = 𝑁𝑁𝑁𝑁𝑉𝑉$,&(1 + 𝑔𝑔) + 𝐶𝐶$ − 𝐷𝐷$ o Overestimate their own abilities.
- Fixed-Income Arbitrage: Seek to profit from where: o Can come from the illusion of superior
relative mispricing. o 𝑁𝑁𝑁𝑁𝑉𝑉$,& : fund’s net asset value at the end of knowledge or consistently attributing success
o Yield curve trades involve taking long and the previous period to skill and failure to external factor.
short positions based on expected changes o g: growth rate o Self-enhancing and self-protecting biases are
in the shape of the yield curve in response
o 𝐶𝐶$ : amount of new contributions the two sides of the self-attribution bias.
to macroeconomic conditions.
o Carry trades are executed by shorting (capital calls) during period t - Self-Control Bias: Fail to make decisions that
low-yielding bonds and purchasing o 𝐷𝐷$ : the amount of distributions made are best for their long-term goals because of a
higher-yielding bonds. during period t lack of self discipline.
- Convertible Bond Arbitrage: Seek to take - One particular model for forecasting - Status Quo Bias: Inclined to do nothing
advantage of discrepancies between the prices contributions uses the following formula: rather than change.
of an issuer’s convertible bonds and their
𝐶𝐶$ = 𝑅𝑅𝐶𝐶$ × (𝐶𝐶𝐶𝐶 − 𝑃𝑃𝑃𝑃𝐶𝐶$ ) - Endowment Bias: Value an asset more
straight bonds. where: when they hold the rights to it.
o 𝑅𝑅𝐶𝐶$ : rate of contributions during period t - Regret-Aversion Bias: Avoid decisions
Opportunistic Strategies
- Global Macro Strategies: Generally hold views o 𝐶𝐶𝐶𝐶: capital commitment that could turn out badly.
on macro-level economic activity based on o 𝑃𝑃𝑃𝑃𝐶𝐶$ : amount paid-in-capital prior to period t
top-down analysis and express views by - The formula for forecasting distributions uses a
taking positions in a variety of asset variable for the rate of distributions:
classes and instruments. 𝐷𝐷$ = 𝑅𝑅𝐷𝐷$ × 𝑁𝑁𝑁𝑁𝑉𝑉$,& (1 + 𝑔𝑔)
- Managed Futures: A highly technical and
systematic strategy that is executed using
primarily futures and options on futures.

