CFA Level 3 Notes

SS 5 R 20 LOS j: rolling rule vs. geometric spending


Net interest spread
    Difference between interest earned and interested credited to insurance policy holders.

Utility Adjusted Return
    U = R - (.0005 * A * Variance)
    A is the risk aversion score

Roy's Safety First Score
    (Expected Return - Minimum Return) / StdDev
    We want the highest score

Type I and Type II errors
    Type I = False Positive = Reject null hypothesis when true = Retaining bad manager
    Type II = False Negative = Accept null hypothesis when false = Firing good manager

Justifications to the Value Approach
    1. Currently low earnings will rise / revert towards mean
    2. Volatility alone may be enough to raise price

Roles of Alternative Investments
    1. Exposure to asset classes outside of stocks and bonds
    2. Exposure to special strategies (eg. hedge funds)
    3. Mix of the two above (eg. private equity funds)

Normal Portfolio
    A customized benchmark
    Includes all securities a manager would normally chose from
    Weighted as the manager would weight them in that portfolio.

True Active and Misfit Risks/Returns
    True active return is how the manager did relative to the normal portfolio
    Misfit active return - how the manager did relative to the imperfect benchmark
    Total active risk = volatility of he portfolio relative to the investor's folio.
        total active risk = sqrt [ (true active risk)^2 + (misfit active risk)^2 ]

Short Extension Strategy
    Market Return and Alpha are generated from the same source
    Market return comes from equity long position
    Alpha comes from shorting some equity and investing in better equity
    More constrained compared to a market neutral position

Market Neutral
    Going long good equity/short bad equity in same industry
    Using derivatives for market exposure
    Alpha and market are different sources

Equitized Position
    Supplements market neutral by taking short proceeds and buying equity future wit notional equal to short cash. 

Reasons for short-side inefficiency
    1. Barriers to shorting (borrowing, risk of forcing to buy adversely to cover a short)
    2. Companies try to pump up (never lift down) their own stock
    3. There are more buyers than sellers so analysts issue more buys than sells
    4. Analysts do not want to anger management

Expected Information Ratio (highest to lowest). Info ration: active return/tracking risk
    Enhanced Indexing
    Active Management

Prime Rate charged by banks is a lagging indicator

Russia has the most inefficient institutions among the BRICs

The best method of estimating future dividend payout ratio for the market is to take the historical dividend and relate that to estimated earnings.

Among the BRICs, India has the weakest education system. It has also been the slowest to open up its economy

Implementation Shortfall strategy
    trades early in the day to minimize opportunity cost

Bull Call
    Profits when the market rises
    Buy call with lower strike
    Sell call with higher strike
    Beginning stock price is lower than both strikes
    Max Loss: difference in the premiums

Long Straddle
    Buy both a put and a call
    Same strike and same expiration
    Risk is limited to the two premiums, unlimited upside

Short Straddle
    Selling both and hoping the market won't move a lot. Unlimited downside.
    Earn a small limited profit when implied volatilities are off
    Long butterfly is a bet on lower than implied volatility
    Short 2 calls at X
    Long a call at X-a and X+a

Taxation regimes
    Common progressive is the most common and provides favorable treatment for Interest, Div, CG
    All the "heavy" ones just penalize one area (the heavy area)
        Heavy Dividend, progressive but penalizes dividends
        Heavy CG, progressive but penalizes cap gains
        Heavy Interest, progressive but penalizes interest
    Light cap gains (2nd most popular) 
        Only provides relief for capital gains
    Flat and Light - favorable for all
    Flat and Heavy - only interest is favored

Credit Spread Options
    Calls benefit from the spread widening

Credit Spread Forward
    The long is betting that spreads will increase
    Payoff =  (exp spread - strike) * notional * risk factor

Currency Swap Payment - how much money changes hands if principals aren't completely exchanged.
    Implied Notional Principal is a function of the cashflows. For example, if we're looking to hedge cash flows of 12,000,000 per quarter, and the swap rate is 6.6%, we want notional principal such that NP * (0.066 / 4) = 12,000,000. Which gives us NP = 727,272,727.   How we want that in USD terms, which if the rate is 1.24 CHF/$ gives us: 586,510,264$. Then the payment if the USD swap rate / 4.

Yield Beta
    Tells us how much the yield on a foreign bond will change for 1% yield in domestic bonds. Contributions to duration need to be multiplied by the yield beta.

Ex Post Alpha
Uses "security market line" as a benchmark to asses performance
SML: Return on Asset =  RFR + Beta * (Risk Premium)
Using historical data:
Alpha of the Asset =  Return of the Asset - Return predicted by SML
Alpha = Ra - [RFR + Beta * premium]

Information Ratio
Similar to sharpe : excess return over variability
Active Return / Active Risk

Treynor Measure
(Return - RFR) / beta

(Return - RFR) / std dev

M^2 measure
Uses Capital Markets Line
Compares account return to market return
Is a comparative measure (ie must be compared to other portfolios, like Sharpe)
M2 = RFR + ([ Average Account return - RFR ] / std dev of portoflio) * std dev of market

Let's understand the CML first:
Return of portfolio =  RFR + [(Rm - Rf) / STD M]*(STD P)
[(Rm - Rf) / STD M] is the exces return per unit of risk in the market
we then multiply it by the risk of the portfolio and add to RFR
That's the return required of the portfolio by the CML.

Now let's compare what the M2 measure does. 
1. it takes the excess return of the fund
2. divides it by the risk of the fund
3. this gives us return per unit of risk
4. then it multiplies it by the risk of market
5. and adds it to the RFR
in other words, M^2 is what the market would have earned if it had folio's risk.

to take this further, wat M^2 means is: "if the market had return/risk" ratio of the portfolio, what would it return? If M^2 of the folio is higher, it means the fund returns more per unit of risk. M^2 produces the same conclusion as Sharpe.