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BEHAVIORAL
BEHAVIORAL FINANCE
FINANCEAND INVESTMENT Analyst Biases in Conducting Research TOPICS IN
TOPICS IN PRIVATE WEALTH MANAGEMENT
PRIVATE WEALTH MANAGEMENT
PROCESSES - Collecting too much information can lead to the
AND INVESTMENT PROCESSES After-Tax Returns
illusion of control and representativeness.
Bailard, Biehl, and Kaiser Five-Way Model - Stories can be weaved that are created - A pre-tax holding period return is calculated as
- Adventurer: Confident and willing to take follows:
to fit the data.
chances, so often hold undiversified portfolio 𝑉𝑉. − 𝑉𝑉' + 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼
- Confirmation bias can lead analysts to 𝑅𝑅 =
- Celebrity: Like to be center of attention, 𝑉𝑉'
become entrenched in their prior beliefs.
but recognizes weaknesses so may seek - An after-tax holding period return is a pre-tax
- The gamblers’ fallacy is another cognitive bias
investment advice return adjusted for tax payments:
that can affect analysts. It is a wrong belief that
- Individualist: Independent and confident; 𝑉𝑉. − 𝑉𝑉' + 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 − 𝑇𝑇𝑇𝑇𝑇𝑇
probabilities must revert to a long-term mean. 𝑅𝑅′ =
make decisions after careful analysis 𝑉𝑉'
- Endowment bias and confirmation bias can lead - The Modified Dietz formula can be used to better
- Guardian: Cautious and concerned about
to analysts recommending financially sound
the future; common for older people estimate returns when tax payments have been
companies even if the current stock price does
approaching retirement made within the period:
not justify the investment. 𝑇𝑇𝑇𝑇𝑇𝑇
- Straight Arrow: Sensible and secure; willing 𝑅𝑅 [ = 𝑅𝑅 −
to take on some risk for extra return 𝐶𝐶Y (𝑁𝑁 − 𝑗𝑗)
How Behavioral Factors Affect Committee 𝑉𝑉' + ∑
𝑁𝑁
Decision Making - The after-tax post-liquidation return is calculated
Description of the Four - Social proof is a bias in which individuals as the geometrically linked sub-period returns
Behavioral Investor Types tend to follow the group beliefs.
- Passive Preservers want to preserve wealth less the embedded tax liability that would be
- Group discussions can lead to an due if accumulated unrealized gains were
rather than take risk to generate more wealth.
overconfidence bias. realized upon liquidation:
- Friendly Followers are passive investors that
- Committees often perform poorly because &
follow the investment advice of others, such as 𝐿𝐿𝐿𝐿𝐿𝐿. 𝑇𝑇𝑇𝑇𝑇𝑇 "
they are usually composed of individuals 𝑅𝑅?4 = }(1 + 𝑅𝑅&[) … (1 + 𝑅𝑅"[ ) − ~ −1
friends or advisers. 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉
with similar backgrounds who have
- An Independent Individualist is an active 𝐿𝐿𝐿𝐿𝐿𝐿. 𝑇𝑇𝑇𝑇𝑇𝑇 = (𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣 − 𝑇𝑇𝑇𝑇𝑇𝑇 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏)
debates to arrive at a consensus. × 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔 𝑡𝑡𝑡𝑡𝑡𝑡 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟
investor that is typically strong-willed
= 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔
and independent. How Behavioral Finance × 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔 𝑡𝑡𝑡𝑡𝑡𝑡 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟
- Active Accumulators are aggressive, Influences Market Behavior - Tax alpha is simply the pre-tax excess return
confident and strong-willed. Momentum (relative to a benchmark) less the after-tax
- Most markets exhibit short-term positive excess return.
How Behavioral Factors Affect correlation and long term negative correlation. - The tax efficiency ratio (TER) is a portfolio’s
Portfolio Construction - Availability bias could also explain why after-tax return as a percentage of its
- Inertia and Default investors rely so much on recent information. pre-tax return.
- Naïve Diversification - Regret aversion could drive investors to
- Investing in the Familiar Stocks purchase mutual funds that have performed Capital Accumulation
o Familiarity and overconfidence well in the previous year to avoid regretting - The future value of an investment held in a tax-
o Naïve extrapolation of past returns again not owning it the next year. exempt account is:
o Framing and status quo - The disposition effect encourages 𝐹𝐹𝑉𝑉.(G,%G%BO$ = (1 + 𝑟𝑟)"
o Loyalty investors to hold onto losers just - If the same investment were held in a taxable
o Financial incentives to avoid recognizing the loss. account, its future value would be:
- Excessive Trading 𝐹𝐹𝑉𝑉.(G(U8% = [1 + 𝑟𝑟(1 − 𝑡𝑡)]"
Bubbles and Crashes
- Home Bias - Holding an investment in a tax-deferred account
- Overconfidence leads to
allows it to accumulate gains that are untaxed
overtrading, underestimation of risk, until they are realized:
Behavioral Finance and Analyst Forecasts and lack of diversification. 𝐹𝐹𝑉𝑉.(G,I%#%++%I = (1 + 𝑟𝑟)" (1 − 𝑡𝑡)
Overconfidence in Forecasting Skills - Bubbles can be linked to confirmation, Potential Capital Gain Exposure (PCGE)
- Investment analysts are often overconfident in self-attribution, and hindsight bias. 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃
their abilities and information, which is referred Value and Growth 𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺 − 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 − 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿
to as the illusion of knowledge bias. - Value stocks outperform growth stocks. =
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑁𝑁𝑁𝑁𝑁𝑁 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴
- Analysts also exhibit self-attribution bias, - Overconfidence can affect growth rate
in which they take credit for success and predictions. Emotional investors may be Estate Planning
assign responsibility for failure. attracted to growth. - The relative value of transferring assets as gifts
- Availability bias causes the analysts to give during the donor's lifetime rather than as
too much weight to accessible and readily bequests can be calculated using the following
recalled information. formula:
"
- Hindsight bias inclines the analyst to 𝐹𝐹𝑉𝑉\7#$ .1 + 𝑟𝑟J 21 − 𝑡𝑡J 45 (1 − 𝑇𝑇J )
𝑅𝑅𝑅𝑅 = =
think past events are predictable. 𝐹𝐹𝑉𝑉E%];%A$ [1 + 𝑟𝑟% (1 − 𝑡𝑡% )]" (1 − 𝑇𝑇% )
Influence of Company’s Management on Analysis - If annual returns are taxed at the same rate for
- Company management can present the recipient and donor and the assets can be
information in such a way to exploit biases. transferred as tax-free gifts, the relative value is
- Framing, anchoring and adjustment, formula shown above simplifies to:
and availability are all cognitive biases 1
that can play a role. 1 − 𝑇𝑇%

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RISK
RISK MANAGEMENT
MANAGEMENT FOR
FORINDIVIDUALS
INDIVIDUALS Asset Allocation SWFs - Development Funds
Pension plans have traditionally held large fixed- - Given a broad mandate to spur economic
Economic Balance Sheet income allocations with some equities as a source growth, these funds invest in a variety of
- The assets on an individual's economic (holistic) opportunities — from infrastructure projects to
of growth. Recently, alternative assets have
balance sheet include both their human capital venture capital investments in emerging sectors.
become more common in pension portfolios,
and their financial capital。 although asset allocations can be subject to - Liabilities are ill-defined and it is difficult to
- Human capital is the present value of expected regulatory requirements and limitations. generalize about asset allocations for these
future employment income. types of funds. However, they tend to be long-
- Financial capital includes both personal assets DC Pensions term investors with low liquidity needs and an
and investment assets, which can be classified Liabilities objective to earn a real return in excess of GDP
based on marketability and whether they are Plan sponsors are only liable for their promised or productivity growth.
publicly traded. contributions and the plans themselves have no
liabilities beyond allowing participants to access SWFs - Savings Funds
PORTFOLIO
PORTFOLIOMANAGEMENT
MANAGEMENTFORFOR the assets in their accounts. - The purpose of these funds is to transfer wealth
INSTITUTIONAL INVESTORS to future generations.
INSTITUTIONAL INVESTORS Stakeholders
Plan participants are the primary stakeholders. - Liquidity needs are relatively low, typically
Common Characteristics
Investment Objectives determined by a fixed spending rate.
Institutions tend to share the following
characteristics that distinguish this class of Individual participants have their own specific - An objective to achieving intergenerational
investors from individuals: objectives. The investment firms and insurance equity produces a very long-term time
- Large Scale companies that manage DC plans will want to show horizon with a correspondingly high level
- Long Investment Horizons and that their portfolio options perform well. of risk tolerance.
Low Liquidity Needs Legal/Regulatory Constraints - Portfolio allocations are dominated by equities
- Regulatory Framework Plan sponsors are typically required to provide and alternatives, with relatively few fixed-
- Formal Governance Framework regular financial education courses for income assets.
- Principal-Agent Problems participants. Other legal requirements may include
offering a glide path fund as a default option. SWFs - Reserve Funds
DB Pension Tax Constraints - These funds are used by export-intensive
Liabilities Assets held in DC pension plan accounts are economies to absorb their local currency while
Benefit payments are determined by a formula accumulating excess foreign currency reserves
allowed to accumulate tax-free until they are
based on inputs such as tenure and final salary. as assets.
Estimates of future payments must account for withdrawn, after which they are taxed at the
participant's applicable rate. - The return objective is a rate in excess of the
unknowns such as mortality and inflation.
Risk Considerations yield on the monetary stabilization bonds issued
Stakeholders
The primary stakeholders are participants, - Investment Horizon: DC plans must provide a by the central bank.
sponsors, and governments. range of investment options that account for - A very long-term time horizon allows for high
Investment Objectives differences in the time horizons of individual allocations to equity-like alternatives, but
Primarily to meet obligations to participants. some liquid fixed-income securities are also
participants. All else equal, older participants
Secondary objectives may include limiting surplus held in order to meet relatively unpredictable
volatility or minimizing the sponsor's need to and larger balances are associated with shorter
investment horizons. liquidity needs.
make additional contributions.
Legal/Regulatory Constraints - Liquidity Needs: DC plans receive regular
Governments tend to establish high regulatory SWFs - Pension Reserve Funds
contributions from participants, but must
requirements for pensions, often based on the - Used to pre-fund future pension and health care
maintain sufficient liquidity to meet
principles of prudential supervision, capital costs, these funds are supported by government
withdrawals.
adequacy, market integrity, and consumer budget surpluses.
Asset Allocation
protection. Trustees may be held personally liable - Liquidity needs are minimal during an initial
if they fail to meet their fiduciary duty to While each participant has their own allocation
accumulation phase, allowing for very high
participants. preferences, the aggregate scale of DC plans may
allocations to equities and illiquid alternatives
Tax Constraints give them access to asset classes that would
such as infrastructure, real assets, and
DB pension plans are typically tax-exempt otherwise be unavailable to them. Plans must offer
investors. hedge funds.
participants a menu of different allocations.
Risk Considerations - In the subsequent decumulation phase, the
- Investment Horizon: Typically long-term for investment horizon shortens and funds are
Sovereign Wealth Funds
plans that remain open to new participants. SWFs - Budget Stabilization Funds allocated to more fixed-income assets to help
Workforce characteristics, such as a higher - Typically created by governments that rely meet growing liquidity needs.
average age of participants, will shorten a plan's heavily on natural resource revenues to provide
investment horizon. fiscal support if commodity prices fall. Foundations
- Liquidity Needs: Funds are required to make Liabilities
- The primary objective is to preserve the real
benefit payments. Plan features, such as options Foundations are typically required to give out a
value of assets and liabilities are relatively certain percentage of assets as grants every year.
to accept lump-sum payments, will increase unpredictable, so risk tolerance is relatively low Stakeholders
liquidity needs. with large allocations to highly-liquid, low-risk A private foundation's primary stakeholders are
- Other Risk Considerations: A DB pension plan's debt securities. the individual benefactor (or founding family) and
risk tolerance may be limited by factors such as the groups that receive grants. Tensions may exist
common risk exposure with the sponsor, between increasing current grants and preserving
underfunded status, and the sponsor's assets for future grants.
Investment Objectives
financial status.
Foundations with infinite lives typically seek to
maintain the real value of their assets by setting a
return target equal to the sum of the spending rate,
expected inflation, and any management fees.

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Legal/Regulatory Constraints Investment Objectives Insurers
Foundation directors are typically required to - A university endowment’s main investment Liabilities
exercise a fiduciary standard of care and adhere to objective is to achieve intergenerational equity - Life Insurer:
the principles of modern portfolio theory when between current and future students. o Due to the long-term nature of their liabilities,
making investment decisions. - The primary component of an endowment’s life insurers have traditionally had
Tax Constraints return objective is the spending rate. Other investment horizons of 20 to 40 years.
Foundations are tax-exempt investors, provided components of a return target that is sufficient However, this has changed as insurers have
that they meet minimum annual spending to maintain purchasing power include inflation diversified into new product lines.
requirements. and management fees. o For certain products (e.g., term life insurance,
Risk Considerations Legal/Regulatory Constraints fixed annuities), the insurer bears the
- Investment Horizon: Most foundations expect to Investment committees of endowments are often investment risk.
continue operating in perpetuity. However, required to invest on a total return basis and o Certain life insurance liabilities are highly
limited life foundations are given a specific date achieve sufficient diversification. sensitive to interest rates.
by which they must distribute their assets and Tax Constraints - Property and Casualty Insurers:
cease operating. - Endowments are typically tax-exempt investors. o P&C insurers have shorter duration, more
- Liquidity Needs: Foundations have relatively - Unlike foundations, endowments tend not to be volatile liabilities. As a result, P&C insurers
low liquidity needs. They are not required to subject to minimum spending requirements in tend to allocate a higher proportion of their
make any payments in excess of the minimum order to maintain this status. portfolios to cash and short-term fixed-
threshold to maintain tax-exempt status. Risk Considerations income instruments.
However, foundations may be subject to flow- - Investment Horizon: Because university - Regulators typically require insurers to have a
through rules requiring them to spend endowments are continually accounting for the reserve portfolio to meet policy liabilities.
donations during the year in which they are interests of future students, their investment - A surplus portfolio is used to earn higher
received. horizon is perpetual. returns. Insurers are more willing to accept
Asset Allocation - Liquidity Needs: Have lower liquidity needs liquidity risk in this portfolio, including
- Small allocations to cash and highly liquid than foundations. allocations to alternative assets.
securities are maintained in order to meet - When assessing an endowment’s ability to Stakeholders
immediate spending needs, but long investment tolerate investment risk, consider the The main stakeholders of insurance companies
horizons and low liquidity needs allow for high degree to which the university depends are the policyholders who pay premiums for
allocations to equities and alternatives on its contributions. protection and expect to be compensated
(particularly for larger foundations). Asset Allocation for insured events.
- Limited life foundations hold increasingly large - Small allocations to cash and highly liquid Investment Objectives
allocations of low-risk liquid assets as they securities are maintained in order to meet - An insurance company’s investment objectives
move toward winding down their operations. immediate spending needs. will be consistent with the expected timing and
- Larger endowments have relatively high amount of policyholders’ claims.
Endowments allocations to illiquid alternative assets. - In general, insurers use their investment
Liabilities - The share of alternatives in endowment portfolios to meet their liquidity needs as well
- Endowments do not have specific, legally portfolios has been increasing over time at the as to manage their exposure to interest rate risk,
enforceable liabilities. expense of equities and fixed income securities. credit risk, and exchange rates.
- An endowment’s liabilities are the informal
spending commitments that have been made to Banks Banks and Insurers
future students. Liabilities Legal/Regulatory Constraints
- When an endowment uses a fixed spending - Demand deposits have effectively zero duration - Banks and insurers are subject to a relatively
rate, the amount of its spending in the upcoming as they can be withdrawn at any moment. high level of regulatory and legal constraints
year (Year 1) can be calculated based on the - Time (term) deposits, such as savings accounts compared to other institutional investors.
spending rate (S), inflation (i), the amount and certificates of deposit, have slightly longer - Regulators want to ensure that financial
of spending in the previous year (Year 0), duration because funds cannot be withdrawn intermediaries have sufficient equity capital to
and the average value of assets under without advance notice. provide a buffer against losses on assets (e.g.,
management (AUM): - Banks can also access short-term wholesale loan defaults, negative investment returns) to
𝑌𝑌𝑌𝑌𝑌𝑌𝑌𝑌 1 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 funding, but this is a higher cost source of preserve their ability to meet their obligations
= [𝑤𝑤 × 𝑌𝑌𝑌𝑌𝑌𝑌𝑌𝑌 0 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 × (1 + 𝑖𝑖)] funds than deposits, which are perceived to depositors, lenders, and policyholders.
+[(1 − 𝑤𝑤) × 𝑆𝑆 × 𝐴𝐴𝐴𝐴𝐴𝐴] as more stable. - Regulators also focus on ensuring that financial
o Market value rule: Set w to 0.
Stakeholders intermediaries have sufficient liquidity.
o Constant growth rule: Set w to 1.
- The primary stakeholders of banks are the Tax Constraints
o Hybrid rule (a.k.a. Yale spending rule):
customers who deposit their funds and the Banks and insurance companies are fully
Set w between 0 and 1.
borrowers who receive loans. taxable for-profit entities.
Stakeholders
- Counterparties to derivative contracts and Balance Sheet Management
The two most important stakeholder groups
shareholders also have a strong interest in the - Banks and insurance companies use the liability
for university endowments are current and
ongoing operations of banks. driven investing (LDI) model, which
future students.
Investment Objectives recommends asset allocations based explicitly
Banks typically use their investment portfolios to on their ability to hedge liabilities.
manage their exposure to interest rate risk. - To calculate the change in equity in percentage
terms, we must account for leverage using the
following formula:
𝐴𝐴 𝐴𝐴
%𝛥𝛥𝛥𝛥 = O P %𝛥𝛥𝛥𝛥 − O − 1 P %𝛥𝛥𝛥𝛥
𝐸𝐸 𝐸𝐸

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Managing Interest Rate Risk Strategic Considerations in Rebalancing Developing Liability-Relative Asset Allocations
- Sensitivity to interest rates is captured by the - Higher transaction costs, less risk-averse Characterizing the Liabilities
modified duration measure. investors, more correlated assets, beliefs in Characteristics of liabilities that affect
- The duration of the financial intermediary's momentum, illiquidity, and taxes lead to wider asset allocation in liability-relative asset
allocation include:
equity is calculated as follows: rebalancing ranges.
- Fixed or contingent liabilities
𝐴𝐴 𝐴𝐴 𝛥𝛥𝑦𝑦4 - Belief in mean reversion leads to tighter
𝐷𝐷H = O P 𝐷𝐷: − O − 1 P 𝐷𝐷4 - Legal liabilities and quasi-liabilities
𝐸𝐸 𝐸𝐸 𝛥𝛥𝑦𝑦: rebalancing bands.
Managing Equity Volatility - Duration and convexity of liability cash flows
- Illiquid assets can create a problem.
- Equity volatility (standard deviation) is - Size relative to organization
- Tax issues can create asymmetric bands.
𝐴𝐴 - 𝐴𝐴 - - Factors driving the liability, timing,
𝜎𝜎H- = O P 𝜎𝜎:- + O − 1 P 𝜎𝜎4- and regulations
𝐸𝐸 𝐸𝐸 PRINCIPLES OF
𝐴𝐴 𝐴𝐴 PRINCIPLES OFASSET
ASSETALLOCATION
ALLOCATION
− 2 O P O − 1 P 𝜌𝜌𝜎𝜎: 𝜎𝜎4
𝐸𝐸 𝐸𝐸 Developing Asset-Only Allocations Approaches to Liability-Relative Asset Allocation
- Actions that can reduce the asset volatility and,
Mean-Variance Optimization (MVO) - Surplus optimization substitutes surplus
by extension, equity volatility, include: The investor’s utility, U, from an asset return for the asset return in traditional
o Holding higher quality fixed-income allocation mix, m, can be calculated mean-variance optimization.
securities to reduce credit risk with the following formula:
- 𝑈𝑈B 4V
= 𝐸𝐸.𝑅𝑅A,B 5 − 0.005𝜆𝜆𝜎𝜎 - .𝑅𝑅A,B 5
o Holding more cash and short-term securities 𝑈𝑈B = 𝐸𝐸[𝑅𝑅B ] − 0.005𝜆𝜆𝜎𝜎B
o Surplus return is:
to reduce liquidity risk where 𝜆𝜆 is the investor’s degree of risk aversion.
𝐶𝐶ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣 − 𝐶𝐶ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖 𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣
o Matching the durations of assets and 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣
Criticisms of MVO
liabilities to reduce interest rate risk o Simple, linear correlation, all risk levels, any
- The outputs are very sensitive to the inputs,
- For insurance companies, actions that decrease funded ratio, single period
especially expected returns.
the volatility of liabilities include imposing - A hedging/return-seeking portfolios approach
- The optimal allocations are very concentrated in
penalties on surrenders, having more assigns assets to one of two portfolios. The
a subset of available assets.
predictable underwriting losses, and objective of the hedging portfolio is to hedge the
- Investors are concerned about more than the
diversifying into different product lines to take investor’s liability stream. Any remaining funds
mean and variance of returns.
advantage of the law of large numbers. are invested in the return-seeking portfolio.
- Sources of risk may not be diversified, even if
using many asset classes. o Simple, linear or non-linear correlation,
- MVO allocations are not directly related to the conservative risk levels, positive funded ratio,
liabilities being funded. single period
PORTFOLIO MANAGEMENT
PORTFOLIO (PART(PART
MANAGEMENT II) II) - An integrated asset-liability approach integrates
- MVO is a single-period framework that does not
consider trading costs and taxes. the asset and liability decisions when optimizing
OVERVIEW OF ASSET
OVERVIEW OF ASSETALLOCATION
ALLOCATION a portfolio.
Addressing the Criticisms of MVO o Complex, linear or non-linear correlation, all
Approaches to Asset Allocation
- Asset-only: Focus is solely on the assets, with - Reverse Optimization: Start with allocation risk levels, any funded ratio, multiple periods
mean-variance optimization the most common weights that are assumed to be optimal, along
with covariance and risk aversion estimates. ASSET ALLOCATION
ASSET ALLOCATIONWITH
WITH REAL-WORLD
approach. Liabilities are not explicitly modelled.
Then, the expected returns are solved for. CONSTRAINTSCONSTRAINTS
REAL-WORLD
- Liability-relative: Assets are chosen to fund
the liabilities. Surplus optimization is - Black-Litterman Model: Start with excess returns
Constraints in Asset Allocation
a common approach. from reverse optimization, then applies a - Asset Size
- Goals-based: Assets are divided into method to incorporate the investor’s views. - Liquidity
sub-portfolios to meet specified goals. Each - Resampled Mean-Variance Optimization: - Time Horizon
goal specifies the cash flows, time horizon, Combine MVO with Monte Carlo simulation. - Regulatory and Other External Constraints
and risk tolerance.
Approaches that Address Issues Related Asset Allocation for the Taxable Investor
Asset Classes to Illiquid Assets - The after-tax return is the pre-tax return
The following five criteria helps - Exclude them from the asset allocation decision,
adjusted for taxes:
specify asset classes: but use them for the target strategic asset
𝑟𝑟($ = 𝑟𝑟O$ (1 − 𝑡𝑡)
- Assets within a class should be allocation.
- For equity assets, the typical return includes
relatively homogenous. - Include the less liquid assets and attempt to
dividend income and capital gains:
- Asset classes should be mutually exclusive. model the inputs for the specific risk of assets
𝑟𝑟($ = 𝑝𝑝I 𝑟𝑟O$ (1 − 𝑡𝑡I ) + 𝑝𝑝( 𝑟𝑟O$ 21 − 𝑡𝑡CJ 4
- Asset classes should be diversifying likely to be used.
𝑝𝑝I is the proportion of 𝑟𝑟O$ from
to avoid redundancy. - Include the less liquid assets and model the
dividends 𝑝𝑝( is the proportion of 𝑟𝑟O$ from
- The asset classes collectively should cover most highly diversified characteristics with the true
price appreciation
of the available world investable assets. asset classes.
- The after-tax standard deviation is also affected
- The asset class should be able to absorb a
by the tax rate:
significant portion of the investor’s portfolio Risk Budgeting
The marginal contribution to total risk (MCTR) and 𝜎𝜎($ = 𝜎𝜎O$ (1 − 𝑡𝑡)
without undue liquidity impairments.
the absolute contribution to total risk (ACTR) can
be calculated as: Strategies to Reduce Tax Impact
A Framework for Rebalancing Other strategies can be used to reduce
- 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀7 =
- Calendar rebalancing rebalances on a schedule. the tax impact:
(𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝑜𝑜𝑜𝑜 𝑖𝑖 𝑤𝑤. 𝑟𝑟. 𝑡𝑡. 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝. )(𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃. 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣)
- Percent-range rebalancing rebalances if the - Tax-loss harvesting is intentionally realizing
- 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴7 = (𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊ℎ𝑡𝑡7 )𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀7
portfolio drifts out of a specified range. capital losses to offset capital gains in another
part of the portfolio.
- Strategic asset location is placing less tax-
efficient assets in accounts with more favorable
tax treatment such as tax-exempt or tax-
deferred accounts.

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In general, to minimize overall taxes: o Fixed fees: Includes all fees such as Approaches to Return Attribution
- Equities are placed in taxable accounts commissions, exchange fees, and taxes - When an arithmetic attribution approach is used
because they incur lower tax rates. o The restated formula is: excess return is defined as the difference
- Taxable bonds and high-turnover 𝐼𝐼𝑆𝑆 = 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸. 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 + 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂. 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 + 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 between a portfolio’s return (R) and the return
strategies should be in tax-exempt or on its benchmark (B).
tax-deferred accounts. Expanded Implementation Shortfall - When a geometric attribution approach
- The execution cost can be further decomposed is used, geometric excess return (G) is
- Assets held for liquidity purposes should
into two parts: calculated as follows:
be placed in taxable accounts.
1 + 𝑅𝑅 𝑅𝑅 − 𝐵𝐵
𝐺𝐺 = −1=
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 = É 𝑠𝑠Y 𝑝𝑝Y − çÉ 𝑠𝑠Y é 𝑝𝑝' 1 + 𝐵𝐵 1 + 𝐵𝐵
Short-Term Shifts in Asset Allocation
- Strategic asset allocation (SAA) is for long-term Equity Return Attribution – The Brinson Model
investment policy. - Returns for the portfolio and its benchmark
- Tactical asset allocation (TAA) attempts to 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 = çÉ 𝑠𝑠Y é 𝑝𝑝' − çÉ 𝑠𝑠Y é 𝑝𝑝I
are calculated as the weighted average of
deviate in the short term from SAA to take sector returns:
advantage of current market situations. "
Evaluating Trade Execution
o Discretionary TAA depends on a qualitative 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟: 𝑅𝑅 = É 𝑤𝑤7 𝑅𝑅7
- Trade costs can be stated in absolute
interpretation of political, economic, and terms or on a per share basis, but investment
7T&
"
financial market conditions. It relies on professional typically express these costs 𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵ℎ𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟: 𝐵𝐵 = É 𝑊𝑊7 𝐵𝐵7
manager skills in predicting and timing short- in terms of basis points (bps) using the 7T&
term market moves. following formula: where
o Systematic TAA depends on qualitative signals o 𝑤𝑤7 : portfolio weight of the ith sector
𝑃𝑃è − 𝑃𝑃 ∗
to exploit persistent anomalies in the market, 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 (𝑏𝑏𝑏𝑏𝑏𝑏) = 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 × × 10,000 𝑏𝑏𝑏𝑏𝑏𝑏 o 𝑅𝑅7 : portfolio asset return in the ith sector
𝑃𝑃 ∗
such as value and momentum. where o 𝑊𝑊7 : benchmark weight of the ith sector
o Side has a value of +1 for a buy order of a -1 o 𝐵𝐵7 : benchmark asset return in the ith sector
TRADE STRATEGIES
STRATEGIESAND
ANDEXECUTION
EXECUTION for a sell order - Under the Brinson model, there are
o 𝑃𝑃è is the average execution price of the order three sources of excess return for an
Implementation Shortfall equity investment:
o 𝑃𝑃 ∗ is the reference price
- IS is calculated as the difference between a o Asset allocation effect: 𝐴𝐴7 = (𝑤𝑤7 − 𝑊𝑊7 )𝐵𝐵7
- Market-adjusted cost can be calculated
trade’s paper return and its actual return. o Security selection effect: 𝑆𝑆7 = 𝑊𝑊7 (𝑅𝑅7 − 𝐵𝐵7 )
using the following formula:
- The paper return is the return that would o Interaction effect: 𝐼𝐼7 = (𝑤𝑤7 − 𝑊𝑊7 )(𝑅𝑅7 − 𝐵𝐵7 )
have been earned if all shares were transacted 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 − 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑑𝑑 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 (𝑏𝑏𝑏𝑏𝑏𝑏)
at the decision price without any associated = 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 (𝑏𝑏𝑏𝑏𝑏𝑏) − 𝛽𝛽 × 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 (𝑏𝑏𝑏𝑏𝑏𝑏)
where Equity Return Attribution—Factor-Based
costs or fees:
o 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 (𝑏𝑏𝑏𝑏𝑏𝑏) = 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 × Return Attrition
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 = (𝑃𝑃" − 𝑃𝑃I )𝑆𝑆
K"I%G L^:?,K"I%G (++7_(8 O+7C% - A common factor model used for equity
where × 10,000 𝑏𝑏𝑏𝑏𝑏𝑏
o S is the total order shares (value is positive
K"I%G (++7_(8 O+7C% attribution analysis is the Carhart model:
o 𝛽𝛽 is the stock’s beta relative to 𝑅𝑅O − 𝑅𝑅# = 𝑎𝑎O + 𝑏𝑏O& 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 + 𝑏𝑏O- 𝑆𝑆𝑆𝑆𝑆𝑆
for buy orders and negative for sell orders)
the underlying index +𝑏𝑏O` 𝐻𝐻𝐻𝐻𝐻𝐻 + 𝑏𝑏Oa 𝑊𝑊𝑊𝑊𝑊𝑊 + 𝐸𝐸O
o 𝑃𝑃I is the decision price
- The formula for calculating the
o 𝑃𝑃" is the current price
added value metric is: Fixed-Income Return Attribution
- The actual return of the portfolio - Exposure Decomposition – Duration Based: Top-
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 (𝑏𝑏𝑏𝑏𝑏𝑏)
is calculated as:
= 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 (𝑏𝑏𝑏𝑏𝑏𝑏) − 𝐸𝐸𝐸𝐸𝐸𝐸. 𝑝𝑝𝑝𝑝𝑝𝑝 down approach that breaks down the portfolio
− 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 (𝑏𝑏𝑏𝑏𝑏𝑏) risk exposures based on certain characteristics
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 = çÉ 𝑠𝑠Y é 𝑃𝑃" − É 𝑠𝑠Y 𝑝𝑝Y − 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹
such as bond duration and sector.
PORTFOLIO PERFORMANCE
PORTFOLIO PERFORMANCEEVALUATION
EVALUATION - Yield Curve Decomposition – Duration Based:
where
o 𝑠𝑠Y represents the number of shares executed Can be either top-down or bottom-up. It
Three Approaches to Performance Attribution
- Transaction-based attribution: It uses both estimates the return on investment using the
in the jth trade
portfolio holdings and transaction data to fully relationship between duration and the change
o 𝑝𝑝Y represents the transaction price
explain excess return, including the impact of in yield to maturity (YTM).
of the jth trade
trading costs. Most comprehensive and accurate. %𝑇𝑇𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 𝑟𝑟𝑟𝑟𝑟𝑟. = %𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝑟𝑟𝑟𝑟𝑟𝑟. +%𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑟𝑟𝑟𝑟𝑟𝑟.
o ∑𝑠𝑠Y represents the total number where
of shares executed - Holdings-based attribution: It compares a
%𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑟𝑟𝑟𝑟𝑟𝑟. ≈ −𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 × 𝐶𝐶ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖 𝑌𝑌𝑌𝑌𝑌𝑌
o Fees include all costs paid by the fund to portfolio’s holdings at the beginning and end of
- Yield Curve Decomposition – Full Repricing:
complete the order a period. Holdings are valued at the end of a
A bottom-up technique that measures the
- Rearranging the basic IS formula allows us to period and a return is calculated relative to their
contributions from the change in spot rates
decompose the total trade costs into three parts: value at the end of the previous period.
and the quality of active management.
o Execution cost: Cost that arises due to the - Returns-based analysis: It can be used when
buying/selling pressure of the order complete data on a portfolio’s holdings are
unavailable. Least accurate.
É 𝑠𝑠Y 𝑝𝑝Y − É 𝑠𝑠Y 𝑝𝑝I

o Opportunity cost: Cost that arises when an

order cannot be fully executed due to adverse
price movement or a lack of liquidity during
the trading period

ç𝑆𝑆 − É 𝑠𝑠Y é (𝑃𝑃" − 𝑃𝑃I )

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Benchmarking Investments and Managers Capture ratios measure a portfolio’s ETHICAL AND PROFESSIONAL STANDARDS
Properties of a Valid Benchmark return relative to its benchmark in ETHICAL AND PROFESSIONAL STANDARDS
- Investable: It is possible to invest passively different market conditions.
I(A) Knowledge of the Law
in the benchmark as an alternative accepting o The upside capture (UC) ratio measures
the ratio of the portfolio return to the Obey strictest applicable law. Disassociate
the portfolio’s active risk exposures.
benchmark return in periods when the immediately from any illegal or unethical activity.
- Appropriate: The benchmark is consistent
with a manager’s style and any constraints benchmark return is positive.
imposed by the client. o The downside capture (DC) ratio expresses I(B) Independence and Objectivity
- Measurable: The benchmark’s performance the same relationship in down markets. Do not offer or accept gifts that might impair
can be easily measured. o The upside and downside ratios combine independence and objectivity. Gifts from clients
- Specified in advance: The identity of to give a single capture ratio (CR) that is may be permissible.
the benchmark is known before the calculated as UC divided by DC.
evaluation period begins. - Drawdown is a portfolio’s cumulative I(C) Misrepresentation
- Owned/Accountable: The manager owns peak-to-trough loss over a continuous period.
Cite sources. Do not plagiarize or omit important
the benchmark and agrees to be held Investors measure drawdowns in terms
information. Act quickly to correct any errors.
accountable to it. of both money and time.
- Unambiguous: The composite securities o The financial impact of drawdown is
measured by maximum drawdown, which I(D) Misconduct
and their weights in the benchmark are
clearly identifiable. is a portfolio’s largest peak-to-trough loss Does not apply to personal behavior unless it
- Reflective of opinions: The manager knows (in percent). reflects poorly on the investment profession.
and has opinions on all of the securities o The time component of a drawdown is
in the benchmark. captured by drawdown duration, which is II(A) Material Nonpublic Information
Decomposing Portfolio Returns the amount of time that extends from when a Do not act or cause others to act on material
- A portfolio’s total return, R, can be decomposed portfolio starts to fall from its peak until it nonpublic information. Seek public dissemination.
into the benchmark return, B, and the manager’s returns to that level.
active return, A. II(B) Market Manipulation
𝑅𝑅 = 𝐵𝐵 + 𝐴𝐴 Do not take any actions that distort prices or
- The benchmark return can be further INVESTMENT MANAGER
INVESTMENT MANAGER SELECTION
SELECTION trading volume. Market making and legitimate
decomposed into the market index return, M,
trading strategies are allowed.
and the style return, S. Actual Performance
𝐵𝐵 = 𝑀𝑀 + 𝑆𝑆
Below Above III(A) Loyalty, Prudence, and Care
- Using these formulas, we can think of portfolio
Expectations Expectations Place clients’ interest above yours. Disclose
return as the sum of three components:
𝑅𝑅 = 𝑀𝑀 + 𝑆𝑆 + 𝐴𝐴 Correct policies on proxy voting and soft commissions.
Hire/Retain Type I error
o If a portfolio’s benchmark is a broad market decision
index, the S is zero and R = M + A. III(B) Fair Dealing
Not hire / Correct
o If a portfolio is meant to replicate the Type II error Treat all clients fairly. Treat non-immediate family
Fire decision
performance of a broad market index with like other clients. Communicate investment
The active share measure is based on the difference
zero tracking error (e.g., an index ETF), then between the weights given to securities in a recommendations and changes simultaneously.
both S and A are zero and R = M. portfolio and their benchmark weights.
P
1 III(C) Suitability
Performance Appraisal 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑆𝑆ℎ𝑎𝑎𝑎𝑎𝑎𝑎 = É|𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊ℎ𝑡𝑡7 Use a regularly updated IPS during investment
2
7T&
− 𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵ℎ𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚 𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊ℎ𝑡𝑡7 | decisions. Evaluate decisions in a portfolio context.
Measure Numerator Denominator
Sharpe ratio 𝑟𝑟? − 𝑟𝑟# 𝜎𝜎? III(D) Performance Presentation
Sortino ratio 𝑟𝑟? − 𝑟𝑟. 𝜎𝜎6 Performance data should be fair, accurate, and
complete. Do not promise returns for risky assets.
Treynor ratio 𝑟𝑟? − 𝑟𝑟# 𝛽𝛽?
Information rat. 𝑟𝑟? − 𝑟𝑟E 𝜎𝜎(+',+() III(E) Preservation of Confidentiality
Appraisal ratio 𝛼𝛼 𝜎𝜎b Keep all client information confidential unless:
client is involved in illegal activity, you are legally
required, or you have the client’s permission.

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IV(A) Loyalty BA II PLUS CALCULATOR TIPS Cash Flow Worksheet ( CF , NPV , IRR )
BA II PLUS CALCULATOR TIPS
Get permission before taking outside work (even For non-level payments
unpaid) that competes with employer. Abide by Basic Operations
Input ( CF )
non-compete agreement (if applicable) and do not 2ND : Access secondary functions (in yellow)
CF0: Initial cash flow
take employer’s property. ENTER : Send value to a variable
C01: 1st distinct cash flow after initial cash flow
2ND + ENTER : Toggle between options
IV(B) Additional Compensation Arrangements F01: Frequency of CO1
Obtain written permission from all parties before ↑ ↓ : Navigate between variables/options
C0n: nth distinct cash flow
receiving any compensation for outside work. STO + 0 - 9 : Store current value into memory
F0n: Frequency of C0n
RCL + 0 - 9 : Recall value from memory
IV(C) Responsibilities of Supervisors Note:
Supervisors must adequately train and monitor - Always clear the CF worksheet before starting
Time Value of Money (TVM)
subordinates. Responsibilities may be delegated. a new calculation
V(A) Diligence and Reasonable Basis For annuity, loan, and bond calculations
- The use of F0n is optional. You can leave them as
Exercise diligence and thoroughness. Support N : Number of periods
1 and input repeating cash flows multiple times. If
actions with research and investigation. I/Y : Effective interest rate per period (in %)
you do so, C01 will be the cash flow at time 1, C02
PV : Present value
V(B) Communication with Clients and will be the cash flow at time 2, and so on.
PMT : Payment/coupon amount
Prospective Clients Output ( NPV , IRR )
Make appropriate disclosures. Distinguish between FV : Future value/redemption value
I: Effective interest rate per period (in %)
fact and opinion in analysis and recommendations. CPT + one of the above : Solve for unknown
NPV + CPT : Solve for net present value
2ND + BGN : Toggle between ordinary annuity
V(C) Record Retention IRR + CPT : Solve for internal rate of return
and annuity due
Maintain records to support recommendations and
2ND + CLR TVM : Clear TVM worksheet
decisions. 7-year retention period recommended.
Note:
VI(A) Disclosure of Conflicts - Always clear the TVM worksheet before
Disclose any matters that may impair starting a new calculation
independence and objectivity, prominently
- For bonds, PMT and FV should have the same
and in plain language.
sign, and opposite signs to PV

VI(B) Priority of Transactions

Execute clients’ transactions before accounts
in which you have a beneficial interest.

VI(C) Referral Fees

Disclose referral fees to clients and employer,
including non-monetary arrangements.

VII(A) Conduct as Participants in

CFA Institute Program
Do not share confidential exam details. Expressing
opinions about CFAI policies is permissible.

VII(B) Reference to CFA Institute, the CFA

Designation, and the CFA Program
Do not misrepresent the meaning of CFA Institute
membership, designation, or candidacy.

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